Rev. Rul. 74-177

Advice has been requested whether a taxpayer, under the circumstances described below, will qualify as a regulated investment company under subchapter M (sections 851 through 855) of the Internal Revenue Code of 1954.

The taxpayer is a domestic corporation registered with the Securities and Exchange Commission under the Investment Company Act of 1940, as a management closed-end diversified investment company. Registration is being completed for the public sale of 3x shares of the taxpayer's cumulative preference stock and 4x shares of its common stock. The preferred shares will account for three-sevenths and the common stock will provide four-sevenths of the capital to be raised.

The taxpayer's investment objective is to endeavor to secure current income sufficient to cover preferred dividends and to pay dividends on common shares and, to the extent consistent with this primary objective, to seek the long-term growth of income and capital desired by the common shareholders. A least 80 percent of its assets (exclusive of cash, cash equivalents, and Government securities) will be invested primarily in evidences of ownership or interests or participations issued by real estate investment trusts and, to a lesser extent, in convertible and non-convertible debt instruments and warrants to purchase any of the foregoing issued by real estate investment trusts. The remaining assets may be invested in securities of companies other than real estate investment trusts consistent with the primary investment objective. The taxpayer will not purchase securities (other than Government securities) of an issuer of immediately thereafter it will have more than 5 percent of its assets invested in that issuer or own more than 10 percent of the issuer's voting securities.

The preferred shares, in addition to a preference as to assets, will be entitled to fixed quarterly cumulative dividends, payable out of net investment income. Capital gains will be expressly excluded from the definition of net investment income. Common shares will have dividend rights to net investment income only if there is no arrearage on the preferred shares and if, after payment of any dividend on the common shares there is a 200 percent asset coverage, as defined in Section 18 of the Investment Company Act of 1940, of the preferred shares.

Special distributions will be paid on a pro rata basis to preference shareholders to the extent necessary to assure continued qualification under the Code by complying with the requirement that 90 percent of the net investment income must be distributed when, because of the 200 percent asset coverage restriction, distributions cannot be made to the common shareholders. Any net short-term capital gain will be distributed annually to the common shareholders, subject to the prior rights of the preference shares. Long-term capital gains will inure to the benefit of common shareholders.

Section 851(a) of the Code states the general rule that a corporation must be registered at all times during the taxable year under the Investment Company Act of 1940 as a management company or a unit investment trust if it attempts to qualify as a regulated investment company. Section 851(b)(2) requires a regulated investment company to derive at least 90 percent of its gross income from dividends, interest, and gains from the sale or other disposition of stock or securities. Section 851(b)(4)(A) states the general rule that at the close of each quarter of the taxable year at least 50 percent of the value of the company's total assets must be represented by cash and cash items, Government securities, securities of other regulated investment companies and other securities limited to an amount not greater in value than 5 percent of the value of the company's total assets and to not more than 10 percent of the issuer's outstanding voting securities. Section 851(c)(5) provides, in effect, that the term "securities" as used in section 851(b)(4) shall have the same meaning as when used in the Investment Company Act of 1940.

The Chief Counsel to the Division of Corporate Regulation (now Division of Investment Company Regulation), Securities and Exchange Commission, furnished an opinion to the Internal Revenue Service that evidences of ownership or interests or participations, convertible and non-convertible debt instruments, and warrants to purchase any of the foregoing issued by real estate investment trusts are "securities" within the meaning of section 2(a)(36) of the Investment Company Act of 1940.

Section 852(b)(2)(D) of the Code provides that in computing investment company taxable income there shall be allowed a deduction for dividends paid (as defined in section 561) computed without regard to capital gains dividends.

Section 852(b)(3)(A) of the Code permits a reduction for dividends paid, determined with reference to capital gains, in determining the tax to be imposed on the excess, if any, of the net long-term capital gain over the net short-term capital loss for each taxable year. Section 852(b)(3)(C) defines a capital gain dividend as any dividend or part thereof which is designated by the paying company as a capital gain dividend in a written notice to its shareholders not later than 45 days after the close of its taxable year, and provides that the amount designated as a capital gain dividend should not exceed the excess of the net long-term capital gain over the net short-term capital loss.

Section 562(c) of the Code provides that the 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.

Section 854(b)(1) of the Code provides that in the event that the aggregate dividends received by a regulated investment company are less than 75 percent of its specially defined gross income, then a proportional reduction rule becomes operative which limits the amount of the investment company's ordinary income dividends which is eligible for the dividends received exclusion for individuals under section 116 and the deduction under section 243 for dividends received by corporations. Section 854(b)(3)(B) provides that the term "aggregate dividends received" includes only dividends received from domestic corporations other than from certain specified types. One of the specified types is the real estate investment trust.

The capital structure of a regulated investment company is subject to such requirements of the Securities and Exchange Commission as are necessary for registration under the Investment Company Act of 1940 and that of section 562(c) of the Code which prohibits "preferential dividends." The proposed investments by the taxpayer in real estate investment trusts will be, for purposes of the limitations of section 851(b) "other securities" or "stock or securities." Designating the common shareholders as the only class of shareholders entitled to capital gains dividends does not necessarily constitute a preferential dividend arrangement within the meaning of section 562(c). Finally, payment of special distributions to preferred shareholders under the outlined circumstances will be considered dividends to which such shareholders are entitled without a waiver of rights by the common shareholders.

Accordingly, it is held, based on the foregoing facts, that (1) the taxpayer's issuance of two classes of stock, preferred and common, will not in and of itself prevent it from qualifying as a regulated investment company under section 851(a) of the Code; (2) evidences of ownership or interests or participations, convertible and non-convertible debt instruments and warrants to purchase any of the foregoing issued by real estate investment trusts acquired by the taxpayer will be "other securities" for purposes of section 851(b)(4)(A) and "stock or securities" for purposes of section 851(b)(2); (3) the taxpayer may designate the excess of its net long-term capital gain over the net short-term capital loss as capital gains dividends to its common shareholders and deduct such amount so designated and paid in computing its dividend paid deduction determined with reference to capital gains for purposes of section 852(b)(3)(A); and (4) the taxpayer will be entitled to include dividends (other than capital gains dividends) paid on either the preferred shares or the common shares, including any special distributions paid on the preferred shares, in computing the deduction for dividends paid in arriving at investment company taxable income for purposes of section 852(b)(2)(D).