PLR 200647017: Commodity notes and foreign subsidiary income qualify for RIC income test

Plain-English summary

A fund seeking regulated investment company status planned to invest in notes whose returns tracked commodity indices and in a wholly owned foreign subsidiary. It asked whether income from those investments would count toward the rule requiring a RIC to earn at least 90 percent of its gross income from specified sources. Based on the represented note terms, the IRS ruled that income and gain from the notes qualified. It also ruled that income derived from the subsidiary qualified as income from the fund's investment in its stock, whether or not attributable to subpart F income.

Ruling snapshot

• Question: Would income from the commodity-linked notes and foreign subsidiary satisfy the RIC qualifying income rule?
• Outcome: Approved for both income streams on the stated facts.
• Key authorities: IRC §§ 851(b)(2), 951, 954, 957; Investment Company Act of 1940 § 2(a)(36).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200647017
Third Party Communication: None
Release Date: 11/24/2006
Date of Communication

Index Number: 851.02-00
Person To Contact:
----------------------, ID No. -------------
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Telephone Number:
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Refer Reply To:
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CC:FIP:B02
PLR-125782-06
Date: August 10, 2006
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Legend:

Fund = -----------------------------------------
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Subsidiary = --------------------

State = ---------------------

Country = ----------------------

v = ---------------

w = --------

x = --

y = ------------------------------

z = ---

Index 1 = ------------------------------------------------------------------------

Index 2 = ------------------------------------------------------------------

Index 3 = --------------------------------------------------------------

Index 4 = ---------------------------------------------------------------------------------------
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Dear ------------:

This responds to your request received May 17, 2006, and supplemental correspondence dated June 22, 2006, submitted by your authorized representative on behalf of Fund. Fund requests that the Internal Revenue Service rule that: 1) income and gain arising from the commodities-linked notes described in this letter will constitute qualifying income to Fund under section 851(b)(2) of the Internal Revenue Code of 1986, as amended; and 2) that income earned from the ownership of a wholly-owned subsidiary that is a controlled foreign corporation constitutes qualifying income to Fund under section 851(b)(2).

FACTS

Fund is organized as a State business trust and is registered as an open-end management investment company under the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq., as amended (the 1940 Act). Fund intends to qualify as a regulated investment company (RIC) under section 851.

Commodities-linked Notes

Fund intends to invest in commodities-linked notes having the terms and conditions of the following note (Note): The Note will be issued to a Fund at par value of $v. Its payout formula will be determined with reference to one of the following indices: Index 1, Index 2, Index 3, or Index 4 (Index). Its term will be nine months. Fund, as holder of the Note, has the right to request prepayment of the Note at any time at the calculated redemption price based on the closing Index on the trading day on which the request is received or, in certain circumstances, the next following trading day. In addition, if on any day, the closing price of the Index falls to a level that is at least w% below the closing price of the Index on the day the Note was issued, then a mandatory repayment of the Note is triggered and the Note will “knockout” and automatically redeem based on the closing Index value of the next trading day. The repayment obligation upon early redemption, knockout, or at maturity equals the face amount of the Note plus or minus the following adjustment. In calculating the adjustment, the face amount of the Note is multiplied by (A) a leverage factor of x, and by (B) the percentage increase or decrease of the closing price of the Index on the day the Note was issued as compared to its value on the applicable payment calculation date. The total is then adjusted to account for a coupon amount calculated at a y rate times the face amount of the Note, for an annual fee amount of z basis points of the notional value (leveraged face amount) of the Note, and for the reversal of an interest factor included in the Index.

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Fund makes the following representations with respect to this Note:

(1) The issuer of the Note will receive payment in full of the purchase price of the Note substantially contemporaneously with the delivery of the Note;

(2) Fund while holding the Note will not be required to make any payment to the issuer of the Note in addition to the purchase price paid for the Note, whether as margin, settlement payment, or otherwise, during the life of the Note or at maturity;

(3) The issuer of the Note is not subject by the terms of the instrument to mark- to-market margining requirements of the Commodities Exchange Act, 7 U.S.C. 2, as amended (CEA); and

(4) The Note is not marketed as a contract of sale of a commodity for future delivery (or option on such a contract) subject to the CEA.

Controlled Foreign Corporation

Fund intends to form a wholly-owned subsidiary (Subsidiary) that will be a foreign corporation. Subsidiary will be incorporated as an exempted limited company under the laws of Country. Under the laws of Country, an exempted limited company provides for limited liability for all holders of shares. A shareholder’s liability is limited to the amount, if any, unpaid with respect to the shares acquired by the shareholder. Subsidiary will file an election on Form 8832 to be taxed as a corporation pursuant to §301.7701-3 of the Procedure and Administration regulations.

Fund represents that, although Subsidiary will not be registered as an investment company under the 1940 Act, Subsidiary will comply with the requirements of section 18(f) of the 1940 Act, Investment Company Act Release No. 10666, and related SEC guidance pertaining to asset coverage with respect to transactions in commodity index swap agreements and other transactions in derivatives.

Fund will invest a portion of its assets in its Subsidiary, subject to the limitations set forth in section 851(b)(3). Subsidiary will invest in commodity and financial futures and options contracts, and fixed income securities that serve as collateral for these contracts. Subsidiary may also invest in cash-settled nondeliverable forward contracts.

It is expected that all of Subsidiary’s income will be subpart F income; Fund may also receive income from Subsidiary, however, that is not properly characterized as subpart F income.

LAW AND ANALYSIS

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Section 851(b)(2) provides that a corporation shall not be considered a RIC for any taxable year unless it meets an income test (the “qualifying income requirement”). Under this test, at least 90 percent of its gross income must be derived from certain enumerated sources. Section 851(b)(2) defines qualifying income, in relevant part, as—
dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), and gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the 1940 Act) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to [the RIC’s] business of investing in such stock, securities, or currencies . . . .

Section 2(a)(36) of the 1940 Act defines the term “security” as—
any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

Section 2(f)(1) of the CEA provides that the CEA is not applicable to a hybrid instrument that is predominantly a security. Section 2(f)(2) of the CEA provides that a hybrid instrument shall be considered to be predominantly a security if—

(A) the issuer of the hybrid instrument receives payment in full of the purchase price of the hybrid instrument, substantially contemporaneously with the delivery of the hybrid instrument;

(B) the purchaser or holder of the hybrid instrument is not required to make any payment to the issuer in addition to the purchase price paid under subparagraph (A), whether as margin, settlement payment, or otherwise, during the life of the hybrid instrument or at maturity;

(C) the issuer of the hybrid instrument is not subject by the terms of the instrument to mark-to-market margining requirements; and

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(D) the hybrid instrument is not marketed as a contract of sale of a commodity for future delivery (or option on such a contract) subject to the CEA.

Section 2(f)(3) of the CEA provides, in part, that for purposes of section 2(f)(2)(C) of the CEA, mark-to-market margining requirements do not include the obligation of an issuer of a secured debt instrument to increase the amount of collateral held in pledge for the benefit of the purchaser of the secured debt instrument to secure the repayment obligations of the issuer under the secured debt instrument.

In addition, section 851(b) provides that, for purposes of section 851(b)(2), there shall be treated as dividends amounts included in gross income under section 951(a)(1)(A)(i) or 1293(a) for the taxable year to the extent that, under section 959(a)(1) or 1293(c) (as the case may be), there is a distribution out of the earnings and profits of the taxable year which are attributable to the amounts so included.

Section 957 defines a controlled foreign corporation (CFC) as any foreign corporation in which more than 50 percent of (1) the total combined voting power of all classes of stock entitled to vote, or (2) the total value of the stock is owned by United States shareholders on any day during the corporation’s taxable year. A United States shareholder is defined in section 951(b) as a United States person who owns 10 percent or more of the total voting power of a foreign corporation. Fund will own 100 percent of the voting power of the stock of Subsidiary. Fund is a United States person. Subsidiary therefore will qualify as a CFC under these provisions.

Section 951(a)(1) provides that, if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year, every person who is a United States shareholder of this corporation and who owns stock in this corporation on the last day of the taxable year in which the corporation is a CFC shall include in gross income the sum of the shareholder’s pro rata share of the CFC’s subpart F income for the taxable year.

Section 952 defines subpart F income to include foreign base company income determined under section 954. Under section 954(a)(1), foreign base company income includes foreign personal holding company income determined under section 954(c). Section 954(c) defines foreign personal holding company income to include dividends, interest, royalties, rents, and annuities; gains in excess of losses from transactions (including futures, forward, and similar transactions) in any commodities; and net income from notional principal contracts not entered into for purposes of hedging any other described income item.

Subsidiary’s investments may generate foreign personal holding company income under section 954(c), which is subpart F income. Fund would therefore include in income the sum of the pro rata share of Subsidiary’s subpart F income for the taxable year in accordance with section 951.

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CONCLUSION

Based on the facts as represented, we rule that income and gain arising from the Notes constitutes qualifying income to Fund under section 851(b)(2). We further rule that income derived by Fund from its investments in Subsidiary, whether or not attributable to subpart F income, is income derived with respect to Fund’s business of investing in the stock of Subsidiary and thus constitutes qualifying income to Fund under section 851(b)(2).

This ruling is directed only to the taxpayer who requested it, and is limited to the facts as represented by the taxpayer. Section 6110(k)(3) provides that this letter may not be used or cited as precedent.

Sincerely,

Susan Thompson Baker
Susan Thompson Baker
Assistant to the Branch Chief, Branch 2
Office of Associate Chief Counsel
(Financial Institutions and Products)