Document Type
Case Analysis
Publication Date
1966
Publication Information
42 Notre Dame Law. 251 (1966).
Abstract
In In re Brock, The Supreme Court of Pennsylvania held: a distribution made by a mutual fund or regulated investment company, the source of which distribution is "realized capital gains," is properly allocable to principal under section 5(3) rather than section 5(1) of the Pennsylvania Principal and Income Act of 1947.
A typical mutual fund is an open-end diversified management investment company. Its business is to select, buy, hold, and sell corporate stocks and other securities. The fund's income is twofold. It derives income from interest and dividends on the securities in its portfolio and gains or profits from advantageous sales of its securities. This income, after deduction of management fees, is distributed to the stockholders in two distinct dividends—cash and capital gains.
The confusion presently begirding this area of dividend allocation has been caused, to a large extent, by the unique nature of a mutual fund. The principal issue is whether a mutual fund is analogous to an ordinary business corporation (a separate entity) or to a common trust fund (a mere conduit). The resolution of this issue is crucial. Under the separate entity theory, sales of securities by a mutual fund are treated as sales from inventory, and thus the gains from such sales are ordinary income to the trust allocable to the life income beneficiary. Under the conduit theory, however, such gains are treated as returns of capital and are thus allocable to principal, in the same manner as if the trustee had invested directly rather than through a mutual fund intermediary.
Though the problem in In re Brock involved the nature of a mutual fund, the court based its decision on an interpretation of section 5 of the Pennsylvania Principal and Income Act. The court sought to determine whether capital gains distributions fall within the provisions of section 5(1) or section 5(3) of this act.
After superficially disposing of section 5 (1), the court in Brock held that the second and third sentences of section 5(3) control capital gains distributions of a mutual fund. It is submitted that the court erred in this determination. Section 5 (3) applies only to the apportionment of dividends issued by the normal corporate enterprise. It has no application to capital gains distributions of a mutual fund.
>It is submitted that the court in In re Brock could have reached the same desirable result that it did, without violating the provisions of section 5 of the Pennsylvania Principal and Income Act. This result could have been achieved by a fuller utilization of the conduit theory. The mutual fund is a unique entity. The "many doctrines evolved to fit the usual type of associative enterprise do not fit the fund." The conduit theory recognizes this uniqueness and properly classifies the mutual fund as a mere conduit for management purposes. The mutual fund is not analogous to an ordinary business corporation and the doctrines evolved to govern the normal business corporation should not be superimposed upon a mutual fund. Since section 5 deals only with the dividend allocations of an ordinary business corporation, the Pennsylvania Supreme Court could have held that due to the unique nature of a mutual fund, section 5 did not apply at all. The court then would have been free of statutory restrictions and able to adopt completely the approach of the conduit theory under which capital gains distributions are classified as principal.
Recommended Citation
James H. Seckinger,
Capital Gains Distributions Treated as Principal Under the Uniform Principal and Income Act,
42 Notre Dame Law. 251 (1966)..
Available at:
https://scholarship.law.nd.edu/law_faculty_scholarship/922
Comments
Reprinted with permission of Notre Dame Law Review (previously Notre Dame Lawyer).