Rev. Rul. 74-248

Advice has been requested whether, under the circumstances described below, receipt of a sum of money in settlement of litigation will cause a corporation to lose its status as a regulated investment company as defined in section 851 of the Internal Revenue Code of 1954.

X corporation was formed in 1970 for the purpose of acquiring, by merger, the assets of Y corporation. Y, during its existence, was registered with the Securities and Exchange Commission (SEC) as an open-end investment company under the Investment Company Act of 1940, and elected to be taxed as a regulated investment company under subchapter M (sections 851-855) of the Code. X is registered with the SEC as an open-end investment company and has elected to be taxed as a regulated investment company. In approving the merger, the shareholders of Y, having received shares of X in exchange for their shares in Y, agreed to the appointment of a new investment advisor.

Subsequent to the merger, a shareholder's derivative lawsuit was filed against Z corporation, Y's former investment advisor, in which it was alleged that Z received compensation in exchange for arranging the merger and approval of a successor investment advisor. The shareholders contended that the transactions involved a sale by Z of its advisory office, in breach of its fiduciary duty to Y. They demanded that Z account to Y for the profits it realized from the transactions. In 1972, pursuant to an agreement by the parties to the action, X received a specified amount in total settlement of the litigation. The amount received in settlement of the litigation exceeded ten percent of X's gross income for its taxable year 1972.

In Rev. Rul. 64-247, 1964-2 C.B. 179, the taxpayer brought a legal action against certain of its former officers and directors to recover excess management fees paid to a corporation owned by the former officers and directors. The amounts recovered as a result of this litigation exceeded ten percent of the taxpayer's gross income for its taxable year.

Rev. Rul. 64-247 held that the amounts recovered are includible in the taxpayer's gross income; however, the inclusion of such amounts in its gross income will not cause the taxpayer to fail to meet the definition of a regulated investment company contained in section 851 of the Code, provided that in all other respects the taxpayer qualifies for the regulated investment company status for its taxable year.

Rev. Rul. 64-247 also provides that for purposes of section 854 of the Code, relating to limitations applicable to dividends received from regulated investment companies, the amounts recovered by the taxpayer should be allocated between interest and dividends in proportion to the interest and dividends derived by the taxpayer during the taxable year of the recovery.

Accordingly, although the amount received in settlement of the litigation is ordinary income (see Rev. Rul. 74-251) includible in X's gross income under section 61 of the Code, the inclusion of such amount in its gross income will not cause X to fail to meet the definition of a regulated investment company contained in section 851, provided that in all other respects X qualifies for regulated investment company status for its taxable year 1972.

For purposes of section 854(b) of the Code, relating to limitations applicable to dividends received from regulated investment companies, the settlement sum received by X should be allocated between interest and dividends in proportion to the interest and dividends derived by X during the taxable year the settlement sum is included in gross income.