Download Regulated Investment Companies and Commodity

Volume 10 Issue 3 2012
Regulated Investment Companies
and Commodity-Linked
Instruments: The Current State of
Play
By Amy B. Snyder*
Amy B. Snyder summarizes the current qualifying income issues
faced by RICs, provides an overview of the recent government
scrutiny of RICs and outlines the different forms of commoditylinked investments available to RICs.
In recent years, increasingly, financial advisers have
been recommending commodities to retail investors as part of a diversified investment portfolio, and
investment advisers to mutual funds and other investment
companies
registered under the Investment
m
ent com
mpan
Company
Act
of 1940, as amended (the “1940 Act”),
C
Co
om
om
mp
pany
yA
ct o
have sought
provide
commodity
market expou ht to
o provid
de such com
mmo
sure to retail investors in a registered fund structure.
The increased presence of funds in the commodity
markets has not gone unnoticed by regulators and
lawmakers, and has prompted some to reevaluate
whether, how and to what extent funds should be
permitted to obtain commodity market exposure.1
From a tax perspective, these questions have arisen in
connection with the status of the funds as “regulated
investment companies” (RICs) under Subchapter M
(Code Sec. 851 et seq.) of the Internal Revenue Code
of 1986, as amended (the “Code”), and in particular
their ability to meet the Qualifying Income Test (as
defined below).
Part I of this article provides a summary of the
current Qualifying Income issues faced by RICs seeking exposure to the commodity markets, including
Amy B. Snyder is a Partner at Ropes & Gray LLP in Boston,
MA, specializing in the taxation of investment companies and
other pooled investment vehicles, as well as different types of
financial instruments.
©
the IRS’s guidance in this area. Part II of this article
provides an overview of the recent government scrutiny of RICs and their commodity-related investing,
including the IRS’s decision to “pause” its practice
of issuing private letter rulings on commodity-linked
notes and wholly owned commodity subsidiary structures, and what this scrutiny currently means for RICs
seeking commodity market exposure. Finally, Part
III of this article provides a summary of the different
forms of commodity-linked investments available to
RICs, as alternatives to the commodity-linked notes
and commodity subsidiary structures currently under
IRS examination.
I. Summary of Current Law
A. Qualifying Income Test—The
Statute
Mutual funds and other registered funds typically
elect to be treated as RICs. RICs are required to
meet certain ongoing qualification tests concerning
the sources of their income and the diversification
of their assets in order to maintain their RIC status
and to continue to receive the special tax treatment
conferred on RICs and their shareholders under the
Code. In particular, a fund that qualifies as a RIC
escapes corporate-level U.S. federal income taxation
2012 A.B. Snyder
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
45
Regulated Investment Companies and Commodity-Linked Instruments
on its income to the extent it distributes its earnings
and profits annually to its shareholders. In addition,
a fund’s status as a RIC enables it to pass along to its
shareholders certain fund-level tax attributes, such as
long-term capital gain, entitlement to the foreign tax
credit, and dividends eligible for qualified dividend
income treatment (for individuals) or the dividendsreceived deduction (for corporations). A fund’s failure
to satisfy any of these RIC tests can result in the payment of substantial penalty taxes to maintain its RIC
status, or loss of RIC status entirely in a particular
year, resulting in taxation at the fund level on all of
the fund’s taxable income.
Currently, the primary tax-related obstacle faced by
RICs seeking commodity market exposure is the requirement that 90 percent of a RIC’s gross income be
derived annually from the qualifying income sources
enumerated in Code Sec. 851(b)(2) (the requirement,
the “Qualifying Income Test,” and each such source,
“Qualifying Income”).2 Specifically, under Code Sec.
851(b)(2), to qualify as a RIC for any tax year, at least
90 percent of a fund’s gross income must be derived
from the following sources:
1. Dividends, interest, payments with respect
to securities loans (as defined in Code Sec.
512(a)(5))
2.
the sale or other disposition of
2 Gains
Gain
ns from
f
stock
stock or
o securities (as defined in Sec. 2(a)(36)
of the
th
he 1940
19
940 Act)
Actt)3 or fo
foreign
oreigg currencies
3. Other income (including but not limited
to gains from options, futures or forward
contracts) derived with respect to the
fund’s business of investing in such stock,
securities or foreign currencies4 (clause 3 is
referred to herein as “Other Income”)
4. Net income allocated to the fund from its
interest in a so-called “qualified publicly
traded partnerships” (QPTPs) (as defined in
Part III(B) below)
As part of The Regulated Investment Company
Modernization Act of 2010 (the “RIC Modernization
Act”), enacted in December 2010, Congress added
a savings provision to the Qualifying Income Test.5
Very generally, a RIC that fails to comply with the
Qualifying Income Test now can correct (“cure”) that
failure by paying a tax equal to the amount by which
it failed the test provided such failure was “due to
reasonable cause and not willful neglect.”6
Notably absent from the list of sources of Qualifying Income in Code Sec. 851(b)(2) are income and
gains on commodities.7 Under the current statute,
46
because direct investments in “commodities” are not
“securities” under Sec. 2(a)(36) of the 1940 Act, they
generally do not generate Qualifying Income for purpose of the Qualifying Income Test. As noted above
in clause (2) of the Qualifying Income Test, securities
for purposes of the test is defined by reference to Sec.
2(a)(36) of the 1940 Act. Similarly, as discussed in
more detail below in Part I(B), in Rev. Rul. 2006-1,
the IRS ruled that certain derivatives contracts with
respect to a commodity index are not securities for
purposes of the Qualifying Income Test.8 As a result,
the Qualifying Income Test substantially limits RICs
in respect of the types of commodity-linked instruments in which they can directly invest and the ways
in which they use certain of those instruments.9
B. IRS Published Guidance—2006
Revenue Rulings on Commodities
Derivatives
Prior to the issuance of Rev. Rul. 2006-1, one or
more RICs had taken what were regarded by some
in the industry as aggressive tax positions concerning
the ability of certain commodity-linked instruments
to generate Qualifying Income. In the ruling, a
RIC invested substantially all of its assets in debt
instruments and entered into certain commodity
index derivative contracts—specifically, commodity
swaps—pursuant to which it would pay an amount
equal to the three-month U.S. Treasury Bill rate plus
a spread and receive (or pay) an amount based on
the total return gain (or loss) on a commodity index.
The RIC’s aggregate exposure to the commodity index under the swaps was approximately equal to the
RIC’s aggregate investment in debt instruments. The
IRS concluded that the commodity-linked swaps did
not generate Qualifying Income.
First, the IRS concluded that the commodity swaps
in which the RIC invested were not securities for
purposes of the Qualifying Income Test. That conclusion depended on whether the commodity swaps
were securities under the definition of “security” in
Sec. 2(a)(36) of the 1940 Act as discussed above. The
IRS observed that there was no conclusive authority
on this point under the 1940 Act. In the absence of
such authority, the IRS looked to Congress’s intent
in enacting the cross reference to the 1940 Act securities definition in order to determine whether the
commodity swaps were “securities for purposes of
[Code] [S]ection 851(b)(2).” Specifically, because
the Tax Reform of 1986 (the “1986 Act”)10 added
Volume 10 Issue 3 2012
the 1940-Act security cross reference, as well as the
Other Income provision, to Code Sec. 851(b)(2), the
IRS looked to the legislative history of the 1986 Act.
The IRS ultimately concluded that excluding these
commodity swaps—of which the underlying property
was a commodity index and not a security—from
the term “securities” was consistent with Congress’s
intent in amending Code Sec. 851(b)(2) in 1986.11
Second, after concluding that the swaps were not
securities for purposes of the Qualifying Income Test,
the IRS then considered whether income generated
from such investments nevertheless fell within the
Other Income category. The IRS indicated that the RIC’s
business was “to create investment exposure to changes
in commodity prices, and that the [swap contracts] are
the primary vehicle for doing so,” and determined that
the purpose of the RIC’s investments in debt instruments
was to facilitate its business of providing commodity
index exposure through the use of commodity-linked
derivatives. Hence, the IRS concluded:
[The RIC] ... does not enter into the [commodity
swaps] in connection with a business of investing
in stock, securities, or currencies. Nor does [the
RIC] enter into the [commodity swaps] in order
to reduce or hedge the level of risk in a business
of iinvesting
of
vessting iin stock, securities, or currencies.
In light
fact
that
one
more
ht of tthe
he fa
act th
hat o
ne or m
ore existing RICs had
taken tax positions contrary to those set forth in Rev.
Rul. 2006-1, the IRS’s ruling was given prospective
effect, providing those RICs, initially, with approximately six months to dispose of and replace their
commodity-linked positions generating non-Qualifying Income with Qualifying Income positions.
The IRS’s legal analysis and holding in Rev. Rul.
2006-1 was sufficiently broad so as to call into question whether any derivative or similar instrument
linked to a commodity or commodities index, including, for example, a commodity-linked structured
note, could produce Qualifying Income. In light of
this uncertainty, the IRS published a follow-up ruling,
Rev. Rul. 2006-31, which narrowed the holding of
Rev. Rul. 2006-1 to the swap contracts described in
the ruling and expressly stated that the earlier ruling
was not intended to preclude a conclusion that the
income from “certain instruments (such as certain
structured notes)” that create commodity exposure for
the holder is Qualifying Income. Rev. Rul. 2006-31
also extended the prospective application of the ruling
another three months and clarified that its prospective
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
application “was intended to apply to all derivative
contracts with respect to a commodity index or an
individual commodity” (emphasis added).12
C. Commodity-Linked Investments
by RICs Following Rev. Rul. 2006-1
Following the issuance of Rev. Rul. 2006-1, it was
clear that a RIC seeking affirmative investment exposure to the commodities markets had to explore
other investment options.13 As a result, RICs sought
alternative means of obtaining indirect exposure to
the commodity markets. The two primary means
that developed were: (1) direct investments in
commodity-linked structured notes (CLNs), and (2)
indirect investments in commodities and commoditylinked investments through wholly owned foreign
subsidiaries (“commodity subsidiaries”). Importantly,
these alternatives enabled RICs to transmute the
nonqualifying return on underlying commodities
into Qualifying Income. However, as described
below, some uncertainty existed, and continues to
exist, under the tax law in respect of each of these
investments as to their ability to generate Qualifying
Income. In light of this uncertainty and in the wake
of Rev. Rul. 2006-1,14 beginning in 2006, RICs began
requesting and receiving private letter rulings (PLRs)15
from the IRS concerning the Qualifying Income status
of income and gains generated from each of these
two types of investments. This ruling practice had
become routine, until July 2011 when the IRS announced it was “pausing” its ruling practice in this
area, as discussed in Part II(C) below. However, not
all RICs using these investments have sought PLRs;
some have opted instead to rely on advice of counsel
on these questions.
1. Commodity-Linked Notes. As noted above, in
Rev. Rul. 2006-31, the IRS expressly stated that its
ruling was not intended to preclude a conclusion that
the income from “certain structured notes” that create commodity exposure is Qualifying Income. The
IRS did not, however, provide the basis on which it
would consider CLNs to generate Qualifying Income,
nor define precisely what “certain structured notes” it
had in mind. In the close to 40 PLRs issued on CLNs
since Rev. Rul. 2006-1, the IRS ruled the income and
gains arising from the specific CLNs set forth in the
rulings constituted Qualifying Income. 16 The CLNs on
which RICs have received PLRs have had somewhat
similar terms. Under a typical CLN on which the IRS
has favorably ruled, a RIC pays the issuer of the note
par value upon purchase and, at maturity, receives par
47
Regulated Investment Companies and Commodity-Linked Instruments
value back from the issuer adjusted up or down, as applicable, by the product of (1) par value, (2) the change
in value of a particular commodity-based index, and
(3) a leverage factor not exceeding three. In addition,
the final payment is typically reduced by a specified
fee, but in any event is not less than zero. The CLNs on
which the IRS has favorably ruled also have typically
had certain additional debt-like features,17 including
paying interest (periodically or at maturity) and, in
order to provide some principal protection, requiring
early redemption (or “knock out”) if the value of the
index falls by a specified percentage (e.g., 15 percent)
from its value at the time the RIC acquired the CLN.
Additionally, the CLNs described in the PLRs have
had a maturity not exceeding three years, and have
not been traded on a securities exchange.
For purposes of the Qualifying Income Test, the
threshold question regarding whether CLNs generate Qualifying Income is whether they are securities
under Sec. 2(a)(36) of the 1940 Act. Currently, no
conclusive authority from the Securities and Exchange
Commission (SEC) or a court exists on this question.18
The IRS’s analysis in the CLN PLRs, concluding that
income and gains on the CLNs is Qualifying Income,
is scant, but points to the conclusion that the IRS
considers CLNs to be 1940 Act securities. In this
regard,
the
reg
garrd th
ga
e IIRS
RS appears to rely heavily on the ability
of
CLNs
o th
tthe
he
e CL
Ns on which it rules to qualify as “hybrid
instruments”
“predominantly
securities”
entss” tthat
ha aare
re
e “pre
edomin
under Sec. 2(f)(1) of the Commodities Exchange Act
(CEA). A hybrid instrument is a “security [within the
meaning of the Securities Act of 1933 (“1933 Act”) or
Securities Exchange Act of 1934 (“1934 Act”)] having
one or more payments indexed to the value, level or
rate of, or providing for the delivery of, one or more
commodities.”19 Under the CEA, a hybrid instrument
is deemed to be “predominantly a security” and
therefore excluded from regulation by the Commodity Futures Trading Commission (CFTC)20 if it meets
four conditions set out in Sec. 2(f)(2) of the CEA.21
In the PLRs, the IRS has required RICs to represent
that their CLNs at issue will meet those four criteria.
Hence, the IRS’s ruling criteria suggests that the IRS
respects these notes as (1) 1933 Act and/or 1934 Act
securities that are subject to regulation by the SEC as
hybrid instruments where the security, and not commodity, features, predominate, and (2) in turn, as 1940
Act securities for Qualifying Income Test purposes.22
Similarly, in providing legal advice to RICs on these
CLNs over the past several years, tax practitioners have
looked to their 1940 Act colleagues for assistance in
48
concluding that particular CLNs should be treated as
securities under the fairly broad definition of “security” in Sec. 2(a)(36) of the 1940 Act.
2. Commodity Subsidiaries. The Qualifying Income
question arising in respect of commodity subsidiaries
is more limited than that in respect of CLNs. RICs
typically set up a wholly owned subsidiary taxable
as a “controlled foreign corporation” (CFC) under the
Code, 23 and the subsidiary invests in commodities or
commodity-linked derivatives or other instruments
that would generate non-Qualifying Income for the
RIC if the RIC invested directly in those instruments.
The commodity subsidiaries also invest in fixed
income and other securities (frequently as a means
of collateralizing the subsidiary’s commodities derivatives positions).24 Typically, all of a commodity
subsidiary’s income and gains constitute “subpart
F income” under Code Sec. 951(a)(1)(A)(i) that a
RIC must include in its gross income,25 as ordinary
income, in the taxable year of the RIC in which or
with which the subsidiary’s tax year ends, regardless
of whether the subsidiary actually distributes this
income to the RIC.26 This subpart F income is not generally treated as a dividend for U.S. federal income
tax purposes, and the commodity subsidiary’s actual
distributions of this subpart F income to the RIC are
in fact excluded from income and thus do not separately qualify as dividends.27 Nevertheless, the flush
language in Code Sec. 851(b) expressly provides that
subpart F income of a CFC that a RIC is required to
include in its gross income in a tax year under Code
Sec. 951(a)(1)(A)(i) that is currently distributed to the
RIC (i.e., by the end of the tax year) will be treated
as “dividends” for purpose of the Qualifying Income
Test and thus constitute Qualifying Income.28
This leaves open the question of whether subpart
F income that is not currently distributed to the RIC
and thus not a “dividend” can properly be treated
as generating Qualifying Income for a RIC under the
Qualifying Income Test (i.e., as Other Income). Since
2006, the IRS has issued over 50 PLRs on this question, ruling that such undistributed subpart F income
derived by a RIC from its commodity subsidiary will
be income derived with respect to the RIC’s business
of investing in the stock of the CFC and thus constitute
Qualifying Income (i.e., as Other Income).29
A RIC’s ability to use a commodity subsidiary to
block non-Qualifying Income also is limited by the
RIC asset diversification rule in Code Sec. 851(b)(3).
In particular, a RIC’s investment in the commodity
subsidiary generally cannot represent more than 25
Volume 10 Issue 3 2012
percent of the value of its total assets at the end of each
quarter of each tax year.30 This limitation is all the more
constraining given that it includes any collateral held
by the subsidiary for its derivative positions.31
Another disadvantage to a RIC’s use of a commodity
subsidiary is that the structure potentially raises risk
of recharacterization or other challenges under various tax doctrines, including economic substance32
or “sham corporation,”33 as well as under Code Sec.
269.34 Any such successful challenge would adversely
affect a RIC’s ability to meet the Qualifying Income
Test and other RIC qualification requirements. As
discussed below in Part II, recently, certain lawmakers
have questioned the IRS as to why it has not challenged RICs’ use of commodity subsidiaries under
one or more of these doctrines.35 As a practical matter,
absent Congressional action, it would be difficult for
the IRS to challenge generally these structures in light
of its over 50 PLRs in this area, even considering the
fact that the PLRs were expressly limited to the Qualifying Income question. Moreover, the practice of
using wholly owned offshore corporations to “block”
the character of certain types of income from being
attributed to its owners is widespread and has been
long accepted by Congress and the IRS (e.g., offshore
corporations
used by tax-exempt investors to “block”
p
attribution
tthe
he aat
ribu
utio
on to them of unrelated business taxable
iincome
nco
n
co
ome (UBTI)),
(U
UBTI)) making it difficult for the IRS to challenge RIC
RICs’
use
subsidiaries without
Cs’ u
se of ccommodity
ommod
dityy sub
implicating other similar structures.36 Nevertheless, in
light of this current debate, RICs should take care—
now more than ever—to operate their commodity
subsidiaries in a manner that respects the separate
corporate existence of the subsidiaries.37
II. Recent Government Scrutiny
Commodity-related investments by RICs, in particular their use of commodity subsidiaries and CLNs,
have received the attention of lawmakers and various federal regulators in recent years. This section
summarizes these events, in chronological order,
beginning with the passage of the RIC Modernization Act in 2010, and concludes with a discussion
of what all of this means for RICs currently seeking
commodity market exposure.
A. Congress Adopts the RIC
Modernization Act
The RIC Modernization Act was originally introduced
in Congress in December 2009, at which time the
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
bill proposed to expand the Qualifying Income Test
to include gains on the disposition of commodities
and Other Income derived in connection with a RIC’s
business of investing in commodities to the list of
Qualifying Income.38 The House of Representatives
first approved the bill, including with the commodities provision, in September 2010.39 The bill was
finally enacted as one of the final acts of the 111th
Congress, and signed into law, in December 2010.
Prior to its final passage, the bill was modified in
the Senate to, among other things, remove the commodity provision after some raised concerns about
expanding a RIC’s ability to invest in commodities.40
The bill modifications were made in an apparent
effort to ensure that members of the Senate would
unanimously pass the bill before the end of the session pursuant to the unanimous consent procedures
under which the bill was presented. 41
B. CFTC Examines CommodityFocused Funds and Proposes New
Rulemaking
Separately, in 2010, the CFTC began reconsidering
its regulatory approach to registered funds that have
substantial commodities exposure, including whether
registered funds using commodity subsidiaries and/
or the commodity subsidiaries themselves should be
subject to CFTC regulation. As part of that process,
in January 2011, it proposed to limit the scope of
certain exemptive rules under the CEA on which
registered funds and their commodity subsidiaries
typically rely to avoid CFTC regulation as “commodity pool operators” (CPOs), in particular CFTC
Rule 4.5.42 In early July 2011, the CFTC staff hosted
a public roundtable to discuss its proposed changes
and the reasons therefor.43 IRS officials attended the
roundtable, and commodity subsidiaries were among
the topics discussed, including the tax-related reasons
for setting up these commodity subsidiaries and the
IRS’s PLRs.44 As discussed below, the CFTC finalized
these rules a year later in February 2012, with some
modifications to their proposed form.
C. IRS Announces “Pause” in
Rulings Practice
Shortly after the CFTC’s roundtable in July 2011, the
IRS announced that it was “pausing” its practice of
issuing PLRs on both commodity subsidiaries and
CLNs in order to reconsider the basis upon which
it has issued the existing rulings (totaling over 70
49
Regulated Investment Companies and Commodity-Linked Instruments
since 2006).45 In view of the timing of the IRS’s announcement, it was unclear how much of a role, if
any, pressure from the CFTC had in the IRS’s decision,
although IRS officials confirmed that the IRS and
CFTC were in discussions with one another concerning these issues.46 Since announcing the pause,
the IRS has continued to accept new PLR requests
in this area, but it remains unclear when, if ever, the
IRS will resume its consideration of such requests.
Statements made by IRS officials in the months following the IRS’s announcement indicated that the
IRS intended to publish guidance on which all RICs
could rely in order to reduce or eliminate entirely
the need for PLRs in respect of CLNs or commodities
subsidiaries.47 Officials did not provide any details
about the extent or timing of any such published
guidance, but did suggest that such guidance would
be prospective in nature, equally affecting RICs with
PLRs (those obtained prior to the pause) and RICs
without such PLRs so as to create a “level playing
field” for the industry.48
D. Congressional Committee Holds
Hearings
The IRS’s and CFTC’s actions received the attention of certain lawmakers towards the end of 2011.
cally,
SSpecifi
Sp
p
peecci ca
lly, in November 2011, the Senate Committee
Homeland Security and Governmental
mit
m
ittteee on
n Hom
H
Affairs, Perm
Permanent
manent SSubcommittee
ubcom
mmitteee on Investigations
(the “PSI”) held a hearing concerning speculation in
the commodities markets.49 At this hearing, Senator
Carl Levin (D-MI), the chairman of the PSI, sought to
demonstrate that registered funds using commodity
subsidiaries, among other financial investors, have
contributed to excessive speculation in the commodity markets.50 Weeks later, in December, Senator
Levin, along with Senator Thomas Coburn (R-OK),
the PSI’s ranking minority member, sent a letter to
the IRS requesting that it permanently halt the further
issuance of PLRs to RICs concerning indirect investments in commodities.51
More recently, in January 2012, the PSI held a hearing to examine specifically the IRS’s rulings practice in
respect of CLNs and commodity subsidiaries.52 At the
hearing and in the December letter to the IRS, Senator Levin expressed the view that RICs should not be
permitted to invest indirectly in commodities if they
cannot do so directly and questioned whether the commodity subsidiaries or CLNs lack economic substance
or should be regarded as “sham corporations” or “sham
transactions.” 53 Although both CLNs and commodity
50
subsidiaries were identified by Senator Levin, the commodity subsidiary structures were the primary focus of
the hearing. 54 The IRS Commissioner and the Treasury
Department’s Acting Assistant Secretary for Tax Policy
testified at the hearing, each expressing the view that
the IRS’s rulings provided a reasonable interpretation
of existing law.55 They also stated that, in view of the
Senators’ concerns, they are taking a fresh look at their
policies toward RICs’ use of commodity subsidiaries
and CLNs, and indicated that they are still considering
whether to issue industry-wide guidance in this area.
In addition, the Commissioner indicated that the IRS
does not intend to raise economic substance issues
in respect of CLNs or commodity subsidiaries as he
believed that these practices can be allowed or disallowed on technical grounds.56
Representatives of the industry were not given the
opportunity to testify at the hearing, although the
Investment Company Institute submitted a written
response to the hearing on behalf of its registered fund
members in support of the IRS’s ruling positions.57 It
is unclear whether this attention by lawmakers will
lead to any future legislation concerning registered
funds and their use of commodity subsidiaries, CLNs
or other commodity-linked instruments,58 or will affect
the IRS’s decision making in this area, including the
nature and substance of any future IRS guidance. At a
minimum, it appears to have delayed further any IRS
action concerning its suspended PLR practice. Very recent statements by an IRS official suggest that the IRS’s
pause is likely to continue for the foreseeable future
and that the IRS and Treasury are unlikely to take any
kind of unilateral action concerning these issues.59
E. CFTC Issues Final Rules
A few weeks after the PSI’s hearing, in February 2012,
the CFTC finalized the regulatory amendments to
CFTC Rule 4.5 and other exemptive rules applicable
to registered funds and their commodity subsidiaries
discussed in Part II(B) above.60 The final version of
these amendments provided some modifications to
the form originally proposed by the CFTC in January
2011. In final form, they significantly limit the availability of Rule 4.5 and other CFTC exemptive rules for
registered funds and their commodity subsidiaries.
Very generally, under the CEA, a registered fund
using commodity futures, options on commodities
or commodity futures, or swaps (either directly or
indirectly through a commodity subsidiary or another fund) is considered to be a CPO, triggering an
obligation to register with the CFTC unless the fund
Volume 10 Issue 3 2012
meets the amended exclusion set forth in Rule 4.5.
Previously, Rule 4.5 provided an exclusion from the
definition of CPO to all registered funds, regardless
of their level of trading in commodity interests. 61 The
amended Rule 4.5 provides that a registered fund
can claim an exclusion from the definition of CPO
under the rule only if it trades in commodity interests
solely for bona fide hedging purposes (as defined
in certain rules under the CEA) or meets (1) one of
two trading threshold tests,62 and (2) complies with
certain marketing restrictions.63 In issuing the final
regulations, the CFTC also clarified that the appropriate entity to register with the CFTC as the CPO is
the fund’s investment adviser and not the fund itself
or its board.64 Many commodity-focused funds are
not likely to meet these restrictions, and either their
advisers will be required to register with the CFTC
and comply—and cause their funds to comply—with
various ongoing CFTC recordkeeping, reporting and
disclosure requirements,65 or the funds will need to
make potentially significant changes to their investment programs so as to fall within the amended Rule
4.5 requirements.
In addition, in issuing the final regulations, the
CFTC did not oppose registered funds’ use of commodity subsidiaries, but stated that the subsidiaries
will
will be
be required
re
equire to have their CPOs (generally, their
investment
register with the CFTC unless
invve
veesstm
men
nt advisers)
adv
they may
on their
ay claim
m an
an exemption
exem
mptio
on or
or exclusion
e
own merits. In issuing the final regulations, the CFTC
stated its belief that “each separate legally cognizable
entity must be assessed on its own characteristics
and that a CFC should not be entitled to exclusion
simply because its parent company is a registered
investment company that may be entitled to exclusion
under § 4.5,” disagreeing with the position apparently
previously taken by some registered funds that their
subsidiaries were mere subdivisions of the funds
and thus not separate commodity pools required to
seek a separate exemption from CPO registration.66
Prior to the rule changes, other funds had taken a
view, consistent with the CFTC’s position, that commodity subsidiaries are separate legal entities, and
their subsidiaries previously relied upon a separate
exemption from CPO registration under CFTC Rule
4.13(a)(4). However, as part of its final rulemaking,
the CFTC rescinded the Rule 4.13(a)(4) exemption.67
As a result, under the amended rules, the investment
advisers to commodities subsidiaries likely will need
to be registered unless they can fit within another
exemption from registration.
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
Separately, it is important to mention that, at this
time, CLNs appear to continue to fall outside of the
scope of commodity-related derivatives subject to
CFTC regulation, even after the changes made by
the Dodd-Frank Wall Street Reform and Consumer
Protection Act (“Dodd-Frank”),68 and thus a RIC solely
using CLNs to obtain its commodity market exposure
should be able to continue to rely on the Rule 4.5
exemption to avoid CFTC regulation.69
F. Current State of Play
While the industry awaits further regulatory or legislative action concerning the Qualifying Income issues,
investment advisers looking to set up funds with CLN
and/or commodity subsidiary investments have faced
the question of whether to (1) proceed in the absence
of a PLR, including relying instead on opinions of
counsel at a level of confidence sufficient to satisfy a
fund’s accountants and board, (2) proceed using other
(potentially less attractive or less efficient) forms of
commodity-linked investments, or (3) delay the offering of such funds until the IRS and/or Congress acts.
Further, it bears mention that, as was the case even
prior to the pause, advisers seeking to use commodity
subsidiary structures in their funds can continue to
implement such structures without a need for a PLR
or an opinion of counsel provided the subsidiary
distributes the subpart F income from the subsidiary
to the RIC annually, as discussed above. However,
as noted above, in light of Senator Levin’s concerns
regarding whether a RIC’s commodity subsidiary can
be said to have a separate and legitimate corporate
existence, RICs should take care—now more than
ever—to operate their commodity subsidiaries in a
manner that respects the separate corporate existence
of the subsidiaries. Finally, as discussed above, advisers also now need to consider the effect of the CFTC
rule revisions on a registered fund’s commodityrelated investment strategy and operations.
III. Summary of Current
Forms of Commodity-Linked
Investments: Alternatives
to CLNs and Commodity
Subsidiaries
A. Summary of Alternatives
In light of these recent events, RICs have been exploring other means of obtaining affirmative commodity
51
Regulated Investment Companies and Commodity-Linked Instruments
market exposure. The chart attached hereto as Appendix A provides a very general summary of the
principal alternative commodity-linked investments
available to RICs seeking affirmative exposure to
the commodities markets—that is, in ways that can
generate Qualifying Income for a RIC.70 The chart
in Appendix A provides a brief description of the
Qualifying Income and other important related tax
considerations applicable to such investments. Each
such investment brings its own unique set of advantages and disadvantages, with some providing more
direct and efficient exposure to commodity markets
than others.71
B. Background on QPTPs
Some of the commodity-linked investments listed
in the chart are QPTPs. As discussed below, in this
current climate, QPTPs provide an important advantage for RICs seeking commodity exposure over
CLNs, commodity subsidiaries and some of the other
investments listed in the chart in that it is clear that
net income on QPTPs is Qualifying Income. In view
of the complexities surrounding what it means for
an investment to have QPTP status, the following
provides a brief summary of what QPTPs are and
what QPTP status can mean for entities in which
RICs
R
RI
ICs
C invest.
nvest.
The
flush
of Code Sec. 851(b) provides a
T
hee flus
sh language
an
general rule for
fo
or partnerships
partn
nerships and
and trusts
tru in which a RIC
invests, stating that income derived from a partnership (other than a QPTP) or trust shall be treated as
Qualifying Income only to the extent such income
is attributable to items of income of the partnership
or trust which would be Qualifying Income if realized directly by the RIC. Therefore, a RIC must look
through its equity interest in a non-QPTP partnership
to the partnership’s underlying income/gains for purposes of the RIC meeting the Qualifying Income Test.
In 2004,72 Congress amended Code Sec. 851(b)(2)
to provide more favorable treatment to entities that
qualify as QPTPs, making this general look through
inapplicable to QPTPs and instead providing that
net—not gross—income from interests in QPTPs is
Qualifying Income.
QPTPs are “publicly traded partnerships” (PTPs)
under Code Sec. 7704 that are eligible to be treated
as partnerships (instead of corporations) for U.S.
federal tax purposes.73 In general, PTPs are treated
as corporations for U.S. federal income tax purposes
unless they can meet the passive (qualifying) income
exception in Code Sec. 7704(c).74 Specifically, un-
52
der Code Sec. 7704(c), a PTP will not be taxable as
a corporation in a year if at least 90 percent of its
gross income for such year consists of the qualifying
income sources enumerated in Code Sec. 7704(d).75
The qualifying income definition under Code Sec.
7704(d) relating to PTPs is broader than the RIC
Qualifying Income definition in Code Sec. 851(b)(2).
Very generally, unlike the RIC definition, the PTP definition includes, among other things, certain passive
and active commodity-related income—specifically,
(1) income and gain from commodities and commodity options, futures and forwards to the extent a
principal activity of the partnership is the buying and
selling of commodities or commodity options, futures
or forwards, and (2) income and gain derived from
certain active operations, including the exploration,
development, mining or production, processing, refining, transportation or the marketing of a mineral or
natural resource.76 In general, in order to be a QPTP
(and not just a PTP that is treated is a partnership) in
a particular year, an entity must meet the qualifying
income test under Code Sec. 7704(c), but must fail
the RIC Qualifying Income Test for such year.77
Congress enacted the QPTP provision in order to
provide those entities—that closely resemble corporations in many respects—with improved access to
capital markets by permitting RICs to invest in those
entities.78 Without this legislative change, RICs would
not be able to invest in these entities in any significant
measure, since, as described above, gross income
from a regular partnership is treated as if earned
directly by the RIC under the Qualifying Income
Test and these partnerships generate non-Qualifying
Income for a RIC.79 Notably, this legislative change
opened the door for RICs to obtain both passive and
active exposure to the commodity markets pursuant
to an express provision in the Qualifying Income statute, and thus QPTP investments provide an important
advantage over CLNs, commodity subsidiaries and
some of the other commodity-linked investments
discussed in the chart. As described in the chart
in Appendix A, QPTP investments currently take a
few different forms, including commodity-linked
exchange-traded funds, which invest significantly in
commodity futures and/or other commodity-linked
derivatives, and so-called “master limited partnerships,” which are PTPs engaged in certain energy- or
natural-resource-related operations.
Congress did limit this QPTP benefit for RICs—
namely, in expanding the Qualifying Income Test
to include QPTPs, Congress made corresponding
Volume 10 Issue 3 2012
changes to the RIC asset diversifi cation test in
Code Sec. 851(b)(3) generally to restrict a RIC’s
investments in (all) QPTPs to no more than 25
percent of its total assets and in a single QPTP to
10 percent of the equity securities of such QPTP.80
Finally, another drawback of an investment in a
QPTP entity is that, similar to a RIC, it must annually qualify as a QPTP in order for 100 percent
of its net income to constitute Qualifying Income
for the RIC, although the RIC qualification-related
risks to the RIC of such failure generally should be
fairly small.81
ENDNOTES
* The author would like to thank her colleagues, Susan Johnston, Elizabeth Reza
and Susan Wilker, for their assistance with
drafting this article. An earlier version of
this article was prepared and distributed in
connection with Amy’s participation in a
regulated investment company panel at the
Practising Law Institute’s Taxation of Financial Products and Transactions Program held
on January 17, 2012, in New York, NY.
1
See Part II in this article for a discussion
of recent government scrutiny of RICs and
commodities investments.
2
The asset diversification test under Code
Sec. 851(b)(3) is the other RIC qualification
requirement that can limit a RIC’s investment
in certain commodity-related instruments.
Very generally, the RIC asset diversification
test requires a RIC to diversify its holdings
so that, at the end of each quarter of its tax
year, (1) at least 50 percent of the market
value of the RIC’s total assets consist of cash
aand
an
nd
d cash items, U.S. government securities,
ssecurities
se
ecu
u ies of o
other
othe RICs, and other securitties
tie
iees limited
im
mited in res
respect of any one issuer to
a value not greater
grreaate
er than
than fi
fiv
ve
ve percent
percent of
of thee
value of the RIC’s total assets and not more
than 10 percent of the outstanding voting
securities of such issuer, and (2) not more
than 25 percent of the value of the RIC’s
total assets is invested (a) in the securities
(other than those of the U.S. government
or another RIC) of any one issuer or two or
more issuers that the RIC controls and that
are engaged in the same, similar or related
trades or businesses, or (b) in the securities
of one or more QPTPs (as defined below).
See Code Sec. 851(b)(3).
3
Sec. 2(a)(36) of the 1940 Act currently defines a “security” 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
4
5
6
7
8
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.
The U.S. Department of the Treasury (the
“Treasury”) has the authority to issue regulations that deny Qualifying Income treatment
to foreign currency gains that are not directly
related to a RIC’s principal business of investing in stocks and securities. The Treasury
has not exercised this authority to date, nor is
it likely that the Treasury will seek to exercise
such authority, in particular with retroactive
effect. See Code Sec. 851(b) (flush language
at end); see also note 7 infra for a discussion of a recent (unsuccessful) proposal to
remove this provision from the statute.
P.L. 111-325 (2010), § 201(b) (adding Code
Sec. 851(i)).
See Code Sec. 851(i). Previously, if a RIC
failed to comply with the Qualifying Income
Test by even just $1 at the end of a tax year, it
would have failed to qualify as a RIC for that
year, and thus would have been subject to
an entity-level (35-percent) federal income
tax on its income and gains for such year.
An earlier version of the RIC Modernization
Act introduced in Congress had proposed
to expand the list of Qualifying Income to
include income and gains on commodities
as well as other income derived in connection with a RIC’s business of investing
in commodities. In connection with this
expansion, the bill proposed to remove
Treasury’s current authority in Code Sec.
851(b) to eliminate from the list of Qualifying Income any foreign currency gains not
directly related to a RIC’s principal business
of investing in securities. See note 4 supra
for a discussion of the current statutory
provision; H.R. 4337 (111th Cong.), § 201(a)
(as passed by the House on Sept. 28, 2010)
for the proposed commodity expansion. As
discussed in Part II(A) of this article, these
provisions were removed from the bill prior
to its ultimate passage.
Rev. Rul. 2006-1, 2006-1 CB 261 (Dec. 16,
2005), as modified and clarified by Rev. Rul.
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
9
10
11
12
2006-31, 2006-1 CB 1133 (June 2, 2006).
As discussed below in note 13 infra, RICs
have some ability to invest in commoditylinked instruments that are not 1940 Act
securities provided they can demonstrate
that such investments are made in connection with their business of investing in
securities.
P.L. 99-514 (1986).
The IRS’s reasoning in this regard has been
criticized by practitioners who argue that
the Code Sec. 851(b)(2) unqualified and
unambiguous cross reference to the definition of security under the 1940 Act should
be respected on its face, even in the face of
uncertainty as to a particular instrument’s
status under the 1940 Act. Instead, in the
ruling, the IRS effectively created a different
test, analyzing whether an instrument is a
security “for purposes of Section 851(b)(2)”
in view of its understanding of Congressional
intent in revising the Qualifying Income Test
in 1986. See SUSAN A. JOHNSTON, TAXATION
OF REGULATED INVESTMENT COMPANIES AND THEIR
SHAREHOLDERS, ¶¶ 2.06[3][d][iii]-[iv] (2d
ed. 2011); James R. Brown, Jr., CommodityLinked Instruments and the Proper Scope of
Mutual Fund Taxation, 112 TAX NOTES 505
(Aug. 7, 2006). For a detailed discussion of
the IRS’s analysis in the ruling, see Brown,
supra; Stevie D. Conlon, IRS Ruling Severely
Restricts fund Investments in Commodity
Linked Derivatives, 23 J. TAX’N INV. 202
(2006); Robert Willens, Commodity Futures:
Off Limits for RICs, 112 TAX NOTES 63 (July
3, 2006).
The ruling specifically references options,
futures and forward contracts on commodities and commodity indices. But see
Thomas Beard, SEC No-Action Letter, Fed.
Sec. L. Rep. (CCH) ¶81,141 (Apr. 8, 1975);
CoinVest, Inc., SEC No-Action Letter, CCH
19740610011 (Jun. 10, 1974) (Securities and
Exchange Commission (SEC) staff expressing
view that options on commodities, including
on coins/metals, are 1940 Act securities).
Rev. Rul. 2006-31 extended the effective
date from July 1, 2006, to October 1, 2006,
in light of certain temporary supply/demand
imbalances in the markets. Specifically,
the ruling noted that some RICs that had
previously invested in derivatives contracts
similar to those covered in Rev. Rul. 2006-1
were having difficulty acquiring alternative
(Qualifying Income generating) commodity-
53
Regulated Investment Companies and Commodity-Linked Instruments
13
14
linked investments (e.g., commodity-linked
structured notes) prior to the July 1, 2006,
deadline.
In Rev. Rul. 2006-1, the IRS recognized that
income derived by a RIC from commoditylinked derivatives that are not 1940 Act
securities can be treated as Other Income if
the RIC enters into the contract (1) in order
to reduce or hedge the level of risk in a business of investing in stock, securities, or currencies, or (2) otherwise in connection with
a business of investing in stock, securities or
currencies. Therefore, even if not a 1940-Act
security, a commodity or commodity-related
derivative can nevertheless generate Qualifying Income under the Other Income provision provided the RIC can demonstrate a
sufficiently close relationship with the RIC’s
business of investing in stock, securities or
foreign currencies. In particular, on several
occasions, the IRS, in a series of private letter rulings (PLRs), has found a sufficiently
close nexus in cases where a RIC’s use of
commodity-linked instruments was to hedge
or reduce the risk of the RIC’s investment
in instruments that clearly were 1940-Act
securities. See, e.g., PLRs 200440012 (May
17, 2004) (gains derived from option and
futures contracts on gold that were entered
into in order to reduce a RIC’s risk exposure
inherent in holding long-term positions in
gold-related securities constituted Other
Income); 200652013 (Sept. 21, 2006), as
supplemented by 200916016 (Dec. 11,
2008)
200
2
20
00
08 (gains
(gains derived
der
from swap and option
t on
tio
n contracts
c o ra s on
o commodities used to
hedge
h d price
p ce exposure
xp
inherent
in
in certain
e
production
tion p
payment
aym
yment lo
loans
oa
ans m
made
de
e by
y the
e
RIC was Other Income; loans were ruled
securities); 201103036 (Sept. 22, 2010)
and 201106006 (Oct. 28, 2010) (income
generated on inflation-linked swaps and
related derivatives ruled Other Income;
instruments were used to manage, on a
portfolio-wide basis, effects of inflation on
values of securities within RICs’ portfolios).
For an examination of these recent PLRs,
see JOHNSTON, supra note 11, at ¶¶ 2.06[3]
[d],[f]; William P. Zimmerman and Shawn
K. Baker, Two Recent Private Letter Rulings
Provide a Rationale for Determining When
Certain Derivative Contracts Will be Considered Securities under Code Sect. 851(b)(2)
and Will Produce Qualifying Income for a
Regulated Investment Company, J. TAX’N FIN.
PRODUCTS, VOL. 9 NO. 3, at 51 (2011).
Another reason prompting RICs to request
PLRs from the IRS concerning the Qualifying Income status of these investments was
the issuance in June 2006 of accounting
guidance concerning the accounting and
disclosure of uncertain tax positions under U.S. generally accepted accounting
principles—namely, Financial Accounting
Standards Board (FASB) Interpretation No.
48, “Accounting for Uncertainty in Income
54
15
16
17
18
Taxes” (commonly referred to as “FIN 48”).
Very generally, FIN 48 sets forth a minimum
threshold (“more likely than not”) for the
financial statement recognition of tax positions taken based on the technical merits
of such positions. RICs were required to
comply with FIN 48’s standards for fiscal
years beginning after December 15, 2006.
As a result of the codification of accounting
standards in 2009, FIN 48 is now referred to
as FASB Accounting Standards Codification
(ASC) 740-10.
PLRs do not have the same precedential
force as revenue rulings, because under
Code Sec. 6110(k)(3), only the party to
whom a PLR is issued is permitted to rely
on it. Nevertheless, at least prior to the IRS’s
“pause” in July 2011, the CLN and commodity subsidiary rulings were instructive
regarding the IRS’s thinking in respect of
these instruments, including informally
providing those RICs without PLRs, as well
as practitioners providing advice in this area,
with some comfort that the IRS would not
challenge an investment that was the same
as, or substantially similar to, ones covered
in the PLRs. See Part II.C infra for a discussion of the IRS’s pause.
See, e.g., PLRs 201135001 (Sept. 2, 2011),
201131001 (Aug. 5, 2011), 201113015
(Apr. 1, 2011), 201108018 (Feb. 25, 2011),
201108003 (Feb. 25, 2011), 201107012
(Feb. 18, 2011), 201103033 (Jan. 21, 2011),
200946036 (Jul. 29, 2009), 200831019 (Apr.
18, 2008), 200822012 (Feb. 12, 2008),
200745008 (Aug. 2, 2007), 200745021
(Jun. 20, 2007), 200726026 (Mar. 16, 2007),
200720011 (Feb. 2, 2007), 200705026 (Oct.
31, 2006), 200647017 (Aug. 10, 2006),
200637018 (Jun. 1, 2006), 200628001 (Apr.
10, 2006).
The presence of debt-like features can help
to bolster the Qualifying Income/1940 Act
securities analysis. However, more generally, it is currently unclear whether certain
structured notes, including CLNs, should be
treated as prepaid forward contracts, debt
or something else for U.S. federal income
tax purposes. See notes 3 and 4 in the accompanying chart in Appendix A for more
discussion of this issue.
Although unclear, to the extent a CLN were
deemed to be debt for tax purposes, the
interest income paid thereon would generate Qualifying Income since “interest” is
an express source of Qualifying Income.
Nevertheless, any gains or other income
recognized on CLNs would only expressly
be Qualifying Income if it were a 1940 Act
security and/or one could otherwise rely on
the Other Income provision. Although in
most instances an instrument that is debt for
tax purposes also will constitute a security
under the 1940 Act (e.g., as “debt” or “evidence of indebtedness” in Sec. 2(a)(36) of
the 1940 Act), this is not necessarily the case
19
20
21
22
as the question of whether something is a
1940 Act security ultimately should depend
on SEC and judicial interpretations of the
definitions of security under the 1940 Act
(and by analogy the other securities laws)
and not on their treatment for tax purposes.
See note 22 infra for a discussion of various
SEC no-action letters where the SEC staff
concluded that various notes were 1940 Act
securities.
CEA Sec. 1A(29) (defining “hybrid instrument”); Sec. 1A(41) (defining “security”).
On March 19, 2012, Senator Carl Levin
(D-MI) sent the SEC a letter requesting that
it expand its review of registered funds’
use of derivatives to all commodity-related
instruments, including commodity-related
exchange-traded products, CLNs and
similar vehicles, asking the SEC to consult
and coordinate with the CFTC concerning
these instruments, and expressing the view
that they should be subject to joint CFTCSEC oversight. See Letter from Senator
Levin to Ms. Elizabeth Murphy, Secretary,
SEC, regarding “Concept Release on Use
of Derivatives by Investment Companies
Release No. IC 29776,” dated March 19,
2012, available at www.sec.gov/comments/
s7-33-11/s73311-54.pdf (last visited on May
13, 2012) (“Levin Letter to SEC”). See Part
II(D) of this article for further discussion of
Senator Levin’s examination of registered
funds in the commodity markets.
The four conditions are:
(1) the issuer of the hybrid instrument
receives payment in full of the purchase
price of the hybrid instrument, substantially
contemporaneously with delivery of the
hybrid instrument;
(2) the purchaser or holder of the hybrid
instrument is not required to make any
payment to the issuer in addition to the
purchase price paid under (i), whether as
margin, settlement payment, or otherwise,
during the life of the hybrid instrument or
at maturity;
(3) the issuer of the hybrid instrument is
not subject by the terms of the instrument
to mark-to-market margining requirements;
and
(4) the hybrid instrument is not marketed
as a contract of sale of a commodity for
future delivery (or option on such a contract)
subject to the CEA. See CEA Sec. 2(f)(2).
As noted above, in order to be a hybrid
instrument, a CLN must be a security under
the 1933 Act or 1934 Act and is then “predominantly a security” if it is able to meet
the four requirements set forth in the CEA
(see note 21 supra). In order for the four
“predominantly a security” representations
to have relevance, the IRS presumably must
have first concluded that CLNs are securities
under the 1933 and/or 1934 Acts. The link
to the 1940 Act security status is less clear
in the PLRs, but it bears mention that the
Volume 10 Issue 3 2012
23
SEC has historically interpreted the 1940 Act
definition of security more broadly than the
definitions under the 1933 and 1934 Acts,
in particular in light of the policy goals of
the 1940 Act. See Sec. 1 of 1940 Act (listing policy goals of 1940 Act); see also, e.g.,
GINS Capital Corp., SEC No-Action Letter
(Sep. 16, 1985) (concluding that, in its view,
promissory notes held by a financial institution as evidence of loans are securities for
purposes of the 1940 Act, even though they
may not be so for purposes of the 1933 Act
or the 1934 Act); Education Loan Marketing Association, Inc., SEC No-Action Letter
(Mar. 6, 1986) (citing GINS Capital Corp.,
SEC No-Action Letter, above, in support of
concluding that promissory notes secured
by revenue from repayment of student loans
are securities for purposes of the 1940 Act,
even though they may not be securities for
purposes of the 1933 Act and the 1934 Act);
Harrell International, Inc., SEC No-Action
Letter (May 24, 1989) (concluding that “tailor made” notes secured by assets provided
by the holder of the notes to the issuer of
the notes are securities under the 1940 Act,
even though such notes may not be securities for purposes of the 1933 Act and 1934
Act). Accord Bank of America Canada, SEC
No-Action Letter (July 25, 1983) (noting
that a determination that a note evidencing
a commercial transaction is not a security
under the 1933 Act and the 1934 Act is
not applicable in determining whether a
p
person
eersso eng
engaged
gageed in the business of investing
in ssuch
u h no
uc
notes
otes is in
investing in “securities” in
tthe
h context
xt of
o a determination
mi
of whether
e
the person
o is an in
investment
nvees me
ent co
company
om an
ny u
under
nd
der
the 1940 Act). See also ROBERT H. ROSENBLUM,
INVESTMENT COMPANY DETERMINATION UNDER THE
1940 ACT – EXEMPTIONS AND EXCEPTIONS 31-32
(2003) 31-32 (noting that presumably any
instrument that is a security under the 1933
Act and 1934 Act also is a security under
the 1940 Act, and even if an instrument is
not a security under the 1933 Act and 1934
Act, it still may be regarded as a security for
purposes of the 1940 Act).
Very generally, a CFC is a foreign corporation that is more than 50 percent owned
by United States shareholders, and United
States shareholders are U.S. persons that
own 10 percent or more of the foreign
corporation. If a RIC, which is a domestic
corporation and thus U.S. person for U.S.
federal income tax purposes, owns 100
percent of the commodity subsidiary, then
the commodity subsidiary would be a CFC.
See Code Secs. 951(b), 957. United States
shareholders of CFCs are subject to special
anti-deferral rules under Code Secs. 951 et
seq. (so-called “subpart F”), as discussed below, requiring them, among other things, to
include annually in their income all income/
gains of the CFC in which they invest. See
Code Sec. 951.
24
In some cases, if a RIC invests in a subsidiary that is owned by other investors, the
commodity subsidiary may be a “passive
foreign investment company” (PFIC) instead
of a CFC to that RIC (e.g., because it owns
less than 10 percent of the subsidiary) and
thus subject to the special anti-deferral rules
under Code Secs. 1291 et seq. A foreign
corporation may be a PFIC if, among other
things, 75 percent or more of its annual
gross income is from certain passive sources
(including certain commodities transactions)
(see Code Sec.1297(a)). To avoid the imposition of special PFIC-related taxes (and interest charges) in respect of certain distributions
received from the PFIC, the RIC must either
make a “mark-to-market” election (Code
Sec. 1296) or a “qualified electing fund”
(QEF) election (Code Sec. 1295) in respect
of its PFIC investment. If a RIC makes a
QEF election in respect of the commodity
subsidiary, it will be required to include in
its income its share of the PFIC’s income
and gains annually, regardless of whether
it receives any distribution from the PFIC
during the year (so-called “QEF inclusions”).
See Code Sec. 1293(a). QEF inclusions in
respect of a commodity subsidiary that is
a PFIC give rise to the same Qualifying Income issue as subpart F income in respect of
commodity subsidiary that is a CFC. Similar
to the treatment of subpart F income inclusions described herein, the flush language
in Code Sec. 851(b) treats QEF inclusions
that are currently distributed as dividends
for Qualifying Income purposes, leaving
open the question of whether undistributed
QEF inclusions are Qualifying Income. The
IRS has issued PLRs similarly ruling that QEF
inclusions from commodity subsidiaries are
Other Income derived from a RIC’s business
of investing in the stock of the subsidiary,
regardless of whether such inclusions are
currently distributed to the RIC. See, e.g.,
PLRs 201039002 (Oct. 1, 2010), 200946036
(Nov. 13, 2009), 200743005 (Oct. 26,
2007). For a more complete discussion of
the Qualifying Income question in respect
of commodity subsidiaries, including the
subpart F and QEF inclusion provisions, see
JOHNSTON, supra note 11, at ¶2.06[3][g][ii];
Dale S. Collinson, Qualifying Income of a
RIC from Investment in a CFC, 114 TAX NOTES
673 (Feb. 12, 2007).
In granting PLRs in this area, the IRS generally has required each RIC to represent that,
although its subsidiary will not be registered
as an investment company under the 1940
Act, it will comply with the requirements
of Sec. 18(f) of the 1940 Act, 1940 Act Release No. 10666, and related SEC guidance
pertaining to asset coverage with respect to
derivative transactions. Thus, the IRS has
required, as a condition to receiving a PLR,
that a subsidiary collateralize its derivatives
positions (e.g., by holding its own fixed
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
25
26
27
28
29
income securities). As discussed below, this
also helps to support the treatment of the
subsidiary as an entity that has a separate
and legitimate existence, but any collateral
held at the subsidiary level will increase the
value of the subsidiary for purposes of the
25 percent asset diversification limitation.
The commodity subsidiary is typically
not subject to a corporate-level tax in the
United States in reliance on the exceptions
in Code Sec. 864(b) for trading in securities or commodities and related Treasury
regulations. See Code Secs. 864(b)(2)(A)(B); Reg. §1.864-2(c)-(d); see also Proposed
Reg. §1.864(b)-1 (June 1998) (proposing
to expand the securities and commodities
trading safe harbors to include derivatives
trading). Commodities subsidiaries are
typically organized in the Cayman Islands
or other non-U.S. jurisdictions where they
also will not be subject to local taxes.
See Code Sec. 951(a)(1)(A)(i); see also Code
Secs. 952, 954 (defining subpart F income).
Typically, the RIC and its commodity subsidiary have the same tax year end.
See Code Secs. 959(a)(1), (d); Notice 200470, 2004-2 CB 724 (Oct. 8, 2004), Sec.
4.02 (stating IRS view that subpart F income
inclusions are not dividends under current
Code Sec. 951(a)(1) nor related Treasury
regulations); Osvaldo Rodriquez et ux. 137
TC No. 14 (Dec. 7, 2011) (concluding that
income inclusions under Code Sec. 951(a)
(1)(B) are not dividends absent an express
provision in the Code or Treasury regulations
providing otherwise, and expressing agreement with Notice 2004-70).
As noted in clause 1 of the Qualifying Income Test in Part I(A) above, dividends are
specifically listed as Qualifying Income of a
RIC. See Code Sec. 851(b) (flush language)
(“For purposes of paragraph (2), there shall
be treated as dividends amounts included in
gross income under section 951(a)(1)(A)(i)
or 1293(a) for the taxable year to the extent
that, under section 959(a)(1) or 1293(c) (as
the case may be), there is a distribution out
of the earnings and profits of the taxable
year which are attributable to the amounts
so included”).
See, e.g., PLRs 201134014 (Aug. 26,
2011), 201132008 (Aug. 12, 1011),
201131001 (Aug. 5, 2011), 201129002
(July 22, 2011), 201128022 (July 15, 2011),
201122012 (June 3, 2011), 201120017 (May
20, 2011), 201116014 (Apr. 22, 2011),
201108008 (Feb. 25, 2011), 201107012
(Jan. 18, 2011), 201031007 (Apr. 13, 2010),
201026017 (Mar. 3, 2010), 201025031 (Feb.
23, 2010), 201024005 and 201024002
(Feb. 5, 2010), 201024004 (Feb. 4, 2010),
200947032 (Aug. 13, 2009), 200947026
(Aug. 13, 2009), 200946036 (July 8, 2009),
200932007 (Apr. 29, 2009), 200931003
(Apr. 16, 2009), 200922010 (Feb. 19, 2009),
200923011 (Feb. 18, 2009), 200912003
55
Regulated Investment Companies and Commodity-Linked Instruments
30
31
32
33
34
4
35
36
(Nov. 19, 2008), 200840039 (June 13, 2008),
200822010 (Feb. 12, 2008), 200743005
(July 20, 2007), 200741004 (July 10, 2007),
200647017 (Aug. 10, 2006), 201206015
(June 13, 2006).
See Code Sec. 851(b)(3)(B).
See note 24 supra.
See Code Sec. 7701(o) (codified version of
economic substance doctrine).
Under a “sham corporation” or similar theory, from time to time, courts have ignored
the existence of a corporation as a separate
taxpayer, referring to it as a “sham” (or
similarly “straw,” “dummy,” or “conduit”).”
See, e.g., Kanter Est., CA-7, 337 F3d 833
(2003); Aiken Industries, Inc., 56 TC 925,
Dec. 30,912 (1971); Aldon Homes, Inc.,
33 TC 582, Dec. 23,902 (1959). In general,
however, the courts have followed the principles articulated in Moline Properties, Inc.:
“Whether the purpose [of incorporating]
be to gain an advantage under the law of
the state of incorporation or to avoid or to
comply with the demands of creditors or to
serve the creator’s personal or undisclosed
convenience, so long as that purpose is the
equivalent of business activity or is followed
by the carrying on of business by the corporation, the corporation remains a separate
taxable entity.” See BITTKER & EUSTICE, FEDERAL
INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS,¶ 1.05[1][b], at n. 48 (7th ed. 2006
& Supp. 2012-1), citing Moline Properties,
SCt, 43-1 USTC ¶9464, 319 US 436, 438-39
(1943).
( 94
(1
4
Code
C
Co
od
dee Sec
Sec. 269 (relating
(r
to acquisitions of
corporations
ns m
made
a to evade
vad or avoid
id income
c
tax). For a more ccomplete
omp ete discuss
discussion
on
no
off tthese
he
ese
e
issues, see David H. Shapiro and Jeffrey W.
Maddrey, IRS Implicitly Rules on Economic
Substance Doctrine and Blockers, 130 TAX
NOTES 1461 (Mar. 21, 2011); see also JOHNSTON, supra note 11, at ¶ 2.06[5][b][ii], n.
524.
See, e.g., Jeremiah Coder, Senators Grill Top
Tax Officials on Mutual Fund Commodity Investments, 2012 TNT 18-1 (Jan. 27, 2012).
As noted above, Congress and the IRS have
sanctioned similar blocker-type structures
in the past, in particular the use of CFCs by
tax-exempt entities to avoid UBTI. See, e.g.,
Code Sec. 512(b)(17) (specifically prohibiting the use of CFCs by tax exempts to avoid
UBTI but only in respect of one type of
income—income from certain third-party
insurance activities earned by a CFC owned
by a tax exempt); COMREP ¶ 5121.001,
“Treatment of dues paid to agricultural and
horticultural organizations,” (Small Business
Job Protection Act of 1996, PL 104-188,
Aug. 20, 1996) (RIA) (discussing reason for
enacting Code Sec. 512(b)(17), discussing
favorably earlier IRS rulings concluding that
subpart F inclusions are dividends and thus
not UBTI, and disagreeing with one PLR
that had applied a look-through approach in
56
37
characterizing subpart F inclusions for UBTI
purposes); PLRs 200315035 (Jan. 14, 2003)
and 199952086 (Sept. 30, 1999) (ruling that
debt-financed income earned indirectly by
charitable remainder trusts through CFCs
that, in turn, owned partnership interests
does not result in UBTI for trusts; partnerships were engaged in activities that generated debt-financed income; IRS rulings rely,
in part, on fact that Congress has explicitly
dealt with foreign blockers in Code Sec.
512(b)(17) but for only insurance income).
Further, the codification of the economic
substance doctrine in 2010 (codified at Code
Sec. 7701(o)) should not adversely affect the
ability of a tax-exempt or RIC to use offshore
corporations to block the attribution of UBTI
or non-Qualifying Income. See Code Sec.
7701(o) (“In the case of any transaction to
which the economic substance doctrine is
relevant, such transaction shall be treated as
having economic substance only if (A) the
transaction changes in a meaningful way
... the taxpayer’s economic position, and
(B) the taxpayer has a substantial purpose
(apart from the Federal income tax effects)
for entering into such transaction.”) (emphasis added); Joint Committee on Taxation,
“Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as
amended, in combination with the ‘Patient
Protection and Affordable Care Act’” (JCX18-10), at 152 (Mar. 21, 2010) (“The provision is not intended to alter the tax treatment
of certain basic business transactions that,
under longstanding judicial and administrative practice are respected, merely because
the choice between meaningful economic
alternatives is largely or entirely based on
comparative tax advantages. Among these
basic transactions are ... a U.S. person’s
choice between utilizing a foreign corporation or a domestic corporation to make a
foreign investment.”). For more discussion
of these and other arguments, see Investment Company Institute (“ICI”) Response to
Permanent Subcommittee on Investigations
Hearing on “Compliance with Tax Limits
on Mutual Fund Commodity Speculation,”
dated Jan 26, 2012, available at www.ici.
org/pdf/12_senate_psi_commod.pdf (last
visited on May 13, 2012) (“ICI Response
Letter”); see also Shapiro & Maddrey, supra
note 34.
It may well be difficult for the IRS to challenge generally the fund industry’s use
of commodity subsidiaries under “sham
corporation” or similar principles, although
the IRS certainly could seek to assert such
doctrines against a particular RIC and its
commodity subsidiary to the extent the
subsidiary was operated in a manner that
completely disregarded the subsidiary’s
separate existence. To help mitigate any
such challenge, a RIC’s commodity subsidiary should be organized and operated
38
39
40
41
42
43
as a separate and distinct corporate entity
from the RIC. RICs and their subsidiaries
can take a number of different measures
in this regard, for instance, by having the
subsidiaries enter into their own service
provider agreements (e.g., custody, advisory,
accounting and administrative) and pay their
own fees in connection with the receipt of
such services.
See RIC Modernization Act of 2010, H.R.
4337 (111th Cong.), § 201(a) (introduced
Dec. 16, 2009).
See Sam Goldfarb, House Approves Mutual
Fund and Biofuel Bills, 2010 TNT 188-10
(Sept. 29, 2010).
At least one commodity industry group
submitted a letter to the Senate expressing
concern that the addition of the commodity provision to the Qualifying Income Test
would increase speculation in the commodity markets. See Letter to United States
Senate from Commodity Markets Oversight
Coalition, “Concerns Regarding the RIC
Modernization Act of 2010,” dated Nov. 24,
2010.
See, e.g., Letter from Mr. Keith Lawson,
Senior Counsel—Tax Law, ICI to Mr. Stephen Larson, Associate Chief Counsel, IRS
on “Suspension of Rulings to RICs Seeking
Commodities Exposure,” dated Aug. 18,
2011 (“ICI Ruling Suspension Letter”),
available at www.ici.org/pdf/25425.pdf
(last visited May 14, 2012); Meg Shreve,
House Passes Bill Updating Mutual Fund
Tax Law, 2010 TNT 241-4 (Dec. 16, 2010);
Lee Sheppard, News Analysis: IRS Suspends
RIC Commodities Investments Rulings, 2011
TNT 145-1 (Jul. 28, 2011) (“News Analysis:
IRS Suspension”).
See “Commodity Pool Operators and Commodity Trading Advisors: Amendments to
Compliance Obligations,” CFTC Notice of
Proposed Rulemaking, 76 FR 7976 (Feb.
11, 2011) (“Proposed CFTC Regulations”);
these rules, including as adopted in their
final form in February 2012, are discussed
in more detail in Part II(E) below. See also
CEA Sec. 1A(11) (defining “commodity pool
operator”).
The CFTC claimed that Rule 4.5 and other
exemptive rules under the CEA required
amendment in order “[t]o stop the practice
of registered investment companies offering
futures-only investment products without
Commission oversight.” See Proposed
CFTC Regulations, supra note 42, at 7984.
This proposal was made after the CFTC
consulted with market participants and the
National Futures Association (“NFA”) after
learning about this practice; the NFA, in
turn, submitted a petition for rulemaking to
the CFTC requesting amendments to Rule
4.5. See id., at 7983-84; see also Letter
from Mr. Thomas W. Sexton, III, Senior Vice
President and General Counsel, NFA to Mr.
David Stawick, Office of the Secretariat,
Volume 10 Issue 3 2012
44
45
46
CFTC regarding “Petition for Rulemaking
to Amend CFTC Regulation 4.5,” dated
Aug. 18, 2010 (“NFA Petition”), available
at www.nfa.futures.org/news/newsPetition.
asp?ArticleID=3630 (last visited on May 17,
2012); CFTC Notice regarding NFA Petition,
75 FR 56997 (Sept. 17, 2010). The registered
funds on which the CFTC and NFA focused
included those using so-called “futures
only” or “managed futures” strategies. In
general, these funds seek to provide returns
by investing substantially in a portfolio of
futures or related derivatives on commodities, currencies, and/or securities, including
through the use of a commodity subsidiary.
See NFA Petition; see also, e.g., Marshall
Eckblad, A New ‘Alternative,’ WALL ST. J.
(WSJ.com), Oct. 5, 2011, available at http://
online.wsj.com/article/SB1000142405311
1904006104576503843420587156.html
(last visited May 13, 2012) (discussing considerations for investing in managed futures
funds). The CFTC and NFA also expressed
concern with those funds using commodity
subsidiaries that, in turn, invest in actively
managed commodity pools, including with
the corresponding multiple layers of management and other fees that an investor in
one of these funds can incur. See Transcript
of “CFTC Roundtable to Discuss Proposed
Changes to Registration and Compliance
Regime for Commodity Pool Operators and
Commodity Trading Advisors,” Washington,
D.C. (July 6, 2011), available at www.cftc.
gov/ucm/groups/public/@swaps/documents/
gov/
ov/u
/ m/groups/p
dfsubmission/dfsubmission27_070611dffsu
u b mis sion
n/df
trans.pdf
t
(last
ast visited
i
Mayy 13, 2012)
2 (“CFTC
C
Roundtable
ab e Transcript”).
Traansc
c ipt”) See
Seee Part
P rt II(E)
I (EE) for
for
more discussion of CFTC Rule 4.5.
See CFTC Roundtable Transcript, supra note
43; News Analysis: IRS Suspension, supra
note 41.
See, e.g., News Analysis: IRS Suspension,
supra note 41.
An IRS official very recently stated that
speculation that the CFTC was involved in
or pressured the IRS’s decision was false. See
Joseph Di Sciullo, ABA Meeting: IRS Speakers Track Progress of RIC Guidance Projects,
2012 TNT 93-21 (May 14, 2012) (summarizing statements made by Susan Thompson
Baker, an IRS Branch 2 Senior Technician
Reviewer in the Office of Associate Chief
Counsel (Financial Institutions and Products)
at the May 2012 American Bar Association
Section of Taxation Meeting in Washington,
D.C.). Since the pause, Ms. Baker and other
IRS officials have provided other reasons for
the IRS’s decision, including the failure of
the commodities provision to be included
in the RIC Modernization Act and the high
volume of PLR requests in this area. See,
e.g., id.; ICI Ruling Suspension Letter, supra
note 41; ICI Memorandum to Tax Members
regarding “Status of IRS Reconsideration of
Tax Issues for Funds Investing in Commodi-
47
48
49
50
ties,” dated Oct. 26, 2011 (summarizing
statements made by Mr. Stephen Larson, IRS
Associate Chief Counsel, Financial Institutions and Products, speaking at the October
2011 American Bar Association Section of
Taxation Meeting in Denver, CO) (“Larson
Statements Memo”).
See Larson Statements Memo, supra note
46; Lee A. Sheppard, IRS Will Allow Mutual
Fund Commodities Investments, 2011 TNT
207-1 (Oct. 26, 2011).
According to statements made by Mr. Larson
in October 2011, at that time, the IRS was
not looking to do anything punitive to funds
as it did not believe that the fund industry
has engaged in any abusive behavior concerning CLN and commodity subsidiary
investments. Further, he indicated that, if
any future guidance were to be inconsistent
with the IRS’s existing PLRs in this area,
then any such guidance would provide for
a transition period for RICs. See, e.g., id.;
see also infra note 59 and accompanying
text for more recent statements made by IRS
officials concerning its pause in May 2012,
following the more recent related events
(e.g., as discussed below, the Congressional
hearings concerning RICs and commodityrelated investments).
The hearing was entitled “Excessive Speculation and Compliance with the Dodd-Frank
Act.” For video of the hearing and testimony,
see www.hsgac.senate.gov/subcommittees/
investigations/hearings/excessive-speculation-and-compliance-with-the-dodd-frankact (last visited on May 17, 2012); see also
ICI Memorandum to Various Members
regarding “Mutual Funds A Focus at Senate Hearing on Excessive Speculation in
the Commodity Markets,” dated Nov. 9,
2011; Steven Pearlstein, You bet it’s another
bubble, WASH. POST (Nov. 4, 2011).
See Opening Statements of Senator Carl
Levin from the hearing expressing this view;
but see Opening Statements of Senator Tom
Coburn from the hearing (“[W]e need to be
careful not to accuse investors of wrongdoing when none has occurred. Commodity
index funds, exchange traded funds, and
mutual funds are not diabolical schemes—
they are simply financial instruments that
some investors use as tools to hedge or
gain exposure to commodity markets, thus
protecting against inflation and other risks
in their portfolios.”); see also “Commodity
Markets and Commodity Mutual Funds,” ICI
RESEARCH PERSPECTIVES, Vol. 18, No. 3 (May
2012) (prepared by Christopher L. Plantier)
(asserting, among other things, that the recent increase in commodity prices has not
been driven by mutual fund speculation in
the commodity markets). The PSI prepared
various exhibits for the hearing, including
one that tracked the increase in number of
and assets invested in commodity-related
mutual funds using commodity subsidiaries
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
51
52
53
54
55
56
from 2008 through November 2011 (showing an increase in number of funds from
approximately 12 to 40 funds and in net
assets from approximately $10 billion to $52
billion during that time). See Subcommittee
Exhibits #1c and #7; opening statements,
exhibits of the Subcommittee and the written testimony of the witnesses are available
at www.hsgac.senate.gov/subcommittees/
investigations/hearings/taxation-of-mutualfund-commodity-investments (last visited
on May 13, 2012).
A copy of the letter is available at www.hsgac.senate.gov/download/12-20-11-letterto-irs-from-levin-and-coburn (last visited
on May 17, 2012). Even more recently, in
March 2012, Senator Levin sent the SEC a
letter requesting that it review, as part of
its broader study on the use of derivatives
by registered funds, the use of commodityrelated instruments by registered funds not
only in terms of risk, leverage and diversification issues, but also in terms of whether
they meet the RIC Qualifying Income Test.
The letter also asks the SEC to expand its
review of funds’ use of derivatives to other
commodity-related exchange-traded products, and to consult and coordinate with the
IRS and CFTC concerning these instruments.
See Levin Letter to SEC, supra note 20; Peter
Ortiz, “Senator Pushes for More Derivatives
Restrictions on Funds,” IGNITES.COM (Apr. 4,
2012).
See Coder, supra note 35.
A copy of Senator Levin’s opening statement can be found, and the hearing can be
viewed, at www.hsgac.senate.gov/subcommittees/investigations/hearings/taxation-ofmutual-fund-commodity-investments (last
visited on May 13, 2012). See note 51 supra
for an electronic link to the letter.
The broader debate over the use of offshore
blocker corporations is not new and has
been the subject of Congressional debate,
including proposed legislation as sponsored
or co-sponsored by Senator Levin, from time
to time. See, e.g., Sec. 103 of S. 2075, “Cut
Unjustified Tax Loopholes Act” (introduced
in February 2012); similarly see Sec. 103
of S. 1346, “Stop Tax Haven Abuse Act of
2011” (first introduced in February 2007
as S. 681, reintroduced in revised form in
March 2009 as S. 506, and reintroduced
again with further changes in July 2011 as
S. 1346); summary and text of bill available
at www.levin.senate.gov/newsroom/press/
release/summary-of-the-stop-tax-havenabuse-act-of-2011 (last visited on May 12,
2011).
A copy of the written testimony of IRS
Commissioner Douglas Shulman and Acting Assistant Secretary for Tax Policy Emily
McMahon can be found, and their live testimony can be viewed, at the link cited in
note 53 supra.
As discussed above in respect of commodity
57
Regulated Investment Companies and Commodity-Linked Instruments
57
58
59
60
subsidiaries, as a practical matter, it seems
difficult for the IRS to challenge commodity
subsidiaries or CLNs on an industry-wide
basis under economic substance, “sham
transaction/corporation” or other similar
doctrines considering, inter alia, the number
of PLRs issued in respect of these instruments, the need for a fact-specific inquiry
in seeking to apply these doctrines, and the
potentially broader implications of any such
challenge (e.g., for UBTI blocker corporations, in the case of the subsidiaries, or to
derivative instruments, in the case of CLNs).
See discussion at notes 36 and 37 supra and
accompanying text.
See ICI Response Letter, supra note 36.
Other members of Congress also have
jumped into the debate over whether passive investors, like RICs, in the commodity
markets are fueling excessive speculation,
including formulating various legislative
proposals. See, e.g., Joe Morris, Move in
Congress to Ban Passive Commodity Funds,
IGNITES.COM (Apr. 10, 2012) (reporting that
legislation is being drafted by Sen. Maria
Cantwell (D-WA) that would ban all passive
investors from the commodities markets;
presumably this would include registered
funds).
See Di Sciullo, supra note 46 (summarizing
statements made by Susan Thompson Baker,
an IRS Branch 2 Senior Technician Reviewer
in the Office of Associate Chief Counsel
(Financial Institutions and Products) at the
M y 2012
May
012 American
Americ Bar Association Section
of T
of
Ta
Taxation
axation M
Meeting
eeti in Washington, D.C.).
T
The
h difficulty
ulty for
o the IRS
RS and
a Treasury
su y in
i attempting
g to
o tak
take
kee unilateral
unil teral action
acct on arises
arrisees in
n
light of the fact that Qualifying Income Test
questions concerning registered funds and
commodity-related investments are just one
part of a broader governmental examination,
as discussed above. Further, in the case
of CLNs, the Qualifying Income question
rests on whether or not CLNs are 1940 Act
securities, a question to which the IRS may
well look to the SEC to address.
See “Commodity Pool Operators and Commodity Trading Advisors: Amendments to
Compliance Obligations,” CFTC Final Rule
Release, 77 FR 11252 (Feb. 24, 2012) (“Final
CFTC Regulations”), partially republished
at 77 FR 17328 (Mar. 28, 2012). On April
17, 2012, the ICI and the U.S. Chamber of
Commerce filed a complaint in the U.S.
District Court for the District of Columbia
against the CFTC charging that the CFTC
violated the Administrative Procedure Act
and CEA in enacting the Rule 4.5 changes,
including failing to perform a proper costbenefit analysis. See, e.g., Joe Morris &
Beagan Wilcox Volz, CFTC Suit Follows
Cost-Benefit Playbook, IGNITES.COM (Apr. 18,
2012); Beagan Wilcox Volz, Industry Blasts
SEC-CFTC Regulatory Dissonance, IGNITES.
COM (May 7, 2012).
58
61
62
63
64
65
See 17 C.F.R. § 4.5. The Rule 4.5 exemption,
as amended, provides usage and marketing
restrictions similar to those which had previously been in place until 2003 under a prior
version of Rule 4.5, except that amended
Rule 4.5 applies these restrictions to swaps,
which were not within the definition of
commodity interests in 2003. In 2003,
the CFTC amended Rule 4.5 to eliminate
the prior usage and marketing restrictions
and extend the exemption to all registered
funds, in part, because it believed that the
otherwise regulated nature of registered
funds under the securities laws provided
adequate customer protection. According to
the CFTC/NFA, since these restrictions were
removed from Rule 4.5 in 2003, various
registered funds emerged with “futures only”
or “managed futures” strategies, causing the
agencies to reevaluate the 2003 changes
and again adopt new usage and marketing
restrictions. See NFA Petition, supra note 43;
Proposed CFTC Regulations, supra note 42,
at 7983-84; News Analysis: IRS Suspension,
supra note 41.
Generally, these include limiting (1) the
aggregate initial margin and premiums
required to establish a commodity futures,
option or swap position that is not used for
“bona fide hedging purposes” to five percent
of the liquidation value of the fund’s portfolio, or (2) the aggregate net notional value
of these non-hedging commodity-related
derivative positions to 100 percent of the
liquidation value of the fund’s portfolio.
17 C.F.R. § 4.5(c)(2)(A)-(B). In general, for
purposes of these limitations, a RIC must
take into account any commodity-related
derivative positions it holds through a commodity subsidiary.
A fund claiming exclusion under Rule 4.5
cannot market “participations to the public
as or in a commodity pool or otherwise as or
in a vehicle for trading in” the commodityrelated derivative markets. See 17 C.F.R. §
4.5(c)(2)(iii)(C) (as amended Feb. 24, 2012).
The Final CFTC Regulations’ release provides
a number of factors which the CFTC stated it
would consider in making a determination
as to whether or not a fund complies with
the marketing restriction, including whether
the fund uses a commodity subsidiary. See
Final CFTC Regulations, supra note 60, at
11259.
See Final CFTC Regulations, supra note 60,
at 11259.
The CFTC indicated that advisers to registered funds that cannot claim the exclusion
under amended Rule 4.5 must register no
later than the later of (1) December 31,
2012, or (2) 60 days after the effective
date of final CFTC/SEC rulemaking further
defining the term “swap.” See Final CFTC
Regulations, supra note 60, at 11252. In a
release issued separately on the same day
as the Final CFTC Regulations, the CFTC
66
67
68
69
proposed relief from several of its regulatory
requirements for those fund advisers that
will be required to register as CPOs under
the new rules. The CFTC indicated that this
proposal is intended to address concerns
raised by industry participants that advisers
would be subject to duplicative, inconsistent
and potentially conflicting disclosure and
reporting requirements in having to comply
with both CFTC and SEC rules. See “Harmonization of Compliance Obligations for
Registered Investment Companies Required
to Register as Commodity Pool Operators,”
77 FR 11345 (Feb. 24, 2012). Advisers
required to register as CPOs as a result of
amended Rule 4.5 will not be required to
comply with the CFTC’s recordkeeping,
reporting and disclosure requirements until
60 days after the effectiveness of any such
final harmonization rules. See Final CFTC
Regulations, supra note 60, at 11252.
Final CFTC Regulations, supra note 60, at
11260 (citing CFTC Roundtable Transcript at
165, the CFTC indicated that panelists at the
July 2011 roundtable informed CFTC staff
that some funds had taken this position).
Very generally, former CFTC Rule 4.13(a)(4)
provided an exemption from CPO registration for a pool, such as a commodity subsidiary, where interests in the pool were exempt
from registration under the 1933 Act, such
interests were offered and sold without marketing to the public in the United States, and
each investor in the pool was a “qualified
eligible person” or an “accredited investor.”
Commodity subsidiaries currently operating
under the Rule 4.13(a)(4) exemption have
until December 31, 2012 to comply with the
CFTC rules without relying on Rule 4.13(a)
(4). Newly formed commodity subsidiaries
were not permitted to rely on Rule 4.13(a)
(4) beyond April 24, 2012. See Final CFTC
Regulations, supra note 60, at 11265.
P.L. 111-203 (July 21, 2010).
Commodity-related derivatives subject to
CFTC regulation generally include commodity futures, options on commodities or
commodity futures, and certain swaps, as
described below. CLNs are not commodity futures or options on commodities or
commodity futures. However, Congress’s
enactment of Dodd-Frank creates some
uncertainty regarding whether certain
fi nancial instruments could be subject
to CFTC regulation as swaps. Under
Dodd-Frank, the SEC and CFTC have
split oversight of swaps—the SEC has
jurisdiction over “security-based swaps”
(generally including swaps based on a
single security or a narrow-based security
index), and the CFTC has jurisdiction over
all other “swaps,” including those based
on commodities. See Dodd-Frank Secs.
712(a), 721. The SEC and CFTC have joint
jurisdiction over so-called “mixed swaps”
(generally those swaps having elements
Volume 10 Issue 3 2012
70
71
72
73
74
of both security-based swaps and other
swaps). CLNs appear to fall outside the
statutory definitions of “swap,” “securitybased swap” and “mixed swap” in CEA
Sec. 1a(47)(A) (“swap”), CEA Sec. 1a(47)
(D) & 1934 Act Sec. 3(a)(68)(D) (“mixed
swap”), and 1934 Act Sec. 3(a)(68)(A)
(“security-based swap”), each enacted
as part of Dodd-Frank, as well as the
proposed—but not yet fi nalized—rules
further defining those terms. See, e.g., CEA
Sec. 1a(47)(B)(vii) (excluding from the term
“swap” “any note, bond or evidence of indebtedness that is a security, as defined in
section 2(a)(1)” of the 1933 Act); see also
“Further Definition of ‘Swap,’ ‘SecurityBased Swap,’ and ‘Security-Based Swap
Agreement’; Mixed Swaps; Security-Based
Swap Agreement Recordkeeping,” 76 FR
29818 (May 23, 2011) (joint SEC/CFTC
proposing release). Thus, at this time, it
appears that CLNs continue to be within
the SEC’s, and not CFTC’s, jurisdiction.
It also bears mention that Dodd-Frank
retained the hybrid instrument exception
under the CEA, as discussed above, suggesting that CLNs continue to fall within
that exception. But see Levin Letter to SEC,
supra note 20 (requesting that the SEC
work with the CFTC to consider whether
CLNs, among other instruments, should be
subject to joint SEC/CFTC jurisdiction).
A RIC can invest directly in commodities
or commodity-linked instruments that
ggenerate
ge
ene te non-Qualifying
non-Qua
Income, provided
ssuch
su
uch
h income
income does
doe not exceed 10 percent
off its
i grosss income
in
n o
in each
eac tax year.
yea Doing
D g
so, however,
we er ca
ccan
an be d
diffi
iffficult
cult to
o m
manage
an
nage
e
and control from year to year because
the amount of gains/losses in a given year
depends in part on movements in the commodities and other markets in which the
RIC invests. The savings provision added
by the RIC Modernization Act, as discussed
above, may help to reduce the impact of a
RIC exceeding 10 percent in a given year.
However, it is unclear whether this type of
violation would be considered inadvertent
(i.e., “due to reasonable cause and not willful neglect”) and thus eligible for the savings
provision. See Code Sec. 851(i).
Certain of these other commodity-linked
instruments, in particular commodity-linked
exchange-traded notes and funds, also have
received attention of Senator Levin who believes they too have contributed to excessive
speculation in the commodity markets. See
Levin Letter to SEC, supra note 20.
American Jobs Creation Act of 2004 § 331,
P.L. 108-357 (Oct. 22, 2004).
Generally, a partnership is a PTP if its interests are traded on an established securities
market or are readily tradable on a secondary market (or the substantial equivalent
thereof). See Code Sec. 7704(b).
See Code Sec. 7704(a), (c); see also Code
75
76
77
78
79
Sec. 7704(g) (providing an exception from
the general Code Sec. 7704 rule for certain
grandfathered PTPs.
This passive income exception generally is
not available to 1940 Act registered investment companies. See Code Sec. 7704(c)
(3).
See Code Sec. 7704(d).
Specifically, a QPTP is defined in Code Sec.
851(h) as a PTP described in Code Sec.
7704(b) other than a partnership which
would satisfy the qualifying income requirements of Code Sec. 7704(c)(2) if qualifying
income included only income described in
Code Sec. 851(b)(2)(A).
See COMREP ¶4691.0001, “Net income
from publicly traded partnerships treated as
qualifying income of regulated investment
companies,” (American Jobs Creation Act
of 2004, PL 108-357 (Oct. 22, 2004)) (RIA)
(“2004 Committee Report”).
The addition of net income of a QPTP to
Code Sec. 851(b)(2)’s list of Qualifying
Income does not expressly cover gains
on the sale of QPTP interests. In general,
shares of a QPTP should be securities
under the 1940 Act and thus any gain
on the sale of the shares also should be
Qualifying Income. A similar issue exists
for non-QPTP partnerships because Code
Sec. 851(b)’s general look-through rule for
non-QPTP partnerships also only expressly
covers the character of income allocated
to partners under Code Sec. 702 from a
partnership, and not gain on the sale of
an interest. Hence, it is not entirely clear
under current law whether a RIC should
treat any gain on the sale of a partnership
interest as Qualifying Income provided
such interest is a 1940 Act security (as
it generally should be) or, instead, look
through the partnership interest to the
underlying partnership assets to determine
the proper gain on sale of the interests.
The better view is that gain on the sale of
a partnership interest should be Qualifying
Income provided such interest is a 1940
Act security, although from time to time
the IRS has looked through the partnership
interest to the underlying partnership assets in determining the proper treatment of
gain on the sale of a partnership interest.
See, e.g., Reg. §1.856-3(g) (“where ... a
[real estate investment] trust [(“REIT”)]
sells its interests in a partnership which
owns real property, any gross income
realized from such sale, to the extent it is
attributable to the real property, shall be
deemed gross income from the sale or disposition of real property...”); PLR 9642022
(July 15, 1996) (relying on Reg. §1.856-3(g) to adopt a parallel approach for RICs;
IRS concluded that “the regulation adopts
the aggregate ‘look-through’ approach in
determining how a REIT should account
for its partnership interests for purposes
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
80
81
of all of the income and asset qualification tests under section 856 of the Code”
(emphasis added)). For a more complete
discussion of this issue, see JOHNSTON, supra note 11, at ¶ 2.06[3][g][i]. Notably,
QPTPs present a more compelling case for
not looking through as such an approach
for gains would frustrate the Congressional
intent in adopting the Qualifying Income
rule for QPTP investments.
Code Secs. 851(b)(3)(B)(iii) (as part of the
25-percent diversification test, providing
25-percent limit on securities of one or more
QPTPs); (b)(3)(A)(ii) (as part of the 50-percent
diversification test, providing 10-percent
limit on “outstanding voting securities” of a
single issuer); (c)(5) (defining “outstanding
voting securities” of an issuer to include
equity securities of a QPTP). The legislative
history to the QPTP provisions indicate that
Congress did not intend for RICs to become
conduits through which U.S. tax-exempt
investors and non-U.S. investors could invest
in MLPs and similar entities and avoid UBTI
and “effectively connected income,” respectively, and thus imposed these investment
limitations. See 2004 Committee Report,
supra note 78.
Nevertheless, in some cases, it may be
difficult for a RIC to determine at the time
of its investment in an entity whether that
entity will qualify as a QPTP in the current
or future years. If an entity fails to qualify
as a QPTP in a particular year, such failure
will generally present a RIC qualification
problem for a RIC only where the entity
continues to be treated as a partnership
(instead of becoming a corporation) for tax
purposes. This can occur where an entity
meets both the RIC Qualifying Income Test
and the broader PTP qualifying income
test in the entity’s tax year. In this case,
very generally, any investing RIC would,
for purposes of calculating its compliance
with the RIC Qualifying Income Test for its
tax year, need to take into its income its
allocable share of the gross income of that
entity and such income will only constitute
Qualifying Income to the extent it would
be so qualifying if earned directly by the
RIC under the regular look-through rule for
partnerships discussed above. This would
be problematic for the RIC only where the
aggregate amount of any non-Qualifying
Income allocated to the RIC from the
former QPTP entity and non-Qualifying
Income from other sources totaled more
than 10 percent of the RIC’s gross income.
Importantly, under these circumstances,
the non-Qualifying Income from the former
QPTP entity would be 10 percent or less
of that entity’s gross income and likely a
much smaller percentage of the investing
RIC’s gross income, particularly in light
of the 25-percent and 10-percent QPTP
investment limits discussed above.
59
Regulated Investment Companies and Commodity-Linked Instruments
Appendix A
Alternatives to CLNs and Commodity Subsidiaries:
Summary of Other Commodity-Linked Investments Available to RICs1
Type of Investment
Qualifying Income Analysis
Other Related Tax Considerations
As with CLNs, analytically, this question deMore generally, U.S. federal inpends on whether the ETNs constitute 1940 Act come tax treatment of ETNs (e.g.,
securities and is fact specific.
as a prepaid forward contract or
Brief Description
debt) is not entirely clear.4
ETNs have even stronger position than CLNs
Similar to CLNs,2 except ETNs are publicly offered and traded on U.S. securities that they should be treated as 1940 Act securi- Given relatively limited number
ties because they are “publicly offered” under
exchanges, and typically do not pay or
of counterparties (issuers) in the
the 1933 Act as “securities” and are publicly
accrue interest, do not have a “knock
market, issuer limitations under
traded on major U.S. securities exchanges.
out” provision, and have a longer term
Code Sec. 851(b)(3) limit extent to
(e.g., 15 or 30 years).
which RICs use ETNs.
Nevertheless, even prior to the IRS suspension
of CLN PLRs, the IRS was unwilling to rule on
Also, many ETNs are either unleveraged
the question of whether ETNs generate Qualify(or less leveraged) than CLNs.
ing Income.3
ETNs can offer more liquidity than CLNs
as they are exchange traded.
Some RICs have relied on advice of counsel for
comfort that the specific ETNs in which they
Like CLNs, ETNs create counterparty
invest should generate Qualifying Income.
(issuer) risk for a RIC as payout is contingent on the counterparty’s (issuer’s)
Although any future IRS guidance on CLNs
ability to pay; this risk exposure is over a is unlikely to cover expressly ETNs, given the
longer term for ETNs than CLNs.
similarities between the instruments, it will
potentially bear upon ETN analysis.
A. Commodity-Linked Exchange-Traded
Notes (ETNs)
B. Investments in Commodity-Linked Pooled Investment Vehicles
Exchange-Traded
Exxcch
ch
ha ge-Traded Funds (“ETFs”) investing
futures and other
iin
ng in
i commodities
di
commodity-linked
derivatives
di y-linkked der
vativves5
Brief Description
Typically seek to track the investment returns of a particular commodity or commodity index, minus applicable fees, by
investing in derivatives on such commodity or index, most commonly exchangetraded commodity futures contracts.
May seek short or leveraged exposure to
particular commodity or index.
Given nature of their investments, these ETFs
typically qualify as QPTPs.
Under Qualifying Income Test, 100% of the
net income derived from a QPTP is treated as
Qualifying Income.
In general, shares of an ETF (QPTP) should be
securities under the 1940 Act and thus any gain
on the sale of the shares also should be Qualifying Income.6
Similar to RICs, QPTP status is tested annually
based on an ETF’s gross income; its qualification from year to year will depend on its investment performance.7
Not registered as investment companies
under the 1940 Act, but typically are
commodity pools subject to regulation by Thus, an ETF’s QPTP status should be monithe CFTC.
tored on an ongoing basis.
A RIC will pay advisory and other fees to
ETF adviser and other service providers.
60
Some QPTP issuers provide their QPTP qualifying income status on a monthly basis to their
RIC investors, in order to indicate progress towards QPTP income qualification for the year.
A RIC cannot invest more than
25% of its total assets in one or
more QPTPs or own more than
10% of a single QPTP under the
RIC asset diversification tests in
Code Sec. 851(b)(3).
Investments in entities that are partnerships, and thus provide shareholder tax reporting on a Schedule
K-1, can present operational and
administrative complexities for a
RIC, in particular associated with
the timing of the receipt of Schedule K-1. An investing RIC can have
particular difficulties accurately
and timely calculating its excise
tax distributions and completing
shareholder reports.
A RIC could be required to file
tax returns in one or more of the
states in which the ETF conducts
business.
Volume 10 Issue 3 2012
Type of Investment
Qualifying Income Analysis
Typically RICs generate Qualifying Income,
Commodity-focused open-end (mutual)
and closed-end funds and ETFs registered including on disposition of shares.
under the 1940 Act
The RIC status of a fund should be confirmed
by disclosure documents (e.g., prospectus,
Brief Description
statement of additional information and shareTypically registered as investment
holder reports).
companies under the 1940 Act with a
commodity-focused investment objective/strategy.
Other Related Tax Considerations
As RICs, commodities exposure
of these funds will be more
indirect than other commoditylinked pooled investments and,
depending on the funds’ specific
investments, some will provide
better commodity market exposure than others.
Open-end (mutual) and closed-end
funds gain exposure to commodities
markets through one or more Qualifying Income investments, including those
described herein.
ETFs of this type typically invest primarily
in equity securities of commodity-related
operating companies included in a specified index.
An investing RIC will pay advisory and
other fees to fund adviser and other service
provider; can minimize impact of multiple
layers of fees if RIC is able to invest in
another fund managed by its adviser.
C. Investments in Securities of Commodity-Related Operating Companies
Equity securities in energy, mining, tim- Dividend income and any gain on disposition
ber, agriculture, and other commodity- generally are Qualifying Income.8
related
re
elat operating companies that are
corporations
co
orrp
po atio
ons for U.S. federal income
tax
taax
ax purposes
purposes
Equity securities
i i off operating
i companies
i
may not be as good a proxy for investment in commodities as certain other investments in this chart (e.g., due to other
factors that can affect price like strength
of company management, profitability,
and the extent to which a company
hedges its commodity price exposure).
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
61
Regulated Investment Companies and Commodity-Linked Instruments
Type of Investment
Qualifying Income Analysis
Other Related Tax Considerations
Master Limited Partnerships (MLPs)
MLPs are typically PTPs under Code Sec. 7704
that are eligible to be treated as partnerships,
instead of corporations, for U.S. federal tax purposes in reliance on the PTP qualifying income
exception in Code Sec. 7704(c), requiring at
least 90% of an MLP’s income be derived from
specified sources.
A RIC cannot invest more than
25% of its total assets in securities—both debt and equity—of
one or more QPTPs, or own more
than 10% of a single QPTP under
the RIC asset diversification tests
in Code Sec. 851(b)(3).
Given nature of their investments, MLPs typically qualify as QPTPs.
MLPs are not subject entity-level
tax so they have ability to generate higher cash flows than operating corporations.
Brief Description
A publicly traded company organized
as a limited partnership (LP) or limited
liability company (LLC) which generally
derives income/gain from exploration,
development, mining or production,
gathering, processing, storing, refining,
transportation, distribution or marketing
of mineral or natural resources.
More typically, LPs under state law with
(i) general partners (GPs) that manage the
LPs, own a 2% equity interest in the LPs,
and receive incentive distribution rights
(IDRs) and (ii) limited partners that solely
contribute capital with limited voting
rights and no role in the LPs’ operations
and management.9
Pay periodic (generally quarterly) cash
distributions to unitholders.
MLP equity interests can include LP (or
common) interests, as well as preferred,
convertible subordinated and/or payin-kind interests. Some MLPs also offer
debt securities.10
An MLP’s degree of direct exposure to
commodity
prices varies based on MLP’s
com
co
om
mm
p
activities;
MLPs (e.g., midstream)
ac
ctti
t vii es; some
tiv
som
me M
have
price exposure.11
hav
h
avvee little
li tle commodity
com
mm
Under Qualifying Income Test, 100% of the
net income derived from a QPTP is treated as
Qualifying Income.
In general, shares of an MLP (QPTP) should
be securities under the 1940 Act and thus any
gain on the sale of the shares also should be
Qualifying Income.12
Similar to RICs, QPTP status is tested annually
based on an MLP’s gross income and thus its
QPTP status should be monitored on an ongoing basis.
Because of certain tax features of
MLP activities (e.g., depreciation),
a significant portion of an MLP’s
distributions can be tax deferred,
returns of capital in the hands of
an investing RIC; very generally,
this deferral can continue until the
RIC sells its MLP interest.
A RIC that owns equity interests
in an MLP could be required to
file tax returns and, in some cases,
pay corporate franchise or income
taxes in one or more of the states
in which the MLP operates.
MLPs provide shareholder tax
reporting on a Schedule K-1,
and can present operational and
administrative complexities for a
RIC, in particular associated with
the timing of the receipt of the
Schedules K-1. An investing RIC
can have particular difficulties
accurately and timely calculating
its excise tax distributions and
completing shareholder reports.
A RIC’s service providers may not
be experienced with special tax,
accounting and other issues created by MLPs.
62
Volume 10 Issue 3 2012
Type of Investment
Qualifying Income Analysis
Other Related Tax Considerations
MLP Affiliates
I Shares
I Shares
Brief Description
I Shares
“I shares” represent an indirect investment in an MLP, issued by a corporate
affiliate of the MLP. This MLP affiliate,
in turn, owns “I units,” a special type of
equity security issued by the MLP to that
affiliate. Any distributions made by the
MLP to the affiliate are made in the form
of additional I units.13
Any gain on disposition is Qualifying Income
as gain on the sale of stock of a corporation.
Because the I share issuer is a
regular Subchapter C corporation, the I shares should be not
counted as a security of a QPTP
for purposes of the 25% limitation on securities of one or more
QPTPs or the 10% limitation on
ownership of a single QPTP under
the RIC asset diversification tests
in Code Sec. 851(b)(3).18
The affiliate is typically taxed as a regular Subchapter C corporation for U.S.
federal tax purposes. Generally, because
its I units are not entitled to allocations
of income, gain, loss or deduction of
the underlying MLP until the MLP is
liquidated, it does not have material
amounts of taxable income unless and
until it disposes of the I units or the MLP
is liquidated.14
Distributions by the affiliate to its I
share holders are made in form of additional I shares.
I shares are designed to mirror the performance of the MLP’s direct interests,
but historically, I shares have traded at a
discount
to and are less liquid than their
d
isco
o
15
MLP
M
ML
LP
P unit
nit eequivalent.
quiva
I shares holders receive stock dividends only,
which would generally not be taxable to the
RIC investor under Code Sec. 305(a) and thus
do not implicate the Qualifying Income test.
Other MLP Affiliates
This depends on how the MLP affiliate is
treated for U.S. federal tax purposes.
Many MLP affiliates, in particular parents of
GPs, are taxed as regular Subchapter C corporations and thus any income or gains generated on the equity interests in such entities is
Qualifying Income.
Some MLP affiliates, in particular stand-alone
GPs, are structured similarly to their MLPs as
PTPs that are treated as partnerships in reliance
on the PTP qualifying income exception in
Code Sec. 7704(c).17
Depending on their investments/operations,
these GPs also could qualify as QPTPs, the net
income of which would be Qualifying Income.
Other MLP Affiliates
Unless an MLP affiliate itself is a
QPTP, securities of those affiliates should be not counted as a
security of a QPTP for purposes
of the 25% limitation on securities of one or more QPTPs or the
10% limitation on ownership of a
single QPTP under the RIC asset
diversification tests in Code Sec.
851(b)(3).19
If an MLP affiliate is a regular
Subchapter C corporation, it
will be subject to an entity-level
income tax.
Very limited
mi ed nu
number
umbe o
off I sh
share
hare issuers
exist.16
Other MLP Affiliates
Equity interests in other affiliates of the
MLP, including the GP or parent of the
GP.
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
63
Regulated Investment Companies and Commodity-Linked Instruments
Type of Investment
Qualifying Income Analysis
Other Related Tax Considerations
Open-end (mutual) and closed-end funds
and ETFs registered under the 1940 Act
investing principally in MLPs
Because of the 25% limitation imposed on a
RIC’s investments in MLPs (as QPTPs) as discussed above, these funds frequently are taxed
as regular Subchapter C corporations for U.S.
federal tax purposes, allowing them to invest in
MLPs without such limitation.
For funds that are regular Subchapter C corporations, those
funds are subject to entity-level
taxes, although these funds potentially can receive significantly
tax-deferred, return of capital
distributions from their underlying MLPs (see “MLPs” above);
very generally, this deferral can
continue until the fund sells its
MLP interest.
Brief Description
1940-Act registered investment companies seeking to invest principally in MLPs
and other energy- or natural resourcesrelated investments.
MLP-linked ETFs typically seek to track
investment returns of a particular MLP
index, less applicable fees and taxes, by
investing in interests of MLPs comprising
the index.
Thus, dividend income and any gain on disposition are Qualifying Income.
Some energy/natural resource-focused funds
exist that operate as RICs, although these RICs
necessarily limit their direct investments in
MLP interests to 25% of their total assets.
A RIC will pay advisory and other fees to
fund adviser and other service provider;
can minimize impact of multiple layers
of fees if RIC is able to invest in another
fund managed by its adviser.
Due to this tax deferral, distributions by funds that are Subchapter
C corporations to their investors
tend primarily to constitute returns
of capital.
In contrast, a larger portion of distributions from funds that are RICs
will generally constitute taxable
dividends and not tax-free returns
of capital due to a lower concentration of MLP investments in the
RIC portfolios.
ETFs in this area can have relatively high tracking error to their
underlying index due to fees and
entity-level taxes paid by the ETFs
(as Subchapter C corporations);
indices do not account for taxes
or fees.
MLP-Linked
ked EETNs
TNs
Brief Description
Same basic structure as commoditylinked ETNs with return on the notes
linked to the return of an MLP or an MLP
index, minus applicable fees.
MLP-linked ETNs typically pay periodic
coupons linked to the periodic cash distributions paid on the underlying MLPs.
MLP-Linked Swaps, Options, and other
Derivatives
Brief Description
Derivatives (most commonly options or total return swaps) with returns linked to MLP
securities; some are exchange traded.21
Provide economic exposure to an MLP
without a direct investment in the MLP
itself.
A RIC can have counterparty risk if the
derivative’s payout is contingent on the
counterparty’s ability to pay (currently the
case for over-the-counter derivatives).
64
Similar considerations to those discussed above
for commodity-linked ETNs, although arguably
stronger case for treatment of these MLP-linked
ETNs as 1940 Act securities given that returns
are based on MLP interests that should constitute 1940 Act securities.
Similar considerations to those
discussed above for commoditylinked ETNs.
In addition to tax uncertainty
noted above for commoditylinked ETNs, an additional question arises for MLP-linked ETNs
regarding whether they constitute
constructive ownership transactions under Code Sec. 1260.20
Similar considerations to those discussed above A RIC’s investment in these instrufor MLP-linked ETNs.
ments can be limited by the issuer
limitations under the RIC asset
diversification tests in Code Sec.
851(b)(3).
Similar to MLP-linked ETNs, questions can arise regarding whether
certain of these MLP-linked
derivatives constitute constructive ownership transactions under
Code Sec. 1260.
Volume 10 Issue 3 2012
Type of Investment
Qualifying Income Analysis
Other Related Tax Considerations
Canadian Royalty Companies
Frequently foreign corporations for U.S.
federal tax purposes.25 Thus, dividend income
and any gain on disposition generally are
Qualifying Income.
Canadian royalty companies are
generally now subject to entitylevel taxes on their income at the
combined federal and provincial
corporate tax rates in Canada, regardless of whether such income
is distributed to interest holders.
As a result, these companies are
potentially less profitable, and potentially make fewer distributions
to interest holders, than in past.27
Brief Description
Canadian royalty companies historically
organized as trusts in Canada.22 Due
to recent changes to Canadian tax law
concerning royalty trusts,23 many existing royalty trusts have reorganized as
Canadian corporations within the past
few years.
The principal underlying business of Canadian royalty companies typically is the
exploration, development, production
and/or sale of oil, gas or mineral assets.
There are a limited number of issuers;
interests typically are publicly traded on
Canadian or U.S. exchanges.
It is also possible that a Canadian company
could be a PFIC, depending on the composition of its income and assets in any given
year.26 This is a question of fact and should be
evaluated annually.
A Canadian royalty company that has not
reorganized itself as a corporation under
Canadian law may alternatively be treated as a
partnership, including potentially a QPTP, for
U.S. federal tax purposes (see “MLPs” above for
more information about QPTPs).
Dividends paid to a RIC generally
subject to Canadian withholding
taxes (potentially eligible for the
reduced treaty rate of 15%).
If a regular (non-QPTP) partnership, RIC will
be treated as if it earned its pro rata share of
the partnership’s income directly for Qualifying
Income test purposes.
Canadian royalty companies are generally similar to upstream MLPs in U.S.,
except royalty companies historically
have been involved in exploration and
Given nature of Canadian companies’ opproduction (whereas upstream MLPs gen- erations, all or a substantial portion of such
erally are involved in exploitation and
income will likely be non-Qualifying Income.
production) and have hedged a smaller
percentage of their production volume to
mitigate commodity price risk.24
ENDNOTES
1
2
3
Th
This
T
hiss chart
his
chart is intended
inten
to provide a general
summaryy of the
h Qualifying
Q lify g Income
co
and
other related
la ed ta
tax
x co
considerations
ons de
erations relevant
e evvant to
o
RICs seeking to invest in the identified types
of commodity-linked investments. This chart
does not purport to identify every tax issue
potentially applicable to RICs investing in
these types of instruments. Moreover, the
terms of particular commodity-linked instruments vary greatly and should be evaluated
on a case-by-case basis. A RIC seeking to
invest in a commodity-linked instrument of a
type described herein should independently
evaluate such instrument and any related
Qualifying Income or other considerations
in light of its particular facts and circumstances and in consultation with its tax and
accounting advisors.
See Part I(C) of the article for a discussion of
CLNs.
As discussed in note 4 of this chart infra,
since 2008, the IRS has been examining the
tax treatment of ETNs (e.g., as to timing and
character of income/gains recognized on
such instruments) more generally, including
listing the development of regulations on
prepaid forward contracts in the Treasury/IRS
Priority Guidance Plan. The RIC Qualifying
Income question has not been included in
this list. See Department of the Treasury,
2011-2012 Priority Guidance Plan, First
4
Quarter Update (Oct. 31, 2011), p. 12
(“Guidance Plan”).
In Rev. Rul. 2008-1, the IRS ruled that certain foreign currency-linked ETNs (and their
nonexchange traded counterparts) are debt
for tax purposes; specifically, the instrument
in the ruling was prepaid at issuance, and
issued and redeemed for U.S. dollars with
a return determined by reference to the
euro and market interest rates in respect of
the euro. Given the longstanding common
law on the treatment of foreign currencydenominated obligations, these types of currency ETNs presented a fairly straightforward
case of debt treatment, unlike other types of
ETNs in the market (e.g., commodity-linked
ETNs). In an accompanying release, IRS
Notice 2008-2, the IRS requested comments
on the proper tax treatment of other types of
prepaid forward contracts, including ETNs
(e.g., those with returns based on securities
or commodities), specifically whether parties to these transactions should be required
to accrue income/expense during the term
of the transaction, if the transaction is not
considered debt for tax purposes. The IRS
has not yet issued guidance in response to
this request for comment, although guidance
in respect of these instruments continues to
be listed as a priority by the IRS and Treasury.
See Guidance Plan, supra note 3 of this
JOURNAL OF TAXATION OF FINANCIAL PRODUCTS
5
chart. Recently, the tax treatment of ETNs
and similar instruments has been under examination by Congress. See Joint Committee
on Taxation, “Present Law and Issues Related
to the Taxation of Financial Instruments and
Products” (JCX-56-11) (Dec. 2, 2011), at 86
and U.S. Government Accountability Office,
Report to Congressional Requesters, “Financial Derivatives: Disparate Tax Treatment
and Information Gaps Create Uncertainty
and Potential Abuse,” (Sept. 2011), at 34,
both of which were issued in advance of
a December 6, 2011, joint hearing of the
Senate Finance and House Ways & Means
Committees on Tax Reform and the Tax
Treatment of Financial Products. See also,
e.g., Sen. Levin Says Financial Instruments
Taxation Needs Simplification, 2011 TNT
235-41 (Dec. 6, 2011).
These ETFs treated as QPTPs are distinguishable from exchange-traded pooled vehicles
investing in physical commodities (typically
precious metals). The latter vehicles are also
frequently referred to as ETFs, but generally are not partnerships or QPTPs for tax
purposes. Instead, these other exchangetraded pooled vehicles are typically grantor
trusts for U.S. federal tax purposes such that
their owners are treated as directly owning
their proportionate share of the vehicle’s
underlying commodities and thus generate
65
Regulated Investment Companies and Commodity-Linked Instruments
6
7
8
9
10
66
non-Qualifying Income for RICs.
It is not entirely clear whether the status of
a QPTP interest as a “security” under the
1940 Act should govern the treatment of
gain on the sale of such interest or instead
it is necessary to look through the partnership to the underlying partnership assets in
determining the proper treatment of gain
on the sale of the partnership interest. As
discussed in note 81 of the article, the
significantly better view in the context
of QPTP interests is that their 1940 Act
security status should govern.
ETFs investing in commodity futures or
other derivatives tend to have income from
two primary sources: (1) income/gains on
their commodity derivative positions, and
(2) interest and other income earned on
cash or securities held as margin or collateral for their commodity derivatives. As
discussed in Part III(B) of the article, an
ETF’s failure to qualify as a QPTP in a tax
year generally would present a Qualifying
Income issue for the investing RIC only
where such failure occurs because the ETF
met each of the RIC Qualifying Income
Test and the PTP qualifying income test
for that taxable year. It is possible that
an ETF could fail QPTP status in a year
where its commodities futures or other
derivatives positions were consistently
trending downward throughout a year
so the ETF had little or no gross income
(gains) on its futures positions, and, as a
result,
re
es t, it
itss co
collateral
llate income, which is RIC
Qualifying
Qu
Q
ualify ng Inco
Income, constituted at least
90 percent
9
ent off the ETF’s
TF gross
g
income
n m in
the year.
ea Th
This
hiss typ
type
pe of sce
scenario
enari ggenerally
eneerallyy
seems unlikely to arise absent extreme
market conditions. (For purposes of the
Qualifying Income Test, gross income is
not reduced by losses or expenses and
thus any losses on an ETF’s commodity
futures positions would not be accounted
for in the Qualifying Income calculation.
See Code Sec. 61; Reg. §1.851-2(b)(1);
JOHNSTON, supra note 12 in the article, at
¶ 2.06[2].) See note 83 of the article for
more discussion of the consequences to
an investing RIC of a QPTP failure.
If an operating company is a foreign corporation for tax purposes, then, it potentially would be a CFC or PFIC, raising the
same potential Qualifying Income issue
discussed in note 24 and accompanying
text of the article in respect of commodity
subsidiaries.
Less commonly, some MLPs are structured
as LLCs with no GPs or IDRs, though
management may receive other forms of
management incentives. With LLCs, all
members, including public unitholders,
have voting rights.
The National Association of Publicly
Traded Partnerships provides detailed
information about MLPs on its web-
11
12
13
14
15
16
17
18
site (www.naptp.org). In particular,
see “Master Limited Partnerships 101:
Understanding MLPs” (updated Mar.
22, 2012), available at www.naptp.
org/documentlinks/Investor_Relations/
MLP_101.pdf (last visited Apr. 24, 2012);
see also “Midstream Energy MLPs Primer,”
Morgan Stanley Research (Jan. 12, 2011)
(“Morgan Stanley MLP Primer”); “MLP
Primer—Fourth Edition, Everything You
Wanted to Know About MLPs, but were
Afraid to Ask,” Wells Fargo Securities
Equity Research (Nov. 19, 2010) (“Wells
Fargo MLP Primer”).
Many MLPs (e.g., midstream MLPs operating fee-based assets like pipelines)
are attractive investments due to their
steady yields and potential for distribution growth. Investors seeking more direct
exposure to commodity prices can select
from certain upstream MLPs (engaging in
exploitation, development or acquisition
of oil/gas-producing properties) or gathering and processing MLPs, as they tend to
have the highest degree of commodity
price exposure, although even these MLPs
frequently hedge out a significant percentage of their production volume to protect
against declines commodity prices. See
Wells Fargo MLP Primer, supra note 10,
at 7–10, 84–117.
See note 6 of this chart supra for a discussion about the presence of some uncertainty regarding this treatment.
I shares were developed by a few MLP
issuers in order to expand their investor
base, in particular to certain institutional
investors and tax-advantaged accounts
(e.g., retirement accounts). Tax-exempts
and those investing through tax-advantaged accounts typically cannot invest
directly in MLPs because MLPs generate
UBTI. The corporate structure of the I
shares issuer serves to block any UBTI
from being attributed to these investors.
See Wells Fargo MLP Primer, supra note
10, at 18.
See, e.g., the most recent annual report
of Kinder Morgan Management LLC, an
issuer of I shares linked to an MLP, Kinder
Morgan Energy Partners, L.P., available
online at www.sec.gov/Archives/edgar/
data/1135017/000113501712000006/
kmr10k2011.htm (last visited on May 14,
2012).
See Wells Fargo MLP Primer, supra note
10, at 18
See id. (identifying two such issuers—
Kinder Morgan Management LLC and
Enbridge Energy Management LLC).
See Wells Fargo MLP Primer, supra note
10, at 63–4.
However, a RIC would need to evaluate
whether its ownership of interests in both
the MLP and in its I shares is limited under
Code Sec. 851(b)(3)(B)’s requirement that
19
20
21
22
23
24
25
26
27
no more than 25 percent of the value of its
total assets be invested in the securities of
a single issuer or two or more issuers that
the RIC controls (very generally, defined
by reference to owning 20 percent of
more of the total combined voting power
of an issuer) and that are determined to
be engaged in the same, similar or related
trades or businesses. See Code Sec. 851(b)
(3)(B), (c)(2).
Similar RIC diversification test questions
arise for a RIC’s investments in securities
of an MLP affiliate as in I shares. See note
18 of this chart supra.
Under Code Sec. 1260, a taxpayer can be
treated as having entered into a constructive ownership transaction with respect to
a financial asset (defined to include any
equity interest in a pass-through entity,
including a partnership) if, among other
things, the taxpayer holds a long position
under a notional principal contract with
respect to the asset or enters into a forward
or futures contract to acquire the asset. See
Code Sec. 1260(c)-(d).
See Wells Fargo MLP Primer, supra note
10, at 81.
Canadian royalty companies are distinguishable from a similar U.S. product—
U.S. royalty trusts. U.S. royalty trusts
generally are entities with publicly traded
securities that are established to administer the receipt and distribution of royalties
from depleting oil and gas producing
properties to their interest holders. Oil and
gas royalty trusts in the U.S. are typically
passive and cannot engage in any business
to acquire any asset or redirect royalty
income for new projects. As such, many
of these U.S. royalty trusts are treated as
grantor trusts for U.S. federal tax purposes
and thus pass through tax items such as
income, gain or loss to interest holders
on a gross basis. Because of the nature
of their holdings, these U.S. royalty trusts
may well generate non-Qualifying Income
for a RIC.
Budget Implementation Act, S.C. 2007,
c. 29, amending Sec. 104(6)(b) of the
Canadian Income Tax Act, RSC 1985, c 1
(5th Supp).
See Wells Fargo MLP Primer, supra note
10, at 17–18.
Depending on the RIC’s and other U.S.
investors’ ownership in the company, it
potentially could be a CFC, raising the
same potential Qualifying Income issue
as discussed above in Part I(C)(2) of the
article for commodity subsidiaries.
See Code Sec. 1297 (defining PFIC). If a
company were a PFIC in respect of which
a RIC made a QEF election, Qualifying
Income issues can arise as discussed in
note 24 of the article in respect of commodity subsidiaries.
Historically, royalty trusts generally paid
Volume 10 Issue 3 2012
out to their owners the majority of the cash
flows that they received from the production and sale of their underlying oil and
gas or other reserves, and were, in turn,
able to avoid entity-level income taxes
in Canada on such distributed amounts.
Since reorganizing as corporations, a
royalty company’s cash flows generally are
subject to entity-level taxes at corporate
income tax rates in Canada regardless of
whether they are distributed to its share-
holders. For those royalty trusts that have
opted to remain as trusts, in general, starting in 2011, they are subject to income tax
at the trust level at rates comparable to the
rates applicable to Canadian corporations.
As part of the change in Canadian tax law,
the trusts’ general ability to deduct, in
computing their taxable income for a taxable year, the income that they pay out to
their owners in the year was significantly
narrowed. Under the new law, the trusts
will incur an entity-level income tax on
certain types of income even if such income is distributed out to investors. See
“Canada’s New Government Announces
Tax Fairness Plan,” Department of Finance
Canada Notice 2006-061 (Oct. 31, 2006),
available at www.fin.gc.ca/n06/06-061eng.asp (last visited on May 14, 2012);
Secs. 104(6)(b)(iv) and 122.1(1) of the
Canadian Income Tax Act, RSC 1985, c.
1 (5th Supp).
This article is reprinted with the publisher’s permission from the JOURNAL OF TAXATION OF FINANCIAL
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