Internal Revenue Service (IRS) guidance allows BDCs to satisfy the RIC distributions requirements with dividends that are partially payable in their own stock provided that shareholders have the right to elect to receive the distributions in cash or stock (a Cash-or-Stock Dividend).

 

Most BDCs have elected to be taxed as RICs under subchapter M of the Code. If a BDC qualifies for taxation as a RIC, it will not be subject to corporate-level US federal income tax on the net income and capital gains that it timely distributes to its shareholders.

 

To maintain qualification for taxation as RICs, BDCs must, among other things, distribute to shareholders for each taxable year as taxable dividends at least 90% of their “investment company taxable income,” i.e., net ordinary income plus realized net short-term capital gains in excess of realized net long-term capital losses (the Annual Distribution Requirement). In addition, to avoid a four percent US federal excise tax on undistributed income, BDCs must distribute in each calendar year the sum of (1) 98% of their net ordinary income for the calendar year, (2) 98.2% of their realized capital gain net income (both long-term and short-term) for the one-year period ending October 31 in that calendar year (or the calendar year for a BDC that has elected to use the calendar year), and (3) any income and gains recognized, but not distributed, in preceding years on which no corporate-level US federal income tax was paid (the Excise Tax Avoidance Requirement). Finally, to eliminate liability for corporate-level US federal income tax, BDCs must distribute for each taxable year 100% of their investment company taxable income and their net capital gains (the Corporate Tax Elimination Requirement, and collectively with the Annual Distribution Requirement and the Excise Tax Avoidance Requirement, the RIC Distribution Requirements).

 

 

If a BDC were to declare a dividend that was payable to every shareholder wholly or partially in the BDC’s own stock, the stock portion of the distribution would not satisfy any of a BDC’s RIC Distribution Requirements. This general rule for stock dividends does not apply “[i]f the distribution is, at the election of any of the shareholders (whether exercised before or after the declaration thereof), payable either (A) in its stock, or (B) in property [including cash].” Code Section 305(b)(1). For such Cash-or-Stock Dividends, shareholders electing to receive stock are treated as receiving a taxable dividend equal to the amount of cash that could have been received instead. Thus, BDCs may satisfy their RIC Distributions with Cash-or-Stock Dividends.

 

The IRS confirmed this result in numerous private letter rulings and, more recently, in Rev. Proc. 2017-45. In this guidance, the IRS has indicated that Cash-or-Stock Dividends paid by RICs (including BDCs) or by real estate investment trusts (REITs), which are subject to similar distribution requirements as RICs (the REIT Distribution Requirements), would be treated as taxable dividends that satisfied the RIC Distribution Requirements or the REIT Distribution Requirements provided that shareholders have the right to elect to receive their distributions entirely in cash. Significantly, this result applies even if BDCs limit the aggregate amount of cash available for distribution, as long as at least 20% of the aggregate distributions payable to all shareholders are payable in cash.  If the aggregate cash elections of all shareholders exceed the cash available for distribution, all shareholders electing to receive cash are allocated a portion of the available cash, and the remainder of their distribution is paid in stock. 
 

Eversheds Sutherland Observation: We note that, while Rev. Proc. 2017-45 requires that taxpayers be given the opportunity to elect to receive 100% of their distributions in cash, the revenue procedure does not provide specific guidance regarding the process to be followed for shareholders to make the election. However, certain procedures have been developed to comply with Rev. Proc. 2017-45, and you should discuss those procedures with counsel before issuing Cash-or-Stock Dividends under this guidance.

 

In response to the COVID-19 pandemic, it is possible that the IRS will reduce the portion of a Cash-or-Stock Dividend that must be payable in cash to treat the distribution as a taxable dividend. In this respect, as a result of the economic crisis that began in 2008, the IRS issued guidance that temporarily reduced the minimum percentage of cash that must be distributed to ten percent. See Rev. Proc. 2008-68 (applying to REIT dividends with respect to taxable years ending on or before December 31, 2009); Rev. Proc. 2009-15 (which extended Rev. Proc. 2008-68 to include RIC dividends for taxable years ending on or before December 31, 2009); Rev. Proc. 2010-12 (which extended the period distributions payable with respect to taxable years of RICs or REITs ending on or before December 31, 2011).

Eversheds Sutherland Observation: Currently, Rev. Proc. 2017-45 applies only to publicly offered RICs. Because many private BDCs will not qualify as publicly offered RICs, such BDCs will not be able to rely on the existing published guidance. As a result, private BDCs considering Cash-or-Stock Dividends should first discuss their options with counsel.

 

 

Section 18 of the 1940 Act, as modified by Section 61 of the 1940 Act, imposes a minimum asset coverage requirement on BDCs (at least 200% or 150%, as applicable). As a general matter, BDCs that have indebtedness outstanding may be subject to provisions contained within outstanding debt instruments that prohibit distributions to stockholders unless the BDC is in compliance with its asset coverage requirement at the time of the distribution.  As a result, BDCs that wish to consider a Cash-or-Stock Dividend should ensure that they are in compliance with their applicable asset coverage requirement and any related provisions related to their outstanding indebtedness that may limit impose limitations on distributions. 

 

 

Section 23(b) of the 1940 Act prohibits a BDC from selling “any common stock of which it is the issuer at a price below the current net asset value of such stock . . . except (1) in connection with an offering to the holders of one or more classes of its capital stock . . . .”  As a result, we have considered whether a BDC may issue stock dividends when its shares are trading below its current net asset value (NAV). However, Cash-or-Stock Dividends generally should not be prohibited under this rule because either they are not considered sales for purposes of the rule or they are exempted from the rule as an offering to shareholders.

Other Options for Deferring Distributions

 

BDCs have a number of additional options for deferring their distributions while still satisfying their RIC Distribution Requirements. For example, BDCs may pay distributions in January of next year and have such distributions treated as having been paid on December 31 of the current year for all RIC Distribution Requirement purposes (A January Dividend), or rely on certain spillover dividend procedures to satisfy the Annual Distribution Requirement and the Corporate Tax Elimination Requirement.
 

Eversheds Sutherland Observation: Relying on the January Dividend or spillover dividend procedures will allow BDCs to defer distributions until they are certain of their income and gains for the year, and hopefully, until after the capital markets have become more settled. BDCs also may combine either January Dividends or spillover dividends with Cash-or-Stock Dividends to further preserve cash. BDCs considering combining Cash-or-Stock Dividends with either January Dividends or spillover dividends should discuss the timing requirements of such dividends with counsel to avoid missing any material deadlines.