On December 16, 2005, the Internal Revenue Service issued guidance stating that income from a derivative contract with respect to a commodity index is not qualifying income for regulated investment companies, or mutual funds, under the income test prescribed by Section 851(b)(2) of the Internal Revenue Code.
In Revenue Ruling 2006-1, to be published in the Internal Revenue Bulletin in January 2006, the IRS considered whether the income from a derivative contract, which appears to be a "notional principal contract," commonly referred to as a "swap," that provided for a total-return exposure on a commodity index is "qualifying income" that a mutual fund could use to satisfy the requirement under Section 851(b)(2) of the Internal Revenue Code that at least 90 percent of its gross income must be derived from certain enumerated sources (the "Income Test").
In general, qualifying income for the Income Test includes dividends, interest, certain payments with respect to securities loans and gains from the sale or other disposition of stock, securities or foreign currencies. The Tax Reform Act of 1986 expanded the definition of qualifying income by, among other things, adding a cross-reference to the definition of "securities" found in the Investment Company Act of 1940, as amended (the "’40 Act"), in Section 851(b)(2) and permitting other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to a mutual fund’s business of investing in stock, securities, or currencies to count toward the Income Test.
After citing liberally to legislative history, including Senate floor statements and a letter from the Treasury Department, the IRS concluded that Congress did not intend for the cross-reference to the ’40 Act to expand the term "securities" to include derivative contracts providing for a total-return exposure to a commodity index. The IRS also stated that the fund in the ruling did not enter into these derivative contracts to "reduce or hedge the level of risk in a business of investing in stock, securities or currencies." Rather, the IRS stated that the fund’s business is to create investment exposure to changes in commodity prices, the derivative contracts are the principal vehicle for doing so and the fund invests in other securities (debt instruments) to facilitate its business of providing this commodity-derivative exposure. The IRS therefore concluded that the purpose for entering into derivative contracts is not "in connection with a business of investing in stock, securities, or currencies." Thus, the income from those contracts cannot be considered qualifying income through the "other income" provision of Section 851(b)(2) of the Internal Revenue Code.
The IRS’ basis for stating that the fund’s business is to create investment exposure, and the fund invests in debt instruments to facilitate such exposure, is not clear. The ruling is silent as to the fund’s express investment objectives and the ruling provides that "substantially all" of the fund’s assets consist of debt instruments. On one hand, it appears that the fund described in the ruling could be a typical bond fund that enters into commodity-index swaps as a hedge. On the other hand, the ruling appears directed at a new breed of mutual funds that principally obtain yields from such swaps.
Some fund advisors may be surprised by this ruling because, before it was issued, some may have reasoned that income derived from any swap, including a commodity-index swap, entered into as a hedge against the mutual fund’s other investments is derived from its business of investing in stock, securities or currencies. While the ruling might be interpreted as treating income from a commodity-index swap entered into as a hedge as qualifying income, it concludes that doing so to create "investment exposure" is not. It may prove difficult – if not impossible – for a fund to establish a distinction between these purposes and, in any event, the ruling does not expressly conclude that income from a commodity-index swap entered into as a hedge is qualifying income. Moreover, although the IRS indicated in the ruling that there is no conclusive authority that derivative contracts on commodities are "securities" under the ‘40 Act, we believe there is not as much uncertainty as the ruling suggests.
The IRS appears to recognize that some taxpayers will be surprised by the ruling. In a news release issued on the same day as the ruling, the IRS noted that, in the absence of guidance from the IRS, some funds filed prospectuses with the SEC indicating that they may enter into these investments. To avoid this potential new trap for the unwary, the IRS will apply this newly stated position prospectively and will not apply the holding of the revenue ruling adversely to income that a fund recognizes on or before June 30, 2006.
Revenue Ruling 2006-1 raises a number of questions. The ruling calls into question whether a fund can rely on the definition of securities as found in the ’40 Act. Also, if the IRS is willing to attack commodity-index swaps, will the IRS attack other swap transactions as well? Based upon the reasoning of Revenue Ruling 2006-1, it does not appear that the IRS will attack equity, interest or currency swaps or other swaps based upon stocks and securities (as determined for tax purposes). Nonetheless, mutual funds should carefully evaluate any swap before acquiring it in view of this new ruling.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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