Investment companies that are regulated or registered under the Investment Company Act of 1940 as management companies have received special treatment since the Revenue Act of 1942 was passed.
Up to that time all investment companies other than open-end companies were subject to normal income taxes and surtaxes. Net realized profits also were taxable. This involved an extra layer of tax. First, the investment company paid taxes on 15 percent of its dividend income, 85 percent of dividend income being exempt as in the case of all other corporations. Secondly, the investment company was subject to capital gains taxes. Thirdly, the stockholder had to pay taxes on the dividends that he received from his investment company holdings, and a capital gains tax if he realized a profit from the sale of his stock.
To amend the tax structure so as to recognize that the investment company is simply a conduit through which income from other securities flows to the investor, the Revenue Act of 1942 provided special treatment for regulated investment companies, both open-end and closed-end, that satisfied certain conditions. These conditions are:
1. It must be a domestic corporationnot a personal holding company.
2. It must be registered at all times during the taxable year under the Investment Company Act of 1940.
3. At least 90 percent of its gross income for any taxable year must be derived from dividends, interest, and gains from the sale or other disposition of securities.
4. No more than 30 percent of its gross income can be derived from the sale of securities held less than three months.
5. It must distribute as taxable dividends not less than 90 percent of its net income, exclusive of capital gains, for any taxable year.
6. Its investments must have the requisite diversification. At least 50 percent of its assets must be in cash, cash items (including receivables), government securities, or in a diversified list of securities limited to not more than five percent of its assets in securities of any one issuer and not more than 10 percent of the voting securities of that issuer. Not more than 25 percent of the company's assets may be invested in the securities of any one issuer, or of two or more issuers, which the taxpayer controls and which are engaged in the same, similar, or related business.
7. It must elect to be treated as a regulated investment company rather than as an ordinary corporation. The election is an irrevocable one, though in any year when the above requirements are not met, special tax treatment will be lost.
If a regulated investment company distributes to its shareholders as taxable dividends at least 90 percent of its net income, the amount so distributed is not subject to either the normal corporate tax or the surtax. In the event that all of the net investment income (interest and dividends less expenses) and any net realized short-term capital gains are paid out in the form of dividends, there will be no corporate income or surtax thereon.
No one likes to pay taxes, and this revision of the law has allowed corporations to avoid paying large amounts of tax as long as the overwhelming majority of its taxable dividends are divided amongst shareholders.