PLR 1039002: IRS treated commodity-linked note and foreign-subsidiary income as qualifying RIC income

Plain-English summary

Two regulated investment companies asked whether income and gain from commodity-linked notes would count toward the qualifying-income test for regulated investment companies. They also asked whether income from wholly owned foreign subsidiaries investing in commodities and related instruments would qualify, including subpart F income and qualified electing fund inclusions. The IRS ruled that the note income and gain would be qualifying income under IRC § 851(b)(2). It also ruled that the relevant subsidiary income attributable to the funds would qualify under the same provision, while expressing no opinion on whether the funds otherwise qualified as regulated investment companies.

Ruling snapshot

• Question: Would income from commodity-linked notes and foreign subsidiaries satisfy the regulated investment company qualifying-income requirement?
• Outcome: Approved
• Key authorities: IRC §§ 851, 951, 952, 954, 957, 1293, 1295, and 1297

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201039002 Third Party Communication: None
Release Date: 10/1/2010 Date of Communication: Not Applicable
Index Number: 851.02-00
Person To Contact:
----------------------------------------------- --------------------, ID No. ------------
-------------------------------------------------------- Telephone Number:
------------------------ ---------------------
---------------------------------------------- Refer Reply To:
----------------------- CC:FIP:B02
--------------------------------------- PLR-101134-10
Date:
June 22, 2010

Legend

Fund 1 = -------------------------------------------------------

Fund 2 = ---------------------------

Trust = ------------------------------------------------------------------

Advisor = ----------------------------------------------------------------

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

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

Index 1 = ----------------------------------------------------
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Index 2= ---------------------------------------------------------------------------------------------------
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PLR-101134-10 2

p= ------------

q= --------------

r= --------------

s= ------------------------------

t= ---

u= --------------

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

w= ----------------------

Type A Company = ------------------------------------

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

   This responds to the request dated December 18, 2009, submitted by your

authorized representative on behalf of Fund 1 and Fund 2 (each a “Fund,” collectively
the “Funds”). Funds request rulings that: 1) income and gain arising from Notes A and
B (the “Notes”) 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; and 2)
income and gain earned from Funds’ investment in foreign corporation subsidiaries of
Funds constitutes qualifying income under section 851(b)(2) of the Code.

FACTS

  Funds are organized as series funds of Trust, a State corporation. Funds are

organized 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”). The
investment manager of both Funds is Advisor.

   Pursuant to section 851(g), each Fund will be treated as a separate corporation

for federal tax purposes. Funds have each elected to be treated as a regulated
investment company (“RIC”) under subchapter M of the Code. Funds either have or will
PLR-101134-10 3

adopt the accrual method of accounting and a taxable year ending on June 30.

   Funds will invest in the Notes, and each will establish a wholly-owned foreign

corporate subsidiary which will be authorized to invest in commodities and commodity-
linked instruments, such as the Notes and commodity-linked derivatives.

Commodity-linked Notes

  Funds will invest in commodity linked Notes A and B having the following

characteristics.

Note A

    Note A will have a par value of $p. The payout formula will vary depending on

the performance of Index 1 or Index 2 (“Index”). Note A will have a term of r, and
interest on Note A will be payable monthly during the entire term of the note at a rate
equal to s. Funds, as holders of Note A, have the right to put Note A to the issuer at the
calculated redemption price at any time prior to maturity based on the closing value of
Index (a) on the date of notification, if notification is communicated to the issuer by a
specified time on the business day, or (b) on the business day following the date of
notification if not communicated by such specified time. The issuer of a note has the
right to redeem Note A (in whole but not in part) if (a) the Index is no longer published,
or (b) the issuer is unable to hedge its risk with respect to the Note.

    Under the given terms of Note A, a knockout trigger will occur when the product

of the par value of the note and the percentage point decrease in the closing price of the
Index pertaining to the note between the knockout trigger date and the date when the
Fund acquired Note A exceeds t percent of the Note A’s par value. When the knockout
trigger occurs, Note A will automatically redeem based on the closing value of the Index
on the business day following the day on which the knockout trigger occurred.

   The repayment obligation upon early redemption, knockout, or maturity of Note A

will equal the par value of Note A, plus or minus the par value of Note A multiplied by
the percentage point increase or decrease in the closing price of the Index from the day
Note A was first acquired to the business day on which the redemption occurs. To this
amount the amount of any unpaid interest on Note A is added, and the unpaid portion of
the annual fee of v payable to the issuer is subtracted. Notes based on Index 1 will also
provide for an adjustment for the reversal of the interest rate factor included in the
index.

Note B

   Note B will have a par value of $q. The payout formula will vary depending on

the performance of Index. Note B will have a term of u, and interest on Note B will be
PLR-101134-10 4

payable monthly during the entire term of the note at a rate equal to s. Funds, as
holders of Note B, have the right to put Note B to the issuer at the calculated
redemption price at any time prior to maturity based on the closing Index value (a) on
the date of notification, if notification is communicated to the issuer by a specified time
on the business day, or (b) on the business day following the date of notification if not
communicated by such specified time. The issuer of a note has the right to redeem
Note B (in whole but not in part) if (a) the Index is no longer published, or (b) the issuer
is unable to hedge its risk with respect to the Note.

    Under the given terms of Note B, a knockout trigger will occur when the product

of the par value of the note and the percentage point decrease in the closing price of the
Index pertaining to the note between the knockout trigger date and the date when the
Fund acquired Note B exceeds t percent of the Note B’s par value. When the knockout
trigger occurs, Note B will automatically redeem based on the closing value of the Index
on the business day following the day on which the knockout trigger occurred.

   The repayment obligation upon early redemption, knockout, or maturity of Note B

will equal the par value of Note B, plus or minus the par value of Note B multiplied by
the percentage point increase or decrease in the closing price of the Index from the day
Note B was first acquired to the business day on which the redemption occurs. To this
amount the amount of any unpaid interest on Note B is added, and the unpaid portion of
the annual fee of w payable to the issuer is subtracted. Notes based on Index 1 will
also provide for an adjustment for the reversal of the interest rate factor included in the
index.

   Funds make the following representations with respect to Notes A and B:

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

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

   (3) The issuer of the Notes 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 Notes are 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
PLR-101134-10 5

    Funds will each be authorized to organize a wholly-owned foreign subsidiary

(each a “Subsidiary,” collectively the “Subsidiaries”) under the laws of Country. Each
Subsidiary is incorporated as a Type A Company. Under the laws of Country, a Type A
Company provides 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. As a result, Subsidiaries will be treated as corporations for federal income
tax purposes under default entity classification rules, but they intend to ensure such
classification by filing a protective election on Form 8832 to be treated as corporations
under § 301.7701-3 of the Income Tax Regulations.

   Neither Subsidiary will be registered as an investment company under the 1940

Act; however, each 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 investments that would apply if Subsidiaries
were registered under the 1940 Act.

   Each Fund may invest a portion of its assets in its wholly-owned subsidiary,

subject to the asset diversification limitations of section 851(b)(3). Each Subsidiary will
invest primarily in one or more of the following types of instruments: commodity and
financial futures and option contracts, forward, swap or spot contracts; commodity-
linked notes (including exchange-traded commodity-linked notes); and fixed income
securities that serve as collateral for these contracts. The commodity-linked
instruments will be linked to the performance of one or more commodities (including one
or more commodity indices) or a commodity future or option contract.

    It is expected that each Fund will own all of the outstanding shares of the

Subsidiary it organizes. The Funds represent that so long as a Subsidiary is wholly
owned by one of the Funds, the Subsidiary will be classified as a controlled foreign
corporation (“CFC”) under section 957. Each Fund further represents that it will include
its pro rata share of “Subpart F income” attributable to its respective Subsidiary to the
extent required under section 951.

    One or more other funds managed by Advisor and registered under the 1940 Act

may invest in either Funds’ Subsidiary in varying degrees over time. If a sufficient
number of such other funds invest in a Subsidiary, each Fund may end up owning less
than 10 percent of the voting power of that Subsidiary. In such a case, the Funds
represent that the Subsidiary would qualify as a passive foreign investment company
(“PFIC”) under section 1297. Funds represent that if a Fund becomes a less than ten
percent owner of its respective Subsidiary, it will elect to treat the Subsidiary as a
qualified electing fund (“QEF”) under section 1295 for the first taxable year of the Fund
for which the Subsidiary is a PFIC. Funds further represent that a Fund will not revoke
this election unless and until the Subsidiary is no longer a PFIC. The Fund will take
income from the Subsidiary into account under the PFIC rules of section 1291 et. seq.;
PLR-101134-10 6

specifically, the Fund will include its pro rata share of the QEF inclusions attributable to
the Subsidiary in income in accordance with section 1293(a) for each taxable year a
QEF election is in place.

LAW AND ANALYSIS

   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, as amended)
   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;
PLR-101134-10 7

   (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 § 851(b) provides that, for purposes of section

851(b)(2), there shall be treated as dividends amounts included in gross income under
sections 951(a)(1)(A)(i) or 1293(a) for the taxable year to the extent that, under sections
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.

   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)(1)(A) defines foreign personal holding company income to include
dividends, interest, royalties, rents, and annuities.
PLR-101134-10 8

   Subsidiary’s income from its investments in commodities and commodity-linked

instruments may generate subpart F income. Funds therefore represent that they will
include in income Subsidiary’s subpart F income for the taxable year in accordance with
section 951.

   Section 1297(a) defines a PFIC as a foreign corporation with either (1) seventy-

five percent or more of the gross income of such corporation for the taxable year is
passive income, or (2) the average percentage of assets held by the corporation during
the taxable year which produce passive income or which are held for the production of
passive income is at least fifty percent. Section 1297(b) defines passive income as any
income which is of a kind that would be foreign personal holding company income as
defined in section 954(c), with exceptions for certain active business income.

   Section 1295(a) provides that a PFIC shall be treated as a QEF with respect to

the taxpayer if the taxpayer makes an election with respect to the PFIC and the PFIC
complies with such requirements as the Secretary of the Treasury may prescribe for the
purpose of determining the ordinary earnings and net capital gain or such company.
Section 1295(b) provides that once a taxpayer makes such an election for any taxable
year, the election applies to all subsequent taxable years unless revoked by the
taxpayer with the consent of the Secretary.

   Section 1293(a) provides that every United States person who owns (or is

treated as owning under section 1298(a)) stock of a QEF at any time during the taxable
year of such fund shall include in gross income (A) as ordinary income, such
shareholder’s pro rata share of the ordinary earnings of the QEF for such year, and (B)
as long-term capital gain, such shareholder’s pro rata share of the net capital gain of the
QEF for such year. Any such QEF inclusion shall be for the taxable year of the
shareholder in which or with which the taxable year of the QEF ends.

    Over time, it is possible that other RICs will invest in the CFCs. If other RICs

invest in a foreign corporation so that a Fund owns less than ten percent of the
Subsidiary, Taxpayer represents that the Fund will elect to treat the PFIC as a QEF and
will include in income it’s Subsidiary’s QEF income for the taxable year in accordance
with section 1293.

Conclusion:

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

Notes constitutes qualifying income to the Funds under section 851(b)(2) of the Code.
We further rule that subpart F income, or QEF inclusions of the Subsidiaries attributable
to the Funds, without regard to whether the income has been distributed, is income
derived with respect to Funds’ business of investing in the stock of Subsidiaries and
thus constitutes qualifying income under section 851(b)(2).
PLR-101134-10 9

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

  This ruling is directed only to the taxpayer requesting it. 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)