The Derivatives that R enters into are not stock, debt instruments, or currency (or options, futures, or forward contracts with respect to stock, debt instruments, or currency). Nevertheless, R’s income from the Derivatives may be “other income” if the Derivatives are “securities” for purposes of section 851(b)(2). This determination depends on the effect of the 1986 Act amendments to section 851(b)(2), which added the cross-reference to the definition of securities in the ’40 Act.

There is no conclusive authority, however, as to whether derivative contracts on commodities are included in the ’40 Act’s definition of “securities.” Accordingly, consideration of Congressional intent in enacting that cross-reference is helpful in determining whether commodity derivative contracts are securities for purposes of section 851(b)(2). Evidence of that intent may be found in the background to amendments to section 851(b)(2) in the 1986 Act. The amendments were added as a Senate floor amendment to the bill that eventually became the 1986 Act. The House and Senate committee reports, therefore, do not discuss these provisions, and the relevant discussion of the cross-reference in the report of the Conference Committee is extremely brief. See H.R. Rep. No. 99-426 (1985) (not discussed); S. Rep. No. 99-313 (1986) (not discussed); 2 H.R. Conf. Rep. No. 99-841, at II-243 (1986) (“The Senate amendment clarifies the definition of ‘securities’ by reference to the definition of securities in the Investment Company Act of 1940.”) Thus the best evidence of Congressional intent is found in the floor statement when the provision was added to the Senate bill and in other floor statements and Administration comments concerning related legislation.

The legislative antecedents to the 1986 Act amendments included H.R. 3397, which was introduced on September 20, 1985, by Representatives Flippo,  Kennelly, and McGrath, and S. 2155, which was introduced on March 7, 1986, by Senator Armstrong. These bills proposed the “other income” provision and the cross-reference to the definition of security in the ’40 Act. The former change was to codify a series of letter rulings, and the latter was to reflect then-current Treasury Regulations. See 131 Cong. Rec. 24,570 (1985) (section-by section analysis of H.R. 3397).

With respect to the definition of qualifying income, Senator Armstrong’s floor amendment to the bill that became the 1986 Act was identical to S. 2155. In introducing S. 2155, Senator Armstrong explained that his bill incorporated “minor changes” to H.R. 3397 “to comply with recommendations of the Treasury Department, which has given its support for the Bill.” 132 Cong. Rec. 4045 (1986) (remarks of Senator Armstrong). Senator Armstrong concluded his remarks by inserting into the Congressional Record the letter from the Treasury Department that had recommended changes to H.R 3397. See id. at 4046, 4047-48 (inserting a letter from Acting Assistant Secretary of the Treasury (Tax Policy) J. Roger Mentz, dated February 5, 1986).

Mr. Mentz’s letter explained the fundamental policy served by the qualifying income requirement:

Id. at 4048.

The letter pointed out that the Service had “often gone beyond the literal terms of the statute in order to give a reasonable interpretation to [then-current] section 851(b)(2),” for example by granting letter rulings that certain investment products were securities, gains on the sale or disposition of which resulted in qualifying income. (The products explicitly mentioned were options on securities, futures contracts on securities, stock index futures, options on stock indices, and options on stock index futures.) The letter noted that, despite this flexibility, each RIC could be certain of the treatment of various income items only by obtaining its own letter ruling. See id. at 4047-48. Thus, one justification for the amendments in H.R. 3397 appeared to be providing the needed certainty.

With respect to foreign currency gains, the Treasury letter stated:

Id. at 4048.

The Treasury Department, however, was not prepared at that time to propose statutory rules that would distinguish between currency gains relating to investments in stocks or securities denominated in a foreign currency and other currency gains that Treasury believed should not be qualifying income under section 851(b)(2). The letter, therefore, suggested that foreign currency gains be added to the list of qualifying income but that Treasury be provided with “regulatory authority to exclude from qualifying income any foreign currency gains that are not derived with respect to investment in a foreign-currency denominated security or from hedging activity with respect to such a security.” Id.

When Senator Armstrong offered the relevant provision as an amendment on the Senate floor, he asserted that it “enjoys the support of the Treasury Department” and that its purpose was “to permit the mutual fund industry to make better use of income from stock options, futures contracts and options on stock ind[ic]es, options and futures o[n] foreign currencies, and foreign currency transactions.” 132 Cong. Rec. 14,991-92 (1986).

This discussion demonstrates that the amendments to section 851(b)(2) made by the 1986 Act had a very specific purpose, which was to provide certainty by expanding the statutory description of qualifying income to include income that the Service, in specific cases, had already treated administratively as qualifying income. This included income from derivative contracts on stocks and securities (as the term “security” is generally understood in the U.S. tax law), such as futures and options on stock indices, which create an economic exposure to stock or securities even though the property underlying the derivative may be a collection of stocks and securities, rather than a specific stock or security.

The new rule regarding gains from foreign currencies (and options, futures or forward contracts on foreign currencies) was distinct from both the “other income” provision and the cross-reference to the definition of “security” in the ’40 Act. Thus a separate provision both established the general rule that foreign currency gain is qualifying income and created specific regulatory authority to exclude any foreign currency gains that are not “directly related” to a RIC’s “principal business of investing in stock or securities (or options and futures with respect to stock or securities).” The reason was that these gains were income from property other than stock or securities.

The foregoing indicates that Congress did not intend for the cross-reference to the ’40 Act to incorporate into section 851(b)(2) an expansive construction of the term “securities.” Particularly important was the specific inclusion in the 1986 amendment of foreign-currency-related gains. If the ’40 Act were read expansively, there would be no need for special mention of these gains, because they would be included in the provision for “other income . . . derived with respect to [the RIC’s] business of investing in securities.” Moreover, the authority given to Treasury to exclude from qualifying income “foreign currency gains which are not directly related to the company’s principal business of investing in stock or securities” indicates that the reason for the special treatment for foreign currency was to facilitate a RIC’s principal activity, namely investing in qualifying stock or securities, when the stock or securities are denominated in a foreign currency.

A construction of the term “securities” that excludes derivative contracts providing for a total return exposure to a commodity index is consistent with Congress’ intent in amending section 851(b)(2) in 1986. Accordingly, because the underlying property is a commodity (or commodity index), the Derivatives that R enters into are not securities for purposes of section 851(b)(2).

R invests substantially all of the funds it receives from shareholders in debt instruments, which are securities for purposes of section 851(b)(2). Even though R’s Derivatives are not themselves securities for purposes of section 851(b)(2), income from the Derivatives counts toward the 90-percent test if it is “other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to [R’s] business of investing in” stock, securities, or currencies.

R, however, does not enter into the Derivatives in connection with a business of investing in stock, securities, or currencies. Nor does R enter into the Derivatives in order to reduce or hedge the level of risk in a business of investing in stock, securities, or currencies. R’s business is to create investment exposure to changes in commodity prices, and the Derivatives are the primary vehicle for doing so. R owns the debt instruments to facilitate its business of providing this commodity-derivative exposure. Because R’s Derivatives are not themselves securities and because R does not enter into those contracts with respect to a business of investing in stock, securities, or currencies, income from the Derivatives is not qualifying income for purposes of section 851(b)(2).