Due to economic conditions that have resulted from the COVID-19 pandemic, many regulated investment companies (“RICs”) may have liquidity issues with respect to their investment portfolios. One alternative for RICs that are facing such liquidity issues is to consider delaying distributions so that, rather than paying distributions on a monthly or quarterly basis, the RIC makes its distributions on an annual basis. The tax laws allow a RIC to pay a dividend in January of the next year and have it treated as if it were made on December 31st of the current year. For RICs that use the calendar year as their taxable year, such dividends can satisfy the prior year’s distribution requirement and avoid income and excise taxes. Deferring any remaining 2020 dividends until January 2021 may be a useful cash management strategy for these calendar year RICs. Other RICs may be able to use this strategy to at least avoid the annual excise tax, which is calculated on a calendar year basis for all RICs.
RICs may also consider making a distribution that provides for a cash or stock election, which the IRS indicated in Revenue Procedure 2017-45 will be treated as a dividend for income and excise tax purposes. To qualify for this treatment, generally the RIC must pay at least 20% of the distribution in cash. If the shareholders’ cash elections exceed 20% of the total distribution, the RIC can allocate the cash proportionally among the shareholders electing cash as more fully described below.
Revenue Procedure 2017-45 applies in the following situation:
1. A “publicly offered” RIC makes a distribution to its shareholders with respect to its stock. For this purpose, “publicly offered” means a RIC the shares of which are continuously offered pursuant to a public offering (within the meaning of section 4 of the Securities Act of 1933, as amended), regularly traded on an established securities market, or held by or for no fewer than 500 persons at all times during the taxable year;
2. Pursuant to the declaration of the distribution, each shareholder has a cash-or-stock election with respect to part or all of the distribution. The existence of a cash-or-stock election does not affect the federal income tax treatment of the portion, if any, of the declared dividend that is not subject to the election;
3. The Cash Limitation Percentage (i.e., the ratio of (a) the maximum amount of cash to be distributed to all shareholders as limited by the declaration of the dividend to (b) the amount that would be distributed if all shareholders were entitled to, and actually received, 100% cash in the distribution) is not less than 20%;
4. Every shareholder that is not an Excess Cash Claimant (i.e., a shareholder who has elected to receive more of their distribution in cash than the Cash Limitation Percentage) will receive cash equal to the shareholder's elected cash amount;
5. If the aggregate of all the shareholders’ elected cash amounts does not exceed the maximum amount of cash to be distributed to the shareholders pursuant to the declaration, then every Excess Cash Claimant receives cash equal to that shareholder’s elected cash amount;
6. If the aggregate of all shareholders’ elected cash amounts exceeds the maximum amount of cash to be distributed to the shareholders pursuant to the declaration, then each Excess Cash Claimant receives an amount of cash that is as close in amount as practicable to the sum of—
- (a) the product of the Cash Limitation Percentage and the entire distribution to which that shareholder is entitled; and
- (b) a proportionate share of the remaining cash available for distribution after taking into account the above cash distributions based on the Excess Cash Claimants’ remaining cash claims; and
7. The calculation of the number of shares to be received by a shareholder is determined based upon a formula that—
- (a) utilizes the market price of the shares;
- (b) is designed so that the value of the number of shares to be received in lieu of cash with respect to a share corresponds as closely as practicable to the amount of cash to be received under the declaration with respect to that share; and
- (c) uses data from a period of no more than two weeks ending as close as practicable to the payment date.
In a situation where all shareholders submit cash elections (which may be likely in today’s environment), the above formula will result in all shareholders receiving 20% cash and 80% stock, which means that by using this cash or stock election strategy a RIC will make a pro rata cash distribution to its shareholders equal to 20% of the total distribution combined with, in effect, a pro rata stock split.