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Group Asks IRS to Reconsider Preferential Dividend Ruling

JAN. 23, 2015

Group Asks IRS to Reconsider Preferential Dividend Ruling

DATED JAN. 23, 2015
DOCUMENT ATTRIBUTES

 

January 23, 2015

 

 

The Honorable William J. Wilkins

 

Chief Counsel

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Room 3000

 

Washington, DC 20224

 

Re: Comment Letter Relating to Preferential Dividend Analysis in P.L.R. 201444022

 

Dear Mr. Wilkins:

The Real Estate Roundtable would like to comment on the analysis contained in P.L.R. 201444022,1 which, in the context of a real estate investment trust (a "REIT"), considered the impact of a multi-class stock structure on the determination of preferential dividends under section 562(c) of the Internal Revenue Code. This ruling is having a chilling effect on important segments of the real estate market, and for this reason, we believe it important to address what we believe are problems with the ruling's analysis.

The Real Estate Roundtable is the representative voice for the leaders of the nation's top privately owned and publicly held real estate ownership, development, lending and management firms, as well as the elected leaders of the 17 major national real estate industry trade associations. Collectively, Roundtable members hold portfolios containing over 5 billion square feet of developed property valued at over $1 trillion; over 1.5 million apartment units; and in excess of 1.3 million hotel rooms. Participating Roundtable trade associations represent more than 1.5 million people involved in virtually every aspect of the real estate business.

I. Executive Summary

In P.L.R. 201444022, the Internal Revenue Service (the "Service") determined that dividend payments were preferential even though made consistent with the economic terms of stock described in the relevant organizational documents as separate classes -- Class A and Class B. The variance in economics among shareholders results from different allocations of the share classes between investors based upon the magnitude of a shareholder's investment. The class allocations potentially allow shareholders who make larger investments relative to other shareholders to obtain a higher return by reference to a fixed amount that is tied to a percentage of expected (but not actual) management and advisory fees.

The Class A/B structure similar to that described in P.L.R. 201444022 has been utilized in connection with the formation of a significant number of REITs in the U.S. The structure is intended to create substantively different classes of stock that allow REITs attracting large and sophisticated investors to provide different levels of return based on the magnitude of the investment.

The ruling is having a chilling effect on the formation of new REIT-based funds, which rely heavily on institutional investors for capital. Public and private pension funds, for example, are major sources of capital for private real estate investment.2 The ruling creates confusion and concern, which has to be addressed between sponsors and their institutional investors. In addition to the negative impact on capital formation, the ruling may result in significant withdrawals of capital, thus causing serious harm to existing REITs and the real estate industry more generally.3 Lastly, the ruling is causing existing REITs (and their investors) to entail significant and unnecessary expenses.

We believe the analysis in P.L.R. 201444022 is incorrect for the following reasons:

 

1. The analysis is inconsistent with the literal language of the statute and regulations that are applicable in determining preferential dividends.

2. Reliance on legislative history accompanying a 1986 amendment to the preferential dividend rules to support a conclusion that disproportionate sharing of management fees among investors is improper in all instances is misplaced.

3. There is no Federal tax avoidance purpose influencing the potential disproportionate sharing of management and advisory fees among the relevant REIT investors nor is there any injustice to shareholders. Accordingly, use of the preferential dividend rules to prevent sophisticated investors from bargaining at arm's length with the issuer and sponsor for the level of fees to be charged with respect to their investment serves no valid policy that should be promoted by the Federal tax system.

4. Application of a substance-over-form principle in this context, which ignores the form of the investment and substantive stock terms, is illogical and inconsistent with applicable case law and other analogous authority relating to preferential dividends.

5. Interpreting the statute and regulations by reference to Federal securities laws is not appropriate, particularly when the referenced securities laws would have no application to securities issued by REITs similarly situated to the REIT in P.L.R. 201444022.

6. As a result of the improper single-class conclusion in the ruling, many REIT taxpayers are faced with a no-win conundrum; that is, pay equivalent dividends on both classes and risk shareholder suits that will result in catastrophic financial liability or pay dividends consistent with the rights of the separate classes and risk tax audit challenges that will entail significant expense and potentially create a material outflow of capital.

 

For these reasons, we respectfully urge the reconsideration of the analysis and the conclusion of the ruling.

These points will be discussed in greater detail below.

II. Evolution of Preferential Dividend Issue

In order to properly dissect the analysis in this ruling, it is helpful to understand the history that precedes this ruling. As will be shown, the Service's ruling history leading up to P.L.R. 201444022 is inconsistent with the technical language of the statute and regulations as well as the policies underlying these provisions.

 

A. The Statute and Regulations

 

The rules relating to preferential dividends are contained in section 562. As relevant to REITs, section 562(c) provides:

 

[T]he amount of any distribution shall not be considered as a dividend for purposes of computing the dividends paid deduction, unless such distribution is pro rata, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class of stock as compared with another class except to the extent that the former is entitled (without reference to waivers of their rights by shareholders) to such preference.4

 

Regulations under section 562 provide further details. Those regulations, in part, state as follows:

 

Section 562(c) imposes a limitation upon the general rule that a corporation is entitled to a deduction for dividends paid with respect to all dividends which it actually pays during the taxable year. Before a corporation may be entitled to any such deduction with respect to a distribution regardless of the medium in which the distribution is made, every shareholder of the class of stock with respect to which the distribution is made must be treated the same as every other shareholder of that class, and no class of stock may be treated otherwise than in accordance with its dividend rights as a class . . . The existence of a preference is sufficient to prohibit the deduction regardless of the fact (1) that such preference is authorized by all the shareholders of the corporation or (2) that the part of the distribution received by the shareholder benefited by the preference is taxable to him as a dividend . . . A preference exists if any rights to preference inherent in any class of stock are violated. The disallowance, where any preference in fact exists, extends to the entire amount of the distribution and not merely to a part of such distribution.5

B. Early Legislative Background

 

Rules relating to "mutual investment companies," the predecessor entity to a RIC, were enacted in 1936, at the same time as the rules related to preferential dividends.6 Application of the preferential dividend rules, however, was not limited to mutual investment companies. Instead, these rules were intended also as support for other anti-avoidance rules that included the personal holding company tax, the accumulated earnings tax, and the surtax on undistributed income (i.e., taxes that were intended to discourage the deferral of shareholder-level taxation of corporate income).7 For purposes of these taxes, the amount treated as distributed was determined by reference to the dividends paid credit, which was limited by the preferential dividend rule.

The legislative history from 1938 relating to the predecessor to section 562(c) reflects the purposes of the prohibition on preferential dividends as follows:

 

Subsection (h) of the bill, relating to 'preferential dividends,' has the same purposes as section 27(g) of the existing law [enacted in 1936] which disallows a dividends-paid credit for a distribution which is preferential. No dividends-paid credit should be allowed in the case of a distribution not in conformity with the rights of shareholders generally inherent in their stock holdings, whether the preferential distribution reflects an act of injustice to shareholders or a device acquiesced in by shareholders, rigged with a view to tax avoidance. The preference which prevents the allowance of a dividends-paid credit may be one in favor of one class of stock as well as one in favor of some shares of stock within one class. The provision has been expanded in this bill so as to leave no uncertainty as to its purpose in this respect . . . The committee believes that no distribution which treats shareholders with substantial impartiality and in a manner consistent with their rights under their stock-holding interests, should be regarded as preferential by reason of minor differences in valuations of property distributed.8

C. Sliding Scale Fees and RICs -- Early Guidance

 

In 1985, the Service issued two private letter rulings9 and a general counsel memorandum10 addressing sliding scale fees and preferential dividends in the context of RICs. Specifically, in G.C.M. 39457,11 the Service considered a situation where the RIC proposed to charge certain fees due to the investment manager based on a sliding scale, with larger shareholders paying a smaller percentage on their account balances than the smaller shareholders. In the facts under consideration, the RIC issued a single class of shares. All fees were charged directly to the shareholders and collected through withholding on RIC distributions. The Service concluded that a portion of the expenses charged to the shareholders were more properly treated as RIC-level expenses. The Service indicated that the RIC-level expenses should be treated as paid directly by the RIC and should be deducted from the dividends deemed paid to the shareholders. As a result, the disproportionate expense allocation would result in different proportionate dividends received by shareholders owning the same class of stock, and hence would give rise to preferential dividends.

In support of the position that the disproportionate sharing of RIC-level expenses should give rise to a preferential dividend, the Service quoted section 80a-35(b) of the Investment Company Act of 1940 (the "1940 Act") as follows:

 

For the purposes of this subsection, the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser. An action may be brought under this subsection by the Commission, or by a security holder of such registered investment company on behalf of such company, against such investment adviser, or any affiliated person of such investment adviser, or any other person enumerated in subsection (a) of this section who has a fiduciary duty concerning such compensation or payments, for breach of fiduciary duty in respect to such compensation or payments paid by such registered investment company or by the security holders thereof to such investment adviser or person.12

 

Thereafter, the Service made the following statements with reference to the fiduciary duty owed to RIC investors:

 

Accordingly, if one could conclude that a breach of fiduciary duty under the 1940 Act has occurred, and if one accepts the proposition that any unequal distribution which infringes upon the rights of some or all the shareholders of any class is necessarily preferential, then one must conclude that the Fund's proposed sliding scale fee structure would be a preferential dividend under § 562(c), and that the Funds would be denied the deduction for dividends paid under section 561(a) and 852(b)(2)(D).13

D. 1986 Legislation in Response to the Service's Rulings

 

In 1986, Congressmen McGrath, Flippo, and Kennelly introduced H.R. 3397, which contained a number of proposed amendments to the rules affecting the taxation of RICs. Although not addressed in the proposed legislation, public documents indicate that consideration subsequently was given to modifying H.R. 3397 to address the issue of sliding scale fees raised by the rulings and general counsel memorandum discussed immediately above. Specifically, Congressional testimony delivered by a member of the U.S. Treasury Department ("Treasury") indicates that such an amendment was contemplated and provides some insight regarding Treasury's view with respect to the advisability of legislation permitting sliding scale fees.14 The following statements were made as part of the testimony:

 

Representatives McGrath, Flippo, and Kennelly have requested the view of the Treasury Department concerning a possible modification to H.R. 3397. In particular, the modification would permit RICs to pay higher dividends per share to large shareholders to reflect the lower per share fees or costs incurred with respect to those shareholders . . .

The problem that the proposed modification seeks to address is illustrated by a recent private ruling issued by the Internal Revenue Service . . .

In the case of a sliding scale dividend arrangement that reflects management fees or cost savings, we do not believe that the concerns that motivate the disallowance of a deduction for preferential dividends -- the potential for shareholder injustice or tax avoidance -- are present. Although it may appear to be unfair for large shareholders to receive higher per share dividends than small shareholders, the costs per share of administering a shareholder's account may indeed be greater in the case of small shareholders than in the case of large shareholders. Accordingly, a sliding scale dividend arrangement may serve the valid business purpose of allocating administrative costs to the shareholders who generate those costs. We do not regard this as unjust. More importantly, while we realize that one of the historical policies underlying the preferential dividend provision is shareholder fairness, we believe that the relationship between RICs and their shareholders is more appropriately regulated by the Securities and Exchange Commission through the securities laws than by the Internal Revenue Service through the Internal Revenue Code.

We believe strongly, however, that the preferential dividend rule appropriately applies to dividend arrangements that have a tax avoidance purpose. In our view, a sliding scale dividend arrangement that truly reflects management fees or cost savings is unlikely to serve as a tax avoidance device. Nevertheless, it is possible for such a preferential dividend arrangement to reduce the overall taxes paid by the shareholders of a RIC. This would result, for example, if the larger shareholders of the RIC tend to be pension plans and other tax-exempt organizations and the smaller shareholders tend to be taxable individuals. We believe, however, that sliding scale dividend arrangements that reflect management fees or cost savings are primarily motivated by business reasons rather than tax avoidance. Accordingly, we would not oppose a provision to permit the deduction of dividends paid under such sliding scale arrangements.15

 

Subsequently, as part of the Tax Reform Act of 1986, Congress amended section 562(c) to permit some flexibility in allocating administrative expenses by a RIC. Under the amendment, a distribution to a RIC shareholder who makes an initial investment of at least $10,000,000 will not be treated as non-pro rata or preferential solely by reason of an increase in the distribution by reason of reductions in administrative expenses of the RIC.

The conference report explains this provision as follows:

 

The conference agreement provides that differences in the rate of dividends paid to shareholders are not treated as preferential dividends (within the meaning of section 562(c)), where the differences reflect savings in administrative costs (but not differences in management fees), provided that such dividends are paid by a RIC to shareholders who have made initial investments of at least $10 million.16

 

The report of the Joint Committee on Taxation provides further explanation for the 1986 amendment to section 562(c), stating:

 

The Congress believed that preferential dividends that reflect only savings in administrative costs attributable to the size of a shareholder's holdings (and not differences in investment advisory fees) are not the type of preferential dividends that were intended not to qualify for the dividends paid deduction. The Congress believed that such preference dividends should be allowed only in cases where the shareholder who receives the preferential dividend was required to make an initial investment of at least $10 million.17

 

It is significant that the amended rule permits a variance in administrative expenses borne by shareholders who hold the same class of shares. The legislation contains no reference to the sharing of advisory or management fees with respect to shareholders who hold distinct classes of stock that incorporate the divergent fees within the terms of the stock.

 

E. Evolving Analysis in RIC Context Relating to Allocation of Fees

 

While there has been no change in the statute or regulations relating to the standards for determining what is a preferential dividend since 1986,18 the standards set forth by the Service in its ruling practice have evolved significantly since that time as this practice relates to the sharing of management and advisory fees among investors. The relevant standards initially were considered in the context of RICs, and the standards that eventually were developed appear to have been heavily influenced by analogies to securities rules under the 1940 Act. While RICs generally are investment companies subject to the 1940 Act, the preferential dividend rules also apply to other entities, such as REITs and personal holding companies, which are not subject to the 1940 Act.
1. Respecting Separate Classes Based on Fee Sharing
The initial rulings issued by the Service relating to divergent fee sharing of "load" and "no-load" shares respected divergent economic rights as giving rise to separate classes of stock such that the different fee sharing did not give rise to preferential dividends. For example, in finding that "load" and "no-load" shares were separate classes, the Service stated in P.L.R. 874604519 as follows:

 

[T]he legislative history of the predecessor of section 562 notes that the former dividends-paid credit should not be allowed 'in the case of a distribution not in conformity with the rights of shareholders generally inherent in their stock holdings,' and suggests that separate rights inherent in stock holdings that are supported by state law could form the basis of different classes of stock susceptible to different treatment without violating the prohibition on preferential dividends.20

 

In this ruling, the Service discussed Rev. Rul. 70-59721 which described two classes of stock, one of which was entitled to receive the RIC's net ordinary income and one of which was entitled to receive the RIC's net capital gain. With reference to Rev. Rul. 70-597, the Service stated that, because the dividends paid on the classes were treated as qualifying for the dividends-paid deduction, "it can be inferred that the dividends are not preferential."22 On this basis, the Service concluded that "dividends paid to shareholders of one class of stock may be different than the dividends paid to shareholders of another class of stock as long as the payments are made in accordance with the dividend rights of each class."23
2. Separate Classes Based on Divergent Fee Sharing Treated as a Single Class
In 1991, the Service appeared to undertake a significant shift in its approach to distinguishing classes of stock when it analyzed an arrangement whereby a RIC issued shares that were treated as two separate classes (Class A and Class B) under state law but that were economically identical except for the payment of an "additional distribution fee." The arrangement was intended to encourage long-term holding of RIC stock, with the Class B shares representing the long-term investment securities. With respect to expense sharing, the Class A shares (i.e., the short-term securities) would bear an "additional distribution fee" payable at an annual rate of .95 percent of the average daily net assets allocable to Class A. The Class B shares would not bear this fee.

Although the Service held that the arrangement did not create a preferential dividend issue, the Service made the following statements with regard to determining whether the separate state law classes of stock would be respected as creating separate classes for purposes of section 562:

 

In the instant case, both Class A and Class B would participate in the amended Rule 12b-1 plan. However, the distribution fee that Portfolio would pay to the Distributor pursuant to the amended plan is to be allocated disproportionately between the two classes of shares. Further, the Class A shareholders would have the right to vote as a class only with respect to the additional fee that is to be allocated solely to them. These differences alone are insufficient to cause Class A and Class B to be classified as two different classes under section 562(c) of the Code . . . We conclude from this analysis that Portfolio Y would have only a single class of stock. The shareholders of Class A shares and of Class B shares would have the benefit of the same economic distributions. The differences in voting rights based upon the Rule 12b-1 plan would be inconsequential. Therefore, the rights of all the shareholders of Portfolio Y would be so closely aligned and similar as to warrant the conclusion that all shareholders of Portfolio Y must be treated as a single class.24

 

Although the Class A and B shares were treated as a single class for purposes of section 562, the Service determined that the divergent fees were actually indirect shareholder-level fees, so that the divergent sharing of those fees need not be considered in determining the preferential nature of the shares.25

The Service continued to issue rulings following roughly the same analysis through 1995. Interestingly, in P.L.R. 9520037,26 the Service made the following statements in the legal discussion which had not appeared in prior rulings:

 

The legislative history and regulations show that each shareholder within a class, as that term is used in section 562(c), has certain inherent rights. The Revenue Act of 1936: Hearings on H.R. 12395 Before the Senate Comm. on Finance, 74th Cong., 2d Sess. 62 (1936); H.R. Rep. No. 1860, 75th Cong., 3d Sess. 23 (1938); section 1.562-2 of the Income Tax Regulations. Each shareholder within a class has the right to receive the same distribution on each of his shares belonging to the class as every other shareholder within the class. In addition, the class has the right not to receive less than that to which it is entitled when compared to other classes.

Therefore, a class for purposes of section 562(c) is a group of shareholders whose rights are so closely aligned and so different from other shareholders' rights as to warrant a conclusion that members of the group should all be treated the same and should be protected against the infringement of shareholders outside the group with respect to distributions. For example, section 1.562-2(b), Example (3), indicates that cumulative preferred and common stock may form two classes for these purposes. Among the characteristics that cause cumulative preferred shareholders to be viewed as a class separate from common shareholders is their right to certain preferences on distributions, on redemption, and on liquidation, and their right to vote to protect those preferences.27

 

Based upon this standard, the Service concluded that separate classes under state law that differed based on expense sharing, limited voting rights, certain exchange rights, and convertibility features should be treated as one class.

During this period, members of the Service indicated in public forums that they were continuing to study the issues related to the allocation of management fees and preferential dividends. Some Service commentary indicated a "zero tolerance" for arrangements that facilitated disproportionate sharing of RIC-level management fees.28 Other comments indicated a desire to facilitate parity between Securities and Exchange Commission ("SEC") and Service policy to promote fairness to the investing public, with the Service's policy being carried out through enforcement of the preferential dividend provisions.29

The Service eventually attempted to provide some definitive standards on which taxpayers could rely in determining preferential dividends for RICs. The Service first issued Rev. Proc. 96-47.30 Following issuance of Rev. Proc. 96-47, the Service, in Announcement 96-95,31 requested comments for modifying the revenue procedure and provided some indication as to the technical justification for their position with respect to disparate sharing of management fees. In the announcement, the Service referenced legislative history relating to the 1986 amendment to section 562(c). As previously discussed,32 the amendment provides that, with respect to RIC shareholders who made an initial investment of at least $10 million, distributions shall not be treated as preferential "solely by reason of an increase in the distribution by reason of reductions in administrative expenses of the company."33 The Service quoted the legislative history relating to this amendment provided as follows:

 

The conference agreement provides that differences in the rate of dividends paid to shareholders are not treated as preferential dividends (within the meaning of section 562(c)), where the differences reflect savings in administrative costs (but not differences in management fees), provided that such dividends are paid by a RIC to shareholders who have made initial investments of at least $10 million.34

 

The Service followed Rev. Proc. 96-47 with modified standards in Rev. Proc. 99-40, a safe-harbor revenue procedure, which relied heavily on standards promulgated by the SEC.35 Rev. Proc. 99-40 relied for its standards, in part, on SEC Rule 18f-3 relating to the 1940 Act.36

 

F. Commentator Reaction to the Service's Preferential Dividend Analysis

 

Commentators were critical of the Service's approach with respect to analyzing management fee differentials in evaluating RIC preferential dividends under section 562(c). In this regard, the Tax Section of the New York State Bar Association stated:

 

We do not believe that the 1986 amendment to the Preferential Dividend Rule should be interpreted as expanding the rule and we do not believe that the legislative history to this amendment implies that Congress intended such an expansion. Rules issued under the 1940 Act explicitly prohibit registered investment companies (and thus virtually all categories of RICs) from allocating management fees differently among different classes of shares (or differently among shares of a single class). Given that explicit prohibition under the securities laws, we believe that, if Congress had intended to expand the Preferential Dividend Rule to restrict such allocations, it would have done so directly and explicitly in the statutory language of the 1986 amendment and not indirectly through ambiguous language included in the legislative history to that amendment. We also believe, for the reasons indicated above, that the Preferential Dividend Rule is not intended to promote shareholder fairness and that, even if it were, it should not be relied on to do so because it is ineffective. The SEC and securities laws are better suited than the IRS and tax law to regulate the allocation of fees among investors in an investment fund.37

 

Another commentator stated as follows:

 

It is difficult to know what to make of such a breathtaking difference in analysis [between the analysis of separate classes in rulings like P.L.R. 8746045 and the rulings beginning in 1991]. In my view, the former analysis (separate classes) is far more persuasive. Separate classes are consistent with state law, Rule 18f-3, the analysis of reg. section 1.1361-1(l), and, it would seem, common sense. The latter analysis (a single class, but pro rata) seems totally result-oriented . . . The single-class analysis is particularly problematic in that it is significantly disconnected from the actual language of section 562(c).38

G. Recent Legislation Exempting Publicly-Traded RICs from Preferential Dividend Rules

 

In 2010, Congress enacted the Regulated Investment Company Modernization Act, repealing the preferential dividend rules with respect to publicly offered RICs. In connection with this legislation, the Joint Committee Report provided the following explanation:

 

Present Law.

RICs are allowed a deduction for dividends paid to their shareholders. In order to qualify for the deduction, a dividend must not be a "preferential dividend." For this purpose, a dividend is preferential unless it is distributed pro rata to shareholders, with no preference to any share of stock compared with other shares of the same class, and with no preference to one class as compared with another except to the extent the class is entitled to a preference. A distribution by a RIC to a shareholder whose initial investment was $10 million or more is not treated as preferential if the distribution is increased to reflect reduced administrative cost of the RIC with respect to the shareholder.

Securities law, administered by the Securities Exchange Commission, provides strict limits on the ability of RICs to issue shares with preferences.

Explanation of Provision.

The provision repeals the preferential dividend rule for publicly offered RICs. For this purpose, a RIC is publicly offered if its shares are (1) continuously offered pursuant to a public offering, (2) regularly traded on an established securities market, or (3) held by no fewer than 500 persons at all times during the taxable year.39

 

A leading commentator made the following statements with respect to the Service's preferential dividend analysis following the repeal of the rules for publicly-offered RICs.

 

The 1938 legislative history to the preferential-dividend rule alludes to its applicability to unjust distributions, therein indicating that '[n]o dividends paid credit should be allowed in the case of a distribution not in conformity with the rights of shareholders generally inherent in their stock holdings, whether the preferential distribution reflects an act of injustice to shareholders or a device acquiesced in by shareholders, rigged with a view to tax avoidance.' This history does not suggest that the rule affects the deductibility of distributions made in conformity with just rights. The preferential dividend rule is not designed to regulate how the shareholders of a RIC are permitted to share in the RIC's earnings and assets. On the contrary, the history of the rule indicates that distributions by a RIC must be made in accordance with its shareholders' interests in the RIC's earnings and assets for those distributions to be deductible since any other method of distribution would potentially distort the shareholder-level tax treatment of the RIC's income from the shareholders' economic participation in that income.

By repealing the rule in respect of all publicly offered RICs, constituting the overwhelming majority of RICs, Congress has recognized that the securities law, not the tax law, provides the rules governing fairness among shareholders.40

H. Preferential Dividend Analysis and REITs

 

In 2010, the same year the preferential dividend rules were repealed for publicly-traded RICs, the Service issued the first of a series of private letter rulings applying the same RIC analysis for purposes of analyzing dividends paid by publicly-offered non-traded REITs that charged different distribution fees and certain class-specific expenses to holders of separate state-law classes that were sold to different types of investors.41 Subsequent rulings permitted different selling commissions, dealer manager fees, and distribution fees with respect to separate state-law classes that were targeted to different types of investors.42

The first group of rulings all applied similar analyses. The rulings acknowledged that publicly-offered non-traded REITs technically were not within the scope of Rev. Proc. 99-40 and also were not subject to Rule 18f-3 under the 1940 Act. Nonetheless, the rulings all cited significant review processes and investor protections that would apply in connection with offerings of the relevant securities. In the last of these rulings, the Service stated that "the rationale underlying Rev. Proc. 99-40 applies equally to both RICs and REITs."43 After analyzing each expense sharing arrangement and determining that the arrangements were consistent with the requirements of Rev. Proc. 99-40, the Service concluded that the divergent fee sharing would not cause dividends paid with respect to the shares to constitute preferential dividends under section 562(c).

Subsequent to the issuance of these rulings, the Service appeared to reconsider its rationale for blessing the disproportionate sharing of expenses and fees addressed in the prior rulings. While the ultimate conclusion in these subsequent rulings did not change, references to Rev. Proc. 99-40 were dropped.44 Instead, these rulings simply referenced the statute and regulations under section 562(c) and then concluded, without analysis, that the arrangements would not give rise to preferential dividends.

The most recent ruling addressing the fee arrangements for publicly-offered non-traded REITs appeared to revert back to the analysis of the earlier rulings, again referencing Rev. Proc. 99-40 and stating that "the rationale underlying Rev. Proc. 99-40 is instructive by analogy in determining whether the distribution of fees and expenses to different classes of shareholders results in the fair and equal treatment of those shareholders."45 Unlike the initial rulings, there is no analysis of each separate fee by reference to the Rev. Proc. 99-40 standards. Instead, after declaring Rev. Proc. 99-40 to be "instructive by analogy," the ruling simply concludes that the fee arrangements with respect to the separate classes will not create preferential dividends.

 

I. Case Law Supports Strict Attention to Form in Preferential Dividend Analysis

 

Apart from the Service's analysis, courts have shown some reluctance to find a preferential dividend when dividends are formally distributed in accordance with the terms provided in the relevant organizational documents and bylaws. Specifically, in Coca-Cola Bottling Company of Greenville v. U.S.,46 the Fifth Circuit Court of Appeals analyzed a situation where a corporation had two shareholders, each of whom had contributed 50 percent of the corporation's capital. Although the shareholders had contributed capital 50/50 for their shares, one shareholder was issued 60 shares and the other was issued 40 shares. Despite this share ownership, the shareholders entered into an agreement (embodied in the corporation's bylaws) providing that the corporation would distribute 1/6 of the dividends otherwise payable to the 60-percent owner to the 40-percent owner. As a result, each shareholder would receive 50 percent of the company's dividends. The corporation paid all dividends 50 percent to each shareholder, and the Service argued that the dividends were preferential in disallowing the corporation's dividends paid credit.

The Fifth Circuit held that the corporation's dividends were not preferential because the corporation declared the dividends pro rata in proportion to outstanding shares and should be deemed to have made an equal per share distribution to its shareholders (i.e., 60 percent of the dividends to the 60-percent shareholder and 40 percent of the dividends to the 40-percent shareholder). The court stated that, although it did not know the reason for the shareholders' agreement on the sharing of the dividends, the agreement did not create two classes of stock and did not alter the regular declaration of dividends on each share of stock. The corporation merely provided for the disposition of the dividend proceeds, after declaration, as agreed to by the shareholders in distributing the cash 50/50. In reaching this conclusion, the Fifth Circuit made clear that the shareholders were free to dispose of their dividend proceeds in any manner that they chose.

III. P.L.R. 201444022

 

A. Facts

In P.L.R. 201444022, the taxpayer, a REIT, proposed to create two classes of common shares, Class A and B. The taxpayer's net asset value ("NAV") would be allocated between the Class A and B shares. The base management fee paid to the advisor would be determined only by reference to the taxpayer's NAV that is attributable to the Class A shares, although the base fee would reduce the NAV attributable to Class A and B proportionately. The incentive fee would accrue and be payable with respect to the NAV attributable to both the Class A and B shares.

Taxpayers committing to contribute capital below a fixed amount would be entitled to receive only Class A shares. Taxpayers contributing above this amount would receive a combination of Class A shares and Class B shares, with the proportion of Class B shares received increasing as the capital commitment increased above certain defined levels.

Each Class B share would receive a special dividend equal to a fixed percent of the NAV attributable to Class B, which initially would equal the reduction in the amount of the base fee that otherwise would have been charged by the advisor with respect to the portion of the aggregate NAV of the Class B shares. The special dividend would be declared and paid separately from the common dividends otherwise declared and paid with respect to such shares.47

If the base fee charged by the advisor remained constant over the life of the taxpayer and all investors continued to hold Class A and B shares together in the proportions originally acquired, the special dividend would have the effect of reducing the management fee borne by investors committing larger amounts of capital by a pre-determined amount. If, however, the amount of the base management fee was changed (or waived in a given year),48 the amount of the special dividend could not be adjusted in the absence of an amendment of the REIT's charter, which would require a shareholder vote. A proposed increase in the special dividend would be subject to a vote only with respect to Class A shareholders, and a proposed decrease would be subject to a vote only by the Class B shareholders. Shareholders would be entitled to tender for redemption solely shares of one class or the other, thereby potentially creating a break in the link between the special dividend and the proportionate base fee reduction originally negotiated for the specific shareholder.

In general, each Class A and B share would be entitled to one vote, and the classes would vote jointly on matters affecting the taxpayer as a whole. The classes, however, would vote separately on any matter that might have an adverse affect on the class.

B. Analysis in P.L.R. 201444022

Regarding the relevant law, P.L.R. 201444022 begins by citing to the statute and regulation under section 562 which are quoted earlier in this letter.49 The ruling next highlights the 1986 statutory change permitting divergent sharing of administrative expenses for shareholders who initially invest at least $10 million in a RIC, quoting both the House Conference and Joint Committee reports describing the provision.50 The ruling then describes Rev. Proc. 99-40, applicable to RICs, and indicates that the requirements of the revenue procedure are based on similar requirements contained in Rule 18f-3 of the 1940 Act. Finally, the ruling recognizes that the preferential dividend rule was repealed for publicly-offered RICs in 2010.

With respect to the analysis, the ruling begins by emphasizing the general parallel between the treatment of REITs and RICs, but noting that the 1986 and 2010 changes in the scope of the preferential dividend rules did not apply to REITs. In addition, the ruling notes that shares of the taxpayer that was the subject of the ruling were not publicly offered, so the 2010 change would have no application even if it was equally applicable to RICs and REITs.

With respect to the taxpayer's argument that the Class A and B shares are separate classes and that the shareholders would receive dividends that are consistent with the terms of such classes, the ruling states:

 

To accept Taxpayer's argument on the facts presented here would significantly undermine the preferential dividend rules. The 1986 revision to section 562(c) and its legislative history indicate Congress' understanding and intent that, while differences in distributions paid to certain larger shareholders of a class to reflect reductions in associated administrative expenses are permissible and do not cause the distributions to be preferential dividends, differences in distributions due to a reduction in investment advisory fees for a particular class are not permissible. The purpose and effect of Taxpayer's proposed share arrangements are, however, precisely to differentially allocate investment advisory fees to shareholders holding shares with otherwise identical share rights based on the amount of their respective investments in Taxpayer.51
The ruling then cites to certain terms of the Class A and B shares and states that, "in substance, the proposed [Class A/B] arrangement would exist to implement a tiered investment advisory structure based on the amount invested for shareholders whose shares otherwise confer substantially the same rights and obligations."52 Following this statement, the ruling concludes that the Class A and B shares should not be recognized as separate classes, and in a footnote makes the following statement:

 

Indeed, if Taxpayer's assertions were accepted, the 1986 revision to section 562(c) would have been unnecessary, as any RIC or REIT could have differentiated between shareholders based on administrative expenses by setting up otherwise identical 'classes' of shares with different dividend rights tied to administrative expense differentials.53

 

In response to the point that the special dividend and resulting reduction in the base management fee should not be viewed as equivalent due to the fact that the special dividend is not adjusted upon an adjustment to the base management fee, the ruling states:

 

This fact does not change the substance of the proposed dividend, which is to permit a difference in investment advisory fees between shareholders with otherwise substantially identical rights that own Class A Shares and Class B Shares in different proportions based on the amount of their respective investments in Taxpayer.54

 

Following from this analysis, the ruling concludes that the special dividend would be treated as a preferential dividend and that this would cause all dividends paid on Class A and B shares to be treated as preferential. As a result, no such dividends payable on Class A and B shares would be eligible for the dividends paid deduction and thus the taxpayer may fail to qualify as a REIT due to its failure to meet the 90-percent distribution requirement under section 857(a)(1).

IV. The Analysis in P.L.R. 201444022 Is Not Supportable on Technical or Policy Grounds

 

A. The Plain Meaning of the Statute and Regulations Are Contrary to the Service's Analysis

 

As an initial matter, it seems indisputable that the Class A and B shares could be viewed as separate classes of stock. The classes provide for distinctly different economic rights, may be redeemed separately, and vote separately to protect class-specific rights. In other contexts, these differences would dictate treating the Class A and B shares as different classes.55 In addition, at one point, the Service apparently would have concluded that the Class A and B shares were different classes for purposes of the preferential dividend analysis applicable to RICs.56 The distributions with respect to the shares are paid in strict conformance with the economic rights of the shareholders. Based on a strict reading of section 562(c) and Treas. Reg. § 1.562-2(a), distributions with respect to the Class A and B shares would not be preferential.

The applicable statute and regulations provide no indication that a variance in rights by reference to advisory and management fees, where the variance is embedded in the terms of the shares, should disrupt this analysis. Accordingly, in order to conclude that the Class A and B shares represent a single class of stock for purposes of the preferential dividend analysis, it seems that clear and significant policy considerations must support an analysis that deviates from the plain language of the statute and regulations.

 

B. Implications of 1986 Amendment to Preferential Dividend Rules Appear Misinterpreted

 

As previously described, the Service relied heavily on the 1986 amendment to section 562(c) as evidencing Congressional intent that divergent sharing of management fees among shareholders will give rise to preferential dividends. In P.L.R. 201444022, the Service specifically stated:

 

The 1986 revision to section 562(c) and its legislative history indicate Congress' understanding and intent that, while differences in distributions paid to certain larger shareholders of a class to reflect reductions in associated administrative expenses are permissible and do not cause the distributions to be preferential dividends, differences in distributions due to a reduction in investment advisory fees for a particular class are not permissible.57

 

Looking to the scope of the 1986 amendment and the circumstances under which the amendment occurred, it becomes clear that this statement significantly overstates the implications that properly should be drawn from the enactment of the 1986 amendment to the preferential dividend rules.

Regarding the circumstances, the amendment permitting the disproportionate sharing of certain expenses by RIC shareholders was enacted in response to private letter rulings issued by the Service.58 Those rulings involved the direct payment (through withholding) of a different amount of RIC-level expenses by shareholders owning the same class of shares.59 Under the transactional construct imposed in the rulings (i.e., reduce distributions by RIC-level expenses paid by shareholder), shareholders owning the same class of stock were treated as actually receiving a different amount of distributions. Receipt of different distributions by shareholders owning the same class of stock represents a clear violation of the preferential dividend rules. The 1986 amendment responded to an industry issue that the rulings created for RICs and provided a limited exception where shareholders owning a single class of stock could receive different distributions without creating a preferential dividend.

These circumstances are informative as to the scope of the 1986 amendment. Specifically, the 1986 amendment does not address what are separate classes of stock and the extent to which management and advisory fees may be disproportionately allocated to separate classes. No part of the statutory amendment or legislative history implies any intent to address these issues, and the use of separate classes was not present in the Service's rulings that prompted the legislation. Instead, the 1986 amendment simply allows specific fees to be borne disproportionately by shareholders who own the same class of stock; that is, classes of stock the terms of which provide no indication that expenses will be borne disproportionately.

The Service, in P.L.R. 201444022, interprets the 1986 amendment to section 562(c) as being restrictive, disallowing in all circumstances a disproportionate sharing of management fees among shareholders. In fact, the amendment was intended to only broaden the scope of permissible arrangements under the statute. The 1986 amendment permits, to a very limited extent, the "injustice" that generally had been prohibited under the preferential dividend rules. Shareholders who make an initial investment of at least $10 million are allowed to receive distributions that are inconsistent with the terms of their class of stock to the extent the divergence relates to a savings in administrative expenses. Such an arrangement generally would arise when, as in the Service's rulings, shareholders owning the same class of stock directly pay certain expenses that are more properly allocated to the RIC.

When viewed in light of the scope and circumstances surrounding the enactment of the 1986 amendment, the implication drawn in P.L.R. 201444022 that Congress has a general aversion to permitting larger shareholders to bear a disproportionately small share of management and advisory fees appears to be misdirected and without merit.

 

C. Absence of Broader Policy Considerations Relating to Treating Sliding-Scale Management Fees as Preferential Dividends

 

As this discussion highlights, there is no implication in the statute, regulations, or legislative history relating to preferential dividends that the sharing of management and advisory fees cannot be considered in defining the terms of separate classes of stock. The Service still may question whether there are broader policy issues that clearly support its historic analysis, as reflected in P.L.R. 201444022. The 1986 Treasury testimony, however, convincingly answers this question in the negative, and the relevant portion of that testimony bears repeating:

 

In the case of a sliding scale dividend arrangement that reflects management fees or cost savings, we do not believe that the concerns that motivate the disallowance of a deduction for preferential dividends -- the potential for shareholder injustice or tax avoidance -- are present. Although it may appear to be unfair for large shareholders to receive higher per share dividends than small shareholders, the costs per share of administering a shareholder's account may indeed be greater in the case of small shareholders than in the case of large shareholders. Accordingly, a sliding scale dividend arrangement may serve the valid business purpose of allocating administrative costs to the shareholders who generate those costs. We do not regard this as unjust. More importantly, while we realize that one of the historical policies underlying the preferential dividend provision is shareholder fairness, we believe that the relationship between RICs and their shareholders is more appropriately regulated by the Securities and Exchange Commission through the securities laws than by the Internal Revenue Service through the Internal Revenue Code.

We believe strongly, however, that the preferential dividend rule appropriately applies to dividend arrangements that have a tax avoidance purpose. In our view, a sliding scale dividend arrangement that truly reflects management fees or cost savings is unlikely to serve as a tax avoidance device.60

 

The situations that currently exist involving the Class A/B structure that is the subject of the ruling involve investor pools made up entirely of accredited investors (as defined under section 501(a) of Regulation D under the Securities Act of 1933) and qualified investors (as defined under section 3(a)(54) of the Securities Exchange Act of 1934). These investors, under SEC rules, generally are presumed to be sophisticated and able to protect themselves in making their investments. It seems particularly inappropriate for the Service to assume the role of "investor protector" in relation to the allocation of management and advisory fees when the SEC finds it unnecessary to provide such protection.

Additionally, the Service might properly assert its role in interpreting the preferential dividend rules to prevent tax abuse,61 but the incentives relating to the bargaining for disproportionate sharing of management and advisory fees are not tax savings. REIT sponsors have an incentive to attract investors making larger commitments of capital, as they may achieve economies of scale in managing a larger investment portfolio and also may more easily attract additional investors having shown that earlier investors have expressed confidence in the sponsor by making significant capital commitments. Offering lower fees to investors making larger capital commitments is a rational business choice being made by such sponsors. The Federal tax system should not alter such rational activity that is the product of a properly functioning investment market.

 

D. Application of Substance-Over-Form Principle to the Economic Terms of the Class A/B Structure is Improper

 

The Class A and B shares are designed differently than shares previously considered by the Service. Specifically, the Class A shares represent common shares with economic attributes that would reflect identical sharing of management and advisory fees by all shareholders. In addition to the economic rights of the Class A shares, the Class B shares also include a right to a separate special dividend that reflects an amount equal to the originally negotiated base management fee that otherwise would be borne by reference to the NAV attributable to such Class B shares.

Although the special dividend is determined by reference to the originally negotiated base management fee, that base management fee amount may be changed permanently at some future date or may be fully or partially waived in a given period. In neither situation will the special dividend be altered without a vote of the shareholder group who would be disadvantaged, making it unlikely that the special dividend would change.

In addition, as described in the ruling, the share classes may be offered separately for redemption. Although not described in the ruling, in many structures, the Class A and B shares may be sold separately to third-party purchasers with the sponsor's consent (which consent may not be unreasonably withheld). Accordingly, while the ratio of Class A and B shares issued to an investor may originally be intended to reflect a set fee arrangement,62 an investor may unilaterally alter that arrangement by offering for redemption or transferring to a third party either Class A or B shares alone or in any proportion as desired.

The possible change in base fees and the ability to redeem or dispose Class A and Class B shares separately highlight the fact that the special dividend associated with the Class B shares is a true attribute of that stock that does not simply reflect a set variance in fee sharing for an investor. The special dividend represents a separate income right with respect to the stock that, under multiple realistic scenarios, could become disconnected from the originally negotiated fee arrangement.

Despite these facts, in P.L.R. 201444022, the Service collapsed the A and B classes into a single class based on an improper application of the substance over form principle to support the Service's view of the purpose of the preferential dividend rules. The Service cited no authority for this substance over form analysis, and its application would seem to be inconsistent with the limited case law authority implying a general view that the preferential dividends rules should apply by reference to the form of classes and payments made with respect to the classes.63

Beyond the applicable case law, other substantive arguments strongly support respecting the form of the separate nature of the classes. Note that the Class A and B shares provide equivalent economic returns, except that the special dividend provides an additional level of return measured by reference to the NAV of the Class B shares. The structure is arguably indistinguishable from the example in Treas. Reg. § 1.565-6 describing "consent stock." The example states, "if class A is to receive 3 percent and then share equally or in some fixed proportion with class B in the remainder of the earnings, both class A stock and class B stock are consent stock."64 Given that classification as consent stock is relevant only for purposes of determining whether consent dividends will give rise to a dividends paid deduction with respect to such stock, it seems clear that the dividend arrangement for class A and B stock described in the example does not give rise to a preferential dividend. Taking into account the similarity between the class A and B shares in the example and the Class A and B shares in P.L.R. 201444022, the example strongly supports treatment of the Class A and B shares in the ruling as separate classes of stock for purposes of the preferential dividend analysis.

Considering the economic factors associated with the Class A and B shares that were present in P.L.R. 201444022 and the analysis described immediately above, it seems clear that the Service's single-class determination based on the substance of the arrangement is improper.

 

E. Application of 1940 Act Standards in Preferential Dividend Analysis to REITs is Inappropriate

 

Although not discussed in detail in P.L.R. 201444022, the Service's historic analysis and detailed reference in the ruling to Rev. Proc. 99-40 strongly implies that the Service is evaluating shareholder "fairness" by analogy to 1940 Act standards.65 This analysis, as applied to RICs, relates back to G.C.M. 39457 and the related private letter rulings in 1985.66 The support for application of 1940 Act standards has always been highly questionable,67 as the preferential dividend rules were enacted in 1938, prior to enactment of the 1940 Act, and the preferential dividend rules apply beyond RICs to REITs and personal holding companies, which generally are not subject to the 1940 Act.68 As noted above, private letter rulings issued from 2010 and 2012 drew parallels between the securities rules applicable to the publicly-offered non-traded REITs that were the subject of the rulings and the 1940 Act in support of applying Rev. Proc. 99-40 standards to these REITs.69

At some point, however, the drawing of parallels between applicable securities rules breaks down in applying the preferential dividend rules to all parties who are subject to these rules. Although not discussed in P.L.R. 201444022, as described above, most REITs utilizing the Class A/B structure offer shares only to accredited investors and qualified investors. Shareholder protections provided to such accredited and qualified investors are significantly less than those who are subject to the 1940 Act, as these investors have resources and are presumed to have a level of sophistication that permit them to negotiate and protect themselves in making investment decisions. In this context, it is hard to understand how the Service, without specific direction from Congress, should assume a role as the protector of investor rights, applying standards that are more rigorous than rules imposed by the SEC, the division of the Government that is explicitly tasked with interpreting and enforcing investor rights.

As previously discussed, in testifying on the prospect of amending proposed legislation in order to permit divergent management and advisory fees with respect to a single class of RIC stock, a member of the U.S. Treasury Department stated:

 

[W]hile we realize that one of the historical policies underlying the preferential dividend provision is shareholder fairness, we believe that the relationship between RICs and their shareholders is more appropriately regulated by the Securities and Exchange Commission through the securities laws than by the Internal Revenue Service through the Internal Revenue Code.70

 

Similarly, in repealing the preferential dividend rules with respect to publicly-traded RICs in 2010, the legislative history emphasizes that "securities law, administered by the Securities Exchange Commission, provides strict limits on the ability of RICs to issue shares with preferences."71

As applied to REITs utilizing the Class A/B structure, analysis of the preferential dividend rules by reference to 1940 Act standards is without support. Consistent with the statute and regulations, shareholder "fairness" should be determined by reference to whether shareholders are receiving distributions in accordance with their defined economic rights and not by reference to whether Federal securities rules not applicable to the subject investors are being satisfied.

 

F. Single-Class Conclusion Creates an Untenable Scenario for Existing REITs in Paying Dividends to Shareholders

 

Finally, consider the conundrum that the Service's improper conclusion presents for existing REITs utilizing the Class A/B structure. A REIT cannot rely on the ruling to pay equivalent dividends to the Class A and B shareholders without the prospect of shareholder suits, flood of redemption demands, and loss of prospective investors. This is because such reliance would be inconsistent with the legal dividend obligation of the REIT and the substantive differences embedded in each class of the shares. On the other hand, ignoring the potential application of the ruling risks tax audit and related administrative and legal challenges for the REIT, and it is highly likely that this tax uncertainty will steer away prospective investors, even if the REIT ultimately prevails. Either way, REITs utilizing the Class A/B structure risk facing significant legal costs if not draconian financial consequences that could threaten their future.

 

* * *

 

 

For the reasons discussed, we believe that the Service should reconsider its analysis of the Class A/B structure, as set forth in P.L.R. 201444022. The ruling threatens fund-raising efforts, may cause investors to demand redemption of their REIT stock, and has created significant concern within the real estate market that REITs may be forced to defend similar structures on audit. In addition to the negative impact on capital formation, these circumstances could result in material damage to public pension funds and other investors. We would be pleased to discuss with you this important issue and how it impacts investment in U.S. real estate. Please let us know if you have any questions or would like further information.
Sincerely,

 

 

Jeffrey D. DeBoer

 

President and Chief Executive

 

Officer

 

cc:

 

Mr. Erik Corwin (Internal Revenue Service -- Chief Counsel)

 

Ms. Helen Hubbard (Internal Revenue Service -- Chief Counsel)

 

Mr. David Silber (Internal Revenue Service -- Chief Counsel)

 

Mr. Jonathan Silver (Internal Revenue Service -- Chief Counsel)

 

Ms. Susan Baker (Internal Revenue Service -- Chief Counsel)

 

FOOTNOTES

 

 

1 (July 21, 2014).

2 In October 2014, the 433 largest U.S. public and private pension funds tracked by the research firm Preqin had aggregate assets exceeding $5.8 trillion and, on average, allocated 7 percent of total their assets under management to private real estate investments. Brian Chung, US-Based Pension Funds with AUM Over $1bn Investing in Private Real Estate (Oct. 13, 2014), available at: https://www.preqin.com/blog/101/10048/us-based-pension-funds. At the end of fiscal year 2013, 95 state pension systems held $234 billion, or 9 percent of their assets, in real estate. Stephen Nesbitt, Cliffwater 2014 Report on State Pension Asset Allocation and Performance (Aug. 4, 2014), available at: http://goo.gl/DSj6mS.

3 Note that, unlike regulated investment companies ("RICs"), REITs do not invest in liquid securities but instead invest in illiquid real estate. Given liquidity constraints faced by REITs, significant calls for redemption could threaten the viability of those entities that are subject to such calls.

4 I.R.C. § 562(c) (emphasis added).

5 Treas. Reg. § 1.562-2(a) (emphasis added).

6 Revenue Act of 1936, P.L. 74-740, §§ 13(a)(3), 27(g), and 48(e).

7See NYSBA Tax Section Recommends Repeal of Preferential Dividend Rule, 2008 TNT 68-39 2008 TNT 68-39: Congressional Tax Correspondence (Apr. 8, 2008) (hereafter referred to as the "NYSBA Report").

8 H.R. Conf. Rep. No. 1860 (1938) (emphasis added). Although the legislative history reflects only a general anti-abuse purpose, commentators have stated that the preferential dividend rule was intended to prevent corporations that otherwise were subject to the personal holding company tax, the accumulated earnings tax, and the surtax on undistributed income from avoiding them by making disproportionate distributions to low-bracket taxpayers. NYSBA Report, supra note 5; see also P.L.R. 8903073 (Oct. 26, 1988) (citing ability to defer dividend income to certain shareholders as a target of preferential dividend rules).

9 P.L.R. 8552063 (Sept. 30, 1985); P.L.R. 8601016 (Sept. 30, 1985).

10 G.C.M. 39457 (Dec. 18, 1985).

11Id.

12Id.

13Id. (footnote omitted).

14Treasury Tax Legislative Counsel Ross Testifies Before the House Subcommittee on Bills Affecting Pass-Through Entities, 86 Tax Notes Today 116-8 (June 11, 1986)(hereafter "Treasury Testimony").

15Id. The Treasury Testimony cites P.L.R. 8552063 (September 30, 1985) as the ruling that the proposed modification would address. Id. at n 10..

16 H.R. Conf. Rep. No. 841, at II-246 (1986).

17 Jt. Comm. on Tax'n, General Explanation of the Tax Reform Act of 1986, at 382 (1987).

18 As will be discussed below, the preferential dividend rules no longer apply with respect to publicly-offered RICs.

19 (Aug. 18, 1987).

20 P.L.R. 8746045 (Aug. 18, 1987); P.L.R. 8822082 (Mar. 10, 1988); cf. P.L.R. 8850055 (Sept. 21, 1988).

21 1970-2 C.B. 146.

22 P.L.R. 8746045 (Aug. 18, 1987).

23Id.

24 P.L.R. 9105041 (Aug. 14, 1990); see also P.L.R. 9107017 (Nov. 16, 1990); P.L.R. 9139021 (June 28, 1991).

25Id.

26 (Feb. 17, 1995).

27 P.L.R. 9520037 (Feb. 17, 1995).

28See S. Stratton, IRS Zero Tolerance Policy for RIC Distribution Differentials Outlined at AICPA Meeting, 95 Tax Notes Today 109-6 (June 6, 1995) (quoting Alan B. Munro Jr., then an attorney-adviser in the Office of Assistant Chief Counsel (Financial Institutions and Products), as follows in the context of evaluating preferential dividends: "Management fees always have to be proportionate").

29See S. Stratton, ABA Tax Section Meeting: RIC Lawyers Still Waiting for Guidance, 96 Tax Notes Today 94-40 (May 13, 1996) (Jonathan Zelnik, then an attorney-adviser in Branch 2 in the Office of Assistant Chief Counsel (Financial Institutions and Products), in addressing the suggestion that the Service simply track SEC rules (Rule 18(f)(e)) on allocation of expenses, stated that he thought this was a good idea, and he recognized that both the SEC and the code have somewhat the same policy to contend with: fairness to the investing public).

30 1996-2 C.B. 338.

31 1996-40 I.R.B. 10

32See supra notes 14-17 and accompanying text.

33 I.R.C. § 562(c).

34 H.R. Conf. Rep. No. 99-841, at II-246 (1986).

35 1999-2 C.B. 565.

36See Rule 18f-3, 17 CFR 270.18f-3; Exemption for Open-End Management Investment Companies Issuing Multiple Classes of Shares; Disclosures by Multiple Class and Master-Feeder Funds; Class Voting, Securities Act Release No. 7143, Investment Company Act Release No. 20915, 58 SEC Docket 2231 (Feb. 23, 1995). Rule 18f-3 emphasizes that adivergent allocation of expenses should not result in a cross-subsidization of classes. More specifically, the SEC stated:

This modification is not intended to allow reimbursements or waivers to become de facto modifications of the fees provided for in advisory or other contracts so as to provide a means of cross subsidization between classes. Consistent with its oversight of the class system and its independent fiduciary obligations of each class, the board must monitor the use of waivers or reimbursements to guard against cross-subsidization between classes.
Id.

37NYSBA Report, supra note 7 (footnotes omitted).

38 R. Baneman, Preferential Dividends in the Regulated Investment Context, 2006 Tax Notes Today 64-63 (Apr. 4, 2006).

39 Jt. Comm. On Tax'n, Technical Explanation of H.R. 4337, "The Regulated Investment Company Modernization Act of 2010," For Consideration on the Floor of the House of Representatives (JCX 49-10) (September 28, 2010) (emphasis added and footnotes omitted). With respect to the statement regarding strict limits imposed by the securities laws in the second paragraph, the explanation cites to the Investment Company Act of 1940.

40 S. Johnson, Taxation of Regulated Investment Companies and Their Shareholders, ¶ 3.04[6] [e] [iv].

41 P.L.R. 201109003 (Aug. 24, 2010), supplemented by P.L.R. 201119025 (Feb. 3, 2011).

42 P.L.R. 201135002 (May 17, 2011); P.L.R. 201205004 (Nov. 1, 2011).

43 P.L.R. 201205004 (Nov. 1, 2011).

44See P.L.R. 201244012 (Aug. 2, 2012); P.L.R. 201304004 (Oct. 22, 2012); P.L.R. 201316013 (Jan. 16, 2013); P.L.R.201327006 (Apr. 2, 2013).

45 P.L.R. 201408014 (Nov. 26, 2013).

46 143 F.2d 381 (5th Cir. 1944).

47 The ruling contains no analysis regarding the Service's conclusion that the payment of the special dividend on Class B shares is properly treated as part of the entire distribution made to the Class A and B shareholders, thus causing all such distributions to be treated as preferential. The special dividend considered in the ruling would be separately declared and paid at a different time, arguably requiring a conclusion that, under the Service's broader analysis, it is only the special dividend that should be treated as preferential.

48 It is not uncommon for an adviser to reduce or waive management fees during a period of poor performance.

49See supra notes 4-5 and accompanying text.

50See supra notes 16-17 and accompanying text.

51 P.L.R. 201444022 (July 21, 2014).

52Id.

53Id.

54Id.

55 In the context of the "one-class of stock" rules for S corporations, the regulations state that "a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds." Treas. Reg. § 1.1361-1(l)(1). Regulations under former section 4920 defined "class of stock" to mean all shares of stock issued by a corporation which are identical with respect to the rights and interest which such shares represent in control, profits, and assets of the corporation. Section 147.7-2(c)(3) of the Temporary Regulations under the Interest Equalization Tax Act (as referenced in Rev. Proc. 64-50, 1964-2 C.B. 999). In the context of proposed regulations issued in 2009 relating to recovery of stock basis, the Service stated in the preamble that "different classes of stock have distinct legal entitlements that are respected for federal income tax purposes." REG-143686-07, 2009-1 C.B. 579 (preamble). Proposed regulations under section 302 provide that a class of stock "is defined with respect to economic rights to distributions rather than the labels attached to shares or rights with respect to corporate governance." Prop. Reg. § 1.302-5(b)(2). Proposed regulations under section 358 provide "[s]tock, or securities, as the case may be, which differ . . . because the rights attributable to them differ . . . are considered different classes of stock or securities, as the case may be, for purposes of this section." Prop. Reg. § 1.358-2(a)(2).

56See supra notes 19-23 and accompanying text.

57 P.L.R. 201444022 (July 21, 2014).

58See supra note 15.

59See supra notes 11-13 and accompanying text.

60Treasury Testimony, supra note 14 (emphasis added).

61Compare I.L.M. 200842039 (June 19, 2008) (consent dividend structure implemented by closely-held REIT to artificially shift income to a tax-indifferent party was subject to challenge, in part, under the preferential dividend rules; consent dividends paid by a REIT were in excess of the true economic rights of the preferred shareholders and hence were shams).

62 In other words, if an investor initially is intended to bear a fee equal to 80 percent of the maximum fee payable by a small investor, that investor would receive 80 percent Class A shares and 20 percent Class B shares.

63See supra note 46 and accompanying text.

64 Treas. Reg. § 1.565-6(a)(2), example.

65Cf. supra note 45 and accompanying text discussing P.L.R. 201408014, which specifically states that Rev. Proc. 99-40 is "instructive by analogy" in evaluating dividends paid by REITs.

66See supra note 10-13 and accompanying text.

67See supra notes 37, 38, and 40 and accompanying text.

68 In addition to personal holding companies and mutual investment companies, the preferential dividend rules also originally applied for purposes of determining the accumulated earnings tax and the surtax on undistributed earnings. See supra note 7 and accompanying text.

69See supra note 43 and accompanying text.

70Treasury Testimony, supra note 14

71See supra note 39 and accompanying text.

 

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