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3. A provision is inserted to disallow as a deduction to the company its expenses which are allocable to its income from municipal bond interest. provision was not included in the previously pending legislation since the adjustment would be inconsequential if 95 percent of the gross income were from municipal bond interest. It seems necessary to include such a rule, however, where the municipal bond interest is a substantially lower percentage of the total. Under existing law the requirement for such allocation is contained in section 265 (2) of the code, applicable to individual investors but not to corporations. Since a regulated investment company acts as a conduit for the distribution of its income primarily to individual investors, it would seem appropriate to make the rule for individuals apply to regulated investment companies.

4. The effective date provision has been changed to make the amendment applicable with respect to taxable years ending after the date of its enactment.

VII. CONCLUSION

For the reasons set forth above, the association believes that subchapter M of the Code should be amended to eliminate the forfeiture of the tax-exempt status of municipal bond interest as it passes through regulated investment companies. In the light of the changes which have occurred in interest rates on such bonds in recent years, the present restraint upon the sound exercise of management discretion in selecting portfolio securities should be removed. Municipal bonds should be available for inclusion in the portfolio, where market conditions warrant, to the same extent as in the case of individuals who invest directly.

86th CONGRESS

2nd Session

Mr.

EXHIBIT A

H.R.

IN THE HOUSE OF REPRESENTATIVES

JANUARY - 1960

introduced the following bill which was referred to the Committee on Ways and Means.

A BILL

To amend the Internal Revenue Code of 1954 with respect to the income tax treatment of dividends paid by regulated investment companies out of interest received on State and local securities.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

That (a) section 852 (a) (1) of the Internal Revenue Code of 1954 (relating to requirements applicable to regulated investment companies) is amended to read as follows:

"(1) the deduction for dividends paid during the taxable year (as defined in section 561, but without regard to capital gain dividends) equals or exceeds 90 percent of its investment company taxable income for the taxable year (determined without regard to subsection (b) (2) (D) and also by including in gross income interest excludable from gross income under section 103 (a) (1) and by deducting from gross income any amounts disallowed under section 265 or section 171 (a) (2)), and”.

(b) Section 852(b) (2) (D) (relating to adjustments to taxable income) is amended to read as follows:

"(D) the deduction for dividends paid (as defined in section 561) shall be allowed, but shall be computed without regard to capital gain dividends and exempt-interest dividends."

(c) Section 852 (b) (relating to method of taxation of companies and shareholders) is amended by deleting the present paragraph (4) and by inserting after paragraph (3) the following new paragraphs:

"(4) EXEMPT-INTEREST DIVIDENDS.—

"(A) DEFINITION.-An exempt-interest dividend means any dividend or part thereof (other than a capital gain dividend) paid by a regulated investment company and designated by it as an exempt-interest

dividend in a written notice mailed to its shareholders not later than thirty days after the close of the taxable year. If the aggregate amount so designated with respect to a taxable year of the company (including exempt-interest dividends paid after the close of the taxable year as described in section 855) is greater than the excess of

"(i) the amount of interest excludable from gross income under section 103 (a) (1) of the taxable year, over

"(ii) the amounts disallowed as deductions under section 265 or section 171(a)(2),

the portion of each distribution which shall be an exempt-interest dividend shall be only that proportion of the amount so designated as the amount of such excess for such taxable year bears to the amount so designated.

"(B) TREATMENT OF EXEMPT-INTEREST DIVIDENDS BY SHAREHOLDERS.— An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under section 103 (a) (1). Such purposes include but are not limited to

"(i) the determination of gross income and taxable income, "(ii) the determination of distributable net income under subchapter J,

"(iii) the allowance of, or calculation of the amount of, any credit or deduction, and

"(iv) the determination of the basis in the hands of any shareholder of any share of stock of the company."

"(5) Loss ON SALE OR EXCHANGE OF STOCK HELD LESS THAN 31 DAYS.— "(A) CAPITAL GAIN DIVIDENDS.—If—

"(i) under subparagraph (B) or (D) of paragraph (3), a shareholder of a regulated investment company is required, with respect to any share, to treat any amount as a long-term capital gain, and

"(ii) such share is held by the taxpayer for less than 31 days, then any loss on the sale or exchange of such share shall, to the extent of the amount described in clause (i) of this subparagraph, be treated as loss from the sale or exchange of a capital asset held for more than 6 months.

"(B) EXEMPT-INTEREST DIVIDENDS.-If—

“(i) under subparagraph (B) of paragraph (4), a shareholder of a regulated investment company is required, with respect to any share, to treat any amount as an item of interest excludable from gross income under section 103 (a) (1) and

"(ii) such share is held by the taxpayer for less than 31 days, then any loss on the sale or exchange of such share shall, to the extent of the amount described in clause (i) of this subparagraph, not be recognized.

"(C) DETERMINATION OF HOLDING PERIOD.-For purposes of subparagraphs (A) and (B), the rules of section 246 (c)(3) shall apply in determining whether any share of stock has been held for less than 31 days; except that '30 days' shall be substituted for the number of days specified in subparagraph (B) of section 246 (c) (3).”

SEC. 2. Section 103 of such Code (relating to exclusion from gross income of interest on certain governmental obligations) is amended by redesignating subsection (c) as subsection (d), and by inserting after subsection (b) the following new subsection:

"(c) EXEMPT-INTEREST DIVIDENDS.-For treatment of exempt-interest dividends, see section 852 (b) (4) (B).”

SEC. 3. Section 265 of such Code (relating to non-allowance of deductions for expenses and interest relating to tax-exempt income) is amended by adding at the end thereof the following new paragraphs:

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'(3) CERTAIN REGULATED INVESTMENT COMPANIES.-In the case of a regulated investment company which distributes during the taxable year an exempt-interest dividend (including exempt-interest dividends paid after the close of the taxable year as described in section 855), any amount otherwise allowable as a deduction which is allocable to interest (whether or not any amount of such interest is received or accrued) excludable from gross income under section 103 (a) (1).

"(4) INTEREST RELATED TO EXEMPT-INTEREST DIVIDENDS.-Interest on indebtedness incurred or continued to purchase or carry stock of a regulated investment company which during the taxable year of the holder thereof distributes exempt-interest dividends, but in an amount not in excess of the amount of the exempt-interest dividends received by such holder during such year.

"(5) CROSS REFERENCES.

"(A) For definition of regulated investment company, see section 851(a).

"(B) For definition of exempt-interest dividends, see section 852 (b) (4)."

SEC. 4. The amendments made by this Act shall apply only with respect to taxable years of regulated investment companies ending after the date of the enactment of this Act.

EXHIBIT B

SECTION 42 OF THE TECHNICAL AMENDMENTS BILL OF 1958 (H.R. 8381) AS PASSED BY THE SENATE

SEC. 42. TREATMENT OF DIVIDENDS OF REGULATED INVESTMENT COMPANIES WHOSE ASSETS CONSIST MAINLY OF STATE AND LOCAL OBLIGATIONS.

(a) QUALIFICATIONS

OF REGULATED INVESTMENT COMPANY FOR SPECIAL TAX-EXEMPT-INTEREST DIVIDEND TREATMENT.-Section 851 (relating to definition of regulated investment company) is amended by adding at the end thereof the following new subsection:

"(f) COMPANIES INVESTING IN CERTAIN TAX-EXEMPT SECURITIES.—

"(1) GENERAL RULE.-A corporation shall be treated as meeting the requirements of subsection (b) for a taxable year if it meets the requirements of paragraphs (1), (2), and (3) of such subsection and if (in lieu of the requirements of paragraph (4) of subsection (b) at the close of each quarter of the taxable year

"(A) at least 90 percent of the value of its total assets is represented by cash and cash items (including receivables) and obligations the interest on which is excludable from gross income under paragraph (1) of section 103 (a);

"(B) at least 50 percent of the value of its total assets is represented by

"(i) cash and cash items (including receivables) and Government securities, and

"(ii) other securities for purposes of this calculation limited in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the taxpayer; and "(C) not more than 25 percent of the value of its total assets is invested in the securities of any one issuer ;

but only if the amount of interest excludable from gross income for such taxable year under paragraph (1) of section 103 (a) exceeds 95 percent of its gross income (including such interest as gross income and excluding gains from the sale or other disposition of capital assets).

"(2) SPECIAL RULES.-For purposes of this subsection

"(A) the terms 'gross income' and 'interest', when used in paragraphs (2) and (3) of subsection (b) include interest excludable from gross income under paragraph (1) of section 103 (a); and

"(B) paragraphs (4) and (5) of subsection (c) shall apply."

(b) DETERMINATION OF STATUS.-Section 851 (d) (relating to determination of status) is amended by inserting after "subsections (b) (4) and (c)" the following: "(or the requirements of subsection (f) which are in lieu of the requirements of subsection (b) (4))".

(c) REQUIREMENTS APPLICABLE TO REGULATED INVESTMENT COMPANIES.— Section 852 (a) (1) (relating to requirements applicable to regulated investment companies) is amended to read as follows:

"(1) either

"(A) in the case of a regulated investment company which does not meet the requirements of section 851 (f) for such taxable year, the deduction for dividends paid during the taxable year (as defined in section 561, but without regard to capital gain dividends) equals or

exceeds 90 percent of its investment company taxable income for the taxable year (determined without regard to subsection (b) (2) (D)),

or

"(B) in the case of a regulated investment company which meets the requirements of section 851 (f) for such taxable year, such company

"(i) paid during the taxable year exempt-interest dividends, and "(ii) distributed during such taxable year amounts which would be treated as dividends under section 562 (b) if the deduction for dividends paid (as defined in section 561) were allowed,

which together equal or exceed 90 percent of its investment company taxable income for the taxable year (determined by including in gross income interest excludable from gross income under paragraph (1) of section 103 (a) and by deducting from gross income any amounts disallowed under section 265 or section 171 (a) (2)), and."

(d) ADJUSTMENTS TO REGULATED INVESTMENT COMPANY TAXABLE INCOME.Section 852 (b) (2) (D) (relating to adjustments to taxable income is amended to read as follows:

"(D) In the case of a company which does not meet the requirements of section 851 (f), the deduction for dividends paid (as defined in section 561) shall be allowed, but shall be computed without regard to capital gain dividends."

(e) EXEMPT-INTEREST DIVIDENDS.-Section 852 (b) (relating to method of taxation of companies and shareholders) is amended by adding at the end thereof the following new paragraph:

"(4) EXEMPT-INTEREST DIVIDENDS.—

"(A) DEFINITION.-An exempt-interest dividend means any dividend or part thereof (other than a capital gain dividend), paid by a regulated investment company and designated by it as an exempt-interest dividend in a written notice mailed to its shareholders not later than 30 days after the close of its taxable year, but only if such company meets the requirements of section 851 (f) for such taxable year. If the aggregate amount so designated with respect to a taxable year of the company (including exempt-interest dividends paid after the close of the taxable year as described in section 855) is greater than the investment company taxable income for such taxable year (determined as provided in subsection (a) (1) (B)), the portion of each distribution which shall be an exempt-interest dividend shall be only that proportion of the amount so designated as the amount of the investment company taxable income for such taxable year (determined as provided in subsection (a) (1) (B)) bears to the aggregate amount so designated.

"(B) TREATMENT OF EXEMPT-INTEREST DIVIDENDS BY SHAREHOLDERS.— An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under paragraph (1) of section 103 (a). Such purposes include but are not limited to

"(i) the determination of gross income and taxable income, "(ii) the determination of distributable net income under subchapter J,

"(iii) the allowance of, or calculation of the amount of, any credit or deduction, and

"(iv) the determination of the basis in the hands of any shareholder of any share of stock of the company."

(f) TECHNICAL AMENDMENTS.

(1) Section 103 (relating to exclusion from gross income of interest on certain governmental obligations) is amended by redesignating subsection (c) as subsection (d), and by inserting after subsection (b) the following new subsection:

“(c) EXEMPT-INTEREST DIVIDENDS.-For treatment of exempt-interest dividends, see section 852 (b) (4) (B).”

(2) Section 265 (relating to nonallowance of deductions for expenses and interest relating to tax-exempt income) is amended by adding at the end thereof the following new paragraph:

"(3) INTEREST RELATED TO EXEMPT-INTEREST DIVIDENDS.-Interest on indebtedness incurred or continued to purchase or carry stock of a regulated investment company for any period during which such company meets the requirements of section 851 (f).”

(g) EFFECTIVE DATE.-The amendments made by this section shall apply only with respect to taxable years of regulated investment companies beginning after the date of the enactment of this Act.

In addition, section 43 of the Technical Amendments Bill of 1958 would have inserted as section 852 (b) (5) of the Code provision similar to that included in the draft attached hereto as exhibit A.

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