1 USA Taxation FUNDS AND FUND MANAGEMENT Taxation of funds Taxation of regulated investment companies: income tax Investment companies in the United States (US) are structured either as openend or closed-end management companies, as unit investment trusts or as business development companies, each of which must be organized in the US. An open-end fund redeems its shares on demand at net asset value, while a closed-end fund does not redeem its outstanding shares on demand; rather, its shares trade on the open market at prices that may differ from the fund s underlying net asset value. Both open-end and closed-end investment funds are typically structured as separate legal entities which are normally organized in the US as corporations or as business trusts. However, a corporation or business trust could be used as a legal vehicle to house one or more funds, each of which would be eligible for treatment as a separate taxpayer for US tax purposes. Open-end and closed-end funds (the latter of which typically includes unit investment trusts and business development companies) have characteristics such that they are treated as corporations for tax purposes. Subject to the requirements discussed below, these entities may elect regulated investment company (RIC) tax status. Unlike most other corporations, a RIC is permitted to deduct dividends distributed to its shareholders. The ability to deduct dividends paid generally enables a RIC to avoid tax on its net investment income and net capital gains to the extent any such undistributed amounts are distributed within certain time parameters. If certain requirements are met, a RIC s dividends can retain the character of the earnings from which such earnings are paid. This pass-through treatment, however, is only available for the RIC s dividend income, net capital gains, federally tax-exempt interest income, foreign source income, and certain dividends derived from the RIC s US source interest income and/or short-term capital gains earned by the RIC s non-us shareholders. In addition, state and local taxing jurisdictions generally allow for the pass-through of the character of interest income on direct obligations of the US (e.g., obligations issued by the US Treasury) earned by a RIC and distributed as dividends to the RIC s shareholders for purposes of determining the RIC shareholder s state or local income tax liability. In order to first qualify as a RIC and thereby obtain such preferential tax treatment, the company must pass certain tests on asset composition, type of income generated, and amount of dividends distributed to its shareholders. A RIC must meet these asset composition tests on a quarterly basis. First, at 1
2 2 United States of America Taxation least 50% of the value of the RIC s total assets must consist of cash and cash items, US Government securities, securities of other RICs, and certain other securities in which the RIC has limited (1) its investment in any one issuer to 5% of the RIC s total asset value and (2) its holdings in any one issuer to 10% of the issuer s outstanding voting stock. Second, no more than 25% of the value of the RIC s total assets may be invested in the securities (other than US Government securities or the securities of other RICs) of any single issuer, or the securities of two or more issuers that the RIC controls (20% ownership) and that are engaged in the same, similar or related trades or businesses. A RIC may pass through the character of federally tax-exempt interest from federally tax-exempt state, local and municipal bonds, qualified scholarship funding bonds and other federally tax-exempt obligations through dividends the RIC pays to its shareholders if at least 50 percent of the values of the RIC s assets consist of such obligations at the close of each taxable quarter. In addition, if at least 50 percent of a RIC s assets consist of securities of non-us corporations (including non-us governments), the character of non-us source income and related non-us taxes paid or withheld on such investments may be passed through dividends paid to the RIC s shareholders (see a further discussion of these rules, below). Furthermore, a RIC may pass through the character of any US source interest income which, if earned directly by a non- US person, would not be subject to US nonresident withholding tax, plus any net short-term capital gains earned and distributed by the RIC as dividends to its non-us shareholders. The portion of a RIC s dividends derived from such amounts would not be subject to US nonresident withholding taxes. However, this exemption from US nonresident withholding taxes no longer applies with respect to RIC taxable years beginning after 31 December A RIC is also subject to an income test which provides that at least 90% of the RIC s gross income must consist of passive income, which includes dividends, interest, gains from sales of securities and certain currency transactions, and certain other investment income. Finally, a RIC is subject to a distribution test which requires the fund to distribute, as dividends, at least 90% of the sum of its investment company taxable income, or ICTI (generally referring here to its net investment income including net short-term capital gains plus 90% of its net income from taxexempt obligations, such as federally tax-exempt or municipal bonds). There is no distribution requirement for net capital gains (defined as the excess of net long-term gain over net short-term loss) realized by the RIC. However, a RIC is subject to a 35% tax on any undistributed net capital gains. Although the 90% distribution benchmark is sufficient to qualify for RIC status and thereby receive a dividends paid deduction, a RIC must still distribute 100% of its ICTI and net capital gains (if any) to avoid paying tax. Any undistributed ICTI is generally taxed at the corporate level at the following rates in effect for taxable years ended or ending during calendar year 2010:
3 3 United States of America Taxation ICTI Tax Rate $0-50,000 15% $50,001-75,000 25% $75, ,000 34% $100, ,000 39% $335,001-10,000,000 34% $10,000,001-15,000,000 35% $15,000,001-18,333,333 38% Over $18,333,334 35% If a fund fails to qualify as a RIC, all of its ICTI and net capital gains (without regard to the dividends paid deduction) will be taxed at the corporate level at the above rates. In addition, if a fund investing primarily in tax-exempt obligations fails to qualify as a RIC, its net tax-exempt income (without regard to a dividends paid deduction) will be taxed at the federal alternative minimum tax rate of 20%. In these circumstances, distributions of such income generally will be taxable as ordinary dividend income to shareholders. Once a fund qualifies as a RIC, there are other distribution requirements that must be satisfied to avoid paying a separately-imposed, entity-level excise tax (see discussion under Other Taxes and Expenses). A RIC may elect to have its shareholders include in income, as a long-term capital gain (alternatively generally referred to as a net capital gain), each shareholder s proportionate amount of the RIC s undistributed net capital gain. This inclusion generally occurs in the tax year following the year in which such gains were actually earned by the RIC. To prevent double taxation, the RIC s shareholders concurrently are given a credit for the tax that the RIC paid on their proportionate shares of such undistributed capital gain. The shareholders are then entitled to increase their basis in their RIC stock by 65% (100% -35% tax rate) of the pro rata share of undistributed net capital gain. The RIC s earnings and profits (which generally equals taxable income, plus or minus certain adjustments, and which is commonly referred to as E&P) are reduced by the amount of undistributed net capital gain designated for inclusion in the income of its shareholders. Since a RIC can distribute taxable dividends only to the extent of its E&P, future distributions of retained net capital gain that have been designated for current inclusion by the shareholders generally would not be taxed to the shareholders as either an ordinary or capital gain distribution. However, if a RIC fails to designate undistributed net capital gain for current inclusion by its shareholders, future distributions of the undesignated amount could be taxed as ordinary dividends to the shareholders, thus resulting in double taxation. Taxation of funds: other taxes and expenses In addition to income tax, a RIC is subject to an entity-level excise tax if distributions during any calendar year are below the sum of 98% of the RIC s ordinary income earned during the calendar year plus 98% of its capital gain net income (a netting of both short and long-term gains and losses) realized from 1 November of the preceding calendar year to 31 October of the current calendar year, plus 100% of any undistributed amount from a prior calendar year. Certain foreign currency gains and losses as well as certain gains and losses from a
4 4 United States of America Taxation RIC s transactions in passive foreign investment company ( PFIC ) shares, discussed below, are also generally required to be determined on the basis of a twelve-month period ended 31 October. However, a RIC can elect to determine the portion of its required distribution from capital gain net income as well as certain foreign currency and PFIC gains and losses using its taxable year-end if its taxable year ends in November or December. Excise tax is assessed at a rate of 4% on the excess of this required distribution over the distributions actually made during the calendar year. RICs generally incur registration expenses both upon the creation of the fund and annually thereafter. These fees may be owed to an agency of the Federal Government or the particular state in which a RIC is registered to do business. Unless incurred during the first 90 days after a RIC s registration statement is first declared effective under the Securities Act of 1933 (the initial stock offering period), the expenses may be deducted as ordinary and necessary business expenses of the fund in arriving at ICTI. Registration fees incurred during the initial stock offering period are held to be expenses of acquiring capital necessary to do business and thus, as is the case for other corporations, are treated as nondeductible and non-amortizable capital expenditures. Certain other expenses incurred incidental to the formation and organization of a fund may be capitalized and amortized over a period of 180 months or more as organizational expenditures. Organization expenditures of $5,000 may be immediately expensed by the fund with the balance amortized over a minimum 180-month period. The $5,000 amount allowed to be immediately expensed is reduced where the total organizational expenditures exceed $50,000. Examples of organizational expenditures include legal fees for drafting the corporate charter and by-laws, expenses of organizational meetings of the board of directors and accounting fees directly related to the creation of the corporation. Specifically excluded from the definition of organizational expenditures are stock issuance expenses as discussed above. There are no federal income or excise taxes payable upon the issuance of stock, both at the inception of a fund and thereafter. However, certain states impose a license fee or other tax based on the fund s capital. For example, the State of New York imposes a license fee on companies doing business within New York but incorporated elsewhere. The fee, which is based on percentages of both the par value of issued and outstanding shares and the number of issued and outstanding no-par shares, is payable upon the creation of the fund, as well as upon subsequent issuances of new capital. Taxation of funds: other issues RICs that are organized as corporations generally may choose any accounting/tax period year-end. The duration of the tax year generally is limited to 12 months. If certain requirements are met, however, taxpayers may select a tax year that varies in length from 52 to 53 weeks. Although a RIC organized as a corporation may initially select any year-end for its tax period, the RIC generally must also maintain records on a calendar year basis for ordinary income and on a 1 November through 31 October basis for capital gain net income and net foreign currency and/or PFIC transaction gain or loss in order to comply with the excise tax rules discussed above.
5 5 United States of America Taxation Under the tax law, shareholders in a RIC are treated as receiving income only when distributions are actually or constructively received, not when income is earned by the RIC. For purposes of determining when income is subject to tax, distributions are generally taxed to the shareholders in the year received by the shareholder, with the exception of dividends that are declared by the RIC during October, November or December but paid by the end of January of the succeeding calendar year. These dividends are treated as having been paid and received on December 31 st of the calendar year in which such dividends are declared by the RIC and are taxed to the shareholders during that respective calendar year. 3.2 Taxation of resident unit holders/investors in a resident fund Distributions to RIC shareholders from ICTI generally are taxed at the shareholder level as ordinary dividends, while distributions of net capital gains are taxed on shareholders as long-term capital gains. The applicable rates of tax at this level depend on whether the shareholder is an individual or a corporation. The following individual income tax rates are in effect for tax years ended or ending during the 2010 calendar year:* Single Married Filing Jointly Taxable Income Taxable Income Rate $0-8,375 $0-16,750 10% $8,376-34,000 $16,751-68,000 15% $34,001-82,400 $68, ,300 25% $82, ,850 $137, ,250 28% $171, ,650 $209, ,650 33% Over $373,650 Over $373,650 35% * See previously mentioned rates applicable to corporations. The maximum US personal income tax rate imposed on long-term capital gains generally equals 15%. Property (including securities) must be held for greater than twelve months in order to qualify for long-term capital gains treatment. This reduced tax rate generally will apply to sales and exchanges of RIC shares and the receipt of RIC capital gain dividends. Furthermore, certain qualified dividend income (QDI) earned by US resident individuals before 2011 is subject to a maximum US tax rate of 15%. QDI is generally defined to include dividends from US domestic corporations, dividends from corporations organized in a US possession, dividends from corporations organized in certain countries maintaining adequate exchange of tax information treaty provisions, and dividends from foreign corporations, the stock of which is readily tradable on an established securities market in the US (e.g., stock traded as an ADR). However, substitute payments received in lieu of QDI (e.g., income arising from securities lending transactions) will not be treated as QDI. Certain corporate shareholders may be entitled to exclude from income all or a portion of RIC s distributions of ICTI as dividends eligible for the corporate dividends receive deduction (DRD). In addition, individual US resident shareholders may be entitled to treat all or portion of a RIC s distributions from ICTI as QDI to the extent that the RIC s underlying investments generate QDI. The RIC must designate the percentage of the distribution as eligible for the DRD and/or QDI. A RIC may not pass through the character of dividends eligible for the
6 6 United States of America Taxation DRD from qualifying US corporate issuers unless the RIC held such stock for at least 46 days during the 91-day period that begins 45 days before the stock becomes ex-dividend with respect to that dividend. The holding period for dividends on preferred stock attributable to a period or periods in excess of 366 days is increased to 91 days during the 180-day period that begins 90 days before the stock becomes ex-dividend with respect to that dividend. With respect to dividends eligible from treatment as QDI, a shareholder must hold the shares of a qualified issuer for at least 61 days during a 121-day period beginning 60 days before the shares became ex-dividend. In the case of preferred shares of a qualified issuer, the holding period should be a period of at least 91 days during a 181-day period beginning 90 days before the shares became ex-dividend. A RIC and its shareholders must independently apply these measuring periods in determining what portion of its dividends from ICTI can be designated as QDI. Income and gains of a RIC earned from securities of US resident issuers are generally not subject to withholding. However, RICs holding or transacting in foreign securities may be subject to withholding at source on investment income and, in certain instances, on any gains from the sale or other disposition of certain foreign securities. In this case, foreign taxes paid by a RIC in the form of withholding can be deducted by the RIC in computing ICTI as long as income is grossed-up by the amount of foreign taxes withheld. There may be additional tax consequences if a RIC invests in a foreign corporation which qualifies as a passive foreign investment company (see section 3.3). A RIC in which more than 50% of the value of total assets consists of investments in stock or securities of foreign corporations may elect to pass through to its shareholders the ability to deduct or take a credit for foreign taxes paid by the RIC. In this case, shareholders would include as income their proportionate share of foreign taxes paid by the RIC and then take an offsetting deduction or foreign tax credit. A RIC shareholder may only claim a foreign tax credit with respect to RIC shares if the shareholder has held such shares for a period of at least 16 days during the 30-day period beginning 15 days before the ex-date of the dividend with respect to which the foreign tax is paid. Similarly, a RIC in which more than 50% of the value of total assets consists of federally tax-exempt obligations may elect to pass through to its shareholders the federally tax-exempt interest it earns on those obligations. 3.3 Taxation of resident unit holders/investors in a non-resident fund US shareholders of foreign corporations generally are not taxed on income of such corporations until earnings are repatriated in the form of distributions. However, certain provisions have been established to limit or even eliminate the ability of US shareholders of foreign corporations to defer tax. The most significant anti-deferral provision for RICs involves the treatment of interests in PFICs. A foreign corporation generally will be considered a PFIC if it meets either an income or an asset test. A foreign corporation is a PFIC under the income test if 75% or more of the corporation s gross income is passive in
7 7 United States of America Taxation nature, consisting of (but not limited to) dividends, interest, rents, and royalties. Under the asset test, a foreign corporation is a PFIC if 50% or more of the value of the corporation s total assets are assets which generate passive income or are held for the production of passive income. However, if the foreign corporation meets the definition of a controlled foreign corporation (CFC), then the asset test is determined using the adjusted bases of the foreign corporation s assets rather than fair market value. A CFC is generally any foreign corporation if more than 50% of either the total voting power or value of its stock is owned, directly or indirectly, by US shareholders. If the foreign corporation is a PFIC, a US shareholder is taxed in one of three ways. Absent making any of the PFIC tax elections discussed below, a US shareholder is not taxed currently on any income or gains earned by the PFIC. Once the shareholder either receives an amount considered to be an excess distribution or sells part or all of the PFIC stock, any such distribution or gain is subject to US taxation, respectively as ordinary income or ordinary gain, and an additional amount is assessed on this excess distribution or gain as an interest charge which is determined based upon the shareholder s holding period in such PFIC stock. Alternatively, if the US investor makes a qualifying electing fund (QEF) election, the taxpayer s pro rata share of a PFIC s E&P, determined in accordance with US tax principles, will be taxed currently. Under this approach, the portion of such E&P attributable to net capital gains of the PFIC retains its character as earned by the shareholder. Basis in the PFIC stock is increased to the extent of income recognized by the shareholder and decreased when distributions are received. Furthermore, a gain on the sale of PFIC stock is generally a capital gain if the QEF election has been made. The reason that this approach is not commonly used is that information required to make the QEF election is often difficult to obtain within the time prescribed for making the election. Finally, US tax rules allow US shareholders (including RICs) of a PFIC to make a mark-to-market election with respect to the stock of the PFIC if such stock is marketable (PFIC stock held directly or indirectly by a RIC is deemed marketable for purposes of this election). This mark-to-market election requires that all mark-tomarket gains be recognized as ordinary income. These rules also provide that markto-market losses may be recognized only to the extent of previously recognized mark-to-market gains. Gains from the sale of PFIC stock will be ordinary income. Mark-to-market losses and losses realized on the sale of PFIC stock to the extent of previously recognized PFIC mark-to-market gains will be ordinary losses. 3.4 Taxation of non-resident unit holders/investors in a resident fund Generally, foreign investors in US RICs are subject to US withholding on distributions of ICTI. Taxes are generally withheld at a rate of 30%, but this rate may be reduced or eliminated through a treaty between the US and the nonresident s home country. A foreign corporation that invests in a US RIC is generally subject to withholding tax at 30% (or less by treaty) on distributions of ICTI if such income is not effectively connected with a US trade or business. If income is effectively connected with a US trade or business, the corporation is subject to US tax on its taxable income at the previously mentioned
8 8 United States of America Taxation graduated US corporate rates. However, US tax regulations require persons receiving US source income to certify their US residency or nonresidency in order to reduce or (where applicable) eliminate US withholding taxes on such income. Long-term capital gains distributed by a RIC or capital gains recognized by a non-us resident holder of RIC shares upon the sale or other disposition of such RIC shares generally will not subject to non-us withholding taxes unless the non-us resident RIC shareholder (assuming an individual shareholder) is present in the US for at least 183 days during a calendar year. If the investor meets this requirement, taxes will be withheld at a rate of 30%, or less if reduced by a treaty. Individual non-us resident shareholders may also be subject to gift and estate taxation with respect to shares of a US RIC unless treaty provisions eliminate the tax. The tax is imposed using a graduated rate system, which ranges from 18%-55% for levels of gifts and/or taxable estates from $10,000-$3,000,000. It should be noted that the US estate tax was repealed, effective 1 January 2010; however, the repeal of the US estate tax applies only for the 2010 calendar year. Absent enactment of legislation to the contrary prior to 1 January 2011, the US estate tax will return with a maximum estate tax rate of 55% on gross estates. The maximum US gift tax rate for taxable gifts made during the 2010 calendar year is 35% even though the US estate tax is considered to have been repealed for the 2010 calendar year. Absent enactment of legislation to the contrary prior to 1 January 2011, the US gift tax rate will increase to a maximum 55% tax rate. 3.5 Taxation of fund management/custodian companies The fund manager or investment adviser is typically organized as a corporation, subject to the regular corporate tax rules. Sometimes, however, the manager or investment adviser is organized as a partnership or a limited liability company (LLC), and this structure may be treated as a pass-through entity for tax purposes. 3.6 Entitlement to income With respect to funds taxed as corporations, income arises to the unit holder when it is distributed to the unit holder. Where a fund is taxed as a partnership or LLC, income arises to the unit holder as of the last day of the fund s tax year. 3.7 Double tax agreements Treaty benefits may exist for non-resident funds and/or their investors earning US-source income Non-US resident funds and non-us resident alien individuals generally are subject to US withholding tax on US-source fixed or determinable periodic income (interest, dividends, rents, annuities, etc.) if such income is not effectively connected with the conduct of a US trade or business. Tax is generally withheld at a rate of 30% or less if reduced (or eliminated) by treaty. However, non-us resident alien fund investors are subject to documentation
9 9 United States of America Taxation requirements that need to be satisfied in order to obtain any reduced rate benefits under a US treaty or an exemption from US withholding taxes. Non-US resident funds generally are not subject to US withholding tax on capital gain net income, while non-us resident alien individuals may be subject to US withholding tax on capital gain net income depending on the duration of US residency (see previous discussion). Treaty benefits are available for US-source income paid to foreign residents of a country with which the US has an income tax treaty. Under the US Model Income Tax Treaty, a resident is a person; defined as an individual, estate, trust, partnership, corporation or other body of person; liable for tax in a country based on domicile, residence, citizenship, place of management, place of incorporation or other similar criteria. Therefore, a non-resident fund generally would qualify as a resident of a foreign country and would be entitled to treaty benefits. Despite the fact that the definition of residence has traditionally been broad, in present negotiations with treaty partners, the US, in an effort to prevent treaty shopping, is attempting to modify existing treaties to include a limitation of benefits article. Under this treaty article, treaty benefits would be denied to persons who lacked substantial nexus within any countries governed by such treaty article. If treaty benefits were denied a non-resident fund under the limitations of benefits article, it is unclear whether unit holders would be entitled to benefits under the treaty between the US and the country of residence with which they do have substantial nexus. This uncertainty arises because the disallowance stems from a limitation on treaty benefits and not on the failure to qualify as a resident under the treaty. Treaty benefits also may exist for resident funds receiving non-us source income Resident funds, which are treated as corporations for tax purposes, are entitled to the benefits of income tax treaties between the US and foreign countries on capital gain dividends as long-term capital gains. 3.8 Other tax-favored vehicles Other US investment entities which allow a wide range of investors to participate include hedge funds and private equity funds, real estate investment trusts (REITs), and real estate mortgage investment conduits (REMICs). A hedge fund is a collective investment scheme, generally organized as a partnership or LLC, and is structured to employ one or more particular investment strategies for its investors. A private equity fund is also a collective investment scheme, generally organized as a partnership or LLC, which pools capital for investment in privately owned businesses at different stages of their development. Because both hedge funds and private equity funds are generally treated as flow-through entities for US tax purposes, they are generally not subject to entity-level US taxation. Instead, entity-level income, deductions, gains, and losses are passed directly onto their investors who would ultimately evaluate whether they are subject to tax on their distributive share of such income, deductions, gains, and losses.
10 10 United States of America Taxation A REIT is a corporation, trust or association serving as a conduit through which income from real estate investments can be distributed to investors in the form of dividends as a means of precluding REIT-level taxation. Investors in a REIT, like shareholders of a RIC, are taxed on distributions of ordinary income as dividends and on capital gain dividends as long-term capital gains. A REMIC can be organized as a corporation, partnership, trust or other business entity, the assets of which consist of a pool of mortgages. The income from a REMIC flows through to its investors. Therefore, as a conduit, a REMIC generally is not subject to tax; rather, income earned by the REMIC is taxed at the investor level. 3.9 Transfer taxes, stamp duty, capital duty With respect to trading foreign securities, there are usually no transfer duties payable by a fund upon the purchase or sale of securities of foreign corporations Miscellaneous None. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation KPMG LLP, a United States legal liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.