Final Regs Provide Rules for RICs' and REITs' Earnings and Profits

 [4830-01-u]

 ACTION: Final Regulations.

 SUMMARY: This document contains final income tax regulations relating to regulated investment companies (RICs) and real estate investment trusts (REITs). The regulations provide guidance to RICs and REITs that have earnings and profits (E&P) accumulated by a corporation during a taxable year when the corporation was not taxable as a RIC or REIT. This guidance is needed to clarify the requirements for maintaining RIC or REIT status after a merger or other reorganization. The regulations also provide procedural guidance to REITs that distribute non-REIT E&P.

 DATES: The effective date of these regulations is December 22, 1992.

 These regulations apply to taxable years ending on or after December 22, 1992.

 FOR FURTHER INFORMATION CONTACT: Jonathan D. Silver, 202-622-3920 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document adds sections 1.852-12 and 1.857-11 to the Income Tax Regulations (26 CFR part 1) under sections 852 and 857 of the Internal Revenue Code (Code).

 On December 23, 1992, the Internal Revenue Service published a notice of proposed rulemaking in the Federal Register (57 FR 61017). One commentator submitted written comments concerning the proposed regulations and requested a public hearing. A public hearing on those comments was held on March 1, 1993.

EXPLANATION OF PROVISIONS

 This document provides guidance to a RIC or REIT that has non- RIC or non-REIT E&P (that is, E&P that was accumulated by a corporation during a taxable year when the corporation was not taxable as a RIC or REIT). The regulations clarify that a company is not taxable as a RIC or REIT for a taxable year if it has non-RIC or non-REIT E&P at the close of the taxable year, even if the E&P was succeeded to in a reorganization.

 The regulations prescribe identical rules for both RICs and REITs. Under the regulations, a RIC that succeeds to non-RIC E&P is generally required to distribute that E&P if the RIC is to continue to be taxable as a RIC. Similarly, a REIT that succeeds to non-REIT E&P is generally required to distribute that E&P if the REIT is to continue to be taxable as a REIT.

 The one commentator on the proposed regulations questioned the scope of the regulations and argued that the statutory language of section 852(a)(2) of the Code is directed at a non-RIC that elects RIC status and not at a non-RIC that attains RIC status through a merger or other reorganization with an existing RIC. The commentator suggested that the E&P acquired by a RIC when it acquires a non-RIC through a merger or other reorganization is not "accumulated" for purposes of section 852(a)(2) of the Code since, under section 381(c)(2), the RIC succeeds to the E&P on the date of the reorganization. The commentator also suggested that, in enacting section 852(a)(2), Congress was concerned with operating companies that would sell their assets used in business, purchase investment assets, and then elect RIC status without distributing accumulated E&P. The commentator reasoned that Congress was not concerned with this happening through a merger of a non-RIC into a RIC because the continuity of business enterprise requirement for a reorganization would not be satisfied.

 As asserted by the commentator, the legislative history of section 852(a)(2) of the Code indicates that Congress was concerned with operating companies that sold their assets, invested the proceeds in passive investment assets, and obtained conduit treatment without distributing the earnings from the operating activities. H.R. Rep. No. 432, 98th Cong., 2d Sess., pt. 2, at 1744 ff. (1984). There is no indication, however, that Congress intended to limit the application of the statute to that particular fact situation. The resulting statute clearly is broader than the transaction described in the legislative history and applies to all non-RIC E&P, no matter what its source.

 The same concerns arise no matter how the non-RIC E&P comes to be held by a RIC. For instance, a historic investment business may not elect RIC status without distributing its non-RIC E&P. There is no reason to distinguish between that transaction and one in which the same company merges into a RIC. Moreover, any interpretation of the statute that distinguishes between corporations electing RIC status and corporations reorganizing into RICs would result in inconsistent tax treatment based solely on the form of the transaction.

 After consideration of the comments, the Service continues to believe that the regulations are supported by legislative history and accurately reflect congressional concern. Section 852(a)(2) of the Code was intended to require a RIC that had non-RIC E&P, from whatever source, to distribute that E&P as a prerequisite to the RIC being taxable under subchapter M, part I.

 The legislative history of section 857(a)(3) of the Code indicates that section 857(a)(3) serves a purpose similar to that of section 852(a)(2): Congress did not want companies to be taxable as REITs if they had non-REIT E&P. S. Rep. No. 313, 99th Cong., 2d Sess. 769, 775 (1986). As with RICs, the same principles apply to non-REIT E&P, whether it is carried over when the company converts to REIT status or it is succeeded to when a REIT reorganizes with a corporation that is not taxable as a REIT.

 Finally, the regulations retain the rule in the proposed regulations that distribution rules similar to those in section 852(e) are to apply to REITs. No comments were received on this portion of the proposed regulations.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also 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, these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Nellie Howard of the Office of Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service. However, other personnel from the Service and Treasury Department participated in their development.

LIST OF SUBJECTS IN PART 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Sections 1.852-12 and 1.857-11 are added to read as follows:

SECTION 1.852-12 NON-RIC EARNINGS AND PROFITS.

(a) APPLICABILITY OF SECTION 852(a)(2)(A) -- (1) IN GENERAL. An investment company does not satisfy section 852(a)(2)(A) unless --

(i) Part I of subchapter M applied to the company for all its taxable years ending on or after November 8, 1983; and

(ii) For each corporation to whose earnings and profits the investment company succeeded by the operation of section 381, part I of subchapter M applied for all the corporation's taxable years ending on or after November 8, 1983.

(2) SPECIAL RULE. See section 1071(a)(5)(D) of the Tax Reform Act of 1984, Pub. L. 98-369 (98 Stat. 1051), for a special rule which treats part I of subchapter M as having applied to an investment company's first taxable year ending after November 8, 1983.

(b) APPLICABILITY OF SECTION 852(a)(2)(B) -- (1) IN GENERAL. An investment company does not satisfy section 852(a)(2)(B) unless, as of the close of the taxable year, it has no earnings and profits other than earnings and profits that --

(i) Were earned by a corporation in a year for which part I of subchapter M applied to the corporation and, at all times thereafter, were the earnings and profits of a corporation to which part I of subchapter M applied;

(ii) By the operation of section 381 pursuant to a transaction that occurred before December 22, 1992, became the earnings and profits of a corporation to which part I of subchapter M applied and, at all times thereafter, were the earnings and profits of a corporation to which part I of subchapter M applied;

(iii) Were accumulated in a taxable year ending before January 1, 1984, by a corporation to which part I of subchapter M applied for any taxable year ending before November 8, 1983; or

(iv) Were accumulated in the first taxable year of an investment company that began business in 1983 and that was not a successor corporation.

(2) PRIOR LAW. For purposes of paragraph (b) of this section, a reference to part I of subchapter M includes a reference to the corresponding provisions of prior law.

(c) EFFECTIVE DATE. This regulation is effective for taxable years ending on or after December 22, 1992.

SECTION 1.857-11 NON-REIT EARNINGS AND PROFITS.

(a) APPLICABILITY OF SECTION 857(a)(3)(A). A real estate investment trust does not satisfy section 857(a)(3)(A) unless --

(1) Part II of subchapter M applied to the trust for all its taxable years beginning after February 28, 1986; and

(2) For each corporation to whose earnings and profits the trust succeeded by the operation of section 381, part II of subchapter M applied for all the corporation's taxable years beginning after February 28, 1986.

(b) APPLICABILITY OF SECTION 857(a)(3)(B); IN GENERAL. A real estate investment trust does not satisfy section 857(a)(3)(B) unless, as of the close of the taxable year, it has no earnings and profits other than earnings and profits that --

(1) Were earned by a corporation in a year for which part II of subchapter M applied to the corporation and, at all times thereafter, were the earnings and profits of a corporation to which part II of subchapter M applied; or

(2) By the operation of section 381 pursuant to a transaction that occurred before December 22, 1992, became the earnings and profits of a corporation to which part II of subchapter M applied and, at all times thereafter, were the earnings and profits of a corporation to which part II of subchapter M applied.

(c) DISTRIBUTION PROCEDURES SIMILAR TO THOSE FOR REGULATED INVESTMENT COMPANIES TO APPLY. Distribution procedures similar to those in section 852(e) for regulated investment companies apply to non-REIT earnings and profits of real estate investment trusts.

(d) EFFECTIVE DATE. This regulation is effective for taxable years ending on or after December 22, 1992.