PLR 1107012: Commodity-linked note and CFC income qualified for the RIC income test

Plain-English summary

The IRS considered a regulated investment company that planned to invest in commodity-linked notes and wholly owned foreign subsidiaries. The taxpayer asked whether income from the notes and subpart F income attributed from the controlled foreign corporations would count toward the 90-percent gross-income test in IRC § 851(b)(2). Based on the taxpayer's representations, the IRS ruled that both types of income were qualifying income. The ruling was limited to the taxpayer's stated facts and did not express an opinion on whether the fund otherwise qualified as a regulated investment company.

Ruling snapshot

• Question: Does income from the commodity-linked notes and the fund's investment in its CFC subsidiaries qualify under the IRC § 851(b)(2) income test?
• Outcome: Approved.
• Key authorities: IRC §§ 851, 951, 952, 954, and 957; 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: 201107012
Release Date: 2/18/2011
Index Number: 851.02-00
Person To Contact:
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---------------------- Telephone Number:
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------------------------------------------- Refer Reply To:
---------------------------------------------------- CC:FIP:B02
PLR-119215-10
Date:
September 21, 2010

Legend:

Fund = -----------------------------------------------------------------------

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

Company = ------------------------------------

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

Offshore = ----------------------

Total Return Index = -----------------------------------------------------------------------

Excess Return Index = ------------------------------------------------------------------------

Total Return Subindex = ----------------------------------------------------------

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Excess Return Subindex = ----------------------------------------------------------

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Amount = -----------------

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

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

x = ----

y = --

Rate = ---------

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

   This is in response to a letter dated April 30, 2010, and subsequent

correspondence, requesting rulings that (1) income from commodity-linked notes is
described in section 851(b)(2) of the Internal Revenue Code and (2) income earned by
Fund from an investment in its wholly-owned subsidiaries that qualify as controlled
foreign corporations (“CFCs”) is income under section 851(b)(2) of the Internal Revenue
Code.

                                                 FACTS

  Fund is a series of Trust and is classified as a corporation for federal income tax

purposes. Trust is a business trust organized under the law of State. Fund is registered

PLR-119215-10 3

as an open-end management investment company under the Investment Company Act
of 1940, 15 U.S.C. 80a-1 et seq. (“the 1940 Act”).

  Fund intends to qualify each year as a regulated investment company (“RIC”)

under section 851 of the Code.

   Fund intends to invest in two wholly owned subsidiaries (“Subs”) to be formed

under the laws of Offshore, a non-United States jurisdiction. Each Sub will be formed
as a Company. A Company provides limited liability for its shareholders. It is
represented that each Sub will file an election on Form 8832 to be treated as a
corporation for federal income tax purposes under section 301.7701-3 of the Procedure
and Administration Regulations.

  Fund represents that although Subs do not expect to be registered as investment

companies under the 1940 Act, they will comply with the requirements of section 18(f) of
the 1940 Act, Investment Company Act Release No. 10666, and related Securities and
Exchange Commission guidance pertaining to asset coverage with respect to
investments that would apply if Subs were registered under the 1940 Act.

   Fund will invest a portion of its assets in Subs, subject to the limitations set forth

in section 851(b)(3) of the Code.

   Subs will invest in commodity-related instruments. Such instruments include

commodity index futures, commodity futures, options, exchange-traded funds, forwards,
swaps, structured notes, exchange-traded and over-the-counter derivative instruments,
and equity-like securities that provide direct exposure to commodity prices. Subs may
invest in new instruments as they are developed.

   Fund also intends to invest in four commodities-linked notes (Notes A, B, C and

D).

    Note A will be issued at the par value of Amount. Its payout formula will be

determined with reference to the value of the Excess Return Index. Its term will be
fourteen months. As holder of Note A, Fund will have the right to put Note A to its issuer
at the calculated redemption price based on the closing value of the Excess Return
Index as of the end of the next day after notification to the issuer. In addition, if the
Excess Return Index value falls x% from its value at the time Note A is acquired, Note A
will automatically redeem based on a redemption price calculated using the closing
Excess Return Index value of the following day.

   The repayment obligation upon early redemption, automatic redemption, or at

maturity is calculated under a formula. The formula 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 y multiplied by the percentage of the increase

PLR-119215-10 4

or decrease of the beginning Commodity Index value compared to the ending
Commodity Excess Return Index value for the applicable period (“leveraged amount” or
“notional value”). To this result is added an amount that reflects interest on Note A at a
coupon rate of Rate less a basis points. From this amount is subtracted an annual fee
of b basis points of the leveraged amount.

  The terms of Note B will be the same as those of Note A, except that the Total

Return Index will be used in lieu of the Excess Return Index.

  The terms of Note C will be the same as those of Note A, except that the Excess

Return Subindex will be used in lieu of the Excess Return Index.

  The terms of Note D will be the same as those of Note A, except that the Total

Return Subindex will be used in lieu of the Excess Return Index.

   Fund makes the following representations with respect to the Notes:

(1) The issuers of the Notes will receive payment in full of their purchase prices
substantially contemporaneously with the delivery of the Notes;

(2) The Fund, while holding the Notes, will not be required to make any payment to the
issuers 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 issuers of the Notes are not and will not be subject by the terms of the
instrument to mark-to-market margining requirements of the Commodities Exchange
Act, 7 USC 2, as amended (“CEA”); and

(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.

                                       LAW

    Section 851(b)(2) of the Code provides that a corporation is not 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 sources. Under section 851(b)(2),
qualifying income includes

   . . . 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 its business
   of investing in such stock, securities, or currencies . . . .

PLR-119215-10 5

   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 Notes 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.

PLR-119215-10 6

    In addition, the flush language of section 851(b) of the Code provides that, for

purposes of section 851(b)(2), the term “dividends” includes 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), there is a distribution out of the earnings and
profits of the taxable year which are attributable to the amounts so included.

   Section 957 of the Code defines a 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) 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 the corporation and who owns stock in it 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). Section 954(c)(1) defines foreign personal holding company income to include
dividends, interest, royalties, rents, and annuities; gains in excess of losses from
transactions incommodities (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.

  Subs’ investments may generate foreign personal holding company income

under section 954(c), which is subpart F income. Fund would therefore include in
income Subs’ subpart F income for the taxable year in accordance with section 951.

                        ANALYSIS AND CONCLUSION

   Fund has represented that Subs will be wholly owned subsidiaries of Fund. Fund

is a United States person. Based upon Fund’s representations, Subs will qualify as
CFCs under these provisions.

   Based on the facts as represented, we rule that: (1) income from the Notes is

qualifying income described in section 851(b)(2) of the Code and (2) the subpart F
income attributable to Fund from its investment in Subs is income derived with respect
to the Fund’s business of investing in the stock of Subs and thus constitutes qualifying
income under section 851(b)(2).

PLR-119215-10 7

   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 Fund qualifies as a RIC under subchapter M of the Code.

   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.

     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,


                                               Susan Thompson Baker
                                               Susan Thompson Baker
                                               Senior Technician Reviewer, Branch 2
                                               Office of Associate Chief Counsel
                                               Financial Institutions and Products