7925 / What asset diversification tests must a company satisfy in order to qualify to be taxed as a RIC?

A RIC must satisfy two separate asset diversification tests at the close of each quarter of the tax year in order to maintain qualification as a RIC. First, at least 50 percent of the value of the RIC’s total assets must be comprised of (1) cash and cash items (including receivables), (2) government securities, (3) securities of other RICs and (4) “other securities.”¹

“Other securities,” for purposes of this test, are taken into account only if (a) the RIC does not own securities of the particular issuer that exceed 5 percent of the RIC’s total assets and (b) the amount of securities owned by the RIC does not exceed 10 percent of the outstanding voting securities of the issuer.²

The second asset diversification test, which applies even if the 50 percent test outlined above is satisfied, requires that the RIC not invest more than 25 percent of its total assets in the following:

(1)  the securities (other than government securities or securities of another RIC) of any one issuer;

(2)  the securities (other than the securities of another RIC) of two or more issuers that the RIC controls, and which are engaged in the same or similar trades or businesses (or related trades or businesses); or

(3)  the securities of one or more qualified publicly traded partnership.³

The term “control” for purposes of (2), above, means ownership of 20 percent or more of the total combined voting power of all classes of stock entitled to vote.⁴

The regulations provide that two or more issuers will not be treated as though they are “engaged in the same or similar trades or businesses” merely because they are both engaged in the same broad field of manufacturing (or any other general industry classification). They will be treated as though engaged in the same or similar trade or business if they are engaged in a “distinct branch of business,” so that they produce or deal in the same type of product or service, and these products or services fulfill the same economic need. If the issuer(s) in question produces more than one type of product or service, the principal product or service will be used to determine whether the issuers are engaged in the same or similar trade or business.⁵

For purposes of this second asset diversification test, a proportion of investments made by members of a controlled group may also be included in determining whether the 25 percent threshold has been crossed. In this context, a controlled group is a chain of corporations connected through stock ownership with the RIC, if (1) 20 percent or more of the combined voting power of all classes of each corporation (except the RIC) is owned directly by one or more of the other corporations and (2) the RIC directly owns 20 percent or more of the combined voting power of all classes of stock entitled to vote of at least one of the other corporations.⁶

The IRS has recently released regulations that clarify that controlled groups may only consist of two entities, rather than two levels of entities. Therefore, a wholly owned subsidiary of a RIC is a member of the RIC’s controlled group whether or not the subsidiary controls another
entity.⁷