[Senate Hearing 112-343]
[From the U.S. Government Publishing Office]
S. Hrg. 112-343
COMPLIANCE WITH TAX LIMITS ON MUTUAL FUND COMMODITY SPECULATION
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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
Committee on Homeland Security and Governmental Affairs
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U.S. GOVERNMENT PRINTING OFFICE
73-671 PDF WASHINGTON : 2012
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Washington, DC 20402-0001
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
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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
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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
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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.
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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\
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\1\ See Exhibit No. 1d which appears in the Appendix on page 51.
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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.''
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\1\ See Exhibit No. 3d which appears in the Appendix on page 81.
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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.
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\1\ The prepared statement of Mr. Shulman appears in the Appendix
on page 36.
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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.
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\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.
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\1\ See Exhibit No. 8 which appears in the Appendix on page 195.
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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\
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\1\ See Exhibit No. 9 which appears in the Appendix on page 196.
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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.]
A P P E N D I X
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