Senator Levin Urges SEC to Consider Tax Code Related Commodity Trading in Review of Use of Derivatives by Investment Companies

As part of the SEC’s broad examination of investment company use of derivatives, Senator Carl Levin (D-MI) has urged the SEC to review the use of derivatives by some investment companies to engage in commodity trading through the securities markets in circumvention of restrictions in the federal tax code and in ways that eliminate oversight by the CFTC. In a letter to the SEC, he also urged the Commission to consider how derivative use by some investment companies is diverting investment dollars away from securities toward commodities, increasing speculation in the commodity markets, and contributing to greater commodity price volatility, price distortions, and a weaker economic recovery. The letter recommended that the SEC work with the CFTC and Internal Revenue Service to address those concerns.

Right now, said the Senator, the SEC, IRS, and CFTC all have pending concept releases or policy reviews that provide a rare opportunity to consider these derivative issues. He urged the SEC and IRS to use this opportunity to review mutual fund activities, prevent mutual funds from engaging in large amounts of indirect commodity investments that the law prohibits them from doing directly, and ensure mutual funds comply with the 90 percent rule in a way that justifies their continued tax-exempt status. The SEC and CFTC should acknowledge the widespread use of hybrid products that combine aspects of securities and commodities trading; consider joint registration of traders that use U.S. securities to trade in commodities; and the imposition of increased capital, margin, and liquidity requirements to protect investors and the markets against risky speculative bets. The SEC and CFTC should also acknowledge the importance of preventing manipulation and excessive commodity speculation and use their concept releases to tackle these problems.

From their inception, mutual funds were made subject to dual sets of restrictions under the Investment Company Act and the Internal Revenue Code . Under IRC Section 851, mutual funds have preferential tax status allowing them to avoid payment of any corporate income tax, so long as they derive at least 90 percent of their gross income from securities sales, which means that they can derive no more than 10 percent of their gross income from alternative investments such as commodities. According to Senator Levin, this tax provision creates a favored tax status for mutual funds which has enabled the mutual fund industry to avoid payment of billions of dollars in taxes each year. At the same time, the 90 percent rule encourages mutual funds to focus their investment dollars on securities, providing needed capital for corporate expansions and jobs.

In evaluating derivative use by mutual funds, said the Senator, the SEC should review dollars spent on derivatives, not only in terms of risk or leverage, but also in terns of whether they meet the requirements of IRC Section 851(b)(2), which essentially requires mutual funds to direct the vast majority of their investment dollars to equities markets, rather than commodity or swap markets. Senator Levin believes that it is those investments in the real economy that justify the tax exempt status of mutual funds when it comes to corporate income taxes.

The Senator noted that an earlier hearing before the Investigations Subcommittee, which he chairs, exposed how some mutual funds have become significant investors in commodities, despite the restriction in IRC §851(b)(2).The hearing showed how mutual funds, which had not historically been involved in commodities markets, began petitioning for and receiving private letter rulings from the IRS allowing them to use a variety of tactics to invest in commodities, including through derivatives. Indeed, he noted that the IRS has issued over 70 private letter rulings allowing mutual funds to treat income from investments in certain commodity linked notes or through controlled foreign corporations that invest in commodities as qualified income under Section 851(b)(2).

These letter rulings hold that distributions from the commodity linked notes and dividends from the commodity-related controlled foreign corporations can be treated as income derived from securities, rather than income derived from commodities, to meet the income source restrictions in Section 851(b)(2). By treating this income as derived from securities rather than commodities, said the Senator, the IRS has enabled mutual funds to do indirectly what they are prohibited by law from doing directly.

In addition to allowing mutual funds to use offshore shell entities, the IRS private letter rulings have permitted mutual funds to use so-called commodity-linked notes to make investments in commodities. These structured notes can be used, for example, to create an investment based upon a specified commodity index. The private letters allow mutual funds to treat these structured notes as securities investments, despite the fact that the notes are designed and used solely for the purpose of investing in commodities. Again, a mutual fund's investing in a structured note in order to make commodity investments that would otherwise be prohibited by the income source rule is not the type of securities investment that was contemplated by, or has traditionally qualified under, IRC Section 851(b)(2), emphasized Senator Levin, nor is it the type of investment that justifies a mutual fund's lax exempt status. In late 2011, the IRS placed a moratorium on the issuance of these types of private letter rulings for mutual funds, and is now conducting a review of the policy considerations.

In addition to studying mutual funds, the Subcommittee has examined the role of exchange traded products in US commodity markets, which are a relatively new category of investment vehicle whose shares arc traded through brokers on stock exchanges, in the same manner as corporate stocks. They encompass a wide variety of investment vehicles, including Exchange Traded Funds, which function as investment companies.

Exchange-traded products, which continue to evolve in variety and complexity, can be used to make a wide range of investments, including in securities and commodities. At first, the SEC approved only those that tracked a specified stock or commodity index, but in 2008, noted the Senator, the SEC also began approving actively managed exchange traded products which offer a wide range of investments beyond index products. Commodity-related exchange traded products, which began appearing in 2004, are a relatively small subset, but, said the Senator, merit particular attention during the SEC's review, not only for their heavy use of derivatives, but also for their potential impact on the US economy.

The Concept Release currently focuses on derivative use by investment companies, but in his view,  derivative use by exchange traded products other than exchange traded funds raise the same types of issues involving risk, leverage, liquidity, portfolio diversification, and valuation. They also raise the same types of concerns related to excessive speculation and commodity price distortions. According to Senator Levin, the Concept Release should not artificially confine its review to exchange traded funds, but include all types of exchange traded products, including those involving commodities.

As part of its review of derivative use by investment companies, the Senator urged the SEC to consult and coordinate with the CFTC to take a hard look at the securities being used to invest in commodities, and acknowledge what the market has known for some time, that commodity related exchange traded products, commodity-linked notes, and similar financial vehicles are hybrids that combine aspects of security and commodity instruments. These instruments should be subject to joint SEC·CFTC oversight, he believes, not only to protect investors, but also to protect commodity and equity markets from manipulation and excessive speculation that distorts prices and increases price volatility. Acknowledging these hybrid instruments would allow both agencies jointly to design appropriate disclosure, regulatory, and oversight procedures.