ICI Requests Guidance on Regulated Investment Company Issues

[1] The Investment Company Institute¹ is writing to request the issuance of published guidance clarifying the application to regulated investment companies ("RICs") of the "business continuity" test for satisfying the "continuity of business enterprise" requirement² under the tax-free reorganization rules of Section 368(a)(1) of the Internal Revenue Code.³ Specifically, we request clarification that all RICs are in the same business and, consequently, that a merger of two RICs satisfies the business continuity test so long as the surviving RIC continues to be a RIC following the merger. This request, we believe, is supported by policies under both Subchapter C and Subchapter M. At a minimum, we request guidance holding that business continuity is satisfied so long as the acquiring and target RICs are both in the business of investing either in taxable securities (stocks and/or taxable bonds) or in tax-exempt bonds.

[2] We are requesting this guidance because the uncertainties regarding how to apply the "historic business" standard to RICs make it impossible to know whether the target company's "historic business" is continued. Because of these uncertainties, RICs engaging in tax-free reorganizations generally are compelled to satisfy the "asset continuity" test -- which requires continued use of the target RIC's assets by the acquiring RIC. Unfortunately, the mechanical nature of the asset continuity test imposes significant administrative burdens on RICs and has the potential to harm RIC investors by constraining a portfolio manager's ability to manage the acquiring RIC's portfolio for a significant period of time.

[3] The requested guidance would complement a recently adopted SEC rule under the Investment Company Act of 1940 (Rule 17a-8),⁴ which specifically governs mergers of affiliated RICs.⁵ Like Rule 17a-8, the requested business continuity guidance would remove unnecessary obstacles to mergers of RICs.

I. RIC Difficulties With Continuity of Historic Business Test

A. Existing Interpretive Guidance

[4] The business continuity test is satisfied if the surviving entity continues the historic business of the target corporation.⁶ According to the regulations, the fact that the surviving corporation is "in the same line of business" as the target corporation "tends to establish the requisite continuity, but is not alone sufficient."⁷ There is little meaningful guidance to draw upon when evaluating how the historic business test applies to the merger of two RICs.

[5] Revenue Ruling 87-76 is the only published guidance to date regarding application of the historic business test to a merger involving a RIC. This ruling involves a merger that took place in 1982.⁸ The ruling concludes that the target's "historic business of investing in corporate stocks and bonds is not the same line of business as investing in municipal bonds." Because the ruling appears to involve the merger of a non-RIC (with a balanced portfolio of stocks and bonds) into a RIC (investing in tax-exempt bonds), its significance is unclear in the context of a merger of two RICs.⁹ Moreover, the statement in the regulations that the same line of business tends to establish the requisite continuity of business but is not alone sufficient¹⁰ provides advisers with even less basis for certainty in analyzing the appropriate tax treatment for a particular merger.

B. Establishing a RIC's Historic Business

[6] All RICs hold diversified portfolios of securities that are selected by investment advisers consistent with each RIC's stated investment objective (which may be narrow or broad).¹¹ Investors acquire shares in a RIC, and own an undivided interest in the RIC's assets, and are thereby able to acquire significant asset diversification through a relatively modest investment.

[7] RICs may be organized as either open-end or closed-end investment companies. Open-end investment companies, generally known as mutual funds, are the most common type of RIC. The number of shares outstanding in a mutual fund typically varies each day because mutual fund shares are continuously offered to the public and are redeemable upon shareholder demand.¹² The closed-end investment company, in contrast, typically has a fixed number of shares outstanding that trade on established securities exchanges or secondary markets. The number of closed-end RIC shares may change, however, because of dividend reinvestment programs, subsequent share offerings, or periodic redemption opportunities.¹³

[8] The securities held by the RIC in its portfolio generally do not remain fixed; the extent to which the portfolio changes depends on several factors, including the type of fund and the investment adviser's management style. The investment adviser of an actively-managed RIC buys and sells portfolio securities to meet changing market conditions in pursuit of the RIC's investment objective; in the case of mutual funds, securities are bought and sold to invest proceeds from the issuance of additional RIC shares and to meet redemptions by RIC shareholders. Portfolio trades are an integral part of every actively-managed RIC. Even passively-managed index funds buy and sell portfolio securities; the two most common reasons for such trades by index funds are to replicate the relevant market index when securities are added to or deleted from the relevant index and to accommodate cash flows into or out of the RIC.

[9] RICs are subject to securities and tax regimes -- the Investment Company Act of 1940 ("the 1940 Act") and Subchapter M of the Code -- that collectively have a significant impact on a RIC's business operations and set RICs apart from other businesses.

[10] The Securities and Exchange Commission ("SEC") extensively regulates the operation of a RIC pursuant to the 1940 Act. In addition to a requirement to register with the SEC,¹⁴ a RIC is subject under the 1940 Act to, for example, (1) requirements concerning the composition of its board of directors, including requirements that no more than 60 percent of the directors be "interested persons" of the RIC,¹⁵ (2) limitations on the RIC's ability to borrow money or otherwise to issue "senior securities" (e.g., debt or equity securities with a dividend or liquidation preference),¹⁶ (3) limitations on transactions between the RIC and its "affiliated persons" (and their "affiliated persons"),¹⁷ (4) requirements concerning the custody of the RIC's assets¹⁸ and (5) provisions governing the terms of the RIC's contracts with its investment advisers and principal underwriters.¹⁹

[11] The rules of Subchapter M also govern RICs, their investments and their distribution policies. In order to qualify under Subchapter M, a RIC must satisfy the diversification requirements of Section 851(b)(3) and must receive 90% of its gross income from sources permitted by Section 851(b)(2). Subchapter M provides RICs with a deduction for dividends paid and thereby permits RICs to eliminate taxable income at the RIC level by distributing all such income as dividends to shareholders.²⁰ RICs are effectively forced to distribute their income and gains currently if they are to achieve quasi-pass-through status and avoid the excise tax imposed under Section 4982.²¹ Unlike other corporations, including non-RIC investment companies, the character of the RIC's income is typically retained upon distribution to the RIC's shareholders.²²

[12] These characteristics define a relevant line of business for purposes of the historic business analysis. As a result, any RIC to RIC merger should satisfy the business continuity test, even if the two RICs involved in the merger have investment styles and/or stated investment objectives that are not perfectly aligned. Under existing guidance, however, it is unclear to what extent, if any, such differences preclude RICs from being in the same line of business for purposes of the historic business test.

[13] Revenue Ruling 87-76 concludes that investing in stocks or bonds is not the same line of business as investing in municipal bonds. Although, as noted above, the ruling appears to involve the merger of a non-RIC into a RIC, it has generally been interpreted to mean that a RIC investing in stocks and bonds is not in the same line of business as a RIC investing in municipal bonds.

[14] Following the approach in Revenue Ruling 87-76, one could conclude that a merger of two RICs investing in tax-exempt securities satisfies the historic business test as does a merger of two RICs investing in taxable securities (e.g., stocks and/or bonds). However, the Revenue Ruling does not indicate whether the historic business determination should be made based upon broad investment objectives (such as investing in taxable securities) or based upon narrower objectives (such as investing in stocks, or domestic stocks, or domestic technology stocks). The lack of additional guidance makes it very difficult to apply the rule. Moreover, the uncertainty is compounded by the lack of guidance regarding what additional element is needed beyond the same line of business in order to satisfy continuity of historic business test.

[15] Because of these uncertainties, RICs have by and large been unable to rely on the business continuity test. In effect, the uncertainties render the test unavailable in the context of RIC-RIC mergers, and RICs have been forced to rely on the asset continuity test to satisfy the continuity of business enterprise requirement. As explained below, the asset continuity test presents significant practical problems for RICs.

II. RIC Difficulties With Asset Continuity Test

A. Existing Interpretive Guidance

[16] The "asset continuity" test²³ provides that a merger satisfies the continuity of business requirement if the surviving entity uses a "significant portion" of the target corporation's "historic business assets in a business."²⁴ Although several private letter rulings on this point have allowed tax-free treatment for mergers of RICs where up to 66% of the target's assets have been disposed in conjunction with the merger,²⁵ the regulations do not provide a specific percentage of historic assets that constitutes a "significant portion;" they refer instead to all facts and circumstances. Moreover, it is unclear how long the "substantial portion" of the target's assets must be held in order to satisfy the test. Although some suggest that dispositions in the normal course of business should be disregarded for purposes of the test, it is not clear how "the normal course of business" should be defined. Moreover, maintaining the records to establish that securities were disposed in the normal course of business is a burdensome administrative task for merging funds.

B. Applying the Historic Business Assets Test to RICs

[17] The necessity of relying on the historic business assets test to satisfy the tax-free merger rules can place a significant administrative burden on RICs. While a typical business corporation uses its assets in the business (plant, equipment, intangible property), a RIC's assets are its portfolio securities; these securities typically are bought and sold on a regular basis. The process of trying to prove that a sale by an acquiring RIC of a target RIC's assets is in the ordinary course of business is cumbersome and uncertain. RIC administrators painstakingly track the portfolio positions of the merged RIC and maintain documentation regarding the business purpose for the disposition of the portfolio securities of the target RIC. These records serve no business purpose outside of the tax documentation context.

[18] The historic business assets test also can interfere with a portfolio manager's ability to make prudent investment decisions for the RIC. This test can serve to constrain portfolio managers and, thus, has the potential to negatively impact shareholder value.

III. These Practical Difficulties Are Not Required by Relevant Tax Policy Considerations

A. Valid Business Purposes Served by Mergers of Two RICs

[19] Congress and the Treasury Department have both recognized the valid business purposes served by mergers of two RICs. In 1976, Congress enacted Section 368(a)(2)(F), which denies tax-free reorganization treatment to mergers of investment companies unless the companies are diversified. As originally introduced, the legislation would have circumscribed tax-free treatment for any acquisitive reorganization involving an investment company. Following testimony from the Treasury's Deputy Assistant Secretary for Tax Policy, which described the legitimate business purposes of certain investment company mergers and the policy supporting tax-free treatment for such mergers between investment companies, the legislation was revised before enactment to treat as taxable only those mergers involving entities that do not satisfy the diversification test as set forth in Section 368(a)(2)(F).²⁶

B. COBE Requirements Were Not Adopted with RIC-RIC Mergers in Mind

[20] The continuity of business requirement as embodied in the regulations were adopted in direct response to mergers of non-RICs into RICs.²⁷ The mergers at issue typically involved a "sale by a closely-held corporation of all of its assets and a transfer of the sale proceeds to a mutual fund for stock."²⁸ Such mergers were apparently structured to achieve tax-free liquidation of the target operating company and diversification for the target shareholders. The continuity of business requirement was intended to reign in the proliferation of such mergers.²⁹

[21] Since these regulations were promulgated in 1979, Congress has enacted specific provisions that further serve to curtail the type of non-RIC to RIC mergers that were the target of the continuity of business enterprise regulations. First, in 1984, Congress further reduced the frequency of RIC/non-RIC mergers by eliminating the ability of a RIC to have earnings and profits from a Subchapter C corporation year. Specifically, the tax regime applicable to RICs (Subchapter M) was amended³⁰ to provide that Subchapter M treatment would not be available unless a target's earnings and profits from its Subchapter C years are distributed either before the merger or by the end of the RIC's tax year in which the merger takes place. This 1984 change effectively provides current taxation -- at both the entity and shareholder level -- for the type of transaction that prompted the continuity of business enterprise regulations (because the target's accumulated earnings and profits and the earnings and profits generated by selling its portfolio securities would have to be distributed to shareholders).

[22] Two years later, in 1986, Congress repealed the General Utilities doctrine in order to require corporations to recognize gain or loss on the distribution of property upon a complete liquidation (other than certain subsidiary liquidations).³¹ Shortly thereafter, Congress specifically directed Treasury, via Section 337(d), to prescribe regulations to ensure that the purposes of General Utilities repeal were not circumvented through the use of, inter alia, a RIC.³² Accordingly, Treasury has promulgated temporary and proposed regulations that provide for the recognition of built-in gains upon the conversion of a C corporation into a RIC.³³

C. Mergers Between Two RICs Do Not Create Deferral/Tax Attribute Issues

[23] It is notable that the continuity of business requirement was not implemented with transactions involving target RICs in mind. The primary policy issue with respect to the continuity of business regulations is to prevent the avoidance of tax at the shareholder level for a target corporation. Because RICs distribute currently essentially all of their income to shareholders, any gain on disposition of assets in a potential target RIC flows through to RIC shareholders currently as either an ordinary income dividend (in the case of short-term capital gains) or capital gain dividends (in the case of long-term capital gains). So, in a RIC-RIC merger, the shareholders are taxed on all gains from the sale of the target RIC's assets in connection with the merger. For example, if the target in Revenue Ruling 87-76 had been a RIC, the target shareholders would have recognized all of the gain on the sale of the target's assets.

[24] A secondary policy issue with respect to the continuity of business requirement relates to the carryover of Section 381 attributes. As RICs are not allowed a net operating loss deduction and their capital loss carryovers are limited by Section 382, the carryover of Section 381 attributes is not a significant issue in the RIC merger context. Accordingly, the policy concerns that prompted the business continuity regulations are not implicated by the mergers for which the Institute seeks guidance.

IV. Proposal

[25] Because of the uncertainties discussed above and the absence of any significant tax policy rational to justify such tight regulation of a merger between two RICs, the Institute respectfully requests that guidance be issued clarifying how the historic business test is to be applied in the context of a RIC-RIC merger.

[26] More specifically, we request guidance clarifying that all RICs are in the same business and, accordingly, that the merger of two RICs always will meet the continuity of historic business test and thereby satisfy the continuity of business requirement. Shareholders merging from one RIC into another RIC merely change the corporate form through which they hold their share of a diversified pool of assets. Adjustments to the mix of securities in a RIC do not change the shareholder's "continuing interest" in a constantly changing portfolio.

[27] If the Service is unwilling to issue such guidance, we request, at a minimum, that it issue guidance consistent [with] Rev. Rul. 87-76, clarifying that the merger of two RICs investing in taxable securities will satisfy the continuity of business requirement as will the merger of two RICs investing in tax-exempt securities. Any determination of historic business that looks more finely at a RIC's investment objective runs a significant risk of being unadministrable and/or unusable.

[28] We submit that the guidance requested is consistent with the existing guidance discussed above and with the relevant tax policy considerations. Please do not hesitate to contact the undersigned at (202) 326-5821 or Keith Lawson, the Institute's Senior Counsel for Tax, at (202) 326-5832 if you would like any additional information regarding the Institute's views on this requested guidance.

²Treas. Reg. § 1.368-1(d).

³All Section references herein are to the Internal Revenue Code of 1986, as amended (IRC or the "Code") and the regulations thereunder, unless otherwise indicated.

⁴See SEC Release No. IC-25666 (July 18, 2002); 67 Fed. Reg. 48512 (July 24, 2002).

⁵The rule sets forth various requirements designed to protect the ongoing investment interest of the RICs' shareholders. Among other things, Rule 17a-8 requires each RIC's board (including a majority of disinterested directors) to determine that the merger is in the best interests of the RIC and will not dilute the interests of shareholders. In making such determinations, RIC boards are required to consider, inter alia, any change in the RIC's investment objective that will result from the merger. This requirement essentially acknowledges that there may be valid business purposes for a RIC to adjust its investment objective over time.

⁶Treas. Reg. § 1.368-1(d)(2)(i).

⁷Id.

⁸This is two years prior to the addition of Section 852(a)(2) discussed, infra, which effectively provides current taxation at the entity and shareholder level for RIC mergers with non-RIC targets.

⁹The ruling describes the target as a corporation in the "investment business" (presumably not a RIC); the acquiring entity is described as an "open-end management investment company" (presumably a RIC).

¹⁰Treas. Reg. 1.368-1(d)(2)(i).

¹¹If a RIC's investment objective is deemed to be a matter of "fundamental policy" it may be changed only if authorized by a shareholder vote. 15 U.S.C. 80a, §§ 8(b)(3),13(a)(3).

¹²Mutual fund shares do not trade on stock exchanges; instead, mutual fund investors purchase shares from and redeem shares to the mutual fund at net asset value (or "NAV") which is calculated by dividing the RIC's net assets (valued daily) by the number of shares outstanding.

¹³The shares of closed-end RICs trade on these markets at prices, determined by supply and demand, that may be less than, equal to, or greater than the RIC's NAV.

¹⁴Section 7(a) of the Investment Company Act of 1940 (the "1940 Act").

¹⁵1940 Act, § 10.

¹⁶1940 Act, § 18(f). Recent rule amendments require that, as a condition to relying on certain key exemptive rules under the 1940 Act, a majority of a RIC's directors must not be "interested persons" of the RIC.

¹⁷1940 Act, § 17(a), 17(d), 17(e) and 21(b).

¹⁸1940 Act, § 17(f).

¹⁹1940 Act, § 15.

²⁰See § 852(b)(2).

²¹Section 4982 effectively requires that essentially all of such income be distributed in the calendar year in which it is earned by imposing an excise tax unless certain very high distribution thresholds are met. Additional requirements imposed by Subchapter M include a prohibition on the RIC retaining any Subchapter C earnings and profits.

²²For example, Section 852(b)(3) provides that the character of a RIC's long-term capital gains is retained when such gains are distributed to the RIC's shareholders as a capital gain dividend. Similarly, Section 852(b)(5) provides that tax-exempt interest distributed to shareholders retains its tax-exempt character. RICs are also able to pass foreign tax credits through to shareholders under Section 853.

²³Treas. Reg. § 1.368-1(d)(3).

²⁴Treas. Reg. § 1.368-1(d)(3)(i).

²⁵See, e.g., P.L.R. 200115030, P.L.R. 200116028, P.L.R. 200111023, P.L.R. 200111024.

²⁶P.L. 94-455, § 2131(a) (1976); Taxation of Exchange (Swap) Fund Capital Gains: Hearing on H.R. 11920 Before the House Comm. On Ways and Means, 94th Cong., 2d Sess, 13 (1976) (statement of William M. Goldstein, Deputy Assistant Secretary of the Treasury for Tax Policy to the Committee on Ways and Means) ("Because continuity of interest is also present in these transactions, most reorganizations between investment companies have come within the spirit, as well as the letter of the tax-free reorganization provisions.").

²⁷44 Fed. Reg. 76813 (1979) ("Recent developments involving the availability of tax-free reorganization treatment for certain mutual fund transactions require clarification, in general, of the continuity of business enterprise requirement.").

²⁸Id.

²⁹Id.

³⁰IRC § 852(a)(2), as added by the Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 1071(a)(3)(1984).

³¹General Util. & Operating Co. v. Helvering, 296 US 200 (1935). In addition to the repeal of the General Utilities doctrine, the loss limitations in Section 382 of the code that limit the surviving entity's ability to use the target's losses have arguably reduced the need for the continuity of business enterprise requirement generally.

³²IRC § 337(d), as corrected by the Technical and Miscellaneous Revenue Act of 1988 (TAMARA), Pub. L. No. 100-647, § 1006(e)(5)(A)(i)-(ii).

³³Treas. Reg. §§ 1.337(d)-6T, 7T.