Controlled Foreign Corporations and Commodity Exposure in Mutual Funds

By James W. Kaiser, CPA
Partner, Investment Management Group

One of my colleagues once said to me, “Why won’t the IRS just let regulated investment companies just invest in commodities?”  Many funds seek the commodity exposure, and many are finding creative ways to circumvent this restriction.  I recently worked with a client who is creating a Controlled Foreign Corporation (“CFC”) as a means to gain commodity exposure in their mutual fund.  This concept has been blessed by the IRS via a Private Letter Ruling. 

How does this work? 
A CFC is a foreign (probably Cayman) corporation that invests in commodities and futures contracts on commodities.  It is wholly-owned by a U.S. regulated investment company.  The U.S. investment company invests up to 25% of its assets in the CFC.  Income earned from the CFC is deemed to be a dividend to the mutual fund, which is treated as qualifying income for the purposes of the 90% gross income test.  If a mutual fund invests directly in commodities or futures contracts on commodities, the income earned from such investments will not be treated as qualifying income.  Therefore, the CFC magically cleanses the income from the commodities and converts it to qualifying income.   

What are the operational issues? 
The biggest issue with this setup is that the GAAP and tax treatments are contradictory.  For GAAP purposes, the CFC must be consolidated with the mutual fund, as the fund has a controlling interest – 100% in this scenario.  There is a rather large fund complex with a fund that has this arrangement that did not consolidate.  While I do not know all of the details, that would seem to be incorrect to me.  For U.S. Income tax purposes, the CFC is treated as a separate entity. 

It is expected that there will be numerous purchases and sales of the CFC during the year as the fund’s advisor will attempt to manage the fund’s exposure to commodities, and the fund’s assets will fluctuate during the year due to market fluctuation and subscriptions and redemptions in the fund.  These will generate gains and losses on the books of the fund.  These gains and losses will need to be eliminated in the consolidation of the CFC when preparing the financial statements.

For tax purposes, any income earned by the CFC will be treated as a deemed distribution of income to the fund and increase the funds basis in the CFC.  Losses incurred by the CFC, determined on an annual basis, do not flow through to the fund and are deferred until the fund’s position in the CFC is eliminated.  Any sales of the CFC will first be treated as a redemption of the earnings and profits of the CFC.  Any redemptions in excess of the earnings and profits of the CFC will be treated as a return of capital.  Therefore, there are no capital gains/losses to be realized from the investment in the CFC. 

Another operational issue relates to the IRS diversification requirements that prohibit a single fund investment from exceeding 25% of its gross assets.  There is an exception which allows an investment to exceed 25% of the gross assets if the excess is solely due to market appreciation – i.e. the investment was less than 25% of the gross assets immediately after the most recent purchase.  However, as mentioned above, any income earned from the CFC is deemed to have been distributed and increases the fund’s basis in the CFC.  Is this essentially a purchase of the CFC?  Does this eliminate the market appreciation exception?  I would say no, as the CFC income is determined annually, but one cannot be certain how the IRS would interpret this.  However, since the fund will likely be making routine purchases of the CFC, the magnitude of the market appreciation exception at a minimum will be greatly reduced.  Therefore, if the investment in the CFC exceeds 25% of the gross assets at any quarter end, I would recommend taking the conservative approach and invoke the cure provision by reducing the position to less than 25% within the requisite 30 days after quarter end.

 The last operational issue I uncovered relates to the required distributions necessary to avoid excise tax, especially for a fund that is not a calendar year-end company.  Specifically, how do you determine the amount of income earned from the CFC for the purpose of computing the amount of income to be distributed?  The easy answer is the sales proceeds up to the amount of the earnings and profits of the CFC.  However, the earnings and profits of the CFC cannot be determined until the end of its fiscal year. For sake of ease of consolidation, most will likely be inclined to have the CFC adopt the same fiscal year-end as the fund.   If you are not familiar with the excise tax rules, a fund must distribute by December 31^st of each year 98% of its capital gains earned during a 12 month period ending October 31 and 98% of its income earned during the calendar year.  Therefore, the amount of income earned from a non-calendar year-end CFC is not determinable in time to make the required excise distribution.  This creates two choices for the fund: 1) treat all proceeds as being from earnings and profits of the CFC and subject to distribution; 2) disregard the CFC income for the purposes of excise distribution.  While the first option would avoid any excise tax, it does create the potential for a 1099 error, and the penalty for incorrect 1099s can be quite severe.  While the second option will likely create excise tax equal to 4% of the shortfall of the amount distributed from what was required to be distributed, it will avoid any potential 1099 penalties.  Neither scenario seems ideal.  For these reasons, it is imperative that the CFC choose a calendar year-end, regardless of the year-end of the parent fund.  Unfortunately, this will complicate the consolidation of the fund and the CFC for financial statement purposes.

Pros and Cons
The pros are pretty simple.  Utilizing a CFC is a way to gain commodity exposure in a mutual fund without causing the fund to fail the 90% gross income test and subsequently lose RIC status.  There are a few cons however.  The most significant being that the structure is not very efficient as any income and gains earned by the CFC are deemed to be distributed to the fund as net investment income (no capital gain treatment), and any losses incurred by the CFC are deferred until the position in the CFC is eliminated.  Additionally, this will be a bit of a headache for the fund administrator, which I’m sure is foremost in the minds of the investment advisor.