Yoram Keinan Taxation of Financial Instruments

Class 5

Transcript

1. Hedging Rules (§1221(a)(7) & Reg. §1.1221-2) 1
2. Overview • Businesses routinely use hedging transactions to manage risks related to movements in commodities and securities prices, currencies, and interest rates. • Instruments available to manage such risks include options, futures and forward contracts, and notional principal contracts. 2
3. Example • Corporation X is a corn processor that uses grain corn to manufacture products such as corn starch. • On July 1, X enters into a contract to deliver to a customer a fixed quantity of starch at a fixed price in October. • Because of limited storage space, X will not purchase the corn needed to fulfill the starch contract until September. • If the market price of corn increases between July and September, X’s profit on the starch contract will be reduced or eliminated. 3
4. Example (cont’d) • To protect itself against such risk, X enters into a long futures contract on corn (e.g., a contract to buy corn). • In September, X will buy and take physical delivery of the corn needed to fulfill the starch contract, and at the same time terminate the futures contract by either making or receiving a termination payment of cash. • The amount paid or received to terminate the futures contract will offset any increase or decrease in X’s cost of the corn. • Result: X has effectively locked in the future purchase price of the corn needed to fulfill the starch contract, and X’s profit will no longer be affected by changes in the price of corn between July and September. 4
5. History of the Hedging Rules • Prior to 1993, the tax treatment of hedging transactions was entirely a matter of case law and administrative practice: – Character: gains and losses on business hedging transactions were ordinary income or expense, which matched the character of the gain or loss on the hedged item. – Timing: the timing of recognition of hedging gains and losses was determined under general tax principles, without reference to the fact that the transaction was a hedging transaction. • In 1988, the Supreme Court in Arkansas Best Corp. v. Commissioner held that gain or loss on the sale or exchange of an asset is capital unless the asset falls within one of the specifically enumerated exceptions in §1221. • In Fannie Mae v. Commissioner, the IRS argued that Arkansas Best required the taxpayer to treat its hedging losses as capital, but the Tax Court disagreed and held for the taxpayer. • In 1993, the IRS issued temporary regulations governing hedging transactions, followed by final regulations in 1994. 5
6. Qualification for Tax Hedge Treatment • A “hedging transaction” is any transaction that is entered into in the “normal course” of a taxpayer’s trade or business “primarily to manage” any of the following: – Risk of price changes or currency fluctuations with respect to “ordinary property” that is held or to be held by the taxpayer. – Risk of “interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer,” or – Other risks that the IRS identifies in published guidance. 6
7. Taxation of Hedging Transactions • If a transaction qualifies as a hedge for tax purposes, (1) gain or loss on the transaction is treated as ordinary gain or loss, and (2) the timing of recognition of such gain or loss must “reasonably match” the timing of the gain or loss on the hedged item so as to “clearly reflect income.” • The rules of Reg. §1.446-4 control the timing of income, deduction, gain, or loss and take precedence over the provisions of any other regulations that are inconsistent. 7
8. Exceptions • A position to which §475(a) applies. • A transaction that is integrated under Reg. §1.1275-6 (see later). • A §988 transaction if it is integrated under Reg. §1.988-5 or if other regulations under §988(d) (or an advance ruling described in Reg. §1.988-5(e)) govern when gain or loss from the transaction is taken into account; or • Determination of an issuer’s yield on an issue of tax-exempt bonds for purposes of the arbitrage restrictions to which Reg. §1.148- 4(h) applies. 8
9. Hedging of Debt Instruments 9
10. Overview • Most hedges of debt instruments take one of three forms: – Taxpayer anticipates that it will need to incur long- term fixed-rate debt in the future and wants to lock in the effective interest rate on that borrowing (“rate lock” transactions). – Existing debt that the taxpayer wants to convert, in effect, from fixed-rate to floating-rate, or vice versa. – Existing floating-rate debt that the taxpayer wants to cap (in a sense, a fixed-floating hybrid). • Interest rate swaps and caps are the financial product most often used to accomplish such hedges. 10
11. Hedging of Debt Instruments to be Issued in the Future • A taxpayer that plans to issue fixed-rate debt in the future may want to protect itself against: – The risk that interest rates increase, or – Fluctuation in currency exchange rates. • Hedging of future debt typically takes the following forms: – Issuer sells short the debt of another issuer. – Issuer enters into a forward-starting interest rate swap with a cash settlement feature at the time the debt would otherwise go into effect – Issuer enters into a forward rate agreement under which it will receive or pay cash to make the effective cost of its borrowing a specified target rate. • Typically, the issuer will terminate the interest rate lock when it issues the debt. 11
12. Tax Hedging Rules for Future Debt • Under the hedging regulations: “gain or loss on a transaction that hedges an anticipated fixed-rate borrowing for its entire term is accounted for (solely for purposes of section 1.446-4 of the regulations) as if it decreased or increased the issue price of the debt.” Reg. §1.446-4(e)(4). • If the debt issuance is not “consummated,” then the taxpayer takes into account any income or loss from the transaction when realized. Reg. §1.446-4(e)(8)(i). • A transaction is consummated if, within a reasonable interval around the expected time of the anticipated transaction, either the transaction occurs, or a “different but similar transaction for which the hedge serves to reasonably reduce risk” occurs. Reg. §1.446-4(e)(8)(ii). 12
13. Hedging of Existing Debt: Background • A borrower typically has a choice as to the term of the debt, and whether interest on the debt is to be at a fixed or floating rate. • Floating-rate Debt: – Typically cheaper in the short-run and can become even cheaper if interest rates drop, but presents the risk that interest rates will rise rapidly. – The value of the debt is largely unaffected by changes in interest rates; however, there is a direct relationship between increases in market interest rates and the interest payable the debt. • Fixed-rate Debt: – Stable cash outflow, but locks the borrower in for the term of the debt. If interest rates fall, or even rise slowly, the fixed-rate borrower can be locked into higher financing costs, in comparison with other issuers. – There is an inverse relationship between the value of the debt and prevailing market interest rates; when interest rates rise, the value of the debt falls and vice versa. 13
14. Hedging with Interest Rate Swaps • A taxpayer may issue floating-rate debt and swap it into fixed- rate debt and vice versa, using an interest rate swap. • An interest rate swap is a financial contract that specifies a notional principal amount, a term, a payment interval, a reference fixed rate, a floating interest rate index, and various other terms. • On each payment date, the fixed-rate payor will pay product of the fixed rate and the notional principal amount and the floating-rate payor will pay the product of the floating-rate index and the notional principal amount. The payments are netted. • Swaps of fixed-rate debt into floating-rate debt are referred to as “fair value hedges” because they hedge the debt’s value. • Swaps of floating-rate or short-term debt into fixed-rate debt are referred to as “cash flow hedges.” 14
15. Example: Cash Flow Hedge • Debt (Issuer’s Side) – Face amount: $1,000 – Term: 10 years – Interest Rate: 6-month LIBOR +1% (payable semi-annually) • Hedge: “pay fixed, receive floating” swap – Notional amount equal to the principal amount of the debt. – X makes semiannual payments equal to the excess, if any, of LIBOR over 5% and receives payments equal to the excess, if any, of 5% over LIBOR, in either case multiplied by the notional amount. • Result – The LIBOR payments on the debt and the LIBOR component of the payments on the swap offset, leaving the issuer with a net cost of 6% (5% on the swap plus the 1% spread on the swap). 15
16. Example: Fair Value Hedge • Debt (Purchaser’s side) – Face amount: $1,000 – Term: 10 years – Interest Rate: 6% • Hedge: (Floating-to-fixed Swap) – Hedged risk: If market interest rates increase, the value of the bond will decrease. – Swap’s notional principal amount: $1,000. – The holder will receive payments of LIBOR and make payments of 5.1%, both multiplied by the notional amount, with only the net amount being payable or receivable. • Result – The holder is in the same position as if it owned a bond paying interest at a floating rate of LIBOR plus 0.9% (the difference between the fixed rate on the bond and the fixed rate under the swap). 16
17. Taxation of Interest Rate Swaps Used As Hedges • If a borrower enters into an interest-rate swap and leaves it in place for its entire term, the tax results with or without hedging treatment are the same: – Character: the periodic payments on the swap are treated as ordinary income or expense whether or not the swap is a hedge, and there is no gain or loss to recognize if the swap stays in place for its full term. – Timing: the periodic payments on the swap are taken into account on a current basis under the taxpayer’s regular method of accounting, which is also true of the interest on the debt. Hence, with or without hedge accounting, the timing of the income or expense on the swap reasonably matches the timing of the expense on the debt being hedged. 17
18. Integration of a Debt Instrument and a Hedge (Reg. §1.1275-6) 18
19. Overview • The regulations provide for the integration of a “qualifying debt instrument” with a “§1.1275-6 hedge” if the combined cash flows of the components are substantially equivalent to the cash flows on a fixed or variable rate debt instrument. Reg. §1.1275-6(a). • The integration creates a “synthetic debt instrument” which is a hypothetical debt instrument with the same cash flows as the combined cash flows of the qualified debt instrument and the §1.1275-6 hedge. Reg. §1.1275-6(b)(4). • A similar but separate set of rules exists with respect to integration of foreign currency-denominated debt instruments and hedges. Reg. §1.988-5. 19
20. Definition: Qualified Debt Instrument • A qualifying debt instrument (“QDI”) is any debt instrument, including a synthetic debt instrument arising from another integrated transaction, other than: (i) a tax-exempt obligation, as defined in §1275(a)(3), (ii) a debt instrument to which §1272(a)(6) applies, or (iii) a debt instrument that is subject to Reg. §1.483-4 or §1.1275-4(c) (certain CPDIs issued for non-publicly traded property). Reg. §1.1275-6(b)(1). 20
21. Definition: §1.1275-6 Hedge • A “§1.1275-6 hedge” is any “financial instrument” if the combined cash flows of the QDI and the hedging instrument permit the calculation of a yield to maturity under the principles of §1272, or the right to the combined cash flows would qualify as a VRDI that pays interest at a qualified floating rate or rates. Reg. §1.1275-6(b)(2). • A financial instrument is not a §1.1275-6 hedge if the resulting synthetic debt instrument does not have the same term as the remaining term of the QDI. • A financial instrument that hedges currency risk is not a §1.1275-6 hedge, but may be a hedge under Reg. §1.988- 5. • A debt instrument can be a §1.1275-6 hedge only if it is issued substantially contemporaneously with, and has the same maturity as, the QDI. Reg. §1.1275-6(b)(2)(ii)(B). 21
22. Definitions: Financial Instrument • A “financial instrument” is a spot, forward, futures contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments. • Stock is not a financial instrument for this purpose. Reg. §1.1275-6(b)(3). 22
23. Requirements for Integration • Identification on or before the hedge date. Reg. §1.1275-6(e). • None of the parties to the hedge are related or, if they are, the party providing the hedge marks the hedge (and other transactions) to market. • QDI and hedge are entered into by the same individual or entity. • If the taxpayer is a foreign person engaged in a U.S. trade or business and issues or acquires the QDI or enters into the hedge through that trade or business, income and expense associated with the debt or hedge (other than interest subject to Reg. §1.882-5) would be effectively connected with the U.S. trade or business if Reg. §1.1275-6 were not applied. 23
24. Requirements (cont’d) • Neither the QDI, nor other debt that is part of the same issue, nor the hedge were part of an integrated transaction that was terminated by the taxpayer under the legging out rules within 30 days immediately preceding the issue date of the synthetic debt. • The QDI is issued/acquired by the taxpayer on or before the date of the first payment on the hedge, or issued/ acquired after (but substantially contemporaneously with) the date of the first payment on the hedge. • Neither the hedge nor the QDI was part of a straddle prior to the issue date of the synthetic debt instrument. 24
25. Taxation of Integrated Transactions • An integrated transaction is generally treated as a single transaction by the taxpayer, i.e., as if it actually issued or owned the synthetic debt instrument. • The separate components of an integrated transaction are not subject to rules that would otherwise apply to them on a separate basis, but the synthetic debt instrument may itself be subject to those rules. Reg. §1.1275-6(f)(1). • The issue date of the synthetic debt is the first date on which the taxpayer entered into all the components of the synthetic debt instrument. Reg. §1.1275-6(f)(2). 25
26. Separate Transaction Rules • The Commissioner may publish guidance that requires use of separate transaction rules for any aspect of an integrated transaction. • Regulations provide two instances where separate transaction rules are required to be used (Reg. §1.1275-6(f)(12)): – Withholding tax and information reporting rules – Any rules affecting dealings with other taxpayers. 26
27. Taxation of Derivatives 27
28. Forward Contracts • A forward contract is a privately-negotiated contract that provides for the sale and purchase of property at a specified price on a specified date. • Unlike an option, both sides must perform at the termination date. • An on-market forward contract has zero value at inception. • An off-market forward contract typically involves an upfront payment by one party to the other. • Example: buyer and seller enter a contract on January 1 for the sale of 1,000 shares of IBM stock for $100 on September 1. 28
29. Forward Contracts (cont’d) • Until the forward contract is sold, exchanged, settled or allowed to lapse, the transaction is treated as open, and any gain or loss to the parties is deferred. • Upon settlement, gain or loss is capital to the extent the asset underlying the forward contract would be a capital asset in the hands of the taxpayer. §1234A. 29
30. Futures Contracts • Futures contracts, in general, are economically similar to forward contracts except that they are: (i) standardized, (ii) traded on regulated futures exchanges, (iii) used by clearing organizations, (iv) subject to the mark-to-market system of tax accounting (§1256), and (v) are able to be closed out before maturity. 30
31. Options • An option is a contract pursuant to which the buyer (holder) of the option has the right, but not the obligation, to buy from or to sell to, the seller (issuer or writer), a specified number of units of underlying asset, for a fixed price (the strike price) at or before a specified date in the future (the expiration date). • In contrast to a forward contract, an option is not valued at zero at inception, and the buyer pays a premium for the one-sided protection afforded by the option. 31
32. Call Options • A contract that allows the holder to buy from the issuer a specified quantity of stock at the strike price on or before the expiration date. • If the market value of the underlying stock is above the exercise price, then the holder would exercise the option at or before expiration. • If the market value of the underlying stock is below the exercise price, then the holder would not exercise the option and would allow it to lapse. 32
33. Put Options • A contract that allows the holder to sell to the issuer a specified quantity of stock at the strike price on or before the expiration date. • If the market value of the underlying stock is below the exercise price, then the holder would exercise exercise the option at or before expiration. • If the market value of the underlying stock is above the exercise price, then the holder would not exercise the option and would allow it to lapse. 33
34. Tax Treatment of Options • Pursuant to §1234(b), the writer of an option that is not a §1256 option does not recognize the premium received or any gain/loss until the option expires, lapses, or is exercised, sold, or disposed of. It is an open transaction until settlement or lapse. • The premium paid or received is recognized when sale, exchange, expiration, or closing transaction occurs. • Gain or loss recognized is capital if the underlying asset is a capital asset. • Exercise of an option generally is not a taxable event, though any related sale of the underlying asset is taxable to the seller of such asset. 34
35. §1256 Mark-to-Market • §1256(a) provides for the basic tax consequences applicable to the acquisition and holding of a position in a “§1256 contract.” • Regulated futures contracts, certain foreign currency contracts, listed nonequity options, dealer options and dealer stock futures contracts are subject to §1256. 35
36. Regulated Futures Contracts (RFCs) • 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.” §1256(g)(1). • “Regulated futures contracts” are subject to mark-to-market tax accounting and 60/40 long- term/short-term capital gain/loss treatment. 36
37. Foreign Currency Contracts • A negotiated contract, traded in the interbank market, requiring the delivery of a foreign currency, or which can be settled with reference to the value of a foreign currency. §1256(g)(2)(A). 37
38. §1256 Options • “Dealer equity options” and “nonequity options” are subject to §1256. – A “dealer equity option” is (1) an equity option, (2) purchased or granted by an options dealer in the normal course of its activity in dealing with options, and (3) listed on the qualified board or exchange on which such options dealer is registered. §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) any group of stocks based on a narrow-based securities index. §1256(g)(6). – A “nonequity option” is any listed option that is not an equity option. 38
39. Notional Principal Contracts (NPC) • A financial instrument that provides for the payment of amounts by one party to another 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. Reg. §1.446-3(c)(1)(i). – See Prop. Reg. §1.446-3(c)(1)(i) – 2 or more payments – See Prop. Reg. §1.446-3(c)(1)(i) – deemed payment rule (amount fixed on one date and taken into account on a later date) • NPCs include interest rate swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, and similar agreements. • §1256 contracts, debt instruments, options and forward contracts do not constitute NPCs. Reg. §1.446-3(c)(1)(ii). 39
40. Instruments & NPC Status • NPCs – Interest Rate Swap – Interest Rate Cap – Interest Rate Floor – Interest Rate Collar – Equity Swap – Credit Default Swap – Currency Swap – CDS that permits or requires delivery (under proposed regs) • Not NPCs – Futures Contract – Forward Contract – Option – Debt Instrument – Swaption (option to enter into an NPC) – Guarantee (under proposed regs) 40
41. Swaps • A swap is a contract pursuant to which the parties agree to exchange payments calculated by reference to a notional amount. Examples include interest rate swaps, foreign currency swaps and equity swaps. • Swaps are commonly used for speculation and hedging. • Example – Interest Rate Swap: Notional amount is $1,000. Party A pays party B an amount equal to 5% of the notional amount every year, and party B pays A an amount equal to LIBOR times the notional amount. The amounts due from each party to the other are netted and only one payment is made between them. 41
42. Party A Party B Libor + 1% 4% Swap Example Assume a notional amount of $1 million, LIBOR of 2.50%, and quarterly payments (aka resets). In this example, Party A is making periodic payments to Party B of $8,750 each quarter. Party B is making periodic payments to Party A of $10,000 each quarter. 42
43. Taxation of NPCs 43
44. Definitions • The NPC timing regulations group all payments into three categories: (i) periodic payments, (ii) nonperiodic payments, and (iii) termination payments. • Periodic payments are made or received pursuant to an NPC and that are payable at intervals of 1 year or less during the entire term of the contract, that are based on a specified index, and that are based on either a single notional principal amount or one that varies over the term of the contract in the same proportion as the notional principal amount that measures the other party’s payments. Reg. §1.446-3(e)(1). • Nonperiodic payments are payments made or received under an NPC that are not periodic payments or termination payments. Reg. §1.446-3(f)(1). • Termination payments are made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of a party under a NPC. 44
45. General Tax Rules • A party to a notional principal contract must annually include in gross income any “net income” from the contract or is allowed to deduct any net cost. Reg. §1.446-3(d). • All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of periodic payments and nonperiodic payments for the taxable year to which such portions relate. Reg. §1.446-3(e)(2)(i) & Reg. §1.446-3(f)(2)(i). • Nonperiodic payments must be recognized over the term of an NPC in a manner that reflects the economic substance of the contract. Reg. §1.446-3(f)(2)(i). • Termination payments are recognized in the year in which the contract is extinguished, assigned, or exchanged. Reg. §1.446- 3(h)(2). 45
46. Total Return Swaps (“TRS”) • Non-US shareholders suffer the 30% withholding tax on dividends receive from US corporations, unless reduced or eliminated by an applicable tax treaty. • Payments to non-US persons under a TRS that reference a US equity are non-US source and therefore not subject to the 30% US withholding tax. • The long party to a TRS is in the same economic position as an investor in the underlying US equity, except that it generally cannot vote the shares and is subject to the credit risk of its counterparty. • Non-US taxpayers were avoiding the US withholding tax through the use of TRS and after the PSI Report in 2008, the IRS began assessing tax against the banks that executed these swaps with non-US persons. 46
47. TRS (cont’d) • §871(m) was enacted in 2010 • After two sets of proposed regulations, Treasury and the IRS finalized Reg. §1.871-15 in 2015. – IRS delayed effective date of the regulations – Notice 2016-76 – Notice 2017-42 47
48. Anti-Abuse Rules 48
49. Wash Sales Section 1091 49
50. Wash Sales • Disallows losses – not gains – from the sale or other disposition of stock or securities if: – Within the 61-day window period (i.e., 30 days before the sale and 30 days after) – The taxpayer acquires, or enters into a contract to acquire, substantially identical stock or securities (“SISS”) • “Stock or securities” includes contracts or options to acquire or sell stock or securities – Applies even if the contract or option permits only cash settlement • Basis Adjustment – the basis of the new asset is increased by the disallowed loss – New asset also receives a tacked holding period • The wash sale rules also apply to short sales – Example: short sale opened; stock later purchased to close short sale; new short sale opened within 30 days triggers wash sale 50
51. Wash Sales (cont’d) • Special Rules – If more stock acquired than sold, entire loss is deferred • Example: buy 10 shares, sell 10 at a loss, buy 20, entire loss is deferred – If less stock acquired than sold, only a portion of the loss is deferred • Example: buy 10 shares, sell 10 at a loss, buy 5, only ½ of loss is deferred • Ordering Rule – If there are multiple wash sales, the rules apply in the order in which the securities were sold (i.e., beginning with the earliest disposition) 51
52. Wash Sales (cont’d) • “Substantially Identical” – No clear definition (also used in §§1092, 1233 and 1259) – By analogy, Reg. §1.1233-1(d)(1) sets forth a facts and circumstances test • Securities issued by different corporations generally are not substantially identical, even if they are in the same industry and their securities are responsive to the same winds of economic change • May not be true in the context of reorganizations – Hanlin, 108 F.2d 429, 430 (3d Cir. 1939) • “The words ‘substantially identical’ indicate something less than precise correspondence will suffice to make the transaction a wash sale. . . . [T]he ‘something less’ that is required consists of economic correspondence exclusive of differentiations so slight as to be unreflected in the acquisition and proprietary habits of holders of stocks and securities” – Bonds – authorities have compared call and maturity dates, interest rates, issuers, and types of security, but no precise standards have emerged – Options – IRS has said that the sale of an exchange traded call option at a loss followed by the acquisition of a new option on the same property with the same maturity date (but a different strike price) may be a wash sale (GCM 38285 (1980)) • Contrast with “substantially similar or related property” (“SSRP”) standard used in Reg. §1.246-5 52
53. Constructive Sales Section 1259 53
54. Example: Short Against the Box • Investor holds 500 shares of XYZ Co. bought at $10 per share • In December, the stock is trading at $20 per share, and Investor wants to lock in the gain but defer recognition for tax purposes • Investor borrows 500 shares of XYZ stock from her broker and sells the borrowed shares short • If the stock decreases in value, then Investor will earn a profit on the short sale and lose an equal amount on the stock, and vice versa; this is a complete hedge • Investor locked in its gain and no longer has any risk of loss or opportunity for gain in the stock 54
55. Example: Put Option • Investor holds 500 shares of appreciated stock bought at $10 per share and wants to lock in her gain but defer the tax • In December when the stock is trading at $20 per share, Investor buys an option entitling her to sell her 500 shares of the stock at $20 per share to the option seller within 60 days (i.e., the put option is struck at-the-money) • If the price of the stock drops, then Investor will earn a profit on the put option and lose an equivalent amount on the stock, thereby locking in her gain but deferring recognition for tax purposes • If the price of the stock increases, then Investor will earn a profit on the stock and the option will expire worthless; this is a hedge of the downside risk only • Investor has eliminated her risk of loss of the stock but still retains the possibility for future appreciation on the stock. The cost is the premium that was paid to purchase the put option 55
56. Example: Collar • Same facts as the put option example, except that Investor obtains some or all of the cash to purchase the put option by selling a call option on the stock to receive a premium from the holder of the option • The strike price of the call option is slightly higher than the put strike price and the stock value, say $23 per share • This is referred to as a “collar” – the strike price of the put option is lower than the FMV of the stock, and the strike price of the call option is higher than the FMV of the stock • If there is no net cash cost to Investor, then this is referred to as a “costless collar” • The two options in the collar typically are included in a single financial contract 56
57. Constructive Sales • Designed to prevent taxpayers from locking in economic gain without the recognition of taxable income – Example: short against the box • Instead of selling at a gain, taxpayer holds the appreciated shares and sells short newly-borrowed stock • Taxpayer is long and short the same stock, thus locking in its profit without any income inclusion • Taxpayer could maintain the arrangement until death and, because of the step-up in basis that was permitted pre-2010, taxpayer eliminated the gain completely (subject only to the cost of maintaining the short position) • Misuse of rule led to the enactment of §1259 57
58. Constructive Sales (cont’d) • Taxpayer required to recognize gain (but not loss) if it – Holds an “appreciated financial position,” and – Engages in a “constructive sale” transaction • Gain recognized as if the position were sold at its FMV on the date of the constructive sale • Basis in the position is adjusted upward by the amount of gain recognized to prevent a double inclusion when the position is eventually sold • Position acquires a new holding period on the date of the constructive sale 58
59. Constructive Sales (cont’d) • An “appreciated financial position” is – Any interest (including a futures or forward contract, short sale or option) in stock, a partnership interest and certain debt instruments if there would be gain if such position were disposed of at its FMV • Applies to appreciated derivatives (e.g., futures, forwards, options and short sales) • Generally includes non-marketable and privately-held positions • Generally excludes straight debt, hedges of straight debt and positions that are marked to market 59
60. Constructive Sales (cont’d) • Constructive sales include – Short sales of same or substantially identical property (“SOSIP”) • Example: short against the box – Offsetting NPCs (e.g., total return swap) of SOSIP – Futures or forward contracts to deliver SOSIP • Forward contract – contract to deliver a substantially fixed amount of property for a substantially fixed price – Excludes certain variable prepaid forward contracts – In the case of short sales, the acquisition of SOSIP – Transactions with substantially the same effect (to the extent prescribed in regulations) 60
61. Exception for Closed Transactions • Closed transactions are exempt from the constructive sale rules if: • The constructive sale transaction is closed before the end of the 30th day after the close of the taxable year in which it was executed; • The taxpayer holds the appreciated financial position for an additional 60 days after closing the constructive sale transaction; and • At no time during the 60-day period is the taxpayer’s risk of loss with respect to such position reduced by positions held with respect to SSRP (as provided in §246(c)(4)) 61
62. Constructive Sales – Collars • No regulations published, but legislative history states that regulations, when issued, will provide specific standards involving collars and other common transactions • Some practitioners recommend that §1259 should not apply where a collar has: – a 3-year term; – a “spread” of at least 20% of the current trading price of the underlying security (based on legislative history); and – the spread includes the current trading price of the underlying stock • See NYSBA Committee on Financial Instruments, Comments on “Short-Against-the-Box” Proposal (March 1, 1996) • Rev. Rul. 2003-7 (20% variance is a “not a “substantially fixed amount of property” that could trigger a constructive sale) • Anschutz (Tax Court July 2010 – affirmed Tenth Circuit Dec. 2011) (33.3% variance – no contructive sale) 62
63. Variable Prepaid Forward Contracts (VPFCs) • VPFCs have become a popular technique for taxpayers who hold appreciated stock positions and who wish to (i) limit their downside risk with respect to the stock and (ii) monetize the stock position with the receipt of a cash in an amount equal to a significant percentage of the value of the stock, and (iii) defer the recognition of gain until the contract is terminated. 63
64. VPFCs (cont’d) • Developed to avoid the constructive sale rules while still providing protection against a decline in the stock’s value. • The consideration the taxpayer will receive is fixed but the number of shares it is required to deliver is variable. • The formula for the number of shares to deliver is: (i) a specified maximum number of shares must be delivered if the price of the stock is at or below the floor price, (ii) a specified fraction of that number of shares must be delivered 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 a specified amount. • The floor price typically is the initial value of the stock. 64
65. VPFCs (cont’d) • A taxpayer who owns stock and enters into a forward contract with respect to the same stock generally would not be treated as having sold the stock at the time it enters into the forward contract. • §1259 provides that if a taxpayer holds an “appreciated financial position” (which includes stock) and enters into a constructive sale transaction with respect to the same or substantially identical property, then it will be treated as having sold the stock and will have to recognize the gain. • Is there a forward contract within the meaning of §1259(d)(1)? Is there a constructive sale? 65
66. VPFC Example • Taxpayer owns 10 shares worth $1,200 • Floor price = $100 • Cap price = $130 • Upfront consideration = $1,000 • If final price of stock ≤ $100, then taxpayer delivers 10 shares. • If final price of stock ≥ $130, then deliver 8 shares. • If final price of stock between 100 and 125, then deliver stock with FMV = $1,000. 66
67. Rev. Rul. 2003-7 • The ruling considers the following factual situation: a taxpayer holds appreciated stock of a publicly-held corporation and enters into a 3-year VPFC with an investment bank pursuant to which the taxpayer receives an upfront cash payment from the bank and becomes obligated to deliver a variable number of shares of the stock at the termination. The number of shares to be delivered is determined in accordance with a formula. • The ruling concludes that the taxpayer has not sold its stock because: (i) the taxpayer has an unrestricted right to substitute cash or other shares for the stock; (ii) the taxpayer is not economically compelled to deliver the stock on the termination date; and (iii) the taxpayer retained the right to receive dividends and to vote the stock during the 3-year term of the contract. • The ruling indicates that if the taxpayer had been under a legal obligation or restriction to deliver the stock, the result would have been different. 67
68. Straddles Section 1092 68
69. Straddles • Straddle – “offsetting positions” in “actively traded personal property” • Offsetting positions – a substantial diminution of risk of loss from holding one position in personal property by reason of taxpayer holding one or more other positions in personal property (whether or not of the same kind) • Includes positions held by certain related parties • Includes situations where one side is larger than the other (i.e., unbalanced straddles) 69
70. Straddles (cont’d) ▪ Personal property – personal property (including stock) of a type that is actively traded • Actively traded property includes any personal property for which there is an established financial market (Reg. §1.1092(d)-1) • For example, national securities exchange, interdealer quotation system, interbank market or interdealer market • Special rules for debt markets • NPCs – actively traded if contracts based on the same or substantially similar specified indices are purchased, sold or entered into on an established financial market • Includes stock if the stock is actively traded and at least one of the offsetting positions is a position with respect to such stock or substantially similar or related property (“SSRP”) 70
71. Straddles (cont’d) ▪ Position – an interest (including a futures, forward contract or option) in personal property • Debt denominated in a foreign currency is a position in the foreign currency • Recently finalized regulations (with retroactive effective date) includes debt instruments that have payments linked to the value of personal property or a position with respect to personal property 71
72. Straddle Implications • Loss Deferral Rules • Holding Period & Character Rules • Expense Capitalization under §263(g) • Modified Wash Sale Rules 72
73. Loss Deferral Rules • Realized losses are allowed only to the extent they exceed the amount of unrecognized gain at year-end in ANY offsetting position(s) or successor position(s) – Example: Loss of $150 and unrecognized gain in offsetting position at year-end is $100; deductible loss is $50 – $100 is deferred • Disallowed losses are carried forward and treated as sustained in the succeeding tax year – Reapply general loss deferral rule in succeeding tax year • In an unbalanced straddle, taxpayer compares realized losses to unrecognized gain in all offsetting positions – Exception: identified straddle regime 73
74. Holding Period & Character Rules • Holding Period (“HP”) Rule – The HP of any position that is part of a straddle will begin on the date the taxpayer no longer holds an offsetting position • Short-term HP eliminated when position becomes part of a straddle; restarts after straddle is terminated – Exception: if a position had a long-term capital gain HP before the establishment of the straddle, position retains its HP • Character Rule – Loss on the disposition of a straddle position generally will be treated as long-term capital loss if (i) the taxpayer owned an offsetting position on the day it acquired the loss position and (ii) one or more positions in the straddle had a long-term HP on the day the loss position was acquired – Special rules exist for mixed straddles • Exception: these rules do not apply to hedging transactions 74
75. Expense Capitalization – §263(g) • Certain interest and carrying charges that are allocable to a straddle are not currently deductible and must be capitalized – Reduce capitalized amount by certain income items (See Prop. Reg. §1.263(g)-3(e)) • 2001 Proposed regulations clarify the statutory rules – Expanded definition of property (See Prop. Reg. §1.263(g)-2) – Expanded definition of “interest and carrying charges” (See Prop. Reg. §1.263(g)-3) 75
76. Modified Wash Sale Rules • The “(a)(1) Rule” – Disallows loss on the sale of stock or securities if the taxpayer acquires, or enters into a contract or option to acquire, SISS within the applicable 61-day period – loss not recognized until successor position is sold (i.e., add to basis of property) • The “(a)(2) Rule” – If a taxpayer disposes of less than all of the positions in a straddle, losses are disallowed to the extent they do not exceed the unrecognized gain in (i) a successor position, (ii) an offsetting position to the loss position or (iii) an offsetting position to any successor position • A successor position generally is a position that replaces a loss position and was entered into within the applicable 61-day period • There cannot be a successor position if all positions are disposed of before the putative successor position was purchased • Ordering rule – The (a)(1) Rule applies before the (a)(2) Rule – If a loss is disallowed under the (a)(1) Rule, it will be allowed in a later year only if the SISS that caused the disallowance is disposed of and the (a)(1) Rule and (a)(2) Rule do not apply to disallow the loss 76
77. Identified Straddles • Definition – an identified straddle is one that is clearly identified on the taxpayer’s records on the day the straddle is acquired – No positions can have built-in loss – Positions cannot be part of a larger straddle • Consequences – general loss deferral rule does not apply; losses are deferred through basis adjustments to the offsetting positions – Note that losses are capitalized even in the absence of offsetting gain – Allows taxpayers to segregate offsetting positions so that other positions held by the taxpayer are not treated as offsetting any position in the identified straddle • May provide quicker access to losses 77
78. Exceptions to Straddle Rules ▪ Identified hedging transactions (§1092(e)) ▪ Qualified Covered Calls (§1092(c)(4)) 78
79. Qualified Covered Calls • Straddle rules do not apply to qualified covered calls (“QCCs”) – Definition: writing a QCC and owning the optioned stock are not treated as a straddle as long as they are not part of a larger straddle • See Rev. Rul. 2002-66 (purchased put option disqualifies written call option from QCC status because stock and QCC are part of a larger straddle) – Reason is that QCCs are undertaken primarily to enhance investment return rather than to reduce risk of loss • General Requirements: – Exchange-traded, though certain flex options and OTC options are permitted – Granted more than 30 days before expiration – Not deep-in-the-money – Granted for a term of 33 months or less – Not granted by a dealer in connection with its options dealing activity – Does not produce ordinary income or loss 79
80. Mixed Straddles • A mixed straddle is a straddle: – All of the positions of which are held as capital assets; – At least one (but not all) of the positions of which is a §1256 contract; – For which an election under §1256(d) has not been made; and – Which is not part of a larger straddle 80
81. Reporting Requirements • Disclosure of each position (whether or not part of a straddle) and the amount of unrecognized gain is required when there is unrecognized gain as of the close of the taxable year (§1092(a)(3)(C) & Form 6781) • Exceptions: – Position which is part of an identified straddle, – Position which is property within §1221(a)(1) or (2), or a hedging transaction under §1256(e), and – Where no loss was incurred during the year on any position (other than positions described immediately above) 81