[Federal Register Volume 78, Number 149 (Friday, August 2, 2013)]
[Proposed Rules]
[Pages 46851-46854]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-18717]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-114122-12]
RIN 1545-BK96


Controlled Group Regulation Examples

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document proposes revisions to examples that illustrate 
the controlled group rules related to regulated investment companies 
(RICs). These proposed revisions resolve an issue with how the 
controlled group rules should be applied in connection with the RIC 
``asset diversification'' test. This document also provides notice of a 
public hearing on the proposed regulations.

DATES: Written or electronic comments must be received by October 31, 
2013. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for December 9, 2013, at 10 a.m., must be 
received by October 31, 2013.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-114122-12), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
114122-12), Courier's Desk, Internal Revenue

[[Page 46852]]

Service, 1111 Constitution Avenue NW., Washington, DC, or sent 
electronically, via the Federal eRulemaking Portal at 
www.regulations.gov (indicate IRS and REG-114122-12). The public 
hearing will be held in the Auditorium, beginning at 10 a.m., at the 
Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC 
20224.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulation, 
Julanne Allen at (202) 622-3920; concerning submissions of comments, 
the public hearing, and/or to be placed on the building access list to 
attend the public hearing, Oluwafunmilayo (Funmi) Taylor at (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) relating to the application of the 
``controlled group'' rules found in section 851(c) of the Internal 
Revenue Code of 1986, as amended (Code).
    Section 851(b)(3)(B) provides that, to qualify as a RIC, a taxpayer 
must meet an asset diversification test pursuant to which 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 regulated investment companies) of any one issuer, 
(ii) the securities (other than the securities of other regulated 
investment companies) of two or more issuers which the taxpayer 
controls and which 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 controlled group rules in section 851(c) provide that, when 
ascertaining the value of a taxpayer's investment in the securities of 
a particular issuer for purposes of determining whether the asset 
diversification test has been met, the proportion of any investment in 
the securities of such issuer by a member of the taxpayer's 
``controlled group'' should 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. 
Clarification is needed regarding whether a RIC and its controlled 
subsidiary are a controlled group if the subsidiary does not control 
(within the meaning of section 851(c)(2)) at least one other 
corporation.
    The definition of a controlled group for purposes of the RIC rules 
was first enacted in 1942 and appears to have been modeled on the 
definition of an ``affiliated group'' in the predecessor to current 
section 1504(a). The predecessor to current section 1504(a) used 
language nearly identical, save for different ownership thresholds, to 
the definition of controlled group for purposes of the RIC rules. See 
HR Rep. No. 2333, 77th Cong., 2nd Sess. 122 (1942), 1942-2 CB 372, 462-
63; see also the Revenue Act of 1928, ch. 852, sec. 141(d), 45 Stat. 
791, 831 (1928) (enacting the predecessor to section 1504(a)). The 
current regulations under section 851 include a series of examples, two 
of which reproduce, nearly verbatim, examples contained in the 1942 
legislative history. See Sec.  1.851-5, Examples 3 and 4. Some 
practitioners have interpreted section 851(c)(3) to require the 
presence of two levels of controlled entities for a controlled group to 
exist, and have relied on certain of the examples in the regulations, 
and the 1942 legislative history, to support this interpretation. The 
IRS and the Treasury Department believe that this interpretation is 
unwarranted. Accordingly, through revisions to the existing examples, 
these proposed regulations clarify that two corporations constitute a 
controlled group if the ownership requirements of section 851(c)(3) are 
met.
    The IRS and the Treasury Department believe that the interpretation 
of the controlled group rules reflected in these proposed regulations 
is consistent both with the statutory language of section 851(c)(3) and 
the 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) regardless of whether the 
subsidiary controlled another subsidiary. Likewise, 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), regardless of whether the 
subsidiary controls another entity. See section 1563(a)(1) and Sec.  
1.1563-1(a)(2)(ii), Example 1. The interpretation reflected in these 
proposed regulations is also consistent with the purpose of section 
851(c)(3), which is to aggregate the investments of related 
corporations for purposes of the asset diversification test.
    The IRS and the Treasury Department believe that the language in 
the examples in the existing regulations and in the 1942 legislative 
history was intended merely to simplify the description of certain fact 
patterns, and not to articulate a legal interpretation that is 
inconsistent with the construction of substantially similar language 
elsewhere in the Code and that is unsupported by practical or policy 
considerations grounded in the statutory scheme.

Explanation of Provisions

    The proposed regulations update examples in existing Sec.  1.851-5. 
The controlled group rules of section 851(c) prevent a RIC from 
exceeding the limitations set forth in section 851(b)(3) by indirectly 
investing in the securities of an issuer through a subsidiary. This 
update clarifies the controlled group rules and confirms that they are 
applied in a manner consistent with sections 1504 and 1563.
    First, the proposed changes to the regulations clarify the two 
examples that have caused confusion. In Example 1, additional language 
would clarify which entities in the example are members of a controlled 
group. Currently, the example states that none of the subsidiaries of 
the RIC in the example is a member of a controlled group. The IRS and 
the Treasury Department believe that this statement was intended merely 
to indicate that none of the wholly owned subsidiaries in the example 
controlled another subsidiary. Consistent with the statutory language 
of section 851(c)(3), the proposed regulations would clarify that each 
of the RIC's wholly owned subsidiaries is a member of a controlled 
group with the RIC.
    Example 4, which is derived from the legislative history of section 
851(c)(3), is revised to remove references to ownership by controlled 
group members of greater than 20 percent interests in an issuer. The 
existing language has sometimes been misinterpreted to mean that in 
order for a subsidiary's holdings in an issuer to be aggregated with 
the holdings of the parent RIC, the subsidiary must have a controlling 
interest in the issuer. The proposed revision to Example 4 would ensure 
that Example 4 is applied in a manner

[[Page 46853]]

consistent with the statutory language of section 851(c)(3).
    Second, the proposed changes would add a new example to illustrate 
both the mechanics of the controlled group rules as applied to wholly 
owned subsidiaries and the application of section 851(b)(3)(B)(iii)'s 
rule with respect to securities of qualified publicly traded 
partnerships.
    Third, the proposed changes would update the dates used in the 
examples (1955) to the current year (2013 or 2014, where appropriate) 
and would update references from section 851(b)(4) to refer instead to 
section 851(b)(3). Section 1271(b)(1) of the Taxpayer Relief Act of 
1997, Public Law 105-34 (111 Stat. 788, 1063 (1997)), redesignated 
section 851(b)(4) as section 851(b)(3).
    Finally, for additional clarity, these proposed regulations would 
add citations to section 851(d)(1) in Examples 5 and 6.

Proposed Effective Date

    The proposed changes apply to quarters that begin at least 90 days 
after the date of publication in the Federal Register of a Treasury 
decision adopting these rules as final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to this regulation, and because the regulation does not 
impose a collection of information on small entitles, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking has 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before this proposed regulation is adopted as a final regulation, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted to the IRS. The 
IRS and the Treasury Department request comments on all aspects of the 
proposed examples. All comments will be available for public inspection 
and copying.
    A public hearing has been scheduled for December 9, 2013, beginning 
at 10:00 a.m. in the IRS Auditorium, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC 20224. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 15 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments by October 31, 2013 and an outline of the topics to 
be discussed and the time to be devoted to each topic (signed original 
and eight (8) copies) by October 31, 2013. A period of 10 minutes will 
be allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal author of this notice is Julanne Allen of the Office 
of Associate Chief Counsel (Financial Institutions & Products). For 
further information regarding this notice contact Julanne Allen at 
(202) 622-3920 (not a toll-free call).

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.851-5 also issued under 26 U.S.C. 851(c).

0
Par. 2. Section 1.851-5 is revised to read as follows:
    Sec.  1.851-5 Examples.--The provisions of section 851 may be 
illustrated by the following examples:
    (a) Example 1. Investment Company W at the close of its first 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash.........................................................          5
Government securities........................................         10
Securities of regulated investment companies.................         20
Securities of Corporation A..................................         10
Securities of Corporation B..................................         15
Securities of Corporation C..................................         20
Securities of various corporations (not exceeding 5 percent           20
 of its assets in any one company)...........................
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    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 (i) 20 percent or more of the 
voting stock of any other corporation, (ii) securities issued by 
Corporation C, or (iii) 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.
    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. Investment Company V at the close of a particular 
quarter of the taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Cash.......................................................           10
Government securities......................................           35
Securities of Corporation A................................            7
Securities of Corporation B................................           12
Securities of Corporation C................................           15
Securities of Corporation D................................           21
                                                            ------------
    Total..................................................          100
------------------------------------------------------------------------

    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. Investment Company X at the close of the particular 
quarter of the taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Cash and Government securities.............................           20

[[Page 46854]]

 
Securities of Corporation A................................            5
Securities of Corporation B................................           10
Securities of Corporation C................................           25
Securities of various corporations (not exceeding 5 percent           40
 of its assets in any one company).........................
                                                            ------------
    Total..................................................          100
------------------------------------------------------------------------

    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. Investment Company Y at the close of a particular 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Cash and Government securities.............................           15
Securities of Corporation K (a regulated investment                   30
 company)..................................................
Securities of Corporation A................................           10
Securities of Corporation B................................           20
Securities of various corporations (not exceeding 5 percent           25
 of its assets in any one company).........................
                                                            ------------
    Total..................................................          100
------------------------------------------------------------------------

    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.
    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:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Percentage of assets invested directly in Corporation B....         20.0
Percentage invested through K and L (30% x 20% x 40%)......          2.4
Percentage invested indirectly through A (10% x 30%).......          3.0
                                                            ------------
    Total percentage of assets of Investment Company Y              25.4
     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 2013 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 2013 because of such distributions, nor will it lose 
its status as a regulated investment company for 2014 or 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 a calendar year, at the close of 
the first quarter of 2013, 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 2013, 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. Corporation Q does not lose its status as a regulated 
investment company for the taxable year 2013 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 2014 or any subsequent year solely as a result of such 
market value fluctuations. See section 851(d)(1).
    Example 7. Investment Company T at the close of a particular 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Cash and Government securities.............................           40
Securities of Corporation A................................           20
Securities of various qualified publicly traded                       15
 partnerships (within the meaning of sections 851(b)(3) and
 851(h))...................................................
Securities of various corporations (not exceeding 5 percent           25
 of its assets in any one company).........................
                                                            ------------
    Total..................................................          100
------------------------------------------------------------------------

    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.
    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:

------------------------------------------------------------------------
                                                               Percent
------------------------------------------------------------------------
Percentage of assets invested directly in qualified                 15.0
 publicly traded partnerships..............................
Percentage invested in qualified publicly traded                    16.0
 partnerships indirectly through A (20% x 80%).............
                                                            ------------
    Total percentage of assets of Investment Company T              31.0
     invested in qualified publicly traded partnerships....
------------------------------------------------------------------------

    (b) Effective/applicability date. The proposed revisions apply to 
quarters that begin at least 90 days after the date of publication of 
the Treasury decision adopting these rules as a final regulation in the 
Federal Register.

Beth Tucker,
Deputy Commissioner for Operations Support.
[FR Doc. 2013-18717 Filed 8-1-13; 8:45 am]
BILLING CODE 4830-01-P