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BROCK ESTATE (03/22/66)

decided: March 22, 1966.


Appeal from decree of Orphans' Court of Delaware County, Dec. T., 1940, No. 2, in re estate of Alice Gibson Brock, Jr., also known as Alice Gibson Brock.


H. Durston Saylor, II, with him John W. Frazier, III, and Charles Morris Hamilton, for appellant.

Cuthbert H. Latta, with him O. Warren Higgins, John E. Walsh, and Drinker, Biddle & Reath, for appellee.

David Goldberg, Jerome R. Verlin, and Verlin & Goldberg, for trustees under Rule 65.

Bell, C. J., Musmanno, Jones, Cohen, Eagen, O'Brien and Roberts, JJ. Opinion by Mr. Justice Jones. Dissenting Opinion by Mr. Justice Roberts.

Author: Jones

[ 420 Pa. Page 456]

Alice G. Brock (decedent) died September 14, 1939. Under the presently pertinent portion of her will, the decedent devised and bequeathed her residuary estate, in trust, and directed, inter alia: (1) that certain fixed sums, totaling $18,700, annually be paid from the trust income to seven specifically designated friends and relatives (primary beneficiaries); (2) that any annual trust income in excess of $18,700 be paid annually to two of such designated friends (secondary beneficiaries); (3) that any income released from the trust, by reason of the death or deaths of any and finally all, of the primary or secondary beneficiaries, be paid forever in equal shares to Bryn Mawr College (Bryn Mawr), and the Pennsylvania Academy of the Fine Arts (the Academy).

The present factual status of the trust is that four of the seven primary beneficiaries have died; the annual income exceeds $18,700; the first $7700 of the annual income is being paid to the three surviving primary beneficiaries, the next $11,000 in annual income is being paid in equal shares to Bryn Mawr and the Academy and the income in excess of $18,700 is being paid to the one surviving secondary beneficiary who is the appellant on this appeal.

On September 3, 1964, the trustees*fn1 purchased seven shares of the capital stock of Philadelphia Fund, Inc. (Fund), a mutual fund and regulated investment company.*fn2 On September 30, 1964, the trustees received

[ 420 Pa. Page 457]

    from the Fund a distribution of $1.05. The authorizing resolution of the Fund described this distribution as "a quarterly distribution of 7 cent per share out of ordinary net income and 8 cent per share payable from realized capital gains," and provided for the payment of such distribution "in cash or additional shares of stock, at the option of the receiving stockholders."

The trustees elected to receive payment in cash and received 49 cent designated "ordinary net income" and 56 cent designated "realized capital gains". The trustees then filed an account in the Orphans' Court of Delaware County wherein the entire distribution of $1.05 was allotted to income. Bryn Mawr filed objections to the account on the ground that the amount of distribution from "realized capital gains" (56 cent) should be distributed to principal*fn3 rather than income. The court sustained Bryn Mawr's objection and directed the allocation of the 56 cents distributed from "realized capital gains" to principal.*fn4 From that decree a life tenant has appealed.

[ 420 Pa. Page 458]

The issue, narrow in scope, presents, primarily, a problem of statutory construction: is a distribution made by a mutual fund or regulated investment company the source of which distribution is "realized capital gains" allocable to income or to principal under the Pennsylvania Principal and Income Act of 1947?*fn5 More specifically, does such "capital distribution" fall within the provisions of § (5)(1)*fn6 or of § (5)(3)*fn7 of the Act?

[ 420 Pa. Page 459]

Any realistic approach to this problem must consider necessarily (a) the nature of a mutual fund or regulated investment company including its manner of doing business and its method of distribution of income and capital gains; (b) the view taken on this subject in other jurisdictions and by legal scholars; (c) the view taken by the courts in our own jurisdiction; (d) an analysis of the language of §§ 5(1) and 5(3) of the Principal and Income Act.

The Philadelphia Fund, Inc., a Delaware corporation, is an "open-end investment company (commonly called a mutual fund) and is registered as such under the Investment Company Act of 1940".*fn8 The business of such fund or company is to buy, hold,*fn9 and sell corporate stocks and other securities. Sources of the distributions made by such funds or companies are two-fold: ". . . (1) the interest and dividends which they receive from the securities in their portfolio, which is sometimes referred to as 'cash income'; and (2) the gains or profits which they receive when they make an advantageous sale or exchange of capital assets, which are known as 'capital gains.' After deducting its operating expenses, the company passes along to its shareholders the net income from both of these sources, in the form of dividends. For federal tax purposes, a distinction is made by the investment company as to the source from which these dividends are derived. Dividends derived from the company's ordinary income

[ 420 Pa. Page 460]

    are usually designated as 'cash dividends' and are ordinarily fully taxable to the shareholder. Dividends which represent capital gains are always termed 'capital gains dividends'. Most investment companies provide the shareholder with the option either to receive capital gains dividends in cash or in additional shares which represent cash values. Should the shareholder make no election, the company automatically issues additional shares for the capital gains dividend.

"The shares of investment companies, whether organized as corporations or as Massachusetts trusts, have a market value which fluctuates from time to time, as do the prices of other securities. The prices of the shares of the larger investment companies are quoted daily by the financial press. The capital gains dividends which the shareholder receives bear no relation to the quoted price of the investment company's stock, but represent solely the individual's proportionate interest in the net profit which the company derives from changes in its portfolio of investments. In this connection, however, it should be observed that in the event an investment company sustains a capital loss from the sale or exchange of a security which it holds, the shareholder is never required personally to sustain any part of it, except insofar as such a loss may affect the market value of his shares."*fn10

The stipulated reference to the Fund as an "openend" investment company connotes that, unlike a "closed-end" company which has a relatively stable capitalization, the Fund has no fixed capital, may issue new shares of stock in its discretion and may, and on demand will, redeem any or all of its outstanding shares of stock. In respect to the instant controversy, the difference between "open-end" and "closed-end" companies is without significance.

[ 420 Pa. Page 461]

If an investment company or a mutual fund submits to federal regulation under the provisions of the Investment Company Act*fn11 it acquires the status of a regulated investment company to which are extended certain tax advantages (26 U.S.C. § 854).*fn12 By way of illustration: (a) if the company distributes a minimum of ninety (90%) per cent of its investment income (i.e., interest, dividends, etc.), to its shareholders the company pays no tax on such income; (b) if the company distributes its net "capital gains" to its shareholders, it avoids paying a tax thereon but each shareholder reports his share of such gains in his own return, paying a tax thereon at the rate applicable to him which may be less than 25%; however, the company may retain the gains and pay a tax thereon at the rate of 25% in which event the shareholder may bring his share of the gains into his own return, take credit for his share of the company-paid tax, and, if his rate is less than 25%, secure a refund. Apparently, most funds distribute their gains at least annually.*fn13

Two additional facts must be noted: (a) the fact that an investment company designates the source of its distributions is not a matter of volition with the company but a mandated requirement of Title I, § 19, of the Investment Company Act of 1940, supra; (b) an investment company cannot offset its investment

[ 420 Pa. Page 462]

    losses against investment income under the taxing regulations.

Of great importance in the judicial approach to the instant problem is consideration of the nature of a regulated investment company vis-a-vis its shareholders. As the Supreme Judicial Court of Massachusetts recently (1963) stated in Tait v. Peck, 346 Mass. 521, 194 N.E. 2d 707: "Some commentators have felt that dividends from net capital gains from the sales of securities held in a mutual fund's portfolio are income from the ordinary conduct of the fund's business, that the portfolio holdings are bought and sold like inventory or other corporate property of a business corporation, and that distributions from such gains, at least where there is opportunity to receive the distribution in cash, should be treated as income. Weight is given by these commentators to the circumstance that investors in investment companies rely on both income and capital gains as a part of the expected yield. [p. 711]

"The contrary view is that the sale of a security in an investment company portfolio involves the sale of a capital item, so that, if the gain is distributed the capital is necessarily reduced. In some years such a company may experience net losses. It is argued that if capital gain distributions of other years have been paid to the income beneficiary, the trust principal will inevitably suffer in years of losses, which must be expected even in an era generally inflationary, so that, in effect, the investment company shares may become a wasting investment. It is also urged that a trustee's investment in an investment company is in substance nothing more than a fractional ownership in a diversified portfolio of securities, as to which the trustee should account as if he held the portfolio securities directly. The special character of regulated investment

[ 420 Pa. Page 463]

    companies and their specialized tax treatment under the Internal Revenue Code also have some tendency to give capital gains ...

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