On December 22, 2010, President Obama signed the “Regulated Investment Company Modernization Act of 2010” (the Act). As the name implies, the Act is intended to update many of the tax rules applicable to regulated investment companies (RICs). The changes made by the Act will give RICs more flexibility in their investment decisions and make it less likely that a RIC will inadvertently fail to qualify for RIC tax treatment under the Internal Revenue Code (the Code). In addition, the Act simplifies many of the procedural and reporting requirements applicable to RICs, simplifies the calculation of the federal excise tax on undistributed earnings of RICs, and conforms the treatment of RICs to the treatment of real estate investment trusts (REITs) in a number of respects. The Act is generally revenue neutral and is expected to be beneficial to most RICs. The provisions of the Act will apply to 2011 and subsequent taxable years.

The most significant changes made by the Act include the following:

-Preferential dividend rule repealed for publicly offered RICs. Under section 852(b) of the Code, RICs generally are allowed to deduct from their investment company income and net capital gains any dividends paid to shareholders. However, this deduction is not allowed if a RIC pays any “preferential dividends.” This preferential-dividend rule generally requires that (i) all dividends be paid pro rata among all holders of the same class of shares, so that all members of the class are treated equally and (ii) all preferences among classes of shares be respected. Although the preferential-dividend rule may prevent shareholders of certain privately held RICs from manipulating their respective shares of a RIC’s earnings, such manipulation is highly unlikely to occur in the case of publicly offered RICs. In the context of publicly offered RICs, the IRS generally has interpreted the preferential dividend rule in a manner intended to protect investors by ensuring that all similarly situated shareholders are treated equally. Because the protection of shareholders of publicly offered securities is generally within the domain of the Securities and Exchange Commission, however, and because the Investment Company Act of 1940 contains its own shareholder protection provisions, the preferential-dividend rule generally is unnecessary to protect shareholders in publicly offered RICs. Accordingly, the preferential-dividend rule as applied to publicly offered RICs largely had become a trap exposing those RICs to potential adverse tax treatment as a result of inadvertent processing or computational errors. To eliminate this potential trap, the Act repeals the preferential-dividend rule with respect to publicly offered RICs. The preferential-dividend rule will continue to apply to privately held RICs.

-Provides a savings provision for certain failures to satisfy the gross income or asset diversification tests. RICs generally must derive 90% of their gross income each taxable year from certain income sources designated under section 851(b)(2) of the Code. In addition, under section 851(b)(3), a RIC must satisfy certain asset diversification tests as of the end of each quarter of its taxable year. Under prior law, if a RIC failed to comply with the