K&LNG
DECEMBER 2005
Alert
Investment Management
IRS Rules that a Mutual Fund’s Income from a
Derivative Contract on a Commodity Index Is not
Qualifying Income
On December 16, 2005, the Internal Revenue Service
(“IRS”) released its first authoritative guidance that a
derivative contract with respect to a commodity is not
a “security” for purposes of section 851(b)(2) of the
Internal Revenue Code of 1986, as amended.
Revenue Ruling 2006-1 (“Ruling”), which will be
applied prospectively to income realized after
June 30, 2006, holds that income a regulated
investment company (“RIC”) earns on a derivative
contract with respect to a commodity index does not
satisfy the test in section 851(b)(2) relating to the
source of a RIC’s income (“Income Test”). The
Income Test requires that at least 90% of a RIC’s
income be derived from specific sources, including
(1) gains from the disposition of stock, securities (as
defined in section 2(a)(36) of the Investment
Company Act of 1940, as amended (“1940 Act”)), or
foreign currencies, and (2) “other income (including
. . . gains from options, futures, or forward contracts)
derived with respect to its business of investing in
such stock, securities, or currencies” (“Other
Income”). Although the Ruling concludes that
income from a commodity-related derivative contract
does not qualify as Other Income, the Ruling
suggests that this income could qualify if it is derived
from such a contract in connection with, or to reduce
or hedge the level of risk in, a RIC’s business of
investing in stock, securities, or currencies.
The RIC in the Ruling invests substantially all of its
assets in debt instruments and enters into total-return
swap contracts pursuant to which it will (1) pay an
amount equal to the 3-month U.S. Treasury bill rate
plus a spread and (2) receive (or pay) an amount
based on the total return gain (or loss) on a
commodity index. The derivative contracts are based
on an aggregate notional amount approximately
equal to the amount the RIC has invested in debt
instruments. The payment obligation on each
derivative contract is settled monthly, and each
monthly measuring period constitutes a separate
derivative contract.
The Ruling first discusses the Tax Reform Act of
1986 (“TRA”), which added the cross-reference to
the 1940 Act for the definition of “securities”
mentioned above (as well as adding the Other
Income category to the Income Test). Because
“[t]here is no conclusive authority” as to whether the
1940 Act definition of “securities” includes
derivative contracts on commodities, the Ruling then
examines the legislative history of the TRA to
determine the meaning of that term for purposes of
section 851(b)(2). Based on that examination, the
IRS concludes that construing the term “securities”
to exclude derivative contracts providing for a total
return exposure to a commodity index is consistent
with Congressional intent and holds that they are not
“securities” for purposes of section 851(b)(2).
The Ruling also considers whether income from the
contracts would qualify as Other Income. After
noting that income from derivative contracts
providing for total return exposure to a commodity
index could qualify if it is derived with respect to the
RIC’s business of investing in stocks, securities, or
currencies, the Ruling concludes that it could not
qualify in this case because the RIC in the Ruling
does not enter into the derivative contracts in
connection with, or to reduce or hedge the level of
risk in, such a business. Rather, the RIC owns the
debt instruments to facilitate its business of providing
investment exposure to changes in commodity prices.
Kirkpatrick & Lockhart Nicholson Graham LLP |
DECEMBER 2005
The Ruling thus concludes that because the RIC’s
derivative contracts are not themselves securities and
the RIC does not enter into those contracts with
respect to a business of investing in stock, securities,
or currencies, income from those contracts is not
qualifying income for purposes of section 851(b)(2).
securities of issuers engaged in the businesses of
mining, processing, producing, exploring for,
refining, and selling gold. Private Letter Ruling
200440012 (May 17, 2004). The Ruling’s analysis
of the Other Income category would appear to
support the conclusion in this private letter ruling.
To date, the treatment under the Income Test of
income from derivative contracts, such as futures,
forwards, options, and notional principal contracts,
with respect to commodities has not been clear.
Although the Ruling focuses specifically on a totalreturn swap, its reasoning—that the derivatives are
not securities because the underlying property “is a
commodity (or commodity index)”—would appear to
apply to other commodity-related derivative
instruments.
The Ruling will only be applied adversely to income
that a RIC realizes after June 30, 2006. A press
release accompanying the Ruling notes that a number
of funds recently filed prospectuses with the
Securities and Exchange Commission indicating that
they may invest in derivative contracts on commodity
indexes. Very few of those funds have actually
begun such investment operations. The prospective
application of the Ruling gives these funds roughly
six months to bring their investments into compliance
with the IRS interpretation of section 851(b)(2)
and/or to develop or employ alternative investment
products to replace those contracts.
The Ruling still leaves open the possibility that
income from derivative instruments with respect to
commodities can satisfy the Income Test if the
derivative instruments are entered into in connection
with, or to hedge the level of risk in, a business of
investing in stocks, securities, or currencies. Our
firm recently obtained a private letter ruling for some
RICs holding that gains derived from options and
futures contracts on gold constitute Other Income
where each RIC entered into these contracts to hedge
its exposure on investments in the stock and
2
Theodore L. Press
202.778.9025
tpress@klng.com
Roger S. Wise
202.778.9023
rwise@klng.com
Kirkpatrick & Lockhart Nicholson Graham
LLP
|
DECEMBER 2005
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