PLR 200822010: Income from foreign subsidiaries counts toward fund income test

Plain-English summary

Four investment funds planned to own foreign corporate subsidiaries that would invest in commodity and financial derivatives and fixed income securities. The funds asked whether income from those subsidiaries counted toward the 90 percent income test for regulated investment companies under § 851(b)(2). The IRS ruled that the income was qualifying income because each fund's investment in its subsidiary was an investment in stock. The ruling applies whether the income is included under the controlled foreign corporation rules, comes from another source, or has been distributed. The IRS did not decide whether any fund otherwise qualified as a regulated investment company.

Ruling snapshot

• Question: Would income from wholly owned foreign subsidiaries count as qualifying income under § 851(b)(2)?
• Outcome: Approved, regardless of whether the income was subpart F income or had been distributed.
• Key authorities: IRC §§ 851(b)(2), 951, 952, 954, and 957.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 200822010
Third Party Communication: None
Release Date: 5/30/2008
Date of Communication: Not Applicable
Index Number: 851.02-00
Person To Contact:
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----------------------, ID No. ------------
------------------------------------------------------------ Telephone Number:
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------------------------------------------ Refer Reply To:
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CC:FIP:B02
PLR-137083-07
Date:
February 12, 2008

Legend:

Fund 1 = -------------------------------------------------------------------
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Fund 2 = -------------------------------------------------------------------------
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Fund 3 = --------------------------------------------------------------------
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Fund 4 = --------------------------------------------------------------------------
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Fund = --------------------------
Manager

Trust 1 = ---------------------------

Trust 2 = ----------------------------

State = ------------

Country = ---------------------

Dear --------------:

This responds to your request dated August 13, 2007, and supplemental correspondence dated January 31, 2008, submitted by your authorized representative on behalf of Fund 1, Fund 2, Fund 3, and Fund 4 (each a “Fund,” and collectively, the “Funds”). Funds request that the Internal Revenue Service rule that income earned

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from the ownership of a wholly-owned subsidiary that is a controlled foreign corporation constitutes qualifying income for purposes of section 851(b)(2) of the Internal Revenue Code of 1986, as amended (the “Code”).

FACTS

Funds are sponsored by Fund Manager. Fund 1 and Fund 2 are organized as a separate series of Trust 1, a State statutory business trust and Fund 3 and Fund 4 each are organized as a separate series of Trust 2, a State statutory business trust. Trust 1 and Trust 2 operate as open-end investment management companies. Trust 1 and Trust 2 are registered as investment companies under the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq., as amended (the “1940 Act”), and currently qualify as RICs. Each Fund either has elected or will elect to be taxable as a regulated investment company (“RIC”) under Subchapter M of the Code. Each Fund is (or will be) operated as an open-end management company.

A component of each Fund’s investment objective will be to invest in a wholly- owned foreign corporation that will in turn invest in commodity and financial futures, swaps, options contracts, and also fixed income securities that would serve as collateral for those contracts. The wholly-owned foreign corporation may also invest in cash- settled non-deliverable forward contracts.

Each Fund intends to form a wholly-owned subsidiary (each a “Subsidiary,” and collectively the “Subsidiaries”) that will be a foreign corporation. Each Subsidiary will be incorporated as an exempted limited company under the laws of Country. Under the laws of Country, an exempted limited company provides for limited liability for all holders of shares. A shareholder’s liability is limited to the amount, if any, unpaid with respect to the shares acquired by the shareholder. Each Subsidiary will file an election on Form 8832, Entity Classification Election, to be taxed as a corporation for federal income tax purposes pursuant to section 301.7701-3 of the Procedure and Administration Regulations.

Funds represent that, although the Subsidiaries will not be registered as investment companies under the 1940 Act, each Subsidiary will comply with the requirements of section 18(f) of the 1940 Act, Investment Company Act Release No. 10666, and related SEC guidance pertaining to asset coverage with respect to transactions in commodity index swap agreements and other transactions in derivatives.

Each Fund will invest a portion of its assets in its Subsidiary, subject to the limitations set forth in section 851(b)(3) of the Code. It is expected that all of the Subsidiaries’ income will be subpart F income as defined in section 952. Each Fund, however, may also receive income from its Subsidiary that is not properly characterized as subpart F income.

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LAW AND ANALYSIS

Section 851(b)(2) of the Code provides that a corporation shall not be considered a RIC for any taxable year unless it meets an income test (the “qualifying income requirement”). Under this test, at least 90 percent of its gross income must be derived from certain enumerated sources. Section 851(b)(2) defines qualifying income, in relevant part, as—
dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), and gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the 1940 Act) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to [the RIC’s] business of investing in such stock, securities, or currencies . . . .

Section 851(b) of the Code further provides that, for purposes of section 851(b)(2), there shall be treated as dividends amounts included in gross income under section 951(a)(1)(A)(i) or 1293(a) for the taxable year to the extent that, under section 959(a)(1) or 1293(e) (as the case may be), there is a distribution out of the earnings and profits of the taxable year that are attributable to the amounts so included.

Section 957 of the Code defines a controlled foreign corporation (“CFC”) as any foreign corporation in which more than 50 percent of (1) the total combined voting power of all classes of stock entitled to vote, or (2) the total value of the stock is owned by United States shareholders on any day during the corporation’s taxable year. A United States shareholder is defined in section 951(b) as a United States person who owns 10 percent or more of the total voting power of a foreign corporation. Each Fund is a United States person. Each Fund will satisfy the ownership requirements in section

957. Therefore, each Subsidiary will qualify as a CFC under these provisions.

     Section 951(a)(1) provides that, if a foreign corporation is a CFC for an
     uninterrupted period of 30 days or more during any taxable year, every person who is a United States shareholder of this corporation and who owns stock in this corporation on the last day of the taxable year in which the corporation is a CFC shall include in gross income the sum of the shareholder’s pro rata share of the CFC’s subpart F income for the taxable year.

     Section 952 of the Code defines subpart F income to include foreign base
     company income determined under section 954. Under section 954(a)(1), foreign base company income includes foreign personal holding company income determined under section 954(c). Section 954(c) defines foreign personal holding company income to include dividends, interest, royalties, rents, and annuities.

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Subsidiaries’ investments in commodity and financial futures, swaps, cash- settled non-deliverable forward contracts, option contracts, fixed income securities, and other securities will produce income that may generate foreign personal holding company income, which is subpart F income under section 954(c) of the Code. Each Fund will therefore include in income the sum of its pro rata share of its Subsidiary’s subpart F income for the taxable year in accordance with section 951.

Section 851(b) of the Code includes a specific rule providing dividend treatment for certain subpart F inclusions (those attributable to distributions out of earnings and profits). Subpart F inclusions also constitute RIC qualifying income under section 851(b)(2)(A), which states that qualifying income includes “other income … derived with respect to [the RIC’s] business of investing in … stock, securities, or currencies” (the “other income rule”).

The investment by each Fund in its Subsidiary corporation will be an investment in stock. Each Fund’s income from its Subsidiary will be derived from its stock ownership and thus will be “income derived with respect to its business of investing in such stock” under the other income rule of section 851(b)(2)(A) of the Code.

CONCLUSION

We rule that income derived by each Fund from its investments in its wholly- owned Subsidiary corporation is qualifying income to each Fund under section 851(b)(2) of the Code without regard to whether the income is subpart F income or is from another source and without regard to whether the income has been distributed.

No opinion is expressed as to whether each Fund qualifies as a RIC that is taxable under subchapter M, part I of the Code. This ruling is directed only to the taxpayers who requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

Susan Thompson Baker
Susan Thompson Baker
Assistant to the Branch Chief, Branch 2
Office of the Associate Chief Counsel
(Financial Institutions & Products)