Yoram Keinan is a partner at Carter Ledyard & Milburn LLP.
The U.S. tax regime for derivatives consists of a "cubbyhole approach" and is determined in accordance with various factors, including: the identity of the derivative, the underlying property, the associated cash flows, the identity of the taxpayer, the purpose of the transaction, and anti-abuse rules. Ideally, the tax treatment of a particular instrument should be determined by considering all those factors. Nevertheless, as a practical matter, it is hard to apply all elements at the same time. Congress has been aware of the shortcomings of the existing U.S. tax rules as applied to derivatives. Recently, House Ways and Means Committee Chair Dave Camp, R-Mich., released two tax reform proposals that would provide a workable set of tax rules for derivatives, generally by marking more derivatives to market and consolidating the character rules into ordinary treatment. This article suggests a slightly revised approach to the Camp proposals. It begins with an introduction on derivatives and the applicable U.S. timing and character rules and a discussion of recent developments.
This article is based on a paper presented by the author in February at The Tax Club in New York titled "Is There a Mark-to-Market in Your Future? -- Rethinking the Recent Ways and Means Committee's Proposal to Mark Derivatives to Market." The author wishes to thank the members of The Tax Club for their invaluable input.
Copyright 2014 Yoram Keinan.
All rights reserved.
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Current U.S. timing and character rules pertaining to derivatives are complex and incoherent. Taxpayers are frequently puzzled by the possible alternative treatments for derivative transactions that have equal economic returns. The current U.S. tax rules pertaining to derivatives consist of a cubbyhole approach and not only are inconsistent with each other but also contain many overlaps, which add to the growing confusion. The particular tax consequences are determined in accordance with various factors, including (i) the type of instrument; (ii) the underlying property; (iii) the associated cash-flows; (iv) the taxpayer's identity; (v) the transaction's purpose; (vi) whether the derivative is entered into as part of a larger transaction; and (vii) anti-abuse rules.1 Some rules apply more than one of the above factors, but incoherently.2
With respect to timing, income and deductions are recognized in a variety of ways, including mark-to-market, accrual, cash, wait-and-see, and special timing regimes. For example, non-section 1256 options and forward contracts are subject to a wait-and-see timing regime. Derivatives held by dealers and electing trades are marked to market under section 475 (as ordinary), while section 1256 contracts are marked to market under section 1256 regardless of who holds them. Special timing rules apply to notional principal contracts (NPCs), pursuant to which periodic payments are taxed using accrual principles, termination payments are taxed when realized, and non-periodic payments are subject to a unique set of rules. Furthermore, Congress and Treasury have added anti-abuse rules to address particular situations, which have become not only complex but also inconsistent with established tax principles (such as the realization principle).
The character rules are just as complex, resulting in an enormous uncertainty. The character rules for options illustrate this complexity. Buyers and writers of options are potentially subject to four different character regimes: ordinary, long-term capital gain, short-term capital gain, and the 60/40 rule. To add to confusion, option buyers and writers may be subject to different character rules for the same transaction. Specifically, while for non-section 1256 contracts, the character of gains and losses is determined in accordance with the character of the underlying property, gains and losses from a section 1256 contract are capital (60 percent long-term and 40 percent short-term), regardless of the character of the underlying property. If the contract is a foreign currency denominated contract, gain or loss that is attributed to the changes in exchange rate is generally ordinary. Sections 475 and 1221(a)(7) further mandate ordinary treatment for derivates held by dealers and electing traders and for derivatives used for hedging, respectively.3 Finally, specific character rules apply to derivatives in accordance with anti-abuse rules.
On January 24, 2013, House Ways and Means Committee Chair Dave Camp, R-Mich., released a tax reform proposal on financial instruments (the "2013 Draft"). The Draft would (1) provide uniform tax treatment of financial derivatives; (2) simplify business hedging tax rules; (3) eliminate phantom tax resulting from debt restructurings; (4) harmonize the tax treatment of bonds traded at a discount or premium on the secondary market; (5) increase the accuracy of determining gains and losses on sales of securities; and (6) prevent the harvesting of tax losses on securities. On February 26, 2014, Camp released a discussion draft proposing a comprehensive tax reform (the "2014 Draft"), which includes (as "Subtitle E") a revised version of its 2013 proposal with respect to the taxation of derivatives. Both drafts (to the extent relevant, referred to as the "Drafts") are discussed in greater detail below. This paper particularly discusses the proposed provisions pertaining to derivatives (and ancillary issues) and suggests a modified version to reform timing and character rules for derivatives.
B. Basic Terminology
Derivative: A derivative is generally a "contract between two parties that specifies conditions -- in particular, dates and the resulting values of the underlying variables -- under which payments, or payoffs, are to be made between the parties."4 The Draft provides that a derivative would include (1) any evidence of an interest in, or any derivative financial instrument with respect to, stock in a corporation, an interest in a partnership or trust, an evidence of indebtedness, real property (subject to exceptions for real estate dealers and single tracts of real property), actively traded commodities or currency; (2) any NPC; and (3) any derivative financial instrument with respect to an interest or instrument described in (1) or (2).5
Options: An agreement pursuant to which the option buyer has the right but not the obligation to buy from, or to sell to, the option writer, a specified number of units of underlying property, for a specified strike price at, or before, the expiration date.6 The buyer pays a premium for the option because the writer must be compensated for its risk.
A call option allows the option buyer to buy a specified quantity of underlying property from the writer at the strike price. A put option allows the option buyer to sell a specified quantity of underlying property to the writer at the strike price.7 European-style options have a single exercise date, while American-style options may be exercised at any time during their term. A modified-American (Bermuda) style option can be exercised on specified dates from the issue date to expiration. Options may be physically or cash settled.8 Some options are standardized and trade on exchanges.
Forward contract: A privately negotiated contract that provides for the sale of the underlying property for a specified forward price on a specified forward date.9
Futures contracts: Economically similar to forwards except that they are (1) standardized, (2) traded at regulated exchanges, (3) used by clearing organizations, (4) marked to market daily, and (5) can be closed before maturity. A regulated futures contract (RFC) is a contract "with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and . . . which is traded on or subject to the rules of a qualified board or exchange."10
Notional principal contracts: "[A] financial instrument that requires one party to make two or more payments to the counterparty at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts [emphasis added]."11 To create a clear separation between section 1256 contracts and NPCs, prop. reg. section 1.1256(b)-1(a) provides that "a section 1256 contract does not include a contract that qualifies as a notional principal contract as defined in proposed section 1.446-3(c)."12 Prop. reg. section 1.446-3(c)(1)(iii) provides a specific list of contracts: (i) interest rate swaps, (ii) currency swaps, (iii) basis swaps, (iv) interest rate caps, (v) interest rate floors, (vi) commodity swaps, (vii) equity swaps, (viii) equity index swaps, (ix) credit default swaps, (x) weather-related swaps, and (xi) similar agreements that satisfy the requirements of prop. reg. section 1.446-3(c)(1)(i).
A particular NPC is a swap, pursuant to which the parties agree to exchange payments calculated by reference to a notional amount. A swap is economically equivalent to a series of cash-settled forward contracts.13 A total return swap provides an investor with an economic return similar to ownership of the underlying stock. The investor pays its counterparty (bank) an amount equal to what it would pay to purchase the underlying property. The bank pays the investor (i) a payment based on the appreciation or depreciation in the underlying stock's value over the term of the swap; and (ii) payments of amounts equal to dividends paid on the underlying stock. Enacted in 2010, section 871(m) treats the substitute dividends on certain types of specified NPCs as actual dividends for withholding purposes.
Caps, floors, and collars: A cap seller makes periodic payments equal to the product of a notional principal amount and any excess of a specified index over the agreed cap rate. The cap buyer pays a single premium or makes a series of fixed periodic payments. A floor seller makes periodic payments equal to the product of a notional principal amount and any amount by which a specified index falls below the floor rate. The floor buyer pays a single premium or makes a series of fixed payments. Caps and floors are economically equivalent to a series of cash-settled option contracts. Collars are combinations of caps and floors, whereby one party buys a cap and sells a floor, or buys a floor and sells a cap. Collars could also be built from call and put options.
C. Current U.S. Tax Rules for Derivatives
1. Timing rules. Income, gains, losses, and deductions from derivatives are recognized in different ways, including mark-to-market, accrual, cash, wait-and-see, and special regimes.
a. Timing rules based on the nature of the contract.
Non-section 1256 options. Writing and buying a non-section 1256 option does not constitute a taxable event to either party.14 As the Tax Court explained "the policy rationale for the tax treatment of an option as an open transaction is that the outcome of the transaction is uncertain at the time the payments are made. That uncertainty prevents the proper characterization of the premium at the time it is paid."15
Section 1234(b) governs the tax treatment of the writer of non-section 1256 options on property (e.g., stock, securities, and commodities). The writer does not recognize income until the option expires, lapses, is exercised, sold, or is disposed of. Stated differently, a non-section 1256 option constitutes an open transaction.16 The exercise is a nontaxable purchase of the underlying asset, and the premium adjusts the amount realized on the sale.17 The premium is recognized by the writer upon a sale, exchange, or expiration of the option itself or upon a closing transaction.18
The option buyer is not allowed a deduction for the premium and recognizes gain or loss upon a sale, lapse, or termination of the option equal to the amount realized (if any) minus the premium.19 If the option is exercised, the buyer recognizes no gain or loss and adds the premium to its basis in the property acquired.20
Section 1234(c)(2)(A) provides that a cash-settled option is treated as an option to buy or sell property.21 The exercise of a cash-settled option, however, in contrast to the exercise of a physically settled option, is a taxable event.22 Nevertheless, no gain or loss is recognized by a corporation with respect to lapse or acquisition of an option or futures contract to buy or sell its own stock.23
Forward contracts. A non-section 1256 forward contract also constitutes an open transaction.24 Thus, until the contract is sold, exchanged, or settles, any gain or loss to the parties is deferred. Upon exercise, the recipient of the property is not taxed until a further disposition of the underlying property, and the recipient's basis in the forward contract becomes its basis in the property. Nevertheless, section 1259 provides that if a taxpayer holds an appreciated financial position and enters into, among other things, a fixed-price forward contract to sell that stock (or substantially identical property), the taxpayer will be treated as having made a constructive sale of the property and will realize gain as if the position was sold.
Variable forward contracts were developed mainly to avoid the constructive sale rules while still providing a certain level of protection against a decline in the stock's value.25 The consideration received is fixed, but the number of shares to be delivered is variable.26 Thus, because of the significant variation under the contract terms, the contract does not result in a constructive sale.27
Mark-to-market. Section 1256 was added to the code in 198128 and harmonized the tax treatment of RFCs with the marketplace under what Congress referred to as the doctrine of constructive receipt.29 Each section 1256 contract held by a taxpayer at the close of the year is deemed sold at its fair market value on that day, and the taxpayer must recognize gain or loss on the deemed sale.30 Congress subsequently expanded the scope of section 1256 to certain foreign currency contracts and options.
Notional principal contracts. Reg. section 1.446-3 groups all payments under NPCs into three categories: (i) periodic; (ii) non-periodic;31 and (iii) termination payments. A party to an NPC must annually include any net income from the contract and is allowed to deduct any net cost.32 All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment and a non-periodic payment for the year to which such portions relate.33 A non-periodic payment must be amortized and recognized over the contract's term in a manner that reflects its economic substance.34 A termination payment is a payment made or received to terminate or assign all or a portion of the remaining rights and obligations of any party under an NPC,35 and is recognized by the original party to the contract as income or deduction upon termination.36
In 2004, Treasury issued proposed regulations pertaining to the timing and character of NPCs with contingent non-periodic payments (the "2004 Proposed Regulations").37 Prior to 2004, taxpayers took the view that for such contracts, they can deduct the periodic payments as they accrued and include in income the amount of the contingent payment only in the year of payment.38 The 2004 Proposed Regulations' method was a variation of the non-contingent swap method described in Notice 2001-44 (analogous to the non-contingent bond method for contingent payment debt instruments),39 which requires (1) projecting initially what the contingent payment will be; (2) accounting annually for the appropriate portions of the projected contingent amounts; (3) re-projecting the contingent amounts annually; and (4) reflecting amounts attributable to the difference between projected and re-projected amounts through adjustments that are spread over a one-year period.40 As an alternative, the 2004 Proposed Regulations provided an elective mark-to-market method.41
Seven years later, the 2011 Proposed Regulations acknowledged that currently, NPCs providing for pay-outs based upon non-financial indices such as temperature, precipitation, snowfall, or frost are not treated as swaps for federal income tax purposes because the underlying indices are not financial indices. The current NPC regulations provide that a specified index includes an index that is based on objective financial information, which is defined as any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract.42
The specified index for weather swaps is temperature at a particular location -- an index that is not within the control of any party. Webster's Dictionary includes a definition of economic as "having practical or industrial significance or uses: affecting material resources." Temperature has a dramatic impact on the business of the energy industry because demand for electricity is directly correlated with air conditioner use in the summer and heating equipment use in the winter. Stated alternatively, the weather has a direct affect on the electricity demand by consumers. Thus, weather should be considered to be within the definition of economic information for the energy industry and financial entities with exposure to the energy industry.
The 2011 Proposed Regulations would end the uncertainty by providing that swaps on non-financial indices should be treated as NPCs. Accordingly, prop. reg. section 1.446-3(c)(2)(ii) would clarify that a specified index includes non-financial indices that are comprised of any objectively determinable information that is (i) not within the control of any of the parties to the contract; (ii) is not unique to one of the parties' circumstances; and (iii) cannot be reasonably expected to front-load or back-load payments accruing under the contract.
While the 2011 Proposed Regulations illustrate this expansion with weather derivatives, one could think of many other types of NPCs that reference non-financial indices that would qualify as NPCs if the 2011 Proposed Regulations are adopted (e.g., disaster derivatives).43
Another version of contingent swaps is a credit default swap (CDS),44 pursuant to which the seller would pay the buyer in the event of a default45 by a third-party obligor on a reference obligation. The buyer pays either a lump sum or periodic payments46 and has the right to receive either (i) cash equal to the difference between the reference obligation's value on the purchase date and its value upon default, or (ii) deliver the reference obligation to the seller for cash equal to its face amount.47 A CDS can cover the credit risk of a single debt, various obligations of a single entity, or a group of obligations issued by different issuers.48 The IRS indicated that the economic aspects of CDSs resemble four contracts: options, guarantees, insurance, and NPCs. In the 2011 Proposed Regulations, the IRS finally "cut bait" and agreed to treat CDSs as NPCs. The 2011 Proposed Regulations, however, contain neither a definition for CDSs nor specific examples of transactions that will be treated as CDSs.
b. Timing rules based on the identity of the taxpayer: mark-to market for dealers and traders in securities. Section 475's stated legislative objective is achieving clear reflection of income within the meaning of section 446.49 Pursuant to section 475(a), all securities, including derivatives, held by a dealer are marked to market unless they are specifically identified as being excluded from mark-to-market treatment in the following situations: (1) any security held for investment;50 (2) any debt instrument acquired or originated by the taxpayer in the ordinary course of its trade or business, which is not held for sale;51 and (3) any hedge with respect to either a security not subject to the mark-to-market rules or to any position, right to income, or liability that is not a security.52
Whether one is a dealer in securities is determined based on all facts and circumstances.53 A dealer regularly purchases securities from, or sells securities to, customers in the ordinary course of a trade or business, or regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.54
The term "security" is very broad and includes (1) a share of stock in a corporation; (2) a partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) a note, bond, debenture, or other evidence of indebtedness; (4) an interest rate, currency, or equity NPC; (5) evidence of an interest in, or a derivative financial instrument in, any security described above, or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency (excluding any contract to which section 1256(a) applies); and (6) a position that (i) is not a security described in (1), (2), (3), (4), or (5), (ii) is a hedge with respect to such a security, and (iii) is clearly identified in the dealer's records as being described in this subparagraph before the close of the day on which it was acquired or entered into (or such other time as the Secretary may by regulations prescribe).55 Certain items are excluded from the definition of a security.56
A trader in securities or a dealer or a trader in commodities may elect to be governed by section 475.57 If such an election is made, the electing taxpayer follows most of the rules of section 475.58
c. Timing rules based on the purpose of the transaction: hedging. In 1994, Treasury issued regulations concerning the treatment of hedges, including timing (reg. section 1.446-4) and character rules (reg. section 1.1221-2). The definition of a hedging transaction (contained in the character rules but equally applies to the timing rules) includes (i) a transaction entered into in the normal course of the taxpayer's trade or business, primarily to manage the risk of interest rate changes, price changes, or currency fluctuations; and (ii) the risk being managed relates to ordinary obligations incurred or to be incurred or borrowings made or to be made by the taxpayer.59
The taxpayer's method of accounting for the hedge must clearly reflect income;60 the method must reasonably match the timing of income, deduction, gain, or loss from the hedge with those on the hedged item. Where the hedged item is marked to market, marking the hedge to market clearly reflects income.61 Reg. section 1.446-4(c) acknowledges, however, that "there may be more than one method of accounting that satisfies the clear reflection requirement."
d. Derivatives issued with a debt instrument. Issuers of debt instruments may offer the holder property rights (e.g., a warrant) in addition to debt. In some cases, the additional property rights are necessary to sell the debt. In other cases, issuers choose to offer additional property rights because it lowers their borrowing costs.
i. Investment units. An investment unit is a debt instrument issued with a separate property right.62 The traditional investment unit consists of a debt and a warrant, sold for a price equal to the debt's principal amount. Unlike convertible debt (discussed below), debt issued with a warrant to purchase the issuer's stock is usually issued with the expectation that the debt will be outstanding until it matures. Thus, either if the warrant is exercised or expires, the debt must generally be paid at maturity or on an earlier redemption date. For this reason, the two elements of the unit exist independently and are treated as separate instruments for tax purposes, if certain conditions are met.
The original issue discount regulations provide that when two separate instruments are involved, each of which can be separately traded, the issue price of the unit is allocated between the debt and the property right based on the relative fair market value of each component at the time of issuance.63 If the unit is issued for the principal amount of the debt, the allocation of a portion of the issue price to the property right creates OID on the debt.64 A holder is generally bound by the issuer's allocation, unless the holder explicitly discloses on its return that its allocation differs from the issuer's.65
Thus, in essence, a warrant issued with a debt instrument is subject to different timing treatment than a warrant issued alone (which is an open transaction, as discussed above); the fair market value of the option is deductible by the issuer during the life of the debt (as OID), and the holder must include it in income during this period.
In the mid 90s, several variations of investment units that comprise a debt instrument and a forward contract have emerged. The most common one was Feline PRIDES, in which a publicly traded corporation issues units consisting of a senior note and a forward contract for the purchase price of a variable number of shares of its stock. The debt matures in five years and the forward contract in three years. The issuer pays interest on the note and a fee (a percentage of the unit price) on the contract on a quarterly basis. Three months before the maturity of the forward contract, the issuer must attempt to remarket the notes at a reset rate of interest that would yield proceeds in an amount sufficient to satisfy the unit holder's obligations under the contract.66
Rev. Rul. 2003-97 concluded that the note and forward contract were separate items of property because (i) the holder had an unrestricted legal right to separate the note and forward; and (ii) the holder was not economically compelled to keep the note and forward contract un-separated.67 In addition, to be treated as two separate instruments, the ruling required that (i) upon the issuer's bankruptcy, the forward contract must terminate and the debt must be released to the holder; (ii) the period that the debt remains outstanding after the forward contract's exercise date is significant both absolutely and relatively;68 and (iii) the taxpayer must show that the remarketing of the debt is substantially certain to succeed.
ii. Convertible and exchangeable debt. A convertible debt instrument permits its holder to convert the debt into a specified number of the issuer's stock (under a predetermined conversion price). The conversion rate is the ratio of the number of common shares issuable upon conversion to a unit of a convertible security.69 The conversion feature can be viewed as a call option given to the holder to acquire the issuer's stock, by accepting the stock in lieu of the principal amount of the debt. The debt will either be converted into stock or redeemed for cash. The holder cannot exercise the option to convert unless it forgoes the right for redemption.
The conversion price is usually higher than the market value of the stock to which the debt is converted at the time of issuance. The percentage increase in the issuer's stock price before conversion is available is called the conversion premium. As the trade-off for the conversion feature, the debt pays a reduced rate of interest.70 The conversion right can be satisfied in different ways: (i) physical settlement, which means that the holder will physically receive the issuer's common stock in accordance with the conversion rate; (ii) net share settlement, which means that upon conversion the holder receives some cash (typically equal to the principal amount of the debt) and shares of the issuer so that the total value received is the same as if the holder received a fixed number of shares; or (iii) cash settlement, which means the holder will receive the total conversion value in cash.
Convertible debt has similar economic features to an investment unit, but for tax purposes is treated very differently because it is a single property right.71 Specifically, the conversion feature is generally ignored until exercised. Stated differently, no value is assigned to the conversion feature upon issuance.72 Because stated interest on convertible debt is typically lower then stated interest on comparable non-convertible instruments, and the deductions for the issuer are limited to the stated rate, convertible debt instruments are tax disadvantaged for issuers. In contrast, holders include income on the lower stated interest rate but get an additional value in the form of the conversion feature; therefore, convertible debt instruments are attractive to taxable holders.
A debt instrument may also be exchangeable for stock of a company other than the issuer.73 Exchangeable debt instruments differ from convertible debt in that at maturity, the holders will receive the referenced common stock (based on an exchange formula) that is not the issuer's stock. In some cases, instead of receiving the reference stock, holders are entitled to receive cash based on the value of the referenced shares.
Exchangeable debt is most often issued by a subsidiary, exchangeable into stock of the parent company. If the debt is exchangeable into stock of a related party, the rules are the same as for convertible debt, until an exchange occurs.74 An exchange of debt for related-party stock is treated as a taxable event.75
In summary, derivatives issued in connection with a debt instrument are subject to different timing rules than derivatives issued alone. In addition, the treatment of the derivatives will differ depending on whether it is a separate property right (in which case the investment unit rules will apply) or convertible/exchangeable debt (in which case the property right is not accounted for separately.
e. Statutory anti-abuse rules that affect timing.
Wash sales.76 Section 11877 (the predecessor of section 1091) was enacted in 1921 in response to cases where taxpayers sold securities at a loss in one day and repurchased the same securities within the next day or so (but in a different tax year).78 Under section 1091(a), any loss sustained from the sale (including contracts or options to acquire or sell stock or securities) is not allowed for the year of sale if the taxpayer has acquired (or entered into a contract or option to acquire) substantially identical79 stock or securities within the 61-day period.80 The loss is added to the basis in the newly acquired stock or security, and the holding period is also carried over. The scope of section 1091 was subsequently expanded several times.81
Straddles. Congress adopted the straddle rules in response to concerns that the wash sales and short sales rules are inadequate to prevent abuse.82 Similar to the wash sale rules, the straddle rules constitute a departure from the realization principle. A straddle is an offsetting position83 in actively traded personal property.84 Section 1092(a) provides that losses on one or more positions in a straddle may not be allowed to the extent of the taxpayer's unrecognized gain85 in the offsetting position, and the disallowed loss is carried forward to the succeeding tax year.86 Under section 263(g), straddle interest expense and carrying charges are required to be capitalized.87 The straddle rules were expanded in 1984 (DEFRA),88 1986,89 and 2004.
Constructive sales. Another departure from the realization principle is section 1259(a)(1), pursuant to which, if there is a constructive sale of an appreciated financial position,90 the taxpayer must recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale. A taxpayer is treated as having made a constructive sale if the taxpayer (or a related person) enters into (i) a short sale of the same or substantially identical property; (ii) an offsetting NPC with respect to the same or substantially identical property; or (iii) a futures or forward contract to deliver the same or substantially identical property.91 The term "substantially identical" is also used in connection with the short sale and wash sale rules,92 and has the same meaning for constructive sale purposes.93
2. Character rules. There are four types of payments under a derivative, the character of which must be determined: (i) payments upon physical settlement according to the contract's terms; (ii) periodic and non-periodic payments pursuant to the contract's terms; (iii) payments upon early termination of the contract by a negotiated settlement between the parties; and (iv) payments upon sale or exchange of the contract to a third party (including an assumption payment).
a. Character based on the character of the underlying property.
Non-section 1256 options. A complex set of rules governs the character of income from options. Section 1234 addresses the general taxation rules for the writer and buyer. Section 1234A applies to certain options that are subject to neither section 1234 nor section 1256. Finally, section 1256 applies to dealer equity options and non-equity options.94 While the first two rules apply a look-through approach, the latter determines the character of gains and losses regardless of the underlying property.
Specifically, pursuant to section 1234(a), which applies to the option buyer, gain or loss from the sale, exchange, or lapse of an option constitutes gain or loss from the sale or exchange of property "which has the same character as the property to which the option relates in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him)."95 Thus, the character of gains and losses on the option is determined in accordance with the character of the underlying property.
The same look-through applies if the holder fails to exercise the option, in which case the option is deemed to be sold on the expiration date and the loss is treated under the general look-through rule.96
Physical settlement of an option is treated as a purchase of the underlying asset. When the buyer exercises a call option (purchasing the underlying property), the premium is added to the property's basis. The holding period of the acquired property begins on the day after the exercise.97 The writer adds the premium to the amount realized on the sale of the underlying property. Any gain or loss is treated as short-term or long-term depending on the seller's holding period of the underlying property.
When the buyer exercises a put option (selling the underlying property), its premium reduces the amount realized upon sale of the underlying property. The writer decreases its basis in the property by the amount of premium received. The holding period during which the writer held the option is not tacked to the underlying property's holding period; it begins on the day after exercise.98
If the underlying property is a capital asset, any gain or loss on the underlying property is treated as short-term or long-term, depending on the holding period in the hands of the original owner. In contrast, whether gain or loss will be short-term or long-term upon the disposition of the option itself is determined by the length of time the option buyer held the option.99
There is a special rule for writers of options on stock, securities, commodities, or commodities futures; if such an option lapses or is part of a closing transaction, the gain or loss is short-term regardless of holding period.100 Reg. section 1.1234-1(b) provides that for all other options, the writer's gain from the failure to exercise is ordinary.
When a cash-settled option is settled, the transaction is treated as a sale or exchange of the option. Thus, if the underlying property is a capital asset, gain or loss on the transaction is considered gain or loss from the sale or exchange of a capital asset.
Section 1234A, which governs the character of gain or loss from certain terminations of financial positions, also adopts a look-through approach.101 Gain attributed to the option's termination is treated as gain from the sale of a capital asset; when the option buyer accepts the difference between the underlying property's fair market value and the exercise price upon termination, the capital gain or loss equals the amount received less the basis in the option.
Forward contracts. Based on the same look-through principle, gain or loss recognized upon the settlement of a forward contract is capital if the underlying property is capital. Prop. reg. section 1.1234A-1(c) would clarify that a payment on a forward contract or a bullet swap102 is a termination payment for purposes of section 1234A (i.e., capital).103
b. Character rules based on the character of the position itself.
Section 1256 contracts. As opposed to the look-through rule for non-section 1256 options and forward contracts, section 1256 focuses on the character of the position itself. Holders of section 1256 contracts recognize capital gains and losses on mark-to-market gains and losses and on actual dispositions.104 Regardless of the holding period, 60 percent of the gain or loss is long-term and 40 percent is short-term.105
Notional principal contracts. Reg. section 1.446-3(d) states that the net periodic payments are net income or a net deduction in that year (i.e., ordinary).106 In LTR 9737007, in determining that periodic payments, including the final periodic payment, are ordinary, the IRS reasoned:
Although a NPC is economically similar to a series of cash settled forward contracts, an NPC is a single, indivisible financial instrument. . . . Periodic payments made pursuant to an NPC are more similar to dividends on stock or interest on securities, which items are treated as ordinary income or expense rather than amounts received on the sale or exchange of the underlying instrument. . . . A periodic payment on an NPC does not give rise to a capital gain or loss because there is no sale or exchange of a capital asset. . . . A periodic payment, however, does not terminate a NPC. . . . Periodic payments under a swap agreement are not gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property within the meaning of Section 1234A. They are simply payments made according to the original terms of the single instrument. The final periodic payment periodic payment on a swap is accounted for in the same manner as all other periodic payments made or received on a swap.
The IRS further observed that "periodic payments under a swap are not gain or loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to personal property within the meaning of section 1234A."107
Prop. reg. section 1.162-30 (2004) would clarify that the net periodic and non-periodic payments on NPCs are deductible by the payor under section 162 as ordinary and necessary business expenses.
As for a termination payment, if a taxpayer has positive value and it sells the position to a third party, the IRS ruled that the gain realized is from the sale or exchange of property (capital) unless the NPC is held as ordinary property.108 The case of an early termination rather than a sale of the position is harder.109 The fundamental question is whether an NPC is a right or obligation with respect to property under section 1234A because unlike an option or forward, an NPC is not always a contract to buy or sell specific property.110 The 2004 Proposed Regulations contain a regulation under section 1234A that (i) would clarify that a termination payment has similar meaning for purposes of section 1234A and the NPC regulations, and (ii) provides that any other payments or deemed payments terminate or cancel a right or obligation.111 When an NPC is payable according to its terms, however, all amounts arising from the contract are ordinary.112
c. Character rules based on the purpose of the transaction: Hedging character rules. Prior to 1994, the tax treatment of hedging transactions was entirely a matter of case law and administrative practice. In Corn Products, gains and losses on hedging transactions were held to be ordinary, which matched the character of the gain or loss on the hedged item. The Supreme Court clarified in Arkansas Best that gain or loss on the sale or exchange of an asset is capital unless the asset falls within one of the enumerated exceptions in section 1221.113 In Fannie Mae (1993), the IRS argued that Arkansas Best required the taxpayer to treat its hedging losses as capital, but the Tax Court disagreed. A year later, Treasury issued the hedging regulations.
The primary purpose of the hedging character rule is to match the character of gains and losses from the hedge with the character of gains and losses from the hedged items. The significance of this rule is that taxpayers can match ordinary gains with ordinary losses, thereby avoiding having a character mismatch. To qualify for hedging treatment, the taxpayer must satisfy both substantive and procedural requirements. First, the hedged item must be ordinary asset (or borrowings),114 and the hedge must be entered into in the taxpayer's normal course of business to manage certain enumerated risks. Second, the hedge and hedged item must be properly and timely identified. If both requirements are met, gains and losses on the hedge are ordinary.115
d. Character rules based on the taxpayer's identity: dealers and traders. Section 475 provides for ordinary treatment for mark-to-market gains or losses with respect to securities (including derivatives) that are being held, other than as investments, by security dealers and electing security traders and electing commodities dealers and traders.116 Gain or loss that is recognized before the close of the year (e.g., because the dealer disposed of the security during the year) is also ordinary.
e. Character rules based on the contract's denominated currency. Section 988 governs the tax treatment of transactions, the payments on which are denominated in, or tied to, the value of, nonfunctional currency.117 Gain or loss on a section 988 transaction is ordinary to the extent it is attributable to changes in exchange rates.118 A section 988 transaction includes a forward or futures contract, option, or a similar instrument if the amount that the taxpayer is entitled to receive or required to pay is denominated in nonfunctional currency or is determined by value of one or more nonfunctional currencies.119 A taxpayer may elect capital gain treatment if the contract is (i) a capital asset in the taxpayer's hands and (ii) not part of a straddle.120
Foreign currency gain or loss is recognized under section 988 only upon a realization event with respect to settlement or termination of the transaction.121 The regulations provide that "exchange gain realized from the sale or other disposition of nonfunctional currency shall be the excess of the amount realized over the adjusted basis of such currency."122 The adjusted basis of the currency is determined based on the spot rate on the day of purchase.123 The amount realized is generally determined based on the spot rate on the day of disposition.124
In the case of section 1256 contracts that are also section 988 contracts, the character of the gain is governed by section 988, while timing is subject to section 1256.125 Thus, the contract is marked to market, but resulting gain or loss is ordinary.126
f. Anti-abuse rules that affect the character of derivatives.
Short sales. A short sale is "a contract for the sale of shares which the seller does not own or the certificates for which are not within his control so as to be available for delivery at the time when, under the rules of the Exchange, delivery must be made."127 A short sale remains open until the short seller closes it by purchasing security similar to that borrowed and returns it to the lender.128 In short-against-the-box, the taxpayer sells a security short while holding substantially identical security.
Prior to 1950, taxpayers used short sales to circumvent the holding period rules.129 Congress enacted sections 1233(b) and (d) to prevent such abuses.130 Section 1233 contains three anti-abuse rules that affect the treatment of gains and losses realized on short sales, which only apply if the gain or loss from the short sale is capital: (1) prevents the aging of short-term capital gain into long-term gain;131 (2) restarts certain holding periods;132 and (3) prevents turning long-term losses into short-term losses.133
Conversion transactions. Section 1258 re-characterizes as ordinary income (by imputing interest) a portion or all of an otherwise capital gain recognized from the disposition or termination of any position in a transaction consisting of two or more positions taken with regard to the same or similar property, where substantially all of the taxpayer's return is attributable to the time-value of the taxpayer's net investment in the transaction.134 The amount of gain re-characterized is the lesser of the entire amount of the gain or the applicable imputed income amount.135
Constructive ownership transactions. Section 1260 limits the amount of long-term capital gain that a taxpayer can recognize with respect to certain financial assets. A taxpayer enters into a constructive ownership transaction with respect to any financial asset if it holds a long position under an NPC with respect to such financial asset.136 A financial asset is (i) an equity interest in a pass-thru entity, and (ii) to the extent provided in regulations, any debt or stock of a corporation which is not a pass-thru entity.137
g. Character issues pertaining to derivatives with negative value. A taxpayer holding a position in a derivative with a negative value may want to be relived from its liability by paying a third party so the latter will assume the liability. It is unclear whether the amount so paid is an ordinary expense or a capital loss. In FSAs 1999-763, 1999-985, and 1998-237, the IRS ruled that an interest rate swap constitutes property because it is a "bundle of rights and obligations."138
In Bank One, the Tax Court noted that a swap becomes a liability when it is underwater.139 A related question is whether a swap is a capital asset because the character rules that apply to assets do not easily apply to liabilities and derivatives do not fall under any of the eight exceptions to capital assets enumerated in section 1221(a), unless they constitute either hedges or inventory. In the above field service advice memoranda, the IRS's main support for the property treatment was that the contract's value fluctuates due to market forces (i.e., interest rates).
Economically, a payment made to be relieved from a burdensome contract reflects the present value of the expected cash flows from the contract if it remains outstanding to maturity.140 To support ordinary treatment, it could be asserted that the payment substitutes a stream of ordinary payments to be paid or received.141 There are only a few authorities on the treatment of the payor in an assignment of an underwater contract.
In Stavisky v. Commissioner,142 the Tax Court held that in the context of when-issued contracts, a payment to be relieved from the contract is ordinary. Until today, however, Stavisky has not been applied outside this context.143 The Tax Court held that a payment made to a third party to be relieved from a guarantee is an ordinary expense. Several cases involving the treatment of the payee (assignee) of an underwater contract reached a similar conclusion.144
Furthermore, to be eligible for capital treatment, the taxpayer must show a sale or exchange.145 Generally, a sale occurs when the taxpayer receives consideration in exchange for property. An assignment of a contract is not a sale or exchange. Even assuming that the contract constitutes property, the assigning party does not receive consideration for the property but rather pays to be relieved from the contract. Further, it is hard to establish a basis and amount realized associated with such an assignment. Another question is whether an assignment of a contract should be treated similarly to a cancellation or termination of a contract under section 1234A. Congress added section 1234A to establish that the gain or loss resulting from the cancellation of a contract is a capital.146 The omission of an assignment from the scope of section 1234A may indicate that assignments should not be subject to section 1234A.147
D. The (2013 and 2014) Proposed Reform
1. Overview. The stated goals of the Drafts are threefold. The Drafts would update antiquated tax rules that have not kept pace with innovation in the financial-products market (e.g., market discount and OID rules), and would also make significant changes to the way the United States taxes financial products (mark-to-market). In addition, the proposed rules are said to broaden the tax base and raise revenues. Some of the proposed provisions are revolutionary, while others are more of technical nature. Specifically, the proposed mark-to-market treatment for derivatives, if adopted, would significantly change the current landscape with respect to taxation of financial instruments.
2. History and stated reason for change. Since the 2008 financial crisis, Congress has focused on taxation rules applicable to financial instruments. This was mostly driven by Congress's belief that the rapid growth and abuse of financial instruments such as derivatives contributed to the crisis. Congress also partially blamed the inconsistent and incoherent tax rules governing derivatives and other financial products as a factor contributing to tax shelters.
On December 6, 2011, a joint hearing of the Senate Finance Committee examined the tax treatment of financial products. Based on testimony received during this hearing and input from practitioners, experts, and commentators, the Committee released the discussion draft of proposals to reform the tax treatment of financial products.
The 2013 Draft follows the October 26, 2011, discussion draft on international tax reform. According to the Committee, the Draft, in conjunction with the discussion draft on international reform, would be part of comprehensive tax reform legislation that is intended to broaden the base, lower rates, and move the United States to a more economically competitive tax system on a revenue-neutral basis.
3. Mark-to-market treatment for derivatives.
a. General. According to the 2013 Draft, "[b]roadly extending mark-to-market accounting treatment to derivatives would provide a more accurate and consistent method of taxing these financial products and make them less susceptible to abuse, without affecting most small investors who normally do not invest in these products." The 2013 Draft would require taxpayers engaged in speculative financial activity (as opposed to hedging) to mark certain derivative positions to market. As set forth above, current mark-to-market treatment for derivatives is very limited. The proposed mark-to-market rules would not apply to any derivative that is part of a hedging transaction (as defined above).
b. Overview of the proposed rules. Gain or loss from derivatives would generally be recognized under a mark-to-market rule, and such gains or losses would be ordinary.148 Thus, derivatives that are currently subject to section 1256 would now be taxed simply as ordinary.149 In addition, the gains and losses would be treated as attributable to a trade or business of the taxpayer. Mark-to-market and ordinary treatment would also apply to the termination or transfer of a taxpayer's rights or obligations with respect to a derivative (broadly defined to include offsetting, taking or making delivery, exercise or being exercised, assignment or being assigned, lapse, expiration, settlement, or otherwise). Section 3401 of the 2014 Draft retained this proposal.
c. Fair market value. A determination of fair market value has always been a big obstacle for broader adoption of a mark-to-market regime in the U.S.150 Adoption of the proposed mark-to-market rule obviously would require fair market value determinations for the taxpayer's derivative positions. If the value is not readily ascertainable, it would be determined under the method used by the taxpayer in reports to shareholders, partners, other proprietors, beneficiaries, or as used for purposes of obtaining credit.151
d. Definition of derivative. A derivative would be broadly defined under proposed section 486 as any interest or instrument described above any contract the value of which is determined by reference to stock, partnership interest, debt, real property (except for individual tracts and inventory), actively traded commodities, currency, swaps, and any rate, price, amount, index, formula or algorithm; exceptions for hedges, securities lending transactions and repos, employee stock options, insurance products, Hoover hedges, physically settled commodities contracts, and ADRs.
e. Embedded derivatives. A revolutionary proposal included in the Drafts involves embedded derivatives. Under the Drafts, a derivative would also include any embedded derivative component of a debt instrument (other than certain foreign currency denominated debt instruments, contingent payment debt instrument, variable rate debt instruments, debt instruments subject to alternative payment schedule rules Convertible debt (and Treasury directed to treat convertible debt as CPDI), integrated debt, investment units, or other debt governed by section 1275(d) regulations).152 An embedded derivative means any term of a debt instrument that affects some or all of the cash flows or the value of other payments on the instrument in a manner similar to a derivative.153
g. Special rules for mixed straddles. The mark-to-market and ordinary treatment rules would apply to all positions in a straddle that includes any derivative, even if these positions themselves are not otherwise marked to market (mixed straddle).154 In other words, a position that itself is not a derivative but becomes part of a straddle (see discussion above) with a derivative position during the year would itself become subject to mark-to-market at the time it becomes part of the mixed straddle (i.e., the taxpayer has entered into a position offsetting the derivative position), except for positions involving certain straight debt and qualified covered calls. The holding period of non-derivative positions will be suspended and (in the case of built-in gain positions) be reset.
4. Simplifying the hedging rules. Under proposed section 1221(c), a hedging transaction would be treated as meeting the requirements of section 1221 (as a tax hedging transaction) if it is identified as a hedging transaction for tax purposes, or if the transaction is treated as a hedging transaction within the meaning of generally accepted accounting principles for purposes of the taxpayer's audited financial statement.
5. Wash sales and related parties. The current wash sale rule only applies if the same taxpayer sells and reacquires the security. The Drafts would reform the wash sale rule so that it would apply to transactions involving closely related parties.155 The Drafts, therefore, expand the application of the wash sale rules to the acquisition of substantially identical stock or securities by the taxpayer or a related party. Furthermore, the basis of the substantially identical stock or securities would not be adjusted to include the disallowed loss in the case of any acquisition by a related party other than the taxpayer's spouse.156
The 2014 Draft added a new proposal, pursuant to which no gain or loss will be recognized by a corporation on derivatives with respect to the corporation's own stock, except for certain forward contracts on the corporation's stock.
6. Observations on the proposed reform.
a. Lack of proposed source rules. While the Drafts propose timing and character rules, they completely lack guidance on source rules. The source rules for derivatives have recently received special attention with the enactment of section 871(m) (equity-linked derivatives), and any broad-based reform for derivatives must include a discussion on source.
b. Definition of derivative. The broad definition captures almost every financial position or interest in an underlying asset. While this broad definition is economically correct and captures the true nature of derivatives, the scope of mark-to-market rule should be limited due to the liquidity and valuation concerns.
c. Embedded derivatives. U.S. tax laws generally do not contain rules requiring financial instruments to be bifurcated into their components. One isolated example of a bifurcation rule is with respect to an NPC with a significant non-periodic payment, in which case the non-periodic payment is separated and treated as an embedded loan for tax purposes. This particular rule, however, generally has been viewed as uncertain and confusing, and its benefit is very limited. The proposed inclusion of embedded derivatives in the scope of instruments subject to mark-to-market is in contrast to the current treatment of convertible debt as a single instrument (as opposed to investment units) for tax purposes. To implement this rule, revisions to the OID rules (currently do not allow separate treatment of the conversion feature, in contrast to an investment unit) will be necessary.
On the other hand, because separation of embedded derivatives and marking them to market has been mandated for GAAP purposes since the issuance of FAS 133 in 1981, this complex rule will, at least, achieve more book-tax conformity. Nevertheless, the accounting principles pertaining to which instrument should need to be separated to their components and how the separation (and marking the embedded derivative to market) works have been subject to many uncertainties. Thus, if the code adopts the same approach, extensive guidance must be issued on these issues.
In my view, the complexity and uncertainty pertaining to the embedded derivative rules will most likely outweigh benefit of achieving more book-tax conformity on this issue, and it is proposed not to include this provision in the final legislation.
d. Haig-Simons, valuation, and liquidity. Mark-to-market taxation is a variation of the Haig-Simons concept of income, because it requires yearly valuations and mandates taxation of unrealized capital gains and losses.157 Over the years, many commentators have praised the Haig-Simons taxation principle as a superior method of taxation.158 While commentators have expressed their view that expanding the mark-to-market principle to financial instruments is desirable because of the method's theoretical correctness,159 many have cautioned that mark-to-market could not work due to problems of valuation and liquidity.160 The Drafts lack basic details as to how these two issues should be addressed, which will have to be extensively provided in the legislation and regulations.
Many derivatives, especially the non-publicly-traded ones (and/or where the underlying asset is not publicly traded) are hard to value. On the other hand, many taxpayers that are subject to financial accounting rules and must value their positions for GAAP purposes have to value their positions anyway. Thus, Congress can take the view that valuation for GAAP purposes can be used for tax purposes. However, achieving book-tax conformity is easier said than done, especially because of the different roles of financial accounting and tax rules.
The second obvious obstacle to mark-to-market is liquidity. Many taxpayers with an appreciated position at the end of the year would be faced with a tax bill without having sufficient funds to pay the tax. When Congress enacted section 1256 in 1981, one of the stated reasons for mandating mark-to-market treatment for futures contracts was that the parties to the contract have access to their gains and must pay their losses on a daily basis.161 Congress felt that liquidity would not be an issue for futures contracts. Nevertheless, the scope of section 1256 was later expanded to other types of contracts in which taxpayers cannot access gains or pay losses on a daily basis, such as foreign currency contracts and certain dealer and equity options.
Congress enacted section 475 in 1993 and mandated mark-to-market for dealers in securities. Presumably, Congress felt that dealers do not have liquidity concerns because they hold many positions and most likely will have losses to offset with the gains. Furthermore, Congress felt that dealers could liquidate some positions if their mark-to-market tax burden requires doing it. Later on, traders in securities and dealers and trades in commodities became eligible to elect mark-to-market under sections 475(e) and (f). These legislative developments signal that Congress has been willing to sacrifice taxpayers' liquidity in the case of financial instruments.
The Drafts do not address the liquidity issue at all. Obviously, in the case of a liquid position, the taxpayer should be able to either terminate the derivative with its counterparty at a gain, or sell it to a third party, and use the proceeds to pay the tax. Nevertheless, many derivatives limit the transfer (or termination) of the contract. In addition, many derivative positions, even if they can be transferred, are illiquid. Furthermore, as opposed to physical holding of appreciated assets, where the taxpayer can borrow against the asset to pay the tax, borrowing against a derivative position is much harder and involves legal, business, and economic issues. As a result, solutions are necessary for taxpayers with significant appreciated positions that exceed their negative positions.
e. Book-tax conformity. Current book and tax rules pertaining to derivatives do not conform.162 Most derivatives are marked to market for financial accounting purposes. Specifically, FAS 133 requires recording of all derivatives on the balance sheet at fair value and sets forth specific accounting standards for (i) hedges of changes in the fair value of assets, liabilities, or firm commitments (fair value hedges), which are recorded at fair value in the balance sheet, with any unrealized gains and losses recorded in net income; (ii) hedges of the variable cash flows of forecasted transactions (cash flow hedges), which are also recorded at fair value in the balance sheet, but unrealized gains and losses are recorded in equity, as part of other comprehensive income; and (iii) hedges of foreign currency exposures of net investments in foreign operations (foreign currency net investment hedges), which are special cases of the above two types of hedges.163
In addition, if the hedge is a fair value hedge, the entity must mark the hedged item to market to the extent changes in the fair value of the hedged item are attributable to the risk designated as being hedged. Furthermore, a derivative will be marked to market under FAS 133 even if it is not a hedge; derivatives used for non-hedging are recorded at fair value, with unrealized gains and losses recorded in net income.
Companies subject to GAAP have been required, and therefore have become more capable of, valuing their derivatives for book purposes. Such valuation methods can be used for tax purposes.
The Tax Court decision in Bank One involved the appropriate valuation method of interest rate swaps (and potentially, other derivatives) for section 475 purposes.164 The IRS issued in 2003 (on the same day and consistent with the court's decision in Bank One) an Advance Notice of Proposed Rulemaking (ANPRM),165 suggesting a safe harbor that would allow the taxpayer to elect to use the same values used on its financial statements, for purposes of section 475. On June 12, 2007, Treasury and IRS issued the safe harbor valuation regulations.166 Under this safe harbor, for dealers in securities and for dealers in commodities that elect mark-to-market under section 475(e), the regulations provide a safe harbor for valuations under section 475. If an eligible taxpayer makes the election, the values of certain reported positions on an eligible financial statement in a manner consistent with the requirements of the safe harbor valuation regulations are treated as those positions' fair market values for purposes of section 475.167
The financial accounting standards that are used by taxpayers must be consistent with the requirements of section 475. The taxpayer must satisfy the following criteria:
- The financial accounting method used in the taxpayer's financial statement must be sufficiently consistent with what section 475 requires for tax purposes (and therefore is an eligible method).168
- The taxpayer's financial statement must have sufficient indicia of reliability to ensure that the taxpayer carefully and consistently follows the financial accounting method being used in the statement (an applicable financial statement).169
- The taxpayer's record keeping and record production must enable the IRS to verify that the values used for tax purposes were the same as the values reported on the financial statement; and, when the values to be reported on the tax return are required to incorporate adjustments to the raw values in the financial statement, the taxpayer's record keeping and record production must enable the IRS to reconcile the two sets of values.170
f. Character. The Drafts' proposed ordinary treatment is a welcome change because taxpayers and practitioners have been struggling with the inconsistent character rules for derivatives under the various provisions of the Code. From a tax policy perspective, adoption of ordinary treatment will achieve consistency, simplicity, and neutrality, because gains and losses from derivatives, regardless of the character of the underlying property, the identity of the parties, and the purpose for which the transaction was entered into, will be ordinary. Nevertheless, the Drafts do not provide any detail on how the proposed mark-to-market rules would replace section 1256, and such transition rules are necessary in order to "transform" the tax regime for derivatives to the ordinary regime. In addition, coordination with the provisions pertaining to options and NPCs would be necessary.
In addition, with respect to contracts with negative value, the Drafts do not clarify that the ordinary treatment applies to both payor and payee (for both positive and negative value payments), and whether equal treatment applies to terminations between the parties to the derivative and assignments to third party.
g. Trade or business. Under the Drafts, mark-to-market gains and losses would be treated, for purposes of determining the amount of non-business deductions which are allowed in computing the taxpayer's net operating loss, as attributable to a trade or business of the taxpayer in accordance with section 172(d)(4). It does not appear that the Drafts intended to mandate that all taxpayers subject to mark-to-market are considered to engage in a trade or business for all tax purposes, and this rule is only limited to the determination that any mark-to-market loss would not be a miscellaneous itemized deduction subject to the 2 percent floor.
E. Revised Proposal for Taxation of Derivatives
While the Draft is certainly a great step toward modernizing the taxation rules for derivatives, it still requires modifications (and details) to become workable. As discussed herein, I propose to apply the mark-to-market principle as follows.
a. Valuation. Consistent with the Drafts, I propose that gains and losses from derivatives be marked to market, regardless of the nature of the underlying property, the identity of the parties, and the purpose for which the transaction was entered into. However, consistent with vast majority of commentary (New York State Bar Association, American Bar Association, and more), I propose that mark-to-market apply only with respect to publicly traded positions and/or positions that reference publicly traded property.
In addition, taxpayers that mark derivatives to market for financial accounting purposes should be required to do so for tax purposes, regardless of whether the positions and/or underlying property are publicly traded. These limitations are necessary considering the valuation concern. Furthermore, certain positions that are not publicly traded but are easily valued could be, at the election of the taxpayer, subjected to mark-to-market. Taxpayers should be able to elect mark-to-market treatment using similar principles and procedures accorded to electing taxpayers under section 475(e) and (f).
Taxpayers would generally be allowed to use the same values that they use for GAAP purposes to mark their derivatives to market for tax purposes. Taxpayers may be allowed alternative valuation methods, as long as their methods clearly reflect income under the principles of section 446. Treasury could issue regulations that set forth alternative valuation methods. In addition, Treasury could set forth in regulations that for positions with a de minimis value (e.g., less than $100,000), the taxpayer's valuation method would be presumed to "clearly reflect income."
I also propose that in several years, Congress, Treasury, and the IRS study the adoptability of these rules to more taxpayers and positions, and that particular focus be on whether non-publicly traded positions that do not reference publicly traded property can be reasonably valued to be subject to mark-to-market. If it appears that more positions can be marked to market, the scope of the regime should be expanded.
b. Liquidity. I suggest limiting the mandatory mark-to-market treatment for publicly traded derivatives and derivatives that reference publicly traded property, both of which are considered liquid, so that the taxpayer may dispose of some positions to pay the tax. In addition, for other positions that are required to be marked to market (primarily those that are marked to market for book purposes but are not liquid), a relief from the hardship of paying taxes on gains that are not physically received could be designed using section 1291 as a guide. Under this provision, a holder of stock in a passive foreign investment company (PFIC) can elect not to pay current tax on its gains but rather defer it until the time of distribution of a dividend or realization of capital gain.171 The other alternative for a holder of stock in a PFIC is marking the value of the stock to market.172 Similarly, taxpayers that are subject to mark-to-market would defer the payment of taxes on the net mark-to-market income from the taxpayer's entire derivatives portfolio and be subject to interest on the deferred tax at the applicable federal rate.
Alternatively, taxpayers could be allowed to spread the gain over a certain period with no interest charge. I suggest that the deferral not be indefinite and that Treasury and IRS set forth limitations on the ability to defer the tax. For example, if a taxpayer liquidates a significant amount of its derivatives in a certain year, it may be required to pay the deferred tax liability associated with such positions.
2. Character. The policy case for capital treatment for payment on derivatives is weak -- whether such payments are made pursuant to the terms of the contract or upon sale, exchange, or termination -- because as opposed to a physical long investment position in a security (such as debt or equity), there is no or little initial investment in the case of derivatives, and the taxpayer only acquires a synthetic position in the underlying property. Furthermore, in many cases, what underlies the derivative is not property but rather an index. Thus, not only it is hard to see how derivative position would be property, it is also hard to determine if such property is capital or ordinary. In addition, as opposed to traditional securities, positions in derivatives become a liability when their value drops below zero. As explained above, derivatives typically have positive value for one party to the transaction and a corresponding negative value to the other party. For the latter party, the case for capital gain/loss is even weaker than for the party with the positive value because a position with a negative value is generally not viewed as property but rather is a liability.
Thus, I propose that income, deductions, gains, and losses from derivatives -- regardless of the character of the underlying property, the identity of the parties, and the purpose for which the transaction was entered into -- be ordinary. As an expansion to the Drafts, however, I propose ordinary treatment for all derivatives, regardless of whether they are marked to market. This approach would not only remove the incentive to obtain long-term capital gains treatment, but it would equalize the treatment of contracts with positive and negative value. Furthermore, treating all income deductions, gains, and losses as ordinary would eliminate the unnecessary difference between payments pursuant to the terms of the contract, early terminations, and sale or exchange of the contract.
For this purpose, a new subsection would be added to section 1221(a), which will provide that derivatives are ordinary assets or liabilities. Another alternative would be to amend section 1221(a)(7) (the hedging character rule) to apply to all derivatives and not just to hedging transactions. If such a rule were adopted, there would be no need to have separate character regimes under sections 1256 and 475. A taxpayer would be able to net all of its gains and losses from derivatives in a given year, and the net income or deduction would be added to (or subtracted from) the taxpayer's other ordinary income for the tax year.
Professor Reed Shuldiner summarized in 1992 the shortcomings of the taxation rules for financial instruments in the United States:
The shortcomings in the present tax treatment of financial instruments have high social costs. Uncertain rules increase compliance costs, provide opportunity for abuse, and discourage the legitimate development and use of financial instruments. Rules that are inconsistent with the underlying economics of a transaction distort behavior, lead to an inefficient allocation of resources, and have the potential of placing United States financial institutions at a competitive disadvantage in the world market.173
Twenty-two years later, this statement is still very much valid. Congress must take action with respect to taxation of derivatives. From a tax policy perspective, my proposed rules would enhance equity, certainty, neutrality, and simplicity.
Equity would be enhanced because the current variety of rules for taxation of derivatives creates inequity among taxpayers who economically have the same positions but whose tax results differ.174
Certainty would be achieved through a comprehensive set of rules that reflects the substance, rather than the form, of an instrument.
Simplicity would be achieved because derivatives would be subject to mark-to-market, and as David Weisbach indicates, it would significantly eliminate "complex, realization-based rules and the uncertainty created by realization-based taxation."175 As described herein, current tax law that pertains to derivatives is highly complex and contains various statutory and regulatory rules, exceptions to such rules, coordination provisions, and anti-abuse principles. Most of these rules could be simplified or even eliminated if mark-to-market would apply to all derivatives.176 Furthermore, when all gains are ordinary, it will reduce all character abuse incentives.177
Neutrality. A neutral tax system is one that does not distort the economic decisions of taxpayers. The current realization rule for most derivatives creates inefficiency by virtue of tax planning.178 In the case of derivatives, neutrality will be achieved under the proposed rules because derivatives will be subject to a single set of rules and as a result, instruments with the same substance will be taxed consistently.179
1 Charles T. Plambeck et al., "General Report," in 80b Cahiers de Droit Fiscal International [ C.D. Fisc. Int'l ] 653 (1995); Reuven S. Avi-Yonah and Linda Z. Swartz, "U.S. International Tax Treatment of Financial Derivatives," Tax Notes, Mar. 31, 1997, p. 1703.
2 Steven M. Rosenthal and Mark H. Price, "Time for Reconciliation of Tax and Accounting for Derivatives," Tax Notes, Aug. 9, 1999, p. 895, at 901-905.
3 Another uncertain distinction applies to writers, if the option is on stock, securities, commodities, or commodities futures, and it lapses or is part of a closing transaction, the gain or loss is treated as short-term regardless of the holding period, but for all other options, gain to the writer arising from the failure to exercise it is ordinary.
4 Mark Rubinstein, Rubinstein on Derivatives section 1 (1999).
5 Proposed section 486(a). The term derivative financial instrument includes any option, forward contract, futures contract, short position, swap, or similar financial instrument. Proposed section 486(b).
6 Elrod v. Commissioner, 87 T.C. 1046, 1067 (1987).
7 Federal Home Loan Mortgage Corporation v. Commissioner, 125 T.C. 248, 258 (2005).
8 Section 1234(c)(2).
9 Glass v. Commissioner, 87 T.C. 1087, 1101 (1986).
10 Section 1256(g)(1).
11 Prop. reg. section 1.446-3(c)(1)(i) (hereinafter the "2011 Proposed Regulations"). The 2011 Proposed Regulations rework the various definitions and state that the general definition in prop. reg. section 1.446-3(c) is intended to be the operative definition for all U.S. federal income tax purposes, except where a different or more limited definition is specifically prescribed. Thus, the regulations under sections 512, 863, 954, and 988 have been proposed to be amended to reference the definition of an NPC in prop. reg. section 1.446-3(c). In addition, the 2011 Proposed Regulations specifically provide that to the extent that the tax accounting rules for swaps are inconsistent with the mark-to-market rules for securities dealers and electing securities and commodities traders, the mark-to-market rules prevail.
12 Section 1601 of the Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term section 1256 contract shall not include -- "any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement." Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. The specific uncertainty addressed by the enactment of section 1256(b)(2)(B) was described in the conference report: "The title contains a provision to address the recharacterization of income as a result of increased exchange-trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges." H.R. Conf. Rep. No. 111-517, at 879 (2010).
13 LTR 9730007 (Apr. 10, 1997).
14 Burnet v. Logan, 283 U.S. 404 (1931).
15 Federal Home Loan Mortgage Corporation, 125 T.C. at 267.
16 Rev. Rul. 1978-182, 1978-1 C.B. 265; Rev. Rul. 1958-234, 1958-1 C.B. 279.
17 Id. See also Rev. Rul. 1988-31, 1988-1 C.B. 302; Rev. Rul. 1970-598, 1970-2 C.B. 168.
18 Id. Gain or loss will equal the amount of the premium minus any payment to the transferee of the grantor's obligations, or, on termination, minus any payment by grantor to terminate.
19 Section 1234(a); Rev. Rul. 1978-182, 1978-1 C.B. 265.
20 Rev. Rul. 1988-31, 1988-1 C.B. 302.
21 The purpose of section 1234(c)(2)(A) is "to clarify that gain or loss on the sale, exchange, lapse, or exercise of the [cash settlement] option is capital gain or loss with respect to grantors or holders." H.R. Rep. No. 98-861, at 904 (1984), 1984-3 (Vol. 2) C.B. 158.
22 If the option is exercised (settles in cash), the transaction is treated as a sale or exchange of the option.
23 Section 1032(a).
24 Lucas v. North Tex. Lumber, 281 U.S. 11 (1930). See also Rosenthal and Liz R. Dyor, "Prepaid Forward Contracts and Equity Collars: Tax Traps and Opportunities," 2 J. Tax'n Fin. Products 35 (2001).
25 Edward D. Kleinbard and Erika W. Nijenhuis, "Everything I Know About New Financial Products I Learned from DECS," in 16 Practicing Law Institute, Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 485, 491-93 (2002).
26 The formula for the number of delivered shares is: (i) a specified maximum number of shares if the price of the stock is at or below the floor price; (ii) a specified fraction of that number of shares if the stock appreciates above the cap price; and (iii) if the stock is between the floor price and the cap price, the shares to be delivered will have a fair market value equal to the consideration. The fraction is the ratio of the floor price to the cap price. The floor price is typically the initial value of the stock.
27 Joint Committee on Taxation, "General Explanation of Tax Legislation Enacted in 1997," JCS-23-97, at 176 (1997). The legislative history mentions "significant variation" and "substantially fixed" but does not provide examples relating to forward contracts.
28 P.L. 97-34, section 503 (1981).
29 S. Rep. No. 97-144, at 156-157 (1981).
30 Section 1256(a)(1).
31 Examples include up-front payments made to enter into an off-market swap, cap, or a floor.
32 Reg. section 1.446-3(d).
33 Reg. section 1.446-3(e)(2)(i) and 1.446-3(f)(2)(i).
34 Reg. section 1.446-3(f). In this regard, non-periodic swap payments generally would be allocated based on values of a series of cash-settled forwards written on a specified index at the notional principal amount.
35 Reg. section 1.446-3(h)(1).
36 Reg. section 1.446-3(h)(2).
37 REG-166012-02, 69 Fed. Reg. 8886 (Feb. 26, 2004).
38 Id. (citing reg. section 1.451-1(a)).
39 Reg. section 1.1275-4 (regulations applicable to contingent payment debt instruments).
40 As indicated in David C. Garlock, "The Proposed Notional Principal Contract Regulations: What's Fixed? What's Still Broken?" Tax Notes, Mar. 22, 2004, p. 1515, at 1525, "[w]ith its annual redeterminations, the Noncontingent Swap Method is a hybrid between the Basic Noncontingent Swap Method and a mark-to-market method."
41 Id. See prop. reg. section 1.446-3(i).
42 The definition of specified index in the current regulations was expanded from the definition contained in the original proposed regulations in response to comments made to the IRS. The IRS then believed that, so long as the specified index was not in the control of any party to the NPC, there was no federal income tax policy that would have been served by a narrow definition: "To accommodate these requests [that the definition of specified index be expanded], the final regulations provide that a specified index may include almost any fixed rate, price or amount based on current, objectively determinable financial or economic information."
43 Another such non-financial index is mortality. The 2011 Proposed Regulations would also offer comfort to participants in the mortality swap market that contracts referencing longevity should be treated as NPCs.
44 Notice 2004-52, 2004-32 IRB 168 (Aug. 9, 2004).
45 Id. A default constitutes an issuer's failure to make payments on any of its obligations, typically upon insolvency or bankruptcy, or a specified price change in the reference entity's debt or a rating downgrade.
46 Id. The periodic payments generally consist of a fixed number of basis points applied to a notional principal amount, which is equal to the reference obligation's value. Normally, the buyer will stop making payments when the default occurs.
47 Id. Physical settlement generally reflects the net economics of cash settlement because the protection buyer is compensated for the reduction in the reference obligation's value by allowing it to sell the reference obligation to the seller at par.
48 Id. A CDS may reference multiple obligations. The seller will pay the buyer in the event one or more of those obligations default, regardless of whether the buyer actually holds any of the defaulting obligations.
49 JCT, "Tax Reform Proposals: Accounting Issues," JCS-39-85, at 6 (Sept. 13, 1985).
50 Section 475(b)(1)(A).
51 Section 475(b)(1)(B).
52 Section 475(b)(1)(C).
53 Reg. section 1.475(c)-1(a); reg. section 1.475(c)-1(a)(2)(ii), examples 2 and 3.
54 Section 475(c)(1).
55 Section 475(c)(2).
56 Those items include (1) a security if section 1032 prevents the taxpayer from recognizing gain or loss (includes stock of the taxpayer and any options on the stock, e.g., a mutual fund would not be treated as a dealer in securities because it sells and redeems its own shares); (2) liabilities of the taxpayer; (3) a real estate mortgage investment conduit residual interest acquired on or after January 4, 1995, and negative value REMIC residuals acquired before January 4, 1995; (4) synthetic debt that is treated as integrated debt under reg. section 1.1275-6; and (5) non-financial customer paper as defined in section 475(c)(4). Reg. section 1.475(c)-2.
57 Sections 475(e) and 475(f). A commodity is (A) actively traded; (B) an NPC with respect to a commodity; (C) an evidence of an interest in a derivative in a commodity such as an option, forward contract, futures contract, short position, or similar instrument in a commodity; and (D) any position which is not a commodity described in (A), (B), or (C), but is a hedge of such commodity. Section 475(e)(2).
58 Rev. Proc. 99-17, 1999-1 C.B. 503, provides guidance for taxpayers wishing to make the election.
59 Reg. section 1.1221-2(b).
60 Reg. section 1.446-4(b).
61 Reg. section 1.446-4(e)(2).
62 Section 1273(c)(2).
63 Reg. section 1.1273-2(h)(1). See also Rev. Rul. 88-31, 1988-1 C.B. 302; Rev. Rul. 78-142, 1978-1 C.B. 111; Rev. Rul. 75-33, 1975-1 C.B. 115; Rev. Rul. 70-108, 1970-1 C.B. 78. Cf. Convergent Technologies Inc. v. Commissioner, 70 T.C.M. 87 (1995); Sun Microsystems Inc. v. Commissioner, 66 T.C.M. 997 (1993); FSA 199907002 (Oct. 30, 1998).
64 Id. If the warrant value is small, as is typical, it seems reasonable to allocate to the warrant an amount equal to its value and the rest to the debt.
65 Reg. section 1.1273-2(h)(2).
66 Most issuers of Feline PRIDES have concluded that the forward contract has no value at inception.
67 See also Rev. Rul. 88-31, 1988-1 C.B. 302, which applied a similar analysis to conclude that stock and a contingent payment right that varied inversely with the value of the stock over a certain price range were two separate financial instruments.
68 As described above, the IRS blessed the transaction where the forward contract's matured in three years while the debt matured two years later.
69 For example, $100 face value of debt convertible into five shares of common stock would have a conversion ratio of 5 to 1.
70 The interest reduction depends on the term on the debt, the conversion premium, and stock volatility.
71 Reg. section 1.1272-1(e); reg. section 1.1273-2(j).
73 TAM 200530027 (July 29, 2005), concluding that the debt constitutes a straddle with the underlying stock.
74 Reg. section 1.1273-2(j).
75 Reg. section 1.1001-3(c)(2)(ii) excepts only conversions into stock of the issuer.
76 H.R. Rep. No. 67-350, at 11 (1921); S. Rep. No. 67-275, at 14 (1921).
77 26 U.S.C. section 118.
78 Shoenberg v. Commissioner, 77 F.2d 446, 449-450 (8th Cir. 1935). As Congress explained, in such cases, the taxpayer has not changed its economic position and the claimed loss is fictitious.
79 Substantially identical property is stock, securities, when-issued securities, and commodity futures transactions, but not written options or the purchase of a call option. Substantial identity covers something less than a precise correspondence. Hanlin v. Commissioner, 108 F.2d 429 (3d Cir. 1939). A focus is generally placed on differences in economic terms that would affect an investor's decision to acquire or hold the property. See, e.g., Rev. Rul. 85-87, 1985-1 C.B. 268; Rev. Rul. 56-406, 1956-2 C.B. 523.
80 The 61-day period begins 30 days before the date of the sale or disposition and ends 30 days after the date of the sale or disposition.
81 Section 1091 was amended in 1988 to provide that the phrase "stock or securities" includes options or contracts to acquire or sell stock or securities. H.R. Rep. No. 100-1104, Vol. II, at 131-132 (1988). The Community Renewal Tax Relief Act of 2000 added section 1091(f) pursuant to which a contract or option that is cash-settled is an option to acquire property for this purpose.
82 P.L. 97-34, sections 501-507 (1981).
83 A taxpayer holds an offsetting position if there is a substantial diminution of a taxpayer's risk of loss from holding any position with respect to personal property by reason of holding one or more positions with respect to personal property -- the contra position. Section 1092(c)(2).
84 Personal property is any personal property of a type which is actively traded. Property is actively traded if there is an established financial market for the personal property (e.g., a national securities exchange, interdealer quotations system, or interbank market).
85 Unrecognized gain is defined in section 1092(a)(3) as "the amount of gain which would be taken into account with respect to such position if such position were sold on the last business day of such taxable year at its fair market value."
86 According to section 1092(d)(2), the term "position" means "an interest (including a futures or forward contract or option) in personal property."
87 This rule applies to interest and other carrying charges that are allocable to a leg in a straddle. The effect of this rule is to defer any interest or carrying charges until the positions are terminated and to reduce the gain or increase the loss.
88 P.L. 98-369, sections 101-108 (1984) (Deficit Reduction Act of 1984).
89 P.L. 99-514, section 1808(c) (stock exclusion does not apply to "any interest in stock").
90 A position is an interest, including a futures or forward contract, short sale, or option. An appreciated financial position is any position with respect to any stock, debt instrument, or partnership interest if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. Section 1259(b).
91 Section 1259(c)(1).
92 See sections 1233 and 1091.
93 The phrase "substantially identical" is applied according to the facts of each case. Reg. section 1.1233-1(d). Substantial identity covers something less than a precise correspondence. Hanlin v. Commissioner, 108 F.2d 429 (3d Cir. 1939), aff'g. 38 BTA 811 (1938), nonacq. 1939-1 C.B. (1) 55.
94 A dealer equity option is (1) an equity option, (2) purchased or granted by an option dealer in the normal course of its dealer activity, and (3) listed on a qualified board or exchange on which such dealer is registered. Section 1256(g)(4). An equity option is an option (i) to buy or sell stock or (ii) the value of which is determined, directly or indirectly, by reference to (a) any stock, (b) group of stocks, or (c) stock index. Section 1256(g)(6). A non-equity option is a listed option that is not an equity option.
95 Section 1234(a) does not apply to options that constitute "inventory" and to writers of options in the course of the writer's trade or business, both of which are ordinary under sections 1221(a)(1) and (2).
96 Reg. section 1.1234-1(b).
97 Rev. Rul. 1988-31, 1988-1 C.B. 302; Rev. Rul. 1970-598, 1970-2 C.B. 168.
98 Rev. Rul. 1978-182, 1978-1 C.B. 265, citing to section 1222 and Rev. Rul. 1958-234, 1958-1 C.B. 279; Rev. Rul. 1988-31, 1988-1 C.B. 302; Rev. Rul. 1970-598, 1970-2 C.B. 168.
99 Under sections 1222 and 1223, if the option is held for one year or less, the resulting gain or loss from a sale or exchange will be short-term. If the option is held for more than one year, the gain or loss upon the sale or exchange of the option will be long-term.
100 Section 1234(b)(1). Section 1234(b)(2)(A) defines a closing transaction as "any termination of the taxpayer's obligation under an option in property other than through the exercise or lapse of the option."
101 In 1997, Congress expanded section 1234A to apply to a right or obligation with respect to any property. Section 1234A, however, applies only to rights and obligations with respect to property if such property (not the position) is capital asset in the hands of the taxpayer.
102 A bullet swap is "a financial instrument [other than a futures contract, forward, option, or debt instrument] that provides for the computation of an amount or amounts due from one party to another by reference to a specified index upon a notional principal amount, and that provides for settlement of all the parties' obligations at or close to maturity of the contract."
103 The IRS explained that as opposed to NPCs, bullet swaps and forward contracts do not have ordinary income or expense arising from periodic or non-periodic payments and, since all payments are at or near the maturity date, section 1234A may treat all gains and losses as capital gain or loss.
104 Section 1256(a)(3).
106 See, e.g., preamble to prop. reg. section 1.446-3; and JCT, "General Explanation of the Tax Reform Act of 1986."
107 LTR 97370007.
108 FSA 1999-985.
109 Edward D. Kleinbard, "Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System," 69 Tex. L. Rev. 1319, at 1340 (1991).
110 Garlock, supra note 40.
111 Id. Discussing REG-166012-02, 69 Fed. Reg. 8886 (Feb. 26, 2004).
113 Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988).
114 Reg. section 1.1221-2(b).
115 Section 1221(a)(7).
116 Section 475(d)(3)(A).
117 In addition, the transaction must fall within one of four categories: (1) acquiring a debt instrument or becoming obligated under a debt instrument; (2) acquiring or otherwise taking into account any item of expense, gross income, or receipts to be paid or received after the date on which it is taken into account; (3) entering into or acquiring any forward contract, futures contract, option, or similar financial instrument; or (4) disposing of nonfunctional currency. Sections 988(c)(1)(B) and (C).
118 Section 988(a)(1)(A). See also reg. section 1.988-3(a).
119 Section 988(c)(1). In general, a taxpayer's functional currency is the currency of the business's economic environment and the currency in which the books and records are kept. Reg. section 1.988-1(c) (referencing the definition in section 985 and reg. section 1.985-1).
120 Section 988(a)(1)(B) and reg. section 1.988-3(b).
121 Reg. section 1.988-2(a)(1)(i).
122 Reg. section 1.988-2(a)(2)(i).
123 Reg. section 1.988-2(a)(2)(iii).
124 Reg. section 1.988-2(a)(2)(ii)(A).
125 Section 988 treatment does not apply to any foreign currency contract that would be marked to market under section 1256. Reg. section 1.988-1(a)(7). However, a taxpayer may elect to have section 988 apply to the section 1256 contracts. Section 988(c)(1)(D)(ii); reg. section 1.988-1(a)(7)(ii).
126 Section 988(a)(1)(A) and (a)(3).
127 Provost v. United States, 269 U.S. 443, 450-451 (1926). See also Commissioner v. Levis' Estate, 127 F.2d. 796, 797 (2d Cir. 1942).
128 Reg. section 1.1233-1(a)(1). Gain or loss from the short sale is determined only when the sale is closed, not when the short sale takes place. Reg. section 1.1233-1(a)(4).
129 Smith v. Commissioner, 78 T.C. 350, 373 (1982).
130 H.R. Rep. No. 81-2319, at 55 (1950); S. Rep. No. 84-1255, at 2 (1955).
131 If on the date of the short sale, substantially identical property has been held by the taxpayer for not more than 1 year, the gain or loss from closing the short sale is short-term. This rule also applies if the taxpayer acquires substantially identical property after the short sale and holds the substantially identical property for more than one year and then closes the short sale with the substantially identical property.
132 The holding period of the substantially identical property on the earlier of the date of the closing of the short sale or the date of a sale, gift, or other disposition of the property. The holding period rule only applies to the amount of substantially identical property sold short.
133 If, for more than one year, a short seller has held substantially identical property to the property that was sold short, any capital loss realized on the short sale is long-term capital loss. This amount is limited to the amount of the substantially identical property held as of the date of the short sale.
134 Section 1258(c).
135 Section 1258(b). A conversion transaction is one of the following: (i) holding property (whether or not actively traded), and entering into a contract to sell such property (or substantially identical property) at a price determined in accordance with such contract, but only if such property was acquired and such contract was entered into on a substantially contemporaneous basis; (ii) an applicable straddle; (iii) any other transaction which is marketed or sold as producing capital gains from a transaction where substantially all of a taxpayer's expected return is attributable to the time value of money; or (iv) any other transaction specified in regulations.
136 Section 1260(d)(1)(A).
137 Section 1260(c).
138 Relying on Commissioner v. Ferrer, 304 F.2d 125, 131 (2d Cir. 1962). The IRS indicated that forward and futures contracts also constitute property and should be treated similarly.
139 120 T.C. 174 (2003).
140 Cf. David A. Weisbach, "Reconsidering the Accrual of Interest Income," 78 Taxes 36 (March 2000); Reed Shuldiner, "A General Approach to the Taxation of Financial Instruments," 71 Tex. L. Rev. 243 (1992).
141 This argument is consistent with arguments made by taxpayers in cases such as Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955); Federal National Mortgage Association v. Commissioner, 100 T.C. 541 (1993); and Commissioner v. Ferrer, 304 F.2d 125, 131 (2d Cir. 1962).
142 34 T.C. 140 (1960), aff'd, 291 F.2d 48 (2d Cir. 1961).
143 Kirk Van Brunt, "Tax Aspects of REMIC Residual Interests," 2 Fla. Tax Rev. 149, n.193 (1994) (citing New York State Bar Association Tax Section, "Report on Proposed Regulations on Methods of Accounting for Notional Principal Contracts," at n.84 (Jan. 6, 1992).
144 Mansfield Journal Co. v. Commissioner, 274 F.2d 284, 286 (6th Cir. 1960); General Artists Corp. v. Commissioner, 205 F.2d 360 (2d Cir. 1953).
145 Section 1001.
146 S. Rep. 97-144, at 170 (1981).
147 In the above three field service advice memoranda, the IRS argued that section 1234A was intended to clarify existing law and not to create a new rule.
148 Under proposed section 485, all mark-to-market gains and losses from derivatives would be ordinary.
149 The Drafts would create new sections 485-486 for taxation of derivatives and repeal sections 1256, 1234B, and 1236.
150 Cottage Savings Association v. Commissioner, 499 U.S. 554, 559 (1991) ("Under an appreciation-based system of taxation, taxpayers and the Commissioner would have to undertake the 'cumbersome, abrasive, and unpredictable administrative task' of valuing assets on an annual basis to determine whether the assets had appreciated or depreciated in value").
151 Fair market value would be determined without regard to any premium or discount related to the relative size of the taxpayer's position to the total available trading units of an instrument.
152 Proposed section 486(d)(1).
153 Proposed section 486(d)(2).
154 Proposed section 485(c)(1).
155 Section 1091(a) will be amended by striking the taxpayer has acquired and inserting the taxpayer (or a related party) has acquired.
156 Any wash sale losses will be permanently disallowed (rather than deferred), other than wash sales involving spouses or wash sales followed by the reacquisition of securities that are substantially identical to the securities that were sold in a wash sale.
157 See, e.g., Weisbach, "A Partial Mark-to-Market Tax System," 53 Tax L. Rev. 95 (1999) ("Haig-Simons taxation generally is viewed as the ideal form of income taxation") citing Robert M. Haig, "The Concept of Income -- Economic and Legal Aspects," in The Federal Income Tax 1 (1921), reprinted in Am. Econ. Ass'n, Readings in the Economics of Taxation 54 (1959); and Henry C. Simons, Personal Income Taxation 50 (1938).
158 Weisbach (1999), supra note 157.
159 Id. at 106 ("The benefits of moving financial instruments to mark-to-market taxation would be enormous").
160 Cf. id. at 105 ("the problems of valuation and liquidity are not sufficient to overcome the benefits").
161 S. Rep. No. 97-144, at 156-157 (1981).
162 For example, with respect to hedging transactions, while tax hedging rules generally match the timing of income and deductions from the hedging transaction with that of the hedged item, FAS 133 requires that all hedging derivatives be marked to market, and in some circumstances (fair value hedges), the timing of the hedge will be matched to the hedged item by marking both of them to market. In addition, except for the timing mismatch, not all GAAP hedges are tax hedges (e.g., capital asset hedges), and not all tax hedges are GAAP hedges (e.g., certain hedges that fail the GAAP effectiveness requirement).
163 A hedging instrument for this purpose must satisfy the following requirements: (i) cash flows or fair value from the instrument must fluctuate and vary based on changes in one or more underlying variables; (ii) the instrument must be based on one or more notional amounts and/or payments; (iii) the instrument must require no, or insignificant, initial net investment; and (iv) the instrument can readily be settled by a net cash payment. FAS 133, para. 6. Regular way securities trades such as purchases or sales of securities that settle in the normal course for the particular security do not constitute "derivatives" under FAS 133.
164 Primarily, Bank One discussed valuation of swaps; however, in footnote 68 of the decision, the Tax Court indicated that its decision may apply more broadly to other derivatives subject to section 475: "We hereinafter limit our analysis to the treatment of interest rate swaps. We believe on the basis of our understanding of the other financial derivatives at issue that the tax treatment of those derivatives follows naturally from our decision as to FNBC's interest rate swaps. If we are mistaken on that point, then either party may bring this to our attention."
165 REG-100420-03, 68 Fed. Reg. 23632 (May 5, 2003).
166 T.D. 9328, 72 Fed. Reg. 32172.
167 Reg. section 1.475(a)-4(b).
168 Reg. section 1.475(a)-4(d).
169 Reg. section 1.475(a)-4(h).
170 See generally the preamble to T.D. 9328 (discussing the broad policies underlying the particular requirements in the safe harbor valuation regulations).
171 The gain must be divided equally on the number of days the shareholder has held the shares (the holding period). Then the tax is calculated, and the applicable interest is charged on the amount of the tax that should have been paid.
172 Section 1296.
173 Shuldiner, supra note 140, at 246.
174 See, e.g., Schenk (1995) at 632. ("Can anyone seriously argue that a taxpayer who has entered into a short against the box has less ability to contribute to the commonweal than one who has simply sold the underlying stock? Similarly, does a taxpayer who has purchased a put on appreciated stock he holds have less ability to pay than one who sells the stock for the strike price? In the abstract, the tax burden is distributed inequitably if the former has a lower tax burden than the latter. The rub is that, once the realization rule has been adopted, the tax burden already is distributed unequally. A taxpayer who has entered into a short against the box has approximately the same ability to pay as a taxpayer who merely holds appreciated stock, and therefore arguably should have the same tax burden.").
175 Weisbach (1999), supra note 157, at 122, 131.
176 See id. at 122 ("Much of the complexity of current law stems from the realization requirement. Pure mark-to-market taxation potentially offers dramatic simplification because all of the realization rules could be re pealed.").
177 Id. at 123.
178 Schenk (1995), supra note 174, at 633-634 ("The efficiency consequences of a realization-narrowing rule are much more ambiguous. The realization rule itself creates inefficiencies; for example, it encourages taxpayers to arrange their affairs to postpone the realization of gains.").
179 Weisbach (1999), supra note 157, at 131-132 ("The other potential benefit of a partial mark-to-market regime is that it might be more efficient than current law. There are three major efficiency benefits. First, a partial mark-to-market regime with neutral rates would reduce the disparity in tax rates on capital income. Second, it would eliminate the lock-in effect for assets subject to the mark-to-market regime. Third, it would reduce behavior designed to avoid or reduce taxes.") This element can also be defined as "consistency." Id.
END OF FOOTNOTES
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