Did the IRS Just Kill Commodity Index Funds? (ETF: DBC)
Related Stocks: DBC
Tom Coyne (The Index Investor) submits: On December 16th, 2005 the U.S. Internal Revenue Service issued its first “Revenue Ruling” of 2006 (don’t ask us about the dating issue!). It deals with a very narrowly defined issue: Does income from a specific type of derivative contract count as “qualifying income” for a Registered Investment Company (a legal term for a mutual fund) under IRS regulations?
The derivative contract in question is a commodity swap. Broadly speaking, in a swap contract, two counterparties agree to exchange payments with each other on certain dates for an agreed length of time. These payments are based on some “notional principal” amount of money. Here is an example. The earliest swap contracts were based on interest rates, with one party (say, Company A that had issued fixed rate bonds, but thought that rates were going to decline) exchanging interest payments with another (say, Company B that had issued floating rate loans, but thought interest rates were going to increase). These two would enter into a swap agreement, according to which each quarter Company A would pay LIBOR (the London Interbank Offer Rate, a basic floating reference rate) times $500 million to Company B, and receive 8% (the fixed rate) times $500 million. In practice, the amounts these companies owed to each other were netted, and only a single payment was made to the party owed money.
Now let’s move on to one of the first examples of a commodity swap, which our editor worked on a long time ago in a galaxy far, far away. This time, Company One is a copper producer that has financed its mine with floating rate loans. Since the price of copper fluctuates, its CFO worries that the price of copper will fall faster than interest rates, resulting in a decline in profits (or worse). Company Two operates in a very competitive industry, and uses a lot of copper to produce its products. Its biggest fear is a rise in the price of copper that will (because it cannot easily raise its own prices) cause its profits to fall. And Company Three has issued fixed rate debt, but believes interest rates will fall in the future. In this case, given their respective fears, a three-way swap can make all three companies better off.
Here’s how the deal works. Company One makes payments (to the bank arranging the swaps) that are based on the floating price of copper (times a notional principal amount of the metal). In return, its payments are based on a floating interest rate times a notional principal amount of money). Company Two receives a payment based on the floating price of copper, and makes a payment based on a fixed rate of interest. And Company Three (entering into a classic interest rate swap) receives a payment based on a fixed rate of interest, while making a floating rate based payment.
Now that you understand how commodity swaps work in principle (and I have compressed about five years of corporate finance history into a few paragraphs), let’s move on to the IRS Revenue Ruling that is causing all the trouble.
PIMCO operates a commodity index fund (PCRDX) that tracks the performance of the Dow Jones AIG Commodities Index. As we have discussed in the past, commodities index funds invest in derivative contracts tied to the performance a given commodities index. However, because these contracts can be purchased on margin (that is, for an initial amount less to their full face value), commodity index funds invest the balance of their money in bonds. At PIMCO, they usually use real return bonds, which is consistent with their overall view of commodities index funds as an inflation hedge. The IRS Ruling turns on the question of the type of commodities derivative contract used by PIMCO. One option would be to invest in exchange traded futures contracts based on the Dow Jones AIG index. The basic problem here is that the trading volume in these futures contracts has been growing more slowly than the inflow of money into PCRDX. If there was no other way to obtain exposure to the Dow Jones AIG index, a rising demand for the DJ AIG futures contracts relative to their supply would force up their price, and drive down returns for investors in PCRDX. Because they are a first-class operation, PIMCO logically looked for other options that would impose a lower cost on investors in PCRDX. Commodity swaps were the answer, because the market for them is much deeper (and therefore cheaper to access) than the market for exchange traded futures contracts. Specifically, PCRDX entered into swaps where it made payments based on a floating interest rate, and received payments based on changes in the Dow Jones AIG Commodities Index. So far, so good.
However, these swap contracts raised a legal question, as to whether the payments received by PCRDX were “qualified income” that counted towards its ability to be classified as a Registered Investment Company for tax purposes. Not meeting this requirement would cause adverse tax consequences for PCRDX and its investors. In its Revenue Ruling, the IRS essentially decided that, because the commodity swap contracts were not tied to the underlying securities (real return bonds) held by PCRDX, the income from them was not “qualified income.” Fortunately, the IRS decided that this ruling would only start to apply on July 1, 2006, and that it would have no retroactive effect. In other words, if you own PCRDX today, there is no adverse tax consequence.
So where does this leave matters? PIMCO (and anyone else considering the launch of a commodities index fund) has three non-exclusive options. The first (and least likely) is to persuade the IRS to change their ruling. The second (which would, as noted above, increase costs and decrease investor returns) would be to switch from commodity index swaps to the use of commodity index futures contracts (on which profits and losses are considered “qualifying income” by the IRS). The third (which we support) would be to lobby for the passage of new legislation that makes income from commodity index swaps “qualifying income” under IRS regulations. To this end, we will be writing to the chairmen of the U.S. Senate Finance and U.S. House of Representatives Ways and Means Committees to register our opinion that, in light of the considerable diversification benefits commodity index funds offer to individual investors (who, after all, are being asked to bear more of the risk associated with retirement saving), it is imperative that the IRS regulations be changed before the July 1, 2006 deadline. If you care to join us in writing these letters, the relevant addresses are as follows:
Representative Bill Thomas
Chairman
Committee on Ways and Means
U.S. House of Representatives
Washington, DC 20515
(202) 225-3625
Senator Chuck Grassley
Chairman
Committee on Finance
United States Senate
Washington, DC 20510
(202) 224-4515
etfinvestor.com
My comment: I hold this in a taxable account. I will watch for progress of corrective legislation, and if it looks feasible i will keep it. If not, I will sell it wait the requisite 30 days and buy it back in an IRA. |
