IRS Rules that Income from Derivatives on a Commodity Index is not “Qualifying Income” for Purposes of Subchapter M

The Internal Revenue Service recently issued Revenue Ruling 2006-1, which holds that income from a derivatives contract that provides exposure to a commodity index is not qualifying income for purposes of Section 851(b)(2) of the Internal Revenue Code.

The ruling involves a fund that invests substantially all its assets in debt securities and then enters into derivatives contracts linked to the return on a commodity index. The purpose of the contracts is to create investment exposure to changes in commodity prices.

Section 851(b)(2) of the Code provides that a fund will not be considered a “regulated investment company” unless 90% of its gross income is derived from certain enumerated sources. Those sources include dividends, interest, payments with respect to securities loans, gains from the sale or other disposition of stock or securities or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to the fund’s business of investing in such stock, securities, or currencies. A fund that does not meet the requirements of Section 851(b)(2) would be taxable on all of its income, whether or not that income is distributed to shareholders.

In reaching its holding, the IRS examined the legislative history of Section 851 and determined that derivative contracts on commodities indices are not securities for purposes of Section 851(b)(2). The IRS further determined that income from such contracts is not “other income derived with respect to the fund’s business of investing in stocks, securities or currencies” because the contracts are not securities and the purpose of entering into the contracts is to create investment exposure to changes in commodity prices not as part of the fund’s business of investing in stocks, securities or currencies.

The Revenue Ruling applies only to income received by a fund after June 30, 2006. According to the IRS, prospective application of the Ruling will provide funds enough time to respond to the position and to communicate that response to their shareholders.

Securities Industry FYI is a service of the BrokerDealer and Investment Management Practices of Morgan Lewis. If you have any questions concerning these important legal developments, please contact the following Morgan Lewis attorney:

Washington, D.C.
Jack P. Drogin
202.739.5380
jdrogin@morganlewis.com