PLR 201104013: Commodity-linked notes and foreign subsidiary income qualify for RIC income testing

Plain-English summary

A regulated investment company asked whether income from four commodity-linked notes and income from a wholly owned foreign subsidiary would count as qualifying income under IRC § 851(b)(2). The IRS treated the notes as securities for the analysis because the facts represented that they were paid for in full, required no additional margin payments, were not subject to specified mark-to-market requirements, and were not marketed as commodity futures contracts. It also accepted that the subsidiary would be a controlled foreign corporation and that the fund would include the subsidiary's subpart F income. The IRS ruled that income and gain from the notes, and the subsidiary's attributable subpart F income, constituted qualifying income for the fund. The ruling was limited to the represented facts.

Ruling snapshot

• Question: Does income from the commodity-linked notes and the wholly owned foreign subsidiary satisfy the RIC qualifying-income test?
• Outcome: Approved.
• Key authorities: IRC § 851(b)(2); IRC §§ 951, 952, 954, and 957; Investment Company Act of 1940 § 2(a)(36); Commodity Exchange Act § 2(f).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201104013
Release Date: 1/28/2011
Person To Contact:
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Index Number: 851.02-00
Telephone Number:
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Refer Reply To:
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CC:FIP:B01
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PLR-123164-10
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October 20, 2010
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Country = ----------------------

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

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

This responds to the request dated March 31, 2010, submitted by your authorized representative on behalf of the Fund. Fund requests that the Internal Revenue Service rule: (1) that income earned from investments in the commodity-linked notes described in this letter constitutes qualifying income to the Fund under section 851(b)(2) of the Internal Revenue Code of 1986, as amended (“the Code”), and (2) that income earned from an investment in a foreign corporation subsidiary of the Fund constitutes qualifying income to the Fund under section 851(b)(2).
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Facts

Fund is registered as an investment company under the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq., as amended (“1940 Act”), and will elect to be treated as a regulated investment company (“RIC”) under subchapter M of the Code. Fund is an open-end fund.

Commodity-Linked Notes:

The Fund intends to invest in commodity-linked notes having the terms and conditions of the following four notes (the Notes):

Note A:
Note A will be issued at a par value of $a. Its payout formula will be determined with reference to the value of a Total Return Index (“Total Return Index Value”). The leverage factor included in the payout formula for Note A will be equal to b. Note A will have a scheduled term of c months. Note A will have a coupon rate of d. The Fund, as holder of Note A, will have the right to put Note A to the issuer at the calculated redemption price based on the closing Total Return Index Value as of the end of the next day after notification to the issuer. In addition, if the Total Return Index Value falls e% from the value at the time Note A is issued, Note A will be automatically redeemed based on a redemption price calculated using the closing Total Return Index Value on the next day.

The repayment obligation upon early redemption, automatic redemption, or maturity is calculated under a formula that provides for repayment of the face amount of Note A increased or decreased by an amount equal to the face amount of Note A multiplied by a leverage factor of b multiplied by the percentage of the increase or decrease of the beginning Total Return Index Value level compared to the ending Total Return Index Value level for the applicable period. To this amount is added an amount that reflects interest on Note A at a coupon rate of d. From this amount is subtracted an annual fee amount of f basis points of the notional value (leveraged face amount) of Note A. The redemption price formula under Note A will also include an adjustment for the reversal of the interest rate factor included in the total return computation.

Note B:
Note B will be issued at a par value of $a. Its payout formula will be determined with reference to the value of an Excess Return Index (“Excess Return Index Value”). The leverage factor included in the payout formula for Note B will be equal to b. Note B will have a scheduled term of c months. Note B will have a coupon rate of d. The Fund, as holder of Note B, will have the right to put Note B to the issuer at the calculated redemption price based on the closing Excess Return Index Value as of the end of the next day after notification to the issuer. In addition, if the Excess Return Index Value
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falls e% from the value at the time Note B is issued, Note B will be automatically redeemed based on a redemption price calculated using the closing Total Return Index Value on the next day.

The repayment obligation upon early redemption, automatic redemption, or maturity is calculated under a formula that provides for repayment of the face amount of Note B increased or decreased by an amount equal to the face amount of Note B multiplied by a leverage factor of b multiplied by the percentage of the increase or decrease of the beginning Excess Return Index Value level compared to the ending Excess Return Index Value level for the applicable period. To this amount is added an amount that reflects interest on Note B at a coupon rate of d. From this amount is subtracted an annual fee amount of f basis points of the notional value (leveraged face amount) of Note B.

Note C:
Note C will be issued at a par value of $a. Its payout formula will be determined with reference to the value of a Total Return Sub Index (“Total Return Sub Index Value”). The leverage factor included in the payout formula for Note C will be equal to b. Note C will have a scheduled term of c months. Note C will have a coupon rate of d. The Fund, as holder of Note C, will have the right to put Note C to the issuer at the calculated redemption price based on the closing Total Return Sub Index Value as of the end of the next day after notification to the issuer. In addition, if the Total Return Sub Index Value falls e% from the value at the time Note C is issued, Note C will be automatically redeemed based on a redemption price calculated using the closing Total Return Sub Index Value on the next day.

The repayment obligation upon early redemption, automatic redemption, or maturity is calculated under a formula that provides for the repayment of the face amount of Note C increased or decreased by an amount equal to the face amount of Note C multiplied by a leverage factor of b multiplied by the percentage of the increase or decrease of the beginning Total Return Sub Index Value level compared to the ending Total Return Sub Index Value level for the applicable period. To this amount is added an amount that reflects interest on Note C at the coupon rate of d. From this amount is subtracted an annual fee amount of f basis points of the notional value (leveraged face amount) of Note C. The redemption price formula will also include an adjustment for the reversal of the interest rate factor included in the total return computation.

Note D:
Note D will be issued at a par value of $a. Its payout formula will be determined with reference to the value of an Excess Return Sub Index (“Excess Return Sub Index Value”). The leverage factor included in the payout formula for Note D will be equal to b. Note C will have a scheduled term of c months. Note D will have a coupon rate of d. The Fund, as holder of Note D, will have the right to put Note D to the issuer at the
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calculated redemption price based on the closing Excess Return Sub Index Value as of the end of the next day after notification to the issuer. In addition, if the Excess Return Sub Index Value falls e% from the value at the time Note D is issued, Note D will be automatically redeemed based on a redemption price calculated using the closing Excess Return Sub Index Value on the next day.

The repayment obligation upon early redemption, automatic redemption, or maturity is calculated under a formula that provides for repayment of the face amount of Note D increased or decreased by an amount equal to the face amount of Note D multiplied by a leverage factor of b multiplied by the percentage of the increase or decrease of the beginning Excess Return Sub Index Value compared to the ending Excess Return Sub Index Value level for the applicable period. To this amount is added an amount that reflects interest on Note D at the coupon rate of d. From this amount is subtracted an annual fee amount of f basis points of the notional value (leveraged face amount) of Note D.

Fund makes the following representations with respect to these four Notes:

(1) The issuer of a Note has received or will receive payment in full of the purchase price of the Note substantially contemporaneously with the delivery of the Note;
(2) The Fund, while holding a 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 a Note is not and will not be 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);
(4) The Notes are not and will not be marketed as a contract of sale of a commodity for future delivery (or option on such a contract) subject to the CEA; and

(5) Fund does not have any direct or indirect control over the decisions made with respect to the components (or weighting of such components), of any Index or Sub Index.

Controlled Foreign Corporations:

The Fund also plans to form a wholly-owned foreign corporation subsidiary (Subsidiary). The Subsidiary will be incorporated as a Type A Company under the laws of Country. Under the laws of Country, a Type A 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. The Subsidiary will file
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protective elections on Form 8832 to be taxed as a corporation pursuant to Treas. Regs. § 301.7701-3.

The Fund represents that although the Subsidiary will not be registered as investment company under the 1940 Act, the Subsidiary will comply with the requirements of section 18(f) of the 1940 Act, Investment Company Release No. 10666, and related SEC guidance pertaining to asset coverage with respect to investments that would apply if the Subsidiary was registered under the 1940 Act.

The Fund will invest a portion of its assets in its Subsidiary, subject to the diversification limitations of section 851(b)(3). It is expected that the Subsidiary will invest primarily in commodities, commodity futures contracts, commodity-linked notes, commodity linked option and swap contracts and other commodity linked derivatives. The Subsidiary will also invest in other investments, including fixed income securities, either as investments or to serve as margin or collateral for the Subsidiary’s derivatives positions.

The Subsidiary will be wholly owned by Fund and, as such, the Fund represents that the Subsidiary will be classified as a controlled foreign corporation (CFC). The Fund will include its “subpart F” income attributable to Subsidiary under the rules applicable to CFCs under the Code.

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
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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 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.

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
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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. Fund represents that it will own 100 percent of the voting power of the stock of Subsidiary. Fund is a United States person. The Fund therefore represent that Subsidiary will qualify as CFCs 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 shareholder’s pro rata share of the CFC’s subpart F income for the taxable year.

Section 952(a)(2) 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.

Subsidiary’s income from their investments in commodities and commodity-linked instruments may generate subpart F income. The Fund therefore represents that it will include in income the 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 Notes constitutes qualifying income to the Fund under section 851(b)(2) of the Code. We further rule that subpart F income of Subsidiary attributable to the Fund is income derived with respect to the Fund’s business of investing in the stock of Subsidiary and thus constitutes qualifying income under section 851(b)(2).

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.
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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
Branch Chief, Branch 1
Office of Associate Chief Counsel
(Financial Institutions & Products)