The Internal Revenue Service (IRS) recently issued a notice of proposed rulemaking which, if adopted, could affect the analysis for determining whether or not an investment produces qualifying income for purposes of the income test under Subchapter M of the Internal Revenue Code. The proposed guidance starts by setting forth the standards for the income test and asset diversification test which both include “securities” (e.g. gains from the sale of securities is qualifying income under the income test). The IRS summarizes by stating that “[a]n asset is therefore a security for purposes of the income test and the asset diversification requirements if it is a security under the 1940 Act.” The proposed guidance goes on to state that “[a]ny 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.” In Revenue Rule 2006-1 the IRS ruled that income from a swap on a commodity index was not a security for purposes of the income test and was not derived from the RIC’s business of investing in stocks, securities or currencies. The practical effect of Revenue Ruling 2006-1 was that income from a commodity swap was deemed to be “bad income” under the income test and accordingly RICs started utilizing structured notes or Cayman subsidiaries to obtain their commodity exposure to ensure that the income was qualifying income for purposes of the income test. As part of the Proposed Guidance, the IRS is requesting comment as to whether or not Rev. Rul. 2006-1 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determinations of whether a financial instrument or position held by a RIC is a security under the 1940 Act should be withdrawn effective as of the date of publication in the Federal Register of a Treasury decision adopting these proposed regulations as final regulations.” Therefore, if the guidance is adopted as proposed, and the prior guidance such as Rev. Ruling 2006-1 is rescinded, then the practical effect would be that a RIC could look solely to SEC guidance (and not to IRS interpretations) as to whether or not a specific investment, such as a commodity swap, is a security under the 1940 Act and therefore constitutes qualifying income for purposes of the income test under subchapter M.
Comments are due December 27, 2016. The guidance can be found here.