as diversified. If the bill is passed the committee believes that the tax problem of these companies should receive prompt consideration by the Congress. (H. Rept. No. 2639, p. 10, 76th Cong., 3d sess.) Accordingly, in the Revenue Act of 1942 the provisions of supplement Q in the 1939 Code (the predecessor of subchapter M in the 1954 Code) relating to investment companies were substantially amended, the principal changes being as follows: (1) The provisions were made applicable to closed-end as well as open-end companies. (2) The requirement that the companies distribute at least 90 percent of their total net income in order to qualify under supplement Q was modified so as to require distribution only of 90 percent of the ordinary net income, exclusive of capital gains. (3) Capital gain dividends (i.e., dividends paid out of net long-term capital gains) were made taxable to shareholders as long-term capital gains instead of as ordinary income. (4) Supplement Q treatment was made elective with the investment company, the election once made being binding for future years. (5) For purposes of determining whether or not distributions by regulated investment companies to shareholders are taxable dividends, net capital losses were disallowed as deductions in computing earnings and profits of the current year. In this form, with minor amendments made in 1950 and 1951, supplement Q remained until the enactment of the 1954 Code. In the 1954 Code the provisions pertaining to regulated investment companies, previously contained in supplement Q, were placed in subchapter M. The provisions were somewhat recast to conform with other changes made elsewhere in the Code. Moreover, with respect to regulated investment companies having 50 percent of the value of their assets invested in foreign securities, a provision was inserted permitting foreign taxes paid by the companies to be taken as tax credits by the shareholders in their individual returns in which they report the dividends paid by the companies out of the income on the foreign securities. (Sec. 853.) In 1956 a provision was inserted to permit regulated investment companies to retain their net long-term capital gain with the same tax effect both for the company and the shareholder as if the gains had been distributed currently as capital gain dividends and reinvested in the company by the shareholder. If the company elects to use this procedure in order that capital gains, whether realized or unrealized, may be retained in the corpus of the fund for investment, the company pays over 25 percent of the net realized capital gain to the Treasury; the shareholder includes his pro rata share of the capital gain in his own return subject to tax at his own applicable tax bracket and takes credit for his share of the 25-percent tax previously paid to the Treasury. This procedure has been used by several closed-end companies which desire to maintain intact their principal and has operated quite successfully. Finally, in the Technical Amendments Act of 1958 minor corrective changes were made. In conjunction with other changes in the Code regarding transactions in stocks before and after dividend dates, it was provided that any loss incurred by sale of regulated investment company stock within 30 days of its purchase must be treated as a long-term capital loss to the extent of any capital gain dividend received during that period. Another amendment corrected an inadvertent change made in the drafting of the 1954 Code revision concerning the determination of earnings and profits of the companies. III. SUMMARY OF THE REGULATED INVESTMENT COMPANY PROVISIONS The special provisions pertaining to regulated investment companies are applicable only if the companies meet the following require ments: (1) Regulation. The companies must be registered with the Securities and Exchange Commission under the Investment Company Act of 1940 and thus be subject to regulation under that statute for the protection of the investing shareholders. (2) Public ownership.-The companies must be public companies whose stocks are widely held. This requirement stems from two sources. First, under the Investment Company Act, § 3 (c) (1), they may not be required to register with the SEC unless they have at least 100 shareholders. Secondly, Internal Revenue Code § 851(a) stipulates that the companies cannot be personal holding companies. Since the nature of their income is such as to fulfill the gross income requirements, the effect of this prohibition is that the stock of the companies must be so widely held that no five individuals (treating families and partners as single individuals) may own in the aggregate more than 50 percent of the outstanding stock. The companies are required under regulations to obtain information annually from their shareholders to establish that the ownership of their stock is not so concentrated as to violate this prohibition (§ 852(b)). (3) Diversification.-The companies must maintain a diversified group of investments (§ 851 (b)(4)). In general, at least one-half of their assets must be composed of investments in securities which do not represent more than 5 percent of the assets of the investment company nor more than 10 percent of the voting securities of the issuer (§ 851 (b) (4) (A)). Moreover, not more than 25 percent of the value of the total assets may be invested in the securities of any one issuer (§ 851 (b) (4) (B)). (4) Nature of gross income.-At least 90 percent of the gross income of the company must be derived from dividends, interest and gains from the sale of securities (§ 851 (b) (2)). Less than 30 percent of the gross income must be derived from the sale of securities held for less than 3 months. (In actual practice income of this latter type is believed to be negligible.) (§ 851 (b) (3).) (5) Requirement for current distribution of income. The companies are required to distribute in the current year (or, under certain conditions, in the next succeeding year) 90 percent of their net income, exclusive of net long-term capital gains (§ 852(a) and § 855). In actual practice, most regulated investment companies endeavor to distribute as nearly as they can all of their net income and most of them distribute as well all of their net long-term capital gains. If the companies conform to these strict requirements, they are deprived of the deduction for dividends received (§ 241 and following) but are allowed the deduction for dividends paid (§ 561 and 47060-59-pt. 3-9 following). Thus they are taxed (at the usual corporate rates) only on the income which they do not distribute currently to their shareholders. The tax on the distributed income is payable currently by the shareholders on their individual returns upon the receipt of the dividends from the regulated investment companies. Net long-term capital gains distributed currently by the companies as capital-gain dividends are taxable to the shareholders as long-term capital gains rather than as ordinary dividends. A capital-gain dividend is one which is designated as such by the company in a written notice mailed to shareholders not more than 30 days after the close of its taxable year; but the amount which may be treated as a capital-gain dividend cannot exceed the actual net long-term capital gain of the company for its taxable year (§ 852(b) (3)). In the case of the few regulated investment companies which have more than half of their assets invested in securities of foreign corporations, the foreign tax credit otherwise allowable to the company if it had retained the income on such securities is allowed as a foreign tax credit to the shareholders to whom such income is currently distributed (§ 853). IV. EFFECTIVENESS OF THE CODE OF PROVISIONS In actual operation the provisions of the Code regarding regulated investment companies and their shareholders have, I believe, accomplished their primary objectives of making the income tax burden on persons investing through an investment company substantially the same as that of a person who invests in securities directly. They have permitted the person of moderate means to invest in securities with diversification of risk and expert investment management without being subjected to any greater income tax burden than a wealthier individual who can secure those benefits without the pooling of his resources with those of others. Moreover, from an administrative standpoint the structure has operated efficiently. In view of the nature of the income of the companies, and the careful records which they maintain, the companies are able to determine their income with considerable precision. The annual written notices required to be sent by the companies to the individual shareholders regarding the distributions made to them in the preceding year have facilitated the proper filling out of their individual returns. The statutory provisions and regulations have produced practically no litigation in some 20 years. Thus the system in actual practice has worked smoothly and effectively. I should like to call to the committee's attention, however, the need for one important amendment to the provisions. I refer to the matter of the treatment of interest on State and municipal bonds. This interest is, of course, exempt from tax under Section 103 of the Code if received by a regulated investment company, as in the case of other holders of such securities, but under present law when the interest is distributed currently to shareholders as dividends it loses its exempt character and becomes instead a taxable dividend. The increase in interest rates on municipal bonds within the past few years has been so marked as to make it desirable in some cases to include such bonds in an investment program for individuals in the lowest income tax brackets. Several years ago President Eisenhower recommended to the Congress an amendment with respect to this matter, and after considerable study, the National Association of Investment Companies has concluded that it would be desirable to permit the interest on those bonds to pass through in its tax-free status to the shareholders. A separate memorandum with respect to this matter is attached as an appendix to my statement. V. CONCLUSION By permitting the pooling of investment resources of a large number of persons of modest resources without added income tax burden, the small investor has been given an opportunity to acquire a share in a diversified group of investments under professional management without an added layer of taxes as compared with those who are able to secure those advantages by direct investment. The fact that in the past 20 years since this tax structure took its present form the asssets of regulated investment companies have grown from some $1 billion to more than $16 billion, and the number of shareholder accounts from some 750,000 to some 4,300,000, attests to the merit of the system. Thus substantial equity funds have been made available to the country's industrial enterprises. Accordingly, in my opinion the regulated investment company provisions of the Code have provided in significant measure a "tax climate *** favorable to economic growth." As Chairman Mills noted in the announcement of these hearings on May 18, 1959, this should be a prime objective of our tax law. At the same time they have served to increase substantially the participation of the small investor in the Nation's economy and its industry. These accomplishments, I believe, are the earmarks of a dynamic, democratic and equitable tax structure. Appendix MEMORANDUM RE PROPOSED AMENDMENT OF INTERNAL REVENUE CODE TO PRESERVE TAX-EXEMPT STATUS OF STATE AND MUNICIPAL BOND INTEREST RECEIVED BY REGULATED INVESTMENT COMPANIES AND DISTRIBUTED TO THEIR SHAREHOLDERS Since 1955 the Congress has had under consideration a proposed amendment to the Internal Revenue Code to permit interest on State and municipal bonds held by regulated investment companies to retain its tax-exempt status when distributed by such companies currently to their shareholders. This memorandum has been prepared on behalf of the National Association of Investment Companies to review the considerations which it believes make the adoption of the amendment desirable at this time. The study which the association has made of this matter has led to the following conclusions: (1) The great increase in the volume of State and municipal bonds outstanding in the past few years and the accompanying narrowing of the differential in interest rates on these bonds as compared with those on taxable issues of the Federal Government and corporations have made them desirable investments for persons in the low and medium income tax brackets. (2) Because of the form in which State and municipal bonds are offered and the nature of the market in which they are now traded, it is not feasible today for persons of moderate means to invest in these bonds. (3) Regulated investment companies offer a means by which investments in these bonds can be made available to such persons. (4) The managements of regulated investment companies, which have the duty of investing the pooled funds of a large number of such persons, should be permitted to include State and municipal bonds in their investment portfolios, when investment conditions warrant, to the same extent as would be appropriate if they were investing such funds in a joint account for the benefit of those persons. The fact that, as a matter of practical necessity, a corporation is used as the vehicle of accomplishing the objective of joint investment should not alter the managements' selection of the investments for the benefit of those persons. However, the present forfeiture of the tax-exempt status of State and municipal bond interest as it passes through the investment company currently to its shareholders generally eliminates such bonds from consideration as investments. (5) In order to remove this present obstacle to the inclusion of State and municipal bonds in the securities portfolios of regulated investment companies when market conditions warrant, and to make it possible for persons of moderate means to include an interest in such bonds in a properly balanced investment program, the Code should be amended to permit interest on such bonds to retain its tax-exempt status when it passes through the company currently to its shareholders. The reasons for these conclusions are outlined below. I. THE PRESENT PROVISIONS OF THE CODE In the Internal Revenue Code, section 103 specifically provides that- (1) the obligation of a State, a Territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia; *** (For convenience, these obligations will be referred to as "municipal bonds.") The code specifically provides that interest derived by a partnership on securities of this type owned by it retains its tax-exempt character in the hands of a partner to whom it is distributed. I.R.C. § 702. The code also provides that tax-exempt interest derived by the estate or trust on securities held by it retains its tax-exempt character in the hands of a beneficiary to whom it is distributed. I.R.C. § 652. While there is no specific provision in the code relating to tax-exempt interest distributed by a corporation to its shareholders, it has been held that such distributions constitute taxable distributions to the shareholders. The income has been regarded as losing its character as interest when it passes through the corporate entity and as being transmuted into dividend income in the hands of the shareholder. As a result it is not in his hands regarded as excludable from income but as a dividend eligible for the dividends received credit and dividend exclusion in the hands of individual or corporate recipients. II. THE STATUS OF REGULATED INVESTMENT COMPANIES UNDER THE CODE For some 20 years the Internal Revenue Code has contained special provisions (now found in subchapter M) relating to the taxation of regulated investment companies and their shareholders. They exist in recognition of the fact that regulated investment companies afford to investors, primarily those of moderate means, an opportunity to pool their investment resources with those of other persons for investment in securities. The investment company issues its own stock to investors and applies the funds it receives from them to make investments in a diversified group of securities. The investment company is subject to regulation by the Securities and Exchange Commission under the Investment Company Act of 1940. Through the medium of the investment company an individual of modest means can obtain diversification of risk and experienced investment management which he might not otherwise be able to afford. The income-tax provisions applicable to regulated investment companies and their shareholders have been designed to subject an individual investing via a regulated investment company to substantially the same tax burden as he would have borne had he invested directly in his proportion of the underlying securities. The investment company is treated as a conduit through which its income passes currently to its shareholders. Thus if the investment company dis |