The Senate Permanent Subcommittee on Investigations held a hearing Thursday to explore decisions by the Internal Revenue Service that have increased commodity speculation by allowing some mutual funds to use offshore shell corporations and complex financial instruments to circumvent longstanding Tax Code limits on mutual fund trading in commodities.

“Over the last six years, in private letter rulings responding to mutual fund petitions, the IRS has opened the floodgates to ever-increasing levels of commodity speculation by the $11 trillion mutual fund industry, despite tax laws that put limits on commodity investments by mutual funds,” said Sen. Carl Levin, D-Mich., who chairs the subcommittee. “Excessive speculation hurts American families who pay inflated prices for gasoline and heating oil, American businesses that face uncertainty about the cost of raw materials, and American farmers trying to sell their crops at a fair price. The effect of IRS actions allowing mutual funds to use offshore schemes and financial engineering to get around the tax law is more commodity speculation. The current moratorium halting additional private letter rulings in this area should be made permanent.”

For 70 years, mutual funds have enjoyed preferential tax treatment. The Tax Code provides in part that, as long as mutual funds derive 90 percent of their income from interest, securities, or foreign currency investments, and no more than 10 percent from alternatives such as commodities, they do not have to pay the corporate income taxes that apply to other corporations. Instead, mutual funds pass on their profits to their investors who are then responsible for paying any taxes due. This preferential tax treatment is worth billions of dollars per year to the mutual fund industry.

Despite the Tax Code restrictions, the mutual fund industry began petitioning the IRS to approve various strategies allowing them to increase their investments in commodities without losing their preferential tax status. In response, beginning in 2006, in a series of 72 private rulings, the IRS agreed to two methods that allow mutual funds to maintain their favorable tax status while making heavy investments in commodity markets.  Both enable mutual funds to make indirect commodity investments that the tax law would bar them from making directly.

One method allows a mutual fund to set up an offshore corporation, use it to invest in commodities, and then treat the resulting income—not as income from commodities—but as from an investment in the stock of the offshore corporation that the mutual fund set up. Mutual funds have used this method to make commodity investments through offshore shell corporations that have no employees, no physical offices, and no obvious nontax purpose for their operations. The second method allows mutual funds to use complex financial instruments called “commodity linked notes,” which mutual funds use essentially to contract with a third party, such as a bank, to act as their agent to invest in commodities.

Mutual funds have used both methods to make increasingly large commodity investments, including through 40 offshore commodity-related offshore shell corporations with an accumulated total of $50 billion in assets.

Thursday’s hearing built on a subcommittee hearing in November that examined the growing influence of speculators in commodities markets. Evidence presented at that hearing indicated that speculators play an increasingly large role in the markets, and that excessive speculation can harm American families and businesses by increasing price volatility, overriding normal supply and demand factors, making price hedging more difficult, and in some cases driving up commodity prices.

“In November, CFTC Chairman Gensler told us that speculators already dominate many commodity markets, including holding over 80 percent of the outstanding futures contracts for oil,” Levin said in a statement. “That level of speculation means speculators are increasingly calling the tune on commodity prices, instead of normal market forces of supply and demand. The threat of increased oil and other commodity prices deepens when the IRS upends longstanding tax restrictions and opens the markets to a new tidal wave of commodity speculation by mutual funds.”

In June 2011, the IRS suspended the issuance of private letter rulings in this area pending a review of the policy issues. In December 2011, Levin and Subcommittee Ranking Member Sen. Tom Coburn sent a joint letter to the IRS urging it “to permanently halt the further issuance of private letter rulings that allow mutual funds to circumvent the income source restrictions in IRC 851(b)(2) and make unlimited indirect investments in commodities” and to “reevaluate the tax treatment of all mutual funds currently allowed to treat indirect commodity investments as income derived from ‘securities’ under Section 851.”

Thursday’s hearing included testimony from IRS Commissioner Douglas Shulman and Treasury Acting Assistant Secretary for Tax Policy Emily McMahon.

Shulman noted that the IRS is involved in this issue because it is charged with providing guidance to taxpayers as to whether investments in registered investment companies choose to make will produce qualifying RIC income, as defined in the tax law.

“In order to maintain its tax status, a RIC must derive 90 percent of its income from investments that meet the qualifications of Section 851, which generally requires that investments be related to stock, securities, or foreign currencies,” he said in his opening statement. “The term ‘securities’ is specifically defined in Section 851 by cross reference to the definition of that same term in the Investment Company Act of 1940. It is the scope of that definition —and particularly its application to investments providing indirect exposure to commodities—that have been the focus of the approximately 70 private letter rulings that are the subject of this hearing.”

Shulman noted that by late 2005 the investment markets had developed to a point where many RICs felt the need to add exposure to commodity prices to their investment portfolios. As a result, they requested guidance from the IRS as to whether the investments they made to achieve this exposure would qualify for the 90 percent income test. The IRS was unable to find any authoritative guidance on the proper scope of the definition of “security” from either the Securities and Exchange Commission or the Commodities Futures Trading Commission, which is the primary regulator for the commodity markets in the United States.

“This situation resulted in the IRS being asked to issue private letter rulings addressing specific proposed RIC commodity-related investments based on the IRS’s own best interpretation of the tax law, including cross-references to the 1940 Act,” said Shulman. “Private letter rulings were issued on this subject starting in 2006. By 2010 the volume of private letter ruling requests was becoming a concern, and consideration was given to issuing some form of broader published guidance. The RIC Modernization Act was then pending, though, and at that point the bill contained a provision that would have affirmatively treated income from direct investments in commodities as qualifying income. As a result, consideration of a guidance project was put on hold. The provision in the RIC Modernization Act relating to commodities was removed prior to passage, however, leaving the statutory language on this issue unchanged.”

In July 2011, the IRS notified the RIC industry that it would not issue further private letter rulings until the staff could look at the overall set of issues and consider guidance of broader applicability. That remains the agency’s current posture, Shulman noted.

McMahon agreed with Shulman that the IRS had suspended the issuance of private letter rulings addressing commodity-related investments by RICs, and added that Treasury Department personnel were not involved in that decision.

Subsequent to the suspension, the Investment Company Institute called several members of the staff of the Office of Tax Policy to ask why the IRS issuance of rulings had been suspended and what the future might hold, she noted. The Treasury Department staff could not, and did not, provide answers to those questions. On Sept.28, 2011, at the ICI’s request, ICI representatives met with Treasury and IRS personnel to discuss ICI proposals for published guidance that would permit commodity-related investments by RICs.

“The Treasury Department and IRS are considering the possibility of issuing published guidance on the subject of commodity-related investments by RICs,” she said.

“The extent to which investors should be able to obtain exposure to commodity price fluctuations through investments in RICs is not fundamentally a tax policy issue,” said McMahon. “The Code provisions in question do raise, however, the issue of whether the Treasury Department and the IRS should be required to interpret a non-tax statute (in this case, the 1940 Act) that does not otherwise fall within their jurisdiction in order to determine the availability of favorable tax treatment under the Code. The Securities and Exchange Commission has not issued any guidance of which we are aware that addresses whether the financial instruments described in the IRS private letter rulings are securities for 1940 Act purposes (as required to produce qualifying income). At the same time, we are not aware of any action the SEC has taken to preclude RICs from making these investments. Administering the relevant Code provisions under these circumstances is challenging from both a practical and a policy perspective.”

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