Evolution of commodity-linked investments by mutual funds.

• Author: Snow, Stephen

Historically, a mutual fired seeking to maintain status as a regulated investment company (RIC) has had limited economic exposure to commodity prices. For example, neither commodity futures contracts nor direct purchases or sales of commodities generate RIC qualifying income under Sec. 851(b)(2). Recently, Rev. Rul. 2006-1 held that a commodity-linked swap also does not generate RIC qualifying income. Based on a detailed analysis of the relevant legislative history, the IRS ruled that, in the absence of "conclusive authority" on the status of a swap as an Investment Company Act of 1940 ('40 Act) security, a commodity swap does not generate RIC qualifying income. However, more recently, letter rulings have allowed RICs to use commodity-linked structured securities to gain economic exposure to commodity prices and simultaneously generate qualifying income. This has given rise to numerous questions as to the proper treatment of such instruments.

Letter Rulings

In IRS Letter Rulings 200628001, 200637018, 200647017, 200701020 and 200705026, the Service held that certain commodity-linked "notes" (instruments) could generate RIC qualifying income. (This possibility was suggested in Rev. Rul. 2006-31, which modified and clarified Rev. Rul. 2006-i.) In each case, the instruments required an initial investment by the fund and provided a return based on a formula referenced to a commodity-linked index. At maturity (usually more than a year after the investment), the issuer had to repay the initial investment to the fund, multiplied by the percentage (magnified by a "leverage factor" e.g., three) of increase or decrease of the index level during the investment's term. The issuer was also required to repay or retire the instrument before maturity if the index declined by a certain amount (e.g., 15%). For example, if the relevant index declined by 5% during the instrument's term, assuming a leverage factor of three, the issuer would repay 85% of the fund's initial investment.

The economics of the instruments and a commodity swap are similar, in that both create investment exposure to changes in commodity prices. However, a purchaser of the instruments is not required to make any payments beyond the initial investment (in comparison, a commodity swap involves no initial investment, but thereafter requires periodic settlement payments). In addition, the instruments automatically terminate if the underlying index drops in value beyond a certain...