Senate hearings have examined the use of IRS letter rulings enabling U.S. mutual funds to use offshore shell corporations and financially engineered notes to make commodity investments, despite longstanding tax code restrictions. According to Senator Carl Levin (D-MI), Chair of the Investigations Subcommittee, by issuing the private letter rulings that it has in the mutual fund area, the IRS is undermining its own longstanding efforts to go after sham corporations and transactions used to avoid paying tax. For most of the 70 years they have been in existence, said Senator Levin, mutual funds were not significant participants in U.S. commodity markets. But Six years ago mutual funds began petitioning for and receiving IRS private letter rulings that, for the first time, enabled them to invest heavily in commodities, despite restrictions in Section 851(b)(2) of the Internal Revenue Code.
Senator Tom Coburn (R-OK) said that the private letter rulings are an ad hoc way for the IRS to approve of the various tax structures used to set up these mutual funds, effectively allowing funds to use creative structures to facilitate commodity investments that would otherwise not be allowed. Even more, said Senator Coburn, some are concerned that as these rulings let mutual funds increase these investments, it can lead to excessive speculation into commodities.
In June 2011, the IRS suspended issuance of private letter rulings in this area pending a review of the policy issues. In his testimony, IRS Commissioner Douglas Shulman noted that the IRS notified the mutual fund 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 IRS’ current posture.
Pressed by Senator Levin to apply the codified economic substance doctrine, which allows the IRS to disregard transactions that have no substantial nontax purpose, to its review and to these transactions, Commissioner Shulman resisted, calling the doctrine a very specific tool that the IRS applies carefully. The economic substance doctrine is very fact intensive, noted the Commissioner, and has typically been raised in other circumstances, not with specific taxpayers who have been granted private letter rulings. Further, he said that the IRS does not need to raise the doctrine in its policy review, and can probably allow or disallow this type of conduct without implicating the economic substance doctrine.
Chairman Levin maintains that mutual funds have not offered any substantial business or economic purpose for creating these offshore controlled foreign corporations or constructing commodity-linked notes. He said that their only purpose is to serve the mutual funds’ effort to re-characterize the resulting income as derived from securities, so they can make unlimited commodity investments while retaining their privileged tax status.
Commissioner Shulman explained that, in order to maintain its tax status, a mutual fund 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. 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 were the subject of this hearing.
By late 2005, he explained, the investment markets had developed to a point where many mutual funds 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 investments 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 SEC or the CFTC. This situation resulted in the IRS being asked to issue private letter rulings addressing specific proposed mutual fund commodity-related investments based on the IRS’s own best interpretation of the tax law, including cross-references to the 1940 Act.
In December 2011, Senator Levin and 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 Section 851(b)(2) of the Internal Revenue Code 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.
At the hearing, Senator Coburn noted that by calling a timeout the IRS has provided a useful opportunity to talk about how to resolve these important matters. The practices used by mutual funds are entirely legal, and even blessed by the IRS, he noted, which means that we are left with a question of policy, not a question of compliance with the law.
Section 851(b)(2), which has been in the tax code since mutual funds got started in the 1930s, restricts the types of income that mutual funds are allowed to obtain in exchange for favorable tax treatment. Senator Levin observed that mutual funds abiding by this section’s income source restrictions do not have to pay corporate income taxes like other corporations. He said that this tax break collectively saves the mutual fund industry billions of dollars each year. The statute requires that 90 percent of a mutual fund’s gross income must be derived from securities, interest, or foreign currency investments. That means not more than 10 percent of their income can come from alternatives like commodities.
This 90 percent rule has been in place for decades, emphasized the oversight chair, in 2006 the mutual fund industry began pressing the IRS to permit it to use complex financial transactions that would, in essence, enable funds to get around the rule and engage in commodity investments beyond the 10 percent limit. In response, from 2006 to 2010, the IRS issued 72 private letter rulings allowing the mutual funds to whom the letters were addressed to use either wholly-owned offshore corporations or financial instruments called commodity linked notes to make unrestricted commodity investments, notwithstanding the 10 percent limit in Section 851. The IRS private letter rulings said that the mutual funds could treat the income from those sources, not as income from a commodities investment, but as income from a securities investment in the stock of the company they owned or in the note they designed to avoid the restrictions of Section 851.
In addition, the IRS has issued private letter rulings stating that mutual funds can use commodity-linked notes to invest in commodities and treat the resulting income as from a securities investment, even though the notes were created for the sole purpose of investing in commodities and end-running Section 851. By treating this type of income as derived from securities rather than commodities, said Senator Levin, the IRS has elevated form over substance, enabled mutual funds to use agents as though they were independent actors, and use financial engineering to do indirectly what the law doesn’t let them do directly. The result is opening the door to increasing commodity speculation, he emphasized.
Emily McMahon, Treasury Acting Assistant Secretary for Tax Policy, noted that a private letter ruling is a determination issued by the IRS to a particular taxpayer that interprets and applies the tax laws to the taxpayer’s particular set of facts. As a matter of policy and practice, the Treasury Department does not participate in the consideration or issuance of private letter rulings. She added that Treasury and the IRS are considering the possibility of issuing published guidance on the subject of commodity-related investments by mutual funds.
The official further noted that the extent to which investors should be able to obtain exposure to commodity price fluctuations through investments in mutual funds is not fundamentally a tax policy issue. The Code provisions in question do raise, however, the issue of whether Treasury and the IRS should be required to interpret a non-tax statute, the Investment Company Act, that does not otherwise fall within their jurisdiction in order to determine the availability of favorable tax treatment under the Code.
The SEC has not issued any guidance of which Treasury is aware that addresses whether the financial instruments described in the IRS private letter rulings are securities for 1940 Act purposes. At the same time, Treasury is not aware of any action the SEC has taken to preclude mutual funds from making these investments. She said that administering the relevant Code provisions under these circumstances is challenging from both a practical and a policy perspective.