Rev. Rul. 70-525

Advice has been requested concerning the Federal income tax status of two investment companies that were established by a life insurance company and the tax consequences of distributions made by such investment companies to its shareholders under the circumstances described below.

L, a life insurance company, developed a financial security program which in part gives its customers an opportunity, through purchases of interests in an investment company, to obtain advantages commonly associated with mutual funds and retain benefits of the life insurance company's investment management skills. The program is implemented through the combined operations of L, its investment plan account, and its YZ Fund.

YZ Fund is an open-end management company that is registered under the Investment Company Act of 1940, as amended. Presently, shares of YZ Fund are not sold directly to the public but are made available only to L, L's investment plan account, and to one or more other unit investment trusts that may be established by L. L acts as principal underwriter and investment advisor for YZ Fund.

YZ Fund invests its assets primarily in common stock. It is similar to other mutual funds registered as "management companies" under the Investment Company Act. YZ Fund has filed an election to be a regulated investment company. It distributes to all of its shareholders its ordinary income and capital gains in January following the close of the taxable year to which they relate. Pursuant to resolutions of L's board of directors, the investment plan account was established as a unit investment trust with L as the sponsor and depositor, and it was registered under the Investment Company Act of 1940. In accordance with the Act, L, as depositor, entered into a contract of custodianship with a bank under which the bank holds all of the assets of the investment plan account in trust until distribution thereof to, or for the account of, the holders of participating interests in such assets. The only assets of the investment plan account are shares of the YZ Fund.

A resolution adopted by L's board of directors authorizes the sale of security shares of the investment plan account. In order to purchase security shares an individual must first establish a transfer account with L. Such shares evidence beneficial interest in the assets of the investment plan account and are sold to planholders under the systematic investment plan contract of L's financial security program. After each purchase, a planholder receives a notice stating the number of shares credited to his account, the value of each share on date of payment, and the total number of shares then standing to his account.

At the time of each purchase, the cost of the security shares is charged to the transfer account of the planholder, and a charge is made by L for sales and administrative expenses and deducted from the transfer account. The net price paid to the investment plan account for the security shares is invested in shares of YZ Fund. As depositor of the investment plan account, L is authorized to substitute the shares of another mutual fund, on notice to the holders of security shares, if such action appears to be in their best interest.

The assets of the investment plan account are held for the sole benefit of holders of security shares and are not subject to claims of any policyholders or creditors of L. Under state law, L is required to include the assets and liabilities of the investment plan account as part of the assets and liabilities set forth in its annual statement of separate account business that is filed with the state and also to report receipts and disbursements from such investment plan account. Thus, the investment plan account is a segregated asset account under the insurance laws or regulations of a state.

In January of each year, the investment plan account's annual net income and capital gains for its prior taxable year are allocated to planholders in the same proportion as their ownership of security shares. An annual custodial charge is deducted from each planholder's allocable share. The balance is applied to increase the number of security shares credited to the planholder unless either the planholder or L elects to have such balance paid in cash.

L, as depositor, has caused the investment plan account to elect to be a regulated investment company as defined in section 851(a) of the Internal Revenue Code of 1954 and has caused the account to comply with the diversification and distribution requirements of sections 851(b) and 852(a) of the Code. Each load, fee, and charge earned by L for services performed in the operation of the YZ Fund and the investment plan account has been included in L's income, and all expenses incurred by L in rendering such services have been deducted by L.

Section 851(a) of the Code provides that the term "regulated investment company" means any domestic corporation which at all times during the taxable year is registered under the Investment Company Act of 1940, as amended, either as a management company or as a unit investment trust if, under Section 851(b) of the Code, the company has elected to be a regulated investment company. In addition, the company must comply with certain income and investment requirements.

Section 851(f) of the Code, enacted by the Tax Reform Act of 1969, provides that a unit investment trust is not to be treated as a corporation, partnership or trust and that the assets of such periodic payment plan shall be treated as owned by the holders of shares in the plan. The provision does not apply to a unit investment trust which is a segregated asset account under the insurance laws or regulations of a State, whether or not the assets are subject to variable annuity contracts. Accordingly, section 851(f) of the Code does not apply because the investment plan account is a unit investment trust which is a segregated asset account under the insurance laws of a state.

Section 1.852-10(e) of the Income Tax Regulations defines a unit investment trust as a business arrangement which is registered as a unit investment trust under the Investment Company Act of 1940; issues "periodic payment plan certificates" as defined in the 1940 Act; possesses, as substantially all of its assets, securities issued by a "management company" as defined in the 1940 Act; and meets the diversification, election and distribution requirements set forth in sections 851 and 852(a) of the Code.

Section 852(a) of the Code provides, in pertinent part, that to be taxed as a regulated investment company a company must distribute during the taxable year to its shareholders, as taxable dividends (other than capital gain dividends), an amount not less than 90 percent of its investment company taxable income for the taxable year computed without capital gain dividends.

Section 301.7701-4(c) of the Regulations on Procedure and Administration provides that a trust of the type commonly known as a fixed investment trust is an association if there is power under the trust agreement to vary the investment of the certificate holders.

In the instant case, L, as depositor of the investment plan account, is authorized to substitute the shares of another mutual fund for shares of YZ Fund if such action appears to be in the best interest of the planholder.

Accordingly, it is held as follows:

(1) Since the investment plan account is registered under the Investment Company Act of 1940 as a unit investment trust, it has met the diversification, election, and distribution requirements set forth in sections 851 and 852(a) of the Code, and there exist corporate characteristics of centralized management in that shares of another mutual fund may be substituted for shares of YZ Fund, it is classified as an association taxable as a corporation which qualifies as a regulated investment company and is not within the special provisions of section 851(f) as enacted by the Tax Reform Act of 1969.

(2) The assets, liabilities, income, expenses, credits, and other items held and accounted for by the investment plan account are, for Federal income tax purposes, regarded as owned or incurred by the investment plan account and not by L.

(3) Since the planholders have an unqualified right to withdraw the amount credited to their account, the amounts so credited are treated as a distribution by the investment plan account for purposes of sections 561 and 852(b) of the Code and are taken into account by the planholders under section 61(a)(7) of the Code. In addition, the annual custodial charge that is deducted from the planholder's allocated share of the investment plan account's net income and capital gains is also treated as a distribution by the investment plan account. Thus, the amount withheld to pay the custodial charge is includible in the gross income of the planholders, and the custodial charge is deductible by them provided they itemize their deductions on their Federal income tax returns.

(4) YZ Fund is taxable as a regulated investment company, as defined in section 851(a) of the Code, since it is registered under the Investment Company Act of 1940, has elected to be a regulated investment company, and meets the diversification and distribution requirements of sections 851(b) and 852(a) of the Code.