Evolution of Commodity-Linked Investments by Mutual Funds

Editor: Annette B. Smith, CPA

Historically, a mutual fund seeking to maintain status as a regulated investment company (RIC) has had limited economic exposure to commodity prices. For example, neither commodity futures contracts nor direct purchases or sales of commodities generate RIC qualifying income under Sec. 851(b)(2). Recently, Rev. Rul. 2006-1 held that a commodity-linked swap also does not generate RIC qualifying income. Based on a detailed analysis of the relevant legislative history, the IRS ruled that, in the absence of “conclusive authority” on the status of a swap as an Investment Company Act of 1940 (’40 Act) security, a commodity swap does not generate RIC qualifying income. However, more recently, letter rulings have allowed RICs to use commodity-linked structured securities to gain economic exposure to commodity prices and simultaneously generate qualifying income. This has given rise to numerous questions as to the proper treatment of such instruments.

Letter Rulings

In IRS Letter Rulings 200628001, 200637018, 200647017, 200701020 and 200705026, the Service held that certain commodity-linked “notes” (instruments) could generate RIC qualifying income. (This possibility was suggested in Rev. Rul. 2006-31, which modified and clarified Rev. Rul. 2006-1.) In each case, the instruments required an initial investment by the fund and provided a return based on a formula referenced to a commodity-linked index. At maturity (usually more than a year after the investment), the issuer had to repay the initial investment to the fund, multiplied by the percentage (magnified by a “leverage factor,” e.g., three) of increase or decrease of the index level during the investment’s term. The issuer was also required to repay or retire the instrument before maturity if the index declined by a certain amount (e.g., 15%). For example, if the relevant index declined by 5% during the instrument’s term, assuming a leverage factor of three, the issuer would repay 85% of the fund’s initial investment.

The economics of the instruments and a commodity swap are similar, in that both create investment exposure to changes in commodity prices. However, a purchaser of the instruments is not required to make any payments beyond the initial investment (in comparison, a commodity swap involves no initial investment, but thereafter requires periodic settlement payments). In addition, the instruments automatically terminate if the underlying index drops in value beyond a certain predetermined level (in contrast, commodity swaps are structured as total-return instruments). Although these features may moderate an investor’s exposure to the relevant commodity index, they do not affect how the instrument is related to the commodity or how the commodity performs.

The letter rulings conclude that the income and gains from the instruments will be RIC qualifying income. When contrasted with the holding and analysis of Rev. Rul. 2006-1, the letter rulings suggest that the instruments produce qualifying income because they constitute ’40 Act securities. However, the rulings provide no guidance on how to account for income or gain on the instruments. This lack of guidance has led to confusion as to the proper treatment of the instruments for Federal income tax purposes.

Tax Treatment

If the instruments were treated as debt, they presumably would be subject to the contingent-payment-debt-instrument rules of Regs. Sec. 1.1275-4. Consequently, a fund would accrue interest currently; on an instrument’s maturity, it would recognize ordinary income or loss. Although the instruments have been labeled commodity-linked “notes,” that label does not dictate debt treatment for tax purposes. As there is no requirement to deliver a sum certain at maturity, it may be difficult to conclude with sufficient comfort that the instruments are debt.

Because no payments are due on the instruments until maturity and the settlement price depends on the related commodity index, they arguably resemble prepaid, cash-settled forward contracts. This treatment would allow the fund to defer any gain or loss until the instruments mature. Such gain or loss likely would be long-term.

A third treatment has also been suggested. Certain issuances of these instruments call for them to be bifurcated (for tax purposes) into a (1) deposit of a fixed amount to secure the obligation and (2) financial contract that pays at maturity an amount based on the performance of the related commodities index. The letter rulings do not bifurcate the instrument. An open question is whether the letter rulings would allow a fund applying this characterization to recognize qualifying income as to the second component.

As for character and timing issues, the proper characterization of the instruments is critical as a fund determines its distribution requirements. Further Service guidance would be welcome and would promote consistency among taxpayers. From the IRS’s perspective, such guidance might have collateral consequences for other taxpayers.

Even without such guidance, the continuing evolution of commodity-linked investments could enable commodity-linked swaps (previously ruled in Rev. Rul. 2006-1 not to produce RIC qualifying income) to generate qualifying income, because they may come to generate “other income” derived from investing in qualifying instruments (i.e., the instruments). Commodity investing via swaps may yet find its way into the mainstream of RIC investing.

EditorsNotes

Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.

If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or annette.smith@us.pwc.com.