WASHINGTON - Mutual funds are moving into the commodities market and top U.S. tax officials on Thursday at a Senate hearing defended their decisions to permit this expansion, while lawmakers expressed concerns that funds may be skirting the law to avoid taxes.

Democratic Senator Carl Levin, chairman of the Senate's permanent subcommittee on investigations, grilled Obama administration officials over his view that investing in commodities such as oil and metals may feed speculation.

The mutual fund industry's overall stake in commodities has risen to more than $50 billion in 2011 from less than $10 billion in 2008, according to data compiled by the subcommittee, gleaned from Morningstar and mutual fund materials.

That is a big jump, but the total is still only one-half of 1 percent of the industry's $11 trillion in assets. Mutual funds pool investors' assets and traditionally sink them into stocks and bonds.

U.S. Internal Revenue Service Commissioner Douglas Shulman defended the government's actions, in a series of testy exchanges with Levin and the top Republican on the panel.

Shulman said he saw mutual funds not necessarily aiming at avoiding taxes. "They are setting them up to get some exposure to commodities," Shulman told the lawmakers.

A decades-old law says that 90 percent of mutual funds' gross income must come from what are considered safe investments, such as securities or foreign currencies. In return, funds are generally exempt from corporate income tax.

The 90 percent law had been interpreted as capping commodity income for funds at 10 percent of gross income, but the IRS in recent years has been signing off on a case-by-case basis on the use of complex structures involving commodities.

The IRS has halted such approvals pending development of a clear policy. Shulman said earlier laws leave room for debate.

The definition of a "security ... is not static and contains several generic items designed to encompass new instruments as they develop," Shulman told the lawmakers.

But he said the agency has "an open mind on the issue."

Emily McMahon, acting assistant secretary for tax policy at the Treasury Department, said the issue is not black and white.

"Income derived from such securities is not explicitly excluded from qualifying income merely because it reflects exposure to commodity prices," she said.

Levin said commodities markets are fueled by speculators and are not a place for mutual funds. He said the funds' use of units in tax havens like the Cayman Islands was clearly intended to avoid triggering corporate taxation.

"These (units) are corporate fictions, offshore shams, paper exercises whose sole purpose is to make a blatant end-run around the legal restrictions on commodity investments by mutual funds," Levin said.

For its part, the industry defends the practice and notes that the law is silent on commodities. It also argues the structures they employ are, in fact, securities.

Levin's concerns about speculation "are not germane to the proper implementation of tax law," the Investment Company Institute, a mutual fund trade group, said in a statement.

The group also said investors are demanding exposure to commodities.

Republican Senator Tom Coburn said he didn't think speculation was the issue, but he said the funds were clearly going offshore to avoid being taxed.

"The reason for putting that account offshore is to lessen the tax," Coburn said. (Reporting By Kim Dixon; Editing by Kevin Drawbaugh)

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