COVID-19 Considerations for RICs and REITs and Temporary Relief on Certain Stock Distributions

May 15, 2020

New guidance from the Internal Revenue Service will allows RICs and REITs to retain more capital by distributing less cash to shareholders in certain stock distributions—welcome relief during the current economic volatility resulting from the coronavirus (COVID-19) pandemic.

The Internal Revenue Service (IRS) has issued Revenue Procedure 2020-19, providing temporary relief for certain distributions by a publicly offered regulated investment company (RIC) or publicly offered real estate investment trust (REIT) if the amount of the overall distributions that may be paid in cash is limited by a percentage threshold. If such distributions are made pursuant to a “cash-or-stock election” that meets the requirements of the revenue procedure, the entire distribution will be treated as a taxable distribution of property under Section 301 of the Internal Revenue Code of 1986, as amended (the Code), through the application of Section 305(b) and therefore will be eligible for the dividends‑paid deduction.

The new guidance temporarily expands the existing safe harbor of Revenue Procedure 2017-45 (see our prior coverage). That safe harbor, by its terms, applies to a distribution where the amount of cash to be paid is limited only if the shareholders, assuming they all elect to receive cash, will receive at least 20% of the aggregate declared distribution in cash. The new guidance temporarily reduces the 20% threshold to 10%. As both RICs and REITS are facing increased liquidity needs during the current period of economic volatility, the ability to retain capital by distributing less cash to shareholders will be welcome relief for RICs and REITs in satisfying their distribution requirements.

During the 2008–2009 financial crisis, the IRS issued similar public guidance in Revenue Procedure 2008-68 (for REITs) and Revenue Procedure 2009-15 (for RICs) that applied to distributions made during specified years if shareholders would have received at least 10% of the declared distributions in cash, assuming all shareholders elected to receive cash. The IRS extended that guidance in Revenue Procedure 2010-12 and then made it permanent in Revenue Procedure 2017-45, but increased the 10% threshold to 20%.

In Revenue Procedure 2020-19, the IRS has effectively revived the relief provided during the prior financial crisis by temporarily allowing distributions to fall within the safe harbor if no shareholder electing to receive money would receive less than 10% of the shareholder's entire entitlement in cash. The broader application of the safe harbor only applies to distributions declared on or after April 1, 2020, and on or before December 31, 2020.

Morgan Lewis Observation

The ability of a RIC or REIT to limit the use of its cash in meeting distribution requirements can be a crucial tool during liquidity crunches such as during the current COVID-19 pandemic. While the relief provided by Revenue Procedure 2020-19 will therefore be warmly received by RICs and REITs alike, it is not clear why the IRS has limited the relief to distributions declared prior to the end of the calendar year as opposed to providing longer-term or open-ended relief during the COVID-19 emergency.

Similarly, although consistent with prior guidance, it is unclear why from a policy perspective the IRS continues to limit the application of relief in this context to only publicly offered RICs under Section 67(c)(2)(B) of the Code and publicly offered REITs under Section 562(c)(2).[1] As we previously observed, shares of publicly offered RICs and REITs may generally be sold on the market or redeemed at net asset value, while shares of other RICs and REITs are generally somewhat less liquid. Publicly offered RICs and REITs are also exempt from the preferential dividend rule, while other RICs and REITs are not.

In any event, it appears that non-publicly offered RICs and REITs will need to seek private letter rulings from the IRS to receive clarity on this legal issue. At this time, it is not clear whether the IRS will provide relief to non-publicly offered RICs and REITs.

Other Practical Considerations for RICS and REITS

During the current COVID-19 pandemic, both RICs and REITs are likely to experience some of the following tax-related challenges that may put pressure on their ability to satisfy applicable requirements under Subchapter M of the Code.

Common Challenges Specific to RICs and REITs

As a result of volatile markets, RICs or REITs may have trouble satisfying the applicable asset-based limitations under Section 851(b)(3) or Section 856(c)(4), as applicable. Under these circumstances, carefully consider the cure provisions under the asset tests, which include the following:

  • Certain RICs and REITs may be able to avail themselves of the market fluctuation exception to avoid an asset failure under Section 851(b)(3) or 856(c)(4), as applicable. For every quarter other than its first quarter, a RIC or REIT generally will not fail the applicable asset test unless the failure is a result of an “acquisition” and the failure exists immediately after the acquisition as well as at quarter-end. Thus, securities or other property that might cause an asset test issue if newly acquired generally will not cause an asset test issue if the issue results from market fluctuation. Importantly, the market fluctuation exception is not available for a RIC or REIT’s first quarter. Thus, newly formed RICs and REITs need to manage asset test compliance carefully when markets are volatile.
  • RICs and REITs may be able to avail themselves of the 30-day cure period to correct asset test issues. A RIC or REIT can generally cure an asset test discrepancy by eliminating the discrepancy within 30 days after the close of the quarter.
  • RICs and REITs generally have six months to cure certain de minimis failures. If the asset test failure is attributable to assets with a value that does not exceed the lesser of (1) 1% of the value of the RIC or REIT’s total assets at quarter-end and (2) $10 million, the RIC or REIT has six months after the last day of the quarter to cure the failure.
  • RICs and REITs also have certain cure provisions available to them for non–de minimis failures of the respective asset tests, provided that there is a notification to the IRS of the failure, the payment of an excise tax to the IRS, and the disposition of the asset causing the failure, and such failure was due to reasonable cause and not willful neglect. For purposes of the last requirement, the REIT regulations provide that “reasonable cause” for income test failure can be established by “reliance” on a reasoned written opinion of a tax advisor. Note, there are no comparable regulations on point for asset test failures for REITs or regulations for RICs with respect to income or asset test failures, but it is generally recommend for both REITs and RICs to proactively seek such opinions before issues arise.

Both RICs and REITs can also avail themselves of savings provisions with respect to potential failures of the applicable income tests. As described above with respect to asset test failures, RICs or REITs that need to avail themselves of a savings provision to ensure compliance with applicable tax requirements should carefully and contemporaneously document their compliance with the savings or cure provision, so that they can prove such compliance to the IRS or other taxing authorities.

Open-ended RICs (i.e., those that offer to redeem their shares on demand) may experience significant redemptions causing the RICs to have to liquidate. The liquidation of a RIC raises at least two challenges:

  • A RIC must generally meet the various requirements under the asset diversification test in Section 851(b)(3) at the close of each quarter, including its last quarter. Thus, a RIC needs to ensure that it is diversified at the close of the quarter that ends with its liquidation. Similarly, under Sections 852 and 853, a RIC that intends to pass through the special character of certain tax items to shareholders (i.e., exempt interest income and foreign tax credits) must meet one of certain thresholds relating to the nature of its assets at the close of each quarter or taxable year. Thus, such a RIC would also need to meet the applicable threshold at the close of its quarter and year that ends with its liquidation. Careful consideration should be taken by RICs and REITs that are contemplating winding down to ensure that they continue to maintain their status as RICs or REITs and meet all quarter-end and year-end tests under the various tests applicable to such entities.
  • A RIC or REIT must generally claim a dividends-paid deduction (DPD) equal to its net income and gains in order to zero out its entity-level income tax liability for each taxable year, including the taxable year ending with its liquidation. Typically, liquidating RICs and REITs satisfy such distribution requirement by claiming a DPD in respect of liquidating distributions. Special rules, however, may limit a RIC or REIT that is a personal holding company (PHC) to claim a DPD for liquidating distributions. Note, while the closely held rules of Section 856(a)(6) generally prevent a REIT from dropping into PHC status, the rules for determining PHC status do not contain the waiver of partnership attribution. This could cause a REIT to drop into PHC status while still maintaining its REIT qualification. A RIC or REIT could become a PHC as a result of significant redemptions or other capital changes that reduce the shareholder base, potentially triggering the need to liquidate. Care needs to be taken to ensure that a liquidating RIC or REIT can fully eliminate its entity-level tax liability when it liquidates by claiming a DPD, particularly if the RIC or REIT is or becomes a PHC. The failure to have a sufficient DPD could cause a RIC or REIT to fail to meet the applicable requirements and accordingly owe corporate-level tax on its taxable income during its taxable year ending with the liquidation.

Challenges Specific to RICs

In times of market difficulty, a RIC’s advisers may choose to buoy the value of the RIC by waiving or rebating fees. There is not any consensus as to how such payments are taxed to a recipient RIC. Such payments may be simply be a rebate and thus not taxable to the RIC. Alternatively, the payment may represent a nonshareholder contribution to capital under Section 118 that is excludable from income. A nonshareholder contribution to capital, however, will require the RIC to adjust the basis of assets acquired during the subsequent 12-month period under Section 362(c)(2), which often leads to operational challenges of tracking the basis of such assets.

If, however, the payment to the RIC is treated as income in the hands of the RIC, depending on the size of such payment, it may need to qualify under the RIC “good income” test that generally requires that at least 90% of the RIC’s gross income be derived from certain sources. It is not entirely clear that payments from advisers should always be treated as good income for purposes of this requirement, but authorities generally support the conclusion that waivers and rebates of advisory fees should not cause a RIC to fail the good-income test. To ensure that waivers or rebates of fees do not pose a challenge to a RIC, funds should memorialize any waivers or rebates in writing and carefully confirm that the waivers or rebates do not exceed fees.

Challenges Specific to REITs

In these challenging times, REITs may find themselves having to liquidate or sell certain assets earlier than previously intended. Such sales may implicate an analysis of whether the sale is a “prohibited transaction” subject to a tax equal to 100% of the net income from the sale. In the case of REITs, the sale of property could be a prohibited transaction if the property is held primarily for sale to customers in the ordinary course of a trade or business. REITs may find themselves needing to dispose of such property without fitting such sales within the applicable safe harbor from prohibited transactions. Although there is no explicit exception from the “prohibited transaction” tax for liquidations, the IRS has in certain cases treated a liquidation as not constituting a prohibited transaction.

In addition, the failure to fit squarely within the safe harbor does not necessarily cause the disposition of the property to be a prohibited transaction. However, care must be taken to determine whether such sales fit within the general factors set forth by the courts in determining whether such sales were primarily for the sale to customers. Therefore, it is prudent for REITs to have proper documentation in place that will facilitate a REIT’s intent for holding properties that may need to be sold sooner than expected and outside of the safe harbor.

Coronavirus COVID-19 Task Force

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If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Daniel A. Nelson
Jason P. Traue
Adam M. Holmes
Meghan E. McCarthy

Washington, DC
Richard C. LaFalce

[1] Note, that there is a different definition of a publicly offered RIC as compared to a publicly offered REIT.