LIMITED SUBSTITUTION POWER DURING FIRST 90 DAYS OF INVESTMENT TRUST WILL NOT CAUSE TRUST TO BE CLASSIFIED AS AN ASSOCIATION TAXABLE AS A CORPORATION

Rev. Rul. 86-92

ISSUE

If contracts to purchase certain bonds are deposited in an investment trust and, in the event the specified bonds cannot be obtained, the trust agreement permits the sponsor of the trust to provide instead different bonds of the same character and quality as those specified in the contracts or to provide no bonds at all, then for purposes of section 301.7701-4(c) of the Regulations on Procedure and Administration, does the sponsor possess a power to vary the investment of the certificate holders?

FACTS

A securities broker, as sponsor, formed an investment trust with a bank as trustee. The sponsor deposited in the trust certain tax- exempt bonds and contracts to purchase tax-exempt bonds (contracts to purchase). In exchange for these contributions, the sponsor received certificates representing a single class of undivided beneficial ownership in the assets of the trust. The sponsor then sold all of the certificates to investors.

The contracts to purchase permit the trust to purchase bonds on a "when, as, and if issued" basis. The contracts to purchase provide that all bonds subject to the contracts must be transferred to the trust within 90 days of the creation of the trust. If bonds subject to the contracts to purchase are not transferred to the trust within the 90-day period and if this failure is due to reasons beyond the control of the sponsor or the trustee, the sponsor has 20 days within which to transfer to the trust different bonds of substantially the same character and quality as those covered by the "failed" contracts to purchase. If the sponsor does not do so, the trustee must refund to the certificate holders on the next payment date that portion of the sales charge, principal, and accrued interest attributable to the failed contracts to purchase.

Any bond acquired to replace a bond in a "failed" contract to purchase (1) must be tax-exempt, (2) must have a fixed maturity date no later than the date of maturity of the bond it replaces, (3) must have a fixed interest rate not less than that of the bond it replaces and a yield to maturity at least equal to that of the bond it replaces, (4) must have a rating at least equal to the bond it replaces, (5) must have a purchase price no greater than the principal attributable to the bond it replaces, and (6) must not be a "when, as, and if issued" bond.

LAW AND ANALYSIS

Section 301.7701-4(c) of the regulations provides that an investment trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. See Commissioner v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942). An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust and not as an association taxable as a corporation if there is no power under the trust agreement to vary the investment of the certificate holders.

A power to vary the investment of the certificate holders exists if there is a managerial power under the trust instrument that enables a trust to take advantage of market variations to improve the investment of the investors. See North American Bond Trust, 122 F.2d at 546; Rev. Rul. 75-192, 1975-1 C.B. 384; and Rev. Rul. 78-149, 1978- 1 C.B. 448.

Under the trust agreement in the present revenue ruling, neither the trustee nor the sponsor has the power to take advantage of market variations to improve the investment of the certificate holders. The trustee may only accept bonds specified in the contracts to purchase or bonds of substantially the same character and quality selected by the sponsor, and even the latter may be done only if bonds are not furnished under one of the contracts to purchase. Should a contract to purchase fail, the sponsor has only the power to provide bonds of the same character and quality as those specified in the failed contract to purchase, or simply to fail to provide some bonds. In the latter case, the trustee must refund to the certificate holders that portion of the sales charge, principal, and accrued interest that is attributable to the failed contract. The powers at issue here are unlike those in Rev. Rul. 78-149, where reinvestment was used to take advantage of variations in the market over a twenty-year period. The powers in the present case are merely incidental to the organization of the trust during its first 110 days and do not constitute a power to vary the investment of the certificate holders. Once the bonds are placed in the trust, there is no change in the make-up of the trust corpus and no additional investment.

HOLDING

For purposes of section 301.7701-4(c) of the regulations, an investment trust agreement does not contain a power to vary the investment of the certificate holders solely because the governing instrument of an investment trust provides that, in the event of a contract failure, the sponsor may provide bonds of substantially the same character and quality as those bonds specified in the contracts to purchase that were deposited in the trust. Accordingly, under the facts set forth above, the trust is classified for federal income tax purposes as a trust and not as an associated taxable as a corporation.