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Firm Criticizes, Seeks Changes to Proposed RIC Rules

DEC. 23, 2016

Firm Criticizes, Seeks Changes to Proposed RIC Rules

DATED DEC. 23, 2016
DOCUMENT ATTRIBUTES

 

December 23, 2016

 

 

CC:PA:LPD:PR (REG 123600-16)

 

Room 5203

 

Internal Revenue Service

 

PO BOX 7604

 

Ben Franklin Station

 

Washington, DC 20044

 

 

CC:PA:LPD:PR (REG 123600-16)

 

Courier's Desk

 

Internal Revenue Service

 

1111 Constitution Avenue

 

Washington, DC 20044

 

RE: Comments on REG-123600-16: Proposed Regulations under Section 851 of the Code

 

Dear Sir or Madam:

The IRS has issued Proposed Regulations under section 851 (the "Proposed Regulations")1 of the Internal Revenue Code of 1986, as amended (the "Code").2

This letter is respectfully submitted by Dechert LLP, in response to a request for comments with respect to the Proposed Regulations.

Dechert LLP is an international law firm with wide-ranging federal tax and financial services practices that serve clients in the United States and abroad. In the United States, we represent a substantial number of funds taxed as regulated investment companies ("RICs") under the Code, including mutual funds, closed-end funds, and exchange-traded funds ("ETFs") registered under the Investment Company Act of 1940, as amended (the "1940 Act")3 and companies electing treatment as business development companies ("BDCs") under the 1940 Act.

In developing these comments, we have drawn on our extensive experience relating to tax issues involving RICs and issues involving the 1940 Act. Although we have discussed certain matters addressed in the Proposed Regulations with some of our clients, the comments that follow reflect only the views of a group of attorneys in our federal tax practice and financial services practice, and do not necessarily reflect the views of our clients, other members of our federal tax or financial services group or the firm generally.

 

A. Background on RICs

 

The Code contains special rules relating to the taxation of RICs. Under section 851(a), a U.S. corporation (or entity otherwise taxed as a corporation) is generally able to qualify as a RIC for a taxable year if it is either registered, at all times during the taxable year, with the Securities and Exchange Commission ("SEC") as a management company or unit investment trust under the 1940 Act, or has in effect an election under the 1940 Act to be treated as a BDC.

Section 851(b) limits the section 851(a) definition of a RIC by providing that an eligible corporation shall not be considered a RIC for a taxable year unless it makes, or has made an election to be a RIC, and also satisfies certain requirements relating to the source of its income and the diversification of its assets.4

Under section 851(b)(2), a RIC must derive at least 90% of its gross income from dividends, interest, payments with respect to certain securities loans, 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, or net income derived from interests in certain qualified publicly traded partnerships (the "qualifying income requirement").

Under section 851(b)(3), a RIC must also satisfy certain diversification requirements with respect to its assets, generally at the close of each quarter of the taxable year (the "diversification requirements").5

A RIC that satisfies certain minimum distribution requirements6 is generally taxed as a pass-through entity that acts as a partial conduit of income and gains to its shareholders.

 

B. Background of the Proposed Regulations

 

1. Definition of Securities
As discussed further below, the Tax Reform Act of 1986 (the "1986 TRA")7 amended section 851(b)(2) to specifically clarify that a security for purposes of the qualifying income requirement is defined by reference to section 2(a)(36) of the 1940 Act.8

The 1986 TRA also expanded qualifying gross income for purposes of section 851(b)(2) to include a RICs "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." (the "Other Income Clause").

Section 851(c) provides rules and definitions that apply for purposes of the asset diversification requirements of section 851(b)(3), but does not specifically define "security." Section 851(c)(6), however, provides that the terms used in section 851(b)(3) and section 851(c) have the same meaning as when used in the 1940 Act. An asset is therefore a security for purposes of the qualifying income test and the asset diversification requirements if it is a security under the 1940 Act.

The Preamble to the Proposed Regulations (the "Preamble") notes that the Treasury Department and the IRS have in the past addressed whether certain instruments or positions are securities for purposes of section 851.

2. Revenue Rulings Involving Exposure to Commodities
The IRS has generally treated income from investments in commodities and derivatives on commodities as not being qualifying income for purposes of the qualifying income requirement under section 851(b)(2).9 In Rev. Rul. 2006-1,10 the IRS ruled that a derivative contract entered into by a RIC that provides for a total return exposure on a commodity index is not a security for purposes of section 851(b)(2), and that income from such a derivative contract is not qualifying income. Under the derivative contract, the RIC would pay the counterparty an amount based on a Treasury bill rate plus a spread and would be entitled to receive (or required to pay) an amount based on the total return on the commodity index. The ruling stated that there is no "conclusive authority" as to whether derivative contracts on commodities are included in the definition of securities under section 2(a)(36) of the 1940 Act.

Rev. Rul. 2006-1 also held that the income from such a derivative contract is not qualifying "other income" for purposes of section 851(b)(2) because that income is not derived with respect to the RICs business of investing in stocks, securities, or currencies, nor did the RIC enter into the contract in order to reduce or hedge the level of risk in a business of investing in stocks, securities, or currencies.11 The RIC instead entered into the derivatives to create investment exposure to changes in commodity prices.

Rev. Rul. 2006-1 was modified and clarified by Rev. Rul. 2006-31,12 which states that Rev. Rul. 2006-1 "was not intended to preclude a conclusion that the income from certain instruments (such as certain structured notes) that create commodity exposure for the holder is qualifying income under section 851(b)(2)."

3. Private Letter Rulings Involving Investments in Commodity Linked Note.
After issuing Rev. Rul. 2006-31, the IRS subsequently issued a substantial number of private letter rulings ("PLRs") which concluded that income and gains from certain notes linked to a commodity index ("commodity linked notes") are qualifying income under section 851(b)(2).13 As an initial matter, the notes covered by the PLRs satisfied the requirements for a hybrid instrument to be "predominantly a security" under section 2(f)(2) of the Commodity Exchange Act, as amended (the "Commodity Exchange Act").14 Under these requirements:
  • The issuer of the note must receive payment in full of the purchase price of the note substantially contemporaneously with the delivery of the note;

  • The RIC, while holding the note, must not be required to make any payment to the issuer of the notes in addition to the purchase price paid for the note, whether as margin, settlement payment, or otherwise, during the life of the notes or at maturity;

  • The issuer of the note must not be subject by the terms of the instrument to mark-to-market margining requirements of the Commodity Exchange Act; and

  • The note must not be, 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 Commodity Exchange Act.

 

In addition to the criteria in the Commodity Exchange Act listed above, the commodity linked notes covered by the PLRs typically placed certain restrictions on the applicable underlying commodity index and required certain other features that were generally intended to limit the value of the contingent commodity return as compared to the fixed return under the note.15 These features took into account prior guidance issued by the Commodity Futures Trading Commission ("CFTC") relating to hybrid instruments.16
4. Investments in Foreign Subsidiaries Investing in Commodities
The IRS also issued a substantial number of PLRs involving RICs that intended to form a wholly-owned offshore subsidiary, that would be taxed under the Code as a controlled foreign corporation ("CFC"),17 and which was intended to invest in commodities and/or derivatives on commodities.

If a RIC directly, or indirectly, owns at least 10% of the voting stock in a CFC, the RIC generally must include in its gross income its pro rata share of the CFCs "subpart F income"18 under section 951(a)(1)(A)(i), even if the CFC does not distribute that income to its shareholders. Such subpart F income inclusion normally does not technically qualify as a "dividend," because section 316 defines a "dividend" as any distribution of property by a corporation to its shareholders that meets certain requirements.19 Section 959(a)(1) generally provides that, if a CFC does make distributions to its shareholders, such distributions are not included in the gross income of shareholders to the extent that such amounts are, or have been, included in the gross income of the shareholders under section 951(a).

Thus, as a general matter, a U.S. shareholder in a CFC normally does not technically have "dividend" income with respect to subpart F inclusions under section 951(a), because amounts of subpart F income included under section 951(a) are not dividends and any related distributions actually received are generally not included in gross income under section 959(a)(1) because generally the amounts have already been included in taxable income by the U.S. shareholder.

Section 851(b) and the regulations thereunder20 provide a special rule that amounts included in a RICs gross income as subpart F income under section 951(a)(1)(A)(i) are treated as dividend income for purposes of the qualifying income requirement under section 851(b)(2) to the extent that under section 959(a)(1) there is a distribution out of the earnings and profits of the taxable year which are attributable to the amounts so included (the "RIC CFC Dividend Rule").

Thus, under the RIC CFC Dividend Rule, a RIC generally would be able to treat subpart F income inclusions as dividend income, for purposes of the qualifying income requirement under section 851(b)(2), to the extent that there is a distribution of such subpart F income.

The RIC CFC Dividend Rule was added to section 851 in 1975,21 at a time when RIC qualifying income was generally limited to dividends, interest and gains from stocks and securities. As a result, the RIC CFC Dividend Rule was needed at the time to treat distributed CFC income inclusions as dividends that were qualifying income for purposes of section 851(b)(2).

As discussed below, a similar rule was also added by the 1986 TRA to provide that amounts included in gross income under section 1293(a) (relating to certain passive foreign investment companies ("PFICs") that are qualified electing funds ("QEFs") (a "PFIC QEF"), are treated as dividends for purposes of the qualifying income requirement, to the extent that there is a distribution under section 1293(c) out of the earnings and profits of the taxable year which are attributable to the amounts so included.

As discussed further below, after the amendments to section 851(b) made by the 1986 TRA, subpart F income inclusions with respect to stock in a CFC, and any other income or gains from stock in a CFC, as well as income inclusions from a PFIC QEF should be viewed as qualifying income under section 851(b)(2), even if such income inclusions are not distributed to the RIC, because such income should be considered "other income . . . derived with respect to [the RICs] business of investing in stock." 22The IRS initially agreed with this approach in several PLRs23 involving RICs that each intended to form a wholly owned offshore subsidiary that would be taxed as a CFC, which was intended to invest in derivatives on commodities. The initial PLRs concluded that income derived by the RIC from its investment in its wholly-owned subsidiary, whether or not attributable to subpart F income, would be income derived with respect to the RICs business of investing in the stock of the subsidiary and would thus be qualifying other income to the RIC under section 851(b)(2).24 Subsequent PLRs limited their holding to subpart F income attributed to the RIC from its subsidiary.25

It should be noted that the conclusion reached by the IRS in prior PLRs which held that subpart F income derived from a wholly owned subsidiary was qualifying income was not dependent on whether such subpart F income was distributed. Thus, although under the RIC CFC Dividend Rule under § 851(b), distributed subpart F income generally is treated as a dividend for purposes of section 851(b)(2), the PLRs also included undistributed subpart F income of the CFC subsidiary that was included in the RICs income as qualifying "other income" under section 851(b)(2).

The IRS also issued PLRs which included income inclusions from PFIC QEFs as qualifying RIC income.26

5. Suspension of Issuing Private Letter Rulings and Subsequent Developments
In July 2011, the IRS suspended the issuance of PLRs relating to commodity linked notes and the issuance of PLRs relating to indirect investments in commodities through a wholly-owned CFC was also suspended.27 At the time of such suspensions, the IRS did not revoke previously issued PLRs or issue negative guidance.

In December 2011, Senators Carl Levin and Tom Coburn sent a joint letter to the Commissioner of the IRS, Douglas H. Shulman, in which they asked the IRS to permanently suspend the issuance of the PLRs relating to indirect RIC investments in commodities.28 In addition, on January 26, 2012, the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations held a hearing relating to the issuance of the PLRs involving wholly owned offshore subsidiaries of RICs investing in commodities and PLRs related to investments by RICs in commodity linked notes. Senator Levin reiterated his view that the conclusions in the PLRs were incorrect and he urged the IRS not to issue further rulings.29Commissioner Shulman responded that he believed that the conclusions in the PLRs were a reasonable interpretation of current law.30 Commissioner Shulman also indicated, however, that, in connection with its reconsideration of all of the issues relating to CFC subsidiaries of RICs investing in commodities and related investments, the IRS would consider the views expressed by Senator Levin.31

 

C. The Proposed Regulations

 

1. Defining Securities
The Preamble notes that the Treasury Department and the IRS have in the past addressed whether certain instruments or positions are securities for purposes of section 851, including Rev. Rul. 2006-1 and Rev. Rul. 2006-31. As discussed above, the IRS issued a substantial number of PLRs which ruled that income from certain commodity linked notes held by a RIC was qualifying income under section 851(b)(2). Many of these rulings, and numerous additional PLRs also addressed the treatment of a RICs income from a CFC that had investments in commodities and/or derivatives on commodities.

The Preamble states that by 2010, the IRS was devoting substantial resources to these private letter ruling requests and that in July 2011 the IRS notified taxpayers that the IRS would not issue further private letter rulings addressing specific proposed RIC commodity-related investments while the IRS reviewed the issues and considered guidance of broader applicability.

The Preamble further states that "determining whether certain investments that provide RICs with commodity exposure are securities for purposes of the income test and the asset diversification requirements requires the IRS implicitly to determine what is a security within the meaning of section 2(a)(36) of the 1940 Act. Section 38 of the 1940 Act, however, grants exclusive rulemaking authority under the 1940 Act to the Securities and Exchange Commission (SEC), including 'defining accounting, technical, and trade terms' used in the 1940 Act. Any future guidance regarding whether particular financial instruments, including investments that provide RICs with commodity exposure, are securities for purposes of the 1940 Act is therefore within the jurisdiction of the SEC."

The Preamble goes on to provide that "the Treasury Department and the IRS have reviewed the issues, considered the concerns expressed, considered resource constraints, and determined that the IRS should no longer issue letter rulings on questions relating to the treatment of a corporation as a RIC that require a determination of whether a financial instrument or position is a security under the 1940 Act. Contemporaneously with the publication of these proposed regulations, the Treasury Department and the IRS are issuing Rev. Proc. 2016-50 (2016-43 IRB 522), which provides that the IRS ordinarily will not issue rulings or determination letters on any issue relating to the treatment of a corporation as a RIC that requires a determination of whether a financial instrument or position is a security under the 1940 Act.32 Thus, for example, the IRS ordinarily will not issue a ruling on whether income is of a type described in the income test of section 851(b)(2) if that ruling depends on whether an instrument is a security under the 1940 Act."

The Preamble also states that the IRS will also consider adding the issue to the no rule list at the first opportunity.

In the Preamble the Treasury Department and the IRS also request comments as to whether Rev. Rul. 2006-1, Rev. Rul. 2006-31, and other previously issued guidance that involves determinations of whether a financial instrument or position held by a RIC is a security under the 1940 Act should be withdrawn effective as of the date of publication in the Federal Register of a Treasury Decision adopting the Proposed Regulations as final regulations.

2. Inclusions Under Section 951(a)(1)(A)(i) or 1293(a)
The Proposed Regulations also provide that for purposes of section 851(b)(2), amounts included in gross income by a RIC for a taxable year under section 951(a)(1)(A)(i) in respect of a foreign corporation that is a CFC, or under section 1293(a) with respect to a PFIC subject to a QEF election, will be treated as dividends only 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 that are attributable to the amounts included in gross income for the taxable year under section 951(a)(1)(A)(i) or section 1293(a)

The Proposed Regulations also provide a new rule that for purposes of qualifying income requirement under section 851(b)(2), amounts included in gross income under sections 951(a)(1) or 1293(a) (relating to CFC or PFIC QEF inclusions) are not treated as "other income" derived with respect to a RICs business of investing in stock, securities or currencies (the "Proposed Other Income Restriction").

As discussed above, the IRS previously issued PLRs which ruled that CFC inclusions and PFIC QEF inclusions were "other income" derived with respect to a RICs business of investing in stock, securities, or currencies. Thus the Proposed Other Income Restriction would reverse the holdings in such prior private letter rulings. The Proposed Other Income Restriction would apply to taxable years that begin on or after the date that is 90 days after the date of publication in the Federal Register of a Treasury decision adopting the Proposed Regulations as final regulations.

The discussion in the Preamble indicates that the Proposed Other Income Restriction is based on an interpretation by the Treasury and the IRS of the legislative history of the amendments made by the 1986 TRA to section 851.33 As we discuss below, we do not agree with such interpretation of the legislative history of the 1986 TRA and also believe that it would not be appropriate to adopt the Proposed Other Income Restriction.

 

D. Discussion on Comments Relating to the Proposed Regulations

 

1. Restriction on Issuances of Private Letter Rulings under Section 851.
As discussed in section C.l, above, the IRS has determined that it ordinarily will not issue private letter rulings or determination letters on any issue relating to the treatment of a corporation as a RIC that requires a determination of whether a financial instrument or position is a security under the 1940 Act.

Section 2.01 of Rev. Proc. 2016-3,34 provides that the IRS may decline to issue a letter ruling or a determination letter when appropriate in the interest of sound tax administration (including due to resource constraints) or on other grounds whenever warranted by the facts or circumstances of a particular case.

We understand and agree that that the PLRs relating to commodity linked notes and/or foreign subsidiaries investing in commodity derivatives (the "Commodity PLRs") did result in a tremendous amount of strain on IRS resources. The IRS issued more than 70 Commodity PLRs35 and we understand that substantial additional private letter ruling requests were pending when the IRS suspended the issuance of Commodity PLRs. Many of the Commodity PLRs involved multiple RIC taxpayers. The private letter ruling requests relating to commodity linked notes also involved substantial IRS resources because the requests often involved numerous varying linked commodity indexes and subindexes and index providers often published new types and variations on commodity indexes and subindexes.

Under the circumstances, it was clearly appropriate for the IRS to suspend the issuance of Commodity PLRs in July 2011. As discussed in the Preamble the rulings were suspended "while the IRS reviewed the issues and considered guidance of broader applicability."

The controversy surrounding Senator Levin's views was apparently a factor that has prevented or delayed any possible published Revenue Rulings relating to a RICs exposure to commodities. After the suspension of Commodity PLRs for more than five years, it is not now necessary or useful to provide any published guidance relating to commodity linked notes in light of other IRS priorities. During the suspension, RICs and their investment advisors desiring commodity exposure have typically consulted with their tax advisors and other tax professionals with respect to the issues relating to commodity exposure, including those relating to investments previously addressed in the Commodity PLRs.

It should be noted, however, that, in our view, the prior PLRs relating to commodity linked notes were correctly decided. Also, the PLRs were not primarily based on a determination as to whether the commodity linked notes were securities within the meaning of section 2(a)(36) of the 1940 Act and were instead primarily based on the fact that the notes covered by the PLRs satisfied the requirements for a hybrid instrument to be "predominantly a security" under section 2(f)(2) of the Commodity Exchange Act,36 and certain other CFTC guidance relating to hybrid instruments. Because the PLRs relating to the commodity linked notes were correctly decided and because there has been no relevant change in law, it would be appropriate if the IRS decided to not revoke such PLRs. Any possible revocation by the IRS of the prior PLRs relating to commodity linked notes should be prospective with significant delays relating to the timing of any such revocations.

We do have concerns relating to whether the Revenue Procedure will result in the absence of future guidance relating to RIC issues, either in the form of private letter rulings or Revenue Rulings. The Revenue Procedure provides that the IRS "ordinarily" will not issue rulings or determination letters on any issue relating to the treatment of a corporation as a RIC that requires a determination of whether a financial instrument or position is a security under the 1940 Act.

We would recommend that the IRS not formally add this issue to the no rule list. We are also hopeful that the IRS would still consider ruling requests in situations where the status of an investment as a security under section 2(a)(36) of the 1940 Act is sufficiently clear either under the language of section 2(a)(36) or in situations where a taxpayer can show that the SEC has issued relevant guidance on the treatment as an instrument as a security. In the case of a possible Revenue Ruling, it may also be appropriate for the IRS to consult with the SEC on a particular issue.

RICs often have a need to request guidance, particularly on any uncertain issues that potentially relate to whether a RICs would satisfy the RIC requirements under section 851. Historically, the IRS has been able to provide guidance through PLRs and/or Revenue Rulings. Except for the Commodity PLRs, there have not recently been significant requests for PLRs that are repetitive. Further, the IRS will, of course, retain the discretion to decline a proposed request for PLR.

Although the RIC provisions and the rules under the 1940 Act are generally intended to be consistent, since the enactment of the 1940 Act the IRS has issued a very substantial number of private letter rulings and Revenue Rulings involving RICs that are related to terms included in the 1940 Act. Subject to IRS resource restraints and priorities, we are hopeful that after the Revenue Procedure, the IRS will continue to issue guidance to RICs through Revenue Rulings, and when appropriate through PLRs.

2. Treatment of Income Inclusions from CFCs and PFICs Subject to QEF Elections
As discussed in section C.2, above, the Proposed Regulations provide that for purposes of section 851(b)(2), amounts included in gross income by a RIC for a taxable year under section 951(a)(1)(A)(i) in respect of a foreign corporation that is a CFC, or under section 1293(a) with respect to a PFIC subject to a QEF election, will be treated as dividends only 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 that are attributable to the amounts included in gross income for the taxable year under section 951(a)(1)(A)(i) or section 1293(a) (the "RIC CFC and PFIC QEF Dividend Rules").

As set forth in the Proposed Regulations, the RIC CFC and PFIC QEF Dividend Rules, are consistent with the statutory language in section 851(b) and we are not sure why it would be necessary to adopt additional regulations on this point.

However, under the Proposed Other Income Restriction, the Proposed Regulations would also provide a new rule that for purposes of the qualifying income requirement under section 851(b)(2), amounts included in gross income under sections 951(a)(1) or 1293(a) (relating to CFC or PFIC QEF inclusions) are not treated as "other income" derived with respect to a RICs business of investing in stock, securities or currencies.

As discussed above, the IRS previously issued private letter rulings which ruled that CFC inclusions and PFIC QEF inclusions were "other income" derived with respect to a RICs business of investing in stock, securities, or currencies. Thus the Proposed Other Income Restriction would reverse the holdings in such prior private letter rulings.

The Proposed Other Income Restriction would require a RIC to comply with the RIC CFC and PFIC QEF Dividend Rules in order for the RIC to have qualifying income under section 851(b)(2) with respect to income inclusions from CFCs and/or PFIC QEFs.

We strongly believe that the Proposed Other Income Restriction is not a correct interpretation of the intent under section 851(b)(2) and we strongly urge that any final regulations remove the Proposed Other Income Restriction.

Although the IRS has dealt with PLRs involving wholly owned CFCs investing in commodities and commodity derivatives, the Proposed Other Income Restriction would also have a substantial detrimental effect in other situations where a RIC invests in CFCs and PFIC QEFs. The proposed treatment of CFCs and PFICs subject to a QEF election would be problematic to RICs that may not have the ability to control distributions by the CFCs or PFICs, including situations where the CFC or PFIC QEF in which the RIC invests has income inclusions in excess of available and/or allowable distributions.

As a result of the continuing expansion of global capital markets in stocks, many RICs make investments in stocks of foreign issuers that are treated as CFCs or PFICs in situations where there are no distributions made by the CFC or PFIC. In addition various other types of investments and structures have been, developed that would be significantly impacted by the Proposed Other Income Restriction. As an example, BDCs and other RICs hold shares of stock or other equity interests in certain collateralized loan obligations ("CLOs"), the issuers of which are treated as either CFCs or PFICs. BDCs and other RICs often make investments in CLOs where the current income inclusions to the RIC may vastly exceed available and/or allowable distributions from the CLO to the RIC.

Investments in CFCs and PFICs are clearly investments in stock for purposes of section 851, and any income from the stock should be qualifying "other income" from stock without regard to whether the RIC CFC or PFIC QEF Dividend Rule is satisfied.

As discussed above, the discussion in the Preamble indicates that the Proposed Other Income Restriction is based on an interpretation by the Treasury and the IRS of the legislative history of the amendments made by the 1986 TRA to section 851. The 1986 TRA added the Other Income Clause to section 851(b)(2) and it also added an amendment to section 851(b) which added the PFIC QEF Dividend Rule. The Treasury and IRS believe that because the language in the PFIC QEF Dividend Rule is more specific it should take priority over the Other Income Clause.

Although both the RIC CFC and PFIC QEF Dividend rules are specific as to the treatment on income inclusions from CFCs and PFICs QETs as dividend income, the rules only apply to dividend income. RICs are also able to have other types of qualifying income under section 851(b)(2) including "other income" from the business of investing in stocks and securities. Any income derived from stock should also be viewed as other income from an investment in stock, irrespective of whether an income inclusion under CFCs or PFIC QEFs can also be treated as dividend income.

The amendment in the 1986 TRA which added the PFIC Dividend Rule was included as a part of the rules relating in PFICs added in section 1235(a) of the 1986 TRA which added sections 1291 through 1297 to the Code. At the time that the rules relating to PFICs in 1986 were formulated, as contained in the House of Representatives version of 1986 TRA, qualifying income from stock generally only included dividends and gains from stock. As a result, it is understandable that the PFIC rates in section 1235(a) of the 1986 TRA would have included the RIC QEF Dividend Rule in section 851(b), which was included as a technical correction in section 1235(f) of the 1986 TRA.

The legislative antecedents to the 1986 TRA with respect to the other amendments to section 851(b)(2), included H.R. 3397, which was introduced on September 20, 1985, by Representatives Flippo, Kennelly, and McGrath, and S. 2155, which was introduced on March 7, 1986, by Senator Armstrong. These bills proposed the "other income" provision and the cross-reference to the definition of security in the 1940 Act.37 Thus, the Other Income Clause was added to the 1986 TRA legislation by a Senate floor amendment independently from the PFIC QEF language that was part of provisions relating to PFICs.

We therefore strongly believe that the Other Income Clause should also apply to CFC and PFIC inclusions. The Other Income Clause is intended to have broader applicability, and the Other Income Clause was added into the 1986 TRA independently from the PFIC QEF Dividend Rule in the course of the drafting of the 1986 TRA legislation. Income from investments in stock are clearly qualifying "other income" derived with respect to a RICs business of investing in stock, securities, or currencies "other income." This view is clearly consistent with the rulings prior Commodity PLRs.

Our view is also consistent with an article written by Dale Collinson in 2007 ("the Collinson Article").38 Mr. Collinson was an official in the Financial Institutions and Products branch at the IRS who was heavily involved in the 2006 Revenue Rulings and was also heavily involved in the rationale supporting the conclusions in the Commodity PLRs. The Collinson Article thoroughly discusses the legislative history behind the 1986 TRA, including both the Other Income Clause and the PFIC QEF Dividend Rule. Mr. Collinson concludes that the Other Income Clause should take precedence and he also suggests that in some future "deadwood bill" it would likely be useful to delete the dividend rule relating to CFC and PFIC QEF inclusions that "is no longer necessary because of the enactment of the other income provision."39

3. Effect on Previously Issued Guidance
The Treasury Department and the IRS also request comments as to whether Rev. Rul. 2006-1, Rev. Rul. 2006-31, and other previously issued guidance that involves determinations of whether a financial instrument or position held by a RIC is a security under the 1940 Act should be withdrawn effective as of the date of publication in the Federal Register of a Treasury decision adopting the Proposed Regulations as final regulations.

The withdrawal of the prior Revenue Rulings and other previously issued guidance could potentially have an effect on the treatment of other types of investments under the qualifying income requirement.

Rev. Rul. 2006-1 also includes a discussion relating to the legislative history of the 1986 TRA and states as follows:

 

When Senator Armstrong offered the relevant provision as an amendment on the Senate floor, he asserted that it "enjoys the support of the Treasury Department" and that its purpose was "to permit the mutual fund industry to make better use of income from stock options, futures contracts and options on stock indexes, options and futures o[n] foreign currencies, and foreign currency transactions." 132 Cong. Rec. 14,991-92 (1986).

This discussion demonstrates that the amendments to section 851(b)(2) made by the 1986 Act had a very specific purpose, which was to provide certainty by expanding the statutory description of qualifying income to include income that the Service, in specific cases, had already treated administratively as qualifying income. This included income from derivative contracts on stocks and securities (as the term "security" is generally understood in the U.S. tax law), such as futures and options on stock indices, which create an economic exposure to stock or securities even though the property underlying the derivative may be a collection of stocks, and securities, rather than a specific stock or security

 

The discussion in Rev. Rul. 2006-1 clearly indicates that income from derivative contracts on stocks and securities (as the term "security" is generally understood in the U. S. tax law), including futures and options on stocks or securities indices were intended by the 1986 TRA to be qualifying income for purposes of section 851(b)(2). Various derivatives on stocks or securities, including derivatives on stocks or securities indices, are either specifically included as "securities" under section 2(a)(36) of the 1940 Act and/or should be treated as deriving "other income" from the RICs business of investing in stocks or securities.

RICs have relied on the above discussion in Rev. Rul. 2006-1 during more than 10 years and a substantial number of RICs invest in derivative contracts on stocks and securities, including futures and options on stocks and securities indices. The withdrawal of Rev. Rul. 2006-1 would create confusion and potential uncertainty.

It should also be noted that the holding in Rev. Rul. 2006-1 relating to the treatment of certain derivative contracts on a commodity index under section 851(b)(2) was not based on a conclusion that such derivatives were included as securities under section 2(a)(36) of the 1940 Act. In contrast, the ruling held that such a derivative was not a security for purposes of section 851(b)(2) because the IRS did not believe that there was "conclusive authority" that such a derivative was a security under section 2(a)(36) of the 1940 Act.

Rev. Rul. 2006-31 is also important in clarifying Rev. Rul. 2006-1, which states that the prior ruling "was not intended to preclude a conclusion that income that certain instruments (such as certain structured notes) that create commodity exposure for the holder is qualifying income under section 851(b)(2)."

The holdings and discussions in Rev. Rul. 2006-1 and Rev. Rul. 2006-31 were correct. Both Revenue Rulings have been also cited in numerous private letter rulings during the last eleven years. RICs and investment advisors to RICs have made investments in reliance in such Revenue Rulings. In addition, law firms, accounting firms, and other tax professionals have provided tax opinions or less formal guidance or derived comfort from Rev. Rul. 2006-1 and Rev. Rul. 2006-31 and from private letter rulings involving the treatment of items for purposes of section 851(b)(2). Although a taxpayer may not rely on private letter rulings issued to other taxpayers, the reasoning in these rulings can be helpful in considering the treatment of income under section 851(b)(2).

Although we understand that the IRS may wish to revoke prior PLRs involving commodity linked notes and/or investments by RICs in subsidiaries investing in commodities and/or derivatives on commodities, the IRS could instead properly determine that such prior rulings need not be revoked. As discussed above, the holdings and analysis in the PLRs were correct and are still correct.

In conclusion, we believe that Rev. Rul. 2006-1 and Rev. Rul. 2006-31 should not be withdrawn. Although we understand that the IRS may wish to revoke the prior Commodity PLRs, it would also be appropriate if the IRS concluded that such private letter rulings should not be revoked. If the IRS does decide to revoke the prior Commodity PLRs, any such revocations should be only made prospectively with a significant delay to allow time for the involved RICs to either change their investments, potentially change disclosure, and to possibly obtain opinions or other guidance from their tax professionals.

 

* * * * *

 

 

We appreciate the opportunity to comment on the Proposed Regulations.

Please feel free to contact Richard M. Hervey at 212-698-3568, Ari Zak at 212-698-3655, or Jeffrey Sion at 212-698-3518 with any questions about this submission.

Very truly yours,

 

 

Dechert LLP

 

 

cc:

 

Helen M. Hubbard

 

Associate Chief Counsel (Financial Institutions & Products)

 

Internal Revenue Service

 

1111 Constitution Avenue

 

Washington, DC 20224

 

 

Susan T. Baker

 

Associate Chief Counsel (Financial Institutions & Products)

 

Internal Revenue Service

 

1111 Constitution Avenue

 

Washington, DC 20224

 

 

Matthew Howard

 

Associate Chief Counsel (Financial Institutions & Products)

 

Internal Revenue Service

 

1111 Constitution Avenue

 

Washington, DC 20224

 

 

Pamela Lew

 

Associate Chief Counsel (Financial Institutions & Products)

 

Internal Revenue Service

 

1111 Constitution Avenue

 

Washington, DC 20224

 

FOOTNOTES

 

 

1 Proposed Regulations § 1.851-2(b), IRS REG-123600-16, 81 Fed. Reg. 66576 (Sept. 28, 2016), 2016-43 IRB 523. The Proposed Regulations, if adopted, would apply to taxable years that begin on or after the date that is 90 days after the date of publication in the Federal Register of a Treasury decision adopting the Proposed Regulations as final regulations.

2 Unless otherwise specified, all section or § references are to sections of the Code.

3 Pub. L. No. 76-768, 56 Stat. 847, as amended; 15 U.S.C. §§ 80a-1 to 80b-2.

4 § 851(b)(2), § 851(b)(3). An entity must also satisfy certain minimum distribution requirements with respect to a taxable year under § 852(a), in order to qualify for treatment as a RIC with respect to such taxable year.

5 § 851(b)(3). Under one of these diversification requirements (the "50% diversification requirement"), a RIC must, generally at the close of each quarter of the taxable year, have at least 50% of the value of its total assets invested in cash, cash items (including receivables), Government securities, securities of other RICs, and investments in other securities that, with respect to any one issuer, do not represent more than 5% of the total assets of the RIC or more than 10% of the voting securities of such issuer. § 851(b)(3)(A). Under a second diversification requirement (the "25% diversification requirement"), generally at the close of each quarter of the taxable year, not more than 25% of the value of the RICs total assets may be invested in: (i) the securities (other than Government securities or the securities of other RICs) of any one issuer; (ii) the securities (other than the securities of other RICs) of two or more issuers that the RIC "controls" and that are engaged in the same or similar trades or businesses or related trades or businesses; or (iii) the securities of one or more "qualified publicly traded partnerships." § 851(b)(3)(B).

6 § 852(a).

7 Pub. L. No. 99-514, 100 Stat. 2085 (1986).

8 Section 2(a)(36) of the 1940 Act defines the term "security" as follows:

Security means any note, stock, treasury stock, security futures, 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.

9See Rev. Rul. 2006-31, 2006-1 CB 1133.

10 2006-1 CB 261.

11 The IRS has issued certain private letter rulings that provide in certain cases income from a derivative that acts as a hedge to securities may be treated as qualifying income. See e.g. PLRs 200440012, 200652013.

12 2006-1 CB 1133. Rev. Rul. 2006-1 was applied on a prospective basis to income recognized after June 30, 2006. This effective date was further extended by Rev. Rul. 2006-31, which stated that the IRS will not apply the principles of Rev. Rul. 2006-1 adversely with respect to amounts of income recognized on or before September 30, 2006, by a taxpayer from a derivative contract (including an option, futures, or forward contract) on a commodity index or an individual commodity.

13See, e.g., PLRs 201135001, 201131001, 201108018, 201108003, 201107012, 201104013, 201043016, 200822012, 200705026, 200701020, 200647017, 200637018, and 200628001.

14 7 U.S.C. § 2.

15 Although particular PLRs varied, the approved notes typically had the following characteristics: (i) the notes were based on a broad-based commodity index or on a sub-index of a broad-based commodity index with at least two commodity components; (ii) the notes were issued at par value; (iii) the notes paid interest at a coupon rate which was typically payable either quarterly or on maturity; (iv) the principal payable under the notes was based on a formula that included a leverage factor of no greater than 3.0 (i.e. the formula included a change in principal based on no more than three times the movement in the underlying index); (v) the notes typically had a maturity of slightly more than one year; (vi) the RIC was able to put the note to the issuer on any business day with a specified notice period; and (vii) the notes would be automatically triggered and redeemed (based on the next day's price) upon a specified drop in the index and/or principal payment formula. If the trigger was based upon a specified drop in the principal payment formula the trigger was typically no greater than 45% of the original principal. If the trigger is based on a drop in the index then the trigger was typically no greater than 45% divided by the leverage factor. As an example, if the leverage factor is three, the trigger could be a 15% drop in the index

16See CFTC Regulation Part 34; 1989 CFTC Statutory Interpretation Concerning Certain Hybrid Instruments.

17 The Code provisions on CFCs are included in subpart F of the Code under §§ 951-965.

18See § 952.

19See also Reg. § 1.951-1(a)(2).

20 Reg. § 1.851-2(b)(2).

21 Tax Reduction Act of 1975, Pub. L. No. 94-12, § 602, 89 Stat. 26, 58. See Collinson, Qualifying Income of a RIC from Investment in a CFC, 2007 Tax Notes Today 30-49 (Feb. 13, 2007).

22 § 851(b)(2)(A).

23 PLR 200647017. See also PLRs 200741004, 200743005, 200822010, 200840039, and 200842014.

24 PLR 200647017. See also PLRs 200741004, 200743005, 200822010, 200840039, and 200842014.

25 PLRs 200912003, 200922010, 200923011, 200931003, 200931008, 200932007, 200936002, 200939017, 200946036, 200947032, 200947026, 201005023, 201007044, 201020003, 201024004, 201024003, 201025031, 201026017, 201030004, 201034011, 201037014, 201037012, 201039002, 201041033, 201042015, 201042001, 201043017, 201048022, 201048021, 201049015, 201051014, 201102055, 201102047, 201103009, 201103033, 201103017, 201104013, 201107012, 201108008, 201108018, 201116014, 201120017, 201122012, 201128022, 201129002, 201131001, 201132008, and 201134014.

26 PLRs 200743005, 200946036 and 201039002.

27 Sheppard, News Analysis: IRS Suspends RIC Commodities Investments Rulings, 2011 Tax Notes Today 145-1 (July 28, 2011).

28 2012 Tax Notes Today 17-31.

29See Compliance With Tax Limits on Mutual Fund Commodity Speculation, Senate Hearing 112-343 (Jan. 26, 2012).

30Id.

31See Testimony from IRS Commissioner Douglas H. Schulman, 2012 Tax Notes Today 18-37; Compliance With Tax Limits on Mutual Fund Commodity Speculation, Senate Hearing 112-343 (Jan. 26, 2012).

32 Rev. Proc. 2016-50, 2016-43 IRB 522, applicable to all requests for letter rulings, including any requests pending in the IRS National Office and any requests submitted on or after September 27, 2016 (the "Revenue Procedure").

33 The Preamble states as follows:

 

Section 851(b) was amended by the Tax Reduction Act of 1975, Pub. L. No. 94-12, § 602, 89 Stat. 26, 58 (the "1975 Act") (for inclusions under section 951(a)(1)(A)(i)), and by the Tax Reform Act of 1986, Pub. L. No. 99-514, § 1235, 100 Stat. 2085, 2575 (the "1986 Act") (for inclusions under section 1293(a)), to specify how a RIC treats amounts included in income under section 951(a)(1)(A)(i) or 1293(a) for purposes of the income test of section 851(b)(2).

The significance of treating an inclusion as a dividend under section 851 is that a dividend is qualifying income under section 851(b)(2). The amendments to section 851(b) made by the 1975 Act and the 1986 Act unambiguously condition dividend treatment of an inclusion under section 951(a)(1)(A)(i) or 1293(a) on a distribution from the foreign corporation's earnings and profits attributable to the amount included. Absent a distribution, there is no support in the Code for treating an inclusion under section 951(a)(1)(A)(i) or 1293(a) as a dividend under section 851.

Notwithstanding the distribution required by section 851(b), in certain circumstances the IRS has previously issued letter rulings under section 851(b)(2) that permit an inclusion under section 951(a)(1)(A)(i) or 1293(a) to qualify as "other income" derived with respect to a RICs business of investing in currencies or 1940 Act stock or securities even in the absence of a distribution. Reading section 851(b)(2) in this manner ignores the requirement in section 851(b) that amounts be distributed in order to treat these inclusions as dividends. This distribution requirement is a more specific provision than the other income clause. In addition, it cannot be suggested that the distribution requirement was superseded by the other income clause because the other income clause and the distribution requirement for inclusions under section 1293(a) were both added by the 1986 Act. Therefore, these proposed regulations specify that an inclusion under section 951(a)(1)(A)(i) or 1293(a) is treated as a dividend for purposes of section 851(b)(2) only to the extent that the distribution requirement in section 851(b) is met. These proposed regulations further provide that, for purposes of section 851(b)(2), an inclusion under section 951(a)(1) or 1293(a) does not qualify as other income derived with respect to a RICs business of investing in stock, securities, or currencies.

 

34 2016-1 IRB 126.

35 2012 Tax Notes Today 17-31.

36 7 U.S.C. 2.

37See 131 Cong. Rec. 24,570 (1985) (section-by section analysis of H.R. 3397).

38 Collinson, Qualifying Income of a RIC from Investment in a CFC, 2007 Tax Notes Today 30-49 (Feb. 13, 2007).

39Id.

 

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