Rev. Rul. 89-81

Rev. Rul. 89-81

ISSUE

If a regulated investment company (RIC) has two or more classes of stock and it designates the dividends that it pays on one class as consisting of more than that class' proportionate share of a particular type of income, are the designations of the excess over the class' proportionate share effective for federal tax purposes?

FACTS

Fund is a closed-end diversified management investment company registered under the Investment Company Act of 1940, as amended (15 U.S.C. sections 80a-1 to 80b-2). Fund qualifies as a regulated investment company under section 851 of the Internal Revenue Code.

Fund has issued two classes of stock, one common class and one preferred class.

Holders of the preferred shares are entitled to receive cumulative dividends at a fixed rate. In addition, under the terms of the preferred shares, Fund is required to designate for purposes of section 854(b)(1) of the Code, the dividends paid on the preferred shares as dividends qualifying for the dividends received deduction under section 243 to the extent that those dividends do not exceed the aggregate dividends received by Fund determined in accordance with section 854.

Holders of the common shares are entitled to receive all income not required to satisfy the claims of the preferred shares. Dividends paid on the common shares are designated by Fund as dividends qualifying for the dividends received deduction only to the extent that the aggregate dividends received by Fund exceed the dividends paid on the preferred shares.

For 1989, without regard to the dividends paid deduction, Fund had investment company taxable income of $100x and net capital gain of $100x. Fund received $50x of aggregate dividends in 1989.

In 1989, Fund paid a total of $50x of dividends to the holders of its preferred stock and a total of $170x of dividends to the holders of its common stock. Fund designated all $30x of dividends paid to the holders of its preferred stock as dividends qualifying for the dividends received deduction. Of dividends paid to the holders of its common stock, Fund designated $20x as dividends qualifying for the dividends received deduction and $100x as capital gain dividends.

LAW

Under section 851(a) of the Code, the term "regulated investment company" includes a domestic corporation that is a management company registered under the Investment Company Act of 1940, as amended.

Under section 851(b) of the Code, the corporation must elect to be treated as a RIC, must derive at least 90 percent of its gross income from dividends, interest, and other specified sources, and must satisfy certain other requirements.

If a corporation meets these requirements, it is treated in certain respects as a conduit entity for tax purposes. Dividends paid by the RIC are generally taxable as ordinary income to the shareholders, and the RIC is allowed a deduction for such dividends in computing its investment company taxable income under sections 852(b)(2)(D) and 561. Dividends designated by the RIC as capital gain dividends are treated as long-term capital gains in the hands of the shareholders, and, in computing its net capital gain, the RIC is allowed a dividends paid deduction for these amounts so that the RIC is taxed only on the excess. Section 852(b)(3) of the Code. Similarly, depending on the types of gross income received by the RIC, appropriate portions of any dividends paid may be designated by the RIC -- and consequently taxed to the shareholders -- as exempt- interest dividends (section 852(b)(5)) or as dividends qualifying for the dividends received deduction (section 854). See also section 853, which permits the RIC to elect to be treated as a conduit for purposes of the foreign tax credit.

ANALYSIS

A corporation registered under the Investment Company Act of 1940 as a closed-end management investment company may have more than one class of stock. The question presented is whether a designation to one class of shareholders of more than that class' proportionate share of a particular type of income is effective for federal tax purposes. The tax treatment of RICs that make such designations has been addressed by the Service in two published revenue rulings.

In Rev. Rul. 70-597, 1970-2 C.B. 146, an investment company issued income shares and capital shares. Holders of the income shares received all net income from the initial investment portfolio of the company, and holders of the capital shares received the benefit of all capital gains. The ruling held that the company could elect to be treated as a RIC and that the dividends paid to the two classes of shareholders qualified for the dividends paid deduction under section 852 of the Code. In addition, the ruling held that undistributed net capital gain designated in respect of the capital shares was treated in accordance with the provisions of section 852(b)(3)(D).

In Rev. Rul. 74-177, 1974-1 C.B. 166, an otherwise qualifying RIC issued common and preferred shares. Holders of the preferred shares enjoyed a preference as to assets and received fixed quarterly cumulative dividends payable out of net investment income. Holders of the common shares generally were entitled to receive distributions of any remaining net investment income. Holders of the common shares also generally received annual distributions of all net short-term capital gain. Long-term capital gains accrued to the benefit of the holders of the common shares. The ruling held that the issuance of the two classes of stock with the rights described above did not prevent the corporation from qualifying as a RIC and that the RIC was entitled to include the amounts paid and designated in accordance with those rights in commuting the relevant dividends paid deduction.

The Internal Revenue Service has reconsidered these rulings and has determined that, to the extent that they approve non- proportionate designations of particular types of income, they do not represent proper interpretations of law. The designation of the dividends paid to the holders of one class of stock as consisting of more than that class' proportionate share of a particular type of income is inconsistent with the purposes underlying sections 851 through 855.

RICs are provided special tax treatment to enable small investors to pool their resources and obtain diversification of investment and experienced management without paying the penalty of a second layer of tax. Thus, the RIC vehicle affords small investors the benefits already available to large investors through direct investment in assets.

Although there is no express rule that designations of all RIC distributions must be proportionate, Congress appears to have assumed that designations of distributions are proportionate. One example of this is found in the legislative history of section 854, the section which provides that the dividends designated as qualifying for the shareholders' dividends received deduction may not exceed the aggregate dividends received by the RIC. The Conference Report for this section indicates that Congress intended that each share of stock "have the same designation . . . made with respect to it" and that "the RIC cannot designate the same quarterly dividend as being from dividend income for some shareholders and from tax-exempt interest for others." H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 815 (1984), 1984-3 (Vol. 2) C.B. 69.

Of similar import is the history of section 852(b)(5), the provision that allows certain RICs to pay exempt-interest dividends to the extent of their tax-exempt interest income. In introducing the amendment that became section 852(b)(5), its sponsor noted that it was "wholly consistent with the concept of a mutual fund, under which the shareholders of the fund are considered, for tax purposes, as the actual owners of the fund's holdings, and the direct recipients of their share of the fund's earnings." 122 Cong. Rec. 26,111 (1976) (statement of Senator Percy).

A proportionate rule is expressly stated in section 853, which allows an election that enables a RIC's shareholders to qualify for foreign tax credits. Pursuant to this election, each shareholder of the RIC is treated as having paid a proportionate share of the taxes paid by the RIC to a foreign country and as having received a proportionate share of the gross income derived by the RIC from sources within a foreign country. The legislative history of this provision speaks both of the RIC being a conduit and of RIC shareholders being placed in the same position as persons directly owning stock in foreign corporations. H.R. Rep. No. 1337, 83d Cong., 2d Sess. 241 (1954). Although the proportionate rule is explicitly stated with respect to foreign tax credits, there is no indication that proportionate designations were other than the normal rule applicable to RICs.

The only legislative history that is arguably inconsistent concerns section 852(b)(5)(C), which provides that 50 percent of the interest received by a RIC on loans to employee stock ownership plans (ESOPs) may be passed through to shareholders as tax-exempt interest. Citing Rev. Rul. 74-177, the Conference Committee Report states that the conferees "understand that it may be appropriate for a mutual fund to have two classes of stock, one of which would pay exempt- interest dividends and the other of which would pay taxable dividends." 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-559 (1986), 1986-3 (Vol. 4) C.B. 559. In isolation, this statement appears to be in conflict with the legislative history of earlier provisions. In context, however, it is only a comment that the Service, in its published rulings, had permitted non-proportionate designations of distributions.

With the exception of this single reference to Rev. Rul. 74-177, there is no evidence in the legislative history that RICs were intended to be other than straight pass-through entities or that designations of distributions to shareholders could be made on other than a proportionate basis.

In the present situation, in 1989 Fund designated to the holders of its preferred stock more than their proportionate share of the dividends qualifying for the dividends received deduction. Fund's preferred stockholders received 15% of the total dividends paid by Fund in 1989. Thus, their proportionate share of the dividends qualifying for the dividends received deduction is $7.5x, 15% of the $50x aggregate dividends received by Fund. Similarly, Fund designated to the holders of its common stock more than their proportionate share of the capital gain dividends. Fund's common shareholders received 85% of the total dividends paid by Fund in 1989. Thus, their proportionate share of the capital gain dividends is $85x, 85% of the $100x net capital gain received by Fund. The designation by Fund of more than these amounts is not effective for federal tax purposes. As a result, Fund's preferred stockholders may treat only $7.5x of the dividends they received as dividends qualifying for the dividends received deduction, and Fund's common stockholders may treat only $85x of the dividends they received as capital gain dividends. In addition, Fund may include only $85x of the dividends it designated as capital gain dividends in computing its dividends paid deduction for purposes of section 852(b)(3)(A).

Analogous principles apply to make ineffective non-proportionate designations of other types of income.

HOLDING

If a regulated investment company has two or more classes of stock and it designates the dividends that it pays on one class as consisting of more than that class' proportionate share of a particular type of income, the designations are not effective for federal tax purposes to the extent that they exceed the class' proportionate share of that type of income.

EFFECT ON OTHER RULINGS

To the extent that they hold that non-proportionate designations are effective for federal tax purposes, Rev. Rul. 70-597, 1970-2 C.B. 146, and Rev. Rul. 74-177, 1974-1 C.B. 166, are modified.

PROSPECTIVE APPLICATION

Under the authority contained in section 7805(b) of the Code, if a RIC makes a non-proportionate designation pursuant to a rule described in a registration statement that was filed with the Securities and Exchange Commission before June 13, 1989, this revenue ruling will not be applied to render the designation ineffective for federal tax purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is James F. Malloy, Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Nellie B. Howard on (202) 566-3516 (not a toll-free call).