Asset Diversification Test: A Timely Refresher

When a corporation wants to be treated as a regulated investment company (RIC) under the Internal Revenue Code for federal income tax purposes, it must meet certain requirements, including an asset diversification test (referred to here as "the Asset Test"). The Asset Test is formulaic, but during times of great market fluctuations, with RICs potentially buying and/or selling securities, the Asset Test should be kept in mind to ensure that an entity does not lose its RIC status. Below is a summary of the Asset Test, issues related to market value fluctuations and potential remedies if a RIC fails the Asset Test.

Diversification

Generally, the Asset Test can be broken into two percentage tests: the 50% test and the 25% test. Under the 50% test, at least 50% of the value of a RIC’s total assets must consist of cash and cash items, U.S. government securities, securities of other regulated investment companies, and securities of other issuers as to which (a) the RIC has not invested more than 5% of the value of its total assets in securities of the issuer and (b) the RIC does not hold more than 10% of the outstanding voting securities of the issuer. Under the 25% test, no more than 25% of the value of the RIC’s total assets may be invested in the securities of (1) any one issuer (other than U.S. government securities and securities of other regulated investment companies), (2) two or more issuers that the RIC controls and which are engaged in the same or similar trades or businesses, or (3) one or more qualified publicly traded partnerships (including master limited partnerships).

Timing

The Asset Test generally must be met at the close of each quarter of a RIC’s taxable year. But if a corporation fails to meet the Asset Test at the end of a quarter due, in whole or in part, to the acquisition of a security during the quarter, the Asset Test will be deemed to be met if the noncompliance is cured within 30 days after the end of the quarter.

Fluctuations in Value and Dispositions of Assets

Mere fluctuations in value will not themselves cause a RIC to fail the Asset Test, provided that the RIC has met the Asset Test for at least one quarter. Section 851(d)(1) of the Internal Revenue Code provides that if a RIC meets the Asset Test for a particular quarter and then falls out of compliance in a subsequent quarter, the RIC will still not fail the Asset Test for that subsequent quarter unless the noncompliance results, in whole or in part, from the acquisition of a security or other property by the RIC and exists immediately after that acquisition.

The “acquisition” requirement also means that noncompliance with the Asset Test percentages due solely to a RIC’s disposition of assets will not be problematic. For example, if a RIC’s noncompliance is attributable only to a reduction in the RIC’s total assets as a result of dividends to shareholders or repurchases of the RIC’s shares, that will not cause the RIC to fail the Asset Test.

Discrepancy

When determining whether there is a “discrepancy” between the values of the RIC’s investments and the percentages required under the Asset Test that results in a violation of the test, the determination is made immediately after an acquisition. Except in the case of the first quarter of a RIC’s first taxable year, a violation of the Asset Test cannot exist if there is no acquisition. Treasury Regulations Section 1.851-5(a), Examples 5 & 6 illustrate this. In Example 6, a RIC (the taxable year of which is the calendar year) meets the Asset Test at the close of the first quarter of 2016 and has 20% of its assets invested in Corporation P. At the end of 2016 the RIC has more than 25% of its assets invested in Corporation P, therefore not meeting the percentages described above. The change in percentages is due solely to fluctuations in the market values of the RIC’s investments. The example concludes that the RIC did not, and will not, lose its RIC status solely as a result of market value fluctuations. Example 5 presents similar facts except that the increase above 25% for a RIC’s particular investment is the result of distributions made by the RIC to its shareholders, which reduce the RIC’s overall total assets; here, too, the RIC retains its status. Thus, unless there is an acquisition, a RIC will not fail the Asset Test even though there is noncompliance with the relevant percentages.

Acquisition

So what constitutes an “acquisition” for this purpose? The Internal Revenue Code does not define the term acquisition, but the Internal Revenue Service (IRS) generally takes a broad view. The IRS noted in Revenue Ruling 76-392 that “it [is] reasonable to give the term ‘acquisition’ an expansive interpretation to further the legislative objective of prohibiting the concentration of investment assets.” To that end, the IRS has taken the position that the receipt of securities from a tax-free reorganization or antitrust order of a court will constitute an acquisition, whereas a stock split or an exchange of preferred stock for common stock of a company in connection with its initial public offering will not. Therefore, it is important to understand that an “acquisition” includes more types of transactions than just the cash purchase of an investment.

Wholly or Partly the Result of Such Acquisition

If there is a discrepancy and there is an acquisition, the next question to answer is whether that discrepancy is wholly or partly the result of such acquisition. If, for example, we have the same facts described above in Example 6, would an acquisition of an investment that in and of itself does not violate the Asset Test cause the RIC to fail the Asset Test because the RIC had more than 25% of its asset in Corporation P? In Private Ruling 8707033, the IRS looked at similar facts and concluded that where a RIC has more than 25% of its assets invested in a single issuer solely because of market fluctuations, the acquisition of other investments that satisfy the Asset Test would not cause the RIC to fail the Asset Test. Thus, a RIC’s acquisition of investments other than those that do not comply with the percentage limitations of the Asset Test is not the sort of "acquisition" that creates a problem under the test

Note, however, that even a minor acquisition can cause a major problem if it contributes to the discrepancy. If even as little as one share is added to a position that exceeds the relevant 5% or 25% test, it will then be necessary to decrease the percentage for that position all the way back down to 5% or 25%, as the case may be. For example, in Example 5 or 6 above, if the RIC were to purchase even one more share of Corporation P after the RIC’s ownership of that position has exceeded 25% of the RIC’s total assets, then the RIC would need to bring that percentage down to 25% or below to cure the problem — even though that might entail the disposition of a much larger number of Corporation P shares.

Remedying a Failure

If a RIC does fail the Asset Test, steps can be taken to cure the failure. Generally, if the RIC can eliminate the discrepancy within 30 days of the end of quarter, then RIC status will be preserved. The IRS concluded in Revenue Ruling 69-134 that a RIC can cure a discrepancy in the 30-day period by “any action that could have been taken prior to the close of the quarter.” So, a RIC can dispose of any securities to cure the discrepancy, not just the securities that cause the noncompliance. Moreover, because the Asset Test is based on a RIC’s gross assets, a RIC may also be able to cure a noncompliance by borrowing funds and using them to acquire qualifying assets (such as U.S. government securities) so as to increase the denominator in the relevant fraction.

For a de minimis failure, the Code provides broader relief. The de minimis Asset Test failure provision is available where a RIC fails the Asset Test at the end of a quarter by the lesser of (1) 1% of the total value of the RIC’s assets at the end of the quarter and (2) $10 million. The RIC will then have six months to cure the failure by either disposing of the assets causing the failure or in manner prescribed by the Treasury. The Treasury has not released additional guidance.

A RIC can also cure a non-de minimis failure if it meets certain requirements. The RIC must provide a schedule identifying the assets that caused the failure, the failure must be due to “reasonable cause and not due to willful neglect,” and within six months of the end of the quarter in which the RIC failed the Asset Test, the RIC must either dispose of the assets that caused the failure or otherwise satisfy the Asset Test. In addition, the RIC must pay a tax equal to the greater of (1) $50,000 or (2) a corporate tax on the net income generated by the assets that caused the failure during the failure period.

Final Thoughts

During market uncertainty, market values can fluctuate greatly and decisions can be made to secure gains or avoid losses. These decisions can have unexpected consequences to a fund’s status as a RIC if the Asset Test is not carefully followed. It is important for a fund’s administrators and board members to be conscious of these restrictions that are imposed on a fund’s investments. We are here to help. Please contact us with any concerns or questions.