A Pending IRS Ruling Puts $50 Billion Worth Of Commodity Mutual Funds At Risk

A tax lawyer I know sent me a link to an article about a tax ruling. I’m thinking “Boring”, who cares about that? Then I read the article. A few lines jumped out: 

Commodity prices could come under severe pressure if the U.S. Internal Revenue Service (IRS) decides to revoke previous rulings. 

Without the tax exemption, mutual funds would have to restructure or liquidate their holdings. 

The resulting liquidation would put tremendous pressure on commodity prices and reverse much of the build up of speculative money in commodity markets over the past decade. 

An enormous industry has built up on a very thin legal foundation, and now it’s starting to sway dangerously in the wind. 

I’m no tax lawyer, so I recommend that readers draw their own conclusions about this screwy story. Link. My take: 

Mutual Funds (MFs) are restricted as to their investments in commodities by a law that was established in 1936 and revised in 1954. The rules are straightforward. No mutual fund registered in the USA is allowed to own more that 10% of total assets in commodities. (There are negative tax consequences to the MFs if they exceed the limit.) 

The law hurt the MFs, so they sought a way around the laws. One after another the MFs requested an exception from the Internal Revenue Service (IRS). The rulings allowed the clever MFs to set up commodity investments using derivatives. To meet the guidelines for the special tax treatment, the funds set up “sham” companies in the Cayman Islands. From the article: 

These offshore shell corporations, established by mutual funds, are in every case wholly owned Cayman Island corporations. They are shells. There are no physical offices, no employees of their own, no independent operations. The mutual fund’s U.S. employees run their commodities portfolios from their U.S. offices. 

After 2006, the IRS issued a total of 72 Private Letter Rulings to MFs that gave the go-ahead for the MFs to investment 100% in commodities via derivatives and offshore shell companies. The IRS stopped issuing these PLRs in 2011. As of today, there are 28 requests for similar PLRs. The IRS has left these in an inbox for over a year now.

Behind this standstill at the IRS is the guiding hand of Administration. What are its objectives?

Many Democrats, including Obama, have pointed at the “evil speculators” who push up commodity prices. Any regulatory/tax changes that discouraged the speculation would, therefore, be a “positive” outcome.

Individuals who invest in commodities via mutual funds do pay taxes on any of the gains that are realised. But those gains are often deferred for years; therefore the timing of the tax receipts is also deferred. This is a disadvantageous position for a government that is running trillion dollar annual deficits.

Some thoughts on this:

This is nuts! $50Bn of small investor money is tied up in commodity derivatives booked with offshore corporate shells to skirt existing regulations and to avoid current US taxes? And its happening with “side deals”?

-Something has to give. 72 mutual funds have permission to avoid the law (the PLRs). These entities have a “green light”, but no one else is allowed to play in this lucrative sandbox? There can’t be a carve-out for a select few. Either this is legal (confirmed by Congress), or it’s not.

-A very powerful Senator, Carl Levin, (D-Mi) is behind the effort to eliminate the mutual fund exemption (reverse the existing PLRS) for commodity investment. His words on the topic; clearly he is no fan:

“The controlled foreign corporations are corporate fictions, offshore shams, paper exercises whose sole purpose is to make an end run around the legal restrictions on commodity investments by mutual funds.”

-Nothing will happen on this until well after the election. If there are no changes at the White House, and the composition of Congress remains about the same, then this issue will come up in Q1 2013. 

-If Congress did vote on this, and they concluded (as per Senator Levin) that MFs should not be allowed to avoid current law via PLRs, then it could result in a fairly large hiccup in the commodity markets. A significant portion of the $50Bn now invested by MFs would have to be unwound. 

-On the other hand, Congress could go in the other direction and confirm what the IRS has said in the PLRs. It could amend existing law to resolve the uncertainty. This would also create a hiccup as new money moved into the playground. 

-The outcome of this has hiccup potential, but the lasting consequences would be minimal (either way). In the end, global supply and demand sets prices for commodities, not tax and regulatory issues in the US. 

-If you were looking for an example of just how screwed up the system is, this might be it. We rely on 80-year old laws (that have been patched with private deals for a select few) to govern the way individuals invest. The cobbled-up system is broken; hiccups will be the result.

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