Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

UBTI Issues For RICs and RIC Shareholders- Part II

In this, the second post in our series of RIC UBTI issues, we give a high level overview of the circumstances where a RIC or RIC shareholder can find themselves subject to tax on UBTI, despite the fact that a RIC generally will act as a UBTI blocker of such income.

Investments in REMIC Residual Interests

The RIC cannot act as UBTI blocker in instances where it owns “residual interests” in a real estate mortgage investment conduit (REMIC). The RIC cannot shield its shareholders from the pass-through of “excess inclusions” from the REMIC residual interest. Such excess inclusions are treated as UBTI for tax-exempt shareholders, and a RIC is required to allocate its “excess inclusion income” to each shareholder. A full explanation of the definition of “excess inclusions” is beyond the scope of this series. Briefly, excess inclusions are a classification of income earned by a REMIC residual interest which the REMIC must report to its equity owners. Such income garners special tax treatment aimed at making sure that it is taxed in all circumstances. For example, a taxpayer cannot utilize a net operating loss or deduct certain tax deductions against excess inclusions. Additionally, foreign taxpayers cannot utilize tax treaty benefits such as exclusions from taxation or reduced withholding rates against excess inclusions. Further, certain types of entities known as “disqualified organizations” are simply prohibited from owning REMIC residual interests, period. Disqualified organizations are tax-exempt entities that are not subject to the tax on UBTI. Such organizations include governmental entities (such as states or political sub-divisions), political organizations, homeowners cooperatives and charitable remainder trusts, among a few others. In the context of a RIC, “excess inclusion income” represents the excess of its aggregate excess inclusions over the RIC’s taxable income (excluding any net capital gain) (IRC 830(d)(1)). For this purpose, a RIC’s taxable income is defined to be net of its deduction for dividends paid to its shareholders. Accordingly, since a RIC will almost always zero out its taxable income through use of its dividends paid deduction, excess inclusion income will typically always equal excess inclusions that a RIC earns from its REMIC residual interest investments. Further, as will be discussed below, a RIC can be allocated excess inclusion income by virtue of an investment in a REIT.

If a RIC has a “disqualified shareholder,” it does not pass through the excess inclusion income to such disqualified shareholder but instead the RIC must pay an entity level tax on the amount of the excess inclusion income allocated to all of its disqualified shareholders. Disqualified shareholders are those that are disqualified organizations as defined above. This tax is deductible by the RIC in computing its taxable income and can be specially allocated to the shareholders to which it is attributable and reduce the amounts of the dividends paid to these shareholders without being considered a preferential dividend. Furthermore, the shareholders other than disqualified shareholders cannot offset the excess inclusion portion of the dividends reported by the RIC with any current, carryforward, or carryback net operating losses or with certain other tax deductions.

Investments in Real Estate Investment Trusts (REITs)

It is becoming more and more commonplace for RICs to invest in REITs. As mentioned above, a RIC can be allocated excess inclusion income by virtue of its investment in a REIT. Not all RIC investments in REITs generate excess inclusion income. A REIT that strictly invests only in real estate will not generate excess inclusion income. Excess inclusion income can arise if the RIC invests in a REIT that either is, or invests in, a taxable mortgage pool. In this scenario, the RIC and its shareholders must treat excess inclusion income in the same manner as with direct investments in REMIC residual interests, discussed above. Note, however, that the current tax regulations on this topic are subject to further IRS guidance.

Other instances Where UBTI Can Arise:

  • If a tax-exempt entity’s RIC investment itself is debt financed, such as when the exempt organization borrows funds to purchase or hold RIC shares, a portion of the RIC’s dividends and capital gains are treated as debt-financed income, and therefore UBTI.
  • If the RIC were to be treated as engaged in the lending business (in our experience a rare circumstance).
  • If the RIC were to be treated as a dealer in securities, holding inventory property (in our experience a rare circumstance).


In the third and final post in our series, we will dive into more detail on what is probably the most common situation whereby a RIC will find itself with excess inclusion income and therefore UBTI. That is when it results from an investment in a REIT that either is a taxable mortgage pool or holds investments in a taxable mortgage pool.