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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 PRODUCTS, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited. To subscribe to the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 67