Cash settlement and note from investment adviser are qualifying RIC income.

AuthorMunro, Alan
PositionRegulated investment company

In Letter Ruling 200739010, the Service ruled that a regulated investment company's (RIC's) receipt of cash and a note from its investment adviser (IA) are qualifying income under Sec. 851(b)(2). Further, although the note caused a Sec. 851(b)(3) asset-test failure, the IRS ruled that satisfaction of the note within 30 days of the close of the quarter cured the failure.

Facts

A RIC invested in a passive foreign investment company (PFIC), which invested in segregated portfolio companies (SPCs) taxable as partnerships. The SPCs held deposits as collateral for the PFIC's trading activities with a company that operated as a private bank. At a certain point, the IA to the PFIC and the SPCs requested a return of its invested money from this private bank. After the money was transferred, the bank's parent company froze all customer accounts, preventing any persons from receiving invested money; the bank and its parent corporation filed voluntary bankruptcy petitions.

The RIC made two tenders to the PFIC for redemption of its PFIC shares. Subsequently, the RIC determined that, as a result of the bankruptcy, its PFIC shares had depreciated between 8% and 30% of the tender fair market value; in addition, the PFIC's adviser indicated that the shares were not transferable.

Ultimately, to maintain goodwill and its reputation, the IA paid the RIC an amount equal to the amount that would have been paid on the two earlier tenders. The IA transferred cash and a note to the RIC as settlement of its interests in the PFIC and the RIC agreed to give the IA any amounts it received from the PFIC.

The IA satisfied the note and the RIC liquidated the next day by distributing its PFIC shares to a liquidating trust. The RIC represented that the transactions were not entered into to artificially inflate its qualifying income and that, at the close of its quarter, the RIC otherwise satisfied the diversification test of Sec. 851(b)(3) if the value of the note was treated as cash held by the RIC.

Analysis

Generally, to qualify as a RIC, at least 90% of its gross income must be from certain sources, including dividends; interest; gain from the sale or other disposition of stock, securities, or foreign currencies; or other income derived from its business of investing in such stock, securities, or currencies.

Rev. Rul. 92-56 examined the issue of qualifying income of a RIC. It held that if, in the normal course of its business, a RIC received a reimbursement from its...

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