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December 19, 1989
TO: CLOSED-END FUND MEMBERS NO. 68-89
TAX MEMBERS NO. 48-89
UNIT INVESTMENT TRUST MEMBERS NO. 70-89
OPERATIONS COMMITTEE NO. 27-89
ACCOUNTING/TREASURERS COMMITTEE NO. 55-89
TRANSFER AGENT ADVISORY COMMITTEE NO. 31-89
RE: OMNIBUS BUDGET RECONCILIATION ACT OF 1989 (OBRA) ENACTED
__________________________________________________________
The Omnibus Budget Reconciliation Act of 1989 ("OBRA") was
passed by Congress on November 22, 1989; on December 19, 1989,
President Bush signed the Act into law. Many important tax
provisions affecting regulated investment companies ("RICs") are
included in the Act. Most of these provisions are similar to
provisions included in the House and Senate bills. (See
Institute Memoranda to Tax Members No. 42-89, Closed-End Fund
Members No. 61-89, Unit Investment Trust Members No. 58-89,
Accounting/Treasurers Committee No. 46-89, Operations Committee
No. 21-89 and Transfer Agent Shareholder Advisory Committee No.
27-89, dated October 24, 1989; and to Tax Members No. 32-89,
Closed-End Fund Members No. 43-89, Unit Investment Trust Members
No. 49-89, Accounting/Treasurers Committee No. 38-89, Operations
Committee No. 17-89, and Transfer Agent Shareholder Accounting
Advisory Committee No. 24-89, dated September 27, 1989.)
The following is a summary of the provisions of the Act
which affect RICs and their shareholders. The relevant portions
of the Act and the Conference Committee Report are attached.
I. PHANTOM INCOME
1. Phantom Income (Attachment 1)
The Act modifies Code section 67(c) to permanently exclude
"publicly offered regulated investment companies" (as that term
is defined in section 67(c)(2)(B)) from the application of the
phantom income tax. As you know, Congress inadvertently repealed
the phantom income tax last year in the Technical and
Miscellaneous Revenue Act of 1988 ("TAMRA"). (See Institute
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Memorandum to Tax Members No. 59-88, Closed-End Fund Members No.
55-88, Unit Investment Trust Members No. 69-88 and Accounting/
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Treasurer Advisory Committee No. 41-88, dated November 14, 1988).
In OBRA, this year, Congress reinstated the phantom income tax
for certain entities other than publicly offered regulated
investment companies. Specifically, Congress repealed section
67(c)(4), which would have terminated all of section 67(c)
effective January 1, 1990, but did not repeal or place any
termination date on the exception from section 67(c) for publicly
offered regulated investment companies. The effect of the
statutory change is to eliminate the need for further extensions
of the exemption from the phantom income tax for shareholders in
publicly offered regulated investment companies; the exemption is
now permanent.
II. RIC-SPECIFIC PROVISIONS
2. Section 4982 Ordinary Income Distribution Requirement
(Attachment 2).
The Act increases the section 4982 minimum distribution
requirement for ordinary income from 97 percent to 98 percent.
This amendment applies to calendar years ending after July 10,
1989.
3. Sales Load Basis Deferral (Attachment 3).
Section 852 is amended by the Act to require any
shareholder who purchases shares in one RIC (RIC "A"), and either
(i) redeems out of RIC "A" and then reinvests in RIC "A" or (ii)
transfers all or part of the investment in RIC "A" to a second
RIC (RIC "B"), to exclude from the basis of any RIC "A" shares
that are disposed of within 90 days from the purchase date
(rather than 6 months in the Senate bill or 30 days in the House
bill) the sales load incurred in acquiring those shares to the
extent that the sales load on the later-acquired shares is
reduced because a load was previously paid in acquiring the RIC
"A" shares. Any sales charge not included in the basis of RIC
"A" shares will be treated as incurred to acquire the new shares.
However, the new shares acquired will also be subject to this 90
day holding period requirement. This amendment applies to sales
loads incurred after October 3, 1989.
4. Dividend Accrual on Ex-dividend Date (Attachment 4).
The Act amends section 852(b) to require a RIC to treat a
dividend declared with respect to stock owned on the record date
as received on the later of (i) the date the stock owned by the
RIC becomes ex-dividend with respect to such dividend, or (ii)
the date the RIC acquires such stock. If the dividend is not
paid, the RIC will receive a loss when it is established that the
dividend will not be received. This amendment applies to any
dividend where the stock becomes ex-dividend on or after December
20, 1989 (the day after the date of enactment - December 19,
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1989).
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III. RIC-RELATED PROVISIONS
5. Applicable High Yield Discount Obligations (Attachment 5).
The Act bifurcates original issue discount ("OID") on
"applicable high yield discount obligations" into two parts. No
deduction is permissible to the issuer for the "disqualified
portion" of the OID; the deduction for the remainder of such OID
will not be allowable until paid. The holder of an applicable
high yield discount obligation (such as a RIC) will generally
treat the disqualified portion of the OID as a dividend for
purposes of the dividends received deduction.
An "applicable high yield discount obligation" is defined
as, any debt instrument (i) with a maturity date of more than 5
years from the date of issue, (ii) with a yield to maturity that
equals or exceeds the sum of the applicable Federal rate for the
calendar month in which the obligation was issued plus 5
percentage points, and (iii) which has "significant original
issue discount." The disqualified portion of the OID is
generally the portion of the total return on the obligation that
bears the same ratio to the total return as the disqualified
yield bears to the total yield to maturity on the instrument.
The term "disqualified yield" means that portion of the yield
that exceeds the applicable Federal rate for the month in which
the obligation was issued (the "AFR") plus six percentage points.
This provision is effective generally for instruments
issued after July 10, 1989. An assumption by a taxpayer of an
instrument issued by another taxpayer is treated as a new
issuance for purposes of this rule. The effective date rule is
subject to exceptions, however, including one which exempts from
the rule those instruments issued pursuant to the terms of a debt
instrument that was issued before the effective date, such as a
payment-in-kind ("PIK") bond issued after July 10, 1989 as
interest on a PIK bond issued before July 10, 1989.
6. Disqualified Preferred Stock (Attachment 6).
The Act amends section 1059 to treat as an extraordinary
dividend any dividend with respect to "disqualified preferred
stock," i.e., a stock which (i) when issued, had a dividend rate
that declined (or could reasonably be expected to decline) in the
future, (ii) had an issue price that exceeded its liquidation
rights or its stated redemption price, or (iii) was otherwise
structured to avoid the other provisions of section 1059 and to
enable corporate shareholders to reduce tax through a combination
of dividend received deductions and loss on the disposition of
the stock.
The provision is not intended to apply to (i) preferred
stock dividends where the declining dividend rate is due to an
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unforeseen economic downturn in the issuer's business or (ii)
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dividends on floating rate or auction rate preferred stock whose
dividend rate declines solely in response to market changes.
Treatment of a dividend as extraordinary will result in a
reduction in a corporate shareholder's basis in its stock by the
portion of the dividend eligible for the dividends received
deduction. This amendment applies generally to stock issued
after July 10, 1989.
7. Debt/Equity Regulatory Authority (Attachment 7).
The Act clarifies the Treasury Department's regulatory
authority under section 385 to treat an instrument as part stock
and part debt. This authority applies prospectively with respect
to instruments issued after public guidance is released.
8. Reduction in Built-In Gain or Loss Threshold
(Attachment 8).
The Act restricts the use of net unrealized built-in gains
and losses under sections 382 and 384. Under pre-OBRA law, the
limitations on the use of such gains or losses applied only if
the net unrealized built-in gain or loss exceeded 25 percent of
the fair market value of the corporation's assets. Under the
Act, these limitations will apply if the net unrealized built-in
gain or loss exceeds the lower of (1) 15 percent of the fair
market value of the corporation's assets or (2) $10 million.
This provision is generally effective for ownership changes and
acquisitions after October 2, 1989.
9. Foreign Currency Gains and Losses (Attachment 9).
The Act also provides that the income and loss
characterization rules in section 988 apply without regard to
other income tax provisions in the Code. Thus, where ordinary
income and loss characterizations apply pursuant to section 988
to gains and losses from trading section 1256 contracts, the
gains and losses will not be considered gains or losses from the
sale or exchange of capital assets pursuant to section
1256(f)(3). This technical correction has the same effective
date as the Technical and Miscellaneous Revenue Act of 1988
provision it amends, i.e., it applies to forward contracts,
futures contracts, options and similar instruments entered into
or acquired after October 21, 1988.
IV. CIVIL TAX PENALTY REFORM
The Act also makes numerous changes to the Code's civil tax
penalty provisions.
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10. Information Reporting Penalty System (Attachment 10).
Under pre-OBRA law, separate Code sections provided
penalties for (1) failures to supply taxpayer identification
numbers (TINs), (2) failures to file certain information returns,
(3) failures to furnish certain payee statements, and (4)
failures to include correct (non-TIN) information on returns or
statements. The Act restructures the reporting penalties by
providing specific Code sections to penalize (1) failures to file
correct (non-TIN) information on IRS returns, (2) failures to
furnish correct payee statements to shareholders and (3) failures
to comply with other information reporting requirements (such as
the requirement to supply correct TINs on returns and
statements).
Several other changes to the information reporting penalty
provisions are also significant. First, the Act makes two
changes to the TIN reporting provisions. Unlike pre-OBRA law,
where the $50 per failure penalty for filing a return with no TIN
or for including an incorrect TIN on a dividend return or
statement was not limited by any ceiling, the Act caps the
penalty for a payor at $100,000 per calendar year.
A second change modifies the conditions that must be
satisfied to assert a defense to the $50 penalty. Under pre-OBRA
law, only a payor who exercised "due diligence" could assert a
defense against the imposition of the penalty. Under the Act, no
penalty will be imposed with respect to any such failure which is
shown to be due to "reasonable cause" and not to "willful
neglect." Due diligence is described in the House Ways and Means
Committee Report (where this OBRA provision was included) as a
"higher waiver standard" than reasonable cause. The Committee
Report further states that "[t]he committee intends that for this
purpose, reasonable cause exists if significant mitigating
factors are present, such as the fact that a person has an
established history of complying with the information reporting
requirements."
The prior law penalties of $50 for failing to file
information returns with the IRS and for failing to furnish payee
statements to shareholders are combined under the Act with the $5
penalty for failing to include correct (non-TIN) information on
returns or statements in two new penalties: (1) a $50 per failure
penalty for failing to file correct information returns to the
IRS and (2) a $50 per failure penalty for failing to furnish
correct payee statements to shareholders. The Act caps the $50
penalty for failing to file correct information returns to the
IRS at $250,000 and caps the $50 penalty for failing to furnish
correct payee statements to shareholders at $100,000. As under
pre-OBRA law, these failure to file and failure to furnish
penalties will not be imposed with respect to any failure shown
to be due to reasonable cause and not to willful neglect.
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In addition, the penalty for failure to file correct
information returns with the IRS is modified to provide a sliding
scale penalty schedule. Thus, payors are encouraged to file
correct information returns even though such returns might be
filed after the prescribed filing date. The sliding scale penalty
system will not apply to either failures to include correct TINs
on information returns or statements or failures to provide
correct payee statements to shareholders.
The Act also provides that when incorrect information
returns filed with the IRS are corrected on or before August 1 of
that year, the original return will be treated as having been
filed with the correct information. This relief will be limited,
however, to the greater of 10 returns or one-half of one percent
of the total number of returns that are required to be filed by
the person during the calendar year. Failures to include correct
TINs on information returns and statements and failures to
provide correct payee statements to shareholders will not be
eligible for this relief.
Pre-OBRA rules for failures that are due to intentional
disregard of the filing requirements will be retained under the
Act for failures to file correct information returns with the IRS
and will be added for failures to furnish correct payee
statements to shareholders. As under pre-OBRA law, no special
rules will apply to any intentional disregard of the requirements
to supply TINs on returns filed with the IRS or on statements
sent to shareholders.
The information reporting provisions of the Act generally
apply to information returns and payee statements the due date
for which (determined without regard to extensions) is after
December 31, 1989.
11. Delinquency Penalties (Attachment 11).
The Act modifies the penalty for the failure to make timely
deposits of tax in order to encourage depositors to correct their
failures. Under pre-OBRA law, a penalty could be imposed equal
to 10 percent of the amount of the underpayment unless it was
shown that the failure was due to reasonable cause and not
willful neglect. The Act imposes a four-tier penalty structure
under which a depositor's penalty will increase the longer the
underpayment remains uncorrected. As under pre-OBRA law, no
penalty will be imposed if the failure to make a timely deposit
is due to reasonable cause and not willful neglect. This
modification will apply to deposits that are required to be made
after December 31, 1989.
In addition, the Act provides that in cases where a tax on
the U.S. income of a foreign person is required to be withheld,
but has not in fact been withheld, and the person who would have
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been entitled to a credit for any tax withheld has satisfied its
proper tax liability, the withholding agent will remain liable
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for any penalties and additions to tax otherwise applicable for
failure to withhold. This modification applies to failures to
deduct and withhold taxes after December 31, 1989.
12. Administrative Recommendations to the IRS
(Attachment 12).
The House Ways and Means Committee included in their Report
numerous administrative recommendations to the IRS regarding the
information reporting system which are also adopted by the
Conference Committee. The first recommendation, for example,
states that "[t]he IRS should adopt a clear policy of working
with the third-party payor community to assure accurate and
timely filing of information, in a format that is usable by the
IRS and the taxpayer without unduly burdening the third party
that is required to provide this information." Many of the other
recommendations are also relevant.
V. MISCELLANEOUS NON-TAX MATTER
13. HUD Refinancing (Attachment 13)
The recently enacted appropriation bill for the Department
of Housing and Urban Development ("HUD") contains a provision for
HUD to initiate a program to offer incentives for homeowners to
refinance Section 235 FHA-insured loans. It is expected by
Congress that HUD will implement this provision in a manner that
will not unnecessarily impact secondary market operations.
* * *
We will keep you informed of developments regarding this
legislation.
Keith D. Lawson
Assistant General Counsel
Attachments