Elimination of the possibility of a corporate tax in those limited areas where the income is distributable to shareholders would provide, as the growth of the mutual investment funds have demonstrated, the maximum investment incentive.

Taxpayers and tax administrators alike have long used and become accustomed to the conduit or partnership method of reporting income. The continued use of this method by all real estate investment syndicates, and its extension to real estate and business corporations, should cause no administrative burden. The imposition of a corporate tax on real estate investment syndicates will not produce additional reveIt will merely compel these syndicates to liquidate, upset the real estate market, and cause severe hardship to participants who acted in reliance on longstanding Treasury Department regulations.

nue.

REAL ESTATE INVESTMENT TRUSTS

H. Cecil Kilpatrick

My name is H. Cecil Kilpatrick. I am an attorney at law, engaged in practice in the District of Columbia. I represent a group of real estate investment trusts which are seeking the same type of income tax treatment for such trusts as is given to common trust funds and regulated investment companies (hereinafter called collectively "mutual funds") by subchapter M of chapter 1 of subtitle A of the Internal Revenue Code of 1954.

Three bills which would produce this result are now pending before this committee. These bills would relieve real estate investment trusts which meet certain rigid tests from payment of corporate income taxes on income distributed to their beneficiaries.

While I am a representative of trusts which seek this change in existing law, and may therefore be viewed as an advocate of such a change, I shall endeavor to follow the chairman's request and present the matter objectively, addressing myself basically to the criteria and objectives of tax reform set out in section I-A of the outline supplied to me.

1. HISTORICAL BACKGROUND

A brief review of the nature and history of real estate investment trusts and their tax treatment under Federal law may be helpful to the committee.

(a) The real estate investment trust

Before the turn of the century there were a number of attorneys practicing in Boston who had great familiarity with real estate conveyancing and probate law, and who handled the property and affairs of a considerable clientele. Real estate and interests therein were then a traditional medium of fiduciary trust investment. But at the time referred to, with an almost phenomenal growth taking place in our country, particularly in the West, parcels of commercial property, and the buildings thereon, were rapidly becoming far too expensive and large for individual investment consistent with proper diversification and limitation of risk.

The real estate trust was conceived and thought of as a medium of common investment in the improvement of real estate by persons of moderate means investing conservatively, but investing at the same time with a view to gradual growth in the value of their holdings. These entities were set up as trusts partly because their founders thought in trust terms as probate lawyers. Their financing was a model of conservative soundness, often with a limitation of the trustees' power to mortgage the properties purchased for more than

1 H.R. 2992, introduced by Mr. Curtis of Missouri; H.R. 3477, introduced by Mr. Keogh of New York; and H.R. 3985, introduced by Mr. Simpson of Pennsylvania. An outline of the provisions of these bills is attached.

a percentage (30 percent, for example) of the par value of the shares. Thus, the attractiveness of the shares was not at all in "leverage' the mercurial reaction of narrow equity over a large debt--which modern taxation has made so deceptively attractive, but in the soundness of a picture unembarrassed by debt and managed by persons combining the caution of the experienced fiduciary with the imagination necessary to conceive of growing communities in distant places. The type of persons who subscribed to the shares justified the plans and the intentions of the promoters.

Shares were not bought to be traded or sold for quick profit, but to be held for income and growth. Thus was created a flexible yet stable medium whereby persons of ordinary means could own interests in diversified real estate. Tens of millions of dollars were invested in these trusts, and capital flowed out from Boston not only through New England, but into communities as far west as Seattle and as far south as Alabama and was heavily invested in growing cities like Detroit, Kansas City, Chicago, Milwaukee, and San Francisco, to mention examples. While the original investments were of Boston capital, there was no formal limitation in that regard, and today shares are owned by persons in many different States. That this was all in the national interest is hardly worth debating.

Paralleling the creation and growth of the real estate investment trusts were the mutual funds.

In 1893 in a period of great activity in the formation of real estate investment trusts with transferable shares, what is considered to be the first mutual fund in the United States was formed under the name

of Boston Personal Property Trust. Its indenture was strikingly similar to that of the Boston Ground Rent Trust, a real estate investment trust, organized in the year 1889. Three of the original trustees of Boston Personal Property Trust were three of the original trustees of Boston Ground Rent Trust. Title to the property in each case was vested in the board of trustees and the participation of individuals in the common pool was represented in each case by transferable shares. Both trusts enjoyed conduit treatment until 1936 and both enjoyed equal opportunities to grow and expand. However, since 1940 the Boston Personal Property Trust has been freed of taxation while the real estate investment trusts have been burdened with the corporate tax. Since 1940 the so-called mutual funds expanded from approximately $1 billion to $15 billion in assets while the real estate trusts have been under constant pressure for liquidation and many have, in fact, been liquidated.

(b) Tax treatment

Prior to 1936, these trusts were taxed as strict trusts and therefore were not taxed on their distributed income. (See Crocker v. Malley (1919), 249 U.S. 223.) However, other trusts were set up to operate all kinds of business, as contrasted with passive investment in rental real estate and real estate mortages, and these business trusts sought to get the same favorable tax treatment. The taxing authorities in reliance on the longstanding statutory provision for taxing "associations" as corporations, attacked this attempted extension of the trust device. There was a great deal of litigation covering this issue but

3

the court decisions 2 and the Treasury regulations seemed to agree that, unless the trust carried on some active business operation other than the mere holding of property and collection of rental income therefrom, it could not be taxed as a corporation.

4

However, in 1935, four cases (at least three of which involved trusts engaged in active business operations) were decided by the Supreme Court on the same date, and that Court took a different view. While the Government argued in those cases, in distinguishing Crocker v. Malley, supra, that the line was to be drawn, as Treasury regulations then drew it, between active business operations, on the one hand, and trusts "engaged merely in collecting the income and conserving the property against the day when it is to be distributed to the beneficiaries," the Court laid down a narrower rule. It held, in effect, that a trust having the following attributes is includible in the statutory term "association" and hence taxable as a corporation without regard to the character of the business:

(a) Holding title to property as an entity;

(b) Centralized management by a board of trustees, as a continuing body with provision for succession, operating like the directors of a corporation;

(c) Transferable and inheritable certificates of beneficial interest, like corporate stock;

(d) Limitation of liability of the participants to the property embarked in the undertaking.

The decision in the Morrissey and related cases caused great consternation on the part of investment trusts--both security and real estate investment trusts-which under the regulations and decisions above noted, had not been subjected to the corporate tax. The trusts which confined their investments to stocks and bonds immediately appeared before the Senate Finance Committee and asked for legislative relief on the ground that these organizations served merely as conduits to permit small investors a means of obtaining an interest in a diversified group of securities. As a result, section 48 (e) of the Revenue Act of 1936 gave this conduit treatment to a "mutual investment company" which was defined as

5

any corporation (whether chartered or created as an investment trust or otherwise) *** if *** it is organized for the purpose of, and substantially all its business consists of holding, investing, or reinvesting in stocks or securities.

The Second Revenue Act of 1940 extended the same conduit treatment, insofar as the excess profits tax was concerned, to "investment companies under which the Investment Company Act of 1940 are registered as diversified companies at all times during the taxable year," as well as "mutual investment companies," and the Revenue Act of 1942 extended similar normal income tax treatment to that given for excess profits taxes.

However, nothing has been done to extend similar tax treatment to real estate investment trusts.

2 See Malley v. Howard, 281 Fed. 363 (1st Cir. 1922); Chicago Title & Trust Co. v. Smietanka, 275 Fed. 60 (D.C. II. 1921); Hecht v. Malley, 265 U.S. 144 (1924).

3 Regs. 45, art. 1504; O.D. 931, 4 Cum. Bull. 11; I.T. 1584, II-I Cum. Bull. I. Morrissey v. Commissioner, 296 U.S. 344; Swanson v. Commissioner, 296 U.S. 362; Helvering v. Combs, 296 U.S. 365; and Helvering v. Coleman Gilbert Associates, 296 U.S. 369.

5 Senate Finance Committee hearings on H.R. 12395, 74th Cong., 2d sess., pp. 776 et seq. and 799 et seq.

2. EQUITY AND FAIRNESS

The chairman of this committee, in a speech delivered to the Tax Foundation in New York in December of last year, said that one of the essential factors to be considered in any reevaluation of our tax structure is its fairness between taxpayers, and that our tax laws "must accord the same tax treatment to what is essentially the same type of operation irrespective of the form in which it is cast."

The common characteristic of the mutual fund and the real estate investment trust is the providing of a means for the small investor to get expert management and diversification of his investment through an organization performing no other function than to put the pooled savings of many people in purely passive types of investment in which the individual investor could not otherwise participate. Neither form of organization is engaged in active business operations, such as manufacturing, merchandising, or the rendition of personal services for profit.

If equity and fairness dictate the same tax treatment to what is essentially the same type of operation, and if the present tax treatment of the mutual funds is sound, it would appear that the same treatment should be accorded the real estate investment trust, unless there is some basic difference in the nature of the two types of organization which make it fair to tax one and not the other. Perhaps, before examining the essential points of similarity between the two, we should first consider the question of whether the present tax treatment of the mutual funds is the correct one.

I have no doubt that other witnesses will appear before this committee to attest the fairness of extending the conduit treatment to the distributed income of the mutual funds. It seems to me that this treatment is not only fair, but has proven itself to be in the public interest. From 1913 to 1936, with no change in the statutes, these pure investment trusts were accorded the tax treatment which recognized that they were mere conduits of income. Only through court decisions in cases, which were litigated only because the organizations had gone beyond this and engaged in active business operations, was the law suddenly interpreted, contrary to 17 years of administrative and judicial interpretation, to superimpose a corporate tax upon trusts having certain formal characteristics, without regard to whether they were engaged in active business operations. Because of the importance to the economy of permitting a pooling of funds by small investors, who could not otherwise participate in large investment enterprises, Congress promptly overruled the Morrissey case, as applied to the mutual funds.

Are there differences between real estate investment trusts of the type provided by the pending legislation and mutual funds which justify a corporate tax of 30 to 52 percent on the income of the former and no tax upon the income of the latter?

The only material difference that has been suggested is that the real estate investment trusts are engaged more in active business operations because they supply certain services and facilities to their tenants, such as elevator operation, janitor services, heat, light, and other