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Incoming Ways and Means Chair Supports Reform of Tax Code Provisions for Investment Companies

By Jim Hamilton

The incoming Chair of the House Ways and Means Committee, Rep. Dave Camp (R-Michigan) strongly supports the complete legislative overhaul of federal tax code provisions affecting investment companies. Specifically, Rep. Camp is a manager of the Regulated Investment Company Modernization Act, HR 4337, which passed the House by voice vote on September 28, 2010, which would modify and update IRC provisions pertaining to investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable securities laws. The Regulated Investment Company Modernization Act would reduce the burden arising from amended year-end tax information statements, improve a mutual fund's ability to meet its distribution requirements, create remedies for inadvertent mutual find qualification failures, improve the tax treatment of investing in a fund-of-funds structure, and update the tax treatment of fund capital losses.

On the day the House passed the legislation, Rep. Camp said that the legislation would modernize federal tax code provisions governing mutual funds that have not been updated in any meaningful or comprehensive way since the adoption of the Internal Revenue Code of 1986, and some of the provisions date back more than 60 years. Noting that he is not aware of any controversy or opposition to the legislation, Rep. Camp broadly emphasized that it is entirely appropriate for Ways and Means to periodically review the tax law to ensure that targeted provisions of importance to particular segments of the economy, including the mutual fund industry and their investors, are kept up to date. (Cong. Record, Sept. 28, 2010, H7069-7070).

Numerous developments during the past two decades, including the evelopment of new fund structures and distribution channels, have placed considerable stress on the current tax code sections. In general, regulated investment companies under the Code are domestic corporation that either meet are excepted from SEC registration requirements under the InvestmentCompany Act, that derive at least 90 percent of their ordinary income from passive investment income, and that have a portfolio of investments that meet certain diversification requirements. Regulated investment companies under the Code can be either open-end companies (mutual funds) or closed-end companies.

The legislation would update the capital loss carryforward rules for regulated investment companies so that they match the capital loss carryforward rules for individuals. As a result, an investment company would be permitted unlimited carryforwards of their net capital losses under the HR 4337 and a net long term capital loss will retain its character when carried forward instead of being treated as a short term capital loss as under present law. The legislation would also include commodities as a source of good income. Currently, an investment company must derive at least ninety percent of its income from sources of good income, such as dividends, interest, and gains from the sale or other disposition of stock; and commodities are not one of these enumerated sources.

Further, it a fund currently fails to comply with the ninety percent ``good income?? requirement by even one dollar it is subject to tax as a corporation at a thirty-five percent rate. The legislation would permit an investment company to cure inadvertent failures to comply with the gross income test by paying a tax equal to the amount by which the company failed the gross income test.An investment company must also satisfy asset diversification tests under the tax code. . Similar requirements apply to real estate investment trusts (REITs). Unlike investment companies, however, REITs have statutory means to remedy inadvertent failures of such tests. For example, if a REIT fails the asset tests by a de minimis amount and the REIT comes into compliance within six months after it identifies the failure, then the REIT is treated as satisfying the asset tests. For non-de minimis asset test failures, a REIT can avoid disqualification under subchapter M if the failure is due to reasonable cause and not willful neglect and the REIT notifies the IRS, disposes of the assets, and pays an excise tax equal to the greater of $50,000 or the highest corporate tax rate times the net income from the bad assets during the period of failure.

The legislation would extend these REIT remedies to investment companies.Under current law, investment companies are required to send a written designation notice to shareholders within sixty days of the end of their taxable year notifying the shareholders of the tax treatment of various distributions made during the course of the year. Since, this requirement predates the comprehensive Form 1099 information reporting requirements that are also imposed on investment companies, HR 4337 would eliminate the now-obsolete 60-day shareholder notification requirement.

Full post as published by Jim Hamilton's World of Securities Regulation on November 07, 2010 (boomark / email).