Beware the new "investment company" rules.

• Author: Lipton, Richard M.

Recent years have seen a resurgence in transactions involving "corporate joint ventures," "strategic partnerships," and the like. The Taxpayer Relief Act of 1997 (the "1997 Act") has created a significant risk that the formation of such joint ventures could be taxable as a result of changes to the definition of an investment company. Indeed, these changes could result in taxation of such commonplace transactions as the formation of a nonconsolidated subsidiary or the transfer of appreciated property to a partnership with an unrelated person. This potential trap for the unwary should be on the checklist of every tax professional.

Background

Sections 351 and 721 of the Internal Revenue Code(1) have long provided that transfers of property to a corporation or partnership, respectively, are not a taxable event if the transferor receives either sufficient stock or a partnership interest in exchange. Specifically, under section 351(a), no gain or loss is recognized if property is transferred to a corporation by one of more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c))(2) of the corporation. Likewise, under section 721(a), gain or loss is not recognized if property is transferred to a partnership in exchange for an interest in the partnership.

This general rule of nonrecognition has long been subject to an exception in the case of transfers to entities that were treated as "investment companies." Specifically, section 351(e) has provided since 1967 that gain or loss would be recognized upon the transfer of property to an investment company. Similarly, section 721(b) provided hat gain, but not loss, is recognized upon a contribution of property by a partner to a partnership that would be treated as an investment company if the partnership were a corporation. This provision was added to the Code to prevent "swaps" of stock through formation of an investment company.

Section 351(e) did not itself specify a definition of an "investment company," but a definition was provided by the Internal Revenue Service in regulations issued in 1967. Under Treas. Reg. [sections] 1.351-1(c)(1), a transfer of property after June 30, 1967, was considered to be a transfer to an investment company if W the transfer results, directly or indirectly, in diversification of the transferors' interests, and (ii) the transferee is (a) a regulated investment company (RIC), (b) a real estate investment trust (REIT), or (c) a corporation more than 80 percent of the value of whose assets (excluding cash and non-convertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in RICs or REITs. The determination whether a corporation was an investment company was made by reference to the circumstances in existence immediately after the transfer in question, although where circumstances change thereafter pursuant to a plan in existence at the time of the transfer, such plan could also be taken into account.(3)

Under the regulations, except in the case of transfers to RICs or REITs (which were self-evident), the threshold questions in applying the investment company rules were whether more than 80 percent of the value of the assets of the transferee corporation were (i) readily marketable stock or securities that (ii) were held for investment. For purposes of this test, stock and securities were considered to be readily marketable only if they were part of a class of stock or securities which was traded on a securities exchange or traded or quoted regularly in the over-the-counter market. Readily marketable stock or securities also included convertible debentures, convertible preferred stock, warrants, and other stock rights if the stock for which they may be converted or exchanged is readily marketable.(4) Stock and securities in subsidiary corporations were disregarded and the parent corporation was deemed to own its ratable share of the subsidiary's assets; a corporation was considered a subsidiary if the parent owns 50 percent or more of (i) the combined voting power of all classes of stock entitled to vote, or (ii) the total value of all classes of stock outstanding.(5)

Although the definition of readily marketable stock or securities was relatively limited under the regulations, the "held for investment" test in the regulations was relatively broad. Specifically, under the regulations, all stock and securities were considered to be held for investment unless such stock and securities were (i) held primarily for sale to customers in the ordinary course of a business, or (ii) used in the trade or business of banking, insurance, brokerage, or a similar trade or business.(6)

Even if these two requirements were satisfied, a transfer to a corporation of readily marketable stock or securities that were held for investment (or a transfer to a RIC or a REIT) was not taxable under section 351(e) unless the transfer resulted in "diversification." Under the regulations, a transfer ordinarily results in diversification of the transferors' interests if two or more persons transfer...