Interpretive Letter to Wallace W. Kunzman, Jr., Kunzman & Bollinger, Inc.

Direct Participation Programs Representatives are eligible to sell shares of a non-listed business development company that qualifies as a regulated investment company under the Internal Revenue Code at the time of sale.


December 1, 2014

Mr. Wallace W. Kunzman, Jr.
Kunzman & Bollinger, Inc.
5100 N. Brookline, Suite 600
Oklahoma City, OK 73112

Re: NASD Rule 1032(c) - Direct Participation Programs Representatives

Dear Mr. Kunzman:

This is in response to your letter dated June 11, 2014, in which you request interpretive guidance on behalf of Realty Capital Securities, LLC, a FINRA member, regarding whether Direct Participation Programs Representatives are eligible to sell shares of a non-listed1 business development company (“BDC”) that has elected to be taxed as a regulated investment company (“RIC”).

Background

Based upon your letter and our subsequent conversations, we understand the facts to be as follows.  BDCs were created by Congress in 1980 as a special category of pooled investment vehicles designed to facilitate access to capital and financing for small and growing companies.2 BDCs are domestic closed-end investment companies regulated under the Investment Company Act of 1940 (“Investment Company Act”).3 However, BDCs are not registered under the Investment Company Act.  To obtain BDC status, a company must elect pursuant to Section 54(a) of the Investment Company Act to be subject to the provisions of Sections 55 through 65 of the Investment Company Act.  The company must then file a Form N-6F (Notice of Intent to Elect to be Subject to Sections 55 through 65 of the Investment Company Act of 1940) and a Form N-54A (Notification of Election to be Subject to Sections 55 through 65 of the Investment Company Act of 1940 Filed Pursuant to Section 54(a) of the Act) with the Securities and Exchange Commission.

BDCs are required to register a class of their equity securities under Section 12 of the Securities Exchange Act of 1934 (“Exchange Act”), and they are required to file periodic reports under the Exchange Act similar to public companies.  BDCs may also be registered under the Securities Act of 1933 by registering a class of securities on Form N-2 (Registration Statement for Closed-End Management Investment Companies).  In addition, a BDC may be listed on a national securities exchange, or it may be non-listed.  Further, a non-listed BDC eventually may be listed on a national securities exchange as a result of a future liquidity event.

Section 55(a) of the Investment Company Act prohibits a BDC from acquiring any assets unless, at the time the purchase is made, specified eligible assets represent at least 70% of the BDC’s total assets (other than non-investment assets used to conduct the BDC’s operations).  Eligible assets include securities purchased from an issuer that is an “eligible portfolio company,”4 cash, cash items, government securities or high quality debt securities maturing in one year or less.  In addition, a BDC is required to offer, and provide upon request, “significant managerial assistance” to any portfolio company whose securities are included in the 70% portfolio.5 BDCs may be internally or externally managed.

To eliminate or reduce entity-level taxation for federal income tax purposes, BDCs typically organize as: (1) limited partnerships; or (2) corporations that elect to be taxed as RICs under Subchapter M of the Internal Revenue Code (“IRC”).  The IRC defines a RIC as any domestic corporation that, at all times during the taxable year, is either registered under the Investment Company Act as a management company or unit investment trust, or has elected to be treated as a BDC under the Investment Company Act.6

To qualify as a RIC, a company must, among other requirements,7 distribute to its shareholders each year at least 90% of its investment company taxable income, which generally refers to its net ordinary income plus the excess, if any, of realized net short-term capital gains over realized net long-term capital losses, and 90% of its net tax-exempt interest income.8  Further, a RIC may choose to distribute more than 90% of its investment company taxable income and net tax-exempt interest income.  In addition, while not required to do so, a RIC may also distribute to its shareholders its net capital gain, which is the excess of its net long-term capital gain over its net short-term capital loss. 

A RIC is not subject to entity-level federal income tax on income and capital gains that are distributed to the company’s shareholders as dividends because it is permitted to deduct such dividends in computing its tax.9  However, a RIC will be taxed at the entity level on any taxable income or capital gains that it retains.10  Shareholders that receive distributions of a RIC’s income and capital gains are subject to income tax on the distributions generally as ordinary income or long-term capital gains.

You seek guidance on whether Direct Participation Programs Representatives are eligible to sell shares of a non-listed BDC that is qualified as a RIC at the time of sale.

Response

Pursuant to NASD Rule 1032(c), a representative may register as a Direct Participation Programs Representative if the representative’s11 activities are limited solely to the solicitation, purchase or sale of equity interests in or debt of a direct participation program (“DPP”) as defined in NASD Rule 1022(e)(2) and the representative passes an appropriate qualification examination.12 The Series 22 examination qualifies an individual to function as a Direct Participation Programs Representative.

NASD Rule 1022(e)(2) defines a DPP as a program that provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution, including, but not limited to, oil and gas programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof.  The definition of a DPP excludes a real estate investment trust (“REIT”), tax qualified pension and profit sharing plans pursuant to Sections 401 and 403(a) of the IRC and individual retirement plans under Section 408 of the IRC, tax sheltered annuities pursuant to the provisions of Section 403(b) of the IRC and any company including separate accounts registered pursuant to the Investment Company Act.  The definition also excludes any program that is listed on a national securities exchange or any program for which an application for listing on a national securities exchange has been made. 

An entity receives flow-through tax treatment for purposes of NASD Rule 1022(e)(2) if it is not taxed at the entity level for income and capital gains distributed to investors as dividends, but rather the tax consequences flow through to its investors.  Moreover, an entity is not required to receive complete flow-through tax treatment for purposes of the rule.  For example, the rule expressly includes Subchapter S entities, which are taxed at the entity level on their built-in gains and excess net passive income, among the types of programs that provide for flow-through tax treatment.

As described above, a RIC is not subject to federal income tax on income and capital gains distributed to its shareholders because it can deduct them when computing its tax, but it will be taxed at the entity level on any taxable income or capital gains that it retains.  Therefore, a RIC is effectively able to eliminate its tax on its income and capital gains distributed to shareholders through a distribution deduction.  While a RIC is not a flow-through entity in a traditional sense, it may obtain flow-through tax status on distributed taxable income and capital gains as a result of a distribution deduction.13 Moreover, a RIC is required to distribute as dividends to its shareholders at least 90% of its taxable income each year.  In addition, a RIC may distribute to its shareholders more than 90% of its taxable income each year.14  Therefore, the staff believes that a RIC is an entity that receives flow-through tax treatment for purposes of NASD Rule 1022(e)(2).

However, not all entities that receive flow-through tax treatment are considered to be DPPs as defined in NASD Rule 1022(e)(2) because the rule expressly excludes several entities from the definition of a DPP.  As described above, the definition of DPP excludes REITs, tax qualified pension and profit sharing plans, individual retirement plans, tax sheltered annuities, entities registered under the Investment Company Act, and entities that are listed, or have applied to be listed, on a national securities exchange.  Thus, for instance, a RIC that is registered pursuant to the Investment Company Act, such as a registered mutual fund, does not meet the definition of a DPP under NASD Rule 1022(e)(2), regardless of whether it receives flow-through tax treatment.  BDCs, including BDCs that qualify as RICs, are not registered under the Investment Company Act.  Further, you are seeking guidance regarding the application of the registration rules to non-listed BDCs.

Based on the foregoing, the staff believes that a non-listed BDC that qualifies as a RIC under the IRC at the time of sale is a DPP for purposes of NASD Rules 1022(e)(2) and 1032(c) and that Direct Participation Programs Representatives are eligible to sell shares of it.

We trust that this letter is responsive to your request.  Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors.  This letter responds only to the issues you have raised based on the facts as you have described them, and does not address any other rule or interpretation of FINRA, or all the possible regulatory and legal issues involved.  In addition, you should be aware that any changes in the facts as you have described them will require further consideration and may cause us to reach a different conclusion.

Very truly yours,

Afshin Atabaki

cc:        Erin Vocke,

Vice President and Director New Orleans District Office


  1. As used in this letter, the term “non-listed” means an entity that is not listed, and has not applied to be listed, on a national securities exchange.
  2. See Small Business Investment Incentive Act of 1980, Pub. L. No. 96-477, 94 Stat. 2275.
  3. See Section 2(a)(48) of the Investment Company Act.
  4. See Section 2(a)(46) of the Investment Company Act.
  5. See Sections 2(a)(47) and 2(a)(48) of the Investment Company Act.
  6. See 26 U.S.C. § 851(a).  The RIC definition also includes a common trust fund or similar fund excluded by Section 3(c)(3) of the Investment Company Act from the definition of “investment company” and is not included in the definition of “common trust fund” by 26 U.S.C. § 584(a).
  7. A RIC also is subject to asset diversification and source-of-income requirements.  See 26 U.S.C. § 851.
  8. See 26 U.S.C. § 852.
  9. See id.
  10. See 26 U.S.C. § 852.  In addition, a RIC is subject to an entity-level nondeductible federal excise tax of 4% if it does not distribute: (1) at least 98% of its ordinary income for the calendar year; (2) 98.2% of its net capital gain for the one-year period ending October 31 of such calendar year; and (3) any undistributed ordinary income and net capital gain from the prior excise tax year.  See 26 U.S.C. § 4982.
  11. The term “representative” is defined in NASD Rule 1031(b) (Definition of Representative).
  12. See also Incorporated NYSE Rule 345.15(3) (Limited Registration) and Incorporated NYSE Rule Interpretation 345.15/02 (Categories of Registration).
  13. See Stephen D. Fisher, RICs and the Retail Investor: A Marriage of Convenience or Necessity?, 66 Tax Law. 331, 356 (2013).
  14. As noted above, a RIC may also distribute its net capital gains.