The Tax Cuts and Jobs Act (the Act), which the President signed on December 22, 2017, contains a number of provisions that may affect regulated investment companies (RICs). Because these provisions generally apply to tax years beginning after December 31, 2017, RIC complexes should determine the impact of the new legislation as quickly as possible.

As a threshold matter, it is important to note what is not in the Act — specifically, mandatory first-in, first-out (FIFO) lot selection. The Senate bill generally required taxpayers to use FIFO. That bill provided an exception for RICs; RIC shareholders, however, would have had to select lots using either FIFO or average cost. The final legislation contains no such provision. Accordingly, the lot selection rules that existed prior to the legislation (including the use of specific identification) remain in effect.

Key provisions for RICs

Accelerated inclusion of gross income. The Act generally requires accrual-basis taxpayers, including RICs, to recognize certain items of gross income no later than the tax year in which that gross income is taken into account under generally accepted accounting principles (GAAP). The provision may only require immediate inclusion of some types of loan-related and credit-card-related fee income or it may be far broader. For example, the provision may require current inclusion in income of market discount. Although most RICs elect current inclusion of market discount on taxable bonds, they tend not to make this election for municipal bonds, since market discount on municipal bonds is taxable. The provision similarly may require accelerated inclusion of income on instruments that are classified as debt for GAAP purposes and equity for tax purposes, such as some types of preferred stock. The exact scope of the provision is uncertain at this time, and additional clarification is being sought. The Conference Committee Statement on the Act does indicate that the provision is not intended to impose a general mark-to-market regime on securities.

No pass-through of new partial deduction for REIT dividends and master limited partnership (MLP) income. The law generally allows non-corporate taxpayers to deduct 20% of the REIT dividends they receive (other than capital gain dividends and dividends taxable as qualified dividend income) and the MLP income they are allocated. As a corporation, a RIC is ineligible for this deduction. In addition, it appears that RICs cannot pass the deduction to their non-corporate shareholders. It is possible that a technical correction will address this deficiency, since there is no policy reason to deny RIC shareholders the REIT and MLP deduction.

Limitation on deduction for business interest. The Act generally limits the deductibility of net business interest expense to 30% of "adjusted taxable income." Although open-end RICs generally do not incur debt, business development companies (BDCs) and some closed-end RICs do borrow. The limitation should not be relevant to these entities if a significant portion of their assets consists of debt instruments, since their interest income likely will exceed their interest expense, resulting in no net interest expense. BDCs and closed-end RICs that borrow and invest in other asset classes, however, will need to consider whether the limitation applies to them. It currently is unclear whether RICs and BDCs are engaged in a business for purposes of the limitation.

Dividend exclusion, additional income inclusions for 10% shareholders of certain foreign corporations. The Act generally exempts 100% of the foreign-source portion of dividends a US corporation receives from a foreign corporation (other than a passive foreign investment company (PFIC) that is not also a controlled foreign corporation (CFC)) in which the US corporation owns at least a 10% interest (Specified 10%-Owned Foreign Corporation), assuming certain requirements are met. RICs (and REITs) are not eligible for this favorable exclusion. RICs, however, rarely own 10% or more of foreign corporations other than wholly owned investment entities, and the Act does not change the rules requiring current inclusion of "Subpart F income" from these entities. If a RIC (or other applicable taxpayer) does own 10% or more of a Specified 10% Foreign Owned Corporation or CFC in that foreign corporation's final tax year beginning before January 1, 2018, the RIC (like taxpayers to which the 100% exclusion applies) will be subject to a toll charge in the form of an income inclusion based on the RIC's pro rata share of the foreign corporation's post-1986 tax-deferred earnings (that is, earnings that previously were not subject to US tax) during the period the foreign corporation was a CFC or had a 10%-or-greater US corporate shareholder. In addition, for tax years beginning after December 31, 2017, RICs (and other taxpayers) that are 10%-or-greater shareholders of CFCs may have to include a new category of Subpart F income, global intangible low-taxed income (GILTI). Again, this provision should not affect the tax treatment of a RIC's wholly owned investment subsidiaries, since RICs already include Subpart F income from these subsidiaries on a current basis. If a RIC is subject to this provision for other investments, however, the RIC cannot claim the 50% exclusion for GILTI income that is available for most US corporations.

Taxability of municipal bonds issued for pre-refundings. RICs that invest in municipal bonds often hold bonds that have been defeased (or pre-refunded) — that is, bonds for which a municipality has issued a new "advance refunding bond" and set aside the new-bond proceeds in escrow to pay principal and interest on the original bond. The municipality usually invests the escrow in US government securities, such as Treasuries, and the original bond is treated as a government security for purposes of the RIC asset diversification (there is no limit on investments in US government securities under the test). The Act makes interest on advance refunding bonds taxable — interest on the original bond, however, remains tax-exempt (assuming it was tax-exempt at issuance). This change applies to advance refunding bonds issued after December 31, 2017. RICs that invest in pre-refunded bonds to facilitate compliance with the asset diversification test should be aware that the number of advance refundings could decline as a result of this new rule.

More stringent insurance business exception to PFIC status. The Act modifies the insurance business exception to PFIC status so that it applies only if a foreign corporation would be taxed as an insurance company if it were a US corporation and if its applicable insurance liabilities constitute: (1) more than 25% of the foreign company's assets; or (2) at least 10% of the entity's assets if the decline below 25% is due to temporary circumstances. This change applies to tax years beginning after December 31, 2017. Under current law, the test for the exception is based on whether a corporation is predominantly engaged in an insurance business (the IRS has indicated that it analyzes whether risks assumed under contracts issued by a foreign company organized as an insurer are truly insurance risks, whether the risks are limited under the terms of the contracts, and the status of the company as an insurance company). RICs will need to modify their PFIC-identification procedures accordingly.

Conclusion

The Act makes a number of changes that could significantly affect RICs. The scope of several of these changes is unclear at the present time, so it will be important to monitor for clarifications and guidance as the Act's provisions take effect.

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