Post-October Losses of RICS -- Final Regulations Under Section 852

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations concerning the treatment by a regulated investment company (RIC) of a net capital loss, a net long-term capital loss, or a net foreign currency loss attributable to periods after October 31 of its taxable year (a "post-October loss"). The applicable tax law was amended by the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988. The final regulations provide guidance relating to the treatment of a post-October loss in determining a RIC's taxable income, the amount that a RIC may designate as capital gain dividends, and the RIC's earnings and profits.

 EFFECTIVE DATE: The regulations are effective for taxable years of a regulated investment company ending after October 31, 1987.

 FOR FURTHER INFORMATION CONTACT: Lauren G. Shaw of the Office of Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention CC:FI&P:2), or telephone (202) 566-3828 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information contained in this final regulation have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1094. The estimated annual burden per respondent varies from 10 minutes to 20 minutes, depending on individual circumstances, with an estimated average of 15 minutes.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents or recordkeepers may require greater or less time, depending on their particular circumstances.

 Comments regarding the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Reports Clearance officer T:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

 On January 31, 1990, the Federal Register published a notice of proposed rulemaking (55 FR 3231) [FI-105-88] by cross-reference to temporary regulations [T.D. 8287] published in the Federal Register for the same day (55 FR 3211) under section 852 of the Internal Revenue Code of 1986. The temporary and proposed regulations reflected the addition of Code section 852(b)(8) and the amendment of Code sections 852(b)(3) and 852(c) by sections 651(b)(2) and (3) of the Tax Reform Act of 1986 (Pub. L. 99-514; 100 Stat. 2085) and sections 1006(l)(3), (4), and (7) of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 100-647; 102 Stat. 3342).

 The regulations were intended to improve the coordination between the income tax provisions applicable to a RIC under section 852 and the provisions of section 4982, which imposes an excise tax on a RIC that fails to distribute a certain amount of its income. Section 4982 uses a 12-month period ending on October 31 in determining capital gain net income subject to the excise tax distribution requirement for the calendar year. To avoid certain mismatches between the distribution requirements under the excise tax provisions and those under the income tax provisions, section 852 provides for special income tax treatment of a post-October loss.

 The regulations provided guidance relating to the determination of the amount that a RIC may designate as capital gain dividends and to the determination of earnings and profits by a RIC when it has a post-October loss.

 In addition, the regulations provided procedures by which a RIC could elect to defer part or all of a post-October loss to the succeeding year for purposes of determining its taxable income. The regulations also provided guidance relating to the proper calculation of taxable income and earnings and profits for the years affected by the election.

 One public comment was received concerning these regulations. No public hearing was requested, and accordingly none was held. After consideration of the written comment, the temporary regulations are adopted as revised by this Treasury Decision and the notice of proposed rulemaking is withdrawn.

PUBLIC COMMENT

 The commentator suggested that section 1.852-11T(c) (relating to the definition of a post-October loss) be amended to clarify that post-October declines in value on instruments that are required to be marked to market on October 31 for section 4982 purposes will be treated as post-October losses.

 The conference report to the Tax Reform Act of 1986 states that "the conferees understand that in applying this rule [for determining the RIC's capital gain net income for excise tax purposes], the period ending October 31 of each calendar year would be treated as the taxpayer's taxable year for purposes of the capital loss carryover provisions and for purposes of the year-end straddle and mark to market rules." H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-243 n.29. Thus, all provisions that normally apply in determining a RIC's capital gains or losses for taxable income purposes on the last day of its taxable year also apply in determining its capital gain net income for excise tax purposes on October 31. In the case of assets that are required to be marked to market, for example, the amounts determined on October 31 then become the benchmark for future determinations of gains or losses for excise tax (but not income tax) purposes. Because of this, it is possible for an asset to have two separate adjusted bases -- one for income tax purposes and another for excise tax purposes. This does not pose a problem if there is no post-October loss for the taxable year. However, if there is a post- October loss, there must be parallel treatment of gains and losses for both income tax and excise tax purposes so that the RIC's earnings and profits for the year will be adequate to treat all amounts distributed for excise tax purposes as dividends.

 Accordingly, section 1.852-11(c) of the final regulations provides that any item (other than a capital loss carryover) that is required to be taken into account or any rule that must be applied, for purposes of section 4982, on October 31 as if it were the last day of the RIC's taxable year must also be taken into account or applied both on October 31 and again on the last day of the RIC's taxable year for purposes of determining whether the RIC has a post- October loss for the taxable year. Thus, for example, if losses are not taken into account for purposes of section 4982 due to application of section 1092 on October 31 but are taken into account for purposes of determining the RIC's taxable income for the taxable year, the losses will be treated as sustained during the post-October period of the taxable year for purposes of determining whether the RIC has a post-October capital loss.

 If, using this methodology, the RIC has a post-October loss, any item that must be marked to market for purposes of section 4982 on October 31 as if it were the last day of the RIC's taxable year must also be marked to market on October 31 and again on the last day of the RIC's taxable year for purposes of determining its taxable income. This rule does not apply, however, for purposes of determining the RIC's gross income for purposes of sections 851(b)(2) or (3).

 The commentator also suggested that section 1.852-11T(f) (relating to the elective deferral of post-October capital losses and post-October currency losses for purposes of determining taxable income) be amended to clarify that the deferral of a post-October loss for taxable income purposes causes such losses to be treated as arising on the first day of the RIC's next fiscal year for purposes of computing the capital loss carryforward period. In response to this comment, the regulations have been revised to clarify that a post-October loss deferred for purposes of determining a RIC's taxable income is treated as having actually arisen on the first day of the RIC's taxable year immediately succeeding the loss year not only for the loss year and the immediately succeeding year, but also for all years following. See section 1.853-11(f).

 The commentator further suggested that section 1.852-11T(j) (relating to the transition rules) be amended to (1) permit year-to- year netting of overdistributions and underdistributions, and (2) permit a retroactive capital gain designation to be made solely for purposes of computing the RIC-level dividends paid deduction.

 The purpose of the RIC excise tax is to match the timing of the shareholders' inclusion in taxable income of dividends received from a RIC to the calendar year in which the RIC earned the income. A RIC that has been forced to overdistribute or that did not designate the maximum amount allowable as capital gain dividends because no election was available at the time may nevertheless have paid out in total more than its actual income. Accordingly, the regulations are amended to provide that a RIC may "pay" a retroactive dividend under rules similar to the provisions for throwback (spillover) dividends under section 855 of the Code, either out of an overdistribution arising in the succeeding year as a result of the retroactive election or by paying a dividend on or before December 31, 1990. The regulations also provide that a RIC may recharacterize previously distributed dividends as capital gain dividends for purposes of determining its dividends paid deduction for the years affected.

 Dividends "paid" by either method may be either ordinary or capital, within the limitations prescribed by section 852(b)(3)(C) of the Code and section 1.852-11(e) of the regulations. A change in the timing or character of distributions may, however, apply for certain other purposes relating to dividend distributions for years affected by the retroactive election (as, for example, the determination of the RIC's distribution requirements under section 4982).

 Furthermore, as of the date of these amendments, some RICs may have already paid a retroactive dividend in accordance with the rules set forth in temporary regulations section 1.852-1lT. Although the final regulations set forth in this Treasury Decision require a RIC to make an irrevocable election in order to pay a retroactive dividend, the manner in which a RIC must make a retroactive election and pay a retroactive dividend under section 1.852-11T is the same as the method of making the election to pay an additional dividend required in the final rules. Therefore, if a RIC complies with the provisions of temporary regulations section 1.852-11T(j), it also complies with the provisions of section 1.852-11(j).

 The regulations have also been revised to permit a retroactive capital gain designation to be made for purposes of computing the RIC-level dividends paid deduction.

 Finally, the commentator recommended that the operation of the transition rules not affect the tax treatment of RIC shareholders. The Internal Revenue Service recognizes that the retroactive adjustments to RIC income and deductions are necessary because the regulations regarding deferral of post-October losses were not issued at the time the distributions were originally made. Thus, to the extent that a RIC's reporting position changes as a result of making a retroactive election, the Service views the adjustments made as being purely a matter of RIC accounting and having no effect on its shareholders.

 The Internal Revenue Service has determined however that no amendment to the regulations is necessary under the circumstances and therefore no amendment to the regulations has been adopted.

SPECIAL ANALYSES

 The Commissioner of Internal Revenue has determined that this final rule is not a major rule as defined in Executive Order 12291 and that a regulatory impact analysis therefore is not required.

 Although a notice of proposed rulemaking that solicited public comment was issued, the Internal Revenue Service concluded when the notice was issued that the notice and public procedure requirements of 5 U.S.C. 553 did not apply. Accordingly, the final regulations do not constitute regulations subject to the Regulatory Flexibility Act (5 U.S.C. Chapter 6).

DRAFTING INFORMATION

The principal author of these regulations is Lauren G. Shaw of the Office of Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations on matters of both substance and style.

LIST OF SUBJECTS

26 CFR PART 1.851-1 -- 1.860-1

Income taxes, Investment companies, Real estate investment trusts.

26 CFR PART 602

Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, Title 26, Parts 1 and 602 of the Code of Federal Regulations is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS ENDING AFTER OCTOBER 31, 1987

Paragraph 1. The authority for Part 1 is amended by removing the entry for section 1.852-11T and adding the following entry, for section 1.852-11:

Authority: 26 U.S.C. 7805; * * * Section 1.852-11 is also issued under 26 U.S.C. 852(b)(3)(C), 852(b)(8), and 852(c).

Par. 2. Section 1.852-11T is redesignated as section 1.852-11 and the word "(Temporary)" is removed from the end of the section heading.

Par. 3. section 1.852-11, as redesignated, is amended as follows:

1. The words "paragraph (c)(1) of this section" are removed from each place they appear in paragraphs (e)(2)(i), (f)(3)(i), and (f)(3)(ii)(A) and the words "paragraph (c)(1)(i) of this section" are added in their place.

2. The words "paragraph (c)(2) of this section" are removed from each place they appear in paragraphs (e)(2)(ii), (f)(3)(iii), and (f)(3)(iv) and the words "paragraph (c)(1)(ii) of this section" are added in their place.

3. The words "paragraph (c)(1) or (c)(2) of this section" are removed from paragraph (e)(3) and the words "paragraph (c)(1)(i) or (c)(1)(ii) of this section" are added in their place.

4. The words "from sales or exchanges after October 31 of" are removed from each place they appear in paragraphs (e)(2)(i), (e)(2)(ii), (f)(3)(i), (f)(3)(ii)(A), (f)(3)(iii), (f)(3)(iv), and (j)(1) and the words "taken into account in computing the post- October capital loss for" are added in their place.

5. The words "attributable to sales or exchanges after October 31 of" are removed from paragraph (f)(3)(ii)(B) and the words "taken into account in computing the post-October capital loss for" are added in their place.

6. The words "from sales or exchanges during" are removed from example (2) of paragraph (h) and the word "for" is added in their place.

7. The words "from sales or exchanges made during" are removed from examples (5) and (8) of paragraph (h) and the word "for" is added in their place.

8. The words "attributable to transactions after October 31 of" are removed from each place they appear in paragraphs (f)(3)(v) and (f)(3)(vi) and the words "taken into account in computing the post- October currency loss for" are added in their place.

9. The words "transactions during" are removed from example (11) of paragraph (h).

10. Paragraphs (a), (c), (d)(1), (f)(4), (j)(2)(i), (j)(4), and (j)(5) are revised to read as follows:

SECTION 1.852-11 TREATMENT OF CERTAIN LOSSES ATTRIBUTABLE TO PERIODS AFTER OCTOBER 31 OF A TAXABLE YEAR.

(a) OUTLINE OF PROVISIONS. This paragraph lists the provisions of this section.

 (a) Outline of provisions.

(i) Any net capital loss attributable to the portion of a regulated investment company's taxable year after October 31; or

(ii) If there is no such net capital loss, any net long- term capital loss attributable to the portion of a regulated investment company's taxable year after October 31.

(2) METHODOLOGY. The amount of any net capital loss or any net long-term capital loss attributable to the portion of the regulated investment company's taxable year after October 31 shall be determined in accordance with general tax law principles (other than section 1212) by treating the period beginning on November 1 of the taxable year of the regulated investment company and ending on the last day of such taxable year as though it were the taxable year of the regulated investment company. For purposes of this paragraph (c)(2), any item (other than a capital loss carryover) that is required to be taken into account or any rule that must be applied, for purposes of section 4982, on October 31 as if it were the last day of the regulated investment company's taxable year must also be taken into account or applied in the same manner as required under section 4982, both on October 31 and again on the last day of the regulated investment company's taxable year.

(3) OCTOBER 31 TREATED AS LAST DAY OF TAXABLE YEAR FOR PURPOSE OF DETERMINING TAXABLE INCOME UNDER CERTAIN CIRCUMSTANCES -- (i) IN GENERAL. If a regulated investment company has a post-October capital loss for a taxable year, any item that must be marked to market for purposes of section 4982 on October 31 as if it were the last day of the regulated investment company's taxable year must also be marked to market on October 31 and again on the last day of the regulated investment company's taxable year for purposes of determining its taxable income. If the regulated investment company does not have a post-October capital loss for a taxable year, the regulated investment company must treat items must be marked to market for purposes of section 4982 on October 31 as if it were the last day of the regulated investment company's taxable year as marked to market only on the last day of its taxable year for purposes of determining its taxable income.

(ii) EFFECT ON GROSS INCOME. The marking to market of any item on October 31 of a regulated investment company's taxable year for purposes of determining its taxable income under paragraph (c)(3)(i) of this section shall not affect the amount of the gross income of such company for such taxable year for purposes of section 851(b)(2) or (3).

(d) POST-OCTOBER CURRENCY LOSS DEFINED. For purposes of this section --

(1) POST-OCTOBER CURRENCY LOSS. The term "post-October currency loss" means any net foreign currency loss attributable to the portion of a regulated investment company's taxable year after October 31. For purposes of the preceding sentence, principles similar to those of paragraphs (c)(2) and (c)(3) of this section shall apply. * * *

(f) * * *

(4) AMOUNT OF LOSS TAKEN INTO ACCOUNT IN SUCCEEDING YEAR AND SUBSEQUENT YEARS. If a regulated investment company has a post- October capital loss or a post-October currency loss for any taxable year and an election under paragraph (f)(1) is made for that year, then, for purposes of determining the taxable income of the company for the succeeding year and all subsequent years, all capital gains and losses taken into account in determining the post-October capital loss, and all foreign currency gains and losses taken into account in determining the post-October currency loss, that are not taken into account under the rules of paragraph (f)(3) of this section in determining the taxable income of the regulated investment company for the taxable year in which the loss arose shall be treated as arising on the first day of the succeeding year.

* * *

(j) * * *

(2) RETROACTIVE ELECTION -- (i) IN GENERAL. A regulated investment company may make an election (a "retroactive election") under paragraph (f)(l) for a taxable year with respect to which it has filed an income tax return on or before May 1, 1990 (a "retroactive election year") by filing an amended return (including any necessary schedules) for the retroactive election year reflecting the appropriate amounts and by attaching a written statement to the return that complies with the requirements of paragraph (i)(2) of this section.

* * *

(4) RETROACTIVE DIVIDEND -- (i) IN GENERAL. A regulated investment company that makes a retroactive election under this section for a retroactive election year may elect to treat any dividend (or portion thereof) declared and paid (or treated as paid under section 852(b)(7)) by the regulated investment company after the retroactive election year and on or before December 31, 1990 as having been paid during the retroactive election year (a "retroactive dividend"). This election shall be irrevocable with respect to the retroactive dividend to which it applies.

(ii) METHOD OF MAKING ELECTION. The election under this paragraph (j)(4) must be made by the regulated investment company by treating the dividend (or portion thereof) to which the election applies as a dividend paid during the retroactive election year in computing its deduction for dividends paid in its tax returns for all applicable years (including the amended return(s) required to be filed under paragraphs (j)(2) and (3) of this section).

(iii) DEDUCTION FOR DIVIDENDS PAID -- (A) IN GENERAL. Subject to the rules of sections 561 and 562, a regulated investment company shall include the amount of any retroactive dividend in computing its deduction for dividends paid for the retroactive election year. No deduction for dividends paid shall be allowed under this paragraph (j)(4)(iii)(A) for any amount not paid (or treated as paid under section 852(b)(7)) on or before December 31, 1990.

(B) LIMITATION ON ORDINARY DIVIDENDS. The amount of retroactive dividends (other than retroactive dividends qualifying as capital gain dividends) paid for a retroactive election year under this section shall not exceed the increase, if any, in the investment company taxable income of the regulated investment company (determined without regard to the deduction for dividends paid (as defined in section 561)) that is attributable solely to the regulated investment company having made the retroactive election.

(C) LIMITATION ON CAPITAL GAIN DIVIDENDS. The amount of retroactive dividends qualifying as capital gain dividends paid for a retroactive election year under this section shall not exceed the increase, if any, in the amount of the excess described in section 852(b)(3)(A) (relating to the excess of the net capital gain over the deduction for capital gain dividends paid) that is attributable solely to the regulated investment company having made the retroactive election.

(D) EFFECT ON OTHER YEARS. A retroactive dividend shall not be includible in computing the deduction for dividends paid for --

(1) The taxable year in which such distribution is actually paid (or treated as paid under section 852(b)(7)); or

(2) Under section 855(a), the taxable year preceding the retroactive election year.

(iv) EARNINGS AND PROFITS. A retroactive dividend shall be considered as paid out of the earnings and profits of the retroactive election year (computed with the application of sections 852(c) and 855, section 1.852-5, section 1.855-1, and this section), and not out of the earnings and profits of the taxable year in which the distribution is actually paid (or treated as paid under section 852(b)(7)).

(v) RECEIPT BY SHAREHOLDERS. Except as provided in section 852(b)(7), a retroactive dividend shall be included in the gross income of the shareholders of the regulated investment company for the taxable year in which the dividend is received by them.

(vi) FOREIGN TAX ELECTION. If a regulated investment company to which section 853 (relating to foreign taxes) is applicable for a retroactive election year elects to treat a dividend paid (or treated as paid under section 852(b)(7)) during the taxable year as a retroactive dividend, the shareholders of the regulated investment company shall consider the amounts described in section 853(b)(2) allocable to such distribution as paid or received, as the case may be, in the shareholder's taxable year in which the distribution is made.

(vii) EXAMPLE. The provisions of this paragraph (j)(4) may be illustrated by the following example:

EXAMPLE. X is a regulated investment company that computes its income on a calendar year basis. No election is in effect under section 4982(e)(4). X has the following income for 1988:

   FOREIGN CURRENCY GAINS AND LOSSES:

(B) If X makes a retroactive election under this section to defer the entire $75 post-October currency loss and the entire $50 post-October capital loss for the post-October period of its 1988 taxable year for purposes of computing its taxable income, that deferral increases X's investment company taxable income for 1988 by $25 (due to an increase in foreign currency gain of $75 and a decrease in short-term capital gain of $50) to $200 and increases the excess described in section 852(b)(3)(A) for 1988 by $100 from $0 to $100. The amount that X may treat as a retroactive ordinary dividend is limited to $25, and the amount that X may treat as a retroactive capital gain dividend is limited to $100.

(5) CERTAIN DISTRIBUTIONS MAY BE DESIGNATED RETROACTIVELY AS CAPITAL GAIN DIVIDENDS. To the extent that a regulated investment company designated as capital gain dividends for a taxable year less than the maximum amount permitted under paragraph (e) of this section for that taxable year, the regulated investment company may designate an additional amount of dividends paid (or treated as paid under sections 852(b)(7) or 855, or paragraph (j)(4) of this section) for the taxable year as capital gain dividends, notwithstanding that a written notice was not mailed to its shareholders within 60 days after the close of the taxable year in which the distribution was paid (or treated as paid under section 852(b)(7)).

* * *

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority citation for Part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. The table of OMB control numbers in section 602.101(c) is amended by removing the entry for section 1.852-11T and adding an entry reading: "1.852-11T * * * 1545-1094" to read: "1.852-11 * * * 1545-1094".