the stock with the intention to liquidate. The principle of the Kimbell-Diamond decision would thus be legislated out of existence.

Under the proposed repeal of section 337 there would be no revival of the uncertainty posed by the Court Holding and Cumberland Public Service cases, for the tax to the corporation upon liquidations in kind would make irrelevant the question of whether property sales coincident with liquidation were made by the corporation or by its shareholders.

If the integrity of the corporate tax were secured by adoption of the above proposals, more latitude should be given for transactions within the corporate structure. The following revisions would deserve consideration:

(1) Elimination of double corporate taxation by granting a 100 percent deduction for dividends received by corporations.

(2) Removal of restrictions on the filing of consolidated returns. Such returns should be encouraged for both substantive and administrative reasons. Consistently with the increase of the deduction for dividends received to 100 percent, the 2 percent penalty tax on consolidated returns should be removed.

The limitation of surtax exemptions to one for a consolidated group of corporations seems to serve no important function, and may well deserve to be abandoned. Congress has recognized that some statutory limitation on the proliferation of surtax exemptions is necessary and has enacted such a limitation in section 1551. However, there is no good reason why an additional and severer limitation should be provided for consolidated returns alone. This additional limitation does not significantly protect the revenue; it merely prevents consolidated return filing. Such a limitation might make sense under a mandatory consolidated return system; it does not under a permissive

one.

Finally, the present rules governing the making of a new election to file consolidated or separate returns are so ineffective that it would be better to abandon them. They tend to deter consolidation, but do not effectively prevent the breaking of consolidation where that becomes important. More frequently than not, a change in law or regulations presents a new election; where this is not the case, the acquisition of a new subsidiary is usually not too difficult to arrange. A rule that in practice becomes so narrow an exception should be discarded as an unnecessary irritant.

(3) In general, the approach of the Advisory Group on Subchapter C to the reorganization area seems laudable. The definition of the term "reorganization" should be broadened to permit greater flexibility in corporate rearrangements. At the same time, care should be taken to see that distributions to continuing shareholders are treated as dividends wherever they would be so treated if distributed apart from the reorganization. However, individual features of the Advisory Group's approach require careful review and in some instances modification.

(4) The reorganization, liquidation and consolidated return provisions which turn upon 80 percent stock ownership might well be placed instead at 50 percent. The 80 percent level has no significance in corporate law; to define control for tax purposes at 80 percent permits inconsequential shifts in the level of stock ownership to change

tax results significantly. Shifts from majority to minority ownership would be undertaken more reluctantly. This change would also provide some of the added flexibility already mentioned as desirable.

(5) The limitations on the inheritance of net operating losses under section 382 seem eminently to deserve repeal. The mechanical approaches of the two halves of section 382 do not realistically separate tax avoidance cases from cases not involving tax avoidance. Under section 382 (b) it is not apparent why the amount of the inherited net operating loss should turn on the relevant sizes of the two corporations, except where the loss corporation is a comparative shell, in which case section 269 would disallow the loss in any event. Section 382(a) has a slightly more rational basis, but the appropriate cases of loss disallowance which it strikes down are, it is believed, also reached by section 269. The latter section now seems more potent, in view of recent court decisions, than it did in 1954 when Congress added the mechanical provisions of section 382.

REGULATED INVESTMENT COMPANIES-TAX

TREATMENT

Edwin S. Cohen

My name is Edwin S. Cohen. I am a member of the law firm of Root, Barrett, Cohen, Knapp & Smith, 26 Broadway, New York, N.Y. My firm is tax counsel to the National Association of Investment Companies.

The association has a membership of 155 open-end and 24 closedend investment companies. Most of the members of the association have elected to qualify, for tax purposes, as regulated investment companies under subchapter M of the Internal Revenue Code of

1954.

The basic framework of subchapter M governing taxation of regulated investment companies and their shareholders originated in the Revenue Act of 1936 and developed into substantially its present form in the Revenue Act of 1942. It has been my privilege to have had experience with the operation of these provisions during this entire period. They have, I believe, accomplished their objectives with marked success. With intelligent administration by the Treasury Department and careful work and cooperation of the companies, the provisions have operated with administrative ease and efficiency.

I. THE NATURE AND FUNCTION OF REGULATED INVESTMENT COMPANIES

Regulated investment companies are designed to afford to a large number of individuals of moderate means an opportunity to pool their investment resources in order to secure diversification of risk and experienced investment management. The companies issue their shares publicly to investors and then invest the funds so received in a diversified portfolio of securities which are carefully selected and continuously supervised by professional managers.

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Regulated investments companies are of two types, "open end" and closed end." Closed-end companies have fixed capital structures which are modified only infrequently, and their shares are traded between shareholders on national securities exchanges or in the "over-the-counter" market. However, the shares of open-end investment companies, which hold some 90 percent of the assets held by the association's member companies, are not generally available for purchase and sale in the open market. Instead, a person desiring to invest in such a company generally buys newly issued shares on original issue from the company. When he wishes to withdraw from the company he normally sells his shares back to the company for redemption at their current value and the company stands ready to redeem them from him at any time upon presentation by him. Thus, unlike a normal business corporation or a closed-end investment company, the capital of an open-end investment company is in a constant state of flux as shares are issued daily to some persons and redeemed from others.

The companies are carefully regulated on both the Federal and the State level to insure that the interests of persons investing in such companies are protected. Under Federal law, investment company issues are subject to the disclosure provisions of the Securities Act of 1933; and as to their structures and their managements, they are subject to the regulatory provisions of the Investment Company Act of 1940. On the State level they are subject to the "Blue Sky" laws of the various States, and to the regulations of several States concerning the management of investment companies if their shares are offered in those States. Thus investment companies operate under a number of laws designed to insure disclosure and fair dealing.

The investor of moderate means has the choice of investing directly in operating companies whose stocks are publicly traded, or of pooling his funds with those of many other persons by investing indirectly through the medium of a regulated investment company. In making this choice he must weigh the advantages of diversification of risk and professional management advice and supervision afforded by the investment company against the expense of such management and any substantial differential in Federal income taxes.

The tax considerations thus are of special significance. If the individual invests directly in operating companies he will face the normal layer of corporate income taxation imposed on the operating company, and the additional layer of income tax upon dividends which he receives and capital gains he may realize on the sale of the stock. If, however, he invests indirectly through the investment company, and income taxes had to be paid by the investment company, the individual would be faced with the burden of still another layer of taxation.

From the standpoint of Federal tax policy, the investment company thus presents a situation wholly different from that of ordinary business corporations. It represents, in general, an intermediate layer between the investor and the entities whose securities it acquires with the investor's funds. It does not compete with those entities but merely provides an alternative means for investing in them. Consequently, if the use of the investment company substantially increased the Federal tax burden on the shareholder, the company could not survive as an investment medium for the individual, for he would be forced to invest directly instead of through the investment company.

In recognition of these factors, the Federal tax laws for more than 20 years have provided a system of taxation for regulated investment companies which differs from that imposed upon other types of corporations.

II. HISTORICAL DEVELOPMENT OF THE INTERNAL REVENUE CODE PROVISIONS CONCERNING REGULATED INVESTMENT COMPANIES

The development of the present regulated investment company provisions in subchapter M of the Internal Revenue Code (secs. 851-856) began more than 20 years ago. Prior to 1935 there had been no tax of consequence on the ordinary income of investment companies, since tax was not imposed on dividends received by one domestic corporation from another. Furthermore, there had been no serious problem

of capital gains tax since most of the investment companies had been formed in the late twenties when stock market prices were high and most capital gains were offset by capital losses which had developed during the depression years.

When the Public Utility Holding Company Act of 1935 was pending in Congress, President Roosevelt sent a message to Congress in which he proposed the imposition of a tax on dividends received by corporations, in order to discourage holding companies. Recognizing the problem such a tax would create for investment companies, the President said:

Bona fide investment trusts that submit to public regulation and perform the function of permitting small investors to obtain the benefit of diversification of risk may well be exempted from this tax. (House Ways and Means Committee, Rept. No. 1681, 74th Cong., 1st sess.)

The Revenue Act of 1935 reduced the deduction for dividends received from 100 to 90 percent, thereby imposing tax upon 10 percent of dividends received by one corporation from another domestic corporation, effective with respect to taxable years beginning after December 31, 1935. (Rev. Act of 1935, § 102(h)). No special provision was made for investment companies at that time.

The Revenue Act of 1936, which also became effective with respect to taxable years beginning after December 31, 1935 (and therefore fully superseded the provisions in the 1935 act as of their effective date), further reduced the dividends received credit from 90 to 85 percent. (Rev. Act of 1936, §26(b)). In this act special provisions were inserted regarding investment companies, though only with respect to open-end companies. The 1936 act introduced into the Federal tax system the so-called undistributed profits tax as a surtax on corporations, in addition to the normal tax. The undistributed profits tax was applied as the only type of tax on the income of openend investment companies which were publicly owned and had a diversified investment portfolio. To qualify for this treatment the company had to distribute at least 90 percent of its net income, including capital gains. By distributing 100 percent of its income the open-end investment company could eliminate the corporate tax in its entirety (Rev. Act of 1936, §§13 (a) and 48 (e)), but its shareholders, of course, paid income tax currently on all the net income of the

company.

Amendatory legislation regarding investment companies was considered while the Revenue Act of 1938 was pending in Congress. Except for minor matters, however, it was deferred until after the enactment of the Investment Company Act, which was then under consideration and which did not become law until 1940. At the time the Investment Company Act was passed, the House Committee on Interstate and Foreign Commerce called special attention to the tax problems affecting the companies, saying:

Representatives of the Securities and Exchange Commission in connection with the bill and members of the industry who appeared at the hearings called the attention of the subcommittee to the serious tax problem affecting investment companies. This problem has already been recognized by the Congress in the case of certain open-end management investment companies which receive special tax treatment under existing Federal revenue acts. The record before the committee indicates that the tax problem is very pressing with respect to closed-end management investment companies of the type classified in this bill