Rev. Rul. 88-41

1988-1 C.B. 253, 1988-22 I.R.B. 19.

                       Internal Revenue Service

                                 Revenue Ruling

    PERSONAL HOLDING COMPANY AND REGULATED INVESTMENT COMPANY; LIABILITY FOR

                                      TAX

                            Published: May 31, 1988

SECTION 541. - IMPOSITION OF PERSONAL HOLDING COMPANY TAX, 26 CFR 1.541-1: Imposition of tax

(Also Sections 561, 852, 4982; 1.561-1, 1.852-1.)

  Personal holding company and regulated investment company; liability for tax. A regulated investment company that is also a personal holding company is liable for tax under both sections 541 and 852(b)(1) of the Code on its retained income.

  A regulated investment company (RIC), which is also a personal holding company (PHC), has taxable income of $100x in its tax year ending December 31, 1988. The company distributes $90x of its $100x and, pursuant to sections 561 and 852(b)(2)(D), is allowed a dividends paid deduction of $90x; the distribution fulfills the requirements of section 852(a). The RIC/PHC retains the remaining $10x of its taxable income and has no other adjustments.

  ISSUE. Is the company liable for tax under both section 852(b)(1) as a RIC and under section 541 as a PHC?

  HOLDING. The Service has held that the RIC/PHC is liable for tax under both sections 852(b)(1) and 541.

  ANALYSIS. Citing amendments to section 852(b)(1) made by the 1984 and 1986 tax acts, the Service noted that a RIC must pay tax on its taxable income as provided in section 11, as though its investment income were taxable income under section 11. In addition, the Service noted, section 852(b)(1) provides that a RIC that is a PHC is liable for tax on investment company income computed at

the highest rate of tax specified in section 11(b); this rate is 34 percent for tax years beginning on or after July 1, 1987.

  Noting the RIC/PHC's investment company taxable income of $10x, the Service applied the 34 percent corporate tax rate to arrive at a RIC tax of $3.4x in 1988. Next, the Service applied the section 541 tax that is imposed on undistributed personal holding company income, as defined in section 545. Adjusting the company's income for the dividends paid deduction and the RIC tax paid, the Service applied the 28 percent tax of section 541 to the $6.6x of undistributed PHC income to arrive at a PHC tax of $1.848x. In sum, the Service wrote, the 1988 effective tax rate on the RIC/PHC's retained income of $10x is 52.48 percent: $3.4x on its investment company taxable income and $1.848x on its undistributed PHC income. The company, the Service noted, may also be subject to the section 4982 excise tax on undistributed RIC income.

                                     ISSUE

  If a regulated investment company that is also a personal holding company retains income, and thus has investment company taxable income and undistributed personal holding company income, is the company liable for tax under both sections 541 and 852(b)(1) of the Internal Revenue Code?

                                     FACTS

  X is a regulated investment company (RIC) within the meaning of section 851 of the Code. X is also a personal holding company within the meaning of section 542(a). (RICs are not included among the exceptions from the definition 'personal holding company' provided in section 542(c)). X returns on a calendar year basis.

  In its tax year ending December 31, 1988, X has taxable income of 100x dollars. That 100x dollars is also personal holding company income within the meaning of section 543 of the Code.

  X distributes 90x dollars (90 percent) of its 100x dollars taxable income and, pursuant to sections 561 and 852(b)(2)(D) of the Code, is allowed a dividends paid deduction of 90x dollars for the distribution. This distribution fulfills the requirements of section 852(a). X retains the remaining 10x dollars of its taxable income. X has no adjustments to its 100x dollars of taxable income of a personal holding company except the dividends paid deduction of 90x dollars and the deduction allowable under section 545(b)(1) for certain federal income taxes.

                                LAW AND ANALYSIS

  Section 852(b)(1) of the Code, as amended by section 1071(a)(2) of the Tax Reform Act of 1984, 1984-3 (Vol. 1) C.B. 557, and section 1878(j)(2) of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 822, provides that there is imposed for each taxable year upon the investment company taxable income of every RIC a tax computed as provided in section 11, as though the investment company taxable income were the taxable income referred to in section 11.

  Section 852(b)(1) further provides that, in the case of a RIC that is a personal holding company (as defined in section 542), the tax upon investment company taxable income shall be computed at the highest rate of tax specified in section 11(b). For tax years beginning on or after July 1, 1987, this rate is 34 percent.

  Section 852(b)(2) of the Code defines investment company taxable income as the taxable income of the RIC with certain adjustments, including the deduction for dividends paid (as defined in section 561) but computed without regard to capital gain dividends and exempt-interest dividends.

  In this situation, X has 100x dollars of taxable income reduced by 90x dollars for its dividends paid deduction, leaving investment company taxable income of 10x dollars. Under section 852(b)(1) of the Code, X must pay tax on this undistributed income because it is investment company taxable income. Because X is a RIC that is also a personal holding company, that tax is computed at the highest corporate rate under section 11(b). The 34 percent rate of tax is applied to the retained investment company taxable income to arrive at a RIC tax of 3.4x dollars in 1988.

  Section 541 of the Code provides that in addition to the other taxes imposed by chapter 1, there is imposed for each tax year on the undistributed personal holding company income (as defined in section 545) of every personal holding company (as defined in section 542) a personal holding company tax equal to 28 percent of the undistributed personal holding company income.

  Section 545(a) of the Code provides that undistributed personal holding company income means the taxable income of a personal holding company less certain adjustments and less the dividends paid deduction as defined in section 561.

  Section 545(b)(1) of the Code provides that one of the adjustments allowed by section 545(a) is a deduction for federal income taxes accrued during the tax year, other than the accumulated earnings tax imposed by section 531 and the personal holding company tax imposed by section 541. Thus, in computing the personal holding company tax of X, a deduction allowed for amounts accrued for tax on its investment company taxable income.

  For 1988, X has 100x dollars of taxable income reduced by 90x dollars for its dividends paid deduction and 3.4x dollars for tax accrued on its investment company taxable income, leaving 6.6x dollars of undistributed personal holding company income. The 28 percent rate of tax is applied to this amount to arrive at a personal holding company tax of 1.848x dollars.

  Thus, the effective rate of tax in 1988 on X's retained income of 10x dollars is 52.48 percent (3.4x dollars on its investment company taxable income and 1.848x dollars on its undistributed personal holding company income).

  X may also be subject to the excise tax on undistributed income of regulated investment companies provided for in section 4982 of the Code.

                                    HOLDING

  X must pay tax under section 852(b)(1) of the Code on the 10x dollars investment company taxable income and under section 541 on the portion of the 10x dollars that is also undistributed personal holding company income.

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Patrick T. McGroarty of the Corporation Tax Division. For further information regarding this revenue ruling contract Mr. McGroarty on (202) 566- 4733 (not a toll-free call).

Rev. Rul. 88-41, 1988-1 C.B. 253, 1988-22 I.R.B. 19.