Tax ruling threatens commodity mutual funds: Kemp

LONDON Fri Sep 14, 2012 7:46am EDT

Sen. Carl Levin opens a nomination hearing on Capitol Hill June 28, 2011. REUTERS/Yuri Gripas

Sen. Carl Levin opens a nomination hearing on Capitol Hill June 28, 2011.

Credit: Reuters/Yuri Gripas

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LONDON (Reuters) - Commodity prices could come under severe pressure if the U.S. Internal Revenue Service (IRS) decides to revoke previous rulings that have allowed mutual funds to pour over $50 billion into commodity derivatives through subsidiaries in the Cayman Islands and structured notes while remaining exempt from corporate income tax.

"The controlled foreign corporations are corporate fictions, offshore shams, paper exercises whose sole purpose is to make an end run around the legal restrictions on commodity investments by mutual funds," Chairman Carl Levin complained at a hearing of the Senate Permanent Subcommittee on Investigations in January.

Mutual funds have made commodity investing accessible to a much wider range of investors, not just the rich individuals able to participate in hedge funds.

Unlike hedge funds, however, there are strict limits on the assets mutual funds can own while preserving their exemption from corporate income tax.

Until 2006, those restrictions were generally thought to prohibit mutual funds from generating more than 10 percent of their income from commodities and other alternative investments.

But without any change in the law, fund operators have secured a series of special rulings from the IRS allowing them to sidestep the restrictions, obtaining up to 100 percent of their income from commodities by setting up subsidiaries in the Caymans as controlled foreign corporations, or structuring the investment as a fixed-income instrument (bond) where the amount of principal repaid is linked to an index of one or more commodities.

On this surprisingly thin legal basis, the mutual fund industry has built a major new asset class since 2006. Now it's under attack, as critics in Congress question whether the IRS has gone too far in allowing mutual funds to circumvent the restrictions that would otherwise prevent them from launching specialist commodity funds.

PRIVATE LETTER RULINGS

Between 2006 and 2011, the IRS issued 72 private letter rulings (PLRs) to mutual funds confirming that commodity investments via offshore subsidiaries or structured notes would enable them to keep their status as regulated investment companies (RICs) and receive a corporate tax exemption.

A PLR is a written determination issued to a taxpayer by the IRS in response to a written inquiry. It interprets tax law and applies it to the taxpayer's specific set of facts. A taxpayer may rely on a PLR when dealing with the IRS provided it has stated the circumstances fully and correctly. But it is not meant to create a precedent for others.

In exceptional circumstances, PLRs can be revoked (sometimes retroactively) if the IRS finds it has made an error or if there is a change in the law.

By the end of 2011, the 40 largest commodity-related mutual funds had amassed over $50 billion in assets based on these PLRs (link.reuters.com/xut52t).

But in July 2011, worried about the profusion of PLRs, and the continued refusal of Congress to give mutual funds clear statutory authority for commodity investing, the IRS called a time-out. It told the industry it would not respond to any more requests for PLRs until it can determine the legal position properly and provide more general guidance.

The moratorium has left at least 28 PLR requests in the queue unanswered. Two more funds are reported to have pressed ahead without securing a PLR, defying the IRS.

MAXIMUM UNCERTAINTY

Relying on PLRs to give the green light to commodity mutual funds, and the IRS's decision to stop issuing new ones, has put a cloud over the whole sector.

Without the tax exemption, mutual funds would have to restructure or liquidate their holdings. They "would (have to) use some other structure. They would make another investment. They would go into another business" IRS Commissioner Douglas Shulman told the Subcommittee on Investigations on January 26.

"I know of (only) one circumstance in all of mutual funds where a mutual fund decided to be taxable, so it is very rare for a mutual fund to pay taxes."

If the IRS determines its earlier rulings were wrong, and revokes the existing PLRs, commodity-focused mutual funds would have to find another way to structure their investments, scale back their holdings to below the 10 percent income limit, or exit the sector altogether.

The resulting liquidation would put tremendous pressure on commodity prices and reverse much of the build up of speculative money in commodity markets over the past decade - which is precisely what some opponents of the PLRs want. Chairman Levin is a leading critic of the impact investment flows have had on food and fuel prices.

On the other hand, if the IRS eventually determines income from commodity investments via offshore subsidiaries and structured notes is qualifying income after all, it could see another large in-rush of funds into the sector.

In addition to the pending applications, many other mutual funds could be launched if the IRS issues a generally applicable ruling that everyone can rely on rather than forcing each fund to seek its own PLR.

Either way, the IRS decision could transform the landscape for retail commodity investors, and have a major impact on commodity prices.

A TORTURED HISTORY

In return for their exemption from corporate income tax, Congress stipulated that recognized investment companies, which is the formal tax law term for mutual funds, must derive at least 90 percent of their income from dividends, interest, payments with respect to securities loans and gains from the sale or other disposition of stock or securities.

The restrictive list of possible investments was included in the original law granting tax breaks to mutual funds in 1936 and confirmed when Congress revisited the issue in 1954. It is now Section 851(b)(2) of the tax code (26 USC 851(b)(2)).

In 1986, Congress broadened the list of permitted investments as part of a comprehensive overhaul of the tax code to include gains from "foreign currencies, or other income (including but not limited to gains from options or futures contracts) derived with respect to its business of investing in such stock, securities or currencies".

But it was thought that Congress had specifically excluded gains from commodities. The law itself remained silent on the matter. In a letter to Congressman Ronnie Flippo, however, one of the sponsors of the 1986 mutual fund amendment, the U.S. Treasury stated its unequivocal opposition.

"We would generally not treat as qualifying income gains from trading in commodities, even if the purpose of that trading is to hedge a related stock investment," the Treasury wrote.

Treasury opposition appeared to become a part of the legislative record. One of the Senate sponsors of the amendment specifically stated it "enjoys the support of the Treasury" and that its purpose was "to permit the mutual fund industry to make better use of income from stock options, futures contracts and options on stock indices, options and futures on foreign currencies, and foreign currency transactions."

And there the position appeared to rest.

OPENING THE FLOOD GATES

In response to enquiries from the industry, the IRS published a general revenue ruling in January 2006 stating unambiguously:

"A derivative contract with respect to a commodity index is not a security for the purposes of section 851(b)(2). Under the facts above, income from such a contract is not qualifying income for the purposes of section 851(b)(2) because the income from the contract is not derived with respect to the business of investing in stocks, securities or currencies." (Revenue Ruling 2006-1, January 9, 2006).

But over the next six months, under pressure from the industry, the IRS wavered. In June 2006, the IRS issued another general ruling which "clarified" that the previous ruling:

It "was not intended to preclude a conclusion that income from certain instruments (such as structured notes) that create a commodity exposure for the holder is qualifying income under Section 851(b)(2)" (Rev Ruling 2006-31, June 19, 2006).

The June revenue ruling triggered an avalanche of requests for private revenue letters confirming commodity investments could count as qualifying income. The first PLR was issued on July 14 and two more were issued before the end of the year.

Eight more PLRs went out in 2007. Six followed in 2008. Then 12 went out in 2009, 22 in 2010 and 21 in 2011, before the IRS brought the curtain down.

Thirty-five PLRs confirmed a mutual fund could invest through a controlled foreign corporation; 18 confirmed it could get exposure through a structured note; and 19 confirmed the fund could use both techniques, according to an analysis by Senate staff.

But there must still have been some doubt about the legal status of these investments because in 2010, the House of Representatives and Senate considered the Recognized Investment Company Modernisation Act.

The bill was explicitly endorsed by the Investment Company Institute, which lobbies on behalf of the mutual fund industry, as a means to "modernize the tax laws that govern mutual funds." The Institute noted "these laws have not been updated in any meaningful or comprehensive way since 1986."

Section 201 of the modernisation bill would have amended Section 851(b)(2) to change the reference from currencies to commodities (a more general term).

The bill was passed by the House, and then by the Senate. But senators made one change: striking section 201 in an amendment offered by Senator Jeff Bingaman.

Significantly, when offered an opportunity to give mutual funds explicit authority to invest in commodities, Congress refused.

It is that legislative history which appears to have given the IRS reason to reconsider its earlier rulings. Tax officials could no longer be sure (if they ever really were) that Congress intended Section 851(b)(2) qualifying investment income to include revenues from commodities, or that the courts would read the tax statute in this way.

IT'S NOT OUR PROBLEM

At the hearing in January, Levin pressed the IRS commissioner on why the tax department took such a relaxed view of mutual funds setting up subsidiaries in the Caymans and transforming commodity derivative investments into debt-like structured notes to enable them to make investments that would not otherwise be allowed.

"We have learned that these offshore shell corporations, these wholly owned subsidiaries established by mutual funds, are in every case wholly owned Cayman Island corporations. They are shells. There are no physical offices, no employees of their own, no independent operations. The mutual fund's U.S. employees run their commodities portfolios from their U.S. offices," the chairman explained.

"One mutual fund told us that all of the commodity investment decisions come from their Rockville, Maryland office."

"All of the profits and losses by their offshore shells are returned to the mutual funds that own them here in the United States. No income is kept offshore, no tax is evaded."

Levin went on to press the revenue commissioner if tax was being avoided, even if it not being evaded. Why was the IRS not aggressively trying to clamp down on these offshore corporations and their structured notes, the senator asked repeatedly.

The answer appeared to be that the IRS did not think it was its problem. Tax is not being evaded. And it is only being avoided if the mutual funds would have invested in commodities without the tax perk.

The IRS argued that without the exemption the mutual funds would not invest in commodities and would find another asset class they could invest in without paying corporate income tax instead. In that sense no tax that would otherwise be due was being lost because there would have been no activity to tax in any event.

"(The IRS) has been very aggressive attacking sham corporations that are trying to use the (tax) code in ways that are not permissible to lower taxes in the United States. We typically raise this doctrine for structures designed to lower tax, such as phony losses, inflated bases, and that is where we have gone to court," Shulman said.

But because the mutual funds were not avoiding tax in the ordinary sense, and because all their income is taxed once it is distributed to individual investors, the IRS was not worried about the clever tax structuring of offshore corporations and notes.

Shulman insisted that it is not the function of the IRS to police the law on permissible commodity investments.

Levin shot back: "They want to have their cake, which is investing in commodities, and eat it too, by not paying what the tax would be if they did that directly in the United States."

COMMODITIES AT THE CROSSROADS

All this leaves both the mutual fund industry and the IRS in something of a quandary.

"Tax law clearly permits mutual funds to invest indirectly in commodities through controlled foreign corporations or commodity linked notes," according to the Investment Company Institute. "Moreover, no congressional policy prohibits fund investment directly or indirectly in commodities."

The Institute's full response to the Subcommittee has been posted on its website: here

But it seems to overstate the case. Congress has never explicitly allowed heavily regulated mutual funds to derive more than a small fraction of their income from commodities.

When Congress was given the opportunity to give them explicit permission, it refused. So it must be doubtful whether the legislative history can really be read in a way that suggests lawmakers thought they were giving mutual funds the right to invest more than 10 percent in commodities.

At the same time, commodity investing is popular, and millions of ordinary Americans have chosen to get exposure to commodity prices through mutual funds. It is not clear the IRS could simply revoke the PLRs and risk shutting down the whole industry.

"Everyday investors increasingly want commodities in their portfolios, and are looking to buy them in record amounts," in part because of concerns about inflation, Republican Senator Tom Coburn explained at the hearing in January.

No wonder the IRS is treading carefully. However much the IRS does not want to get involved, though it may not have much choice. It may not be responsible for regulating commodity investment, but it does have an obligation to determine the tax treatment of commodity-related mutual funds.

Opponents of commodity investment will continue to point out the lack of an explicit legislative mandate for all this activity. An enormous industry has built up on a very thin legal foundation, and now it's starting to sway dangerously in the wind.

(John Kemp is a Reuters market analyst. The views expressed are his own)

(Editing by William Hardy)

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