Internal Revenue Code Diversification Requirements

Posted by admin on Oct 25, 2011 4:25:48 PM

In order to avail itself of the favorable tax treatment afforded to a “regulated investment company” or “RIC," a fund must meet the following requirements:

The 50% Test

At the close of each quarter of the taxable year—at least 50% of the value of the fund’s total assets must be represented by the following:

  • Cash and cash items (including receivables)
  • Government securities
  • Securities of other RICs
  • Other securities that meet both of the following tests:
    1. With respect of any one issuer, represent an amount not greater in than 5% of the value of the fund’s total assets
    2. With respect of any one issuer, is not more than 10% of the outstanding voting securities of such issuer

The 25% Test

At the close of each quarter of the taxable year— not more than 25% of the value of its total assets can be invested in:

  • Securities (other than Government securities or the securities of other RICs) of any one issuer
  • Securities (other than the securities of other RICs) of two or more issuers which the fund controls and which are engaged in the same or similar trades or businesses or related trades or businesses
  • Securities of one or more qualified publicly traded partnerships

Exceptions to the Above Rules and Cures for Failures

A fund which meets the requirements of the tests detailed above as of the close of any quarter shall not lose its status as a RIC because of a discrepancy during a subsequent quarter between the value of its various investments and such requirements unless such discrepancy exists immediately after the acquisition of any security or other property and is wholly or partly the result of such acquisition. This basically means that a fund will not lose its status as a RIC even though it fails to satisfy the diversification requirements detailed above, if the discrepancy results from fluctuations in the market value of the securities in the fund’s portfolio or from distributions made by the fund.

A fund which does not meet the requirements detailed above as of the close of any quarter by reason of a discrepancy existing immediately after the acquisition of any security or other property which is wholly or partly the result of such acquisition during such quarter, shall not lose its status for such quarter as a RIC if such discrepancy is eliminated within 30 days after the close of such quarter and in such case shall be considered to have met such requirements at the close of such quarter for purposes of applying the preceding sentence. This provision basically allows a fund which fails one of the diversification tests detailed above by virtue of the acquisition of a security or securities to dispose of the offending securities within 30 days of the end of the quarter and “cure” the failure. However, this provision cannot be utilized in a fund’s first quarter as a RIC.

Changes Resulting From RIC Modernization Act of 2010

The RIC Modernization Act provides for relief in addition to the relief provisions described in the previous paragraph. A de minimis provision has been added if failure of the asset diversification tests is a result of ownership of an asset of not more than the lesser of 1% of the total assets of the fund or $10,000,000. If this relief provision applies, the fund must dispose of the offending assets in order to meet the requirements within six months of the end of the quarter in which it identified the failure, unless the asset tests are otherwise met within the six month period.

Relief has also been added for reasonable cause failures where the de minimis provision does not apply. For this relief provision to apply, the failure must not have been a result of willful neglect, a filing must be made with the IRS following the identification of the failure listing the assets that caused the failure, and the fund must dispose of the assets causing the failure within six months of the end of the quarter in which it identified the failure to cure the failure unless the fund would otherwise be in compliance within the six month period. If this relief provision applies, a tax will be imposed equal to the greater of $50,000 or the product of the net income generated by the assets causing the failure by the highest corporate tax rates. It is important to note that both the tax imposed under the gross income test and asset diversification test relief provisions described above are tax deductible on the fund’s 1120-RIC tax return.

 

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