Commodity-linked note income treated as qualifying RIC income

Plain-English summary

The IRS ruled that income and gain from a specified commodity-linked note constitute qualifying income for six regulated investment company funds under IRC § 851(b)(2). The note’s payout is linked to a commodity index and includes features such as early redemption, a knockout provision, and a maturity payment. The ruling relies on representations that the note is predominantly a security under the applicable Commodity Exchange Act provisions. The conclusion is limited to the represented facts and does not independently address other RIC qualification requirements.

Ruling snapshot

• Question: Does income and gain from the commodity-linked note constitute qualifying income under § 851(b)(2)?
• Outcome: Approved
• Key authorities: IRC §§ 851, 512, and 6110; Commodity Exchange Act § 2(f); Investment Company Act § 2(a)(36)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201043016
Release Date: 10/29/2010
Index Number: 851.02-00
Person To Contact:
-------------------- ------------------------, ID No. ---------------
------------------- Telephone Number:
---------------------------------- ---------------------
------------------------------------------- Refer Reply To:
----------------------------- CC:FIP:B01
-------------- PLR-111571-10
------------------------------------ Date:
July 15, 2010

Legend:

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

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

Fund 3 = --------------------------------------

Fund 4 = --------------------------------------

Fund 5 = ------------------------------------------------

Fund 6 = -----------------------------------------

Trust 1 = ---------------------

Trust 2 = ------------------------------------------------

PLR-111571-10 2

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

Date 1 = ------------------

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

Date 3 = -------------------

Index = ------------------------------------------------------------------

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

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

c = ----

d = --

e = --------------------

f = ------------------------------------------

g = --------------------------------------------------------------------------------

-
---------

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

   This responds to the request dated March 12, 2010, and supplemental

correspondence dated May 3, 2010, submitted by your authorized representative on
behalf of the Funds. Funds request that the Internal Revenue Service rule that income
earned from investments in the commodity-linked note described in this letter
constitutes qualifying income to the Funds under section 851(b)(2) of the Internal
Revenue Code of 1986, as amended (“the Code”).

Facts:
Fund 1, Fund 2, Fund 3, Fund 4, Fund 5, and Fund 6 (each a “Fund,” and
collectively the “Funds”) qualify and are treated as regulated investment companies
(RICs) under section 851(a) of the Code. Each fund is a series of an open-end
management investment company registered under the Investment Company Act of
1940, 15 U.S.C. 80a-1 et seq., as amended (the “1940 Act”). Funds 1, 2, 3, 4, and 5

PLR-111571-10 3

are series of Trust 1, a business trust organized under the laws of State. Fund 6 is a
series of Trust 2, also a business trust organized under the laws of State.

  The Funds are accrual method taxpayers whose annual accounting period ends

on Date 1.

    The Funds intend to invest in commodity-linked notes having the following terms

and conditions (the “Note”). The Note will be issued to a Fund at a face value of $a. Its
payout formula will be determined with reference to Index. The term of the Note will be
b. Each Fund, as holder of a Note, will have the right to put the Note to the issuer at the
calculated redemption price based upon the closing Index value as of the end of the
next business day after notification to the issuer, or as of the same day closing value if
notice is made by ten o’clock in the morning, New York time. In addition, if the Index
value falls to a level that is equal to or more than c% below the initial reference value on
any day, the Note will “knockout” and automatically redeem at the calculated
redemption price based upon the closing Index as of the end of the next business day.
If the Note has not been “knocked out” by Date 2, the Note will be automatically
redeemed at maturity, on Date 3, at the calculated redemption price based upon the
closing Index as of Date 2.

   The repayment obligation upon early redemption, knockout, or at maturity is

calculated under a formula that provides for an amount equal to the face amount of the
Note multiplied by a leveraged, adjusted change in the Index value. The Note will use a
leverage factor of d. The adjusted change in the Index value is reached by taking the
percentage of the increase or decrease of the beginning value of Index compared to the
ending value of Index for the applicable period and subtracting an issuer fee in the
amount of e and an interest rate of f. In addition to the amount received under the
formula, a payout upon redemption, knockout, or at maturity will include any unpaid
coupon payments at the coupon rate of g.

   The Funds make the following representations with respect to the Note:

   (1) the issuer of the Note will receive payment from each Fund for the Note
       substantially contemporaneously with the delivery of the Note to the Fund;

   (2) once issued, the Funds will not need to make any additional payments to the
       issuer of the Note;

   (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 for future delivery on such a contract) subject to the CEA.

PLR-111571-10 4

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. 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;

PLR-111571-10 5

          (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 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.

Conclusion:

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

Note constitutes qualifying income to the Funds under section 851(b)(2) of the Code.

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

facts as represented by the taxpayers. Section 6110(k)(3) provides that this letter 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,


                                               Diana Imholtz
                                               Diana Imholtz
                                               Chief, Branch 1
                                               Office of Associate Chief Counsel
                                               (Financial Institutions and Products)