Diversified Investment Company

The Larkfield Growth Fund wants to hold itself out as a DIVERSIFIED company under the Investment Company Act of 1940. With respect to 75 percent of its total assets, the fund may hold no more than:

1. A.5 percent of its total assets in any one issuer, with no limit on the proportion of that issuer's voting securities it may own.Wrong. The voting-securities limit is a distinct prong of the test and is not optional.
2. B.10 percent of its total assets in any one issuer, and 5 percent of that issuer's outstanding voting securities.Wrong - the two figures are swapped. The tighter 5 percent limit applies to the fund's own asset concentration.
3. C.25 percent of its total assets in any one industry, with no issuer-level limitation.Wrong. Industry concentration is a separate policy a fund must disclose; the diversification test operates at the issuer level.
4. D.5 percent of its total assets in any one issuer, and 10 percent of the outstanding voting securities of any one issuer.Correct. This is the 75-5-10 test: the 5 percent limit is measured against the fund's assets, the 10 percent against the issuer's voting shares.

Why: The familiar 75-5-10 test: with respect to at least 75 percent of total assets, a diversified company may not put more than 5 percent of its total assets into the securities of any one issuer, and may not own more than 10 percent of the outstanding VOTING securities of any one issuer. The remaining 25 percent of the portfolio is unrestricted by this test, which is how a fund can build a few larger positions and still be diversified. Note that this is a labelling test under the Investment Company Act; it is separate from the Subchapter M requirements a fund satisfies in order to pass income through as a regulated investment company.

Wrenmoor Equity Fund wants to hold itself out as a diversified investment company under the Investment Company Act of 1940. Applying the 75-5-10 test, the fund must ensure that:

1. A.No more than 5% of total assets is invested in any one issuer across the entire portfolio.The 5% limit applies only within the 75% bucket, leaving 25% unconstrained.
2. B.With respect to 75% of total assets, no more than 5% is in any one issuer and no more than 10% of any issuer's voting securities is held.Correct. This is precisely the 75-5-10 diversification test.
3. C.At least 75% of assets are held in securities of issuers organized in the United States.The test concerns concentration by issuer, not domicile.
4. D.No more than 10% of total assets is invested in any one industry.Industry concentration is a separate disclosure policy, not the 75-5-10 test.

Why: To qualify as diversified, a fund must satisfy the 75-5-10 test: with respect to at least 75% of total assets, no more than 5% may be invested in the securities of any single issuer and the fund may not hold more than 10% of the outstanding voting securities of any single issuer. The remaining 25% of assets is unconstrained by these limits, which is what permits a diversified fund to carry a few concentrated positions.

The Larkfield Income Fund collects interest and dividends from its portfolio and wants to avoid paying corporate income tax at the fund level on that income. Under Subchapter M of the Internal Revenue Code, what must the fund do?

1. A.Distribute at least 90 percent of its net investment income to shareholders, so it may deduct those distributions and be taxed only on what it retainsCorrect. The 90 percent distribution test is the core of Subchapter M conduit treatment.
2. B.Distribute at least 90 percent of its realized capital gains, with net investment income taxed at the fund level regardlessThe test is stated in terms of net investment income, and distributed gains are likewise passed through to shareholders.
3. C.Nothing further, because registration under the Investment Company Act automatically exempts a fund from entity-level taxRegistration is a securities law status. Conduit tax treatment requires satisfying the Subchapter M tests.
4. D.Distribute 100 percent of its net investment income, since any retained amount disqualifies the fund entirelyRetaining income does not disqualify the fund; it simply means the retained portion is taxed at the fund level.

Why: Subchapter M treats a qualifying regulated investment company as a conduit, or pipeline. If the fund distributes at least 90 percent of its net investment income to shareholders, it may deduct those distributions and is taxed only on whatever it retains. The income is then taxed once, in the shareholder's hands, retaining its character as ordinary income or as capital gain. Qualification also requires meeting diversification and gross income tests; registration alone does not confer conduit treatment.