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Internal Revenue Bulletin - October 5, 2015 - T.D. 9737
Internal Revenue Bulletin: 2015-40 October 5, 2015 T.D. 9737
This document contains final rules with revisions to examples that illustrate the controlled group rules applicable to regulated
investment companies (RICs). The revised examples illustrate how the controlled group rules affect the RIC asset diversification
Effective Date: These regulations are effective on September 15, 2015.
Applicability Dates: For dates of applicability, see §§ 1.851–3(b), 1.851–5(b).
Julanne Allen or Susan Baker of the Office of Associate Chief Counsel (Financial Institutions and Products) at (202) 317-6945
(Julanne Allen) or (202) 317-7053 (Susan Baker) (not toll-free numbers).
This document contains amendments to the Income Tax Regulations (26 CFR, part 1) relating to the application of the controlled
group rules under section 851(c) to RICs.
To qualify as a RIC, a taxpayer must meet asset diversification tests pursuant to which, at the close of each quarter of the
RIC’s taxable year, not more than 25 percent of the value of the taxpayer’s total assets may be invested in (i) the securities
(other than Government securities or the securities of other RICs) of any one issuer; (ii) the securities (other than the
securities of other RICs) of two or more issuers that the taxpayer controls and that are determined, under regulations prescribed
by the Secretary, to be engaged in the same or similar trades or businesses or related trades or businesses; or (iii) the
securities of one or more qualified publicly traded partnerships (as defined in section 851(h)) (the 25 percent tests). See section 851(b)(3)(B).
Section 851(c) provides special rules applicable to the asset diversification requirements of section 851(b)(3), including
the 25 percent tests. The controlled group rules in section 851(c)(1) provide that, when ascertaining the value of a taxpayer’s
investment in the securities of an issuer for purposes of determining whether the 25 percent tests have been met, the taxpayer’s
proper proportion of any investment in the securities of such issuer that are held by a member of the taxpayer’s “controlled
group” must be aggregated with the taxpayer’s investment in such issuer, as determined under regulations.
Section 851(c)(3) defines a controlled group as one or more chains of corporations connected through stock ownership with
the taxpayer if (i) 20 percent or more of the total combined voting power of all classes of stock entitled to vote of each
of the corporations (except the taxpayer) is owned directly by one or more of the other corporations, and (ii) the taxpayer
owns directly at least 20 percent or more of the total combined voting power of all classes of stock entitled to vote of at
least one of the other corporations.
On August 2, 2013, the Treasury Department and the IRS published in the Federal Register a notice of proposed rulemaking (REG–114122–12 at 78 FR 46851) (NPRM). The proposed regulations would revise certain examples
in § 1.851–5 to clarify that a RIC and its controlled subsidiary are a controlled group even if the group consists of only
that RIC and its subsidiary.
No public hearing was requested or held. Written comments responding to the NPRM were received. The written comments are available
for public inspection at http://www.regulations.gov or upon request. After consideration of all the comments, these final
regulations adopt the provisions of the proposed regulations with certain clarifications. The comments and clarifications
are discussed in this preamble.
Comments received in response to the NPRM’s request for comments addressed three general categories of issues: (1) application
of the proposed changes to a parent RIC investing in the stock of subsidiary RICs (a Fund of Funds structure); (2) application
of the proposed changes to a RIC’s indirect investment in qualified publicly traded partnerships, as defined in section 851(h)
(QPTPs); and (3) clarification of existing regulatory language implementing the controlled group rules of section 851(c).
Commenters recognized that the changes to the examples in § 1.851–5 apply to structures in which the investments of a RIC
(Upper RIC) include stock of one or more subsidiary RICs (Lower RICs). Commenters noted that there may be uncertainty in determining
whether an Upper RIC satisfies its 25 percent tests when what might otherwise be a quarter-end violation by the Lower RIC
is saved from being a violation by one or both of the relief provisions in section 851(d)(1) (sometimes called the “market
value exception” and the “30-day cure provision”) or when the Upper RIC and a Lower RIC have different quarter end testing
To resolve this uncertainty, commenters urged the Treasury Department and the IRS either to provide a safe harbor for Fund
of Funds structures or to exempt these structures from the controlled group rules. Commenters noted that securities of RICs
are listed as qualifying assets for purposes of the “good asset” 50 percent test of section 851(b)(3)(A) and are correspondingly
excluded from the categories of assets listed in the 25 percent tests set forth in sections 851(b)(3)(B)(i) and (ii). In response
to these requests, the Treasury Department and the IRS are issuing Revenue Procedure 2015–45 (2015–39 IRB dated September
28, 2015), which describes conditions under which the IRS will treat an Upper RIC that invests in one or more Lower RICs as
satisfying the 25 percent tests and provides procedures to lessen the burden of demonstrating compliance with the 25 percent
tests, applying the market value exception and the 30-day cure provision, and dealing with different quarter-end testing dates.
2. QPTPs
Comments were received both on the revised language in Example 1 and on proposed Example 7. Example 7 illustrates the application of the controlled group rules to a RIC’s indirect investment in securities of QPTPs.
In 2004, Congress enacted section 851(b)(2)(B), which facilitated investment by RICs in equity interests of QPTPs by providing
that net income from an interest in a QPTP would be treated as qualifying income under the RIC income test set forth in section
851(b)(2) without regard to the character of the income earned by the QPTP. Congress provided for this new ability of RICs
to invest in QPTPs to improve QPTP access to U.S. capital markets.[1]
At the same time, however, Congress enacted section 851(b)(3)(B)(iii), which limits a RIC’s investment in securities of one
or more QPTPs to not more than 25 percent of the value of the RIC’s assets. The Ways and Means Committee report explained
the rationale for this limitation by stating:
[T]he Committee bill requires that present-law limitations on ownership and composition of assets of mutual funds apply to
any investment in a publicly traded partnership by a mutual fund. The Committee believes that these limitations will serve
to limit the use of mutual funds as conduits for avoidance of unrelated business income tax or withholding rules [for effectively
connected income] that would otherwise apply with respect to publicly traded partnership income.
H.R. Rep. No. 108–548, pt. 1 at 152 (2004). Commenters relied on this legislative history in support of their position that
the section 851(b)(3)(B)(iii) QPTP test (which focuses on a RIC’s holdings of securities of a category of issuers) is fundamentally
different from the section 851(b)(3)(B)(i) and (ii) tests (which focus on a RIC’s holdings of securities of particular issuers).
These commenters contended that an interest in a QPTP should not be subject to the clarified controlled group rules in the
NPRM when the interest in the QPTP is held by a corporation that is not a RIC.
The Treasury Department and the IRS do not find this argument sufficiently persuasive to overcome the plain language of section
851(c) regarding the application of the controlled group rules. Pursuant to its introductory language, section 851(c) applies
generally “[f]or purposes of subsection 851(b)(3),” and pursuant to section 851(c)(1), the look-through rule for controlled
group members applies specifically “for purposes of subparagraph (B)” of section 851(b)(3), in each case without distinguishing
between the various 25 percent tests. Moreover, the Treasury Department and the IRS note that Congress, in the same legislation
in which it enacted section 851(b)(3)(B)(iii), had the opportunity to amend these rules in the manner urged by the commenters.
In that legislation, Congress made other changes to conform section 851(c) to the changes relating to QPTPs by redesignating
former section 851(c)(5) as section 851(c)(6) and adding a new section 851(c)(5), which defines the term “outstanding voting
securities of such issuer” to include equity securities of QPTPs. Congress made no changes, however, to limit the application
of the section 851(c) controlled group rules to solely the 25 percent tests under section 851(b)(3)(i) and (ii).
Thus, the Treasury Department and the IRS believe, consistent with the statutory language, that the controlled group rules
should apply to section 851(b)(3)(B)(iii) because (1) Congress specifically provided that a RIC’s investment in QPTP securities
should be limited to 25 percent of the RIC’s total asset value; (2) the controlled group rules of section 851(c) by their
terms apply to all of section 851(b)(3), including section 851(b)(3)(B)(iii); and (3) Congress did not carve out section 851(b)(3)(B)(iii)
when it updated section 851(c).
3. Clarifying regulatory language
Some practitioners have interpreted section 851(c)(3) to require the presence of at least two levels of controlled entities
for a controlled group to exist and have relied on certain of the examples in the existing regulations to support this interpretation.
These final regulations clarify, through revisions to the existing examples, that as few as two corporations are enough to
constitute a controlled group if the ownership requirements of section 851(c)(3) are met.
The Treasury Department and the IRS believe that the interpretation of the controlled group rules reflected in these final
regulations is consistent with both the statutory language of section 851(c)(3) and the well-established interpretation of
analogous Code provisions. For example, for purposes of the consolidated return rules, the IRS has consistently treated a
parent and its directly owned subsidiary as “affiliated” within the meaning of section 1504(a)(1). Similarly, in limiting
certain tax benefits for affiliated corporations, the IRS treats a parent and its subsidiary as a “controlled group” under
section 1563, which uses language similar to section 1504(a). See section 1563(a)(1) and § 1.1563–1(a)(2)(ii), Example 1. The interpretation reflected in these final regulations is also consistent with the purpose of section 851(c)(3), which
is to aggregate the investments of a RIC’s related corporations for purposes of determining whether the RIC satisfies its
25 percent tests.
As stated in the preamble to the NPRM, the Treasury Department and the IRS believe that the language in the examples in the
existing regulations was intended merely to simplify the description of certain fact patterns and not to articulate a legal
interpretation that is inconsistent with the statutory language of section 851(c) and the construction of substantially similar
language elsewhere in the Code.
Commenters noted that § 1.851–3 states that “[i]n determining the value of the taxpayer’s investment in the securities of
any one issuer, for the purposes of subparagraph (B) of section 851(b)[(3)], there shall be included its proper proportion of the
investment of any other corporation, a member of a controlled group, in the securities of such issuer” (emphasis added). Commenters
cited the phrase “any one issuer” in support of the proposition that the controlled group rules should not be applied for
purposes of section 851(b)(3)(B)(iii), which addresses not the value of a RIC’s direct and indirect holdings of securities
of any single issuer but rather a RIC’s aggregate direct and indirect holdings of securities of a category of issuers (that
is, QPTPs). While the Treasury Department and the IRS do not believe that the use of “any one issuer” in § 1.851–3 bears the
weight these commenters attribute to it, in order to respond to the comment and more closely align § 1.851–3 with the statutory
language of section 851(c)(1), these final regulations update the language of § 1.851–3 by changing “any one issuer” to “an
Commenters similarly maintained that because section 851(c)(1) refers to use of the controlled group rules “in ascertaining
the value of the taxpayer’s investment in the securities of an issuer” (emphasis added), the rules should not apply for purposes of a limitation that applies to holdings of securities in a category
of issuers, such as the section 851(b)(3)(B)(iii) limitation on investment in QPTPs. The Treasury Department and the IRS do
not agree with this reading of the statute. As noted above, the controlled group rules expressly apply for purposes of section
851(b)(3)(B) without qualification. The Treasury Department and the IRS believe that the more natural reading of the statutory
language is that, in assessing compliance with section 851(b)(3), a RIC applies the controlled group rules to determine its
indirect holdings in each individual issuer (including each QPTP), and the RIC then aggregates its direct and indirect holdings
in each individual issuer for purposes of applying the test in section 851(b)(3)(B)(i); aggregates its direct and indirect
holdings of securities of issuers engaged in the same or similar trades or businesses or related trades or businesses for
purposes of applying the test in section 851(b)(3)(B)(ii); and aggregates its direct and indirect holdings of securities of
issuers that are QPTPs for purposes of applying the test in section 851(b)(3)(B)(iii).
Finally, commenters suggested that operative rules should be set forth in substantive rules in addition to being demonstrated
in the examples. They urged the Treasury Department and the IRS to provide regulatory text setting forth general rules, with
the examples in § 1.851–5 demonstrating the application of those rules. The Treasury Department and the IRS believe that the
revised examples are intended to, and do, make sufficiently clear how the statutory rules are to be interpreted and applied,
and accordingly no changes are being made in response to this comment.
The final regulations apply to quarters that begin on or after December 14, 2015. Under section 851(d)(1), whether a taxpayer
loses status as a RIC in one quarter may depend on whether the taxpayer satisfied section 851(b)(3) and (c) at the close of
one or more prior quarters. For purposes of applying the first sentence of section 851(d)(1) to a quarter that begins on or
after March 14, 2016, these final regulations apply in determining whether the taxpayer met the requirements of section 851(b)(3)
and (c) at the close of prior quarters.
6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these final regulations were
submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small businesses.
The principal author of these regulations is Julanne Allen, Office of Associate Chief Counsel (Financial Institutions and
Products). However, other personnel from the Treasury Department and the IRS participated in their development.
Sections 1.851–3 and 1.851–5 are also issued under 26 U.S.C. 851(c).
Par. 2. Section 1.851–3 is revised to read as follows:
§ 1.851–3 Rules applicable to section 851(b)(3).
(a) In general. In determining the value of the taxpayer’s investment in the securities of an issuer, for purposes of subparagraph (B) of
section 851(b)(3), there shall be included its proper proportion of the investment of any other corporation, a member of a
controlled group, in the securities of such issuer. See Example 4 in § 1.851–5. For purposes of §§ 1.851–2, 1.851–4, 1.851–5, and 1.851–6, the terms “controls,” “controlled group,” and “value”
have the meaning assigned to them by section 851(c). All other terms used in these sections have the same meaning as when
used in the Investment Company Act of 1940 (15 U.S.C., chapter 2D), as amended.
(b) Effective/applicability dates. The rules of this section apply to quarters that begin on or after December 14, 2015. For purposes of applying the first sentence of section 851(d)(1) to a quarter that begins on or after March 14, 2016, the
rules of this section apply in determining whether the taxpayer met the requirements of section 851(b)(3) and (c) at the close
of prior quarters.
Par. 3. Section 1.851–5 is revised to read as follows:
§ 1.851–5 Examples.
(a) Examples. The provisions of section 851 may be illustrated by the following examples:
Example 1. (i) Investment Company W at the close of its first quarter of its taxable year has its assets invested as follows:
Securities of regulated investment companies
Securities of Corporation A
Securities of Corporation B
Securities of Corporation C
Securities of various corporations (not exceeding 5 percent of its assets in any one company)
(ii) Investment Company W owns all of the voting stock of Corporations A and B, 15 percent of the voting stock of Corporation
C, and less than 10 percent of the voting stock of regulated investment companies and various other corporations. Neither
Corporation A nor Corporation B owns:
(C) Securities issued by any of the regulated investment companies or various corporations whose securities are owned by Investment
Company W. Except for Corporation A and Corporation B, none of the corporations (including the regulated investment companies)
is a member of a controlled group with Investment Company W.
(iii) Investment Company W meets the requirements under section 851(b)(3) at the end of its first quarter. It complies with
subparagraph (A) of section 851(b)(3) because it has 55 percent of its assets invested as provided in that subparagraph. It
complies with subparagraph (B) of section 851(b)(3) because it does not have more than 25 percent of its assets invested in
the securities of any one issuer, of two or more issuers that it controls, or of one or more qualified publicly traded partnerships
(as defined in section 851(h)).
Example 2. (i) Investment Company V at the close of a particular quarter of the taxable year has its assets invested as follows:
Securities of Corporation D
(ii) Investment Company V fails to meet the requirements of subparagraph (A) of section 851(b)(3) since its assets invested
in Corporations A, B, C, and D exceed in each case 5 percent of the value of the total assets of the company at the close
of the particular quarter.
Example 3. (i) Investment Company X at the close of a particular quarter of the taxable year has its assets invested as follows:
(ii) Investment Company X owns more than 20 percent of the voting power of Corporations B and C and less than 10 percent of
the voting power of all of the other corporations. Corporation B manufactures radios and Corporation C acts as its distributor
and also distributes radios for other companies. Investment Company X fails to meet the requirements of subparagraph (B) of
section 851(b)(3) since it has 35 percent of its assets invested in the securities of two issuers which it controls and which
are engaged in related trades or businesses.
Example 4. (i) Investment Company Y at the close of a particular quarter of its taxable year has its assets invested as follows:
Securities of Corporation K (a regulated investment company)
(ii) Corporation K has 20 percent of its assets invested in Corporation L, and Corporation L has 40 percent of its assets
invested in Corporation B. Corporation A also has 30 percent of its assets invested in Corporation B. Investment Company Y
owns more than 20 percent of the voting power of Corporations A and K. Corporation K owns more than 20 percent of the voting
power of Corporation L.
(iii) At the end of that quarter, Investment Company Y is disqualified under subparagraph (B)(i) of section 851(b)(3) because,
after applying section 851(c)(1), more than 25 percent of the value of Investment Company Y’s total assets is invested in
the securities of Corporation B. This result is shown by the following calculation:
Percentage of assets invested directly in Corporation B
Percentage invested indirectly through K and L (30% × 20% × 40%)
Percentage invested indirectly through A (10% × 30%)
Total percentage of assets of Investment Company Y invested in Corporation B
Example 5. Investment Company Z, which keeps its books and makes its returns on the basis of the calendar year, at the close
of the first quarter of 2016 meets the requirements of section 851(b)(3) and has 20 percent of its assets invested in Corporation
A. Later during the taxable year it makes distributions to its shareholders and because of such distributions, it finds at
the close of the taxable year that it has more than 25 percent of its remaining assets invested in Corporation A. Investment
Company Z does not lose its status as a regulated investment company for the taxable year 2016 because of such distributions,
nor will it lose its status as a regulated investment company for any subsequent year solely as a result of such distributions.
See section 851(d)(1).
Example 6. Investment Company Q, which keeps its books and makes its returns on the basis of the calendar year, at the close of the
first quarter of 2016 meets the requirements of section 851(b)(3) and has 20 percent of its assets invested in Corporation
P. At the close of the taxable year 2016, it finds that it has more than 25 percent of its assets invested in Corporation
P. This situation results entirely from fluctuations in the market values of the securities in Investment Company Q’s portfolio
and is not due in whole or in part to the acquisition of any security or other property. Investment Company Q does not lose
its status as a regulated investment company for the taxable year 2016 because of such fluctuations in the market values of
the securities in its portfolio, nor will it lose its status as a regulated investment company for any subsequent year solely
as a result of such market value fluctuations. See section 851(d)(1).
Example 7. (i) Investment Company T at the close of a particular quarter of its taxable year has its assets invested as follows:
Securities of various qualified publicly traded partnerships (within the meaning of sections 851(b)(3) and 851(h))
(ii) Investment Company T owns more than 20 percent of the voting power of Corporation A and less than 10 percent of the voting
power of all of the other corporations. Corporation A has 80 percent of its assets invested in qualified publicly traded partnerships.
(iii) Investment Company T is disqualified under subparagraph (B)(iii) of section 851(b)(3), because, after applying section
851(c)(1), more than 25 percent of the value of Investment Company T’s total assets is invested in the securities of one or
more qualified publicly traded partnerships. This result is shown by the following calculation:
Percentage of assets invested directly in qualified publicly traded partnerships
Percentage invested in qualified publicly traded partnerships indirectly through A (20% × 80%)
Total percentage of assets of Investment Company T invested in qualified publicly traded partnerships
(Filed by the Office of the Federal Register on September 14, 2015, 8:45 a.m., and published in the issue of the Federal Register
for September 15, 2015, 80 F.R. 23137)
[1] “The Congress understood that . . .[p]ublicly traded partnerships with specified types of income are not treated as corporations,
however, for the reason that if the income is from sources that are commonly considered to be passive investments, then there
is less reason to treat the publicly traded partnership as a corporation. The Congress understood that these types of publicly
traded partnerships may have improved access to capital markets if their interests were permitted investments of mutual funds.
Therefore, the Act treats publicly traded partnership interests as permitted investments for mutual funds (‘RICs’).” Joint
Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress at 249 (JCS–5–05), May 2005 (footnote