SECTION 2. BACKGROUND

For individuals, estates, and trusts, § 1(h) imposes differing rates of tax on net capital gains depending on the type of

transaction in which the gains arise and on the taxable income of the taxpayer. The types of transaction in which a capital gain arises may cause the gain to fall into one of three rate groups: a 28-percent group (generally, gains from collectibles), a 25-percent group (generally, unrecaptured section 1250 gain), and a 20-percent group (most other net capital gain). Gains from transactions in the 20-percent group may be taxed at a 20-percent rate, a 15percent rate, or a 0-percent rate, depending on the taxpayer’s taxable income. ²

Certain gains from the sale or exchange of qualified small business stock held for more than five years are subject to a partial exclusion under § 1202(a) and a 28percent rate on the non-excluded portion under § 1(h)(7).

The Secretary has authority to issue regulations concerning the application of § 1(h) to sales and exchanges by (and of interests in) pass-thru entities, including RICs. See § 1(h)(9).

Under § 852(b)(3), a RIC that has net capital gain for a taxable year may distribute capital gain dividends to its shareholders. A capital gain dividend is a dividend, or part thereof, that is properly reported as such by the RIC in written statements furnished to its shareholders. In general, a capital gain dividend paid by a RIC is treated by the shareholders that receive it as a gain from the sale or exchange of a capital asset held for more than one year.

If a RIC’s net capital gain for a taxable year exceeds its deduction for dividends paid determined with reference to capital gain dividends only, then the RIC is subject to tax as determined under § 1201(a) on that excess. See § 852(b)(3)(A). Under § 852(b)(3)(D), the RIC may designate an amount of “undistributed capital gains” with respect to its shares. The RIC’s designation must be in a written notice mailed to the RIC’s shareholders prior to the expiration of 60 days after the close of the RIC’s taxable year. As a result of this designation, all of the following occur:

1Some relevant provisions of § 852 that were amended by the RIC Modernization Act were further amended by technical corrections in the Tax Increase Prevention Act of 2014, Pub. L. No. 113–295, 128 Stat. 4010. The descriptions in this notice of the affected provisions generally treat the corrections as if they were made at the time of the enactment of the RIC Modernization Act.

2See § 1(h). The description of the rate groups reflects amendments to § 1(h) after the publication of Notice 97–64. These post-1997 amendments were contained in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “JGTRRA”), Pub. L. No. 108–27, 117 Stat. 752, and the American Taxpayer Relief Act of 2012 (the “ATRA”), Pub. L. No. 112–240, 123 Stat. 2313.

3The RIC’s net capital gain for a taxable year determines the amount of capital gain dividends that may be treated as distributed with respect to that taxable year. Thus, the RIC’s net capital gain for the taxable year affects not only dividends that are treated by shareholders as paid during the year but also dividends governed by either § 855 or § 860.

June 15, 2015 1058 Bulletin No. 2015–24

§ 852(b)(3)(C) to disregard any net capital loss or net long-term capital loss attributable to transactions after October 31 of the taxable year. Any such post-October net capital loss or net long-term capital loss was treated for those purposes as arising on the first day of the next taxable year. For purposes of determining a RIC’s taxable income, however, § 1.852–11(f) of the Income Tax Regulations provided for elective deferral of any portion of the post-October net capital loss or net longterm capital loss.

Notice 97–64 describes rules under which a RIC may make additional designations of capital gain dividends and undistributed capital gains to reflect the various rate groups under § 1(h). That notice also establishes a bifurcation adjustment under which a RIC is required in certain circumstances to bifurcate its taxable year into a pre-November portion and a postOctober portion for purposes of determining the appropriate additional designations of capital gain dividends that the RIC may make with respect to that taxable year. Gains and losses are netted separately for each portion of the taxable year. The purpose of the bifurcation adjustment is to prevent post-October losses from causing pre-November gains to be recharacterized as gains from another rate group after the RIC has—

• Taken the pre-November gains into account in a calculation of the required distribution described in § 4982(b);

• Made one or more late-December distributions to its shareholders that appeared necessary under that calculation to avoid excise tax under § 4982(a); and

• Made one or more reports to shareholders regarding those distributions reflecting the conclusions of the calculation.

Notice 2004–39 explains in part how changes to § 1(h) made by the JGTRRA apply to certain RIC capital gain dividends. Notice 2004–39 provides that the rules described in Notice 97–64 continue to apply to RIC capital gain dividends, subject to appropriate modifications to

take into account later changes to § 1(h). The changes to § 1(h) made by the ATRA generally did not affect the conclusions in Notice 2004–39.

Sections 871(k)(2) and 881(e) allow a RIC to report as short-term capital gain dividends certain dividends paid to nonresident aliens and foreign corporations. ⁴

Prior to the amendment of § 871(k)(2) by the RIC Modernization Act, a RIC was required to determine the amount of shortterm capital gain dividends for a taxable year without regard to any net capital loss or net short-term capital loss attributable to transactions after October 31 of the year. Any such net capital loss or net shortterm capital loss was treated as arising on the first day of the next taxable year.

Section 308 of the RIC Modernization Act made two significant changes affecting the deferral by a RIC of capital losses arising in the portion of a taxable year after October 31. First, it made the deferral of eligible losses elective for all purposes. Under § 852(b)(8)(A), a RIC may elect to defer any portion of its eligible losses, and that election applies for purposes of computing both the RIC’s taxable income and the maximum amounts the RIC may distribute as capital gain dividends under § 852(b)(3)(C) and short-term capital gain dividends under §§ 871(k)(2)(C) and 881(e)(2). See § 852(b)(8)(A). Second, the RIC Modernization Act expanded the category of capital losses that may be deferred. A RIC’s elective deferral applies to its “late year ordinary loss,” which includes any “post-October capital loss.” A post-October capital loss includes not only a net capital loss, or net long-term capital loss, attributable to the portion of the taxable year after October 31, but also a net short-term capital loss attributable to that portion of the taxable year. See § 852(b)(8)(C).

In describing this provision, the Staff of the Joint Committee on Taxation explained that the principles of § 1.852–11 are to apply to the elective deferral of a qualified late-year loss, which includes a post-October capital loss, subject to any subsequent change in the regulations. See Staff of Joint Committee on Taxation,

General Explanation of Tax Legislation Enacted in the 111th Congress (JCS–2– 11), March 2011, at 682 n.1913. Section 1.852–11(f) provides that, if a RIC elects to defer all or a portion of a post-October capital loss, its taxable income for the taxable year in which that loss arose is determined by including none of the capital gains or losses that were taken into account in computing the post-October capital loss, except for capital losses that equal in the aggregate the amount of the post-October capital loss that is not deferred. Any such non-deferred loss is treated as consisting first of any shortterm capital losses to the extent thereof and then of any long-term capital losses taken into account in computing the postOctober capital loss.