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tributes currently to its shareholders all its net ordinary income and net capital gains so that the shareholders incur current tax on such income and gains, the company itself is relieved of tax. Net long-term capital gains realized by the company and distributed to shareholders are treated as long-term capital gains in the hands of the shareholders rather than as dividend income to them. Further, under certain circumstances credit for foreign taxes paid by the company is made available to its shareholders.

As a result of these provisions an individual investing via a regulated investment company is subjected, in general terms, to no greater Federal tax burden than if he had invested directly in the securities in which his funds have been invested by the investment company along with those of many other participants.

No provision exists in the present law, however, to make this treatment applicable with respect to investments made by regulated investment companies in municipal bonds so as to accord to the person investing via such a company the same Federal income-tax treatment with respect to interest on such bonds as he would have if he invested in them directly.

III. IMPACT OF THE STEADY RISE IN STATE AND MUNICIPAL BOND INTEREST RATES

The absence of a statutory provision preserving the status of municipal bond interest as it passes through a regulated investment company to its shareholders was not a matter of concern when the Federal tax rules relating to these companies were enacted some 20 years ago. At that time, and for many years thereafter, the interest rates on municipal bonds were much lower than those on bonds of comparable quality issued by the Federal Government or corporations. Consequently, municipal bonds were not generally attractive to individual investors unless they were in a relatively high income-tax bracket, and regulated investment companies are not primarily designed for that group. In the past several years, however, as the States, municipalities, and other political subdivisions have greatly increased the quantity of their borrowings the interest rate on their obligations has increased to a marked extent. As a result, the differential between interest on tax-exempt issues and that on taxable issues has narrowed to the point at which municipal bonds become desirable investments for persons in the lowest income-tax brackets.

The total outstanding municipal bond indebtedness at the close of 1948 amounted to $18.4 billion, after having remained at approximately the same level for some 20 years. In the next 10 years, however, the total of such obligations increased more than threefold until by December 31, 1958, it amounted to $57.4 billion. While the new issues of municipal bonds never exceeded $1.5 billion in any year before the close of World War II, the total issued in 1957 amounted to $7 billion and in 1958 to $7.4 billion. There appears to be every indication that the increased expenditures for schools and other governmental needs will cause the rate of offerings and the total outstanding indebtedness to continue at a high level for years to come.

In 1946, immediately after World War II, the interest rate on 20-year municipal bonds having a rating of Aaa, according to Moody's Manual bond index, was 1.10 percent. At the same time, according to Moody's index, the interest rate on long-term obligations of the Federal Government was 2.19 percent and Aaa longterm obligations of corporations was 2.53 percent. Thus the municipal bond interest rate was only 50 percent of the long-term Federal rate and 43 percent of the comparable corporate rate. Accordingly, at that time municipal bonds would not have been attractive to an individual investor as compared with Federal or corporate bond issues unless he was in a Federal income tax bracket of 50 percent or more.

In the intervening years, however, while interest rates on all these issues had risen, the interest rate on municipal bonds has increased to a far greater extent proportionately. Thus as of July 31, 1959, the latest date for which comparative figures are available, Moody's index of the Aaa municipal bond interest rate had risen to 3.51 percent (more than three times the 1946 rate) whereas the Federal rate was 4.11 percent and the Aaa corporate rate 4.47 percent.* As a result, the municipal bond rate at July 31, 1959, was 85 percent of the Federal rate and 79 percent of the corporate rate.

At the present time, therefore, municipal bonds are desirable investments, as compared with Federal and corporate issues, in the case of individuals who are in the lowest tax brackets. As an illustration, let us assume that an unmarried individual has a net income, after personal exemptions, of $2,000. He is, therefore, in a 22 percent Federal income tax bracket. Let us assume that he has $100 to invest and is trying to choose between three types of high-grade, longterm bonds each of which carries the average yield in its category: (1) a Aaa municipal bond yielding 3.51 percent; (2) a Federal Government bond yielding 4.11 percent; and (3) a corporate bond yielding 4.47 percent. Despite the fact that the yield of the municipal bond, before taxes, is less than that of the other two bonds, the after-tax yield of the municipal bonds, even in a tax bracket as low as 22 percent, will be greater than the after-tax yield of the other two bonds. The following table shows the comparative figures :

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Yield after taxes.

3. 51

3. 21

3.49

Thus even for an individual in a low tax bracket, municipal bonds today constitute an attractive investment in comparison with other available bonds.

IV. REGULATED INVESTMENT COMPANIES AS A VEHICLE FOR INVESTMENTS IN MUNICIPAL

BONDS BY PERSONS OF MODERATE MEANS

Assuming, then, that persons in the low- and medium-tax brackets should today give serious consideration to investing a portion of his funds in municipal bonds, he will find that as a practical matter it is not feasible for him to do so because of the nature of the market in municipal bonds. It is believed, however, that for the reasons mentioned below regulated investment companies furnish a practical mechanism by which investments in municipal bonds may be made available to such persons.

The municipal bond market has characteristics quite different from those existing with respect to Federal Government obligations and corporate securities. Chief among these unusual conditions are the following:

1. The securities are generally issued in denominations of $1,000, a minimum price too high for the average person maintaining a periodic savings program.

2. There are some 170,000 different State and local governmental units is

*The Moody's indexes of the several interest rates each year in the period from 1946 to July 31, 1959, were as follows:

Yearly

Aaa State and U.S. Govern- Aaa corporate
local govern-
ment long-

bonds ment bonds term bonds (taxable) (nontaxable) (taxable)

1946. 1947. 1948. 1949. 1950. 1951. 1952 1953 1954. 1955. 1956. 1957 1958 7/31/1959..

1. 10 1. 45 1.87 1.65 1.87 1.93 2. 16 2. 33 2.04 2. 18 2. 51 3. 10 2.92 3. 51

2. 19 2. 25 2. 44 2. 31 2. 32 2.57 2. 68 2.94 2. 55 2. 84 3. 08 3. 47 3. 43 4. 11

2. 53 2. 61 2.82 2. 66 2. 62 2. 86 2.96 3. 20 2. 90 3.06 3. 36 3.89 3.79 4. 47

suing municipal bonds. Many of these units have outstanding different securities issued at different times at varying interest rates. Many issues are brought out in serial form and with varying maturity dates, thereby complicating the pricing of the securities. The market is, therefore, a highly intricate one.

3. Quotations of prices of municipal bonds are not as readily available as those for other securities. Only a very limited number of municipal bonds are listed on any securities exchange. The financial sections of daily newspapers contain few, if any, quotations of municipal bonds since the large number of such issues outstanding makes the carrying of such information a burdensome task.

4. An individual seeking to liquidate his investment in municipal bonds prior to their maturity is likely to suffer a sacrifice in price if he is disposing of less than $10,000 to $25,000 in principal amount. As an illustration of this circumstance, a test was made recently by picking at random 10 issues of municipalities in various parts of the country which were quoted on a recent date as being available for purchase at par of 100. Three well-known firms which are dealers in municipal bonds were asked for quotations as to the prices at which they would purchase each of the 10 securities in lots of $2,000 and in lots of $10,000 for each issue. The results of this inquiry were as follows:

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In summary, though a person desiring to buy the bonds would have had to pay par of 100 for each of the 10 issues, nevertheless if he desired to sell them in lots of $2,000 he would have received an average price of 9142, losing 842 points; and if he were selling in lots of $10,000, he would have received on the average 9614, losing 334 points. Moreover, these are prices quoted by dealers in a large city; an individual selling through a smaller firm in another city might well have to pay a commission to his local dealer as well. It will also be noted that the prices quoted by the several dealers for the same issue vary as much as three points in some cases, indicating the need for sellers to shop among dealers—an effort which the small investor would doubtless find difficult. Thus a small investor in municipal bonds may well face a material loss in liquidating his investment if he finds it necessary to sell prior to maturity.

These various difficulties would be overcome if his investment in municipal securities were made via a regulated investment company, for the following reasons:

1. The shares of regulated investment companies are priced at modest levels, generally in the area of $10 to $25 per share. They are suitable, therefore, to periodic savings programs of individuals.

2. The market values of shares of regulated investment companies are readily ascertainable by the investor, since the net asset values are determined daily and quotations are reported in many daily newspapers throughout the country.

3. The shares of most regulated investment companies are redeemable, at any time, at the election of the shareholder at their actual net asset value. The investor may liquidate his interest promptly without delay or difficulty.

4. The shareholder has the advantage of diversification of investments and expert investment management supervision, which he might not be able to obtain if he invested individually. Moreover, by virtue of the sharing of investment risks among a large number of investors, it might be possible to include bonds of smaller and lesser known municipalities bearing higher interest rates, thus

increasing the yield as compared with that which a person of moderate means might be able to obtain on individual investment.

V. THE POTENTIAL ROLE OF REGULATED INVESTMENT COMPANIES WITH RESPECT TO

INVESTMENTS IN MUNICIPAL BONDS

Under the Investment Company Act of 1940 every regulated investment company must state publicly its broad investment policy. Many investment companies have a policy of investing only in common stocks. A few companies have a policy of investing only in bonds. A substantial number of companies maintain so-called “balanced funds"—i.e., they invest a portion of their assets in bonds, a portion in preferred stocks and a portion in common stocks.

A survey of the latest published reports available as of June 30, 1959, for the 179 member companies of the National Association of Investment Companies shows that they had assets totaling approximately $16,700 million, yet less than $17,800,000 (approximately one-tenth of 1 percent) was invested by these companies in municipal bonds.

The managements of regulated investment companies bear the responsibility of finding for the benefit of their participating stockholders desirable investments complying with the announced policy of each company. The selection of these investments necessarily depends upon market conditions existing from time to time. The narrowing of the gap between the interest rates on municipal issues as compared with those on Federal and corporate securities has brought those issues into the group of potentially desirable investments for substantially all investment company stockholders. The managements believe that to the extent practicable the investments selected by the investment company should correspond to those which they would make for the individuals if they were handling on a joint basis the investment accounts of all those individuals without the intervention of a corporate entity. If the managements would consider investments in municipal bonds desirable for the group of investors in such circumstances, it is believed that they should, within the bounds of practicality, be empowered to make the same investment decisions when the corporate form is used as a convenience for the joint handling of these many investor accounts. The fact that a corporation (or a trust which is treated as a corporation for tax purposes) is used as the investing vehicle for so many individuals should not affect, either one way or the other, the selection of the investments.

The present forfeiture of the tax-exempt status of municipal bond interest when it passes through an investment company today removes from potential ownership a large group of securities which might well be resorted to for a portion of the investments under existing market conditions if the accounts were being handled on a joint basis without the intervention of a corporation. It is believed that this restraint upon the wise exercise of investment discretion should be removed in order that persons pooling their funds through the medium of regulated investment companies may have their funds invested in substantially the same manner and with substantially the same tax results as exist in the case of persons who invest directly.

It may be noted that amendment of the Internal Revenue Code to permit this result would not involve loss of revenue because at present the amount of municipal bonds owned by regulated investment companies is insignificant.

VI. HISTORY AND NATURE OF THE PROPOSED AMENDMENT

The first proposal for legislation concerning this matter was contained in the President's Economic Report to the Congress in January 1955. In that report the President recommended that the Congress "revise the tax laws so as to permit a regulated investment company, holding the bulk of its assets in the form of taxexempt securities, to pass through to its shareholders the tax-exempt status of the income received on such securities." Thereafter representatives of the National Association of Investment Companies met with representatives of the Treasury Department and of the Joint Committee on Internal Revenue Taxation in order to review the basic principles to be embodied in a bill to carry out this objective. Following these conferences a tentative draft was prepared and introduced on July 16, 1956, by Mr. Cooper (H.R. 12252) and Mr. Reed (H.R. 12253).

Early in the following Congress substantially identical bills were introduced by Mr. Cooper (H.R. 1221), Mr. Reed (H.R. 1222), and Mr. Curtis (H.R. 4380). On July 19, 1957, after further conferences, revised bills, similar in substance but with certain changes in detail, were introduced by Mr. Cooper (H.R. 8810), Mr. Reed (H.R. 8811), and Mr. Curtis (H.R. 8812).

On January 31, 1958, hearings were held by the Ways and Means Committee with respect to these bills and H.R. 8702, another bill which would extend the "pass-through” to a much larger group of companies, including personal holding companies. Thereafter a provision substantially identical with the text of the three bills, H.R. 8810, 8811, and 8812, was inserted by the Senate Finance Committee in the Technical Amendments Act of 1958 (H.R. 8381) as section 42 of that bill. The provision was included in the bill in the form in which it passed the Senate, but it was deleted in conference.

The effect of the three bills, and of section 42 of the Technical Amendments Act of 1958 as it passed the Senate, was to preserve the tax-exempt character of municipal bond interest distributed to the shareholders of a regulated investment company if the company derived at least 95 percent of its gross income from municipal bond interest and had at least 90 percent in value of its assets invested in municipal bonds.

The National Association of Investment Companies has given further serious consideration to this matter in the intervening period. It believes that the principle of the “pass-through” of the tax-exempt status of municipal bond interest received by regulated investment companies and distributed to their shareholders is sound and should be enacted. It has come to the conclusion, however, that the "pass-through” should not be confined, as it was in the previously pending legislation, to companies which specialize in municipal bonds to the extent that such bonds represent 90 percent of the assets of the company and the interest thereon represents 95 percent of its total income. The association believes that it is desirable to make the principle applicable to all regulated investment companies regardless of the proportion of their assets invested in municipal bonds or the proportion of their total income derived from interest on those bonds.

The association believes that the application of the “pass-through” principle to regulated investment companies which have part of their assets invested in bonds and part in stocks is desirable in order to permit the management of such companies to include municipal bonds in their portfolios when current market conditions warrant. The management would then be in a position to acquire municipal bonds, if they considered such a move desirable in a balanced investment program for the shareholders, to the same extent as they would do so if they were handling in a common account the pooled funds of the individual participants. It is believed that this is a sound principle to apply to these companies, consistent with the basic philosophy of subchapter M that persons investing via a regulated investment company be placed on substantially the same basis taxwise as those persons who have sufficient funds to invest in securities directly. The fact that a corporation (or a trust which is treated for tax purposes as a corporation) must be used as the investing vehicle for so many individuals should not alter their Federal income tax position, either for or against them, nor should the tax structure be such as to alter the sound exercise of the management's investment decisions on their behalf.

Accordingly, there is attached hereto as appendix A a suggested form of amendment to the code which would extend the “pass through” principle to regulated investment companies generally. There is also attached as appendix B the previously pending legislation, which would have confined the passthrough to those regulated investment companies which deprive 95 percent of their gross income from municipal bond interest and have 90 percent of their assets invested in municipal bonds.

The new draft requires, as did the previous one, that the company's investments be diversified, and further that the company distribute currently at least 90 percent of its entire net income, including both taxable and nontaxable income. In the new draft (exbibit A) the principal changes from the previously pending legislation are the following:

1. The previous requirement that 95 percent of the gross income consist of municipal bond interest and that 90 percent of the assets be invested in such bonds has been deleted.

2. The previous provision that the entire dividend paid by the company be treated in the hands of the shareholders as tax-exempt interest has been modified so that the amount of the dividend which may be so treated cannot exceed the net income of the company from municipal bond interest.

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