On September 27, the Internal Revenue Service (the “IRS”) issued Proposed Regulations that would require “commodity subsidiaries” of regulated investment companies (“RICs”) to currently distribute their income in order for such income to be treated as qualifying income for purposes of Subchapter M of the Internal Revenue Code.

RICs are required to receive at least 90 percent of their income for each year from certain specified sources (“qualifying income”). Income generated from commodity investments is generally not qualifying income. Over the past decade, RICs have sought to gain exposure to commodity investments by forming wholly-owned foreign subsidiaries that invest in commodities. The foreign subsidiary invests directly in commodities but because the investment by the RIC is in the securities of the subsidiary, the income derived by the RIC from the subsidiary is treated as qualifying income for RIC qualification purposes.

Under the “controlled foreign corporation” (“CFC”) rules, a RIC is taxed on the foreign subsidiary’s income even if the foreign subsidiary does not make current distributions to the RIC. From 2007 through 2011, the IRS issued a series of private letter rulings holding that income inclusions under the CFC rules by a RIC were qualifying income even if the amounts were not currently distributed.

Under the Proposed Regulations, the income inclusions under the CFC rules would not be treated as “qualifying income” for RIC purposes. Therefore, a RIC with a commodity subsidiary would be required to ensure that the commodity subsidiary distributes its current income to the RIC before the end of each taxable year. This will ensure that the income from the commodity subsidiary will be treated as “qualifying income.” The Proposed Regulations are effective 90 days after finally published in the Federal Register.

In conjunction with these Proposed Regulations, the IRS also announced that it would no longer issue private letter rulings to RICs on whether a financial instrument or position is treated as a “security” under the Investment Company Act of 1940. This determination is often important in determining whether income from a financial instrument is treated as “qualifying income” of a RIC.

If you have any questions regarding the Proposed Regulations, please contact Jim Cofer at (212) 574-1688 or cofer@sewkis.com.