[Senate Hearing 112-343]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 112-343
 
    COMPLIANCE WITH TAX LIMITS ON MUTUAL FUND COMMODITY SPECULATION 

=======================================================================

                                HEARING

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON
               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS


                             SECOND SESSION

                               __________

                            JANUARY 26, 2012

                               __________

         Available via the World Wide Web: http://www.fdsys.gov

                       Printed for the use of the
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        COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii              TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware           SCOTT P. BROWN, Massachusetts
MARK L. PRYOR, Arkansas              JOHN McCAIN, Arizona
MARY L. LANDRIEU, Louisiana          RON JOHNSON, Wisconsin
CLAIRE McCASKILL, Missouri           ROB PORTMAN, Ohio
JON TESTER, Montana                  RAND PAUL, Kentucky
MARK BEGICH, Alaska                  JERRY MORAN, Kansas

                  Michael L. Alexander, Staff Director
               Nicholas A. Rossi, Minority Staff Director
                  Trina Driessnack Tyrer, Chief Clerk
                 Patricia R. Hogan, Publications Clerk
                                 ------                                

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                     CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware           TOM COBURN, Oklahoma
MARY L. LANDRIEU, Louisiana          SUSAN M. COLLINS, Maine
CLAIRE McCASKILL, Missouri           SCOTT P. BROWN, Massachusetts
JON TESTER, Montana                  JOHN McCAIN, Arizona
MARK BEGICH, Alaska                  RAND PAUL, Kentucky
            Elise J. Bean, Staff Director and Chief Counsel
                         David H. Katz, Counsel
          Christopher Barkley, Staff Director to the Minority
                     Mary D. Robertson, Chief Clerk



























                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Levin................................................     1
    Senator Coburn...............................................     6
    Senator Carper...............................................    16
Prepared statements:
    Senator Levin................................................    29
    Senator Coburn...............................................    34

                               WITNESSES
                       Thursday, January 26, 2012

Hon. Douglas H. Shulman, Commissioner, Internal Revenue Service..     7
Emily S. McMahon, Acting Assistant Secretary for Tax Policy, U.S. 
  Department of the Treasury.....................................     9

                     Alphabetical List of Witnesses

McMahon, Emily S.:
    Testimony....................................................     9
    Prepared statement...........................................    42
Shulman, Hon. Douglas H.:
    Testimony....................................................     7
    Prepared statement...........................................    36

                              EXHIBIT LIST

 1.a. GIncrease in Commodity Related Mutual Funds, 2008-2011, 
  chart prepared by the Permanent Subcommittee on Investigations.    44

   b. G72 IRS Private Letters Authorizing Commodity Investments 
  by Mutual Funds, 2006-2011, chart prepared by the Permanent 
  Subcommittee on Investigations.................................    45

   c. GIRS Private Letters Authorizing Commodity Investments by 
  Mutual Funds, list prepared by the Permanent Subcommittee on 
  Investigations.................................................    46

   d. GLetter from Senators Levin and Coburn of the Permanent 
  Subcommittee on Investigations to the Internal Revenue Service 
  regarding Private Letter Rulings to Mutual Funds Seeking 
  Commodities Exposure, dated December 20, 2011..................    51

 2. Examples of Internal Revenue Service (IRS) Private Letter 
  Rulings:

   a. GIRS Private Letter Ruling No. 200628001, released 7/14/
  2006...........................................................    57

   b. GIRS Private Letter Ruling No. 200647017, released 11/24/
  2006...........................................................    61

   c. GIRS Private Letter Ruling No. 200741004, released 10/12/
  2007...........................................................    67

 3. Legislative History of Section 851:

   a. GTitle 26 U.S.C. Sec. 851..................................    71

   b. GLetter from J. Roger Mentz, Acting Assistant Secretary 
  (Tax Policy), U. S. Department of the Treasury, to Honorable 
  Ronnie G. Flippo, U.S. House of Representative, regarding H.R. 
  3397 amending provisions of the Internal Revenue Code relating 
  to regulated investment companies, dated February 5, 1986......    75

   c. GIRS Revenue Ruling 2006-1 regarding Regulated investment 
  company (RIC) request related to a derivative contract reliant 
  on a commodity index, dated January 9, 2006....................    78

   d. GIRS Implicitly Rules on Economic Substance Doctrine and 
  Blockers, Tax Notes, March 21, 2001............................    81

 4. Legislative History of Regulated Investment Company 
  Modernization Act:

   a. GJoint Committee on Taxation Report on Regulated Investment 
  Company Modernization Act of 2010 excerpt explaining Section 
  201 of the bill addressing income from commodities.............    86

   b. GCongressional Record excerpts regarding House approval of 
  H.R. 4337, Regulated Investment Company Modernization Act of 
  2010 on September 28, 2010.....................................    89

   c. GCongressional Record excerpts regarding Senate approval of 
  H.R. 4337, Regulated Investment Company Modernization Act of 
  2010 on December 8, 2010.......................................    93

   d. GCongressional Record excerpts regarding final House 
  approval and enactment into law of H.R. 4337, Regulated 
  Investment Company Modernization Act of 2010 on December 15, 
  2010...........................................................    94

 5. Commodity Related Mutual Funds:

   a. GSelected Commodity Related Mutual Funds, list prepared by 
  the Permanent Subcommittee on Investigations...................    97

   b. GInformation related to:

       GDirexion Commodity Trends Strategy Fund..........    98
       GHighbridge Dynamic Commodities Strategy Fund.....   102
       GMutualHedge Frontier Legends Fund................   104
       GOppenheimer Commodity Strategy Total Return Fund.   118
       GPIMCO CommodityRealReturn Strategy Fund and......   124
       GPIMCO CommoditiesPLUS Strategy Fund..............   124
       GRydex/SGI Long Short Commodities Strategy Fund...   129
       GRydex/SGI Managed Futures Strategy Fund..........   131
       GVan Eck CM Commodity Index Fund..................   133

 6. The Existence and Consequences of Excessive Speculation:

   a. GExecutive Summary and Findings and Recommendations from 
  the June 2007 Staff Report of the Senate Permanent Subcommittee 
  on Investigations entitled, ``Excessive Speculation in the 
  Natural Gas Market''...........................................   135

   b. GExecutive Summary and Findings and Recommendations from 
  the June 2009 Staff Report of the Senate Permanent Subcommittee 
  on Investigations entitled, ``Excessive Speculation in the 
  Wheat Market''.................................................   145

   c. GLetter from 450 economists to the G20 Finance Ministers 
  regarding impact of speculation on food prices, October 11, 
  2011...........................................................   165

   d. GBetter Markets press release regarding October 14, 2011 
  research report, New Research Shows That Wall Street 
  Speculators Are Driving Up Food and Fuel Prices and That 
  Commodity Index Funds Should Be Banned.........................   187

 7. GNews Analysis: IRS Suspends RIC Commodities Investments 
  Rulings, written by Lee A. Sheppard, Tax Analysts, 2011........   192

 8. GSelect Commodity Price Indices. Source: Chart appearing at 
  http://www.indexmundi.com/commodities/, attributing data to 
  International Monetary Fund Primary Commodity Price Indices....   195

 9. GResponses to supplemental questions for the record submitted 
  by Senator Carl Levin to The Honorable Douglas H. Shulman, 
  Commissioner, Internal Revenue Service.........................   196

10. GResponses to supplemental question for the record submitted 
  by Senator Carl Levin to Emily McMahon, Acting Assistant 
  Secretary for Tax Policy, U.S. Department of the Treasury......   199


    COMPLIANCE WITH TAX LIMITS ON MUTUAL FUND COMMODITY SPECULATION

                              ----------                              


                       THURSDAY, JANUARY 26, 2012

                                 U.S. Senate,      
              Permanent Subcommittee on Investigations,    
                    of the Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 10:31 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Carl Levin, 
Chairman of the Subcommittee, presiding.
    Present: Senators Levin, Carper, and Coburn.
    Staff Present: Elise J. Bean, Staff Director and Chief 
Counsel; Mary D. Robertson, Chief Clerk; David H. Katz, 
Counsel; Christopher Barkley, Staff Director to the Minority; 
Eric Walker, Detailee (FDIC); Dennis Bogusz, Congressional 
Fellow; Courtney Cardin, Law Clerk; Michael Wolf, Law Clerk; 
Arielle Woronoff, Law Clerk; Bill Gaertner, Law Clerk; Tamir 
Haddad, Intern; Julie Kovin, Law Clerk; David Smith and Amanda 
Slater (Senator Carper).

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Good morning, everybody. For 10 years now, 
this Subcommittee has focused attention on the problem of 
excessive speculation in the commodity markets, including the 
crude oil, natural gas, and wheat markets. Most recently, in 
last November's hearing, we examined efforts to apply a new 
position limits rule to protect consumers, businesses, and the 
commodity markets themselves from excessive speculation. For 
years now, the American people have been whipsawed by 
unpredictable and often escalating commodity prices. We have 
been hurt at the pump, we have been hurt at the dinner table, 
and we have been hurt in our pocketbooks. We are talking about 
gasoline prices, electricity and heating costs, food prices, 
and industrial raw materials that together affect virtually 
every American family and business budget.
    The fundamental purpose of commodity markets, unlike stock 
markets, is not to attract investors, but to enable producers 
and users of physical commodities to arrive at a fair price for 
their goods and to hedge their price risks over time. 
Speculators, who don't intend to use or deliver the commodities 
that they trade or hedge commodity prices so that they can have 
price certainty, seek instead to profit from the price changes. 
A market which was intended to facilitate price discovery and 
hedging is now dominated by speculators who are driving up 
price volatility, hedging failures, and in many cases, driving 
up commodity prices. The reality today is that commodity prices 
are more reflective of trading by speculators than fundamental 
forces of supply and demand.
    At our November hearing, the Commodity Futures Trading 
Commission told us that 80 percent of the outstanding futures 
contracts for crude oil are now held by speculators. CFTC 
Commissioner Bart Chilton has said:
    ``For those who say no evidence exists linking excessive 
speculation and prices, they just are not looking. Scores of 
studies and papers,'' he said, ``exist which document the 
linkage.''
    Now, the unprecedented flood of speculative money in 
commodity markets today comes from index traders, hedge funds, 
money managers, and exchange-traded products. Our November 
hearing also exposed a new wave of commodity speculation coming 
from the $11 trillion mutual fund industry. Exhibit 1a is a 
chart which shows that, since 2008--and that chart is in front 
of us, to my left--more than 40 commodity-related mutual funds 
have begun pouring speculative funds into the commodities 
markets and now have accumulated assets of over $50 billion.\1\
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    \1\ See Exhibit No. 1a which appears in the Appendix on page 44.
---------------------------------------------------------------------------
    For most of the 70 years they have been in existence, 
mutual funds were not significant participants in U.S. 
commodity markets. Now, some mutual funds have become major 
commodity speculators, and more want to follow. When we looked 
at what had changed, we discovered that 6 years ago mutual 
funds began petitioning for and receiving IRS private letter 
rulings that, for the first time, enabled them to invest 
heavily in commodities, despite longstanding provisions in 
Section 851(b)(2) of the Internal Revenue Code. Those private 
letter rulings of the IRS essentially opened the floodgates to 
the mutual fund petitioners, allowing them to engage in 
billions of dollars in commodity speculation.
    Section 851(b)(2), which has been in the Tax Code since 
mutual funds got started in the 1930s, restricts the types of 
income that mutual funds are allowed to obtain. That allowance 
is put on them in the law in exchange for favorable tax 
treatment. If the mutual funds abide by this section's income 
source restrictions, those mutual funds do not have to pay 
corporate income taxes like other corporations. This tax break 
collectively saves the mutual fund industry billions of dollars 
each year. In simple terms, the statute requires that 90 
percent of a mutual fund's gross income must be derived from 
securities, interest, or foreign currency investments. That 
means not more than 10 percent of their income can come from 
alternatives like commodities.
    This 90-percent rule has been in place for decades. But in 
2006, as financial engineering took hold on Wall Street, the 
mutual fund industry began pressing the IRS to permit it to use 
complex financial transactions that would, in essence, enable 
mutual funds to get around the 90-percent rule and engage in 
commodity investments beyond the 10-percent limit. Dozens of 
individual mutual funds made these requests in petitions for 
private letter rulings.
    In response, from 2006 to 2010, the IRS issued 72 private 
letter rulings allowing the mutual funds to whom the letters 
were addressed to use either wholly owned offshore corporations 
or financial instruments called ``commodity-linked notes'' to 
make unrestricted commodity investments, notwithstanding the 
10-percent limit in Section 851. The IRS private letter rulings 
said that the mutual funds could treat the income from those 
sources not as income from a commodities investment but as 
income from a ``securities'' investment in the stock of the 
company that they owned or in a note that was designed to avoid 
the restrictions of Section 851.
    For example, the IRS allowed mutual funds to establish 
wholly owned controlled foreign corporations (CFCs), whose sole 
function is to trade commodities in the futures and swaps 
markets. In every case we have examined, mutual funds have 
established these CFCs as offshore shell corporations in the 
Cayman Islands, the classic example of a tax haven. The CFCs--
these offshore shell corporations--have no offices, no 
employees of their own, no independent business operations; 
their commodity portfolios are run by employees who work in the 
United States for the mutual fund that set up the offshore 
arrangement. For example, one mutual fund told us that all of 
the commodity investment decisions for their offshore 
corporation were made by the mutual fund's employees in 
Rockville, Maryland. Another told us that all commodity trading 
decisions were made by their traders in New York. Still another 
mutual fund told us openly that their offshore commodity fund 
had no ``Cayman presence,'' describing it as ``smoke and 
mirrors'' to obtain the tax benefit.
    Now, these CFCs 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. At the same time, the IRS has issued private letter 
rulings explicitly allowing those offshore schemes. The IRS 
private letter rulings provide, for example, that if a mutual 
fund owns the stock of the offshore shell corporation that it 
established, it can treat income from commodity investments 
made by that offshore shell corporation and distributed back to 
the United States as income from a securities investment rather 
than a commodities investment.
    In addition, the IRS has issued private letter rulings 
stating that mutual funds can use commodity-linked notes to 
invest in commodities and treat the resulting income as from a 
securities investment, even though the notes were created for 
the sole purpose of investing in commodities and end-running 
Section 851.
    Now, by treating this type of income as derived from 
securities rather than from commodities, the IRS has elevated 
form over substance, enabling mutual funds to use agents as 
though they were independent actors, and to use financial 
engineering to do indirectly what the law does not let them do 
directly. The result is opening the door to increasing 
commodity speculation.
    But that is not all. In the past, under the 90-percent 
rule, mutual funds spent the lion's share of their money on 
stocks, bonds, and other securities, providing needed capital 
for economic growth and for jobs. They were an engine of 
investment in America. But as the commodity spigot opens, every 
dollar spent on commodity speculation diverts money from their 
securities investments. So instead of investing in U.S. 
businesses, mutual funds will spend more and more increasing 
sums making bets on commodity price movements. Capital 
investments do our economy a lot more good than betting on 
prices.
    Now, to understand the context of the issues at stake, let 
us take a look at the history of the tax law's limits on mutual 
funds. When Federal tax breaks for mutual funds were first 
enacted in 1936, Congress adopted limits on what mutual funds 
could invest in. They allowed mutual funds to utilize income 
from interest, stock dividends, and stock sales. Commodities 
were not on the list of allowed investments. That was the same 
year, by the way, that Congress enacted the Commodities 
Exchange Act of 1936, the first Federal law to control 
excessive speculation in commodity markets. So Congress was 
well aware of U.S. commodity markets and did not make 
commodities an allowable investment for mutual funds in 1936.
    In 1954, Congress enacted Subchapter M of the Internal 
Revenue Code to reform taxation of mutual funds. Subchapter M 
again listed the types of income that mutual funds were allowed 
to earn in exchange for favorable tax treatment. That list was 
unchanged from 1936, and commodities were not on the list.
    In 1986, 50 years after the first mutual funds got started, 
Congress slightly expanded the types of income that a mutual 
fund could earn while retaining its tax advantages, adding 
investments in foreign currencies to investments in securities. 
Commodities were not added by Congress. The Treasury Department 
issued a letter at the time noting that it ``would generally 
not treat as qualifying income gains from trading 
commodities.''
    In 2010, the mutual fund industry supported an unsuccessful 
legislative attempt to change the Tax Code to allow mutual 
funds to make unrestricted commodity investments. As introduced 
in 2009, and passed by the House in 2010, the Regulated 
Investment Company Modernization Act would have explicitly 
permitted mutual funds to utilize income from ``commodities'' 
under Section 851. But the Senate did not accept that 
provision. It was removed from the bill which only then was 
approved by the Senate. Removal of the commodities provision 
was, in fact, the only change made in the House-passed bill. 
The bill was sent back to the House which agreed to the bill as 
amended by the Senate. So the short story is that Congress did 
not agree to adding commodities to the list of acceptable 
income for mutual funds under the 90-percent rule. If the 
industry wants to try again to change the law to allow more 
commodity investments by mutual funds, the change needs to be 
considered not by private letter rulings or regulation, but by 
Congress after a full debate of the pros and cons.
    Six months after Congress made its decision in that 
Modernization Act, in June 2011, the IRS suspended its issuance 
of new private letter rulings in this area so it could review 
the underlying policy issues. Later in the year, Senator Coburn 
and I sent a joint letter to the Treasury and the IRS asking 
the IRS ``to permanently halt the further issuance of [the] 
private letter rulings.'' And our letter is Hearing Exhibit 
1d.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1d which appears in the Appendix on page 51.
---------------------------------------------------------------------------
    Now, some have suggested that the IRS ought to allow mutual 
funds to use offshore corporations to make commodity 
investments based on the court case known as Moline Properties, 
which required the IRS to recognize a certain corporate 
structure. But in Moline Properties, the Supreme Court stated 
that, ``in matters relating to the revenue, the corporate form 
may be disregarded where it is a sham or unreal.'' The Cayman 
corporations being used for mutual fund commodity investments 
have no employees, no place of business, no profits of their 
own, and no obvious nontax purpose. There is no office, other 
than mailboxes. They are exactly the type of sham corporations 
that the Supreme Court said that the IRS can disregard.
    Now, another relevant event is the 2010 congressional 
codification of the economic substance doctrine which permits 
the IRS to disregard transactions that have no substantial 
nontax purpose. Mutual funds have not offered any substantial 
business or economic purpose for considering these offshore 
CFCs or constructing commodity-linked notes. Their only purpose 
is to serve the mutual funds' effort to recharacterize the 
resulting income as derived from ``securities'' so that they 
can make unlimited commodity investments while retaining their 
privileged tax status. A Tax Notes analysis by two tax 
practitioners, Hearing Exhibit 3d,\1\ observed that ``it is 
hard to imagine that there could be a nontax purpose 
outweighing the tax purpose on the facts of the rulings.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 3d which appears in the Appendix on page 81.
---------------------------------------------------------------------------
    Now, finally, there is a long line of cases and private 
letter rulings in which Federal courts have upheld the IRS' 
efforts to go after sham corporations or transactions which 
have no purpose other than tax avoidance or which serve only as 
conduits for parties seeking to avoid taxation. They include 
cases like Gregory v. Helvering, Aldon Homes, Aiken Industries, 
and the recent case of Southgate Master Fund. In Southgate, the 
Fifth Circuit, citing numerous precedents, wrote the following:
    ``The starting point for our analysis is the cardinal 
principle of income taxation: a transaction's tax consequences 
depend on its substance, not its form. This principle `is no 
schoolboy's rule; it is the cornerstone of sound taxation[.]' 
'' The court wrote: ``This foundational principle finds its 
voice in the judicial anti-abuse doctrines, which `prevent 
taxpayers from subverting the legislative purpose of the tax 
code by engaging in transactions that are fictitious or lack 
economic reality simply to reap a tax benefit.' ''
    One of the issues we are going to explore today is why the 
IRS did not follow that approach when analyzing requests by the 
mutual funds to use offshore corporations and structured notes 
to make their commodity investments. By issuing the private 
letter rulings that it has issued in the mutual fund area, the 
IRS is undermining its own longstanding efforts to go after 
sham corporations and transactions that are used to avoid 
paying a tax.
    These are not arcane issues; they raise fundamental issues 
affecting our economic future, the functioning of our Tax Code, 
and the use of offshore schemes and financial engineering to 
avoid our tax laws. The IRS private letter rulings have 
unleashed a new flood of speculative commodity investments that 
are damaging to American families, businesses, and our economy. 
Commodity speculation that contributes to $4-a-gallon gasoline 
is no joke, and neither is a tax policy that threatens to fuel 
a new explosion in speculation in commodities. The IRS letter 
rulings enable U.S. firms to use offshore shell corporations 
and financially engineered notes to make commodity investments, 
despite longstanding Tax Code restrictions, and it sets 
precedents that eat away at the integrity of our Tax Code. We 
should not just stand by and let that happen.
    Today's oversight hearing is intended to address these 
concerns. We will be hearing from IRS Commissioner Douglas 
Shulman and Emily McMahon, who is the Acting Assistant 
Secretary of the Treasury for the Office of Tax Policy, two of 
the most senior tax officials in the Administration. We thank 
them for their presence. We are grateful that you were able to 
be here with us today.
    I now invite our Ranking Member, Dr. Coburn, to share his 
views.

              OPENING STATEMENT OF SENATOR COBURN

    Senator Coburn. Thank you, Mr. Chairman, and thank you all 
for being here. Some points.
    There is no definition of ``excessive speculation.'' We 
live in global markets. The price of oil does not have anything 
to do with what the speculation on the Chicago Board of 
Exchange is right now because there is a worldwide market for 
oil, and with the click of a computer button, you can trade 
that--whether you trade here or you trade in London or you 
trade in Paris or you trade in Abu Dhabi.
    The fact is we have seen what we think is something that 
goes around the intention of what Congress has created in terms 
of mutual funds and the greater risk that is associated with 
commodity speculation. And with that, Mr. Chairman, I agree.
    The second point is tax avoidance is not illegal. Tax 
evasion is, and we need to keep that in mind as we look at it. 
I do not know what the answer is to the questions that have 
been raised today and the ultimate answer in terms of the 
letters that you have granted. But I know a couple things are 
true. One is that we need to continue to have the freest and 
fairest and open markets we can have to have the best price 
discovery, and speculation is a significant component of that. 
I have asked multiple panels before me what excessive 
speculation is, and I have never been able to get an answer to 
that. The fact is that worldwide demand is growing for almost 
everything that is listed on our commodity exchanges and some 
of the commodity exchanges throughout the world. But the fact 
is we do not price just in our country commodities. They are 
priced based on worldwide demand.
    So my hope is as we go through this--I agree with the 
Chairman. If our intent is not to allow a mutual fund to 
speculate in commodities, then we should not be allowing the 
mutual funds so that the consumer knows that. That is one. But 
that will not stop speculation in commodities because they will 
just go somewhere else if they are intent on doing that. So I 
think it is important we keep in mind that we are going to have 
minimal effect, even if we come to a conclusion through this 
hearing, on what is going to be the ultimate outcome in terms 
of speculative behavior in the world because we no longer are 
isolated just in our country.
    I think it is true that we ought to have much more 
transparency and straightforwardness about what our intent is. 
And so I thank you for being here. My hope is that we can have 
a better understanding of what has happened, what needs to 
happen, and what we might need to do to achieve that 
transparency in light of the fact that we know we are in a 
world market and that money is going to go where the greatest 
return is based on what the risk is. And where I would agree 
with the Chairman, is I think we need to make sure that people 
know who are investing in these mutual funds that are not 
speculating commodities what the significant risk is. And it is 
my belief they do know that now, but I think we have an 
obligation to make sure that is the case.
    I yield back.
    Senator Levin. Thank you very much, Dr. Coburn, for your 
work and the work of your staff in this matter. It is our joint 
intent that even though there may not be consensus on the 
effect of speculation, that there is consensus that our laws 
are intended to be followed, and they cannot be and should not 
be run around by sham transactions.
    I now want to welcome our witnesses for this morning's 
hearing: Doug Shulman, who is the Commissioner of the Internal 
Revenue Service, and Emily McMahon, the Acting Assistant 
Secretary for Tax Policy for the Department of the Treasury.
    Commissioner Shulman, I want to thank you for being here 
again today. You have testified before this Subcommittee in the 
past. We welcome you back, and we are always pleased to have 
you.
    Ms. McMahon, I think this may be your first appearance, and 
we give you a warm welcome as well.
    Pursuant to Rule VI, all witnesses who testify before the 
Subcommittee are required to be sworn. At this time I would ask 
you then to please stand and raise your right hand. Do you 
swear that the testimony you are about to give will be the 
truth, the whole truth, and nothing but the truth, so help you, 
God?
    Mr. Shulman. I do.
    Ms. McMahon. I do.
    Senator Levin. We will use our traditional timing system 
today, and please limit your oral testimony to 10 minutes. At a 
minute before that 10-minute period runs out, you will be given 
a signal by a yellow light a minute before the red light comes 
on, which will give you an opportunity to conclude your 
remarks.
    Commissioner Shulman, we will have you go first, and after 
we have heard your testimony and Ms. McMahon's testimony, we 
will then proceed to questions.

TESTIMONY OF HON. DOUGLAS H. SHULMAN,\1\ COMMISSIONER, INTERNAL 
                        REVENUE SERVICE

    Mr. Shulman. Thank you, Chairman Levin and Ranking Member 
Coburn. I appreciate having the opportunity to testify before 
the SubcCommittee on the issue of regulated investment 
companies, or RICs, investing in commodities.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Shulman appears in the Appendix 
on page 36.
---------------------------------------------------------------------------
    Let me start by explaining that the IRS is involved in this 
issue because it is charged with, as the Chairman said, 
providing guidance to taxpayers as to whether investments that 
RICs choose to make will produce qualifying RIC income, as 
defined by the tax law.
    In order to maintain its tax status, a RIC must derive 90 
percent of its income from investments that meet the 
qualifications of Section 851 of the Code, which generally 
requires investments be related to stock, securities, or 
foreign currencies. The term ``securities'' is specifically 
defined in the Tax Code in Section 851 by cross-reference to 
the definition of that same term in the Investment Company Act 
of 1940.
    It is the scope of that definition of the word 
``security''--and particularly its application to investments 
providing indirect exposure to commodities--that has been the 
focus of the 70 or so private letter rulings that are the 
subject of this hearing.
    Now, while I was not at the agency at the time our position 
was first established and did not participate in any of the 
decisions about our position or the private letter ruling 
process in the past, it may be useful for me to provide a brief 
explanation of how the IRS arrived at the position reflected in 
the private letter rulings and then summarize the IRS's posture 
on this issue today.
    In 2005, some RICs started, to guidance from the IRS, as to 
whether certain investments made to achieve exposure to 
commodity prices would qualify for the 90-percent income test. 
The IRS was unable to find any authoritative guidance on the 
proper scope of the definition of ``security'' from either the 
Securities and Exchange Commission or the Commodity Futures 
Trading Commission.
    This situation resulted in the IRS being asked to issue 
private letter rulings addressing specific proposed RIC 
commodity-related investments based on the IRS's own best 
interpretation of the tax law, including the cross-references 
to the 1940 Act. Private letter rulings were issued on this 
subject starting in 2006. As you said, they were issued on two 
basic structures: structured notes and investments in 
controlled foreign corporations. I have attached details of our 
counsel's analysis of this issue to my written testimony to 
give you a better sense of their analysis.
    Last summer, though, as you mentioned, the IRS decided to 
stop issuing private letter rulings until our staff could look 
at the overall set of issues and consider guidance of broader 
applicability. That is where we are today.
    Mr. Chairman, I want to just close by stating that I am 
confident that our staff did its best to interpret a difficult 
set of tax law provisions. And while I believe that their 
conclusions were reasonable in the context of an unclear 
statute, at the agency we have an open mind on this issue. The 
fact that we suspended private letter rulings last summer 
allows the opportunity for us to take a fresh look at this 
issue.
    You have raised important policy and legal questions that I 
assure you will be fully considered as we determine the 
appropriate next steps.
    So with that, that ends my testimony, and I will obviously 
be happy to answer questions when the time comes.
    Senator Levin. Thank you very much, Commissioner. Secretary 
McMahon.

 TESTIMONY OF EMILY S. MCMAHON,\1\ ACTING ASSISTANT SECRETARY 
        FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY

    Ms. McMahon. Thank you, Chairman Levin and Ranking Member 
Coburn. I appreciate the opportunity to testify today on the 
issue of investments in commodities by regulated investment 
companies.
---------------------------------------------------------------------------
    \1\ The prepared statement of Ms. McMahon appears in the Appendix 
on page 42.
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    Commissioner Shulman's testimony describes a series of 
private letter rulings issued by the Internal Revenue Service 
on this subject. I would like to begin by describing the role 
of the Treasury Department in the private letter ruling and 
published guidance process.
    A private letter ruling is a determination issued by the 
IRS to a particular taxpayer that interprets and applies the 
tax laws to the taxpayer's particular set of facts. As a matter 
of policy and practice, the Treasury Department does not 
participate in the consideration or issuance of private letter 
rulings by the IRS. Moreover, other than in highly unusual 
circumstances, Treasury Department personnel do not know which 
taxpayers have requested or received private letter rulings. 
Treasury Department personnel become aware of the issuance of a 
private letter ruling only when that ruling is eventually 
issued to the public by the IRS in redacted form. Consistent 
with that policy and practice, the Treasury Department did not 
participate in the formulation, or review or oversee the 
issuance, of any of the private letter rulings addressing 
commodity-related investments by RICs. Nor has the Treasury 
Department studied the effect of the private letter rulings on 
the mutual fund industry.
    The Office of Tax Policy is actively involved, however, in 
the development of published guidance, including both tax 
regulations and other administrative guidance published in the 
Internal Revenue Bulletin. In this capacity, Treasury personnel 
participate in the development of the substantive law that 
private letter rulings reflect.
    Thus, in 2005 and 2006, Treasury Department personnel did 
participate in the development of two published revenue rulings 
that address commodity-related investments by a RIC. These 
revenue rulings, 2006-1 and 2006-31, are described in more 
detail in Commissioner Shulman's written testimony. Subsequent 
to those revenue rulings, the IRS and Treasury Department 
periodically discussed the possibility of additional guidance 
in this area as a potential candidate for the Priority Guidance 
Plan.
    As stated in Commissioner Shulman's testimony, the IRS has 
suspended the issuance of private letter rulings addressing 
commodity-related investments by RICs. Treasury Department 
personnel were not involved in that decision.
    Subsequent to the suspension, the Investment Company 
Institute (ICI) called several members of the staff of the 
Office of Tax Policy to ask why the IRS issuance of rulings had 
been suspended and what the future might hold. Treasury staff 
could not, and did not, provide answers to those questions. On 
September 28, 2011, at the ICI's request, ICI representatives 
met with Treasury and IRS personnel to discuss ICI proposals 
for published guidance that would permit commodity-related 
investments by RICs.
    The Treasury Department and IRS are currently considering 
the possibility of issuing published guidance on this subject.
    The Subcommittee's letter inviting me to testify at this 
hearing stated that the Regulated Investment Company 
Modernization Act of 2010 ``reaffirmed [Congress'] intent to 
exclude commodities from mutual funds' qualifying income under 
Section 851.'' The House version of the bill, H.R. 4337, would 
have expanded the definition of qualifying income to include 
income derived from direct or indirect exposure to commodities. 
However, that amendment to the definition was removed from the 
bill before enactment, leaving unchanged the statutory 
provisions upon which the IRS revenue rulings and private 
letter rulings were based. Under those provisions, the 
definition of qualifying income is linked to the 1940 Act 
definition of ``security,'' and income derived from such 
securities is not explicitly excluded from qualifying income 
merely because it reflects exposure to commodity prices.
    Under Section 7701 of the Internal Revenue Code, whenever 
the economic substance doctrine is relevant to a transaction, 
the transaction is treated as having economic substance only 
if, as a factual matter, the transaction changes in a 
meaningful way the taxpayer's economic position and the 
taxpayer has a substantial nontax purpose for entering into the 
transaction. These questions are inherently factual. The 
private letter rulings issued by the IRS do not address the 
potential application of the economic substance doctrine, and 
the Treasury Department does not have independent knowledge of 
the facts underlying the rulings. Therefore, we cannot express 
a view on the application of Section 7701(o) to the 
transactions described in the private letter rulings.
    Finally, I would note that the extent to which investors 
should be able to obtain exposure to commodity price 
fluctuations through investments in RICs is not fundamentally a 
tax policy issue. The Code provisions in question do raise, 
however, the issue of whether the Treasury Department and the 
IRS should be required to interpret a nontax statute--in this 
case, the 1940 Act--that does not otherwise fall within their 
jurisdiction in order to determine the availability of 
favorable tax treatment under the Code. The Securities and 
Exchange Commission has not issued any guidance of which we are 
aware that addresses the financial instruments described in the 
IRS private letter rulings, whether those financial instruments 
are securities for 1940 Act purposes, as required to produce 
qualifying income. At the same time, we are not aware of any 
action the SEC has taken to preclude RICs from making those 
investments. Administering the relevant Code provisions under 
these circumstances is challenging from both a practical and a 
policy perspective.
    Thank you, and I look forward to taking your questions.
    Senator Levin. Thank you, Ms. McMahon.
    First, a short bit on the impact of speculation in 
commodities on our cost of gasoline, and then I am going to get 
to really what is the part of this where I think that Senator 
Coburn and I agree. We obviously do not agree on the question 
of whether or not speculation has an impact on commodity 
prices. We have different points of view on it. Fair enough. We 
have had hearings on the subject. People have different 
opinions of the subject. But where we do not have different 
opinions is on the question of whether or not we can tolerate 
sham corporations in the Caymans being used to avoid the tax 
laws of this country. But first just a bit on commodity prices.
    Take a look at Exhibit 8,\1\ if you both would. We are 
going to put it up for you as well, but it is in your book. It 
is a chart reflecting commodity index prices for fuel, food, 
and metals going back 20 years. You can see on this chart that 
until about 2002, the prices were relatively stable. But 
beginning in 2002, about 10 years ago, prices began to get more 
volatile and started to climb. The year 2002 is also about the 
time when investments in commodity index funds started to 
become popular. The chart shows a crash in prices in 2008 
during the financial crisis, but you can see that the prices 
never fall back to the pre-2002 level, and since May 2009, 
prices have again increased dramatically, approaching record 
levels.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 8 which appears in the Appendix on page 195.
---------------------------------------------------------------------------
    Now, this chart, by the way, was put together by a data 
analysis firm called Index Mundi using IMF data, and it is, 
again, part of the exhibits here and will be made part of the 
record.
    Now, the real question that we need to confront and you 
folks needs to confront, and I very much welcome your 
testimony, Commissioner, that you are willing to take a fresh 
look at this despite those letters that have been issued, is 
the moratorium, which you issued in June 2010, which was good 
news. That is the status quo, a moratorium, and our request in 
a letter that we have written you, a joint letter from Dr. 
Coburn and myself, asked that you make that moratorium 
permanent.
    Are there nontax purposes for these transactions that the 
offshore tax havens are making and then transferring the 
proceeds to their parent corporation?
    What your letters do is state that mutual funds can set up 
a foreign corporation it controls whose sole purpose is to 
invest in commodities. If the mutual funds own that stock, 
which they do, they can treat the distribution of income from 
that wholly owned offshore shell corporation as income derived 
with respect to a mutual fund's ``business of investing in 
securities'' rather than as a commodities investment.
    Now, that means that the mutual fund can treat the offshore 
shell company's income as meeting the 90-percent test in 
Section 851 and outside of the 10-percent limit on alternative 
investments.
    Now, here is what we have learned. We have learned that 
these offshore shell corporations, these wholly owned 
subsidiaries established by the mutual funds, are in every case 
wholly owned Cayman Island corporations. They are shells. 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. There are no 
offices in the Cayman Islands with people that are making 
decisions on what these CFCs do.
    One mutual fund told us that all of the commodity 
investment decisions come from their Rockville, Maryland, 
office, as I said. And another one acknowledged that there is 
no Cayman presence; it is just ``smoke and mirrors,'' in their 
words, to obtain the tax benefit.
    All of the profits and losses by their offshore shells are 
returned to the mutual funds that own them here in the United 
States. No income is kept offshore, no U.S. taxes are evaded. 
That is not the issue here. The income is returned, and when we 
say no taxes are evaded here, of course, there is a tax which 
would apply to mutual funds if they violate the 90-percent 
rule, so that is really the question here. It is not an evasion 
issue, as Senator Coburn points out. It is an avoidance issue 
by use of shell corporations which have no purpose, no business 
purpose, no nontax purpose at all.
    Now, clearly--and I think, Commissioner, you will agree 
with this--if the offshore shell corporation did not return the 
income, the mutual fund would lose its favored tax status. So 
the mutual funds try to ensure that that income is returned to 
the United States, which is further proof that it is nothing 
but a shell corporation.
    Now, the facts indicate--and the mutual funds acknowledge 
this, by the way--that these shell corporations are paper 
exercises, which the mutual funds use to make commodity 
investments. They characterize the resulting income as being 
derived from the business of investing in securities, however, 
instead of commodities investments.
    Now, issuing these letters and then approving of this 
offshore gimmick means that the IRS is elevating form over 
substance. Mutual funds are not investing in their offshore 
shells. They are running them. They are using a sham or a 
conduit to do indirectly what they cannot do directly by law.
    Now, you have a line of cases where the courts have 
supported the IRS when you have refused to recognize sham 
corporations. You have a number of private letter rulings where 
you have not recognized sham corporations. In one private 
letter ruling in 2001--citing the Moline case, by the way--the 
IRS advises taxpayers that ``a parent corporation and its 
subsidiary are separate taxable entities unless the subsidiary 
is a sham or acts as a mere agent of the parent.'' For 80 years 
you have been fighting to be able to disregard sham 
corporations. The IRS has tried to disregard them where there 
is no nontax purpose in their creation.
    So here we have wholly owned corporate shells, no 
employees, no place of business, no independent operations, no 
income that is not turned over to the U.S. parent. The shell is 
typically run by the mutual fund's own employees here in the 
United States who control the commodity portfolio.
    In Gregory v. Helvering, the Supreme Court warns against 
exalting artifice above reality.
    In Southgate, the Fifth Circuit says the tax consequences 
of a transaction are determined based on the underlying 
substance of the transaction rather than its legal form.
    The issue here is not whether or not the offshore 
corporation's stock is a security. That is not the issue here. 
Whatever definition of ``security'' you want to take, whether 
or not it has been defined by the SEC, whether it is defined by 
the CFTC, that is not the issue. Of course, it is a security. 
It is stock. The issue is whether or not the offshore 
corporation which issues that security and transfers it to its 
parent is a sham corporation with no substantial nontax 
purpose. The issue is whether the offshore shell is a conduit 
that the IRS can and should disregard to ensure compliance with 
Section 851. So we do not have to debate what constitutes a 
security here. That is stock. That is not the issue.
    Now, Commissioner, let me ask you this question: If a 
mutual fund were to violate the income restrictions of Section 
851, the tax consequences would be, would they not, that the 
fund would have to pay up to 35 percent in corporate income 
taxes on its income.
    Mr. Shulman. Yes, I think that is correct. I think, 
generally, that is correct. The way you get not taxed at the 
entity level is by meeting the restrictions. I think in 
practice mutual funds all meet it, or else they would not be a 
mutual fund, and they would set up a structure another way. So 
there is generally not taxes coming in from these things as 
they blow through their 90 percent. They either set it up this 
way or they do not, unless the allocation shifts unexpectedly 
during the year.
    Senator Levin. But you do agree that if they violated those 
income restrictions in that Tax Code Section 851, they would 
then have to pay the corporate income tax?
    Mr. Shulman. Yes.
    Senator Levin. Now, do you both agree that if a mutual fund 
bought and sold commodity futures or a commodity swap--in other 
words, if a mutual fund made a direct investment in 
commodities, the income from those investments would not 
qualify as income from securities or interest or foreign 
currencies under the 90-percent income in Section 851?
    Ms. McMahon. Yes, I would agree with that. Yes.
    Senator Levin. All right. So now the question is whether or 
not they can avoid that impact by creating a shell corporation, 
which everyone agrees is a paper corporation with no business 
purpose, no economic purpose down in the Caymans. The question 
is whether or not by creating that corporation and just having 
the stock of that corporation transfer to them that converts it 
somehow magically into a securities transaction.
    Now, why do you think mutual funds are setting up these 
corporations offshore rather than here in the United States? 
Commissioner Shulman.
    Mr. Shulman. Well, I think they are setting up these 
structures to get some commodity exposure.
    Senator Levin. To be able to invest in commodities, which 
they are restricted from doing in Section 851?
    Mr. Shulman. Well, they are setting them up to get some 
exposure to commodities and trying to do in a way that meets 
the test in the tax law.
    Senator Levin. And avoids any Section 851 violation.
    Mr. Shulman. Sure, it would.
    Senator Levin. OK. Now, if they used a wholly owned U.S. 
corporation to do the commodity investing, would that 
corporation's profits then be subject to U.S. tax?
    Mr. Shulman. I assume so, depending on the structures.
    Senator Levin. So a Cayman corporation is not subject to 
U.S. tax or any other corporate income tax, so they can 
accumulate and invest money more quickly than corporations 
which do pay taxes. So as you say, the reason that they are 
doing this is so that they can avoid a conflict with Section 
851. If they directly invested in commodities, they would then 
be subject to the limitations of Section 851.
    Now, the question that then raises is: Did the IRS ask the 
mutual funds who created the shell corporations in the Caymans 
whether there was a business purpose other than tax avoidance? 
Was that asked of them when they requested the letter?
    Mr. Shulman. As I said, I was not involved in the private 
letter rulings. Actually, I did not focus on this issue until 
after we suspended them. So I do not know what was asked.
    Senator Levin. Can you look back and check that?
    Mr. Shulman. Yes.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 9 which appears in the Appendix on page 196.
---------------------------------------------------------------------------
    Senator Levin. OK.
    Senator Levin. Now, does the IRS care about people 
circumventing our tax laws through the use of shell/sham 
corporations offshore?
    Mr. Shulman. The answer is yes, let me just give you a 
little further analysis on that. You had asked about economic 
substance and why we didn't attack this under the economic 
substance rule, and you quoted some of the cases we have been 
involved in.
    One, as I think you rightly pointed out, this agency has 
been very aggressive attacking sham corporations that are 
trying to use the Code in ways that are not permissible to 
lower taxes in the United States. We typically raise this 
doctrine for structures designed to lower tax, such as phony 
losses, inflated bases, and that is where we have gone to 
court, and that is where most of the common law comes from.
    In this case, I would argue that we should have the debate 
that you have put on the table. Does the Code allow investment 
in controlled foreign corporations that then invest in some 
sort of a commodity-related investment, which is very different 
because there is no tax being avoided. There is tax paid on 
those investments in the United States by the mutual fund's 
shareholders, just as if those mutual fund's shareholders were 
not in a mutual fund and were investing directly in 
commodities.
    Senator Levin. Well, isn't the tax that is being avoided 
the corporate tax which would be triggered if it was not 
qualified income under Section 851?
    Mr. Shulman. As I said before, the activity would not 
happen, and that is legitimate.
    Senator Levin. Now, that is a different point. If the IRS 
said that activity that you just have engaged in, creating a 
shell corporation with no nontax purpose, that sham business, 
that income is going to count under Section 851. If you told 
them that and they still did it, they would have to pay a 
corporate tax in the United States, right?
    Mr. Shulman. Sure, but I guess what I am saying is----
    Senator Levin. You do not think they will do it.
    Mr. Shulman. My guess is they would not do it.
    Senator Levin. That proves that tax avoidance is their 
purpose, which is exactly our point. That is the proof of it, 
that they would not engage in that transaction if, in fact, it 
had the result under the law. So avoiding that tax is their 
goal, and the question is: Can they use a sham corporation, a 
shell corporation in the Caymans that has no business purpose, 
no economic purpose, can they use it to achieve that goal? And 
your letter says, ``Yes, you can use''--or, ``We are not even 
going to ask. We are not going to ask you whether or not that 
shell corporation has any business purpose.'' I do not know 
that. You are going to check that out for me as to whether or 
not you asked the question.
    But, my heavens, if the IRS is fighting against these 
offshore shell corporations, how do we look the other way? How 
do we give a green light to the use of them to qualify this 
kind of investment under our Tax Code? It so totally runs 
contrary to what you are fighting for, which is do not use 
these shell corporations offshore for any nontax purpose; we 
are going to pierce this veil. That is what you fight for. And 
yet you write a letter--not you but your predecessors--that 
says either, ``We are not going to ask you if there is any 
business purpose to this,'' or, ``We know there is no business 
purpose to it, but technically that can be considered a 
security, the stock which is issued by your wholly owned 
corporation, with no people down there, no presence down there. 
We are going to count that as a security for the purpose of 
Section 851, even though it is based on a totally shell/sham 
corporation.'' That runs inconsistent with your effort to 
pierce those shell corporations.
    Mr. Shulman. Yes, what I am trying to do is distinguish--I 
will repeat, we have suspended the private letter rulings, we 
are open to this, and there are a whole bunch of points you 
have made that you have written to us that we are going to take 
very seriously as we figure out where to go forward. So that is 
the state of play.
    What I am trying to distinguish is that a very specific 
issue with people who came forward and asked about the 
technical reading of the law. There are lots of places where 
the corporate form is respected in the tax law, and what we try 
to do is analyze what is the right reading of the law, would it 
be sustained in the courts, etc.
    I think I am just trying to move away from a broad 
generalization about our approach. We have been very aggressive 
with sham corporations that are designed to lower taxes, and 
keep this as a narrow discussion about corporations and mutual 
funds trying to get commodity exposure, which I think was their 
purpose, not to avoid tax because the tax flows through.
    Senator Levin. Well, it is designed to avoid triggering a 
tax.
    Mr. Shulman. I do not want to insult you by repeating it, 
but as I have said, those taxes are never triggered. They 
either would have set up this thing or not.
    Senator Levin. They want to avoid triggering the taxes, 
right?
    Mr. Shulman. That is not how I would look at it.
    Senator Levin. They want to avoid triggering a tax? You do 
not think that is the whole purpose here, they want to avoid 
triggering a tax?
    Mr. Shulman. Well, they just want to set up----
    Senator Levin. They want to have their cake, which is 
investing in commodities, and eat it, too, by not paying what 
the tax would be if they did that directly in the United 
States.
    Mr. Shulman. They want to invest in commodities----
    Senator Levin. That is their open goal, for heaven's sake. 
They acknowledge that is what their goal is. The question is 
whether the IRS is going to tolerate the use of those shell 
corporations to achieve that goal or whether or not they ought 
to come to Congress and change the law. That is the question.
    Mr. Shulman. Right.
    Senator Levin. When you put your imprimatur on that, it 
does not undermine your efforts, your important efforts, 
sometimes heroic efforts, sometimes against great odds, to 
pierce the veil of these phony shell corporations in the 
Caymans and other offshore tax havens. That is what is created 
here for you. That is the headache you are creating for 
yourself. It may be slightly different. It is not where they 
are trying to get a tax reduction. It may be where they are 
trying to avoid triggering a tax. But the outcome is exactly 
the same. You are putting your stamp of approval in these 
letters. Thank God now there is a moratorium, but you put your 
stamp of approval on a mechanism which is inconsistent with 
what you are arguing in so many cases, very properly, that you 
are not going to be deterred from the use of sham transactions. 
That is what the stakes are here.
    Do you want to comment? I am going to call on my 
colleagues.
    Mr. Shulman. No, I mean, my comment would be similar to 
what I said before, which is as Commissioner of the IRS, an 
agency that has been very aggressive attacking a lot of 
corporations around issues of economic substance. I want to be 
very clear for the record that the private letter rulings that 
we issued that only pertain and can only be relied on by the 
one company that we issue it to, not broad applicability, are 
not precedent and in no way speak about the other attacks that 
we have around the economic substance doctrine. So that is what 
I am trying to say.
    Senator Levin. Thank you, Commissioner. Senator Carper.

              OPENING STATEMENT OF SENATOR CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Ms. McMahon, I sort of join this in mid-flight. Just 
explain to me what do you think the Chairman is up to here. 
What is he driving at? How would you describe it?
    Ms. McMahon. As I understand it, the Chairman has several 
concerns: generally the question of whether mutual funds, RICs, 
should be allowed to have commodity exposure. I think our view 
on that broader question is that that is not a tax policy 
question per se, and we are not experts on that topic.
    However, there is a second question as to whether the tax 
law as it currently exists should be interpreted in a manner 
that would facilitate or permit mutual funds to have indirect 
commodity exposure, and I understand that Chairman Levin is 
concerned that our interpretation, the IRS interpretation, of 
the existing law has inappropriately facilitated commodity 
exposure, RICs' obtaining commodity exposure.
    I think the statutory language that we are looking at is 
not very clear on this question, and because of that the IRS 
has been placed in a difficult position of trying to determine 
what the limits may or may not be on these investments. I think 
their interpretation so far has been a reasonable one under the 
circumstances, but I would echo Commissioner Shulman's 
statement that we have an open mind on this question, and we 
are thinking very hard about the points that have been raised 
here today.
    Senator Carper. Mr. Shulman, is that a fair 
characterization of what Senator Levin is aiming at here?
    Mr. Shulman. It sounded good, but I generally do not 
characterize Chairmen's statements and thoughts.
    Ms. McMahon. I would not have done so either if I had not 
been asked to do so. [Laughter.]
    Mr. Shulman. It was a good job.
    Senator Carper. My next question is of the Chairman: How 
did she do? What do you think?
    Senator Levin. Well, she was pretty close on number two. 
Number one really is something this Subcommittee has looked 
into, the first issue she raised about the impact of 
speculation on commodity prices. But you can agree--and Dr. 
Coburn does not have the same view I do on that issue. But 
where Dr. Coburn and I have agreed and sent a letter to the IRS 
is that the moratorium on these letters which they have sent, 
which gives the green light to specific mutual funds to proceed 
in this area, runs right into a number of doctrines. One is the 
law which specifies what the mutual funds can use for interest 
and income. But, second, it runs head on into what the IRS is 
fighting for, which is to pierce these phony corporations 
offshore who have no nontax purpose, and that is what the issue 
is here. There is a moratorium on these, which we are grateful 
for, from about a year and a half ago I guess now. Our letter 
requests that it be made permanent.
    You can argue the first issue. People will disagree on 
commodities and whether or not speculation in commodities has 
an effect on price, and what the effect is. The Commodity 
Futures Trading Commission Commissioner says, sure, there is an 
effect on price. We put charts up showing the effect. But 
whether that is true or not, I think we all agree--and the 
Commissioner and the Secretary agree here--that we cannot 
permit sham transactions to lead to tax avoidance. That is the 
issue here.
    Senator Carper. Do you concur with that, Mr. Shulman?
    Mr. Shulman. Yes, we have been aggressive, using the 
economic substance doctrine for corporations that we think do 
not meet the test of the doctrine, and would be sustained in 
the courts, are used to lower taxes.
    Senator Carper. All right. What advice do you have for us? 
This is a question for both of you.
    Mr. Shulman. I think the simplest advice is I would agree, 
the IRS does not like being in a position where the law is 
unclear and it has to go and make interpretations. The best 
thing that could happen with this debate is if the outcome 
desired is the outcome that this Subcommittee has been 
discussing in the letter, is to get clarity in the law and have 
Congress pass the law and get clear one way or the other. 
Absent that, we are going to be forced to be in this 
uncomfortable position of doing what we do all the time with a 
grossly complex law. This is having to make interpretations 
about what is the best reading of the law, what will be 
sustained in the courts, that is what we will do.
    As the Chairman noted, we stopped issuing these private 
letter rulings, and we think there needs to be either law, 
preferably, but in the absence of law, guidance of general 
applicability that can be relied on across the industry and 
stop taking these one-off with very specific fact patterns and 
moving forward in that direction.
    Senator Carper. In my old job as governor of Delaware, from 
time to time we would suggest to the legislature what tax law 
changes we thought should be made to provide clarity in areas 
like this. Has this Administration provided similar guidance to 
us in the form of recommended legislation to address these 
issues?
    Ms. McMahon. Senator, I do not believe that we have 
recommended a particular clarification one way or another on 
this point.
    Senator Carper. Could I just ask if that is the case, then 
why not?
    Ms. McMahon. Well, I think that, as I said earlier, there 
is a fundamental question, which is not a tax question, as to 
whether RICs should or should not be permitted to have 
commodity exposure. That is not something that we as tax 
experts can answer. I think once that question has been 
answered one way or another, it would be very helpful to have 
the tax law clarified to be consistent with the conclusion on 
that question. But we, the Treasury Department, have not so far 
expressed a view, I believe, on the----
    Senator Carper. Has some other part of the Administration 
that owns that issued--have they said----
    Ms. McMahon. Well, I think that question is fundamentally 
the responsibility of the CFTC or SEC.
    Senator Carper. All right. Do any other tax-exempt entities 
use controlled foreign corporations to gain exposure to certain 
investments?
    Ms. McMahon. Yes, Senator.
    Senator Carper. Could you talk about that just for a little 
bit, please?
    Ms. McMahon. Well, it is fairly common for tax-exempt 
entities that invest in various types of private equity or 
other investment funds to invest in those funds through 
offshore corporations in order to avoid possible taxation under 
the unrelated business income tax rules.
    Senator Carper. OK. A second but related line of questions 
is: Can mutual funds only gain access to commodities through 
these controlled foreign corporations or commodity-linked 
notes? Is that pretty much it?
    Ms. McMahon. I am not aware of other ways in which they 
might.
    Senator Carper. Mr. Shulman, are you?
    Mr. Shulman. I think there is a variety of ways that I am 
aware of, and let me just clarify for you. This is an issue 
that I studied up on as part of this hearing. It is not one I 
was involved with. I am just moving into it. But I think there 
are controlled foreign corporations, there are the structured 
notes. I think mutual funds can invest in partnerships if they 
wish to, but all these things get complicated with tax 
structuring. There are qualified publicly traded partnerships 
that are available to invest in. So there is a variety of 
vehicles, but from my understanding, the predominant way is 
through these two--the structured notes and the controlled 
foreign corporations, which were the subject of the private 
letter rulings.
    Senator Carper. Let me see if I understand this. We have 
these mutual funds that are, if you will, investing in 
commodities. They are not doing it here through corporations in 
the United States, so States that are interested in--and all 
States are interested in having corporations register in them, 
including Delaware. But what we have is a situation where 
instead of these mutual funds establishing or investing in 
corporations here in America, registered in one of our 50 
States, and presumably taxes being paid to the Federal 
Government for those investments, we encourage that activity to 
take place outside of this country in places like the Cayman 
Islands, and corporations from which States derive no value, no 
income, and from which the Federal Government derives no taxes. 
Is that the situation we are in?
    Mr. Shulman. I would not characterize it that way. First of 
all, the IRS is not in the business in the way that our lawyers 
who look when private letter rulings come in, they do not look 
at what they are encouraging or not. They are trying to say 
what is allowed under the statute.
    Senator Carper. I am not suggesting it is what you 
encourage. I am not suggesting this is what the IRS is 
encouraging. But we as a Federal Government, is this what we 
are encouraging?
    Mr. Shulman. Sure. I mentioned earlier, and I think the 
Chairman mentioned as well, the basic tax of mutual funds is 
being paid in these entities. There is not tax not being paid 
because the way mutual funds are taxed is the underlying 
activity flows through to the investors and they pay. So 
someone who lives in Delaware would be paying their Delaware 
taxes and their Federal taxes based on whatever the income was 
there. But that is a whole different discussion which is 
obviously a legitimate one.
    Senator Carper. All right. Can I change the subject just 
for a second, Mr. Chairman? One of the things that the 
Chairman, Dr. Coburn, and I are very much focused on is deficit 
reduction. I am sure everybody in the room cares about it, and 
there are different ways to do that: grow the economy, curtail 
spending, look for wasteful spending in the Federal Government. 
Another way is the maximize the income that we are trying to 
bring into the treasury by making sure that folks are paying 
their fair share, whether they happen to be an individual or a 
business. So we focus a lot on forgone taxes, but you have an 
opportunity, I presume, to look at the revenue flow coming into 
the treasury. I do not know if you look at it every week or 
every month. In my role as governor, I drilled down every 
month, the beginning of every month, when we got the revenue 
report from the Division of Revenue. We looked at literally 
every category to see what was happening month by month by 
month, and I tried to stay on it. I do not do that so much as a 
Senator, but I presume you do that in your role. We are about 3 
months into this fiscal year. I do not know if we have numbers 
through the end of December. But if you would just give us like 
a quick snapshot of what does the revenue picture look like for 
the first 3 months of this fiscal year. Are we doing a little 
better than we might have anticipated, better than budget or 
not? And is growth better or worse than might otherwise have 
been expected?
    I know that is not what you prepared or were asked to 
testify on, but it would be of great interest to me as we try 
to maximize revenues here.
    Mr. Shulman. Yes, I do not have this off the top of my head 
because, as you said, it was not exactly what I was prepared 
for, let us come back to you, and we would be happy to give you 
details of the revenue----
    Senator Carper. I would like you to answer that for the 
record, if you would.
    Mr. Shulman. Yes, for the record I will come back and give 
you revenue flows. We track it closely at the Treasury 
Department. It's mostly the folks who do economics at Treasury, 
and I do not want to give you a wrong answer.
    Senator Carper. What we are hearing anecdotally is the 
deficit number continues to drop, down from 1.5 to 1.3. Now we 
are down to under a trillion, only $980 billion. That is still 
a lot of money. That is encouraging. I just wondered if we 
could sort of get you to pinpoint where the growth is.
    Mr. Chairman, as usual, you raise intriguing and important 
issues. This is one that is certainly intriguing. Thank you for 
letting me participate.
    Senator Levin. Thank you so much for your participation.
    Just one quick question, perhaps, while Senator Carper is 
here. You made reference, I think, to certain rulings relative 
to charities or nonprofits. Is that correct, Ms. McMahon?
    Ms. McMahon. Well, I think I was intending to say that----
    Senator Levin. The UBIT reference you made.
    Ms. McMahon. Right, that there were structures commonly 
used that employ----
    Senator Levin. By the nonprofits and charities?
    Ms. McMahon. Right.
    Senator Levin. Are mutual funds a charity?
    Ms. McMahon. No.
    Senator Levin. And one other thing that I mentioned before 
you got here, Senator Carper, was that there was an effort made 
to add the investments or speculation in commodities a year and 
a half ago, and the House said it is OK, but we said we would 
not pass the bill with that provision in it. So the Senate did 
not accept that amendment which the House passed, so that is 
part of the legislative history. I assume that is relevant 
history, is it, Commissioner Shulman? That is relevant history 
that the Senate did not adopt that specific language?
    Mr. Shulman. Well, it is something that you raised, and we 
will obviously----
    Senator Levin. Is it relevant legislative history is my 
question.
    Mr. Shulman. To answer directly, we generally do not view 
things that are moved into a statute and pulled out in the 
middle of the process before it is passed into law as 
definitive guidance.
    Senator Levin. How about relevant? I did not use 
``definitive.'' Nothing is definitive here. But how about 
relevant?
    Mr. Shulman. Generally, tax provisions that are put in and 
pulled out before the law is ever passed, unless----
    Senator Levin. It does not show anything about 
congressional intent? That is not relevant to what the 
congressional intent is, if it is not a----
    Mr. Shulman. I do not think it is definitive.
    Senator Levin. OK. Let us try relevant. Is it relevant? Try 
it again.
    Mr. Shulman. I think it could send a variety of signals, 
but I am not prepared to say every time there is a provision in 
legislation and it moves out between the Houses that we are 
going to view that as congressional intent.
    Senator Levin. I guess I am asking you, is it relevant to 
the question of congressional intent? Just relevant.
    Mr. Shulman. Sure. It is a piece of information in the 
whole analysis, yes.
    Senator Levin. That is all I was asking. We have gone over 
economic substance and sham doctrines. There is another well-
established tax doctrine, too, which relates to conduits. In 
1972, I guess, the principles were set out in a case called 
Aiken Industries and subsequent regulations of the IRS that the 
IRS is allowed to disregard any entity which functions as an 
intermediary for a taxpayer and to treat its income as income 
attributable to the taxpayer itself. One ruling in 2002 
explains, ``Where the parent corporation so controls the 
affairs of the subsidiary that it is merely an instrumentality 
of the parent, the corporate entity of the subsidiary may be 
disregarded.''
    Are you familiar with that doctrine, the conduit doctrine?
    Mr. Shulman. Yes, I am familiar at a high level.
    Senator Levin. OK. Will you look into the facts that exist 
about these shell corporations and in your review of this whole 
matter take a look as to whether or not they are simply 
conduits, and in the case of those notes whether or not the 
banks that enter into those notes are simply agents or 
instrumentalities for the mutual funds? Will you check out that 
doctrine?
    Mr. Shulman. Absolutely.
    Senator Levin. Do you know, Commissioner, how many private 
letter ruling requests are pending relative to these 72 rulings 
which have been issued?
    Mr. Shulman. Yes, 72 issued. There are 28 that have 
requested private letter rulings since we stopped issuing them.
    Senator Levin. OK, and those are the ones that there is a 
moratorium on?
    Mr. Shulman. Correct.
    Senator Levin. Commissioner, you said that a private letter 
ruling can be relied on by only one taxpayer, and I think that 
is, in fact, your policy. However, we know of two mutual funds 
that have set up offshore corporations to trade in commodities 
without any private letter ruling. They told us they thought 
that they were allowed to do so based on other letters, so I 
think your statement here today is very important and hopefully 
will be relied upon and counted on as being factually accurate 
that the letters which are issued only relate to those 
particular companies or mutual funds which requested those 
letters. That is the status. But I did want you to know that 
there are a couple mutual funds who did not get those letters 
who are operating those offshore tax shelters or tax 
structures. I am just informing you of that, and if you are 
interested as to the names of those, my staff can give those to 
you.
    Perfect. That was my next question. We are all set for you. 
Are you ready?
    Senator Coburn. Thank you. You probably asked all the 
questions.
    Senator Levin. I hope so, yes.
    Senator Coburn. Thank you.
    I know Senator Levin has asked this question, but my most 
important thought about this issue is: Is the purpose for 
setting up an offshore commodities trading firm to avoid taxes? 
Is there another reason to do that other than to avoid taxes?
    Mr. Shulman. We had some discussion about this. Generally, 
people came in for private letter rulings, which we have 
suspended, but they come in to say, ``If we set it up with 
these detailed facts, does the IRS interpret that that is 
allowable under the law?'' In the past we said yes. Now we are 
going to take a look and see what we think.
    Generally they would not set it up. They would use some 
other structure. They would make another investment. They would 
go into another business if they did not do it. So taxes at the 
entity level is very rare. I know of one circumstance in all of 
mutual funds where a mutual fund decided to be taxable, so it 
is very rare for a mutual fund to pay taxes. That is what the 
Registered Investment Company Act and Section 851 allows them 
to do.
    I think the other point I made was that I want to be clear 
that the activity that happens in the controlled foreign 
corporation flows through and taxes are paid ultimately by the 
mutual fund's shareholders. So there is no loss of revenue to 
the Federal Government in these transactions, but there is the 
whole question of does the law even allow them to be set up in 
the first place, which I think is the question that was put on 
the table.
    Senator Coburn. Well, actually, I think there is lost 
revenue because if, in fact, a mutual fund is going to invest 
in a company that does commodity trading and does not do it in 
a tax-sheltered location, they are going to pay taxes on that, 
trading profits before they share with the stockholders of the 
fund. In other words, if I set up a corporation, ABC 
Corporation, and I am going to trade commodities, and I am 
going to make money, and you are going to be a shareholder in 
that, and I do that onshore, then I am exposed to corporate 
income taxes in this country, if I do it onshore, correct?
    Mr. Shulman. I think so.
    Senator Coburn. Yes. So, therefore, I am going to pay taxes 
there, and then I am going to give a distribution to the 
stockholders of what is left. And then they are going to pay 
taxes on whatever that distribution is if it is above their 
investment in it or if it is a dividend for it. So the point is 
the reason they are set up in offshore is to eliminate that 
corporate tax on those trades, correct?
    Ms. McMahon. If I could answer that briefly, the income 
that is generated by the controlled foreign corporations 
through commodities activities is actually treated as Subpart F 
income which flows up for U.S. tax purposes to the RIC, and 
ultimately the shareholders, so that there is actually U.S. tax 
in this particular structure.
    Senator Coburn. But at the shareholder level.
    Ms. McMahon. Well, technically the income is includable in 
the income of the RIC.
    Senator Coburn. Right.
    Ms. McMahon. And then as long as the RIC complies with the 
requirements that apply for it to have passthrough treatment, 
it would not be taxed at the RIC level. But it is included----
    Senator Coburn. Right, so it gets taxed by the shareholder.
    Ms. McMahon. And it is taxed by the shareholder. But that 
is no different than any other income that they----
    Senator Coburn. OK. Well, let us take GE for a minute. GE 
pays a dividend, which you pay income tax on, but GE also--GE 
is a terrible example. They have not paid any income tax in a 
number of years. As a matter of fact, you have been paying 
them.
    Let us take John Deere. They make earnings. They pay a 
corporate income tax. They distribute those earnings in terms 
of dividends, and then those earnings, which have already been 
taxed once, are then going to be taxed again by whoever 
receives that dividend. Correct?
    Ms. McMahon. Yes.
    Senator Coburn. So no matter how you base it, the reason 
for putting that account offshore is to lessen the tax that 
could be acceptable if you did the exact same thing onshore.
    Mr. Shulman. First of all, the hypothetical you gave I 
think is accurate. I think if they decide to do the exact same 
activity onshore, it will be taxed at the corporate level. 
Before, Senator Carper asked are there other ways that mutual 
funds can gain access to commodities. There is a variety of 
questions in the law around partnerships, around qualified 
publicly traded partnerships. So the chances of a corporation 
setting up in the United States for the sole purpose of doing 
the kind of direct investment in commodities and then moving--
being fully owned by a mutual fund, the chances of that 
hypothetical actually occurring are pretty slim.
    The real question is--which I want to be clear, I think it 
is a legitimate question that is being put on the table here. 
Can these things be set up to invest in commodities or not?
    Senator Coburn. Well, I think the Chairman's and my reading 
of the law is we do not think so.
    Senator Levin. Well, we do not think so, but I am amazed at 
your reluctance to say yes to the most obvious question--you 
said yes to me finally about an hour ago--to Dr. Coburn's 
question. The reason that these are set up in these offshore 
locations is so that they can avoid that impact of that section 
of the Tax Code. The answer is--they acknowledge that, for 
God's sake. Why can't the IRS look that square in the face and 
say, ``Of course, that is the reason they are doing it.'' You 
did it an hour ago. I am amazed at your reluctance to simply 
say yes to Dr. Coburn's question. Of course, that is the 
reason. They acknowledge that is the reason. And you say, 
``Well, they are not going to do something which would lead to 
their paying taxes.'' Of course, that is true. So the other 
side of that coin is the reason they are putting it in the 
Caymans is to avoid that problem. Why not just say yes and then 
go on from there? I mean, why is there any reluctance? That is 
what I do not understand here.
    Mr. Shulman. Why do I have reluctance?
    Senator Levin. Yes, to say that is the reason that they are 
in the Caymans.
    Mr. Shulman. Because having responsibility for the whole 
U.S. tax system, some of the things that have been asked 
implicate some of the other cases we have and other things that 
are happening outside. And so to make blanket generalizations 
about our views on controlled foreign corporations, when we 
will attack them, when we will not and when they are tax 
avoidance and when they are not has other implications beyond 
the issue at hand.
    My reluctance is that I am trying to be respectful, and I 
am very clear what this hearing is about. It is the private 
letter rulings and you believing that they were issued contrary 
to the intent of the law and that our lawyers' interpretation 
was wrong. I have told you we have stopped the private letter 
rulings, and we are going to take a broad look at that. So my 
goal would be on the record to leave it at that and not say 
things that are going to implicate us continuing our aggressive 
push around things like offshore tax evasion and around 
aggressive corporate structures to avoid paying taxes.
    The question on the table, which is a legitimate one, is: 
Should through the Code there be the ability to invest 
indirectly in commodities through structured notes or through 
controlled foreign corporations? And we are going to take a 
hard look at that.
    Senator Coburn. Nobody that has applied for one of these 
private letter rulings and has gotten it has done anything 
wrong. Their motivation is to make money. You have granted a 
private letter ruling, and they have taken advantage of that. 
So this is not to implicate anybody that has been there.
    But in terms of transparency of markets, my main concern in 
visiting with the Chairman on this is that people are going to 
invest in speculative things if that is where they think they 
can get the most return, and they think they can. The thing 
that ought to be there is transparency so that they know what 
the risk is as they go into this, and when you have a mutual 
fund that is doing this, a large amount of money can be lost. 
Or at least the risk for a large amount of money is out there; 
otherwise, they would not be speculating in commodities in the 
first place.
    As I said earlier, I do not know what too much speculation 
is, but I know we cannot do anything in the long term in this 
country that is going to affect that because we are in a world 
market. The only way we are going to do that is through 
international agreements if we think that is justifiable.
    So I do not have any criticism with what you have done. The 
fact that you are looking at it I think is great, and I think 
we ought to continue to do that, and we ought to be maybe more 
clear in how we write laws and to give you more guidance, and 
once of our worst habits in Congress is we say we write a law 
and this is the intent. We will let the Administration or the 
bureaucracy decide what the rulings on it are. I think we need 
to know a little bit more about that before we put it out to 
give you the rulings to write. In other words, you would not be 
sitting here today if we were much more clear about what the 
intent was in 2010.
    Thank you.
    Senator Levin. Thank you, Dr. Coburn.
    Do you know of any nontax purpose that mutual funds have 
for opening up these corporations in the Caymans?
    Mr. Shulman. Well, the CFCs in the private letter rulings I 
think were set up specifically so that they could invest in 
commodities.
    Senator Levin. And be consistent with the Tax Code? And 
comply with----
    Mr. Shulman. And income definitions.
    Senator Levin. And hope that they are complying with the 
Tax Code and Section 851.
    Mr. Shulman. Yes.
    Senator Levin. I happen to agree with Dr. Coburn, by the 
way. This is not a question of mutual funds taking advantage of 
what they are trying to take advantage of. I think the 
investment in commodities has the impact we have talked about, 
but we do not have to agree on that. What seems to me is so 
clear is the purpose of their investment or their creation of 
these shell corporations. There is no doubt about it. They do 
not deny it. Just ask them. They will tell you. They are trying 
to avoid the implications of not being eligible for nontax 
treatment under Section 851. They are not hiding that. What 
troubles me is that if you allow that, if you allow the shell 
corporations to be used for that purpose, there is only a tax 
avoidance purpose that they want to comply with--they have to 
comply with Section 851, as you point out. They do not want to 
pay taxes at a corporate level. That is what Dr. Coburn's 
question is. What troubles me is why there is any doubt in your 
mind as to what the purpose is. They acknowledge it. But then 
when the IRS says they are going to allow that to be used, 
allow a shell/sham corporation to be used for that purpose, it 
undermines all the efforts we are making to put those shell/
sham corporations out of business, frankly. They have no 
purpose other than tax avoidance.
    By the way, I agree with Dr. Coburn. We are not talking 
illegality here. We are talking tax avoidance.
    So I am going to end this on a positive note even though I 
have expressed my dismay at the reluctance to acknowledge what 
is open. Ask the mutual funds. I am sure there are many 
representatives here. And as you point out, they do not want to 
pay taxes. And they would not go there if they had to pay 
taxes. Of course, that is the point. That is why they are going 
there. But you cannot quite say that, and that is what troubles 
me because if you cannot say that, then I wonder about how much 
you are really going to go after these conduits, these shell 
corporations, however they are used, by the way. That is the 
part that leaves me with uncertainty.
    But what is certain is what you have said here, and that is 
that you are going to take a look at this from that 
perspective, can the IRS resume accurately put its blessing on 
the use of what are openly shell corporations with no nontax 
purpose? Can you put your imprimatur on that anymore? And what 
are the implications of your doing that for all the other areas 
where you are trying to prevent that from happening? And if 
there are other ways that mutual funds can speculate consistent 
with the law, that is one thing. I mean, I am not going to 
start giving tax advice. I do not think there are because I 
think the law is clear, by the way. It has been clear for 80 
years. We listed what can be done and what that means, unless 
those things are what you are doing, you do not get tax freedom 
at the corporate level.
    The economic substance doctrine has been codified by 
Congress, by the way. This is not any uncertainty or ambiguity. 
In 2010, we codified the economic substance doctrine. It says 
that you can disregard transactions or entities that create no 
meaningful change in the economic position of the taxpayer and 
have no substantial purpose other than--and this is the word of 
the law--``to achieve a tax effect.'' The effect here is to 
avoid violating or being inconsistent with a section of the Tax 
Code, which would trigger a tax at the corporate level. That is 
the purpose. That is the effect.
    And so would you finally agree, to end on a positive note, 
that in 2010 that economic substance doctrine applies to the 
transactions that are analyzed in the private letter rulings? 
Would you agree that the law saying that you may apply an 
economic substance doctrine to transactions, that is 
applicable, should you decide to apply it, to these 
transactions?
    Mr. Shulman. So while I like the idea of ending on a 
positive note, I am not sure I can agree to that. I think that 
economic substance is very fact intensive. We typically raise 
this in other circumstances. We typically do not raise economic 
substance with specific taxpayers that we have granted private 
letter rulings.
    Senator Levin. I am talking about in the policy that you 
are going to look at, the overall generic policy.
    Mr. Shulman. I just think it is something different. I do 
not think we need to raise that in the policy. I think we could 
decide to allow this or disallow this without implicating 
economic substance. It is really about a reading of the law, 
and I think it is not necessary and, frankly, all of our court 
cases where we have been successful with economic substance 
have very different sets of fact patterns than these.
    Senator Levin. Well, we passed a law in 2010 talking about 
economic substance saying that something has got to be real, it 
cannot be fake, and we are going after these totally phony 
transactions, which is what this is acknowledged to be. It is a 
shell. It is a sham. And for you to say that it might not be 
even relevant to your decision here--is it at least relevant? 
Is it something you would want to look at?
    Mr. Shulman. You have brought up the point about it, and I 
gave you my commitment that all of our points we are going to 
look at closely. I will tell you, though, the economic 
substance doctrine is a very specific tool, and we have a lot 
of tools. We have private letter rulings. We have suspended 
those. We have regulation or guidance. We have said we are 
going to look at that. And then obviously Congress could get 
very clear with the law, which would be our preference to all 
this. And so I do not want to implicate the economic substance 
doctrine where we do not have to, and I am not sure it is 
necessary here because we want to continue to win in court. 
Congress codified a judicial doctrine based on common law 
principles that we have been very aggressive and very careful 
about developing our positions, and that is why we have been so 
successful. And I do not want to generalize about the kinds of 
transactions where that could win. When we see an issue that we 
want to attack on economic substance, we will. Our lawyers will 
look at that. We have had a good record with that, and we plan 
to continue that.
    Senator Levin. Finally, if there is no economic substance 
to the creation of these corporations other than tax avoidance 
issues, if there is no nontax purpose, to use your words, to 
create these corporations, is that relevant?
    Mr. Shulman. Sure, I mean, the prongs of the economic 
substance doctrine we would look at, and to the extent that any 
position was changed going forward and people violated those 
prongs, everything is fair game. I am just saying right now we 
do not need to go attack these economic substance. We can 
actually put guidance out or have the law changed.
    Senator Levin. Thank you both. We have a vote that is on 
now, and apparently there is only 5 minutes left. To end on a 
positive note, we appreciate your reassurance that you are 
going to take a fresh look at this and you are going to apply 
doctrines in ways hopefully that are not going to create 
precedents that are negative in terms of going after sham 
transactions, we are going to leave on that positive note. 
Again, we are grateful for your appearance here today.
    [Whereupon, at 12:10 p.m., the Subcommittee was adjourned.]



















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