Posted by Claire Toraason
Regulated Investment Companies (RICs) are common and very popular investment vehicles for many reasons. However, the tax code restricts the types of investments RICs can make, therefore limiting options for both funds and their investors.
The use of blocker entities is an established strategy that allows RICs to invest in commodities and other non-traditional assets otherwise not allowed under current tax law. Blocker entities, generally in the form of domestic or foreign subsidiaries, can help RICs looking to expand their investment portfolio beyond traditional securities.
The Internal Revenue Code requires a RIC to earn at least 90% of its gross income from qualifying income sources — such as dividends, interest, gains from sale of securities and other income earned in the business of investing in securities. However, this requirement restricts many RICs, limiting their exposure to certain types of investments where non-qualifying income is inherent. These investments include, for example, commodities, digital assets, real estate, and certain private credit and private equity vehicles.
Setting up a subsidiary to act as a blocker for these non-qualified income sources may allow funds and their shareholders exposure to types of investments that would otherwise be inaccessible in the RIC wrapper. Mechanically, the RIC fund invests in the blocker entity, while the blocker invests in the underlying, “restricted-to RICs,” assets. The presence of the subsidiary blocker between the RIC and the asset producing non-qualifying income protects the RIC from direct exposure to the non-qualifying income. This way, the RIC invests directly in corporate stock, which is an investment that produces qualifying income for the RIC.
The subsidiaries a RIC chooses to establish can be incorporated either offshore or domestically, but both come with unique tax considerations to consider before choosing this path.
For managed futures and other commodity-based strategies, foreign subsidiaries are used to shield the RIC from the non-qualifying income generated from the fund’s commodity exposure. Foreign subsidiaries are usually Cayman entities that elect to be taxed as a corporation, and they are controlled foreign corporations (CFCs) for U.S. tax purposes.
The most obvious benefit of a CFC relative to the domestic blocker is that the CFC may not generate a U.S. tax liability. However, avoiding corporate tax is dependent on the CFC’s investments. Generally, the foreign blocker is only used when U.S. trade or business income will not be generated by the CFC’s investments.
There are special rules that govern the timing of CFC income recognition from the perspective of the RIC. Net gain from a CFC is recognized to the RIC as ordinary income, regardless of whether a distribution is made from the blocker entity to the RIC. The adviser, therefore, has limited ability to time the income inclusion at the RIC level. Additionally, net losses occurring within a CFC for a taxable year are unable to be carried forward to future periods. As a result, the tax consequences from a shareholder’s perspective may be unfavorable in a series of years where there is material movement in the price of an underlying asset. Any mark-to-market losses on a commodity futures contract, for example, may be lost in a year in which a CFC finds itself with a net loss. The following year, a rebound in the price of the hypothetical commodity futures contract may create a distribution requirement for a RIC.
RICs also may choose to block non-qualifying income via a domestic blocker entity, though consideration needs to be given to the potential federal and state taxes on taxable income, as well as deferred tax liabilities that must be booked against a domestic blocker’s net unrealized gains. Depending on the nature of the investments the RIC is accessing via the blocker, however, the tax rate for the domestic subsidiary may be below the expected tax paid by a foreign blocker. The domestic corporation is also able to carry forward net operating losses and capital losses, which can be used to offset future taxable income, which is not available within the foreign blocker structure.
Unlike the foreign blocker, income from the domestic blocker is included in the taxable income of the RIC as dividend income when distributed by the blocker. Management has control of when this distribution occurs and can plan accordingly to mitigate adverse tax consequences at the RIC level.
Subsidiary blockers can provide a viable path for RICs to access alternative investments that would otherwise not fit within the RIC investment universe due to potential non-qualifying income. Both domestic and foreign blockers offer benefits and potential drawbacks depending on the underlying investments involved and overall management priorities. RICs considering a subsidiary as a blocker should consider which option makes the most sense based on the fund’s fact pattern and goals.
Contact Claire Toraason at ctoraason@cohenco.com or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.