The Fed’s Fear Scale: Holdings Of Cold Hard Cash At A Record
MONDAY, APRIL 8, 2013 AT 8:53PM
In 1969, notes greater than $100, including the cool $10,000 note that would still pay for a lot of things, were retired due to “declining demand.” Prematurely, it turns out. Because demand for cold hard cash, despite plummeting use of it for transactions, has surged. Reason: fear.
Modern payment technologies have been taking over transactions. Since 2000, transaction volume via debit cards skyrocketed 18.4% per year, electronic bank transfers 13.5% per year, and credit cards 3.7% per year, reported San Francisco Fed President and CEO John Williams in “Cash Is Dead! Long Live Cash!” Conversely, use of checks dropped by 5.8% per year.
Cash does have advantages: it’s reliable even during blackouts or after earthquakes when nothing works anymore; and it’s anonymous so that companies can’t track you when you by pita bread and hummus, information that years later might lead a promotion-hungry genius at some counter-terrorism office to send drones after you. Because cash is murky, the San Francisco Fed could only estimate transaction volume. And it’s down sharply.
The other reason to hang on to cash is as a store of value, albeit a lousy one as interest income is zero…. Oops, same as most bank accounts! As the Cyprus bail-in debacle has demonstrated, handing your cash over to a bank is nothing but a loan, and when the bank craters, the uninsured deposit, and perhaps even the insured deposit, might evaporate or get a crew cut.
So, in these crazy times of ours, when central banks around the world impose zero-interest-rate policies that force people to lend their money interest-free to banks that are shaky, suddenly cold hard cash that you can move out of harm’s way can be a good option.
And people have figured it out. Since 2007, when the financial crisis started, through 2012, the value of US dollars in circulation jumped 42% to $1.1 trillion, or $3,500 per person in the US. The annual growth rate over those five years of 7.25% is over three times the growth rate of the US economy. Most of it in $100 bills. Over the six months after the Lehman moment in September 2008, $100 bills in circulation jumped by $58 billion, or 10%.
So in 2009, when the Fed tried to bamboozle people into thinking that it solved the financial crisis, or when the Obama administration tried to point at some lonely green shoots, and later when they began hyping the decline in the unemployment rate, and when the Fed bandied about stress-test results to trick people into believing that the TBTF banks were in excellent shape, that their inscrutable balance sheets were sound, and that depositors’ money would be safe and secure… with all these wondrous accomplishments, why did people not return these stacks of $100 bills to the banks?
Cash in circulation does decline, periodically. A small dip occurs after the holiday shopping season at the end of the year. And a much larger dip should have occurred when the Fed and the White House gave the all-clear signal. Instead, the curve of cash holdings steepened. Not exactly a vote of confidence.
There was another culprit. In the spring of 2010, as the Eurozone debt crisis got uglier, holdings of dollars rose sharply. “Economic and political turmoil and uncertainty about the future sent Europeans scrambling to convert some of their euros to dollars,” Williams explains. During that time, the share of dollars held overseas rose from an estimated 56% before the debt-crisis fiasco to nearly 66% by the end of 2012.
Last fall, Eurocrats and Eurozone politicians declared with fake conviction in their voices that they’d vanquished the debt crisis with their bold and wise actions, that all was hunky-dory. People didn’t get it; the curve of cash holdings steepened yet again—because, as Williams writes, “cash holdings tend to rise during periods of political and economic turbulence.”
Terms that defined the Eurozone last fall despite the incessant soothing voices wafting down from the top. Terms that found their meaning in March when the tiny island of Cyprus turned into financial mayhem. And holdings of cold hard cash will surely have spiked again.
Zero-interest-rate-policies expose savers to the risks of lending money to the banks with zero return on their investment, and only an iffy guarantee of their investment. In this arrangement, savers pay for inflation, banks benefit from it. An insidious situation. So in trouble spots around the world, people, motivated by fear and lacking incentives to do otherwise, hoard US dollars as a relatively safe asset, as silly as that might seem, given the Fed’s effort to debase them. Until that curve of dollar holdings inverts, nothing is solved. Meanwhile, those old $10,000 notes would come in handy.
Since 2008, 2.2 million jobs have been lost in the US among the 25-54 year olds, even as their numbers grew by over 3 million. Young people who thought they’d scrimp by until they “moved up” now expect to never have a decent life and are trying to adapt to their new reality. Since 2008, America seems to have failed many Americans.
Statistics: Posted by yoda — Tue Apr 09, 2013 12:14 am
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Consumer Metrics Institute: A Hard Year Ahead
by John Rubino on February 28, 2013 ·
The US economy stalled in the 4th quarter, but the analysis that accompanied the latest (slightly positive) GDP revision seemed to imply that the reasons for the weakness – a drawdown of inventories and lower defense spending – would be reversed out in coming months, making 2013 a pretty good year.
But the Consumer Metrics Institute, in its latest take on the data, argues that this year is more likely to be an extended version of Q4. Here’s an excerpt from the much longer report which is available here.
Despite the new-found minuscule “growth” reported in this release, there are ample reasons to remain cautious about the economy:
– Even as revised this data represents an economy that is statistically in a dead stall, “growing” at a rate some 3% less than during the prior quarter (the greatest downward quarter-to-quarter change since the fourth quarter of 2008).
– This data is still reporting 4Q-2012, a quarter that in retrospect may be viewed as the last gasp of the “Great Recovery” — before there were significant economic headwinds created by reductions in consumer take-home pay, rising gas prices, sequestered federal spending and accelerating contractions in global trade. If all other components of the economy stay the same, those factors alone could remove something like 3% from real-time economic “growth” by the end of the first quarter of 2013: the normalization of FICA deductions alone could reduce consumer spending enough to pull the headline number down by 1%, the $.50 per gallon increase in gas prices could similarly remove another 0.5% from the headline number, weakening exports could easily reduce the headline number by another 1% and the federal budget sequestrations — if fully implemented and sustained — should eventually pull (at maximum, despite doomsday rhetoric) an additional 0.5% from the headline number.
– However, with respect to the “sequestrations”: political will and doomsday rhetoric notwithstanding, even if they are implemented by Congressional mandate (or inaction) there may be no reason to expect actual short term government spending to change. The budgetary shenanigans during the third quarter of 2012 (when a defense spending spree created a phantom boost to pre-election economic data by bringing some spending forward by a quarter — and incidentally across a fiscal year boundary) probably taught the US Federal bureaucracy that as a practical matter they can spend at will and with utter impunity from the budgetary intentions of the fiscally conservative majority in the US House of Representatives.
In the day-to-day reality of this Administration there simply may be no legal or political consequences to overspending Congressionally-approved budgets in pursuit of the perceived greater good.
To summarize the most interesting points:
Q3 growth was artificially boosted by moving up future defense spending, which vindicates the people who said we can’t trust an election year recovery. They predicted that the numbers would get worse as soon as the votes were counted, and they were right. Q4 GDP growth was essentially zero. And the incumbents got away with the scam. It’s amazing what we’ve learned to accept from the ruling class.
Some of the things that made Q4 so weak will indeed be reversed out, but this will be more than offset by higher payroll taxes and gas prices and Europe’s inability to buy much from the US or anywhere else in the year ahead.
When confronted with budgetary constraints, the federal government has reached the point in its moral devolution that it will simply spend whatever it wants regardless of what the law says. Again, it’s amazing how low the “business as usual” bar has been set.
And finally, the stock market is behaving like it’s entering another bubble, which sets up an interesting collision between the liquidity-driven boom and zero-growth visions. Since we’re already two-thirds of the way through Q1, a resolution one way or the other should come soon.
Statistics: Posted by yoda — Fri Mar 01, 2013 12:25 am
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Hard Red Winter Wheat Crop Receives Disaster Declaration
11 January 2013
US – Wheat growers in the Southern Plains have know the effects of a drought for about 120 consecutive weeks, and now their neighbors to the north have been added to the drought disaster list, writes Stu Ellis for farmgateblog.com.
Nearly 600 US counties—20 per cent of them—have been declared disaster areas in the first such USDA designation in 2013. Drought and heat, an environment unsatisfactory for the development of the hard red winter wheat crop, have seriously threatened the vitality of the crop.
While disaster declarations were weekly events in 2012, adding dozens of counties at a time to a growing list that included 2,245 by year’s end, the initial declaration came quickly in 2013. And it is all because of the US wheat crop that began its life in the worst condition since USDA began reporting wheat condition and crop progress. USDA officially identified 597 counties as primary disaster areas and made farmers eligible for low interest loans. USDA said, “The 597 counties have shown a drought intensity value of at least D2 (Drought Severe) for eight consecutive weeks based on US Drought Monitor measurements, providing for an automatic designation.”
Statistics: Posted by yoda — Sun Jan 13, 2013 12:57 pm
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California deep freeze continues; farmers hard hit
January 13, 2013 | 7:35 am
Southern California endured another night of freezing temperatures as the cold snap that has gripped the region continued.
According to the National Weather Service, many San Fernando and San Gabriel Valley areas recorded temperatures in the low 30s — and some in the high 20s — overnight. Lancaster and Palmdale recorded 16-degree lows. Even coastal areas such as Long Beach had lows in the 30s.
Temperatures will hit the 50s and low 60s Sunday.
A high-pressure zone sitting off the Pacific coast has channeled a blast of cold air from the Gulf of Alaska down the backbone of the state. Temperatures on Saturday night were expected to dip as low as 25 degrees, triggering freeze warnings across Southern California.
"It’s not unusual for us to get these cold snaps this time of year, but it’s one of the colder ones we’ve had in awhile," said Curt Kaplan, a meteorologist with the National Weather Service’s Oxnard office.
Starting Monday, cold Santa Ana winds will sweep in from the desert. By Wednesday, temperatures should begin to rise.
The cold snap has been a particular concern for citrus farmers across the state, who have been up all night since Thursday. There are $1 billion in oranges, lemons, tangerines and grapefruit still on trees in California, the nation’s largest producer of fresh citrus.
The year had been off to a good start, with a particularly flavorful crop of mandarins and good sugar content across the state. The association has sold up to $300 million in citrus already, with another $1 billion still on the trees.
"We were looking at a very profitable year," said John Nelsen, president of California Citrus Mutual, an association of the state’s 3,900 citrus growers, the majority of which are family farmers.
But a cold snap can change that in hours. In January 2007, citrus growers lost 60% of the state’s crop to freezes. In 1998 it was 85%. The worst season in memory was the Christmas freeze of December 1990, when a week of temperatures in the teens defoliated the orchards, leading to a total loss for that season and the one after, Nelsen said.
Statistics: Posted by yoda — Sun Jan 13, 2013 12:16 pm
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I have always thought of myself as a philosopher first, and a libertarian second. In my more self-congratulatory moments, I tell myself that this is because my highest commitment is to the truth, wherever it may lead, regardless of political program. To be honest, though, I think it largely comes down to personality. The fact is, being in a room full of people who all agree with each other—especially about politics—makes me profoundly uncomfortable. And that discomfort makes me start to question things. Put me in a room full of socialists, and I will start arguing for the virtues of a free market. But transport me to a room full of libertarians and, well…
And that’s why I’m here, blogging for Libertarianism.org. It’s not to be a cheerleader for libertarianism, though I think that doctrine gives us plenty cause for cheer. It’s to raise uncomfortable questions, explore challenges, and poke and prod the weak points in the ideological armor we all sometimes get a little too comfortable in.
In the end, of course, I’m still a libertarian—though perhaps a libertarian of a somewhat unorthodox sort. I think that there are weaknesses in many standard libertarian arguments. And I think that a failure to recognize those weaknesses leads many libertarians to blunder when presenting their position to outsiders, or defending it against objections. But I think that the weaknesses can be overcome; or, when they can’t, that the strengths of the view are sufficient to compensate for them.
I suspect most readers of this blog probably feel the same. Still, until and unless we’ve gone through the hard intellectual work of thinking through the weak spots in your position, we can’t really know this to be true. It might be true, but even true opinions, as John Stuart Mill warned us, “if…not fully, frequently, and fearlessly discussed…will be held as dead dogma, not [as] living truth.” And truth thus held, he notes, “is but one superstition the more, accidentally clinging to the words which enunciate a truth.”
As a philosopher, I don’t think that’s any way for a rational being to live. But, you may ask, so what? Not everyone is a philosopher (thank God). Some people just want to figure out the truth so that they can get on with the important practical business of getting things done—of creating wealth, being a good citizen, and maybe moving our society a little bit farther down the path toward freedom. Does Mill’s point have any practical significance?
I believe that it does. For even if all you want to do is nudge public policy in the direction of freedom, you cannot begin to do that unless you actually know what freedom is, and that is a question which brings you right back to philosophy. For instance, is the protection of intellectual property a way of securing freedom (as is, we libertarians believe, the protection of property in tangible goods)? Or is it itself a violation of freedom? To answer this question requires not just understanding the concept of freedom, but its relation to the concept of property both in external objects and in one’s self. A philosophical understanding of these concepts might not be sufficient to resolve the challenge of intellectual property, but it is surely necessary. (Hey, necessary and sufficient conditions—that’s more philosophy!)
“Balderdash,” you say! If talk about freedom requires so much philosophy, then so much the worse for the concept of freedom. Libertarians can, and should perhaps, just be pragmatic. Forget about philosophy; let’s just do what works.
But not even this quintessentially American pragmatism allows us to escape philosophy’s probing questions. For we cannot know what works unless we know what it means to “work.” A policy “works,” presumably, if it gets us the right results. But what results are right? Economic growth? Increased happiness? More freedom? (whoops, back to that difficult concept again!) To know what works requires, at the very least, that we decide which outcomes are worth pursuing and what means are legitimate for pursuing them. It requires, in other words, that we think philosophically about morality and politics.
So that’s what I’m going to be doing in my future posts here. I invite you to think critically with me about some of the foundational concepts of our shared worldview. In some of my next few posts, I’ll talk about freedom, about self-ownership, and about free exchange. In discussing these issues, I’ll draw on the resources of philosophy, but also on the rich resources of the libertarian intellectual tradition—a tradition that Libertarianism.org in general and George H. Smith’s wonderful posts in particular are doing so much to keep alive. I hope you’ll join me.
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By Daniel J. Mitchell
I’ve explained on many occasions that Franklin Roosevelt’s New Deal was bad news for the economy. The same can be said of Herbert Hoover’s policies, since he also expanded the burden of federal spending, raised tax rates, and increased government intervention.
So when I was specifically asked to take part in a symposium on Barack Obama, Franklin Roosevelt, and the New Deal, I quickly said yes.
I was asked to respond to this question: “Was that an FDR-Sized Stimulus?” Here’s some of what I wrote.
President Obama probably wants to be another FDR, and his policies share an ideological kinship with those that were imposed during the New Deal. But there’s really no comparing the 1930s and today. And that’s a good thing. As explained by Walter Williams and Thomas Sowell, President Roosevelt’s policies are increasingly understood to have had a negative impact on the American economy. …[W]hat should have been a routine or even serious recession became the Great Depression.
In other words, my assessment is that Obama is a Mini-Me version of FDR, which is a lot better (or, to be more accurate, less worse) than the real thing.
To be sure, Obama wants higher tax rates, and he has expanded government control over the economy. And the main achievement of his first year was the so-called stimulus, which was based on the same Keynesian theory that a nation can become richer by switching money from one pocket to another. …Obama did get his health plan through Congress, but its costs, fortunately, pale in comparison to Social Security and its $30 trillion long-run deficit. And the Dodd-Frank bailout bill is peanuts compared to all the intervention of Roosevelt’s New Deal. In other words, Obama’s policies have nudged the nation in the wrong direction and slowed economic growth. FDR, by contrast, dramatically expanded the burden of government and managed to keep us in a depression for a decade. So thank goodness Barack Obama is no Franklin Roosevelt.
The last sentence of the excerpt is a perfect summary of my remarks. I think Obama’s policies have been bad for the economy, but he has done far less damage than FDR because his policy mistakes have been much smaller.
Moreover, Obama has never proposed anything as crazy as FDR’s “Economic Bill of Rights.” As I pointed out in my article, this “would have created a massive entitlement state—putting America on a path to becoming a failed European welfare state a couple of decades before European governments made the same mistake.”
On the other hand, subsequent presidents did create that massive entitlement state and Obama added another straw to the camel’s back with Obamacare. And he is rigidly opposed to the entitlement reforms that would save America from becoming another Greece. So maybe I didn’t give him enough credit for being as bad as FDR.
P.S.: Here’s some 1930s economic humor, and it still applies today.
P.P.S.: The symposium also features an excellent contribution from Professor Lee Ohanian of UCLA.
And from the left, it’s interesting to see that Dean Baker of the Center for Economic and Policy Research basically agrees with me. But only in the sense that he also says Obama is a junior-sized version of FDR. Dean actually thinks Obama should have embraced his inner-FDR and wasted even more money on an even bigger so-called stimulus.
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By Michael F. Cannon
Secretary of Health and Human Services Kathleen Sebelius has been campaigning so enthusiastically for President Obama that she — whoops! — broke a federal law that restricts political activities by executive-branch officials. Federal employees are usually fired for such transgressions, but no one expects that to happen to Sebelius. Heck, she got right back in the saddle.
Every cabinet official (probably) wants to see the president reelected, and no president relishes dismissing a cabinet official. But in this case, there’s an additional incentive for Sebelius to campaign for her boss and for Obama not to fire her.
ObamaCare creates a new Independent Payment Advisory Board that — “fact checkers” notwithstanding — is actually a super-legislature with the power to ration care to everyone, increase taxes, impose conditions on federal grants to states, and wield other legislative powers. According to legend, IPAB will consist of 15 unelected “experts” who are appointed by the president and confirmed by the Senate. Yeah, good one.
In fact, if the president makes no appointments, or the Senate rejects the president’s appointees, then all of IPAB’s considerable powers fall to one person: the Secretary of Health and Human Services. The HHS secretary would effectively become an economic dictator, with more power over the health care sector than any chamber of Congress.
If Obama wins in November, he would have zero incentive to appoint any IPAB members. The confirmation hearings would be a bloodbath, not unlike Don Berwick’s confirmation battle multiplied by 15. Sebelius, on the other hand, would not need to be re-confirmed. She could assume all of IPAB’s powers without the Senate examining her fitness to wield those powers. If Obama fired her, or the voters fire Obama, then the next HHS secretary would have to secure Senate confirmation. Again, bloodbath. That makes Kathleen Sebelius the only person in the universe who could assume those powers without that scrutiny.
No wonder she’s campaigning so hard. No wonder Obama won’t fire her.
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Tax ruling threatens commodity mutual funds: Kemp
By John Kemp
LONDON | Fri Sep 14, 2012 7:46am EDT
(Reuters) – Commodity prices could come under severe pressure if the U.S. Internal Revenue Service (IRS) decides to revoke previous rulings that have allowed mutual funds to pour over $50 billion into commodity derivatives through subsidiaries in the Cayman Islands and structured notes while remaining exempt from corporate income tax.
"The controlled foreign corporations 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," Chairman Carl Levin complained at a hearing of the Senate Permanent Subcommittee on Investigations in January.
Mutual funds have made commodity investing accessible to a much wider range of investors, not just the rich individuals able to participate in hedge funds.
Unlike hedge funds, however, there are strict limits on the assets mutual funds can own while preserving their exemption from corporate income tax.
Until 2006, those restrictions were generally thought to prohibit mutual funds from generating more than 10 percent of their income from commodities and other alternative investments.
But without any change in the law, fund operators have secured a series of special rulings from the IRS allowing them to sidestep the restrictions, obtaining up to 100 percent of their income from commodities by setting up subsidiaries in the Caymans as controlled foreign corporations, or structuring the investment as a fixed-income instrument (bond) where the amount of principal repaid is linked to an index of one or more commodities.
On this surprisingly thin legal basis, the mutual fund industry has built a major new asset class since 2006. Now it’s under attack, as critics in Congress question whether the IRS has gone too far in allowing mutual funds to circumvent the restrictions that would otherwise prevent them from launching specialist commodity funds.
PRIVATE LETTER RULINGS
Between 2006 and 2011, the IRS issued 72 private letter rulings (PLRs) to mutual funds confirming that commodity investments via offshore subsidiaries or structured notes would enable them to keep their status as regulated investment companies (RICs) and receive a corporate tax exemption.
A PLR is a written determination issued to a taxpayer by the IRS in response to a written inquiry. It interprets tax law and applies it to the taxpayer’s specific set of facts. A taxpayer may rely on a PLR when dealing with the IRS provided it has stated the circumstances fully and correctly. But it is not meant to create a precedent for others.
In exceptional circumstances, PLRs can be revoked (sometimes retroactively) if the IRS finds it has made an error or if there is a change in the law.
By the end of 2011, the 40 largest commodity-related mutual funds had amassed over $50 billion in assets based on these PLRs (link.reuters.com/xut52t).
But in July 2011, worried about the profusion of PLRs, and the continued refusal of Congress to give mutual funds clear statutory authority for commodity investing, the IRS called a time-out. It told the industry it would not respond to any more requests for PLRs until it can determine the legal position properly and provide more general guidance.
The moratorium has left at least 28 PLR requests in the queue unanswered. Two more funds are reported to have pressed ahead without securing a PLR, defying the IRS.
Relying on PLRs to give the green light to commodity mutual funds, and the IRS’s decision to stop issuing new ones, has put a cloud over the whole sector.
Without the tax exemption, mutual funds would have to restructure or liquidate their holdings. They "would (have to) use some other structure. They would make another investment. They would go into another business" IRS Commissioner Douglas Shulman told the Subcommittee on Investigations on January 26.
"I know of (only) 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."
If the IRS determines its earlier rulings were wrong, and revokes the existing PLRs, commodity-focused mutual funds would have to find another way to structure their investments, scale back their holdings to below the 10 percent income limit, or exit the sector altogether.
The resulting liquidation would put tremendous pressure on commodity prices and reverse much of the build up of speculative money in commodity markets over the past decade – which is precisely what some opponents of the PLRs want. Chairman Levin is a leading critic of the impact investment flows have had on food and fuel prices.
On the other hand, if the IRS eventually determines income from commodity investments via offshore subsidiaries and structured notes is qualifying income after all, it could see another large in-rush of funds into the sector.
In addition to the pending applications, many other mutual funds could be launched if the IRS issues a generally applicable ruling that everyone can rely on rather than forcing each fund to seek its own PLR.
Either way, the IRS decision could transform the landscape for retail commodity investors, and have a major impact on commodity prices.
A TORTURED HISTORY
In return for their exemption from corporate income tax, Congress stipulated that recognized investment companies, which is the formal tax law term for mutual funds, must derive at least 90 percent of their income from dividends, interest, payments with respect to securities loans and gains from the sale or other disposition of stock or securities.
The restrictive list of possible investments was included in the original law granting tax breaks to mutual funds in 1936 and confirmed when Congress revisited the issue in 1954. It is now Section 851(b)(2) of the tax code (26 USC 851(b)(2)).
In 1986, Congress broadened the list of permitted investments as part of a comprehensive overhaul of the tax code to include gains from "foreign currencies, or other income (including but not limited to gains from options or futures contracts) derived with respect to its business of investing in such stock, securities or currencies".
But it was thought that Congress had specifically excluded gains from commodities. The law itself remained silent on the matter. In a letter to Congressman Ronnie Flippo, however, one of the sponsors of the 1986 mutual fund amendment, the U.S. Treasury stated its unequivocal opposition.
"We would generally not treat as qualifying income gains from trading in commodities, even if the purpose of that trading is to hedge a related stock investment," the Treasury wrote.
Treasury opposition appeared to become a part of the legislative record. One of the Senate sponsors of the amendment specifically stated it "enjoys the support of the Treasury" 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 indices, options and futures on foreign currencies, and foreign currency transactions."
And there the position appeared to rest.
OPENING THE FLOOD GATES
In response to enquiries from the industry, the IRS published a general revenue ruling in January 2006 stating unambiguously:
"A derivative contract with respect to a commodity index is not a security for the purposes of section 851(b)(2). Under the facts above, income from such a contract is not qualifying income for the purposes of section 851(b)(2) because the income from the contract is not derived with respect to the business of investing in stocks, securities or currencies." (Revenue Ruling 2006-1, January 9, 2006).
But over the next six months, under pressure from the industry, the IRS wavered. In June 2006, the IRS issued another general ruling which "clarified" that the previous ruling:
It "was not intended to preclude a conclusion that income from certain instruments (such as structured notes) that create a commodity exposure for the holder is qualifying income under Section 851(b)(2)" (Rev Ruling 2006-31, June 19, 2006).
The June revenue ruling triggered an avalanche of requests for private revenue letters confirming commodity investments could count as qualifying income. The first PLR was issued on July 14 and two more were issued before the end of the year.
Eight more PLRs went out in 2007. Six followed in 2008. Then 12 went out in 2009, 22 in 2010 and 21 in 2011, before the IRS brought the curtain down.
Thirty-five PLRs confirmed a mutual fund could invest through a controlled foreign corporation; 18 confirmed it could get exposure through a structured note; and 19 confirmed the fund could use both techniques, according to an analysis by Senate staff.
But there must still have been some doubt about the legal status of these investments because in 2010, the House of Representatives and Senate considered the Recognized Investment Company Modernisation Act.
The bill was explicitly endorsed by the Investment Company Institute, which lobbies on behalf of the mutual fund industry, as a means to "modernize the tax laws that govern mutual funds." The Institute noted "these laws have not been updated in any meaningful or comprehensive way since 1986."
Section 201 of the modernisation bill would have amended Section 851(b)(2) to change the reference from currencies to commodities (a more general term).
The bill was passed by the House, and then by the Senate. But senators made one change: striking section 201 in an amendment offered by Senator Jeff Bingaman.
Significantly, when offered an opportunity to give mutual funds explicit authority to invest in commodities, Congress refused.
It is that legislative history which appears to have given the IRS reason to reconsider its earlier rulings. Tax officials could no longer be sure (if they ever really were) that Congress intended Section 851(b)(2) qualifying investment income to include revenues from commodities, or that the courts would read the tax statute in this way.
IT’S NOT OUR PROBLEM
At the hearing in January, Levin pressed the IRS commissioner on why the tax department took such a relaxed view of mutual funds setting up subsidiaries in the Caymans and transforming commodity derivative investments into debt-like structured notes to enable them to make investments that would not otherwise be allowed.
"We have learned that these offshore shell corporations, these wholly owned subsidiaries established by mutual funds, are in every case wholly owned Cayman Island corporations. They are shells. There are 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," the chairman explained.
"One mutual fund told us that all of the commodity investment decisions come from their Rockville, Maryland office."
"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 tax is evaded."
Levin went on to press the revenue commissioner if tax was being avoided, even if it not being evaded. Why was the IRS not aggressively trying to clamp down on these offshore corporations and their structured notes, the senator asked repeatedly.
The answer appeared to be that the IRS did not think it was its problem. Tax is not being evaded. And it is only being avoided if the mutual funds would have invested in commodities without the tax perk.
The IRS argued that without the exemption the mutual funds would not invest in commodities and would find another asset class they could invest in without paying corporate income tax instead. In that sense no tax that would otherwise be due was being lost because there would have been no activity to tax in any event.
"(The IRS) has been very aggressive attacking sham corporations that are trying to use the (tax) 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," Shulman said.
But because the mutual funds were not avoiding tax in the ordinary sense, and because all their income is taxed once it is distributed to individual investors, the IRS was not worried about the clever tax structuring of offshore corporations and notes.
Shulman insisted that it is not the function of the IRS to police the law on permissible commodity investments.
Levin shot back: "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."
COMMODITIES AT THE CROSSROADS
All this leaves both the mutual fund industry and the IRS in something of a quandary.
"Tax law clearly permits mutual funds to invest indirectly in commodities through controlled foreign corporations or commodity linked notes," according to the Investment Company Institute. "Moreover, no congressional policy prohibits fund investment directly or indirectly in commodities."
The Institute’s full response to the Subcommittee has been posted on its website: here
But it seems to overstate the case. Congress has never explicitly allowed heavily regulated mutual funds to derive more than a small fraction of their income from commodities.
When Congress was given the opportunity to give them explicit permission, it refused. So it must be doubtful whether the legislative history can really be read in a way that suggests lawmakers thought they were giving mutual funds the right to invest more than 10 percent in commodities.
At the same time, commodity investing is popular, and millions of ordinary Americans have chosen to get exposure to commodity prices through mutual funds. It is not clear the IRS could simply revoke the PLRs and risk shutting down the whole industry.
"Everyday investors increasingly want commodities in their portfolios, and are looking to buy them in record amounts," in part because of concerns about inflation, Republican Senator Tom Coburn explained at the hearing in January.
No wonder the IRS is treading carefully. However much the IRS does not want to get involved, though it may not have much choice. It may not be responsible for regulating commodity investment, but it does have an obligation to determine the tax treatment of commodity-related mutual funds.
Opponents of commodity investment will continue to point out the lack of an explicit legislative mandate for all this activity. An enormous industry has built up on a very thin legal foundation, and now it’s starting to sway dangerously in the wind.
Statistics: Posted by yoda — Tue Sep 18, 2012 1:37 pm
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