The document summarizes recent developments regarding mutual funds investing in commodities. Specifically, it discusses: 1) A Senate hearing where Senators criticized the IRS for private letter rulings allowing mutual funds to invest in commodities through offshore subsidiaries, claiming this maneuvered around rules limiting commodity investments. 2) In response, the IRS suspended new private letter rulings on this issue and will re-examine whether such income should be considered qualifying income for mutual funds. 3) This action creates uncertainty for mutual funds' ability to invest in commodities until the IRS issues new guidance.

1. 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 in
This Alert provides only commodities may soon need to alter their trading strategies. On January 26, Senator Carl
general 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 types
should not be relied upon as
of transactions as an investment in securities. Senator Levin has accused mutual funds
legal advice. This Alert may of maneuvering around well-established rules designed to prevent them from conducting
be 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 the
jurisdictions.
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 on
For more information, contact mutual fund investment portfolios.
your Patton Boggs LLP
attorney or the authors listed
Qualifying Income Rules
below.
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 or
dmoorehead@pattonboggs.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 that
msgreen@pattonboggs.com mutual funds are allowed to receive.1 Under section 851(b)(2) of the Code, mutual funds
George Schutzer
are required to have 90 percent of their income derived from securities, stocks or foreign
gschutzer@pattonboggs.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, including
Rosemary Becchi
rbecchi@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 Greene
jgreene@pattonboggs.com
Legislative Background
Joseph Urso
jurso@pattonboggs.com
Subchapter M was created in the 1930s to reform the taxation of mutual funds. In doing
Erin McGrain so, the statute provided which types of income earned by mutual funds are considered
emcgrain@pattonboggs.com 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 foreign
WWW.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.

2. 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, evidence
of 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, certificate
of 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 entered
into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument
commonly 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).

3. Going Forward
The IRS announced that it is suspending the issuance of PLRs on this issue and that it
will review whether income from investments in CFCs that are investing in commodities
or commodity-linked notes should be characterized as qualifying income. At the January
26 hearing, IRS Commissioner Douglas Shulman indicated that the IRS would consider
the arguments made by Senators Levin and Coburn, including the legislative history
surrounding the RIC Modernization Act. Further, at that same hearing, Acting Assistant
Secretary for Tax Policy at Treasury Emily McMahon stated that this issue could be a
candidate for Treasury’s Priority Guidance Plan, which means that the issuance of
guidance would be a priority for Treasury.
The combination of the IRS statements and action and the Senate hearing puts a major
chill, if not a total freeze, on the ability of mutual funds that do not have PLRs to invest in
CFCs that invest in commodities or to trade in commodity-linked notes. While mutual
funds that have a PLR may continue the activity that the IRS approved until the letters
are revoked or the new formal guidance from the IRS is effective, those funds might
consider seeking “grandfather” provisions and/or appropriate transition provisions if the
IRS reverses course and concludes that the investments do not generate qualifying
income. Mutual funds that invest in commodities through CFCs, desire to invest through
CFCs, or who invest in commodity-linked notes may seek to convince the IRS that its
prior position was correct and/or convince Congress that it should enact the provision
removed from the House version of the RIC Modernization Act of 2010.
Patton Boggs will continue to monitor developments in the taxation of mutual funds. We
would be happy to discuss any questions you may have or explore potential challenges
and opportunities these developments may bring to your organization. For more
information regarding Patton Boggs’ Financial Services and Products and Tax Policy
practices, 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 may
also 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