Investment company mergers - corporations and partnerships compared.

In general, nontaxable corporate combinations under Sec. 368, and the related exchanges of stock and securities under Sec. 354, require a business purpose, continuity of business and continuity of ownership (as described in Regs. Sec. 1.368-1(b)). This regulation, well in advance of the expansive interpretation of the Sec. 1001 taxable exchange rules in Cottage Savings Association, 111 Sup. Ct. 1503 (1991), noted that gain or loss on the exchange of property is taxable if the new property differs in a material particular (either in kind or extent) from the old property--when the reorganization provisions do not apply.

An asset diversification rule applies to reorganization combinations of two or more investment companies, defined as regulated investment companies (RICs), real estate investment trusts (REITs) or "private" companies whose assets are composed 50% or more of the value of stock and securities and 80% or more of assets held for investment. Specifically, Sec. 368(a)(2)(F)(ii) requires that not more than 25% of the value of an investment company's total assets can be invested in stock and securities of any one issuer and not more than 50% of the value of its total assets can be invested in the stock and securities of five or fewer issuers.

On Aug. 17, 1993, final regulations were issued regarding a merger into an RIC. Regs. Sec. 1.852-12 requires that any accumulated earnings and profits of a constituent non-RIC must be distributed by the RIC in order for the resulting RIC to continue its RIC status. A similar regulation applies to REITs (Regs. Sec. 1.857-11).

Combinations of corporate investment companies can be accomplished under Sec. 368 or Sec. 351 for nontaxable transfers of property to a corporation controlled by the transferors. The nontaxable combination of partnership investment companies can be accomplished under Sec. 721 for the nontaxable contribution of property to a partnership in exchange for a partnership interest. Rules are provided in Sec. 708(b)(2)(A) to identify the resulting or surviving partnership after the merger or consolidation of the partnerships.

A transfer of property to an investment company is subject to the exception of Sec. 351(e)(1) and a transfer to a partnership is subject to the counterpart provision of Sec. 721(b). Sec. 351(e) was imposed by Section 203 of the Foreign Investors Tax Act of 1966. The Senate Report to the Act explained that Congress intended to prevent the nontaxable formation of "swap funds" in which an RIC was established under Sec. 351 by concerted transfers of nondiversified appreciated stockholdings tendered by numerous investors. The funds typically involved a public syndication. The report notes that the 1966 Act set aside as unnecessary proposed IRS regulations aimed at the exchange of appreciated securities for mutual fund shares in a public offering. Thus, Prop. Regs. Sec. 1.351-1(c) referred to an immediate or delayed marketplace sale or exchange solicited by a broker when a prospectus was delivered to the tendering RIC stockholders.

Example (2) in current Regs. Sec. 1.351-1(c)(6) follows this legislative history and illustrates the operation of Sec. 351(e)(1) involving a transfer by multiple transferors of individual nondiversified stockholdings resulting in diversification.

Thereafter, syndicated swap funds involving partnerships prompted Congress to

extend the operation of Sec. 35 1 (e) to partnerships in the Tax Reform Act of 1976, which added Sec. 721(b)'s reference to an investment company within the meaning of Sec. 351. No regulations have been adopted under Sec. 721(b). However, in 1993, the IRS ruled that mergers of partnership RICs were nontaxable under Sec. 721(b) when the merging entities held diversified portfolios.

Specifically, Letter Ruling 9310019 concluded that the merger of 12 series of an RIC partnership were nontaxable under Sec. 721(b) when each series was diversified within the meaning of Sec. 368(a)(2)(F)(ii) and the similar provision in Sec. 851(b)(4) for RIC qualification purposes. Identical Letter Rulings 9328035 through 9328037 approved the nontaxable merger of RICs organized as business trusts. The letter rulings applied the nontaxable property transfer provision of Sec. 721 and distinguished Rev. Rul. 87-9, in which one group of transferors contributed stock in a publicly traded corporation and the other shareholders contributed cash, i.e., not involving a diversified portfolio.

It appears that when the diversified portfolios of the same character are held by investment partnerships, a nontaxable "merger" of the partnerships can be accomplished under Sec. 721. Presumably, diversification should be tested by use of the definition in Sec. 368(a)2(F)(ii) or the RIC diversification rule in Sec. 851(b)(4), as the case may be.