This Technical Information Release announces changes made in the recent "Act Further Regulating the Department of Revenue," St. 2004, c. 262, signed into law August 9, 2004, concerning the taxation of security corporations and of nonresident partners.
II. Statutory changes.
A. The taxation of security corporations.
1. The security corporation statute and the recent change.
Certain corporations may qualify for classification and tax treatment as security corporations if they are engaged exclusively in buying, selling, dealing in, or holding securities on their own behalf and not as a broker. G.L. c. 63, § 38B. The prior statute and case law give limited guidance on what is considered a security for purposes of qualifying for the section 38B excise. The recent legislation adds to the statute a new and specific definition of securities that qualify for this purpose, which we reformat for convenience:
(b ½) For the purposes of subsection (a), "securities" includes
(1) equity or debt instruments and options, futures and other derivatives, that are traded on and were acquired through a public exchange or another arms length secondary market;
(2) bonds as defined in and issued pursuant to chapter 23G [bonds, notes or other evidences of indebtedness issued by the Massachusetts Development Finance Agency];
(3) cash and cash equivalents, including savings and checking accounts and certificates of deposit, and foreign currencies;
(4) interests in a real estate investment trust under section 856 of the Code or a regulated investment company under section 851 of the Code, or a real estate mortgage investment conduit under section 860D of the Code, so long as none of the mortgages owned by the conduit were originated by the holder thereof or by an affiliate of the holder;
(5) mortgage-backed securities that are guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association, the Federal Home Loan Bank or the Federal Home Loan Mortgage Corporation;
(6) collateralized mortgage obligations, so long as none of the mortgages that underlie the obligation were originated by the holder thereof or by an affiliate of the holder; and
(7) any other passive investment vehicles that, in the judgment of the commissioner, should be considered to constitute "securities" for the purposes of said subsection (a);
"affiliate" means a member of an affiliated group as defined under section 1504 of the Code; and "debt instruments" shall be deemed to include, but not be limited to, debt obligations of the United States, its agencies or instrumentalities and of any state or political subdivision thereof, their agencies or instrumentalities. Nothing in this subsection shall be construed to limit the instruments that may be held by an investment partnership for purposes of the safe harbor set forth in subsection (b) of section 17 of chapter 62.
St. 2004, c. 262, § 44.
2. Effective date of the new definition of securities.
The effective date provision that applies to the new definition of "securities" states:
Section 44 shall take effect on October 1, 2004, and shall apply to taxable years ending on or after that date; but, a corporation shall not lose its status as a securities corporation for a taxable year that begins before October 1, 2004 if: (1) the instruments that it holds for the portion of the taxable year ending on September 30, 2004 qualify as securities under section 38B of chapter 63 of the General Laws as it read before the effective date of this act; and (2) the instruments that it holds for the portion of the taxable year beginning on October 1, 2004 qualify as securities under section 38B of chapter 63 [ as amended].
St. 2004, c. 262, § 74. Italicized text not in original, added for clarification.
By this provision, all corporations that seek to qualify (or continue to qualify) as a security corporation for a taxable year ending on or after October 1, 2004 must adjust their portfolios before that date to ensure that all securities they hold on or after October 1, 2004 fall within the new definition.
3. The new definition of "securities" will not be construed to preclude a security corporation from acquiring certain qualifying securities from an affiliate.
The Department will not treat a corporation that owns securities that otherwise meet the definition at G.L. c. 63, § 38B(b ½)(1) as failing to qualify as a security corporation solely because it acquires securities from an affiliate, provided the securities were initially acquired by the affiliate through a public exchange or other arm's length secondary market. For purposes of this paragraph, the term "affiliate" means a member of an affiliated group as defined under I.R.C. § 1504.
Corporation A owns 100% of the stock of a subsidiary security corporation S. A transfers to S its portfolio of publicly traded stocks that it purchased through a public stock exchange over a period of years. These stocks will be treated as qualifying securities in the hands of S, and S continues to be eligible for security corporation classification after the transfer.
4. The ownership of REITs, RICs, and REMICs by security corporations.
A security corporation may own interests in Real Estate Investment Trusts (REITs)(IRC § 856), Regulated Investment Companies (RICs)(IRC § 851), and Real Estate Mortgage Investment Conduits (REMICs)(IRC § 860D). G.L. c. 63, § 38B(b ½). Investments in REMICs are only allowed if none of the mortgages owned by the conduit were originated by the holder or an affiliate of the holder, meaning that they were not originated by the entity claiming security corporation classification or one of its affiliates. See G.L. c. 63, § 38B (b ½)(4). This requirement is in addition to, and does not replace, the existing requirement that an ownership interest in a REIT that is a "related member" as defined in G.L. c. 63, § 31 I is not a security for purposes of determining security corporation classification. G.L. c. 63, § 38B(d). Technical Information Release 03-9, describing the effect of this rule, continues in force. See also paragraph (6), below.
5. General, interim guidance on the meaning of "other passive investment vehicles" in G.L. c. 63, § 38B(b ½)(7).
The new statute includes in the definition of securities "any other passive investment vehicles that, in the judgment of the commissioner, should be considered to constitute 'securities' . . . " G.L. c. 63, § 38B(b ½)(7). Pending issuance of further guidance on the meaning of this provision, the Department will not treat a corporation (the "taxpayer") as failing to qualify for classification as a security corporation solely because it holds on or after October 1, 2004 an equity interest (an "instrument") in a business organized as a corporation (the "business") that it purchased at arm's length but which is otherwise not described in section 38B(b ½)(1) (e.g., stock purchased from the original issuer), provided that the taxpayer can demonstrate to the satisfaction of the Commissioner, based on all the facts and circumstances, that (a) the instrument was purchased and is held for passive investment purposes only; and (b) neither the taxpayer nor any of its shareholders, officers, directors, or related persons (i) has either legal or effective control, directly or indirectly, of the business (whether through stock ownership, board representation, contract, or otherwise), either with respect to operations or with respect to any fundamental business matters (e.g., corporate governance, dividend policy, mergers and acquisitions, financings, etc.), (ii) participates actively in management of the business, whether or not serving in a formal capacity such as an officer, (iii) is related to or affiliated with the business, or (iv) holds a debt security in the business or is otherwise a creditor of the business.
Any decision on qualification as a security pursuant to this paragraph shall be in the Commissioner's discretion, and the taxpayer shall have the burden of satisfying the Commissioner with respect to both the applicable facts and circumstances and the application of the standards set out above. The Department in the future may issue further guidance to change, refine, or add to the requirements for qualification under section 38B(b ½)(7), and it is possible that such guidance will, on a prospective basis, further restrict or eliminate the potential for qualification.
6. Continuing applicability of prior rules, interim guidance, and limits of this Technical Information Release.
Unless specifically changed by the new definition of "securities" in G.L. c. 63. § 38B, all rules and requirements under prior law, whether derived from prior administrative guidance or from case law, shall continue to apply in determining a corporation's qualification or continued qualification as a security corporation.
This technical information release only addresses certain aspects of the new legislation. The Department anticipates that it will issue regulations interpreting the statute, with the usual opportunity for public comment.
B. The taxation of non-resident partners.
The new statute restates the first sentence of G.L. c. 62, § 17(b), dealing with nonresident partners and the safe harbor exception for nonresident limited partners of certain securities partnerships:
A nonresident of the commonwealth who is a member of a partnership that is engaged in the conduct of a trade or business in the commonwealth or that owns or leases real property in the commonwealth, except a nonresident limited partner of a limited partnership engaged exclusively in buying, selling, dealing in or holding securities on its own behalf and not as a broker, shall be subject to the taxes imposed by this chapter on his distributive share of the income received or earned by the partnership from sources taxable under this chapter.
St. 2004, c. 262, § 18, by § 72 made effective for tax years beginning on or after January 1, 2005.
In addition, the statutory amendments to G.L. c. 63, § 38B, set forth above, specifically provide that the limitations on qualifying securities in § 38B(b ½) are not intended to limit the instruments that may be held by an investment partnership for the purpose of the safe harbor set forth in G.L. c. 62, § 17(b).
Commissioner of Revenue
October 14, 2004