Part 2: In-Depth Look at Qualifying as a RIC

RICs provide many tax benefits to their shareholders, but these advantages come at the cost of numerous rules and limitations. These rules are important in understanding why private assets present tax complexities.

Background

To avoid corporate level (double) taxation, a fund seeking to qualify as a RIC must meet specific income, asset and distribution tests. Specifically, a RIC must:

• Derive at least 90% of its gross income from specific passive sources, generally including interest, dividends, gains from the sale of stock and securities, and other income derived from investing in stocks and securities (generally known as gross income test, good income test or qualifying income test).
• Invest at least 50% of its assets in cash, cash items, government securities, securities of other RICs and securities of other issuers that, with respect to any one issuer, do not exceed 5% of the value of the RIC’s total assets or 10% of the outstanding voting securities of that issuer (generally known as the 50% asset test or the 5/50 test).
• Invest no more than 25% of its assets in the securities (other than government securities or the securities of other RICs) of any one issuer (generally known as the 25% asset test and, collectively with the 50% asset test, the asset diversification tests or asset tests).
• Distribute at least 90% of its income (generally known as the distribution requirement).

Gross, or Good, Qualifying Income Test

It is important to note the good income test is a gross income test. While this is relevant to all RICs, it is particularly relevant to RICs with private asset investments. A RIC may have a net loss, but it must assess its gross income, before expenses, for purposes of the good income test. Realized capital losses are not included in the test either. This distinction on expenses and losses can be complex and is important when pass-through investments, the structure of many private assets, are part of the portfolio. The assessment of the gross income happens at the pass-through, or underlying investment, level as opposed to the RIC level.

In Practice: Qualified or “good” income notably does not address certain types of income, generally considered “bad” income, typically seen in private assets such as real estate/ rental income and operating income. Identifying income as good or bad could be difficult in practice. Facts and circumstances must be considered, and small nuances in operations could impact the determination.

Timing: The income test must be met at the end of the RIC’s tax year. Therefore, theoretically, the RIC can be out of compliance any other day of the year. However, the test should be monitored throughout the year and managed with the goal of meeting it at year-end. The registered funds industry has historically focused more on meeting the asset tests. A traditional portfolio of securities does not generally produce bad income. Therefore, a securities portfolio’s risk is centered around the mathematical formulas of the asset tests. However, the good income test could be quite difficult to meet with a portfolio of private assets. The test is strict, and the 10% bad income limit does not leave much margin for error.

Asset Diversification Tests

With a portfolio of securities, this test could be an easy math calculation. It can be automated and quite simple to perform on a mainstream Equity Index Fund, for example, but can become complicated when working with alternative investments.

Generally, the most difficult time for passing the asset diversification tests is when the fund is first launching and building its portfolio, and at the end of its life when liquidating and winding down the portfolio. The asset tests are performed at the close of each quarter of the RIC’s tax year. The tests only need to be passed these four times of the year; the fund is not required to be compliant in between tests.

A potential qualification issue when assessing portfolios of private debt, for example, is that the tests assess compliance with issuers, not positions. If there are multiple loans, but the underlying obligor is the same party, the loans may need to be combined when considering if the position is over 5% (nonqualified). You would want to assess if one loan went into default, if the other loans also would be uncollectible. If so, this seems to point to a single issuer.

10% Limit: If a fund holds over 10% of the voting rights in a position, this disqualifies the asset. Usually, this is not a concern when dealing with publicly traded stock but can occur more frequently with private investments. Once the 10% ownership is surpassed, regardless of size in the portfolio, the asset is a bad asset.

The Asset Tests and BDCs: BDCs differ from other closed-end funds taxed as RICs. The SEC describes them as a hybrid between a traditional investment company and an operating company, because they generally invest in debt or equity of small and medium private companies and are allowed to help manage these companies. Therefore, the qualification tax rules have certain exceptions that help BDCs maintain RIC status, regardless of their special function. For example, BDCs are subject to a modified 10% voting rights ownership limitation that may allow them larger ownership than other RICs.

Distribution Requirement

In Practice: While the distribution requirement is straightforward to understand, it is worth mentioning certain investments could add operational difficulties in determining the distribution requirement in a timely manner. In the case of partnership investments, a RIC must include its annual share of the partnership’s income in the RIC’s tax year in which the partnership’s tax year ends.

Because of this, the general recommendation when a portfolio is heavily invested in partnerships or other equity investments, such as passive foreign investment companies (PFICs), is to set up a tax year-end later in the year, with September and October being the most common. This allows for time to receive necessary tax reporting and to better manage income. The fiscal year-end of the fund does not need to match the tax year-end, although it’s worth considering aligning it with financial reporting (annual, semiannual or relevant NAV period) to reduce administrative hurdles. Different book and tax year-ends lead to computational complexities with stub periods.

Private assets make distributions difficult to manage. Generally, tax reporting from private alternative type assets becomes available late in the year. Advisers likely have to assess their comfort level with under-distributions or distributing return of capital to shareholders. Getting the distribution exactly right is not likely for a portfolio with significant exposure to private assets.

Excise Tax: RICs are subject to a 4% excise tax on undistributed income for a calendar year. While RICs can generally pick any fiscal year-end, the excise tax regime requires them to make certain distributions on a calendar year timeline. The excise regime does not impact a fund’s ability to qualify as a RIC. Any excise under-distribution results in a 4% tax liability and does not have further ramifications. If the fund distributes its taxable income, it avoids paying the excise tax.

In practice, many closed-end funds pay some excise tax due to complexities associated with timing of private asset income reporting. Mutual funds and ETFs generally don’t pay any excise tax, as income is easier to estimate and manage for these vehicles.