[Federal Register Volume 60, Number 154 (Thursday, August 10, 1995)]
[Proposed Rules]
[Pages 40794-40796]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-19449]



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DEPARTMENT OF THE TREASURY
26 CFR Part 1

[CO-19-95]
RIN 1545-AT43


Transfers to Investment Companies

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document proposes amendments to regulations relating to 
transfers to investment companies. The amendments are necessary to 
clarify existing regulations relating to certain transfers to a 
controlled corporation. Generally, the regulations will be amended to 
provide when certain transfers will not cause a diversification of the 
transferors' interests.

DATES: Written comments and requests for a public hearing must be 
received by November 8, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (CO-19-95), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (CO-19-95), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Andrew M. Eisenberg, (202) 622-7790 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document proposes amendments to the Income Tax Regulations (26 
CFR part 1) under section 351 of the Internal Revenue Code of 1986. 
Section 351(a) provides that no gain or loss will be recognized if one 
or more persons transfer property to a corporation solely in exchange 
for stock in the corporation and immediately after the exchange the 
transferors control the transferee corporation. Section 351(e)(1) 
provides that section 351(a) will not apply to a transfer of property 
to an investment company.
    The rule of section 351(e)(1) was enacted as part of the Foreign 
Investors Tax Act of 1966, with the goal of preventing individuals from 
achieving tax-free diversification by the transfer of one or a few 
stocks or securities to a corporation (referred to as a swap fund). See 
generally H. Rep. No. 1049, 94th Cong., 2d Sess. (Apr. 27, 1976).
    Section 1.351-1(c)(1) states that a transfer to an investment 
company will occur when (i) the transfer results in diversification of 
the transferors' interests and (ii) the transferee is a Regulated 
Investment Company (RIC), Real Estate Investment Trust (REIT), or a 
corporation more than 80 percent of the value of whose assets 
(excluding cash and non-convertible debt obligations) are readily 
marketable stocks or securities. Section 1.351-1(c)(5) provides that a 
transfer ordinarily results in the diversification of the transferors' 
interests if two or more persons transfer nonidentical assets to a 
corporation in the exchange.
    As part of the Tax Reform Act of 1976 (the 1976 Act), Congress 
enacted sections 683(a) and 721(b), which incorporate the section 
351(e) rules for transfers to a trust and a partnership, respectively.
    The 1976 Act also addressed reorganizations of investment companies 
by enacting section 368(a)(2)(F). This legislation was intended to 
prevent the tax-free merger of a closely held corporation holding an 
undiversified group of assets into a publicly held diversified 
investment company, resulting in a tax-free diversification of the 
interests of the target shareholders.
    Section 368(a)(2)(F)(i) provides that a transaction between two 
``investment companies'' otherwise qualifying as a reorganization will 
not qualify as a reorganization for any corporation in the transaction 
that is not a RIC, REIT, or corporation described in section 
368(a)(2)(F)(ii). Section 368(a)(2)(F)(iii) defines an investment 
company as a RIC, REIT, or corporation with at least 50 percent of its 
assets comprised of stocks or securities and 80 percent of its assets 
held for investment. A corporation satisfies section 368(a)(2)(F)(ii) 
if not more than 25 percent of the value of its total assets is 
invested in the stock and securities of any one issuer and not more 
than 50 percent of the value of its total assets is invested in the 
stock and securities of five or fewer issuers. For purposes of the 
section 368(a)(2)(F)(ii) test, all members of a controlled group of 
corporations (within the meaning of section 1563(a)) shall be treated 
as one issuer. Also, a person holding stock in a RIC, REIT, or other 
investment company (as defined in section 368(a)(2)(F)(iii)) that meets 
the requirements of section 368(a)(2)(F)(ii) shall be treated as 
holding its proportionate share of the assets held by the company. 
Section 368(a)(2)(F)(iv) provides that in determining total assets, 
certain assets shall be excluded, including cash and cash items 
(including receivables), Government securities, and assets acquired to 
meet section 368(a)(2)(F)(ii) or to cease to be an investment company. 
Section 368(a)(2)(F)(v) provides that section 368(a)(2)(F) shall not 
apply if the stock of each investment company is owned substantially by 
the same persons in the same proportions. Section 368(a)(2)(F)(vii) 
defines securities for purposes of clauses (ii) and (iii) of section 
368(a)(2)(F). 

[[Page 40795]]


Reasons for Change

    The IRS wants to clarify that Sec. 1.351-1(c)(5) does not prevent 
tax-free combinations of already diversified portfolios, and that 
combinations of already diversified portfolios are not inconsistent 
with the purposes of section 351(e) (i.e., preventing the tax-free 
transfer of one or a few stocks or securities to swap funds). For 
example, RICs often transfer portfolios of investment assets to 
partnerships under section 721(a) (which is subject to the section 
351(e) rules pursuant to section 721(b)). These transactions are 
appropriately tax-free because the RICs are not transferring one or a 
few stocks or securities, but rather, the RICs are transferring 
diversified portfolios of stocks and securities.
    Also, the nonidentical asset standard of Sec. 1.351-1(c)(5) is 
stricter than the test applied for combinations of investment companies 
under the corporate reorganization provisions (see section 
368(a)(2)(F)(ii)). Transfers of certain diversified portfolios to a 
corporation may be taxable under section 351(e), while the same 
portfolios could be combined through a merger that may qualify as a 
tax-free reorganization.

Explanation of Provisions

    The proposed amendments to Sec. 1.351-1(c) provide that transfers 
of assets will not be treated as transfers that result in 
diversification of the transferors' interests for purposes of 
Sec. 1.351-1(c)(1)(i) if each transferor transfers assets that satisfy 
section 368(a)(2)(F)(ii), as modified. Under this rule, no transfers of 
nonidentical assets to a corporation described in Sec. 1.351-
1(c)(1)(ii) will qualify for nonrecognition treatment under section 351 
unless each transferor transfers assets that satisfy section 
368(a)(2)(F)(ii), as modified.
    For purposes of Sec. 1.351-1(c), relevant provisions of section 
368(a)(2)(F) will apply to the section 368(a)(2)(F)(ii) test. Those 
provisions include the controlled group and look-through rules found in 
clause (ii) (members of a controlled group of corporations are 
considered as one issuer and persons holding stock in certain 
investment companies are treated as holding a proportionate share of 
the investment company's assets), the common ownership rule found in 
clause (v) (diversification will not be considered to occur if the 
interests in the assets to be transferred are held substantially by the 
same persons in the same proportions as the interests in the 
transferee), and the definition of securities found in clause (vii) 
(the term securities includes investments constituting a security 
within the meaning of the Investment Company Act of 1940 (15 U.S.C. 
80a-2(36)). The definition of total assets in section 368(a)(2)(F)(iv) 
will apply, except that Government securities will be included in 
determining total assets, unless the Government securities are acquired 
to meet section 368(a)(2)(F)(ii).
    The proposed modification of the definition of total assets to 
include Government securities addresses a problem caused by transfers 
of funds consisting mostly of Government securities. For example, if 95 
percent of a money market fund's assets are invested in Government 
securities and five percent are invested in the stock of corporation X, 
the Government securities would not be treated as securities (see 
section 368(a)(2)(F)(vii)) and, without the modification, would be 
excluded from total assets for purposes of the 25 and 50 percent test 
of section 368(a)(2)(F)(ii). As a result, the unmodified test would 
treat 100 percent of the fund's assets as X stock and the fund would 
not satisfy the 25 and 50 percent test of section 368(a)(2)(F)(ii). The 
modified test would include Government securities in total assets. The 
fund would satisfy the modified test because the stock of one issuer 
would constitute only five percent of the fund's portfolio. The IRS 
believes that the modification is appropriate because the presence of a 
small amount of nondiversified property in a Government securities 
portfolio (otherwise qualifying under section 368(a)(2)(F)(ii)) should 
not disqualify the portfolio from tax-free treatment.
    The adoption of the modified section 368(a)(2)(F)(ii) test is 
intended to limit section 351(e) to cases more analogous to the typical 
swap fund cases that were the focus of the section 351(e) legislation. 
Also, the adoption of this test should minimize the different tax 
treatment of a section 351 transfer and a section 368 reorganization 
under economically similar situations. This test will also apply for 
purposes of sections 683(a) and 721(b). Finally, a proposed revision to 
Sec. 1.584-4(a) adopts this test.
Proposed Effective Date
    These regulations are proposed to apply to transfers of assets 
occurring on or after the date of publication as final regulations in 
the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying. A public 
hearing may be scheduled if requested in writing by a person that 
timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the hearing will be published 
in the Federal Register.

Drafting Information

    The principal author of these regulations is Andrew M. Eisenberg, 
Office of Assistant Chief Counsel (Corporate), IRS. However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 as proposed to be 
amended in a document published elsewhere in this issue of the Federal 
Register continues to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.351-1 also issued under 26 U.S.C. 351 * * *.

    Par. 2. Section 1.351-1 is amended by:
    1. Redesignating paragraph (c)(6) as paragraph (c)(7).
    2. Adding new paragraph (c)(6) to read as follows:


Sec. 1.351-1  Transfer to corporation controlled by transferor.

* * * * * 

[[Page 40796]]

    (c) * * *
    (6) For purposes of paragraph (c)(5) of this section, a transfer of 
assets will not be treated as resulting in a diversification of the 
transferors' interests if each transferor transfers a diversified 
portfolio of assets. For purposes of this paragraph, a portfolio of 
assets is diversified if it satisfies section 368(a)(2)(F)(ii), 
applying the relevant provisions of section 368(a)(2)(F), except that, 
in applying section 368(a)(2)(F)(iv), Government securities are 
included in determining total assets, unless the Government securities 
are acquired to meet section 368(a)(2)(F)(ii).
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-19449 Filed 8-9-95; 8:45 am]
BILLING CODE 4830-01-U