(a) (1) Analysis of investment intent. To qualify for security corporation classification, the corporation must engage in its activities for an investment purpose. This purpose includes the intent to conserve and augment capital and to provide income through judicious acquisition and retention of securities. Holding an instrument, even one that in another context may qualify as a security, for any purpose other than investment will disqualify an entity from security corporation classification. A corporation that holds securities, such as cash equivalent instruments, in circumstances where the funds invested in an instrument are used directly or by an affiliate for operational purposes, or are used as part of a cash management system, does not qualify as a security corporation.
(2) Special rule for security corporation subsidiaries of financial institutions. Security corporations that are subsidiaries of financial institutions are permitted to deposit cash in an account of a related financial institution (the "related financial account") under certain conditions, notwithstanding the provisions in 830 CMR 63.38B.1(5)(a)(1). This permission is limited to a security corporation that has generated cash from interest, dividends, or other qualifying income earned from its investments, or from the sale, redemption, or maturity of a security, and that deposits the cash in the related financial account solely on a temporary, short-term basis pending reinvestment of the cash by the security corporation in qualifying securities issued by unrelated issuers.
To be eligible for this exception, the following additional conditions must be met:
a. The related financial account must be established, and deposits made therein, on terms and conditions generally available to similarly-situated customers.
b. The security corporation must regularly (e.g. quarterly) declare and pay dividends or otherwise make distributions of all amounts of cash or other property on hand, except to the extent that such cash or other property is either held in cash or invested in qualifying securities issued by unrelated issuers or is deposited in the related financial account on terms meeting the standards set out in this regulation.
c. Deposits by the security corporation in the related financial account must be limited in amount and time on deposit so as to reasonably reflect, and be commensurate with, a demonstrated need for holding cash in an interest-bearing account on a short-term, temporary basis pending reinvestment in qualifying securities issued by unrelated issuers (taking into account the availability to the security corporation of any other cash or property for purposes of investing in qualifying securities, including cash or other property contributed by its parent or other shareholders). Any amounts so deposited that are not promptly reinvested in such qualifying securities must be dividended or otherwise distributed by the security corporation to its parent or other shareholders.
d. In computing its net income, the related financial institution paying interest on the related financial account in which the security corporation is permitted to make temporary, short-term deposits of cash pursuant to 830 CMR 63.38B.1(5)(a)(ii) must add back otherwise deductible interest paid, accrued, or incurred to the security corporation, subject to the exceptional cases where such deductions are allowable, according to the provisions of M.G.L. c. 63, § 31J. The Department will closely examine requests for such addback exceptions, and the taxpayer must establish to the Department's satisfaction the reasonableness of the security corporation deposits in light of the standards set out in this regulation.
e. The security corporation must maintain books and records establishing that it has met the standards set out in this regulation, and be prepared to demonstrate to the satisfaction of the Department that it has met such standards.
Example (5)(a.1). LendCo is in the business of lending money for business and personal reasons, which it secures through promissory notes. The business of lending money is not the acquisition of securities for an investment purpose; thus LendCo is ineligible for security corporation classification.
Example (5)(a.2). InvestCo owns a variety of securities, including stock of BigCo that it purchased through a secondary market. InvestCo has negotiated loans with BigCo and has taken back promissory notes as a means of financing BigCo's operations. InvestCo is ineligible for security corporation classification, for two reasons: (1) Because InvestCo is negotiating loans with BigCo, it is engaged in activities with respect to its holdings that go beyond an investment related purpose; and (2) The notes themselves are not securities within the meaning of 830 CMR 63.38B.1(3)(b)(1), because the notes were not acquired through a public exchange or other arm's length secondary market.
Example (5)(a.3). CloseCo is a closely held corporation. CloseCo holds, in addition to various securities, promissory notes received from its president and a principal stockholder of CloseCo as security for loans made for the accommodation of CloseCo's principals. The notes are unsecured and provide for a favorable rate of interest. CloseCo may not be classified as a security corporation for two reasons. First, the notes were not taken for investment purposes, but as security for loans made for the accommodation of CloseCo's principals. Second, the notes were not purchased on an arm's length secondary market.
Example (5)(a.4). ManufacturingCo is a corporation engaged in manufacturing. In 2007, ManufacturingCo sells its plant, equipment and other assets and ceases its manufacturing business, taking back from Buyer a promissory note that Buyer will repay over a fifteen-year period. After 2008, ManufacturingCo continues to hold the note, and engages in investing in a variety of securities. ManufacturingCo may not be classified as a security corporation for any year during which it holds the original note, because the note was not acquired for investment purposes.
(b) 1. In order to qualify as a security corporation, the taxpayer generally must exercise no management or control over the issuer of the instrument. The taxpayer can have no more than the ordinary rights typically possessed by a corporate shareholder, which include:
a. the right to elect directors;
b. the right to vote on the amendment of a corporate charter;
c. the right to agree to dissolution of the corporation; and
d. the right to agree to the sale of substantially all of the corporation's assets.
Example (5)(b)(1.1). ConsultCo owns a variety of securities. Recently, ConsultCo acquired an 8% limited partnership interest in a limited partnership (LP) that it purchased through a secondary market. The limited partnership is not in the business of dealing in securities. There are ten other limited partners invested in LP, each of which holds an 8% interest. ConsultCo's interest in LP gives it a variety of powers. ConsultCo has the right to vote on amendments to the underlying partnership agreement. It also has rights that exceed those granted to all limited partners under M.G.L. c. 109, which governs limited partnerships. For example, ConsultCo has the right to veto decisions concerning the business activities of the limited partnership; and it has the right to veto borrowing and investment activities of the limited partnership. While an interest in a limited partnership may be a security provided it meets all the requirements of 830 CMR 63.38B.1(4)(a), in this case the rights granted the limited partner exceed those allowed under 830 CMR 63.38B.1. The right to vote on amendments to the underlying partnership agreement is similar to rights given an ordinary corporate shareholder, and does not disqualify the corporation from security corporation classification. The right to veto business or investment decisions of the partnership, however, is not a right held by an ordinary investor, and will prevent the corporation from having security corporation classification.
Example (5)(b)(1.2). VentureCo generates capital through equity investments in high-risk ventures, such as in early-stage development companies. VentureCo introduces other investors to potential investments in companies in which Venture Co invests; VentureCo both extends lines of credit to the developing companies and arranges the extension of credit from lenders to them. It also advises management of the emerging businesses on best practices and strategies. Because VentureCo's activities include both investment activities and non-qualifying business activities, it does not qualify for security corporation classification.
Example (5)(b)(1.3). Parent Corporation owns several subsidiaries, including ManageCo, which contracts to manage publicly traded mutual funds, and InvestCo, which purchased shares in several funds managed by ManageCo through an arm's length secondary market. Provided InvestCo engages in no other disqualifying activity, it is eligible to be classified as a security corporation, notwithstanding ManageCo's contractual relationship with the purchased funds to provide management services.
Example (5)(b)(1.4). InvestCo purchases investments through stock exchanges and arm's length secondary markets. It purchases a 40% interest in NewCo, which gives it the right to vote to hire and fire managers. InvestCo has rights that exceed those ordinarily held by a corporate shareholder, and is ineligible for security corporation classification.
2. In order to qualify as a security corporation, a non-bank holding company must not own a controlling interest in a business entity. In addition to satisfying other requirements for qualification as a security corporation, a non-bank holding company security corporation's investment (whether direct or indirect) in the equity of a business entity (or options or interests exercisable or convertible into equity) must in any event not exceed 50% of the outstanding equity interests in that entity (determined as if options and instruments exercisable or convertible into equity are in fact exercised or converted), whether measured by vote or value. For example, a corporation will not be eligible for security corporation classification if it owns more than 50% of the stock of a subsidiary, or is a related member of the subsidiary.
Example (5)(b)(2). ParentCo owns 51% of HoldingCo, a holding company that it purchased through an arm's length secondary market. HoldingCo owns the stock of two corporations that perform business functions. ParentCo has no explicit rights to manage or control the business of HoldingCo. Because its interest in HoldingCo exceeds 50% of HoldingCo's outstanding equity interests, ParentCo is ineligible for security corporation classification.