An End to Mutual Funds Trading in Commodities?Document Transcript
February 7, 2012 An End to Mutual Funds Trading in Commodities?Tax Policy and Financial Services Client Alert Mutual funds investing in commodity-linked notes or offshore corporations that deal inThis Alert provides only commodities may soon need to alter their trading strategies. On January 26, Senator Carlgeneral information and Levin (D-MI) called a Senate Investigation hearing to highlight and admonish the Internal Revenue Service’s (IRS) private letter rulings (PLRs) that have characterized these typesshould not be relied upon as of transactions as an investment in securities. Senator Levin has accused mutual fundslegal advice. This Alert may of maneuvering around well-established rules designed to prevent them from conductingbe considered attorney a significant amount of transactions in commodities. Bowing to Congressional pressure,advertising under court and the IRS has imposed a moratorium on issuing new PLRs and last week, the U.S.bar rules in certain Treasury Department announced that it is considering re-examining this issue and issuing formal public guidance on the matter. If so, it is likely that Treasury and thejurisdictions. Internal Revenue Service (IRS) will rigorously review their prior decisions and perhaps put an end to allowing such investments. Such actions will have a chilling impact onFor more information, contact mutual fund investment portfolios.your Patton Boggs LLPattorney or the authors listed Qualifying Income Rulesbelow. Mutual funds operate under dual sets of restrictions, including those issued under the Internal Revenue Code (Code) and the Investment Company Act of 1940 (1940 Act).Donald Moorehead Unlike most corporations, mutual funds generally do not pay taxes on their income email@example.com capital gains at the entity level, thereby escaping the 35 percent U.S. corporate tax rate.Micah Green In exchange for this favorable tax treatment, the Code restricts the type of income firstname.lastname@example.org mutual funds are allowed to receive.1 Under section 851(b)(2) of the Code, mutual fundsGeorge Schutzer are required to have 90 percent of their income derived from securities, stocks or email@example.com currencies (referred to as “qualifying income”). This means that no more than 10 percent of a mutual fund’s income can be derived from alternative sources, includingRosemary Becchirbecchi@pattonboggs.com commodities. If more than 10 percent is derived outside of these qualifying restrictions, a mutual fund loses its tax-favored “regulated investment company” status.Joshua Greenejgreene@pattonboggs.com Legislative BackgroundJoseph Ursojurso@pattonboggs.com Subchapter M was created in the 1930s to reform the taxation of mutual funds. In doingErin McGrain so, the statute provided which types of income earned by mutual funds are firstname.lastname@example.org qualifying income, and therefore, eligible for favorable tax treatment. Income earned from commodities was not characterized as qualified income. Tax reform in 1986 expanded the types of income that mutual funds could earn to include investments in foreignWWW.PATTONBOGGS.COM currencies. During the drafting of the RIC Modernization Act of 2010, the House passed legislation which included language that would have added commodities as qualifying income. This provision, however, was the only provision removed by the 1 Typically, mutual funds distribute their earnings to shareholders yearly who are taxed on those amounts received. Mutual funds are taxed only on the amounts they retain.
Senate during the amendment process. The House accepted and passed the Senate amended version, which was then signed by the President. It did not include commodities as a type of qualifying income. Private Letter Rulings In the mid-2000s, mutual funds began seeking guidance from the IRS on whether income derived from a fund’s investments in a wholly-owned subsidiary that is a controlled foreign corporation (CFC) and expected to invest in commodities is qualifying income under section 851(b)(2) of the Code. In addition, mutual funds sought guidance on whether income and gain from commodity-linked notes is qualifying income under section 851(b)(2) as well. In response, the IRS has issued a number of PLRs concluding that both income derived from a CFC’s investments [in commodities] and income and gain from commodity-linked notes are qualifying income for purposes of section 851(b)(2). In examining the ruling requests regarding a mutual fund’s investments in CFCs formed off-shore, where the CFCs invest primarily in commodities, commodity-linked swaps, and other commodity linked-derivatives, the IRS noted that under section 851(b)(2) of the Code income must be derived from “gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the 1940 Act).” The IRS then turned to section 2(a)(36) of the 1940 Act to define “security.” Since the definition of “security”2 includes any stock, the IRS ruled that subpart F income of the wholly-owned subsidiary CFC is income derived with respect to the mutual fund’s business of investing in the stock of the subsidiary, thus constituting qualifying income under section 851(b)(2). Therefore, U.S. mutual funds that sought and obtained PLRs are able to establish and invest in wholly owned subsidiaries off-shore which invest in commodities and characterize that as qualifying income.3 Senate Hearing on Taxation of Mutual Funds and Commodity Investments On January 26, the Senate Homeland Security and Government Affairs Permanent Subcommittee on Investigations held a hearing titled “Compliance with Tax Limits on Mutual Fund Commodity Speculation.” At that hearing, both Chairman Carl Levin (D-MI) and Ranking Member Tom Coburn (R-OK) emphasized that the PLRs have misinterpreted Congressional intent and should be re-examined. They asserted that mutual funds are now establishing wholly owned subsidiaries that are investing primarily in commodities or commodity-linked notes. Chairman Levin argued that mutual funds are engaging in these activities for the sole purpose of avoiding the restrictions found in section 851(b)(2) of the Code, and thus, avoiding corporate taxation.2 Security is defined as “any note, stock, treasury stock, security future, bond, debenture, evidenceof indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate,preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificateof deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle,option, or privilege on any security (including a certificate of deposit) or on any group or index of securities(including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege enteredinto on a national securities exchange relating to foreign currency, or, in general, any interest or instrumentcommonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for,receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”3 I.R.S. Priv. Ltr. Rul. 110290-10 (June 4, 2010); I.R.S. Priv. Ltr. Rul. 101610-11 (May 23, 2011).
Going ForwardThe IRS announced that it is suspending the issuance of PLRs on this issue and that itwill review whether income from investments in CFCs that are investing in commoditiesor commodity-linked notes should be characterized as qualifying income. At the January26 hearing, IRS Commissioner Douglas Shulman indicated that the IRS would considerthe arguments made by Senators Levin and Coburn, including the legislative historysurrounding the RIC Modernization Act. Further, at that same hearing, Acting AssistantSecretary for Tax Policy at Treasury Emily McMahon stated that this issue could be acandidate for Treasury’s Priority Guidance Plan, which means that the issuance ofguidance would be a priority for Treasury.The combination of the IRS statements and action and the Senate hearing puts a majorchill, if not a total freeze, on the ability of mutual funds that do not have PLRs to invest inCFCs that invest in commodities or to trade in commodity-linked notes. While mutualfunds that have a PLR may continue the activity that the IRS approved until the lettersare revoked or the new formal guidance from the IRS is effective, those funds mightconsider seeking “grandfather” provisions and/or appropriate transition provisions if theIRS reverses course and concludes that the investments do not generate qualifyingincome. Mutual funds that invest in commodities through CFCs, desire to invest throughCFCs, or who invest in commodity-linked notes may seek to convince the IRS that itsprior position was correct and/or convince Congress that it should enact the provisionremoved from the House version of the RIC Modernization Act of 2010.Patton Boggs will continue to monitor developments in the taxation of mutual funds. Wewould be happy to discuss any questions you may have or explore potential challengesand opportunities these developments may bring to your organization. For moreinformation regarding Patton Boggs’ Financial Services and Products and Tax Policypractices, simply click the hyperlinks or please visit www.pattonboggs.com.This Alert provides only general information and should not be relied upon as legal advice. This Alert mayalso be considered attorney advertising under court and bar rules in certain jurisdictions. WASHINGTON DC | NORTHERN VIRGINIA | NEW JERSEY | NEW YORK | DALLAS | DENVER | ANCHORAGE DOHA, QATAR | ABU DHABI, UAE