Writer Seeks Change in Regs Affecting RICs

[1] As a follow-up to the conversation that Lou Freeman and David Polster of Skadden Arps had with you and Audrey Nacamuli on February 27, 2004 on our behalf, I have enclosed a memorandum discussing the need to adopt a narrow amendment to the Treasury Regulations under section 382 to prevent RICs from experiencing "ownership changes" in inappropriate circumstances and to address a related matter. Lou and I would appreciate an opportunity to meet with you and your colleagues at Treasury and the Internal Revenue Service at your earliest convenience to discuss the issues in the memorandum in more detail.

Because of the draconian consequences of an ownership change, regulated investment companies with significant capital loss carryforwards may have to turn away large investments from participant-directed retirement plans, thereby limiting the investment options available to participants in these plans. Such a result serves no tax policy and is contrary to the increasingly important public policy of facilitating private investment for retirement.

This memorandum proposes an amendment to the regulations under section 382 to alleviate the adverse consequences described above. The amendment would treat each individual plan participant as the direct owner of the regulated investment company's stock owned in his or her plan account to the extent the investment is directed by the participant. This would allow regulated investment companies with capital loss carryforwards to accept investments by participant- directed plans without regard to the consequences under section 382.

The recommended changes are especially critical in the current economic environment in which many funds have capital loss carryforwards and in which recent scandals involving certain mutual fund complexes have resulted in significant outflows from those complexes and into regulated investment companies managed by other complexes. As a result, the proposal contemplates that the regulation be effective for testing dates after December 31, 2003 and requests a notice be issued as soon as possible allowing regulated investment companies to rely on the proposed changes.

The New Regulations are based on the principle that, in order to prevent ownership changes from occurring in inappropriate circumstances, a participant in a Qualified Trust -- rather than the Qualified Trust itself -- should in certain cases be treated as the direct owner of stock of a loss corporation. Fidelity Management & Research Company (collectively with its affiliates, "Fidelity") is submitting this memorandum because we believe that a narrow expansion of this principle is urgently needed to prevent transactions by certain types of retirement plans from triggering ownership changes in "regulated investment companies" as defined in Subchapter M of the Code ("RICs"). We also believe that a minor change should be made to the New Regulations.

Fidelity is one of the world's largest providers of financial services, with custodied assets of $1.7 trillion, including managed assets of $988.3 billion as of December 31, 2003. Fidelity offers investment management, retirement planning, brokerage, human resources and benefits outsourcing services to 18 million individuals and institutions as well as through 5,500 financial intermediaries. The firm is the largest mutual fund company in the United States, the No. 1 provider of workplace retirement savings plans, one of the largest mutual fund supermarkets and a leading online brokerage firm.

Fidelity appreciates the importance of rules that prevent trafficking in loss corporations. We also agree with the principle underlying the New Regulations that, in order to prevent ownership changes from occurring in inappropriate circumstances, a participant in a Qualified Trust -- rather than the Qualified Trust itself -- should in certain cases be treated as the direct owner of stock of a loss corporation. We believe, however, that application of this principle should be expanded. First, we believe that the existing provisions of the New Regulations should apply not only to Qualified Trusts but also to governmental plans covered by section 457 ("457 plans"),³ which face the same issue that the New Regulations were intended to address with respect to Qualified Trusts.

Second, we believe that the New Regulations should not limit the treatment of participants in Qualified Trusts and 457 plans as direct owners of loss corporations exclusively to situations involving distributions of stock by Qualified Trusts and 457 plans. Instead, we believe the principle should be extended to an additional situation in which the current rules can unfairly trigger an ownership change notwithstanding the complete absence of loss-trafficking potential; specifically, a participant-directed Qualified Trust's or participant-directed 457 plan's acquisition and ongoing ownership of shares of a RIC that is or becomes a loss corporation.

As discussed more fully below, because such acquisitions and ownership do not implicate any of the evils against which section 382 and the Regulations thereunder were aimed, we urge Treasury and the Service:

• To amend Regs. section 1.382-3 to provide that when a participant-directed Qualified Trust or 457 plan holds an interest in a RIC, the Qualified Trust or 457 plan at all times will be disregarded and the Qualified Trust's or 457 plan's participants will be treated as part of the RIC's direct "public group" (as defined in the Temp. Regs. section 1.382-2T(f)(13)), notwithstanding Temp. Regs. section 1.382- 2T(h)(2)(iii)(B), which currently contains a general prohibition on attribution from Qualified Trusts, and Temp. Regs. section 1.382-2T(h)(2)(iii)(C), which currently contains a general prohibition on attribution from, inter alia, the United States and its agencies and instrumentalities, states and their political subdivisions (potentially including 457 plans organized by these entities);

• To amend the existing provisions of Temp. Regs. section 1.382- 10T so that they apply to governmental 457 plans; and

• To provide more immediate relief, to issue a Notice indicating that these amendments will be made with a retroactive effective date that is the same as the date of the Notice.

Qualified Trusts encompass several -- but not all -- categories of arrangements commonly thought of as "retirement plans." Qualified Trusts are defined in section 401(a) as trusts that are created as part of a stock bonus, pension or profit sharing plan of an employer for the exclusive benefit of its employees and that meet numerous requirements. Qualified Trusts include:

• Plans governed by section 401(k) ("401(k)plans");

• Plans governed by section 401(c) ("Keogh plans"), which are available to self-employed individuals;

• Employee stock ownership plans ("ESOPs");

• Traditional employer-provided profit-sharing plans; and

• Traditional employer-provided defined benefit plans.

• Individual retirement accounts ("IRAs");

• Plans governed by section 403(b) ("403(b) plans"), which are available to employees of section 501(c)(3) organizations, educational organizations described in section 170(b)(1)(A)(ii) and certain clergy;⁴ and

• 457 plans.

There are different ways to divide the universe of retirement plans. One common distinction is between "defined benefit plans," in which each employee's future benefit is determined by a specific formula and the plan provides a guaranteed level of benefits on retirement (usually tied to an employee's earnings and/or length of service), and "defined contribution plans," in which employers and/or employees generally make annual or periodic contributions to accounts that are set up for each employee who is eligible to participate in the plan. It is also possible, however, to differentiate between retirement plans that are "participant-directed" and those that are not. In the former case, each participant makes his or her own individual decisions about buying and selling investments, although the plan sponsor or the plan trustee of the retirement plan will determine the universe of investment choices that is available. In the latter case, the plan sponsor or the plan trustee of the retirement plan makes decisions about buying and selling investments. Defined benefit plans are almost never participant-directed; defined contribution plans may or may not be participant-directed.

In some retirement plans, participants select a generic investment model (e.g., aggressive, balanced or conservative) and a plan fiduciary selects the specific investments for the model without any input from the participants. Such plans are considered not to be participant-directed for purposes of this memorandum.

In the context of section 382, the most significant difference among the different types of plans is the number of entities they are deemed to comprise for federal income tax purposes. Even though each participant in a Qualified Trust (other than a defined benefit plan) and a 457 plan has a separate account and, in the case of participant-directed plans, makes his or her own investment decisions, as a technical matter an employer's Qualified Trust and a governmental 457 plan are each legally structured as a single trust rather than multiple trusts. In contrast, each employee's account in an employer's 403(b) plan is treated as a separate entity (except as noted in footnote 4); an individual's IRA also is treated as a separate entity.

Qualified Trusts and 457 plans are often funded with pre-tax dollars (i.e., compensation that has not been subject to federal income tax) and are not taxed currently. Instead, proceeds that are distributed from a Qualified Trust or 457 plan are taxed as ordinary income (except to the extent attributable to the recovery of any after-tax contributions), regardless of whether they represent investment income or gains. Consequently, it is not possible to engage in tax planning within a Qualified Trust or 457 plan to minimize taxes. For example, if a participant is about to receive a distribution from a Qualified Trust, triggering unrealized losses in the participant's Qualified Trust account will have no effect on the taxation of the participant's distribution (nor, for that matter, on any other item of income or gain of the participant).

B. Overview of Section 382 and Temp Regs. Section 1.382-10T

Section 382 et seq. is designed to prevent trafficking in loss corporations when new shareholders that did not bear the economic burden of losses acquire a controlling interest in a loss corporation. See H. Rep. No. 99-426, 1986-3 C.B. (Vol. 2) 256; S. Rep. No. 99-313, 1986-3 C.B. (Vol. 3) 232. Section 382 applies to net operating loss carryforwards, while section 383(b) applies similar principles to capital loss carryforwards. Sections 382 and 383 accomplish this objective by limiting the amount of taxable income and gain that may be offset by certain loss carryovers and recognized built-in losses following an "ownership change" of a loss corporation. The limitation is generally equal to the product of (x) the value of the stock of the loss corporation immediately before the ownership change and (y) the applicable "long-term tax-exempt rate" (4.58% for February 2004).

Under section 382(g) and (i), an ownership change will occur on a "testing date" (as defined in Regs. section 1.382-2(a)(4)) if the loss corporation's stock owned by "5-percent shareholders" increases by more than 50 percentage points (by value) during the shorter of the three-year testing period ending on the testing date or, if shorter, the period beginning on the day after the loss corporation's most recent ownership change (the "testing period"). Determining who is a 5-percent shareholder therefore is critical to the application of section 382.

Section 382(k)(7) defines "5-percent shareholder" generally as any person holding five percent or more of the stock of a loss corporation at any time during the testing period. Under section 382(l)(3), however, stock owned by an "entity" (as defined in Regs. section 1.382-3(a)(1)), such as a corporation, partnership or trust, generally is attributed to, and treated as owned ratably by, the owners or beneficiaries of that entity. Although this attribution dilutes ownership of the loss corporation significantly, it can nevertheless create ownership changes due to the "segregation rules" in the Regulations, as discussed immediately below.

Temp. Regs. section 1.382-2T(g) provides that certain groups of individuals and entities, no one of whom owns five percent or more of a loss corporation but who collectively own five percent or more of the loss corporation (a "public group"), are treated as 5-percent shareholders. For example, all of the direct less-than-five- percent shareholders of a loss corporation are generally members of the same public group.⁵ In addition, under the segregation rules in Temp. Regs. section 1.382-2T(j), if an entity subject to attribution under section 382(l)(3) owns five percent or more of a loss corporation directly or indirectly, then less-than-five-percent shareholders of that entity will themselves constitute a discrete public group. A loss corporation therefore may have multiple public groups, each one of which is treated as a 5-percent shareholder, thereby greatly increasing the potential for an ownership change.⁶

While section 382(l)(3) provides generally for look-though treatment of entities in determining stock ownership of a loss corporation, there is an express exception for Qualified Trusts. Similarly, Temp Regs. section 1.382-2T(h)(2)(iii)(B) provides that a Qualified Trust is treated as an individual unrelated to any other direct or indirect owner of the loss corporation. This exception may have been intended as an administrative convenience for classic defined benefit plans (which were far more prevalent when the exception was adopted), where it is impossible to determine beneficial ownership by participants. Temp. Regs. section 1.382- 2T(h)(2)(iii)(C) contains an analogous rule for governments and their subdivisions, agencies and instrumentalities; it seems unlikely that the drafters contemplated application of this provision to governmental 457 plans. These exceptions apply regardless of whether the Qualified Trust or 457 plan is participant-directed. Consequently, a Qualified Trust or 457 plan will be treated as a single individual notwithstanding the fact that each of its participants makes his or her own decision about whether to purchase or sell stock of a loss corporation.⁷

Prior to issuance of the New Regulations, treating a Qualified Trust as a single individual could lead to anomalous results. For example, if a Qualified Trust distributed to its participants stock of a loss corporation that it had acquired more than three years prior to the distribution, an ownership change could occur even if none of the participants individually acquired five percent or more of the loss corporation's stock.⁸ The New Regulations prevent this result by treating participants who receive the distribution as if they -- not the Qualified Trust -- had acquired the distributed stock on the date that it was acquired by the Qualified Trust. Consequently, the participants owning less than five percent of the stock after the distribution are treated as members of the loss corporation's direct public group with respect to the distributed stock. Note, however, that the New Regulations do not appear to address an identical distribution by a 457 plan.

C. Regulated Investment Companies and Loss Carryforwards

The federal income tax treatment of RICs is governed by Subchapter M of the Code. Although RICs are generally considered to be flow-through entities for federal income tax purposes, they are not as transparent as certain other types of flow-through entities such as partnerships. A partnership (other than a "publicly traded partnership" as defined in section 7704) is never subject to entity level tax and passes through all items of income, gain, loss, deduction and credit to its partners. In contrast, under sections 852 and 4982 a RIC generally will avoid entity-level tax only if it distributes all of its investment company taxable income and net capital gain and claims a corresponding dividends-paid deduction. Under this regime, RICs are unable to pass losses through to their shareholders.

Despite their status as (mostly) flow-through entities, RICs are subject to many of the provisions of Subchapter C of the Code, including sections 382 and 383. Section 382 itself actually is not relevant to RICs, because section 852(b)(2)(B) prohibits RICs from deducting net operating losses in calculating their investment taxable company income. Section 383, however (and therefore the principles of section 382), is relevant to RICs, which are permitted under section 1212(a)(1)(C)(i) to carry capital losses forward for eight years.⁹

Because many RICs offer their shares continuously, the Regulations under section 382 contain special rules for determining whether a RIC has experienced an ownership change. The Investment Company Act of 1940, as amended (the "1940 Act"), divides RICs¹⁰ into two categories, "open-end companies" and "closed-end companies." An "open-end company" is defined in section 5(a)(1) of the 1940 Act as a management company that has outstanding any "redeemable securities."¹¹ Section 2(a)(32) of the 1940 Act defines "redeemable security" generally as a security that allows the holder upon presentation to receive its proportionate share of the issuer's current net assets or the cash equivalent. Open-end company shares are available for purchase and may be redeemed on a daily basis. A "closed-end company" is defined in section 5(a)(2) of the 1940 Act as any management company other than an open-end company; closed-end companies offer their shares only once or at periodic intervals and permit redemptions, if at all, at periodic intervals, in accordance with Rule 23c-3 under the 1940 Act.

Under the segregation rules in Temp. Regs. 1.382-2T(j)(2), a corporation's issuances and redemptions of shares generally gives rise to additional public groups. Consequently, absent a special rule, open-end RICs would be especially prone to ownership changes. To eliminate this problem, Regs. section 1.382-3(k)(1) provides that issuances and redemptions by a RIC of "redeemable securities" (as defined in the 1940 Act) in the ordinary course of business do not trigger application of the segregation rules.

Although Regs. section 1.382-3(k)(1) reduces the possibility that a RIC will experience an ownership change, it by no means eliminates that possibility, particularly because participants in participant-directed Qualified Trusts and 457 plans may acquire or redeem a significant interest in a RIC over a short period of time. Under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), either the plan sponsor or the plan trustee is responsible for selecting the menu of investment options (at least some of which are typically RICs) available to participants, each of whom then selects his or her own individual investments. In certain circumstances, the plan sponsor or the plan trustee may determine that it is in the best interest of plan participants to add and/or remove an investment option. If an investment option is removed, the plan sponsor or the plan trustee will provide notice to the plan participants, and the participants will be asked to select another investment option from the menu in which to reinvest the proceeds from the discontinued option. The plan sponsor or the plan trustee also will establish a default reinvestment option, in which the proceeds of the discontinued option will be reinvested if a participant does not designate a reinvestment option.

If a Qualified Trust or 457 plan owns five percent or more of the discontinued option, and the discontinued option is a loss corporation (including a RIC), the discontinuance will trigger a testing date for that corporation and may result in an ownership change. Similarly, if participants in aggregate acquire a five percent or greater interest in another investment option due to the reinvestment of proceeds from the discontinued option,¹² and the new investment option is a loss corporation, a testing date will be triggered and an ownership change may occur.

Even if the discontinuance and/or reinvestment do not initially create an ownership change, either or both may do so subsequently. For example, assume that participants in a participant-directed Qualified Trust or 457 plan (the "Plan") acquired an interest in an open-end RIC¹³ that represented more than five percent but less than 50 percent of the RIC's shares (by value), and that the RIC had had no other 5-percent shareholders (other than its direct public group (the "Public Group")) during the testing period. An ownership change could occur during the ensuing three years in the following circumstances:

• Continued Investment by the Plan. The Plan continues to invest in the RIC while the Public Group maintains the number of shares it owns, reduces the number of shares it owns or purchases a disproportionately small number of shares relative to purchases by the Plan.

• Significant Redemptions by the Public Group. The Public Group redeems shares while the Plan maintains the number of shares it owns, increases the number of shares it owns or redeems a disproportionately small number of shares relative to redemptions by the Public Group.

• Other Investors Become 5-Percent Shareholders. Other investors become 5-percent shareholders through purchases, redemptions by others or mergers¹⁴ in which the RIC is either the acquiring or the acquired fund.

• Any Combination of the Foregoing.

Although ownership changes have always been an issue for RICs, both the hardship and the possibility of an ownership change have become much greater in recent years. The stock markets experienced their first consecutive three-year decline in several decades for the calendar years 2000 to 2002; the Standard & Poor's 500 index (a broad-based stock index) lost 9.1%, 11.9% and 22.1% in each of those years while the NASDAQ composite index (which largely reflects technology stocks) lost 39.2%, 20.8% and 31.3% during those same three years. In addition, recent scandals involving certain mutual fund complexes have resulted in significant outflows from those complexes and into RICs managed by other complexes, and it is likely that a sizable portion of the money that has moved to different mutual fund complexes belongs to Qualified Trusts and 457 plans. As a result of this confluence of events, viewing RICs as a whole, capital loss carryforwards may never have been higher and yet may never have been in greater jeopardy of being lost due to transactions that present no potential for abuse.

If no aggregation is required when individuals receive the same investment advice and separately decide to make the same investment, and if no aggregation is required when a single trustee makes the same investment on behalf of multiple trusts based on an independent decision for each trust, it seems anomalous to require aggregation where there are multiple individuals who are making independent investment decisions without receiving any investment advice. Yet this is exactly the treatment that Temp. Regs. section 1.382-2T(h)(2)(iii)(B) and (C) impose on participant-directed Qualified Trusts and 457 plans, in which the only "advice" that participants receive is a menu of investment options, a far cry from the explicit recommendation or actual purchase made by the investment adviser/trustee in Example 3.

This treatment stands in marked contrast to the treatment under the Regulations of a participant-directed 403(b) plan that offers RICs as investment options, where participants are not aggregated and instead are treated as members of a loss corporation's direct public group (assuming no participant is a 5-percent shareholder).¹⁸ Yet in substance such a 403(b) plan is virtually identical to participant-directed Qualified Trusts and 457 plans. In each type of plan, each participant selects from a menu of investment options and makes his or her own investment decisions. In each type of plan, each participant has a separate account balance and receives periodic account statements. In each type of plan, the assets attributable to each participant are protected from the creditors of the other participants. Given the extent of these similarities, it seems illogical to treat Qualified Trusts and 457 plans differently from 403(b) plans in testing for ownership changes.

Viewed in the broader context of the entire section 382 Regulations, then, the exception from attribution for participant- directed Qualified Trusts in Temp. Regs. section 1.382- 2T(h)(2)(iii)(B) stands as a curious anomaly, the purpose of which is not entirely clear.¹⁹ The Legislative history to the Tax Reform Act of 1986 makes no reference to such an exception,²⁰ and there does not appear to be any discussion of the exception in the Treasury Decisions that that have accompanied the Regulations issued under section 382. It appears that the exception may have been intended as a rule of convenience for classic defined benefit plans (which were far more prevalent when the exception was adopted), where it is impossible to determine beneficial ownership by participants because it depends on many unknown factors. In the case of a participant-directed Qualified Trust (and 457 plan), however, each participant receives periodic statements indicating his or her exact share ownership in each investment on the menu. As a result, there is no need in this context for a rule of convenience, particularly in light of the draconian results it can produce.²¹

The potential for loss trafficking also does not exist because of the tax-deferred status of Qualified Trusts and 457 plans and the fact that they are often funded with pre-tax dollars. As such, Qualified Trusts and 457 plans are not subject to current taxation on investments in RICS,²³ and participants pay tax on all distributions from a Qualified Trust or 457 plan (except to the extent attributable to the recovery of any after-tax contributions), regardless of whether those distributions are attributable to income and/or gains. Consequently, participants in a Qualified Trust receive no tax benefit from investing in a RIC with built-in losses and capital loss carryforwards. In fact, the end result of such an investment is to decrease taxable investors' share of the losses, thereby potentially increasing the overall level of taxation associated with the RIC's income and gains.

Yet this is precisely the effect of the exceptions in Temp. Regs. section 1.382-2T(h)(2)(iii)(B) and (C). RICs are very likely to turn away large investments from Qualified Trusts and 457 plans that would cause or come close to causing an ownership change due to the adverse impact on taxable shareholders, thereby denying plan participants access to RICs that could be very important in helping them meet their retirement goals. If Regs. section 1.382-3 were amended in the manner we are suggesting, RICs would no longer have to turn away such investments.

Although the recommendation will not eliminate the first two disparities in treatment, it will at least reduce the third disparity in treatment and therefore create a measure of parity between RIC shareholders and direct investors at times when such parity is most needed.

Similarly, after issuing numerous private letter rulings that addressed whether multi-class funds were paying preferential dividends through a detailed analysis of the expense structure of each class, the Service issued Rev. Proc. 96-47, 1996-2 C.B. 338,²⁵ which provides a safeharbor for multi-class structures if certain conditions are met, including compliance with Rule 18f-3 under the 1940 Act. This rule, which sets out the rules for multi-class funds including methodologies for allocating expenses, had been issued the prior year.²⁶

The SEC staff has issued guidance addressing whether a Qualified Trust or each of its participants is treated as the owner of investments for certain purposes under the 1940 Act. Not all collective investment vehicles are required to register under the 1940 Act; section 3(c) of the 1940 Act provides a number of exceptions from the registration requirements. Two of these exceptions are particularly relevant to certain type of investment funds such as hedge funds. Section 3(c)(1) of the 1940 Act provides that a fund that is owned by 100 or fewer investors generally does not have to register, while section 3(c)(7) provides that a fund that is owned exclusively by investors that meet a specified net worth requirement ("Qualified Purchasers")²⁷ generally does not have to register.

In PanAgora Group TruSt,²⁸ an investment fund seeking to rely on section 3(c)(1) of the 1940 Act sought a no-action letter holding that a participant-directed 401(k) plan would be treated as a single investor in determining whether the investment fund had 100 or fewer investors. Noting that (1) each participant made his or her own allocations among investment alternatives to attain individualized levels of potential risks and returns and (2) each participant's retirement benefits would depend on the performance of that participant's investment choices, the SEC staff declined to issue the requested ruling. Instead, the staff disregarded the 401(k) plan and treated the participants as the owners of the investment fund. The staff did state, however, that this approach would not apply to a defined benefit plan or a defined contribution plan that was not participant-directed.

In Standish Ayer,²⁹ an investment fund also seeking to rely on section 3(c)(1) of the 1940 Act sought a no-action letter holding that a Qualified Trust would be treated as a single investor in determining whether the investment fund had 100 or fewer investors. Unlike the Qualified Trust in PanAgora, however, the Qualified Trust in this case was not participant directed. While participants could select generic investment options (e.g., aggressive, balanced, conservative), they did not select specific investments. Instead, a plan fiduciary selected the specific investments, which might or might not include the investment fund seeking the ruling.³⁰ Based on these facts, the staff issued a favorable no-action letter treating the Qualified Trust as a single investor.

In Bun Grocery Company,³¹ the staff issued a no- action letter under section 3(c)(7) to a 401(k) plan similar to the Qualified Trust in Standish Ayer (i.e., not participant-directed) holding that the net worth requirement would be applied at the plan rather than the participant level. As a result, the plan would be a Qualified Purchaser if it held $25 million of investible assets; it was not necessary for each individual participant to have $5 million of investible assets.

All of this 1940 Act authority is consistent with disregarding a participant-directed Qualified Trust or 457 plan that invests in a RIC for purposes of section 382 and treating the Qualified Trust's or 457 plan's participants as direct investors in the RIC.

[Renumber 1.382-3(k)(2) as 1.382-3(k)(3)]

(2) Ownership by certain participant-directed plans. -- (i) General rule. -- Stock ownership of a regulated investment company by a qualified participant-directed plan shall be disregarded and such plan shall not be treated as an entity for purposes of §§ 1.382-2T(h)(2) and 1.382-3(a). The stock owned by such qualified participant-directed plan shall be treated as having been acquired directly by the participants of such plan on the date and in the manner acquired by the plan.

(ii) Qualified participant-directed plan defined. -- Qualified participant-directed plan means a qualified trust described in section 401(a) or an eligible deferred compensation plan (within the meaning of section 457) maintained by an employer described in section 457(e)(1)(A), in each case to the extent that a participant in such plan directs the investment of assets allocated to an individual account attributable to the participant under the plan. The fact that the available investments may be limited or that available investments may change from time to time shall not prevent a plan from being a qualified participant-directed plan. However, a plan is not a qualified participant-directed plan to the extent a participant selects only the investment objective (e.g. growth, income, balanced), but not the actual investments.

Section 382 ownership change for regulated investment companies -- treatment of certain retirement plan investments.

This notice provides guidance to regulated investment companies regarding the treatment for purposes of section 382 of investments by certain retirement plans. This notice sets forth a special rule under which a regulated investment company may disregard stock ownership by certain qualified participant-directed plans and treat the stock as being owned directly by the plan participants.

Temp. Treas. Reg. § 1.382-2T(h)(2)(iii)(B) provides that a qualified trust under section 401(a) is treated as an individual unrelated to any other direct or indirect owner of a loss corporation. As a result, if, for example, participants in a 401(k) plan (which is a qualified trust under section 401(a)) direct investments into a regulated investment company and the aggregate investment for all participants exceeds 5% of the regulated investment company's stock , the 401(k) plan itself will be treated as a " 5% shareholder" for purposes of section 382. Comments have been received suggesting that treating a section 401(a) qualified trust as a 5% shareholder where each individual participant in the plan directs the investment of the assets in his or her account can create ownership changes in situations where there is no coordinated investment decision and no possibility of loss trafficking. This unintended consequence of the section 382 regulations can have the effect of limiting the investment options of participants in participant-directed plans where there is no concern of tax avoidance.

The Internal Revenue Service and the Treasury Department recognize that investments by qualified participant-directed plans in regulated investment companies do not present opportunities for loss trafficking. Accordingly, the Internal Revenue Service and the Treasury Department expect that final regulations will be promulgated under section 382 providing that stock ownership of a regulated investment company by a qualified participant-directed plan shall be disregarded and such plan shall not be treated as an entity for purposes of §§ 1.382-2T(h)(2) and 1.382-3(a). The stock owned by such qualified participant-directed plan shall be treated as having been acquired directly by the participants of such plan on the date and in the manner acquired by the plan. For this purpose, qualified participant-directed plans will include qualified trusts described in section 401(a) or eligible deferred compensation plans (within the meaning of section. 457) maintained by an employer described in section 457(e)(1)(A), in each case to the extent that a participant in such plan directs the investment of assets allocated to an individual account attributable to the participant under the plan. The fact that the available investments may be limited or that available investments may change from time to time shall not prevent a plan from being a qualified participant-directed plan.

Regulated investment companies may rely on this notice for testing periods with testing dates after December 31, 2003, pending the issuance of regulations under section 382.

The Internal Revenue Service invites comments on the matter described in this notice. Please send written comments by [-], to: [-] (Notice 2004-[-]), room [-], Internal Revenue Service, POB 7604, Ben Franklin Station, Washington DC 20044. Submission may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to [-] (Notice 2004[-]), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the "Tax Regs" option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/prod/tax-regs/regslist.html. Comments will be available for public inspection.

Drafting Information

The principal author of this notice is [-] of the office of [-]. For further information regarding this notice contact [-] at (202) 622-[-] (not a toll-free number).

²Unless otherwise indicated, all section references herein are to the Internal Revenue Code of 1986, as amended (the "Code"), and the Treasury Regulations ("Regs.") and Temporary Treasury Regulations ("Temp. Regs.") thereunder (collectively, "Regulations").

³Employers that are tax-exempt also may offer 457 plans. As used in this letter, however, "457 plan" refers exclusively to plans offered by the federal and state governments and their subdivisions, agencies and instrumentalities.

⁴Section 403(b)(7)(B) provides that 403(b) plans that purchase RICs will be treated as Qualified Trusts, but solely for purposes of subchapter F of subtitle A (dealing with exempt organizations) and subtitle F (dealing with procedure and administration).

⁵As discussed below, however, direct less-than-five- percent shareholders may comprise multiple public groups if a corporation has periodic offerings or redemptions of its shares.

⁶A loss corporation with no direct 5-percent shareholders and only a single direct public group at all times cannot experience an ownership change, since its only (deemed) 5- percent shareholder will own 100 percent of its stock at all times. As the number of public groups (and therefore the number of 5-percent shareholders) increases, however, the potential for variation in ownership during the testing period increases, thereby increasing the potential for an ownership change to occur.

⁷Whether a governmental 457 plan is treated as part of a governmental body or an "instrumentality" for purposes of Temp. Regs. section 1.382-2T is not completely free from doubt. Governmental 457 plans are exempt from tax under section 115, which provides in part that gross income does not include "income derived from . . . the exercise of any essential governmental function and accruing to a State or any political subdivision thereof. . . ." (Emphasis added.) This suggests that governmental 457 plans are treated as part of a governmental body and not as a trust independent from the government. If a governmental 457 plan is not subject to Temp. Regs. 1.382-2T(h)(2)(iii)(C), however, it is subject to attribution, and so its participants will be treated as a separate public group under Temp. Regs. section 1.382-2T(j)(1) if the plan is a 5-percent shareholder. A distribution by the plan to its participants of loss corporation stock therefore could trigger an ownership change. Consequently, adverse consequences can result regardless of whether governmental 457 plans are subject to Regs. section 1.382-2T(h)(2)(iii)(C). The remainder of this memorandum assumes that they are subject to this provision.

⁸For example, assume a Qualified Trust acquired 55% of a profitable corporation's stock in 1995 that subsequently experienced economic difficulties and, by 2002, had significant loss carryforwards. If, in 2002, the Qualified Trust distributed the stock to its participants, the distribution would trigger an ownership change.

⁹RICs cannot carry capital losses back to prior years. See section 1212(a)(3)(B).

¹⁰A "RIC" under the 1940 Act is actually a registered investment company rather than a regulated investment company, and the two terms are not synonymous. All tax RICs are registered investment companies under the 1940 Act, but not all registered companies are taxed as RICs (e.g., a 1940 Act registered partnership).

¹¹A RIC generally cannot issue both redeemable and non- redeemable securities.

¹²This result is most likely to occur when a plan sponsor or the plan trustee adds one investment option at the same time as discontinuing another, and the new investment option is the default option.

¹³The same issues would exist, although to a lesser degree, to the extent that a closed-end RIC allowed periodic purchases and redemptions of its shares.

¹⁴The special rule in Regs. section 1.382-3(k)(1) exempting issuances by a RIC from the segregation rules would not apply to a fund merger because the rule requires that an issuance or redemption be in the ordinary course of business.

¹⁵See section 22(e) of the 1940 Act.

¹⁶Amending Regs. section 1.382-3 to provide that participant-directed Qualified Trusts and 457 plans investing in RICs are subject to attribution will not resolve the issue, because this attribution may result in creation of an additional public group.

¹⁷See LTR 9533024 (May 19, 1995) (no aggregation of RICs advised by a common investment advisor).

¹⁸A 403(b) plan through which participants may purchase RICs is treated as a custodial account for those participants and not as a trust. Cf. section 403(b)(7).

¹⁹It seems likely that the authors of the Regulations simply did not consider 457 plans in drafting Temp. Regs. 1.382- 2T(h)(2)(iii)(C).

²⁰See General Explanation of the Tax Reform Act of 1986 (the "Bluebook") at 308, which states simply that, "Stock attributed from a partnership, estate or trust shall not be treated as held by such entity."

²¹At one time, the Service agreed with this position and took an even broader view than the one recommended in this memorandum, holding that plan participants in an ESOP are treated as the owners of company stock for purposes of section 382. See LTR 9510007( December 6, 1994). See also LTR 9533024 ("A person who has the right to the dividends and proceeds from the sale of company stock . . . is the owner of the stock for purposes of section 382. . . .").

²²Certain closed-end funds that are exchange traded may trade with share prices that are higher or lower than net asset value.

²³Since a RIC's income flows through to shareholders as either ordinary dividends, exempt-interest dividends or long-term capital gains, it is not possible for a Qualified Trust to realize unrelated business taxable income ("UBT") when it invests in a RIC, unless it borrows to finance that investment. See section 512(b). A 457 plan cannot realize UBTI in any situation pursuant to section 115.

²⁴See SEC Release No. IC-25058, 66 FR 36,156 (July 11, 2001). Rule 5b-3 codified a position the SEC had taken in a previous no-action letter.

²⁵Rev. Proc. 96-47 was amplified and superseded by Rev. Proc. 99-40, 1999-2 C.B. 565.

²⁶SEC Release Nos. 33-7143, IC-20915, 60 FR 11,876 (March 2, 1995).

²⁷A Qualified Purchaser is defined generally in section 2(a)(51) of the 1940 Act as an individual with at least $5 million of investible assets or an institution with at least $25 million of investible assets.

²⁸1994 SEC No.-Act Lexis 488 (April 29, 1994).

²⁹1995 SEC No.-Act. Lexis 1009 (December 28, 1995).

³⁰The Staff required a representation that less than 50% of assets of any generic investment option would be invested in the fund at any time but indicated that this was a ruling guideline, not a substantive legal standard.

³¹2001 SEC No.-Act. Lexis 578 (May 18, 2001).