United States: IRS Issues Private Letter Rulings to Mutual Funds on Tax-Free Reorganizations, Providing Needed Guidance on the "Continuity of Business Enterprise" Requirement

On Friday, July 8, 2005, the IRS issued to one of our clients several private letter rulings ("PLRs") to the effect that the combination of mutual funds constitute tax-free reorganizations under Section 368(a)(1)(C) of the Internal Revenue Code. In issuing these PLRs, the IRS provided much needed guidance on the "continuity of business enterprise" requirement that must be satisfied in order for a combination of two operating mutual funds to constitute a tax-free reorganization.

In general, mutual funds, defined as "regulated investment companies" ("RICs") under the Internal Revenue Code (the "Code"), are treated as corporations for federal income tax purposes. Accordingly, when two RICs combine, the combination ordinarily must meet the corporate reorganization requirements under Section 368 of the Code to qualify for tax-free treatment. Among other things, a combination must meet the "continuity of business enterprise" ("COBE") requirement to constitute a tax-free reorganization, which is now set forth in Section 1.368-1(d) of the Treasury Regulations. In order to satisfy the COBE requirement, an acquiring corporation must either continue the "historic business" of the acquired corporation or use a "substantial portion" of the acquired corporation's "historic business assets" in the acquiring corporation's business. Treasury Regulations provide that the fact that the acquiring corporation is in the same line of business as the acquired corporations tends to establish the requisite continuity, but is not alone sufficient.¹

For many years, there has been considerable uncertainty on how an acquiring RIC ("Acquiring Fund") could satisfy the COBE requirement in a RIC combination. The uncertainty principally arises from the fact that RICs do not operate traditional, active businesses. Rather, RICs are pools of investment in portfolio securities which are managed by a third party—the advisor. Furthermore, in the only IRS published guidance on the matter, the IRS stated that a debt and equity fund and tax-exempt fund were not in the same line of business for purposes of the COBE requirement.²

This uncertainty was amplified in January 2001, when the IRS established a "no ruling" policy under which it stopped issuing PLRs on RIC combinations. In contrast to published guidance, such as IRS revenue rulings and procedures, IRS PLRs cannot be relied upon by taxpayers, other than the particular taxpayers to whom they are issued, but they can provide insight on the current views of the IRS. (Several months after issuance, PLRs are released to the public with taxpayer-specific information redacted.)

Of the last PLRs issued before the moratorium, most included representations or statements to the effect that the Acquiring Fund would not dispose of more than 66% of the assets of the acquired RIC ("Acquired Fund"), even where the funds had identical objectives, policies and procedures. Until now, there also was no authority directly on point holding that an Acquiring Fund that has sold more than 66% of the Acquired Fund's assets could still satisfy the COBE requirement. In addition, it can be asserted that an Acquired Fund's historic business is as a practical matter defined largely by reference to its assets, in view of the passive nature of a RIC's activities.

Based on the foregoing, there has been concern that dispositions of a large percentage of the Acquired Fund's portfolio securities would result in the Acquiring Fund's failure to satisfy the COBE requirement, even where the funds were identical in all material respects. For this reason, in many instances, Acquiring Funds have held a percentage of the Acquired Fund's assets for some period of time following the combination to ensure satisfaction of the COBE requirement.

Last year, the IRS invited taxpayers to submit PLR requests on the applicability of the COBE requirement to RIC combinations, with the intention of eventually providing "published guidance" that all taxpayers could rely upon. Under this invitation, we submitted such requests on behalf of a client on the following combinations: (i) the combination of two diversified mid-cap growth funds; (ii) the combination of a narrow-based, non-diversified growth Acquired Fund with a broad-based, diversified growth Acquiring Fund; (iii) the combination of an industry-specific Acquired Fund with a diversified dividend and income Acquiring Fund; and (iv) a state-specific tax-exempt Acquired Fund with a national tax-exempt Acquiring Fund. On July 8, 2005, the IRS issued PLRs on all of these combinations. In each instance, the IRS did not require the Acquiring Fund to commit to retain any of the Acquired Fund's assets following the combination.

The IRS required the taxpayer to make representations substantially as follows as a condition to its rulings in the PLRs:

1. The Acquiring Fund is in the same line of business as the Acquired Fund preceding the combination for purposes of the COBE requirement. Following the combination, the Acquiring Fund will continue such line of business and has no plan or intention to change such line of business. Neither the Acquiring Fund nor the Acquired Fund entered into such line of business as part of the plan of reorganization. On the date of the combination, at least 33 1/3% of the Acquired Fund's portfolio assets will meet the investment objectives, strategies, policies, risks and restrictions of Acquiring Fund. The Acquired Fund will not alter its portfolio in connection with the combination. The Acquiring Fund has no plan or intention to change any of its investment objectives, strategies, policies, risks and restrictions after the combination.
2. To the best of the knowledge of the Acquiring Fund's management, as of the record date for the Acquired Fund shareholders entitled to vote on the combination, there was no plan or intention by the Acquired Fund shareholders to sell, exchange, or otherwise dispose of a number of Acquired Fund shares (or Acquiring Fund shares received in the combination), in connection with the combination, that would reduce the Acquired Fund shareholders' ownership of the Acquired Fund shares (or equivalent Acquiring Fund shares) to a number of shares that was less than 50% of the number of the Acquired Fund shares as of the record date.

Although the IRS required the taxpayer to represent that the Acquiring Fund is in the same line of business as the Acquired Fund, as the IRS considers this to be a factual question, the IRS also completed an extensive analysis of supporting facts when determining whether to issue the PLRs. Ordinarily, IRS agents can require taxpayers to support representations made in a PLR upon an audit. However, in view of the substantial investigation completed by the IRS during the PLR process, we suspect that the IRS would be unlikely to challenge the taxpayer's basis for the "same line of business" representation during an audit. Moreover, in light of the diverse nature of the combinations considered, it appears that the IRS is willing to accept that even relatively different funds are in the same line of business for purposes of the COBE requirement. However, how the IRS ultimately will interpret "same line of business" remains uncertain.

We find other representations to be curious. Specifically, the IRS appears to be focusing on the Acquired Fund's activities prior to the combination instead of the Acquiring Fund's actions after the combination. For instance, it is not entirely clear why substantial redemptions by the Acquired Fund's shareholders should be relevant for purposes of the COBE requirement. Also, we are not sure why the Acquired Fund is subject to an "asset retention test" under which it apparently cannot reposition any of its portfolio in connection with the combination. It is common for an Acquired Fund to begin to reposition its portfolio in anticipation of the pending combination, so the representation that the Acquired Fund will not alter its portfolio in connection with the combination may be difficult to provide in some instances. While these issues continue to leave significant uncertainty in dealing with the COBE requirement, the PLRs represent an important forward step in setting clearer guidelines for mutual fund combinations.

The IRS has indicated that it still wishes to eventually provide "published guidance" on the COBE requirement with respect to RIC combinations upon which all taxpayers may rely. Nonetheless, we understand that such guidance is not likely to be included on the IRS' Fiscal Year 2006 Business Plan. However, the IRS is now aware of the industry's sensitivity to this issue and, therefore, the IRS has expressed a willingness to continue to provide PLRs on the topic. As a consequence, we expect that other taxpayers will submit additional PLR requests on this issue in the months to come.

Footnotes:

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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