PLR 200030005: Fund expense reimbursements are not preferential dividends

Plain-English summary

A group of underlying mutual funds and their advisers proposed paying fees to a common adviser to reduce operating expenses of portfolios that invested in those funds. The payments were negotiated and based on the portfolios' holdings of each underlying fund; they would not change per share dividends paid by an underlying fund. The IRS ruled that the expense payments, reimbursements, and waivers were not preferential dividends under section 562(c). That conclusion addressed the stated arrangement even when a portfolio held less than $10 million in an underlying fund. The IRS expressly gave no opinion on whether any underlying fund or portfolio otherwise qualified as a regulated investment company.

Ruling snapshot

• Question: Would the proposed expense reimbursement arrangements produce preferential dividends under section 562(c)?
• Outcome: Approved for the stated reimbursement agreements; RIC qualification undecided.
• Key authorities: IRC §§ 561, 562(c), 851, and 852.

Full text (IRS public release)

Internal Revenue Service                 Department of the Treasury

Index Numbers: 0561.05-00, 0562.03-02,   Washington, DC 20224
0851.00-00, 0852.00-00
Number: 200030005                        Person to Contact:
Release Date: 7/28/2000                  Telephone Number:

Refer Reply To:
CC:DOM:FI&P:3/PLR-119506-99
Date:
April 21, 2000

LEGEND:

TopFund           =

Trust A           =
Trust B           =

Company A         =
Company B         =
Company C         =

Underlying Fund 1 =

Underlying Fund 2 =

Underlying Fund 3 =

Underlying Fund 4 =

Underlying Fund 5 =

Underlying Fund 6 =

Underlying Fund 7 =

Underlying Fund 8 =

PLR-119506-99          2

Underlying Fund 9 =

Underlying Fund 10 =

Underlying Fund 11 =

Underlying Fund 12 =

Underlying Fund 13 =

Underlying Fund 14 =

Underlying Fund 15 =

Underlying Fund 16 =

Underlying Fund 17 =

State W           =
State X           =
State Y           =
State Z           =

Adviser 1         =
Adviser 2         =
Adviser 3         =
Adviser 4         =
Adviser 5         =

Common Adviser    =

Date 1            =
Date 2            =
Date 3            =

PLR-119506-99                               3

Dear            :

This responds to your request for a ruling dated November 30, 1999, submitted
on behalf of all of the Underlying Funds, that certain expense arrangements will not
result in the payment of preferential dividends by any of the Underlying Funds within the
meaning of section 562(c) of the Internal Revenue Code (the “Code”), and therefore will
not adversely affect the qualification of any of the Underlying Funds as regulated
investment companies (“RICs”) under Subchapter M of the Code.

FACTS

The Common Adviser is a corporation organized under the laws of State Z as an
investment adviser under the Investment Advisers Act of 1940, as amended. The
Common Adviser created the TopFund as an open-end management investment
company registered under the 1940 Act. The TopFund is organized as a business trust
under the laws of State W. The TopFund consists of five separate series (referred to
as the “TopFund Portfolios”), each of which is treated as a separate corporation for
federal income tax purposes pursuant to section 851(g) of the Code. Each TopFund
Portfolio intends to elect and qualify annually to be treated as a RIC under Subchapter
M of the Code.

The TopFund Portfolios are designed for investors pursuing long-term
investment goals, especially participants in tax-deferred retirement plans. Each
TopFund Portfolio, pursuant to its fundamental investment objective and policies,
invests almost exclusively in shares of other underlying mutual funds (including the
Underlying Funds) for which either the Common Adviser or an entity unaffiliated with
Common Adviser acts as investment adviser.

Trust A is an open-end management investment company organized as a
business trust under State W law. Trust B is an open-end management investment
company organized as a business trust under State W law. Company A is an open-end
management investment company organized as a corporation under the laws of State
X. Trust A, Trust B, and Company A are all registered under the Investment Company
Act of 1940, as amended (the “1940 Act”), and each has a currently effective
registration statement under the Securities Act of 1933, as amended (the “1933 Act”).

The shares of beneficial interest of Trust A currently are divided into separate
series, each based upon a particular portfolio of securities. Underlying Fund 1 is a
separate series of Trust A that is treated as a separate corporation for federal income
tax purposes pursuant to section 851(g) of the Code, and intends to qualify annually as
a RIC under subchapter M of the Code. Underlying Fund 1 may offer multiple classes
of its shares pursuant to a multiple class distribution arrangement. Underlying Fund 1
has a annual accounting period that ends on Date 1 and uses the accrual method of
accounting for maintaining its accounting books and filing its federal income tax return.

PLR-119506-99                               4

The shares of beneficial interest of Trust B currently are divided into separate
series, each based upon a particular portfolio of securities. Underlying Fund 2 and
Underlying Fund 3 each are a separate series of Trust B that is treated as a separate
corporation for federal income tax purposes pursuant to section 851(g) of the Code,
and intend to qualify annually as RICs under subchapter M of the Code. Both
Underlying Fund 2 and Underlying Fund 3 may offer multiple classes of their shares
pursuant to a multiple class distribution arrangement. Underlying Fund 2 and
Underlying Fund 3 both have annual accounting periods that end on Date 2 and use the
accrual method of accounting for maintaining their accounting books and filing their
federal income tax returns.

The shares of common stock of Company A currently are divided into separate
series, each based on a particular portfolio of securities. Underlying Fund 4, Underlying
Fund 5, Underlying Fund 6, and Underlying Fund 7 are each a separate series of the
Company treated as a separate corporation for federal income tax purposes pursuant
to section 851(g) of the Code, and each intends to qualify annually as a RIC under
subchapter M of the Code. In addition, these Underlying Funds may offer multiple
classes of its shares pursuant to a multiple class distribution arrangement. Underlying
Fund 4, Underlying Fund 5, Underlying Fund 6, and Underlying Fund 7 each have an
annual accounting period that ends on Date 3, and each uses the accrual method of
accounting for maintaining its accounting books and filing its federal income tax returns.

Underlying Fund 8, Underlying Fund 9, and Underlying Fund 10 are each open-
end management companies organized as corporations under the laws of State X.
Each of these Underlying Funds is registered under the Investment Company Act of
1940, as amended (the “1940 Act”), and has a currently effective registration statement
under the Securities Act of 1933, as amended (the “1933 Act”). These Underlying
Funds may offer multiple classes of its shares pursuant to a multiple class distribution
arrangement. Underlying Fund 8, Underlying Fund 9, and Underlying Fund 10 each
have an annual accounting period that ends on Date 1, and each uses the accrual
method of accounting for maintaining its accounting books and filing its federal income
tax returns.

Each of Company B, Company C, and Underlying Fund 17 is an open-end
management investment company organized as a corporation under State X law
registered under the Investment Company Act of 1940, as amended (the “1940 Act”),
and each has a currently effective registration statement under the Securities Act of
1933, as amended (the “1933 Act”). The shares of common stock of Company B and
Company C currently are divided into separate series, each based on a particular
portfolio of securities. Underlying Fund 16 is a separate series of Company C and
Underlying Fund 11, Underlying Fund 12, Underlying Fund 13, Underlying Fund 14, and
Underlying Fund 15 are each a separate series of Company B. Each such separate
series of Company B and Company C is treated as a separate corporation for federal
income tax purposes pursuant to section 851(g) of the Code. Underlying Fund 17 and

PLR-119506-99                               5

each separate series of Company B and Company C intend to qualify annually as RICs
under subchapter M of the Code. In addition, these Underlying Funds may offer
multiple classes of its shares pursuant to a multiple class distribution arrangement. The
annual accounting period for each of these Underlying Fund, except for Underlying
Fund 17, ends on Date 1. The annual accounting period for Underlying Fund 17 ends
on Date 3. Each of these Underlying Funds uses the accrual method of accounting for
maintaining its accounting books and filing its federal income tax returns.

Adviser 1 is a bank organized under the laws of State Y and acts as investment
adviser to Underlying Fund 1. The Underlying Fund contracts with other service
providers, which may or may not be affiliated with Adviser 1, to provide other services,
including fund accounting, transfer agency, dividend paying agent, customer service,
recordkeeping, and underwriting services, in exchange for a fee.

Adviser 2 is a limited liability company organized under the laws of State Z
registered as an investment adviser under the Investment Advisers Act of 1940, as
amended, and acts as investment adviser to Underlying Fund 2 and Underlying Fund 3.
These Underlying Funds contract with other service providers, which may or may not be
affiliated with Adviser 2, to provide other services, including fund accounting, transfer
agency, dividend paying agent, customer service, recordkeeping, and underwriting
services, in exchange for a fee.

Adviser 3 is a limited liability company organized under the laws of State Y
registered as an investment adviser under the Investment Advisers Act of 1940, as
amended, and acts as investment adviser to Underlying Fund 4, Underlying Fund 5,
Underlying Fund 6, and Underlying Fund 7. These Underlying Funds contract with
other service providers, which may or may not be affiliated with Adviser 3, to provide
other services, including fund accounting, transfer agency, dividend paying agent,
customer service, recordkeeping, and underwriting services, in exchange for a fee.

Adviser 4 is a limited liability company organized under the laws of State Z
registered as an investment adviser under the Investment Advisers Act of 1940, as
amended, and acts as investment adviser to Underlying Fund 8, Underlying Fund 9,
and Underlying Fund 10. These Underlying Funds contract with other service
providers, which may or may not be affiliated with Adviser 4, to provide other services,
including fund accounting, transfer agency, dividend paying agent, customer service,
recordkeeping, and underwriting services, in exchange for a fee.

Adviser 5 is a corporation organized under the laws of State Z registered as an
investment adviser under the Investment Advisers Act of 1940, as amended, and acts
as investment adviser to Underlying Fund 11, Underlying Fund 12, Underlying Fund 13,
Underlying Fund 14, Underlying Fund 15, Underlying Fund 16, and Underlying Fund 17.
These Underlying Funds contract with other service providers, which may or may not be
affiliated with Adviser 5, to provide other services, including fund accounting, transfer

PLR-119506-99                                6

agency, dividend paying agent, customer service, recordkeeping, and underwriting
services, in exchange for a fee.

The Common Adviser determines the amount which each TopFund Portfolio will
invest in any Underlying Fund and the timing of such investments. The Common
Adviser may charge the TopFund Portfolios an advisory fee for these asset allocation
services. Any such fee must be approved by the board of trustees of each TopFund
Portfolio, including a majority of the independent trustees (within the meaning of section
2(a)(19) of the 1940 Act), based on a finding that the fee is charged for services
provided that are in addition to, rather than duplicative of, services provided pursuant to
any Underlying Fund’s advisory contract.

Asset-based services, Rule 12b-1 fees, and shareholder servicing fees may be
charged in connection with the distribution of the shares of the TopFund Portfolios. Any
such charges, when aggregated with any such charges paid by a TopFund Portfolio
with respect to shares of the Underlying Fund, shall not exceed the applicable limits set
forth in the Rules of Conduct of the National Association of Securities Dealers, Inc.

A portion of the remaining expenses incurred in operating the TopFund Portfolios
(including expenses for accounting, custody, auditing, legal, participant account and
participant employer recordkeeping and shareholder services, collectively the
“Operating Expenses”) will be paid in accordance with a reimbursement agreement
(“Reimbursement Agreement”). More specifically, in consideration of the benefits
derived by the Advisers and the Underlying Funds from the establishment and
operation of the TopFund Portfolios, all of the Advisers, the Underlying Funds, or both
the Advisers and the Underlying Funds, have entered or will enter into a negotiated
Reimbursement Agreement whereby the Adviser or Underlying Fund has agreed to pay
(conditioned upon the receipt of the ruling requested herein) an arm’s length
negotiated fee to the Common Adviser to be used by the Common Adviser to reduce
the Operating Expenses of the TopFund Portfolios. The Reimbursement Agreements
will be substantially identical in all respects relevant to the representations made in
application for this ruling request.

The fee is based on the average daily value of the shares of the Underlying Fund
held by any TopFund Portfolio during the applicable payment period. The average daily
value of the shares of the Underlying Fund held by a TopFund Portfolio during the
payment period is computed by totaling the aggregate investment in the Underlying
Fund by all TopFund Portfolios (i.e., the per share net asset value multiplied by the total
number of shares hold by the TopFund Portfolios) on each business day in the payment
period, and dividing that sum by the total number of business days in the payment
period.

The creation of the TopFund will benefit its Underlying Fund(s) and its
shareholders to the extent that the TopFund Portfolios attract assets to the Underlying

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Fund(s) which would not otherwise have been invested therein. Also, as the assets in a
Underlying Fund increase, the expense ratios of the Underlying Fund are expected to
be reduced, which will make the Underlying Fund more attractive to investors. In
addition, the cost savings to a Underlying Fund are expected to be derived from the
elimination of numerous separate shareholder accounts which are or would have been
invested directly in the Underlying Fund and the resulting reduction in shareholder
servicing costs.

The Reimbursement Agreement and the expense arrangement provided for in
the Agreement will not affect the per share dividend distributions to the shareholders of
a Underlying Fund. It is anticipated that there will be periods during which any one or
more of the TopFund Portfolios will have an investment of less than $10 million in any
one or more of the Underlying Funds, particularly in the early stages of the TopFund
Portfolios’ existence.

LAW

Section 851(a) defines a RIC, in part, as a domestic corporation registered under
the 1940 Act as a management company.

Section 851(b) limits the definition of a RIC to a corporation meeting certain
election, gross income, and diversification requirements.

Section 851(g) provides a special rule for a RIC having more than one fund.
This provision treats each fund as a separate corporation for all purposes of the Code,
other than the definitional requirement of section 851(a).

A corporation that is a RIC within the meaning of section 851 and that is taxable
under subchapter M, part I, pays tax on its investment company taxable income under
section 852(b)(2) and on the excess, if any, of its net capital gain over its deduction for
dividends paid, determined with reference to capital gain dividends only under section
852(b)(3).

Section 852(b)(2)(D) allows a RIC a deduction for dividends paid (as defined in
section 561(a) with certain modifications). Section 561 defines the deduction for
dividends paid for purposes of section 852 and applies the rules of section 562 to
determine which dividends are eligible for the deduction for dividends paid.

Section 562(c) provides that the amount of any distribution is not considered a
dividend for purposes of computing the dividends paid deduction under section 561
unless the distribution is pro rata, does not prefer any share of stock of a class over any
other share of stock of that same class, and does not prefer one class of stock over
another class except to the extent that one class is entitled (without reference to
waivers of their rights by shareholders) to the preference.

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Section 562(c) further provides that, in the case of a shareholder who made an
initial investment of at least $10 million in the RIC, an increased distribution to such
shareholder will not be treated as non pro rata or as preferential if the increase is made
solely by reason of reductions in administrative expenses of the RIC.

Because of the unique nature of open-end RICs, the payments (including
reimbursements and waivers) of the Operating Expenses of the TopFund Portfolios by
the Advisers or the Underlying Funds pursuant to the Reimbursement Agreement are
not preferential dividends within the meaning of section 562(c).

CONCLUSION

The payments (including reimbursements and waivers) of the Operating
Expenses of the TopFund Portfolios by the Advisers or the Underlying Funds pursuant
to the terms of the Reimbursement Agreement are not preferential dividends within the
meaning of section 562(c).

Except as expressly provided herein, no opinion is expressed or implied
concerning the federal tax consequences of any aspect of any transaction or item
discussed or referenced in this letter. Specifically, no opinion is expressed as to
whether any Underlying Fund or any of the TopFund Portfolios qualify as a RIC that is
taxable under subchapter M, part I, of the Code.

This ruling is directed only to the Underlying Funds. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

A copy of the letter should be attached to each of the Underlying Funds’ Federal
income tax returns for every taxable year in which the Fund has outstanding classes of
shares described above.

In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to each of the Underlying Funds’ authorized representative.

Sincerely,
Assistant Chief Counsel
(Financial Institutions & Products)
By: Alice Bennett, Chief, Branch 3

Enc. 6110 copy