On December 22, 2010, President Obama signed into law the Regulated Investment Company Modernization Act of 2010 (the “Act”). The Act makes significant modifications to the tax rules governing Regulated Investment Companies (“RICs”). It should be noted that the House version of the bill contained a provision that would have allowed RICs to treat income from commodities as “qualifying income,” (i.e., certain specified types of passive income). That provision was removed from the bill passed by the Senate and subsequently signed into law. Except as otherwise noted, the provisions of the Act will be effective for tax years beginning after December 22, 2010.

New Savings Provision for Failures to Meet the Gross Income Test

One of the statutory requirements for a domestic corporation to qualify as a RIC is that at least 90 percent of the corporation’s gross income for each taxable year must be qualifying income (the “Gross Income Test”). The Act contains a new savings provision for inadvertent failures to meet the Gross Income Test. Under this provision, a corporation will be considered to have satisfied the Gross Income Test for a taxable year if (i) the corporation sets forth, in a schedule filed in accordance with regulations to be prescribed by Treasury, a description of each item of its annual gross income and, (ii) the corporation’s failure to meet the Gross Income Test was due to reasonable cause and not willful neglect. With respect to a cured failure of the Gross Income Test, the corporation will, however, be required to pay a tax equal to the amount by which its non-qualifying income exceeds one-ninth of its qualifying income.

This provision applies to tax years that have a return due date (taking into account extensions of time to file) after December 22, 2010.

Modifications of Savings Provisions for Failures to Meet the Asset Tests

Another statutory requirement for a domestic corporation to qualify as a RIC is that at the close of each quarter, at least 50% of the value of the corporation’s total assets must be represented by (i) cash and cash items, government securities and securities of other RICs, and (ii) other securities, generally limited with respect to any one issuer to an amount not greater than 5% of the value of the corporation’s total assets and to not more than 10% of the issuer’s voting securities. Also, not more than 25% of the value of a RIC’s total assets may be invested in (i) the securities of any one issuer, (ii) the securities of two or more issuers controlled by the RIC and engaged in the same or a similar business, or (iii) the securities of one or more qualified publicly-traded partnerships (collectively, the “Asset Tests”). A RIC that satisfies the Asset Tests at the close of any quarter will not lose its status as a RIC because of a discrepancy during subsequent quarters between the value of its investments and the Asset Tests’ 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. The Act provides a special rule for de minimis, inadvertent Asset Test failures and a mechanism by which a RIC can cure other Asset Test failures by paying a penalty tax.

The De Minimis Rule: In the case of a failure to meet one of the Asset Tests due to the ownership of assets, the total value of which does not exceed the lesser of (i) 1% of the RIC’s total assets as of the end of the quarter for which the assets are valued, or (ii) $10 million, the RIC will be considered to have met the Asset Tests if it disposes of the assets that caused the failure within six months of the last day of the quarter in which the RIC identifies that it failed the Asset Test, or it otherwise meets the requirements of the Asset Test.

Curing Mechanism: In the case of other Asset Test failures, the RIC will be considered to have met the Asset Tests if:

(i) the RIC sets forth, in a schedule filed in a manner provided by Treasury, a description of each asset that causes the RIC to fail the Asset Test;

(ii) the failure to meet the Asset Test was due to reasonable cause and not willful neglect; and

(iii) within six months of the last day of the quarter in which the RIC identifies that it failed the Asset Test, the RIC disposes of the assets which caused the Asset Test failure or otherwise meets the requirements of the Asset Test.

In addition, the Act imposes a tax on the RIC equal to the greater of (i) $50,000 and (ii) the income generated by the assets that caused the non- de minimis failure of the Asset Test multiplied by the highest corporate tax rate in effect at the time.

This provision applies to tax years that have a return due (taking into account extensions of time to file) after December 22, 2010, thus providing retroactive relief for Assets Test failures for certain taxpayers.

Repeal of Preferential Dividend Rule For Publicly Offered RICs

In general, in computing its annual “investment company taxable income,” a RIC is entitled to deduct dividends paid to its shareholders in computing its taxable income. Under prior law, however, a RIC was not entitled to a dividends-paid deduction for “preferential dividends” (i.e. dividends that were not paid pro rata to all shareholders). The Act repeals the preferential dividend deduction limitation with respect to publicly-offered RICs. A “publicly-offered RIC” is a RIC that is (i) continuously offered pursuant to a public offering as defined in Section 4 of the Securities Act of 1933, (ii) regularly traded on an established securities market, or (iii) held by no fewer than 500 persons at all times during the taxable year.

Capital Loss Carry Forwards

Under prior law, RICs with net capital losses could carry those losses forward to the next eight taxable years. The losses were carried forward as short-term capital losses arising on the first day of the succeeding taxable year.

Under the Act, RICs will now treat net capital losses in a manner similar to present law treatment applicable to individual taxpayers. Specifically, if a RIC has a net capital loss for a taxable year, the excess of any short-term capital losses over net long-term capital gains is treated as a short-term capital loss arising on the first day of the next taxable year, and the excess of any long-term capital losses over net short-term capital gains is treated as a long-term capital loss arising on the first day of the next taxable year. Also, the number of years that a net capital loss may be carried over is no longer limited.

The Act would also make several other changes affecting RICS, including the following:

• The capital gain dividend and certain other designation requirements are eliminated. Instead, RICs are now able to issue written statements to shareholders indicating the Federal income tax characterization of dividend payments. Such statements are intended to result in fewer amended Form 1099-DIVs and thus fewer amended returns from RIC shareholders.
• A “qualified fund of funds” is now able to take advantage of pass-thru treatment with respect to exempt-interest dividends and foreign tax credits of the underlying RICs that it invests in.
• The timing and payment rules for so-called “spillover dividends” have been modified.
• The allocation of “earnings and profits” to distributions by non-calendar year RICs has been modified.
• The Act provides a specific rule with respect to RICs and the “not essentially equivalent to a dividend” rule in the case of certain redemptions.
• The deferral of late-year losses is now elective for a RIC, rather than mandatory.
• The loss disallowance rule with respect to certain exempt-interest dividends has been modified. This provision applies to losses incurred on sales of stock for which the taxpayer’s holding period begins after December 22, 2010.
• Several excise tax provisions applicable to RICs have been altered, including an increase in the percentage of ordinary income that a RIC must distribute to avoid excise taxes on that income (from 98% to 98.2%)
• The additional penalty with respect to “deficiency dividends” is repealed.
• Certain other technical changes have been made.

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Please contact Ronald Cima (212-574-1471), Jim Cofer (212-574-1688), or Peter Pront (212-574-1221) if you have any questions regarding the implications of this memorandum.