Investment company mergers - corporations and partnerships compared.

• Author: Bryan, H. Houston

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...