DEPARTMENT OF THE TREASURY Internal Revenue Service 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. 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). Reasons for Change The IRS wants to clarify that 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 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 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 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 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 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 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: 1.351-1 Transfer to corporation controlled by transferor. * * * * * (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