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Technical Inconsistencies in the Investment Company Provisions The opportunity to diversify highly appreciated investment portfolios without gain recognition led to enactment of Sec. 351(e) in 1966 and Sec. 368(a)(2)(F) in 1976. The objectives and policy considerations common to both provisions did not result, however, in uniform treatment of investment company status under those provisions. The provisions diverged on the meaning of the term stock and securitiesa term that both provisions treat as a deciding factor in the overall determination of investment company status. Among other differences, the most obvious one concerned the exclusion of nonmarketable stock and securities from the overall definition of stock and securities by Sec. 351(e) and Regs. Sec. 1.351-1(c). By contrast, Sec. 368(a)(2)(F) includes all stock and securities and provides a per se diversification exception that, if met, shuts off the investment company rules, by treating a company as diversified.
Stock and Securities In believing that these differences could undercut the objectives intended by the enactment of Sec. 351(e), Congress revised that provision in 1997 by expanding the meaning of stock and securities to include all stock and securities regardless of marketability, and by adding cash as a listed item. Similarly, in 1996 Treasury amended Regs. Sec. 1.351-1(c), by adding a diversification exception identical to the one found in Sec. 368(a)(2)(F)(ii). Despite these changes, both provisions still differ significantly in their investment company status calculation, because of the varied list of items included as stock and securities under one section, but excluded under the other. Sec. 351(a) provides that certain transferors who transfer property to a corporation solely in exchange for stock will not recognize gain. Sec. 351(e) precludes the nonrecognition if the transferor transfers property to an investment company, regardless of whether the company is an existing investment company or a new one. Similarly, Sec. 368(a) provides a list of transactions treated as reorganizations for purposes of other Code sections (i.e., Secs. 354, 356 and 361) that afford nonrecognition treatment to reorganizations. However, under Sec. 368(a)(2)(F), a transaction otherwise qualifying as a reorganization under Sec. 368(a) is disqualified if it involves the merger of two or more investment companies. A transfer to an investment company under Sec. 351(e) is determined by taking into account all stock and securities, including (among other items) cash, stock and other equity interests in a corporation; evidences of debt; options; forward or futures contracts; notional principal contracts; derivatives; interests in any precious metals; foreign currency; and interests in publicly traded partnerships (as defined in Sec. 7704(b)). Regs. Sec. 1.351-1(c) provides the level and quality of stock and securities that must be present to constitute an investment company. These regulations require that the transfer diversify the transferors interest; this occurs on the transfer by two or more persons of nonidentical property, with the transferee corporation thereafter holding assets, more than 80% of the value of which are held for investment and are stock and securities (i.e., the 80% test). Using similar language, Sec. 368(a) (2)(F)(iii) defines an investment company as a corporation 50% or more of the value of whose total assets (excluding cash and cash items (such as receivables)) are stock and securities, and 80% or more of the value of whose total assets are held for investment. Additionally, Sec. 368(a)(2)(F)(ii) provides a diversification exception: a corporation has a diversified asset base 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 5 or fewer issuers (i.e., the diversification exception).
More Confusion The crucial distinction between Secs. 351(e) and 368(a)(2)(F) lies in Sec. 368(a)(2)(F)(vii), which includes as securities other investments constituting a security within the meaning of the Investment Company Act of 1940 (the Act). The Act includes as securities many items not listed as stock and securities under Sec. 351(e), including treasury stock, debentures, certificates of interest or participation in any profit-sharing agreement, collateral trust certificates, pre-organization certificates or subscriptions, transferable shares, investment contracts or voting interests in oil, gas or other mineral rights. Of more importance, the exact meaning and scope of the items listed under the Act may not readily be apparent. That is the case, for instance, with an investment contract that the Act treats as a security. The courts have defined this term as a joint venture or scheme in which a person invests his or her money in a common enterprise and is led to expect profits solely from the efforts of a promoter or third party, regardless of whether shares are evidenced by formal certificates or by nominal interests in physical assets employed in the enterprise; see SEC v. W.J. Howey Co., 328 US 293 (1946), and Tcherepnin v. Knight, 389 US 332 (1967). In other words, the term refers to a partnership interest in which the transferor is not actively involved in the businesss operation. These definitional differences may create confusion and inconsistent results when applying the diversification exception in a Sec. 351 transaction.
The A, B and C transfers to T do not meet the Sec. 368(a)(2)(F)(ii) diversification exception because, after the transfers, more than 25% of the value of Ts total assets are invested in the stock and securities of one issuer, W ($210/$800 = 26%), and more than 50% of the value of its total assets are invested in the stock and securities of five or fewer issuers ($491/$800 = 61%). For diversification exception purposes, the $400 (cash) is excluded from the total asset value calculation. The W, X, Y and Z stocks are treated as stock and securities. The limited partnership interests in LP2 and LP3 also are treated as stock and securities, because they are deemed investment contracts under the Act; only the LP2 interest is included, however, because it has a higher value than the LP3 interest. However, when Sec. 351(e) and Regs. Sec. 1.351(c)-1 are applied, the answer changes. The transfer does not result in an investment company, because more than 80% of the value of Ts assets are not held for investment and are stock and securities. For purposes of the 80% test, all interests transferred to T are included in the total asset value calculation, including the $400. As a result, the total asset value is $1,200. In determining the percentage of assets that are stock and securities, the stock in W, X, Y and Z is included under Sec. 351(e)(1)(A) and (B)(ii). Only the LLC interest is included, because (unlike the Act referenced by Sec. 368(a)(2)(F)(vii)) only publicly traded partnerships (as relevant here) are treated as stock and securities under Sec. 351(e)(1)(B)(iv). Because only 74% of the value of Ts assets are stock and securities, it is not an investment company for Sec. 351(e) purposes ($889/$1,200 = 74%).
Conclusion As illustrated, the determination of whether an asset is a stock and security can be complex. The same investment company determination involving more complex facts can lead to confusion as taxpayers attempt to determine the asset inclusions and exclusions, while keeping track of the numerical thresholds to avoid. From Cristian Silva, J.D., LL.M., Washington, DC |
