rp-04-28.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part III

Administrative, Procedural, and Miscellaneous

26 CFR 601.201: Rulings and determination letters.
(Also Part I, '' 851, 852; 1.851-2 )

Rev. Proc. 2004–28

SECTION 1. PURPOSE
This revenue procedure describes conditions under which a taxpayer that has
invested in a repurchase agreement (repo) may treat its position in the repo as a
Government security for purposes of qualifying as a regulated investment company
(RIC) under the asset diversification test of section 851(b)(3) of the Internal Revenue
Code.

SECTION 2. BACKGROUND

.01 A repo is a written agreement that provides for a “sale” and “repurchase” of a
security or securities (the Aunderlying securities,@ or the Acollateral@). The purchaser
agrees to purchase the underlying securities at a specific price and the seller, or
Acounterparty,@ agrees to repurchase the same securities on a specific date for a
specified price, plus an additional amount that reflects the time value of the purchaser=s
investment from the date of purchase of the underlying securities to the date of their
repurchase by the seller.

.02 RICs purchase securities in repo transactions as a convenient means to
invest idle cash at competitive rates on a secured basis, generally for short periods of
time. See Securities and Exchange Commission (SEC) Release No. IC–25058, 66 FR
36156, 36156–57 (July 11, 2001):

While a repurchase agreement has legal characteristics of both a sale and
a secured transaction, economically it functions as a loan from the fund to
the counterparty, in which the securities purchased by the fund serve as
collateral for the loan and are placed in the possession or under the
control of the fund’s custodian during the term of the agreement. . . .
. . . .
A fund investing in a properly structured repurchase agreement
looks primarily to the value and liquidity of the collateral rather than the
credit of the counterparty for satisfaction of the repurchase agreement.

2

Id
. at 36157 (footnote omitted).

.03 Section 851(b) provides that certain requirements must be satisfied for a
domestic corporation to be taxed as a RIC under subchapter M, part I.
Section 851(b)(3) imposes certain asset diversification requirements with respect to a
RIC's total assets that must be satisfied as of the close of each quarter of the RIC=s
taxable year.

.04 Section 851(b)(3)(A) requires that at least 50 percent of the value of a
corporation's total assets be represented by cash and cash items (including
receivables), Government securities, securities of other RICs, and other securities
generally limited in respect of any one issuer to an amount not greater in value than
5 percent of the value of the total assets of the RIC and to not more than 10 percent of
the outstanding voting securities of such issuer.

.05 Section 851(b)(3)(B) provides that not more than 25 percent of the RIC's
total assets may be invested in the securities (other than Government securities and the
securities of other RICs) of any one issuer, or of two or more issuers that the RIC
controls and that are determined, under regulations, to be engaged in the same or
similar trades or businesses or related trades or businesses.

.06 Section 5(b)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-1 et
seq. (1940 Act) defines a “diversified company” as a management company that has at
least 75 percent of its assets invested in cash and cash items (including receivables),
Government securities, securities of other investment companies, and other securities
that, for the purpose of this calculation, are limited in respect of any one issuer to an
amount not greater in value than 5 percent of the value of the total assets of the
management company and to not more than 10 percent of the outstanding voting
securities of the issuer. The remaining 25 percent of the management company=s
assets may be invested in any manner.

.07 Effective August 15, 2001, the SEC adopted Rule 5b–3, which is intended to
adapt the 1940 Act to the economic realities of repos and to reflect recent developments
in bankruptcy law protecting parties to repos. SEC Release No. IC–25058. Subject to
certain conditions, Rule 5b-3 permits a fund to Alook through@ the counterparty to the
collateral in determining whether the fund is in compliance with the investment criteria
for diversified funds set forth in section 5(b)(1) of the 1940 Act and with certain other
securities laws.

.08 The following definition is set forth in Rule 5b–3:

(1) Collateralized Fully in the case of a repurchase agreement
means that:

3

(i) The value of the securities collateralizing the
repurchase agreement (reduced by the transaction costs (including
loss of interest) that the investment company reasonably could
expect to incur if the seller defaults) is, and during the entire term of
the repurchase agreement remains, at least equal to the Resale
Price provided for in the agreement;
(ii) The investment company has perfected its security
interest in the collateral;
(iii) The collateral is maintained in an account of the
investment company with its custodian or a third party that qualifies
as a custodian under the [1940] Act;
(iv) The collateral consists entirely of :
(A) Cash items;
(B) Government securities;
(C) Securities that at the time the repurchase
agreement is entered into are rated in the highest rating
category by the requisite nationally recognized statistical
rating organizations [as defined in Rule 5b–3(c)(5)]; or
(D) Unrated Securities that are of comparable quality
to securities that are rated in the highest rating category by
the requisite nationally recognized statistical rating
organizations, as determined by the investment company’s
board of directors or its delegate; and
(v) Upon an Event of Insolvency with respect to the seller,
the repurchase agreement would qualify under a provision of
applicable insolvency law providing an exclusion from any
automatic stay of creditors’ rights against the seller.
Rule 5b–3(c)(1).

.09 The “Collateralized Fully” definition plays a critical role in the application of
the 1940 Act diversification rules to repos:

(a) Repurchase Agreements. For purposes of [the 1940 Act investment
criteria for diversified investment companies and prohibition on
registered investment companies from acquiring an interest in a
broker-dealer, underwriter, or investment advisor], the acquisition of a
repurchase agreement may be deemed to be an acquisition of the
underlying securities, provided the obligation of the seller to
repurchase the securities from the investment company is
Collateralized Fully.

4

Rule 5b–3(a).

The effect of this rule is that, for purposes of the definition of a diversified investment
company in section 5 of the1940 Act, if a repo is Collateralized Fully, a fund may (but
need not) treat an investment in the repo as an investment in the underlying security or
securities.

.10 Section 851(c)(5) provides that, for purposes of section 851(b)(3), all terms
not specifically defined in section 851(c) shall have the same meaning as when used in
the 1940 Act, as amended. The term AGovernment security@ is not specifically defined
in section 851(c).

.11 Section 2(a)(16) of the 1940 Act defines the term AGovernment security@ for
purposes of the 1940 Act without specific reference to funds investing in repos for which
Government securities serve as collateral.

.12 The RIC diversification rules of subchapter M are substantially similar in
structure and purpose to those of section 5(b)(1) of the 1940 Act. Both sets of rules
impose numerical limitations on the percentages and types of assets that may be held
by an investment company. Both sets of rules are intended to protect the investor from
the risks of loss and of illiquidity inherent in the concentration of assets in the securities
of a single or a small number of issuers. See
H.R. Rep. No. 2020, 86
th
Cong., 2
d
Sess.
820–26. In view of the commonality of structure and purpose of both sets of rules and
in view of the need for RICS simultaneously to comply with both, the RIC diversification
provisions of the Code and those of the1940 Act should be interpreted consistently.

SECTION 3. SCOPE

This revenue procedure applies to repos that, within the meaning of Rule 5b–
3(c)(1), are Collateralized Fully with securities that qualify as Government securities for
purposes of section 851(b)(3).

SECTION 4. PROCEDURE

If a taxpayer has invested in a repo to which this revenue procedure applies, the
taxpayer may treat its position in that repo as a Government security for purposes of
section 851(b)(3) even if the taxpayer is not treated as the owner of the underlying
securities for federal tax purposes.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective for repos held by a RIC on or after
August 15, 2001.

5

DRAFTING INFORMATION

The principal author of this revenue procedure is Susan Thompson Baker of the
Office of Assistant Chief Counsel (Financial Institutions and Products). For further
information regarding this revenue procedure, contact her at (202) 622-3940 (not a
toll-free call).