Rev. Rul. 89-79

1989-1 C.B. 172, 1989-25 I.R.B. 7.

                       Internal Revenue Service

                                 Revenue Ruling

     DIVIDENDS PAID DEDUCTION; PREFERENTIAL DIVIDENDS; REGULATED INVESTMENT

                                   COMPANIES

                            Published: June 19, 1989

Section 562. - Rules Applicable in Determining Dividends Eligible for Dividends Paid Deduction, 26 CFR 1.562-2:  Preferential dividends.

(Also Sections 561, 851, 852: 1-561-2, 1.851-1, 1.852-1,1.852-3.)

  Dividends paid deduction; preferential dividends; regulated investment companies. For purposes of applying the $10,000,000 initial investment requirement of section 562(c) of the Code, the term 'shareholder' refers to the legal owner of a regulated investment company's shares rather than to the beneficial owner.

ISSUE

  For purposes of applying the $10,000,000 initial investment requirement of section 562(c) of the Internal Revenue Code, does the term 'shareholder' refer to the legal owner or to the beneficial owner of a regulated investment company's shares?

FACTS

  X is a domestic corporation registered with the Securities and Exchange Commission under the Investment Company Act of 1940, 15 U.S.C. sections 80a-1 to 80b-2, as an open-end management investment company. X qualifies as a regulated investment company within the meaning of section 851(a) of the Code.

  Most persons that invest in X as fiduciaries maintain master shareholder accounts with X. Each of the master shareholder accounts on the books of the regulated investment company may represent shares in X held by the fiduciary on behalf of numerous trusts, estates, and other participants. Through these master accounts, the fiduciaries make purchases and participate in redemptions of shares of X, and receive payments of dividends, on behalf of the beneficial owners of shares of X. The initial investments in X by the fiduciaries sometimes equal or exceed $10,000,000 per account.

  X determines the distributions to be paid with respect to each share on its books by allocating income to each account and then subtracting an allocable portion of its management fees and administrative expenses. X allocates income among accounts in a manner that is proportionate to the number of shares held. X allocates management and administrative expenses among accounts in the following manner.

  Certain administrative expenses of X are uniform with respect to each shareholder account, regardless of the number of shares held in the account. Thus, in the case of such expenses, X's cost-per-share decreases as the account size increases. In the case of accounts in which there was an initial investment of at least $10,000,000, X allocates a portion of such expenses on the basis of a uniform-cost-per-account. X treats a fiduciary as the shareholder in determining the initial investment in an account. X allocates the remaining portion of such administrative expenses among the other accounts on a uniform-cost-per share basis and all management fees are allocated among all accounts on a uniform-cost-per-share basis.

  As a result of this method of allocation, X pays a higher per-share dividend with respect to accounts meeting the $10,000,000 initial investment threshold.

LAW AND ANALYSIS

  Section 851(a) of the Code defines a 'regulated investment company'  (RIC) as any domestic corporation that at all times during the tax year is registered under the Investment Company Act of 1940 (15 U.S.C. sections 80a-1 to 80b-2), as amended, as a management company, business development company, or unit investment trust.

  Section 852(b) of the Code provides for the taxation of RICs. It provides that investment company taxable income shall be the taxable income of the RIC with certain adjustments, including a deduction for dividends paid during the tax year (as defined in section 561).

  Section 561(a) of the Code provides that the deduction for dividends paid equals the sum of the dividends paid during the tax year.

  Section 562(c) of the Code provides that a distribution shall not be considered as a dividend for purposes of computing the dividends paid deduction unless such distribution is pro rata, with no preference to any shares of stock as compared with other shares of the same class, and with no preference to one class of stock as compared with another class except to the extent that the former is entitled (without reference to waivers of their rights by shareholders) to such preference. Section 657(a) of the Tax Reform Act of 1986 (1986 Act), 1986-3 (Vol. 1) C.B. 216, amended section 562(c) to provide that, in the case of a distribution to a shareholder that made an initial investment of at least $10,000,000 in a RIC, the distribution shall not be treated as non pro rata or preferential solely by reason of an increase in the distribution attributable to reductions in administrative expenses of the company. The result of the amendment is that the passthrough of administrative cost savings in the form of increased dividends to eligible shareholders does not cause a RIC's dividends to be treated as preferential dividends that are not deductible under section 561(a).

  Although the term shareholder, when used in the Code, generally refers to the beneficial owner of shares, interpretation of that term, in section 562(c), to refer to the legal owner of the shares is consistent with the purposes of that section. The amendment of section 562(c) was premised on the assumption that large accounts impose on RICs lower per-share administrative costs than small accounts. Congress concluded that the preferential dividend rules should not preclude a RIC from passing through these administrative cost savings to certain large accounts. Typically, these administrative cost savings relate to the size of the account maintained by the legal owner of the shares, rather than by the size of the interests in that account held by the ultimate beneficial owners. That is, the fact that a large fiduciary master shareholder account may represent the interests of multiple beneficial owners does not change the fact that a RIC's per-share administrative costs are lower for the master account than for smaller accounts. Interpreting the term 'shareholder,' as used in section 562(c), to refer to the beneficial owner rather than the legal owner of the RIC shares would frustrate the purposes of the section.

HOLDING

  For purposes of applying the $10,000,000 initial investment requirement of section 562(c) of the Code, the term 'shareholder' refers to the legal owner of a RIC's shares.

EFFECTIVE DATE

  This revenue ruling applies to dividends distributed after October 22, 1986, the effective date of section 657(b) of the 1986 Act, 1986-3 (Vol. 1). C.B. 216.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Paul Handleman of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Jonathan Silver on (202) 566- 3297 (not a toll-free call).

Rev. Rul. 89-79, 1989-1 C.B. 172, 1989-25 I.R.B. 7.