Technical inconsistencies in the investment company provisions.

• Author: Smith, Annette B.

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 securities"--a 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., Sees. 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...