PLR 1030004: Commodities note and CFC income qualify for RIC gross-income test

Plain-English summary

The IRS ruled on several regulated investment companies that planned to invest in a commodities-linked note and in wholly owned foreign subsidiaries. It concluded that income and gain from the note would be qualifying income under section 851(b)(2). It also concluded that qualifying subpart F income from the controlled foreign corporations would be income derived from the funds' businesses of investing in the subsidiaries and would count toward the same test. The ruling depended on the note's payment, margin, marketing, and commodity-law characteristics, as well as the subsidiaries' ownership and status. The IRS did not express an opinion on whether the funds otherwise qualify as RICs under subchapter M.

Ruling snapshot

• Question: Would income from the commodities-linked note and controlled foreign corporations count as qualifying income for the funds?
• Outcome: Approved
• Key authorities: IRC §§ 851, 951, 952, 954, 957, 959, 1293, and 6110

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201030004 Third Party Communication: None
Release Date: 7/30/2010 Date of Communication: Not Applicable]
Person To Contact:
Index Number: 851.02-00 ----------------------, ID No. -------------
Telephone Number:
--------------------
--------------------------- Refer Reply To:
------------- CC:FIP:B02
----------------------------------------------------- PLR-105138-10
------------------------------- Date:
------------------------ April 28, 2010

Legend

Fund A = --------------------------------------------------------------------------------------------
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Fund B = --------------------------------------------------------------------------------------------
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Fund C = --------------------------------------------------------------------------------------------
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Fund D = --------------------------------------------------------------------------------------------
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Fund E = --------------------------------------------------------------------------------------------
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Fund F = --------------------------------------------------------------------------------------------
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Fund G = --------------------------------------------------------------------------------------------
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PLR-105138-10 2

Portfolio H = --------------------------------------------------------------------------------------------
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Portfolio I = --------------------------------------------------------------------------------------------
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Portfolio J = --------------------------------------------------------------------------------------------
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Portfolio K = --------------------------------------------------------------------------------------------
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Portfolio L = --------------------------------------------------------------------------------------------
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Trust M = ---------------------------------------------------

Trust N = --------------------------------------------

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

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

Type X = --------------------------
Company
Index = ----------------------------------------------------------------

Date1 = ------------------

Date 2 = ---------------

a = -----------

b = --------------------------------------------------------------

c = ---

d = --

e = -----------------
PLR-105138-10 3

Dear ----------------:

    This responds to your request dated January 29, 2010 and supplemental

correspondence dated April 7, 2010, submitted by your authorized representative on
behalf of Fund A, Fund B, Fund C, Fund D, Fund E, Fund F and Fund G (each a “Fund”
and, together, the “Funds”). The Funds request that the Internal Revenue Service rule
that: (1) income and gain arising from the commodities-linked note described in this
letter will constitute qualifying income to the Funds under section 851(b)(2) of the
Internal Revenue Code of 1986, as amended (the “Code”), and (2) income derived by
the Funds from their investments in controlled foreign corporation subsidiaries will
constitute qualifying income to the Funds under section 851(b)(2) of the Code.

Facts

   Fund A is a series of Trust M. Each of Fund C, Fund D, Fund E, Fund F and

Fund G is a series of Trust N. Each of Fund B, Trust M and Trust N is a business trust
organized under the laws of State. Trust M and Trust N are registered as open-end
management investment companies under the Investment Company Act of 1940, 15
U.S.C. 80a-1 et seq., as amended (the “1940 Act”). Fund B is registered as a closed-
end management investment company under the 1940 Act. Each Fund intends to
qualify as a regulated investment company (“RIC”) under Subchapter M of the Code.

   Each of Portfolio H, Portfolio I, Portfolio J, Portfolio K, and Portfolio L (each a

“Portfolio” and, together, the “Portfolios”) is a business trust organized under the laws of
State and is treated as a partnership for federal income tax purposes. Each Portfolio is
registered as an open-end management investment company under the 1940 Act.

    Each Fund and Portfolio uses the accrual method of accounting. Fund A has a

fiscal year ending on Date 1. Each of the Portfolios, Fund B, Fund C, Fund D, Fund E,
Fund F and Fund G has a fiscal year ending Date 2.

    Each of Fund C, Fund D, Fund E, Fund F and Fund G intends to invest its assets

in one or more entities treated as partnerships for federal income tax purposes. Fund C
invests in Portfolio H. Fund D invests in Portfolio I. Fund E invests in Portfolio J. Fund
F is permitted to invest in Portfolio H, Portfolio I, Portfolio J, Portfolio K, and other
entities treated as partnerships. Fund G is permitted to invest in Portfolio H, Portfolio I,
Portfolio J, Portfolio K, Portfolio L, and other entities treated as partnerships. Fund F
and Fund G may also make direct investments. Fund A may invest through an entity
treated as a partnership that has not yet been formed, in which Fund F and Fund G may
also invest.

Commodities-linked Note
PLR-105138-10 4

    Fund A, Fund B, Fund F, Fund G and each Portfolio intend to invest in

commodities-linked notes having the terms and conditions of the following note (the
“Note”). The Note will be issued at its par value of $a. The term of the Note will be 13
months. The Note will pay monthly coupon interest at a rate equal to b. The Note’s
payout will be determined by reference to the Index, a total return index. The Portfolios,
Fund A, Fund B, Fund F and Fund G will have the right to put the Note to the issuer at
the calculated redemption price based on the closing value of the Index as of the end of
the next business day after notification to the issuer. If on any day the Index falls to a
level that is c% or less of the beginning value of the Index, the Note will "knockout" and
automatically redeem at the calculated redemption price based on the closing value of
the Index on the next business day.

   The Note’s payout upon maturity, redemption, or knockout is determined under a

formula that provides for a return of the Note’s face amount plus the product of the face
amount, a leverage factor, and the adjusted Index return over the applicable period
(which product may be positive or negative). The Note will have a leverage factor of d.
The adjusted Index return means the percentage change in the Index during the
applicable period reduced by an interest rate factor based on e rates and by certain
fees, each expressed as a percentage. In addition, upon maturity, redemption, or
knockout, the issuer will pay any accrued coupon interest.

  Each Fund makes the following representations with respect to the Note:

  (1) The issuer of the Note will receive payment for the Note substantially

contemporaneously with the delivery of the Note;

    (2) While holding the Note, the Portfolios, Fund A, Fund B, Fund F and Fund G

will not be required to make any additional payments 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 Note to mark-to-

market margining requirements of the Commodities Exchange Act, 7 U.S.C. 2, as
amended (the “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

   Each of the Portfolios, Fund A, Fund B, Fund F, and Fund G intends to form a

wholly-owned subsidiary (each a “Subsidiary” and, together, the “Subsidiaries”). Each
Subsidiary will be incorporated as a Type X Company under the laws of Country. Under
the laws of Country, a Type X Company provides for limited liability for all holders of
PLR-105138-10 5

shares. A shareholder's liability is limited to the amount, if any, unpaid with respect to
the shares acquired by the shareholder. Each 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.

   The Funds represent that, although the Subsidiaries will not be registered as

investment companies under the 1940 Act, the Subsidiaries 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
commodity futures and other transactions in derivatives.

    Each of the Portfolios, Fund A, Fund B, Fund F and Fund G may invest a portion

of its assets in its Subsidiary, subject to the diversification limitations set forth in section
851(b)(3) of the Code. The Subsidiaries are expected to invest primarily in commodities
and commodities-related investments but may also invest in other securities.

    The Funds represent that each Subsidiary will be a controlled foreign corporation

within the meaning of section 957 of the Code (a “CFC”). It is expected that all of the
income of each Subsidiary will be “subpart F income” within the meaning of section 952
of the Code, but the Portfolios, Fund A, Fund B, Fund F and Fund G may also receive
income from the Subsidiaries that is not properly characterized as subpart F income.

Law and Analysis

   Section 851(b)(2) of the Code 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. A corporation that is a partner in a partnership (other
than a qualified publicly traded partnership) must look through such partnership for
purposes of meeting the qualifying income requirement. 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,

PLR-105138-10 6

   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

   (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, the flush language of section 851(b) of the Code 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.
PLR-105138-10 7

   Section 957 of the Code 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 combined voting power of all classes of voting
stock of a foreign corporation. The Funds represent that 100 percent of the voting
power of the stock of each Subsidiary will be owned by the corresponding Fund or
Portfolio, and that each Fund and each Portfolio is a United States person. The Funds
represent that each Subsidiary therefore will qualify as a CFC under these provisions.

    Section 951(a)(1) of the Code 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 shareholder's pro rata share of the CFC's subpart F income
for the taxable year.

   Section 952(a)(2) of the Code 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). Under section 954(c)(1), foreign personal holding company income
includes (among other things): dividends, interest, royalties, rents, and annuities; gains
in excess of losses from transactions in commodities (including futures, forward, and
similar transactions but excluding certain hedging transactions and certain active
business gains and losses); and, subject to certain exceptions, net income from notional
principal contracts.

  The Subsidiaries’ investments may generate foreign personal holding company

income under section 954(c), which is subpart F income. Each Fund and Portfolio
owning an interest in a Subsidiary will therefore include in income its pro rata share of
such Subsidiary’s subpart F income for the taxable year in accordance with section 951.

Conclusion

   Based on the facts as represented, we rule that income and gain arising from the

Note constitutes qualifying income to each of the Funds under section 851(b)(2) of the
Code. We further rule that subpart F income of the Subsidiaries attributable to the
Funds is income derived with respect to the Funds’ businesses of investing in the stock
of the Subsidiaries and thus constitutes qualifying income to the Funds under section
851(b)(2).

  Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
PLR-105138-10 8

referenced in this letter. In particular, no opinion is expressed with regard to whether the
Funds qualify as RICs under subchapter M of the Code.

   This ruling is directed only to the taxpayers requesting it, and is limited to the

facts as represented by the taxpayers. Section 6110(k)(3) of the Code provides that it
may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                   Sincerely,


                                   David B. SIlber
                                   David B. Silber
                                   Chief, Branch 2
                                   Office of Associate Chief Counsel
                                   (Financial Institutions & Products)