By John Kemp
LONDON, Sept 14 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
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
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.
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
A TORTURED HISTORY
In return for their exemption from corporate income tax,
Congress stipulated that recognised 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
"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
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 Recognised 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 "modernise 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
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
"One mutual fund told us that all of the commodity
investment decisions come from their Rockville, Maryland
"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
"(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
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:
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
"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