rr-06-31.pdf

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Part I

Section 851.—Definition of Regulated Investment Company

26 CFR 1.851-2: Limitations
(Also Sections 7704, 7805; 301.7805-1.)

Rev. Rul. 2006-31

Rev. Rul. 2006-1, 2006-2 I.R.B. 261, discusses derivative contracts with
respect to a commodity index (“Derivatives”) that a regulated investment
company (R) enters into under Master Agreements with various counterparties.
Under the Derivatives, R will pay an amount equal to the 3-month U.S. Treasury
bill rate plus a spread and will receive (or pay) an amount based on the total
return gain (or loss) on a commodity index. The payment obligation on each
Derivative is settled monthly by the receipt (in the event of a gain) or payment (in
the event of a loss) of cash, in the net amount under the contract, and each
monthly measuring period constitutes a separate derivative contract under the
Master Agreements.

Rev. Rul. 2006-1 holds that a derivative contract with respect to a
commodity index is not a security for purposes of section 851(b)(2) of the Internal
Revenue Code and that, under the facts stated in the ruling, R
’s income from the
contract is not qualifying income for purposes of section 851(b)(2), because the
income from the contract is not derived with respect to R
’s business of investing
in stocks, securities, or currencies. Rev. Rul. 2006-1 further provides that under
the authority of section 7805(b)(8), the holding of the revenue ruling will not be
applied adversely with respect to amounts of income that a taxpayer recognizes
on or before June 30, 2006.

It has come to the attention of the Service that some taxpayers are
questioning whether the holding of the revenue ruling applies to investments by
regulated investment companies (RICs) in all derivative contracts with respect to
a commodity index, including for example structured notes, rather than just to the
Derivatives described in the revenue ruling.

The ruling was not intended to preclude a conclusion that the income from
certain instruments (such as certain structured notes) that create a commodity

exposure for the holder is qualifying income under section 851(b)(2).
Accordingly, to clarify the holding of Rev. Rul. 2006-1, the HOLDING section is
revised to read:

A Derivative is not a security for purposes of
section 851(b)(2). Under the facts above, R
’s income from a
Derivative is not qualifying income for purposes of
section 851(b)(2), because the income from the contract is not
derived with respect to R
’s business of investing in stocks,
securities, or currencies.

In addition, some taxpayers have questioned whether the prospective
application of the ruling is limited to the Derivatives described in the revenue
ruling or includes all derivative contracts with respect to a commodity index or an
individual commodity, including, for example, commodity futures contracts. The
Service has also been informed that, due to temporary demand/supply
imbalances, some RICs that had previously invested in derivative contracts
similar to the Derivatives described in Rev. Rul. 2006-1 are having difficulty in
acquiring alternative commodity-linked investments that result in qualifying
income for purposes of section 851(b)(2).

The prospective application of the ruling was intended to apply to all
derivative contracts with respect to a commodity index or an individual
commodity. Accordingly, to alleviate temporary supply/demand pressure and to
clarify the scope of the PROSPECTIVE APPLICATION section of
Rev. Rul. 2006-1, that section is revised to read:

Under the authority of section 7805(b)(8), the holding of this
revenue ruling will not be applied adversely with respect to amounts
of income that a taxpayer recognizes on or before September 30,
2006, from a Derivative. Neither will the Service apply the
principles set forth in this revenue ruling adversely with respect to
amounts of income recognized on or before September 30, 2006,
by a taxpayer from a derivative contract (including an option,
futures or forward contract) on a commodity index or an individual
commodity.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 2006–1 is modified and clarified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Dale S. Collinson of the
Office of the Associate Chief Counsel (Financial Institutions & Products). For

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further information regarding this revenue ruling contact him at (202) 622-3900 or
Susan Thompson Baker at (202) 622-3930 (not toll-free calls).

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