On June 2, 2006, the Internal Revenue Service issued guidance clarifying and modifying Revenue Ruling 2006-1, which concerns the treatment of income from commodity-based derivatives by regulated investment companies, or mutual funds. In Revenue Ruling 2006-31, the IRS clarified that its previous revenue ruling on income from derivative contracts with respect to a commodity index was not intended to preclude a conclusion that the income from certain derivative instruments (including, for example, certain structured notes) that create a commodity exposure for the holder is qualifying income under Section 851(b)(2) of the Internal Revenue Code. In addition, the IRS not only clarified that the June 30, 2006 date for prospective application of Revenue Ruling 2006-1 was intended to apply to all derivative contracts with respect to a commodity index or an individual commodity, but it also extended that date such that the IRS will not adversely apply the holdings of the revenue rulings with respect to income recognized on or before September 30, 2006.
The IRS held in Revenue Ruling 2006-1 (Dec. 16, 2005) 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. The IRS considered whether the income from a derivative contract, which the IRS defined as a "Derivative" and 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, the IRS concluded in Revenue Ruling 2006-1 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;" therefore, 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. In addition, Revenue Ruling 2006-1 provided that the holding of the revenue ruling would not be applied adversely to income that a mutual fund recognizes on or before June 30, 2006.
In Revenue Ruling 2006-31, the IRS noted that some taxpayers were unclear as to whether the holding of Revenue Ruling 2006-1 applied to investments by mutual funds in all derivative contracts with respect to a commodity index, rather than just to the derivatives described in the revenue ruling. Taxpayers were also uncertain as to whether the prospective application of the ruling was limited to the derivatives described in Revenue Ruling 2006-1 or included all derivative contracts with respect to a commodity index or an individual commodity. In addition, some mutual funds that had previously invested in derivative contracts informed the IRS that they were having difficulty acquiring alternative commodity-linked investments that produced qualifying income for purposes of Section 851(b)(2) "due to temporary demand/supply imbalances."
In order to clarify the application of the holding, the IRS has amended both the "Holding" and the "Prospective Application" sections of Revenue Ruling 2006-1. The holding of Revenue Ruling 2006-1 stated: "A derivative contract with respect to a commodity index is not a security for purposes of section 851(b)(2). Revenue Ruling 2006-31 amended the holding of Revenue Ruling 2006-1 to state: "A Derivative is not a security for purposes of Section 851(b)(2)." Thus, the IRS clarified that certain other commodity-linked derivatives (such as certain structured notes) may qualify as securities for purposes of Section 851(b)(2). In addition, the revised prospective application paragraph not only changes the June 30, 2006 date to September 30, 2006, but also clarifies that the IRS will not apply the principles of the revenue ruling adversely for income recognized on or before that date "from a derivative contract (including an option, futures or forward contract) on a commodity index or an individual commodity."
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.
© Morrison & Foerster LLP. All rights reserved
