U.S. Income Series
Income, Deductions, Credits and Computation of Tax
	 Portfolio 184-4th: Transactions in Stock, Securities and ...
Transactions in Stock, Securities and Other Financial Instruments
by Harrison B. McCawley, Esq. 
Silverstein and Mullens
Washington, D.C.

Special Consultant to Tax Management
PORTFOLIO DESCRIPTION
Tax Management Portfolio, Transactions in Stock, Securities and Other Financial Instruments,  No. 184-4th, analyzes the tax consequences of transactions involving a variety of financial instruments and products. After discussing the significance of a taxpayer's status as investor, trader or dealer, the portfolio describes the operations of the stock, futures, and commodities exchanges.
The portfolio analyzes the tax straddle rules of §§263(g), 1092, and 1256 in depth, including the §1092(b) regulations, applying the principles of the wash sale and short sale rules to straddle positions. These highly complex rules are intended to prevent certain abuses of straddle transactions with respect to actively traded personal property while allowing taxpayers to use such transactions for legitimate profit-seeking purposes without adverse tax consequences. The portfolio also analyzes the regulations under which hedging transactions are afforded ordinary income and loss treatment.
The portfolio describes a number of financial instruments and products. This portfolio may be used in conjunction with the in-depth discussion of both traditional and modern equity derivatives in 188 T.M., Taxation of Equity Derivatives. This portfolio also may be used in conjunction with the discussion of the wash sale rules, conversion transaction provisions, constructive sale provisions, and constructive ownership rules in 186 T.M., Financial Instruments: Special Rules. International aspects of such instruments are discussed. The portfolio may be used, in conjunction with the in-depth discussion in 921 T.M., Tax Aspects of Foreign Currency, for an analysis of §988 and the regulations implementing §988(d). The portfolio also discusses §1044, which deals with the rollover of securities gain upon investment in Specialized Small Business Investment Companies. Various backup withholding requirements are described as well.
The Worksheets include a flowchart analyzing the relationship between the rules of §§988 and 1256.
This portfolio may be cited as McCawley, 184-4th T.M., Transactions in Stock, Securities and Other Financial Instruments. 
Harrison B. McCawley, A.B., Princeton University (1948); LL.B., Harvard Law School (1951); Attorney, Tax Division, Department of Justice (1955-60); Staff Attorney, Joint Committee on Taxation (1960-72); Refund Counsel, Joint Committee on Taxation (1972-1980).

DETAILED ANALYSIS
I. Introduction
A. Scope of Portfolio
This portfolio provides a detailed analysis of the tax consequences of transactions involving financial instruments and products with special emphasis on the provisions of §§263(g), 1091, 1092, 1044, 1234, and 1256, and the regulations issued thereunder: wash sales and so-called "tax straddle rules."
The portfolio focuses primarily on the §1092 straddle rules, enacted by the Economic Recovery Tax Act of 1981 (ERTA)1 and amended by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),2 the Tax Reform Act of 1984 (1984 TRA),3 and subsequent legislation. The discussion includes extensive analysis of the regulations issued under the authority of §1092(b). These regulations, mandated by Congress, provide rules for applying wash sale and short sale principles to straddle positions. They are sometimes referred to as the "modified" wash sale and short sale rules.
1P.L. 97-34.
2P.L. 97-248. TEFRA made relatively minor changes.
3P.L. 98-369. The 1984 TRA contained several substantial amendments.
The portfolio contains the following major subdivisions: 
Section II discusses the significance of the taxpayer's status as an investor, a trader, or a dealer.
Section III presents an outline of the operations and mechanics of the exchanges (stock, options, commodity futures) through which most of the types of transactions to be discussed are carried out, together with the basic tax rules applicable to such transactions (other than the straddle rules).
Section IV previously discussed the Code and regulatory provisions relating to short sales and wash sales.3.1
Section V sets forth the so-called "tax straddle" rules of §§263(g), 1092 and 1256 together with other related Code and regulatory provisions.
Section VI presents the §1092(b) regulations, which apply wash sale and short sale principles to straddle positions. The discussion includes the elections available to avoid the so-called "killer" rule of Regs. §1.1092(b)-2T(b)(2).
Section VII considers the application of the other Code provisions to various financial instruments and products developed since the basic ERTA rules were enacted, including a discussion of the international aspects of notional principal contracts and conduit transactions using "fast-pay" stock.4
Section VIII discusses the rollover under §1044 of the gain on the sale of publicly traded securities upon the investment in small business investment companies.
Section IX deals with backup withholding requirements.
3.1For a complete discussion of short sales, see 188 T.M., Taxation of Equity Derivatives. For a complete discussion of the wash sale rules, see 186 T.M., Financial Instruments: Special Rules.
4For a complete discussion of notional principal contracts, see 188 T.M., Taxation of Equity Derivatives.
B. Overview
The rules discussed in this portfolio have two principal purposes. First, they permit the taxpayer to determine the timing and the character of gain or loss resulting from most transactions involving one or more of the financial instruments or products commonly utilized for investment, speculation, or hedging transactions. Secondly, they are designed to prevent tax abuse by the use of transactions whose principal purpose is to convert short-term gain (and, sometimes, ordinary income) to long-term gain or to convert long-term loss to short-term (or, sometimes, ordinary) loss. The other purpose is, of course, of limited significance in any year in which there is no rate differential between ordinary income and capital gains.5
5See generally Schinabeck, "Capital-Ordinary Distinction: Does It Still Matter?" 7 Tax Mgmt. Wkly. Rept. 422 (1988).
The portfolio does not cover the provisions contained in subchapter C of the Code relating to exchanges of stock and securities pursuant to corporate reorganizations, recapitalizations, liquidations, redemptions, etc. For coverage of these issues, see 770 T.M., Structuring Corporate Acquisitions -- Tax Aspects, 771 T.M., Corporate Acquisitions -- (A), (B), and (C) Reorganizations; 772 T.M., Corporate Acquisitions -- (D) Reorganizations; and 774 T.M., Single Entity Reorganizations: Recapitalizations and F Reorganizations. For coverage of the tax consequences of the receipt or disposition of stock, stock rights or securities transferred in connection with the performance of services, see 758 T.M., Transfers to Controlled Corporations: In General. Further, while they are sometimes relevant in determining the tax consequences of the kinds of transactions discussed herein, the Code and regulations relating to the measurement and timing of interest and the time value of money in general are not dealt with in any detail in this portfolio. For a detailed analysis of these rules, see 535 T.M., Time Value of Money: OID and Imputed Interest. Traditional equity derivatives, (including options, futures, forwards, and short sales) and modern equity derivatives (including equity swaps, equity-linked debt, prepaid variable forward contracts, and Feline PRIDEs) are the subject of 188 T.M., Taxation of Equity Derivatives. For detailed coverage of the wash sale rules, conversion transactions under §1258, constructive sales under §1259, and constructive ownership transactions under §1260, see 186 T.M., Financial Instruments: Special Rules.
II. Status of Taxpayer as Dealer, Trader, or Investor
A. General
The tax consequences of the transactions discussed in this portfolio may differ significantly depending on whether they are carried out by (1) a dealer, (2) a trader, or (3) an investor. Further, the taxpayer's status determines the character of various items of income, loss or expense and, in some instances, his liability for employment taxes (i.e., FICA and FUTA).
1.	Dealer
a.	Securities Dealer
The term "dealer" has various connotations. For purposes of this discussion, there are three types of dealer: a securities dealer, a commodity futures dealer, and an options dealer.
Note: The meaning of the term "security" or "securities" may vary from Code section to Code section. As used with reference to dealers, unless otherwise specified, it means a share of stock, a corporate debt instrument, or a contract or option to acquire the same.6
6See §1236(c) defining "security" for purposes of the rules relating to transactions entered into by securities dealers.
The regulations7 define a dealer as "a merchant of securities, whether an individual, partnership or corporation, with an established place of business, regularly engaged in the purchase of securities and their resale to customers." The regulations add, "Taxpayers who buy and sell or hold securities for investment and speculation, irrespective of whether such buying or selling constitutes the carrying on of a trade or business . . . are not dealers in securities within the meaning of this section."
7Regs. §1.471-5, providing rules for the valuation of securities for inventory purposes.
The regulations thus clearly recognize that a person may be engaged in the trade or business of buying and selling securities without attaining dealer status. Note that the above definition requires that the securities be held for sale to customers; securities held for sale on an exchange are not so held.8 Note also that a securities dealer is, almost without exception, a broker-dealer who must be registered as such with the SEC and must usually also obtain a license from state securities regulators. While in theory, a dealer, acting as a merchant, seeks to earn a profit from the resale of securities obtained at prices not available to the general public at a mark-up, movements in the market prices of inventory securities have a major impact on profit and loss. Thus, dealers often engage in extensive hedging transactions to minimize the risks of carrying inventory securities.
8Securities sold by a dealer who is a stock specialist, registered as such with an exchange, to other brokers and dealers on the exchange floor are treated as sold to "customers." See Stokes v. Rothensies,61 F. Supp. 444, 449 (E.D. Pa. 1945), aff'd per curiam, 154 F.2d 1022 (3d Cir.1946); Comr. v. Stevens, 78 F.2d 713 (2d Cir. 1935); Rev. Rul. 71-30, 1971-1 C.B. 226.
The securities held by a dealer for sale to customers are inventoried as is any other property held by a merchant, and the regulations9 permit use of the various valuation methods available for other types of property, namely cost, lower of cost or market, or market value. Profit or loss from the sale of inventory securities is ordinary income or loss, as is gain or loss from the disposition of financial instruments (generally stock options or, where the securities are debt instruments, various types of financial futures and options) acquired to hedge inventory.10 The expenses incurred by a dealer in the course of carrying on his trade or business that are "ordinary and necessary" (within the meaning of §162) are fully deductible.10.1
9Regs. §1.471-5.
10§1256(f)(3)(B). See Corn Products Ref. Co. v. Comr., 350 U.S. 46 (1955). This result is not changed by Arkansas Best Corp. v. Comr., 485 U.S. 212 (1988), discussed below.
10.1Thus, in TAM 9345003, the National Office advised that a securities dealer who is a distributor for a mutual fund may treat commissions paid to a broker to sell stock in the mutual fund as ordinary and necessary business expenses.
A dealer may buy and sell securities either as a broker for the account of his customers for a commission or for the dealer's own account to be held for investment. A security dealer's gain from the sale of a security will not be treated as capital gain unless the security was identified in the dealer's records no later than the day it was acquired (or such earlier time as may be required by regulations) as held for investment and was never held at any time after such date for sale to customers11 (as distinguished from sale on an exchange which is not treated as made to a "customer"). Proper identification requires that the investment security be separately accounted from other securities. This separate accounting may be accomplished by book entries that (1) distinguish the investment security from inventory securities, (2) designate it as an investment security, and (3) refer to each security by its serial number or other characteristic symbol.11.1 Once a security has so been identified, then, irrespective of any change in the dealer's purpose for holding it, loss from its sale may never be treated as ordinary loss.12
11§1236(a).
11.1Regs. §1.1236-1(d).
12§1236(b). A limited exception concerning losses by certain financial institutions is contained in §582(c).
Note: The act of identifying a security as held for investment by no means prevents the IRS from determining that it was in fact held for sale to customers either at the time of acquisition or on some later date. Thus, identification under §1236 does not guarantee that gain will be treated as capital gain, but does bar absolutely ordinary loss treatment of any loss sustained.13
13The investment status of shares identified under §1236 is not lost when placed by the dealer in his margin account as collateral. Rev. Rul. 73-403, 1973-2 C.B. 308.
Special rules apply to floor specialists (who must be members of and registered as specialists with a national securities exchange).14 They are given seven days after acquisition in which to identify the purpose for which securities are held, provided such securities were acquired in the course of acting as a specialist in the security.15 Thus, such securities may be held for up to seven days for sale to customers before the dealer elects to identify them as held for investment.
14Specialists are generally dealers in the stock in which they specialize (Rev. Rul. 60-231, 1960-1 C.B. 402; Helvering v. Fried, 299 U.S. 175 (1936)), but there is no absolute bar to the identification of some shares of the stock in which the dealer specializes to an investment account. See Rev. Rul. 71-123, 1971-1 C.B. 227.
15§1236(d).
In the following discussion, note that rules relating to the characterization of gain or loss as capital or ordinary and as long or short-term do not apply, as a general rule, to transactions carried out by dealers in the course of their trade or business of buying and selling securities at a markup to customers, except where specifically noted. Note also that neither the wash sale nor short sale rules, described in 186 T.M., Financial Instruments: Special Rules and 188 T.M., Taxation of Equity Derivatives, respectively, apply to transactions in securities by dealers in the course of their trade or business as dealers.
b.	Commodities and Options Dealers
Prior to the enactment of the straddle provisions by ERTA as amended by the 1984 TRA, the term "dealer" referred to an individual or entity that purchased and resold stock and securities. The terms "commodity dealer" and "options dealer" had no specific connotation, because commodities and options are not usually acquired and held for resale; but are, rather, contracts entered into, usually through the intermediation of the clearing organization of an exchange for speculation, arbitrage, or hedging purposes.
Futures contracts and options on such contracts are bought and sold on the floor of a contract market by floor traders who are members of the market and registered with the Commdities Futures Trading Commission (CFTC). A futures commission merchant (FCM) is a person (individual, partnership, association, corporation, or trust) who is allowed, if registered with the Commodities Futures Trading Commission, to solicit orders from customers and receive money or property to be held as margin. An FCM may also be a floor trader or may employ floor traders to execute the orders received. An FCM or floor trader may buy and sell contracts for his own account. A commodities dealer (for purposes of the Code) is a person, registered with a domestic board of trade designated as a contract market by the CFTC,16 who is actively engaged in trading "Section 1256 contracts" (a term discussed below in detail at V, C, meaning, in the context of this discussion, regulated futures contracts and options on such contracts) subject to the rules of such board.17
16§1402(i)(2)(B).
17§1402(i).
An options dealer is any person registered with an appropriate national securities exchange as a market maker or specialist in listed options18 (or who the IRS determines performs similar functions in any other markets which the IRS has determined to have rules adequate to carry out the purposes of §1256).19
18As explained in III, B, below, a "listed" option means, generally, an option traded on a domestic exchange.
19§1256(g)(8).
The commission income of commodities and options dealers is ordinary income. As explained more fully below, futures contracts and options traded by commodity and options dealers are generally called "Section 1256 contracts" for income tax purposes. Gains and losses of commodity and options dealers from trading in §1256 contracts are generally capital gains and losses,20 and net capital gains are treated as self employment income for FICA purposes.21 An options dealer's gains and losses from transactions carried out in the course of the trade or business of an options dealer (market maker or specialist, depending on the exchange) are subject to a complex set of rules discussed below in VI. However, an options dealer who is also a dealer in securities is subject, generally, to the same treatment as a securities dealer with respect to transactions carried out as a securities dealer.
20See Swartz v. Comr., 89-1 USTC ¶9354 (8th Cir. 1989), in which the court rejected the contention that futures contracts acquired and disposed of by the taxpayer through brokers were held for sale to customers in the course of his business, and affirmed the Tax Court's dictum that this would be true even if the taxpayer were a commodity dealer. In addition, the court rejected the taxpayer's argument that losses sustained were ordinary based on the Corn Products doctrine, in light of Arkansas Best, Inc. v. Comr., 108 S. Ct. 971 (1988), discussed principally at V, F, 3, below. Note, however, that in response to Arkansas Best, the IRS issued temporary regulations that provide, generally, that gain or loss from most common business hedges is treated as ordinary income or loss. See discussion of the tax treatment of §1256 contracts and hedging transactions at V, below.
21§1402(i). The Joint Committee on Taxation's General Explanation of the 1984 TRA (the 1984 Bluebook), 313, notes that no inference is intended as to whether options and commodity dealers are to be viewed as engaged in a trade or business in connection with their transactions in §1256 contracts as the result of the application of self-employment taxes to such persons.
2.	Trader
A trader is engaged primarily in speculative activity from which he derives most of his income, seeking to profit from short-term swings in the market.22 Thus, he will generally be relatively uninterested in the interest or dividend yield of the securities purchased and sold except insofar as they may affect short-term price movements. Likewise, the securities held by the trader are usually characterized by high price volatility rather than long-term growth potential.
22See Liang v. Comr., 23 T.C. 1040 (1955), acq., 1955-1 C.B. 4.
Although a number of decisions involve the issue of whether transactions in securities constitute a trade or business, the leading case in this area involved the question of whether a professional gambler's wagering activity could be considered a trade or business for tax purposes.23 The Supreme Court concluded, in holding that the taxpayer was engaged in the business of gambling, that "to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose in engaging in the activity must be for income or profit." The Court rejected the contention that a taxpayer must hold himself out as providing goods or services to customers in order to be considered engaged in a trade or business of tax purposes. By rejecting the goods or services theory, the Court's decision confirmed the existence of trader status in the securities area for tax purposes.24
23Groetzinger v. Comr., 107 S. Ct. 980 (1987). The issue before the court was whether the taxpayer's gambling loss deductions were tax preference items for purposes of §56 or were expenses attributable to a trade or business carried on by the taxpayer. In its opinion, the Court reviewed a number of decisions bearing on the question, including most of those involving transactions in securities. Among the leading cases cited in the opinion were Higgins v. Comr., 312 U.S. 212 (1941), and Levin v. U.S., 597 F.2d 760 (Ct. Cl. 1979).
24The opinion cautions that its interpretation of the phrase "trade or business" is confined to the specific sections of the Code at issue, §§162 and 62. However, any dispute with the IRS involving whether a taxpayer's securities transactions constituted a trade or business will almost necessarily involve these same sections. See Mayer v. U.S., 94-2 USTC ¶50,509 (Fed. Cl. 1994) (holding that under Groetzinger, a taxpayer, who delegated his investment decisions to money managers, and never personally engaged in a single trading transaction, was not entitled to a trade or business deduction). See also Mayer v. Comr., T.C. Memo 1994-209 (holding taxpayer whose average holding period of securities was greater than one year, and whose investments delivered long-term capital growth, was investor, and not engaged in active trade or business); FSA 199947006 (an average holding period of one year or more will generally indicate investor status).
While trader status does not transform gains and losses from sales and exchanges of securities into ordinary income and loss, the trader's expenses relating to his trade or business are fully deductible "above the line" items. Thus, unlike an investor, a trader's expenses, including subscriptions to financial periodicals, telecommunication and clerical expenses, and depreciation on data processing equipment and related software, etc., are deducted in determining adjusted gross income rather than as itemized expenses. A trader is also entitled to deduct home office expenses.25 Moreover, interest paid on loans the proceeds of which are used to purchase or carry the trader's positions is not subject to the investment interest limitation26 (but may be subject to other restrictions).
25See §280A(c)(1); Moller v. U.S., 83-2 USTC ¶9698 (Fed. Cir. 1983). The home office must be used exclusively on a regular basis as the trader's principal place of business. "Principal place of business" was clarified, by the Taxpayer Relief Act of 1997, to include a business place for which no other fixed location for administrative or management functions exist (applicable to tax years beginning after Dec. 31, 1998). Home office expenses are subject to limitations in §280A(c)(5). See 547 T.M., Home Office, Vacation Home, and Home Rental Deductions.
26See King v. Comr., 89 T.C. 445 (1987). In AOD 1988-009, the IRS announced that it acquiesces in this decision with the caveat that it "does not preclude a future finding that transactions in physical commodities by a commodity futures trader are not part of his trade or business." See also Paoli v. Comr., T.C. Memo 1988-23.
Note: Traders in securities or commodities can elect to get ordinary income treatment for gains and losses from the sales and exchanges of such securities or commodities under §475(f).
The Tax Court, in two 1997 memorandum decisions, reviewed the distinguishing characteristics of dealers, traders, and investors and the tax consequences that attach to the status of each. In one case, Marrin v. Comr.,27 the court held that since the taxpayer held no securities for sale to customers, he was functioning as a trader and, thus, the securities losses were capital. In Hart v. Comr., 27.1 the taxpayer conceded that he had no customers and was not entitled to ordinary loss treatment on securities transactions. However, he sought trader status in order to deduct expenses in determining adjusted gross income and avoid the investment interest limitation of §163(d). The Tax Court set forth three factors to consider in determining whether a taxpayer who manages his own investments is a trader or merely an investor:
(1) the taxpayer's investment intent;
(2) the nature of the income to be derived from the activity; and
(3) the frequency extent and regularity of the taxpayer's securities transactions.
 With respect to the third factor, the court indicated that, in order to be a trader, the taxpayer's trading activity must be substantial, that is, "frequent, regular, and continuous enough to constitute a trade or business," as opposed to sporadic trading. The court concluded that the taxpayer, who had 36, 30, and 15 sales of stock during the years in question, was an investor and not a trader. Hence, his expenses were deductible under §212, and his interest expense was investment interest expense.27.2
27T.C. Memo 1997-24, aff'd, 98-2 USTC ¶50,490 (2d Cir. 1998).
27.1T.C. Memo 1997-11.
27.2These cases are reviewed with interesting commentary in Raby & Raby, "Ordinary Deductions, But Capital Losses for Securities Traders," 74 Tax Notes 611 (2/3/97) [hereinafter Raby & Raby]. The article discusses Mayer v. U.S. and Mayer v. Comr., above, as well as Furer v. Comr., T.C. Memo 1993-65, aff'd per curiam, 33 F.3d 58 (9th Cir.1994) (taxpayer held trader, not dealer). See also  Ball v. Comr., T.C. Memo 2000-245 (taxpayer's office expenses, interest, and depreciation were not deductible trade or business expenses; taxpayer was not a trader where he did not invest on behalf of others and he had only seven or eight sales transactions per year); Paoli v. Comr., T.C. Memo 1991-351 (trading was not substantial where taxpayer had 326 sales transactions, but sales were not regular and continuous); FSA 199947006 (normally, 300 trades per year would not be sufficiently "frequent" to give rise to trader status; trades must be made over the course of the entire taxable year, rather than in clusters, to be "regular and continuous").
The Seventh Circuit has also explored the distinction between dealers and traders. In Bielfeldt v. Comr.,27.3 a taxpayer bought large quantities of Treasury securities from primary dealers, held them off the market, and then resold them when prices rose. In holding that the taxpayer was a trader rather than a dealer and, thus, that his losses were capital losses, the court noted that: (1) the taxpayer's income was based on fluctuations in market value of securities rather than on any service provided by him; and (2) the standard distinction between a trader and a dealer is that a dealer's income is based on the service he provides in the chain of distribution of the assets that he buys and resells, while the trader's income is based on changes in the market value of the assets.
27.3231 F.3d 1035 (7th Cir. 2000), cert. denied, 122 S. Ct. 38  (2001).
Observation: It should also be mentioned that a "dealer in securities" as that term is defined by §475(c)(1) is not required to mark-to-market securities identified as held for investment, which includes "a security that it holds primarily for sale to non-customers (e.g., a trading security)."27.4
27.4See T.D. 8700, 61 Fed. Reg. 67715 (12/24/96). The cases discussed in Raby & Raby, above, may help clarify what securities may be characterized as "trading securities," although the cases do not involve §475. The mark-to-market provisions of §475 are discussed in 543 T.M., The Mark-to-Market Rules of Section 475.
3.	Investor
Most taxpayers fall into the "investor" category. An investor is a person who purchases and sells (including short sales) securities with the principal purpose of realizing investment income in the form of interest, dividends and gains from appreciation in value over a relatively long period of time (one or more years). For purposes of this discussion, it suffices to state that with respect to any person's transactions in stock, securities or any other investment or financial products such person will usually be classified by the IRS as an investor (where dealer status is not clearly evident) unless the person can establish that the person's activities amounted to the carrying on of a trade or business.
An investor's investment activity will usually not be his sole or even principal source of income. Although the investor may have an office devoted primarily to the activity, may incur substantial expenses for advice, information, record keeping, etc., and may derive most of his income from it, it is basically the character of the financial instruments in which he deals and the amount of selling activity that he engages in with respect to those instruments that determines his status.
In Yeager Est. v. Comr.,28 a taxpayer's principal activity consisted of acquiring at depressed prices the stock of companies in financial trouble which his analysis indicated would sooner or later be overcome, permitting the realization of long-term gain. Despite the time devoted to and amounts invested in the transactions in question, the taxpayer was held not to be a trader but an investor. An investor's investment expenses are generally deductible as itemized deductions subject, however, to the floor on miscellaneous deductions.29 One exception to the §67 floor limitation is deductible payments made with respect to property used in a short sale.30 Investment interest, while also not subject to the floor limitation, is deductible only to the extent of net investment income.31 Commissions paid to brokers are capitalized and applied to reduce capital gain or increase capital loss upon the disposition of an investment position.31.1
28T.C. Memo 1988-264, aff'd, 89-2 USTC ¶9633 (2d Cir.1989). The Tax Court's opinion cites and reviews most of the significant decisions involving the investor vs. trader issue. See also Mayer v. U.S., 32 Fed. Cl. 149 (1994) (taxpayer, who delegated decisions about his investments in securities to money managers, was an investor, not a trader, because the managers invested the securities for capital appreciation, without regard for daily market swings; moreover, the managers held most of the securities for over 30 days); Mayer v. Comr., T.C. Memo 1994-209 (taxpayer was investor, and not engaged in trade or business, when holding period for securities averaged one year and investments delivered long-term capital growth).
29See §67.
30§67(b)(9). The reference is to "in lieu of" dividend and interest payments made with respect to borrowed property used in a short sale which are treated, essentially, as interest. Short sales are discussed in 188 T.M., Taxation of Equity Derivatives.
31§163(d).
31.1See Spreckler v. Helvering, 315 U.S. 626 (1942); see also Rev. Rul. 70-627, 1970-2 C.B. 59.
Comment: The same person could be considered an investor with respect to a portion of that person's activities, and a trader with respect to another portion but, for tax purposes, the person's status is apparently determined on the basis of the overall activity. Whether the holder of a portfolio made up predominantly of stocks and bonds held for several months or years would not be able to claim trader status with respect to expenses incurred in and allocable to casual speculative ventures into the futures or options market is unclear. On the other hand, as discussed above, a dealer may be treated as an investor with respect to securities identified at the time of acquisition as held for investment only and not for sale to customers.
III. General Description of Exchange Mechanics; Basic Tax Rules
This section of the portfolio describes the mechanics of trading in stock, securities, options and regulated futures contracts. While the portfolio discusses transactions in financial instruments of all kinds, a significant, if not predominant, portion of such transactions are conducted through a "qualified board or exchange," a technical term defined by §1256(g)(7). This part of the portfolio is devoted primarily to the mechanics of exchange mediated trading and the rules governing the timing and character of gains and losses from such transactions. 
A. Transactions in Stock
1.	General
Stock is usually purchased and sold either by the taxpayer's broker on a regulated national securities exchange, or is purchased from or sold to or by a broker in an over-the-counter (OTC) transaction through the NASDAQ system regulated by the National Association of Securities Dealers (NASD). Large institutional or corporate investors, however, may negotiate sales of listed stock off the exchange in unbrokered transactions. Stock is also purchased or sold by broker/dealers for their own accounts to be held as inventory or for investment. Unlisted stock (usually of a closely held corporation) may be sold privately by the owner(s) to the purchaser(s) without the intermediation of a broker.
With respect to stock traded in the OTC market or on an exchange, a share is generally treated as purchased or sold on the date that the taxpayer enters into a binding contract to buy or sell the stock. This is referred to as the "trade date," as distinguished from the "settlement date" on which delivery of the stock certificate(s) is actually effected and payment made (on the fifth business day after the trade date in a "regular way" transaction). For tax years beginning after 1986, the recognition of gain or loss from the sale of stock on an exchange takes place on the trade date for both cash and accrual method taxpayers.32 The trade date also is the beginning (or end) of the taxpayer's holding period. Where stock is sold in a private transaction, the general rules of commercial law governing sales of property apply; the facts, circumstances, and the contract terms determine the tax consequences.
32See §453(k); Rev. Rul. 93-84, 1993-2 C.B. 225 (cash basis taxpayer must report gain or loss realized from year-end sale of stock or securities, traded on established market, in year in which trade date falls).
When a dividend is declared, it is made payable to stockholders of record as of a specified date. On the day after that date, the stock is said to go "ex-dividend." Assuming no other factors affecting its value are present, its price will usually reflect a decrease approximating the present value of the next dividend. The purchaser of stock who settles on or before the record date is entitled to the dividend; if it is paid to the seller, he must remit it to the buyer. Thus, the price will usually decline four days before the record date.
As with other sales of property, gain or loss from the sale of stock is measured by the difference between the seller's basis and the amount of money plus the fair market value of property (if any) received.33 The seller's basis will usually consist of the amount paid for the stock (adjusted to take into account any distributions of capital, stock dividends, etc.) plus capitalized costs of acquisition (primarily brokers' commissions). Since gain or loss from the sale of stock is capital gain or loss (unless it is a sale of inventory by a dealer), it is necessary to determine whether such gain or loss is short or long-term. This, in turn, requires a determination of the holding period.
33§1001. In Nestle Holdings, Inc. v. Comr., 94 T.C. 803 (1990), the Tax Court held that redeemable preferred stock received on a sale of property is "property (other than money)" for §1001(b) purposes and is therefore includible in the amount realized at its fair market value.
Note:  The holding period may be relevant for certain other determinations (deduction of short sale expenses, amount of dividends received deduction, etc.)
The holding period rules relevant to this discussion may be summarized as follows:34 
(1) Where the basis of property received in an exchange is determined with reference to the basis of the property transferred, the holding period of the property received includes the holding period of the property transferred.35
(2) If property, however acquired, has a basis determined by reference to its basis in the hands of the person from whom acquired, its holding period includes the period for which it was held by such other person.36
(3) Where stock or securities are acquired from a corporation by the exercise of a right (referring, generally, to warrants or options issued by the corporation, its parent or a subsidiary), the holding period of the stock or securities includes only the period beginning on the date the right was exercised.37
34See generally §1223.
35§1223(1).
36§1223(2).
37§1223(6).
Note: Rule (3) does not apply to stock acquired from a third party through the exercise of a stock option, conventional or exchange traded. In the case of a convertible debt instrument or preferred stock, where stock is issued to the holder upon surrender of the instrument without payment, Rule (1) applies and the holding period of the convertible instrument is tacked on to that of the stock received.38
38Rev. Rul. 62-153, 1962-2 C.B. 186. However, if the shareholder must also make some payment to the corporation, the holding period is split. A portion of the stock has a tacked holding period and a portion does not. Rev. Rul. 62-140, 1962-2 C.B. 181.
The seller of stock must be able to determine the basis and holding period of the shares sold. Accurate records should be maintained showing the dates on which securities were acquired and adjustments made to the bases of such securities where appropriate by reason of nontaxable distributions of stock dividends or rights and distributions treated as returns of capital. Identification can usually be made on the basis of the certificate(s) delivered to the buyer by the taxpayer's broker in accordance with the buyer's instructions. Where circumstances make it impossible to accurately identify the shares sold, the general rule is that the first acquired shares are treated as the first sold (FIFO).38.1
38.1See Regs. §1.1012-1(c)(1) through  (5). See also Hall v. Comr., 92 T.C. 1027(1989) (FIFO will be applied to both certificated and noncertificated shares). See also Concord Instruments Corp., T.C. Memo 1994-248 (oral identification to sell shares with highest cost basis is proper identification for purposes of avoiding the FIFO method of accounting for gain on stock sale; case law predating the regulations is not obsolete); Padgett v. Comr., T.C. Memo 1987-130 (requirements of Regs. §1.1012-1(c)(3)(i) satisfied and, therefore, no reason to consider FIFO rule).
An adequate identification is made if it is shown that certificates representing shares of stock from a lot which was purchased or acquired on a certain date or for a certain price were delivered to the taxpayer's transferee.38.2 Where the stock is left in the custody of a broker or other agent, an adequate identification is made if (1) at the time of the sale or transfer, the taxpayer specifies to such broker or other agent having custody of the stock the particular stock to be sold or transferred, and (2) within a reasonable time thereafter, confirmation of such specification is set forth in a written document from such broker or other agent.39
38.2Regs. §1.1012-1(c)(2).
39Regs. §1.1012-1(c)(3)(i). See also Rev. Rul. 61-97, 1961-1 C.B. 394 (adequate identification made where owner specifies in writing the sequence in which shares should be sold, identifies the shares to be sold either by purchase date, cost, or both, and receives a written confirmation of the specification from the agent), clarified by Announcement 61-77, 1961-36 I.R.B. 34 (Rev. Rul. 61-97 is not a tightening up of the requirements of Regs. §1.1012-1(c)(3)(i), but merely a recognition that the procedures used therein are adequate identification); Rev. Rul. 67-436, 1967-2 C.B. 266 (identification procedure satisfies Regs. §1.1012-1(c)(3)(i) requirements where sales cannot be identified on date of sale but are identified before settlement); and PLR 9728021 (standing order by investment company clients to sell shares with highest cost that have been held the longest meet requirements of Regs. §1.1012-1(c)(3)).
Under special rules applicable to dealers in securities, electing traders in securities, and electing dealers and traders in commodities, those taxpayers generally must treat their inventory of securities as sold for fair market value on the last business day of the year and take into account the gain or loss for that year as ordinary income or loss. These special rules are discussed in 543 T.M., The Mark-to-Market Rules of Section 475.
2.	Nonrecognition Provisions
a.	Section 1044 Election
Under §1044, a taxpayer may elect nonrecognition of gain on the sale of publicly traded securities when the proceeds are reinvested within 60 days in a specialized small business investment company (SSBIC).39.1 If the taxpayer makes a §1044 election, gain is recognized only to the extent the amount realized on the sale exceeds the cost of any interest purchased in an SSBIC (reduced by any portion of the cost previously taken into account under §1044), i.e., capital gain is recognized only to the extent the proceeds of the sale are not rolled over into the cost of purchasing common stock or a partnership interest in an SSBIC.39.2 Any gain that a taxpayer does not recognize because of §1044(a) reduces the taxpayer's basis in the SSBIC stock that the taxpayer purchases within the 60-day period.39.3
39.1§1044(a).
39.2Id. Section 1044 does not apply to any gain which is treated as ordinary income. §1044(a) (flush language).
39.3§1044(d). This basis reduction rule does not apply, however, for purposes of §1202. Id. For a discussion of §1202, see III, A, 2, b, below.
The election must be made on or before the due date (including extensions) for the income tax return for the year in which the publicly traded securities are sold.39.4 The election is made by reporting the entire gain from the sale of these securities on Schedule D of the income tax return and attaching a statement showing: (1) how the nonrecognized gain was calculated; (2) the SSBIC in which common stock or a partnership interest was purchased; (3) the date such stock or interest was purchased; and (4) the basis of such stock or interest. The election is revocable with the consent of the Commissioner.39.5
39.4Regs. §1.1044(a)-1.
39.5Regs. §1.1044(a)-1.
The amount of gain that may be excluded in any taxable year is limited by §1044(b). If the taxpayer is an individual, the excluded amount cannot exceed the lesser of: (1) $50,000 ($25,000 for married individuals filing separately), or (2) $500,000 ($250,000 for married individuals filing separately) minus the amount excluded under §1044(a) in all preceding years.39.6 If the taxpayer is a C corporation, the excluded amount cannot exceed the lesser of: (1) $250,000; or (2) $1,000,000 minus the amount excluded under §1044(a) in all preceding years.39.7 For purposes of the limitation on corporations, all corporations that are members of the same controlled group of corporations, within the meaning of §52(a), are treated as one taxpayer, and any gain excluded by the predecessor of a C corporation is treated as having been excluded by the successor corporation.39.8
39.6§1044(b)(1),  (3).
39.7§1044(b)(2).
39.8§1044(b)(4).
"Publicly traded securities" are defined as securities that are traded on an established securities market.39.9 An SSBIC is any partnership or corporation licensed by the Small Business Administration under §301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993).39.10
39.9§1044(c)(1).
39.10§1044(c)(3).
Estates, trusts, partnerships, and S corporations are not eligible to make a §1044 election.39.11
39.11§1044(c)(4).
b.	Small Business Stock
Under §1202, 50% of the gain from the sale or exchange of certain small business stock is excluded from gross income. This gain is excluded if three requirements are met: (1) the taxpayer is not a corporation; (2) the stock is "qualified small business stock;" and (3) the stock is held for more than five years.39.12 The exclusion for gain from the sale of small business stock increases to 60% for stock in a §1397C(b) qualified business entity that is purchased after December 21, 2000 and held for more than five years. §1202(a)(2)(A), as enacted by the Community Renewal Tax Relief Act of 2000.
39.12§1202(a).
For purposes of §1202, stock is "qualified small business stock" if: (1) it is stock in a C corporation; (2) it is originally issued after August 10, 1993; (3) the corporation is a "qualified small business" as of the date of issuance; (4) the corporation meets the "active business" requirements;40 and (5) the stock is acquired by the taxpayer at original issue (with certain exceptions) for money, property (not including stock), or as compensation for services (except as an underwriter).41
40§1202(e).
41§1202(c).
A corporation is a "qualified small business" if: (1) it is a domestic C corporation; (2) its aggregate gross assets at all times after August 9, 1993, and before the issuance do not exceed $50,000,000; (3) its aggregate gross assets immediately after issuance do not exceed $50,000,000; and (4) the corporation agrees to submit reports as required by the Secretary of Treasury.42 The statute defines "aggregate gross assets" as the amount of cash and the aggregate adjusted bases of other property held by the corporation, except that the adjusted basis of any property contributed to the corporation is the property's fair market value at the time of the contribution.43 In calculating a corporation's aggregate gross assets, all corporations that are members of the same parent-subsidiary controlled group (within the meaning of §1563(a)(1), except that 50% of combined voting power is substituted for 80%) are treated as one corporation.44
42§1202(d)(1).
43§1202(d)(2).
44§1202(d)(3).
The "active business" requirement is satisfied if the corporation qualifies as a specialized small business investment company (SSBIC), i.e., if it is an "eligible corporation" and is licensed to operate under §301(d) of the Small Business Investment Act of 1958.45 It is also met if the corporation uses at least 80% of the value of assets in the active conduct of at least one "qualified trade or business" and the corporation is an "eligible corporation."46 A corporation, however, generally does not meet the active business requirement for any period during which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations (unless they are more than 50% owned subsidiaries), or for any period during which more than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business.47 Renting real property is not treated as the active conduct of a qualified trade or business.48
45§1202(c)(2).
46§1202(e)(1).
47§1202(e)(5).
48§1202(e)(7).
A "qualified trade or business" is defined as any trade or business except: (1) a trade or business involving the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; (2) any banking, insurance, financing, or investing business; (3) any farming business; (4) any business involving the production or extraction of oil, gas, and other natural deposits; and (5) any business of operating a hotel, motel, or restaurant.49 A corporation is an "eligible corporation" if it is a domestic corporation and is not: (1) a DISC or former DISC; (2) a corporation with respect to which a §936 election is not in effect for either the corporation or its subsidiary; (3) a RIC, REIT, REMIC, or FASIT; or (4) a cooperative.50
49§1202(e)(3).
50§1202(e)(4).
The amount of the taxpayer's gain eligible for the exclusion is limited. "Eligible gain" is gain from the sale or exchange of qualified small business stock held for more than five years.51 The aggregate amount of the gain from the disposition of stock of one corporation that may be taken into account for purposes of the exclusion is limited to the greater of: (1) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer in earlier years and attributable to dispositions of stock issued by the same corporation; or (2) 10 times the aggregate adjusted bases (without regard to any additions after the date of issuance) of qualified small business stock issued by that corporation and disposed of by the taxpayer during that taxable year.52
51§1202(b)(2).
52§1202(b)(1).
c.	Rollover of Gain into Qualified Small Business Stock
Effective for dispositions after August 5, 1997, individual taxpayers may roll over tax-free gain from the sale or exchange of qualified small business stock held for more than six months where the taxpayer uses the proceeds to purchase other qualified small business stock within 60 days of the sale.53 To qualify, the replacement stock must meet the §1202(e) active business requirement for the six-month period following the purchase.54 For purposes of §1045, the term "qualified small business stock" means stock acquired by the taxpayer at its original issue.55 Note that the holding period of the stock purchased does not include the holding period of the stock sold for purposes of determining whether the six-month holding period is met.56
53§1045.
54§1045(b)(4).
55§1045(b)(1).
56§1045(b)(4).
In Rev. Proc. 98-48,57 the IRS outlined methods for electing deferral under §1045 on sales of qualified small business stock (QSB stock) after August 5, 1997. If the taxpayer makes the election, gain from the sale of QSB stock is recognized only to the extent that the amount realized on the sale exceeds (1) the cost of any QSB stock purchased by the taxpayer during the 60-day period beginning on the date of sale, reduced by (2) any portion of the cost of replacement QSB stock that was previously taken into account under §1045. However, the election is not available to defer gain on the sale that is treated as ordinary income.
571998-38 I.R.B. 7. In response to inquiries regarding the application of §1045 to partnerships and their partners, the IRS and Treasury Department have proposed regulations that would provide rules relating to sales and purchases of interests in a partnership that owns QSB stock, partnership dispositions of QSB stock, partnership distributions of QSB stock, and contributions of QSB stock to a partnership. The preamble to the proposed regulations cautions that partners and partnerships wishing to elect §1045 must continue to follow the procedures of Rev. Proc. 98-48 for rules regarding the time and manner for making the election, the scope of the election, and revocation of the election. See REG-150562-03, 69 Fed. Reg. 42370 (7/15/04) (proposing Prop. Regs. §1.1045-1). For further discussion of the §1045 proposed regulations, see 760 T.M., Small Business Corporation Stock: Special Tax Incentives.
Rev. Proc. 98-48 provides that a §1045 election must be made on or before the later of December 31, 1998, or the due date (including extensions) for filing the income tax return for the taxable year in which the QSB stock was sold. (A transition rule is provided for gains reported on returns filed before October 21, 1998.) The election is made by (1) reporting the entire gain from the sale of QSB stock on Form 1040, Schedule D; (2) writing "Section 1045 rollover" directly below the line on which the gain is reported; and (3) entering the amount of gain deferred under §1045, as a loss, in accordance with Schedule D's instructions. 
A §1045 election is revocable only with IRS consent. To obtain consent, a taxpayer must request a letter ruling under the provisions of the first annual revenue procedure.57.1
57.1For the year 2005, see Rev. Proc. 2005-1, 2005-1 I.R.B. 1.
B. Options
For a complete discussion of options, including timing, character, and source rules, see 188 T.M., Taxation of Equity Derivatives.
C. Regulated Futures Contracts
1.	Definition
A "regulated futures contract" (RFC) is a contract: (1) "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 (2) which is traded on or subject to the rules of a "qualified board or exchange." 58 All futures contracts traded in the United States must be traded on a board of exchange regulated by the CFTC. Hence, all domestically traded futures contracts are RFCs.
58§1256(g)(1). See, e.g., FSA 200041006 (investor's regulated futures contracts fit the category of "on or subject to" under §1256(g)(1) and should be treated as sold at fair market value on the last business day of the year). The term "marking to market" is discussed at II, C, 3, below. See definition of "qualified board or exchange" at III, B, 1, b, above.
Prior to its amendment in 198259 the definition of RFC included the requirement that it require the delivery of personal property. This was eliminated by the 1982 amendment. Thus, a futures contract calling for settlement in cash only (such as a stock index futures contacts) qualifies as an RFC.60
59By P.L. 97-448, §102(c)(5)(A).
60Cf. §1234(c)(2)(A) under which a cash settlement option is treated as an option to buy or sell property.
2.	Operation of Futures Exchanges
A futures contract is a standardized contract under the terms of which a specified number of units of specified actively traded property is to be delivered between designated dates at a price per unit negotiated between the parties to the transaction. The holder of an RFC has contracted either to buy (a long position) or to sell (a short position) the property to which it pertains. The contract price must be arrived at through competitive bidding (open outcry) on the exchange floor.61
61While RFCs originally were limited to agricultural commodities, the CFTC permits trading in RFCs in a wide variety of property including financial instruments, foreign currencies and stock indexes.
A futures contract is to be distinguished from an option in that both parties to an RFC acquire rights and incur obligations as in the case of any other contract for the sale of property. Acquiring an unhedged futures position is thus far riskier than purchasing an option which can be abandoned at the loss of the premium paid. While there is no premium involved, acquisition of a futures position requires the posting of initial margin securing performance of the contract as required by the rules of the exchange's clearing organization and the futures commission merchant handling the transaction.
All RFCs must be guaranteed by clearing members (who may also be FCMs). At the end of each trading day, when the closing price for each futures contract has been determined, all margin accounts are adjusted to reflect the increase or decrease in each contract's value. Where the futures price increases from the previous day's price, the accounts of holders of the long positions (contracts to purchase the commodity) are credited with the increase. The accounts of the holders of short positions (contracts to sell the commodity) are debited. Where the price declines, credits and debits are made in the opposite sense.
Where a futures contract is entered into, the broker62 acting on behalf of the purchaser (or on his own behalf) must agree on a price negotiated in competitive bidding with the broker representing the seller, and this agreement is reported to the clearing organization which, after confirming the transaction, becomes the counterparty to each side of the transaction. Thus, the rights and obligations of the holder of each contract may be asserted against and are owed to the clearing organization; the original parties to the contract cease to have any direct contractual relationship.
62The term "broker" is used herein to designate a futures commission merchant who is authorized to accept margin deposits and to order trades to be made on the exchange floor through a floor trader. Such FCM may or may not also be a clearing member.
3.	Marking to Market
Where a margin account is adjusted, as described above, the holders of the positions whose value has decreased must, if the debit charged against the initial margin posted decreases the amount below a specified maintenance level, make payment to their brokers in an amount sufficient to bring the margin balance to the required level.63 This payment is routed through the clearing organization to the holders of the other side of the contract. This process is termed marking to market, and is what is referred to in the definition of RFC set forth above. In this manner, the clearing organization's books are balanced. Where the margin account of a contract holder is credited to reflect increases in the contract's value, the holder may withdraw any amounts in excess of the margin required to maintain the account. Where the holder of a contract whose value has declined fails to post additional margin sufficient to maintain the margin required, the broker will close the contract and apply the margin already posted to pay the clearing organization any amount due. Thus, the contract holders have constructively realized gain or loss as of the date the accounts are settled.
63"Maintenance margin."
When the holder of a contract chooses to close out his position, this is effected by entering into a second contract offsetting the one to be closed out. Thus, the holder of a long position closes it by entering into a short position, and vice versa. At this time, gain or loss will already have been reflected in the daily credits/debits to the holder's account, as described above, and the holder's margin in excess of any additional amount due the clearing organization is returned. Prior to the enactment of §1256, gain or loss (capital, unless the position was a bona fide hedge) was not recognized before that event.
Example: On Mar. 1, B acquires a long position in Sept. corn. He is said to "buy" x contracts. Assume the Sept. futures price is $2.10 a bushel and that each contract is for 5,000 bushels. He posts initial margin of $500 for each contract. On Mar. 2, the Sept. corn futures price closes at $2.12 a bushel. B's account is credited in the amount of $100 for each contract ($.02 × 5,000). This amount is actually paid to B's broker by the clearing organization which has, in turn, collected it from the brokers of the holders of short positions.64 The latter brokers have made payment from the margin posted by such holders and, where payments due the clearing organization reduce margin to a specified minimum, say $350, will require the holders to post additional margin to bring their accounts up to the $500 level again. Assume that in July, the Sept. corn futures price has advanced to $2.60 a bushel. B will have had credited to his account a total of $2,500 ($.50 × 5,000) on each contract, available for withdrawal. No gain has been realized at this point, however, since the contract is still open.
Assume that B elects to close out his contracts. His broker will find another willing to acquire a long position at the $2.60 price. He will then contract to sell at this price, and the short position thus entered into at the $2.60 price is assigned to the clearing organization along with the offsetting long position being closed out.65 The clearing organization will automatically offset both contracts, terminating B's rights and his obligations to it. This transaction is treated as the sale by B of a capital asset having a zero basis in his hands for $2,500 and capital gain in that amount is realized. If the futures price for Sept. corn had dropped to $1.90 per bushel, closing out the contract would result in a capital loss of $1,000, reflecting the amount of additional margin B has posted and permanently forfeited by closing his position out.
If B chooses to take delivery of the corn under the long position, he will pay the current spot price on delivery. Assume that such price is $2.30 per bushel. B will have repaid to the clearing organization through his broker the $1,500 representing the drop in the futures price from the July $2.60 price, retaining $1,000 withdrawn from his account which is treated as gain realized upon the termination of his rights/obligations under the contract. His basis in the corn is $2.30 a bushel. If the corn is immediately sold at that price, there is no gain or loss on the sale.66
64B, if he chooses, may withdraw the $100 in cash.
65To effect this transaction, there must, of course, be a buyer at that price taking a long Sept. corn position, as there will invariably be due to the liquidity offered by the exchange.
66A futures contract may be a capital asset in the hands of the holder and, the termination of the holder's rights and obligations under a futures contract by the acquisition of an offsetting contract constitutes a "sale or exchange." Covington v. Comr., 42 B.T.A. 61 (1940), aff'd, on this issue, 120 F.2d 768 (5th Cir. 1941). See also Vickers v. Comr., 80 T.C. 394 (1983) (containing a discussion of futures market transactions and their tax consequences).
As indicated in the example above, the holder of a futures contract may elect to exercise his right to purchase the property to be delivered under the contract (or to make delivery of the property where the position is a short one). While the vast majority of futures contracts are closed out as described (over 95%), actual delivery may take place where the contract was entered into by a producer, manufacturer or processor of the commodity in order to hedge against unfavorable price movements.67 Where the holder of a long position makes delivery, the goods are paid for at the spot price on the delivery date. As explained later, upon the termination of his obligation/right under the contract (effected by such delivery) gain or loss is recognized to the same extent as if the contract had been closed out on that date. Gain or loss is also recognized on the sale of the goods at the spot price.
67A "buying hedge" is a long position entered into to insure against price increases in goods to be purchased in the future. A "selling hedge" is a short position insuring a minimum price for goods to be sold in the future. Similar hedges protect the hedger against interest rate or foreign exchange rate fluctuations affecting asset and/or liability positions held or contemplated.
Example: Assume that taxpayer B enters into a long futures contract under which he acquires the right/obligation to purchase 1000 units of commodity C for $2.00 per unit on a future delivery date. On the delivery date, the spot price (and futures price on the last day of trading) has moved to $3.50. B makes delivery of the goods. On the futures contract, he has a gain of $1.50 per unit or $1,500. Assume that the goods used to make delivery were acquired at a price of $3.25. B has an additional gain of $250. If the goods had cost $3.75 per unit, he would have a loss of $250. If B were a dealer in commodity C, the $250 gain/loss would be ordinary. If the futures contract was a properly identified hedging transaction, the gain would also be ordinary income. If it were not, however, it could be capital gain.68
68See §1234A. This result assumes that the contract was a capital asset in B's hands. Irrespective of whether the contract was identified as a hedging transaction, due to the Corn Products, discussed at V, F, 3, the gain might be characterized as ordinary.
4.	Forward Sales Distinguished
Forward sales contracts call for delivery of a specified quantity of fungible goods at a specified future date. They differ from futures contracts in that they are generally not standardized and are not traded on any domestic exchanges or boards of trade. Such transactions are commonly entered into to hedge risks from exposure to foreign currency rate fluctuation, in which case they are contracts to purchase or sell units of a specified currency. Usually, they are entered into with the foreign exchange department of a bank located in a major money market (or between such a bank and a foreign bank).
Most forward sale and purchase agreements relating to major currencies are traded on the interbank market, in which case they are "§1256 contracts," as is explained below at VI and in 188 T.M., Taxation of Equity Derivatives. However, in some instances, where the contracts negotiated reflect interest rates other than those established by the interbank market, currencies other than the major ones, or odd or extraordinarily deep maturity dates, they cannot be traded on this market. Margin, if any, depends to a large degree on the parties' credit and (sometimes) customer status. There is no fixed regulatory minimum, nor is there a mark to market system as in the case of futures.
The rights and obligations of a party to a forward sales contract may be terminated by the making or taking of delivery or closed out by cancellation or acquisition of an offsetting contract, accompanied by payment to or the receipt of payment from the other contracting party. Gain or loss is recognized at that time depending on whether the currency exchange rate has moved favorably or unfavorably to the contract holder.69 While forward contracts have many features in common with futures and short sales, they are not subject to the short sale rules of §1233, discussed in 188 T.M., Taxation of Equity Derivatives.70
69For a discussion of the mechanics of forward contracts, see U.S. v. Dial, 757 F.2d 163, 164-65 (7th Cir. 1985).
70See §1233(e)(2)(A); Section 1233 applies only to short sales involving stocks, securities and commodity futures (not commodities themselves). See King v. Comr., 87 T.C. 1213 (1986), which held that delivery of gold bullion to satisfy a short futures contract was not the closing of a short sale after consideration of the legislative history of §1233 viewed as establishing that Congress deliberately excluded commodities from the definition of "property" in §1233(e)(2)(A), a position strengthened by comparing the definition of "property" in §1234(b)(2)(B) which includes commodities and commodity futures. See Hoover Co. v. Comr., 72 T.C. 206 (1979) (dictum to effect that a forward sale of foreign currency was not a short sale). See also Stein v. Comr., T.C. Memo 1989-489 (taxpayer who purchased long silver futures contracts in June, received actual delivery of silver in Jan. and sold it shortly thereafter, recognized short-term capital gain despite application of one-year holding period applicable to sale of commodities--rather than commodities futures contracts--since tacking of holding periods in futures contracts and actual silver totaled approximately seven months).
5.	Futures Options
Options on futures contracts are traded in a number of futures contract markets. These options provide significantly different risks and rewards from the underlying futures contracts themselves. As is seen from the foregoing discussion involving stock options, the purchaser of an option assumes no risk beyond the premium paid. The grantor, while exposed to substantially greater risk, can always terminate such exposure in a closing purchase transaction.
The grantor of a futures option undertakes, in consideration of the premium received, to enter into a futures contract. In the case of a short call, the grantor, upon exercise of the call, agrees to enter into a short futures contract at the agreed on strike (futures) price with the exercising option holder acquiring the offsetting long futures position at that price. In the case of a short put, he agrees to enter into a long contract with the exercising holder acquiring the offsetting short futures position. The grantor, after making payment of margin reflecting the difference between the strike price and the current futures price, may immediately close out his position or continue to hold it in the hope that the futures price will move favorable, enabling him to recoup part of his loss.
Gain or loss must be recognized on the exercise of an option on a §1256 contract.71 Hence, the net gain or loss (i.e., the amount credited to the exercising holder of a long call where the futures price has risen less the premium paid for the option or the amount required to be paid by the grantor of the short call less the premium received) of the grantors and holders of the futures options discussed above must be recognized at the time of exercise irrespective of whether they elect to retain the long or short futures position acquired or to close such positions out at the time of exercise. If the option is not exercised but is allowed to lapse or is closed out prior to exercise, the gain or loss arising on the lapse or on the closing transaction is treated as capital gain or loss, assuming the underlying commodity would be a capital asset in the hands of the taxpayer.72
71§1234(c)(1).
72See V, I, below, 188 T.M., Taxation of Equity Derivatives, and §1234A(1), which provides that gain or loss from the cancellation, lapse or other expiration of a right or obligation (other than a §1234B securities futures contract) with respect to property (including all actively traded commodities) which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset. While this provision was enacted chiefly to clarify that gain or loss from forward contracts for currency or securities is not to be classified as capital or ordinary depending on the manner in which the holder of the contract elects to terminate his rights or obligations, its scope is broad enough to constitute a codification of the decision in Covington v. Comr., 42 B.T.A. 61 (1940), aff'd on this issue, 120 F.2d 768 (5th Cir. 1941), since it applies to all RFCs which, by reason of §1256(b), are §1256 contracts.
Example: B, for a premium of $x, grants a call option in Jan. on a futures contract that requires Nov. delivery of 10,000 units of commodity C at a price of $1 per unit. If the call is exercised, and the exercise is assigned to B by the clearing organization, B must enter into a short futures contract with the same price. The holder exercising the option acquires an offsetting long position. B may immediately close out the contract acquired through the clearing organization, making payment of an amount equal to the difference between the strike price and the futures price on the date the short position was acquired and disposed of. Assuming that the price has moved to $1.10 per unit, B must immediately post $1,000 with the clearing organization upon acquiring the short position. He realizes loss on the difference between this amount and the premium received whether or not the position acquired is closed out. If the position is closed out on the same date, there is no further gain or loss. Of course, B may retain the short position after posting the required margin. If the price subsequently moves to $1.05, he will have recouped $500 of the margin posted, and may then close out the position. If B closes the position, he must recognize the $500 gain realized at this time.
Finally, as explained in V, below, and in 188 T.M., Taxation of Equity Derivatives, under the rules of §1256, the grantor or holder of a futures option who holds such option on the last business day of the year must treat the position as if it were sold for its fair market value and recognize any gain or loss. Such gain or loss is then taken into account to adjust any gain or loss resulting from the disposition, exercise or termination of the option position.
6.	Security Futures Contracts
See the discussion in 188 T.M., Taxation of Equity Derivatives.
D. Interest Rate Instruments
Various types of corporate debt obligations are traded on domestic and foreign exchanges as well as on the over-the-counter market.73 Obligations issued by the U.S. Treasury, so-called Agency issues, and obligations issued by states and municipalities are traded exclusively on the over-the-counter market. Contracts and obligations relating to foreign currency are traded in the interbank market.
73"Over-the-counter market" refers to all transactions not occurring on an exchange. The participants in this market are primarily dealers, some of whom are market makers in one or more issues, who purchase and sell securities as principals, deriving income from marking up the securities sold (as distinguished from agents for the buyer and seller; most transactions on exchanges are effected by brokers acting as agents). OTC market makers and brokers who represent customers must register with the SEC and become members of the National Association of securities Dealers (NASD). Transactions are usually conducted by telephone or computer terminal.
The so-called "money market" is a facet of the over-the-counter market. It includes regular and residual REMIC interests, mortgage backed securities, collateralized mortgage obligations, certificates of deposit, commercial paper, securities collateralized by credit card receivables or automobile dealer paper, FASITs, etc.
Most of the tax aspects of trading in debt obligations, such as the measurement and timing of interest, are outside the scope of this portfolio. Transactions in such securities are subject to the wash sale and short sale rules, discussed in 186 T.M., Financial Instruments: Special Rules and 188 T.M., Taxation of Equity Derivatives, respectively. The status of taxpayers that purchase and sell debt obligations (i.e., dealer, trader, investor) has the same consequences for tax purposes as in the case of transactions in stock and stock-related instruments. The discussion of transactions in debt instruments is focused on transactions involving options, futures and futures options in Treasury bills, notes and bonds as well as other actively traded debt instruments. Such contracts are entered into for the purpose of speculation, hedging and arbitrage. The tax consequences of hedging transactions are discussed in detail in V, below. This section explains the mechanics, purposes and tax aspects of transactions in interest rate instruments of various types.
1.	Treasury and Agency Issues
The Treasury Department periodically issues negotiable debt instruments. These are purchased primarily by bond dealers who undertake to resell them to banks, financial institutions, and (through brokers) the general public at a mark-up.
Treasury bills (T-bills) are short-term obligations maturing in one year or less. They are issued at discount and bear no interest coupon. The interest earned by the holder is the difference between the price paid and the amount payable at maturity. Given a situation in which there is no change in prevailing short-term interest rates, the value of the bill will increase each day to maturity. If rates rise, the value will decrease; if they fall, the value will increase. Thus, the value of a T-bill as of any point in time subsequent to its issue will depend both on the time remaining to maturity and prevailing market interest rates. T-bills are offered at regularly scheduled auction sales by the Treasury in three maturities, 91 days, 182 days and one year. They are sold to the bidders offering the highest prices.
Treasury notes (medium-term instruments bearing interest coupons payable semiannually, with terms of from two to 10 years) are auctioned by yield; that is, they are sold at or close to par or face value to bidders offering the highest yield which, in turn, becomes the coupon interest payable. T-bonds, having maturities of from 10 to 30 years, are auctioned in the same manner as notes. Both T-bonds and T-notes bear a wide range of coupon interest reflecting the fluctuations in interest rates over the years. The prices quoted do not include accrued interest which must be paid to the seller of the bond if the sale does not take place on the day after one of the interest payment dates.
Under Treasury's STRIPS program, an investor can purchase the obligation to pay the principal amount of a T-bond at maturity without the right to receive interest (a zero coupon bond), or can purchase at discount the right to receive one or more of the interest payments due.74 Essentially the same rights are available from various bond dealers through the purchase of interests in trusts that hold the securities.
74Over-the-counter Treasury strips quotations are provided by the Wall Street Journal and other financial periodicals.
Debt obligations are offered to the public by government "agencies," such as the Government National Mortgage Association (GNMA) and Federal National Mortgage Association (FNMA), which offer mortgage backed securities the payments of principal and interest on which are guaranteed by the Treasury. Similar mortgage backed pass-though securities without government guarantees are offered by the Federal Home Loan Mortgage Corporation (FMAC).
GNMA securities are purchased mainly by banks, S & L's, mutual funds and financial institutions. While nominally 30 year instruments, they are, as are almost all pass-through instruments, subject to prepayment as the underlying mortgages are paid off, and have terms averaging about 12 years.75
75See Freytag v. Comr., 89 T.C. 849 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd, 501 U.S. 868 (1991), for an interesting straddle scheme involving forward contracts in GNMA and FMAC securities.
Treasury and agency issues are noncertificated, that is, the purchaser receives no certificate or other paper evidence of the obligation (other than a confirmation slip from a broker). Instead, transactions are entered into the Federal Reserve Board's book entry system and recorded electronically. Contributing to the prices (or yields) of Treasury obligations, aside from the absence of a risk premium, is the exemption of interest from state and local taxes; likewise, interest on state and municipal obligations is exempt from federal tax (and, generally, income tax of the state of issue).
Options, futures and futures options are offered on all Treasury securities on domestic (and some foreign) exchanges. Delivery under the options and futures contracts is to be made of the type of security to which the contract relates with a specified period to maturity.
2.	T-Bill Futures and Options
T-bill quotations are in terms of yields. They show the bid and asked yields for various maturity dates computed on a discount basis, and the "bond equivalent" yield based on asked prices.
In the Wall Street Journal of September 28, 1989, for example, the quote for T-bills maturing on February 22, 1990 were: bid -- 7.85; asked -- 7.81 and (bond equivalent) based on asked prices -- 8.18.
The discount yield of a T-bill, as so reported, is computed as:
Yield = [(Face Value - Price) × 360/days to maturity]/Face Value. Thus, where the price for a six month bill is 942 ($94,200 for a bill paying $10,000 at maturity in 182 days) the discount yield is (58 × 360) = 20,880 ÷ 182 = 114.73 ÷ 1000 = 11.47%. The "bond equivalent yield" is based on a 365 day year and the price paid. The formula is [(Face Value - Price) × 365/days to maturity]/by the Price. In this case, using the same price of 942, it is 12.35%.
A T-bill futures offered on the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME) (the dominant contract market for such futures) call for delivery of bills with 90 days to maturity. Each contract is for $1,000,000 in face value. The short position must deliver to the long $1,000,000 in bills on the delivery date at the futures price specified in the contract. Futures quotations show, in lieu of prices, the open, high, low and settlement "indexes" for each delivery month. The index figure is actually yield expressed as 100 -- (yield × 100). Thus, where the yield is 8%, the index is 92. The quotation line then shows the yield normally expressed as a percentage figure based on the settlement index. Contracts mature in March, June, September and December of each year with the most distant contract maturing in two years.
Example: In quotations on Sept. 26, 1989, the settlement indexes for Dec., Mar., and June of 1990, were shown as 92.52, 92.67 and 92.70, with corresponding settlement yields of 7.48, 7.33 and 7.30. The futures price, the amount payable by the buyer upon delivery of the T-bills, is derived from the index. Since the yields used in computing the indexes are the discount rather than the bond equivalent yields, the price is determined by applying the formula set forth above. The futures price based on the index of 92.52 is: $1,000,000 - [(90 × .0748 × $1,000,000) ÷ 360] = $981,300. The holder of a long Dec. position acquired with a futures index of 92.52 is entitled to purchase $1,000,000 in face amount of T-bills maturing in 90 days for this price on the date delivery is called for. If short-term interest rates decrease, the value of the bills may be $990,000, and the contract can be closed out (in the same manner as commodity futures contracts) for a gain of $8,700.
A long T-bill futures position will typically be taken by a person seeking to hedge against a decrease in interest rates, such as a lender who contemplates making a loan in the future or rolling over outstanding loans. Futures positions may also be acquired by speculators seeking to profit from interest rate fluctuations. The futures quotations given above indicate a view that short-term interest rates will decrease.
T-bill futures76 were largely superseded by futures on 30-day Eurodollar deposit contracts which offer essentially the same hedging and speculative opportunities but in a much more active market. These contracts are settled in cash (since delivery cannot be made of deposits which are nontransferable). The quotations are in the same form as those for T-bill futures (index quotes with a discount yield based on the formula set forth above rather than a bond equivalent or other yield formula). Contracts are for $1,000,000 face amount of Eurodollars payable in 30 days. The interest rates involved are based on 30-day LIBOR (London Interbank Offered Rate) which is also extensively used in floating rate dollar denominated debt instruments traded on international markets and interest rate swap contracts.
76While sparsely traded on the IMM, T-bill futures options are available with premiums expressed in hundredths of one percent ($25 in the case of 30 day maturities) of the $1,000,000 contract. On September 26, 1989, a contact with a strike price of 9250 (expressed in terms of the index described above). December and March calls were priced at .27 and .51, respectively ($675 and $1,275).
3.	Treasury Note and Bond Futures
Treasury bond futures are by far the most actively traded interest rate instruments on the exchanges where offered. Futures prices are quoted in terms of the price of a bond bearing an 8% coupon with no less than 15 years to maturity (or the earliest call date) with an average term to maturity of 20 years. Each contract calls for the delivery of bonds with a face value of $100,000. The futures prices are quoted in terms of points and 32d's of par. Thus, a price of 95 - 19 translates to $95,000 plus 19 ÷ 32 × $1,000 = $95,593.75. As can be seen, each point or "tick" equals $31.25. The quoted price reflects a yield (based on the average term to maturity of 20 years) of 8.535%, which figure is included in the published futures quotation. A $100,000 contract requires initial margin of $2,500. The bonds delivered if the contract is not closed out must have at least 15 years of their terms remaining (and not be callable before 15 years). In the case of the contract described above, the contract could be closed out at a gain if yields on T-bonds with maturities of 15-20 years remaining dropped below 8.535%.
While trading in T-note futures does not approach the volume of T-bond futures, T-note futures are traded under basically the same rules, except that the quoted yields are based on contracts calling for delivery of 5-year and 2-year notes.
4.	Inflation-Index Debt Instruments
In January 1997, the IRS published temporary regulations.77 These regulations (preceded by Notice 96-51,78 some, but not all, of whose provisions were adopted) provide a special tax regime for debt instruments indexed for inflation. Briefly, these instruments, the first of which were issued by the Treasury in January 1997, but can be issued by any issuer if they comply with the rules set forth in the regulations, provide for constant adjustment of the stated principal amount payable at maturity to reflect increases or decreases in a recognized, IRS approved consumer price (or equivalent) index, with coupon interest payable at a fixed rate based on such adjusted principal amount. These instruments will bear below market interest (since the coupon rate will not reflect inflation premium, and any increase in the index, will be characterized as original issue discount and taxed to the holder currently. These instruments thus may provide an attractive investment to investors not subject to tax (e.g., foreign persons, pension funds, IRAs or §401(k) accounts, etc.) but probably not to investors fully taxable on the deemed OID. The characteristics of these instruments and their tax treatment are analyzed in detail in 535 T.M., Time Value of Money: OID and Imputed Interest.
77Regs. §1.1275-7T, T.D. 8709, 62 Fed. Reg. 615 (1/6/97).
781996-2 C.B. 216.
E. Termination of Rights and Obligations: §1234A
For a complete discussion of terminations and §1234A, see 188 T.M., Taxation of Equity Derivatives.
IV. Wash Sales; Constructive Sales; Constructive Ownership Provisions
A. Introduction
Transactions in stock and securities have long been subject to two sets of rules enacted many years before the tax straddle provisions (added by ERTA and the 1984 TRA), which are the principal subject of this portfolio. These are, respectively, the wash sale rules of §1091, first enacted in 1921, and the short sale rules of §1233, first enacted in 1950. Amendments have been made to both sets of rules in subsequent legislation. While they are generally effective to prevent the types of abusive manipulation of investment positions they were enacted to prevent, by 1981 it was evident to Congress that sophisticated taxpayers had contrived a variety of transactions through which some of the same kinds of tax avoidance these rules were enacted to prevent appeared permissible under a literal application of the statutory language. This was especially true of the short sale rules. The tax straddle provisions of ERTA, as subsequently expanded and amended, may be seen as a response to the schemes developed to exploit deficiencies in the earlier legislation. A review of the wash and short sale rules, which remain in effect as part of the 1986 Code, is essential to an understanding of the considerably more complex tax straddle rules.
As part of ERTA, Congress directed the IRS to prescribe regulations applying the principles of the wash sale and short sale rules to gains and losses from all "straddle positions," a term explained in V, below. These regulations are sometimes referred to as the "modified" wash and short sale rules, as distinguished from the "statutory" rules discussed in other portfolios, noted below. The modified rules overlap and, to this extent, supersede the statutory rules. The modified wash sale rules are discussed below at VI. The short sale rules are discussed in 188 T.M., Taxation of Equity Derivatives. The wash sale rules of §1091 are discussed in 186 T.M., Financial Instruments: Special Rules.
B. Wash Sales
For a detailed discussion of wash sales, including which transactions are targeted, the consequences of the wash sale rules, and the scope of the wash sale rules, see 186 T.M., Financial Instruments: Special Rules.
C. Short Sale Rules
For a detailed discussion of short sales, including applicable timing, character, and source rules, and the effect of short sales on stock ownership, see 188 T.M., Taxation of Equity Derivatives.
D. Constructive Sales: §1259
For a detailed discussion of constructive sales, including which transactions are targeted, the consequences of the constructive sale provisions, what positions can be constructively sold, and other issues arising under the constructive sale provisions, see 186 T.M., Financial Instruments: Special Rules.
E.  Section 1260 -- Constructive Ownership Provisions
For a detailed discussion of constructive ownership transactions (COTs), including which transactions are targeted, the consequences of the constructive ownership provisions, and other issues arising with COTs, see 186 T.M., Financial Instruments: Special Rules.
V. Straddles
A. Introduction
The term "straddle" as used in the Code provisions discussed in this section has a meaning somewhat different from its usage in the marketplace. The market usage refers, generally, to the holding of two or more positions that exactly offset each other, whereas the term as used in §1092 refers to the holding of "offsetting positions" in "actively traded" "personal property," as these terms are defined in §1092. Thus, the term "straddle" includes what the market refers to as a "spread." "Straddle," as used herein, refers to the Code definition.
In general, non-technical terms, the essential features of a straddle are: (1) the positions are valued by some type of market on or through which they may be liquidated at any time, and (2) market forces resulting in any change in value of one position will almost always result in an inverse change in value of the offsetting position, although not necessarily in the same (or even nearly the same) amount.
Straddles are often entered into (usually deliberately, although in some circumstances, a straddle position may be inadvertently acquired) for a wide variety of reasons unrelated to taxation. A speculator may wish to lock in all or a portion of unrealized gain from an appreciated position (as in the case of a short sale against the box, discussed above),79 or may wish to protect against any drop in value below a given point. Straddles are used by traders and investors with widely varying willingness to accept exposure to risk in attempting to profit from market changes. Straddles, which may involve complex patterns of long and short positions, may range from the extremely conservative to the very risky, usually with commensurate potential rewards.80 Straddles are widely employed by corporate money rs and financial institutions to minimize risks incident to the holding of financial assets and the incurring of liabilities, to protect against adverse fluctuations in foreign exchange and interest rates, and to maintain balanced asset/liability positions. In fact, it has been said that the trading portfolio of a bank could be considered to be one giant straddle with thousands of offsetting positions.81 Straddles are extensively used by persons involved in all stages of businesses whose profits may in any way be affected by commodity prices. These include growers, processors, manufacturers and, of course, dealers.82
79A short sale against the box is not technically as "straddle," as explained below, unless the short sale is in the form of a put option, but is usually a form of non-tax motivated (in view of the provisions of §1233) hedging.
80See Kramer, Taxation of Securities, Commodities and Options (1987), at §5.4(c) and (d) for descriptions of various combinations of options positions commonly used for these purposes.
81See Spooner, "Tax Consequences of Trading Foreign Currencies in Spot, Forward, Future and Swap Markets," 2 J. of Bank Tax'n 19, 22 (1988).
82An excellent review of the early development of tax rules for business hedges of this type may be found in Kleinbard & Greenberg, "Business Hedges After Arkansas Best," 43 Tax L. Rev. 393, 397-405 (1988).
Note: The same desire to ballast economic risk that motivates investors to engage in straddle transactions also influences the way modern corporations their capital structures. Consequently, investment banks have developed numerous instruments designed to enable corporations to raise capital by cashing out of their investments in publicly traded subsidiaries without realizing a current gain. Marketed under acronyms such as DECS ("debt exchangeable for common stock" or "dividend enhanced certificates"), ACES ("automatically convertible equity securities"), and PEPS ("premium equity participating securities"), these instruments generally share the trait of providing their holders with a higher yield than would result from the dividends paid on the common stock into which the instrument is convertible. As a tradeoff for the holder's enjoyment of a higher current yield, the instrument's issuer generally retains the right to a substantial portion of the appreciation (if any) in the market value of the underlying stock. The holder, by contrast, bears all of the risk that the underlying stock's value will decrease. As a result of the transfer of various ownership rights that occurs under these types of instruments, the determination of whether they represent an equity interest in their issuer (or its subsidiary) or, instead, debt is problematical.83
83For a discussion of the tax issues that instruments such as those described above present, see Sheppard, "Adding PEP to the Constructive Sales Debate," 70 Tax Notes 13, 1592 (3/18/96), and O'Donnell & Harter, "The Tax Characterization of DECs, ACES, and Other Yield Enhanced Positions with Respect to Stock," 37 Tax Mgmt. Memo. S-9 (2/19/96).
Although the use of straddles is a common practice by persons engaged in a wide variety of business transactions who tend to view the costs entailed as a form of insurance, straddling, prior to the reforms enacted by ERTA and subsequent Acts, was widely used solely to manipulate the timing of gains and losses. In some circumstances straddles could also be used to convert ordinary income or short-term gain to long-term gain. The complex set of rules discussed below is best understood when viewed as essentially anti-abuse measures carefully tailored to allow non-tax oriented business uses of straddles to be carried out without tax penalties.
As discussed in 188 T.M., Taxation of Equity Derivatives, the short sale rules targeted certain abusive manipulation of short sales as well as commodity futures positions to convert short-term to long-term gain (and long-term to short-term loss). However, the short sale rules do not apply to commodity futures spreads, which are widely used by traders in profit oriented transactions, presumably because they were not considered by Congress to have sufficient abuse potential to warrant their being made subject to the short sale rules.84 In time, however, tax advisors found that they offered a way to defer the recognition of capital gain. By 1981, when ERTA was enacted, virtually every large investment or financial planning consultant offered straddle programs to defer taxes on income realized by their customers.
84§1233(e)(2)(B).
Example: In 2002, the taxpayer acquires a long position requiring the taking of delivery of x ounces of silver in Mar. 2003, and a short position requiring the making of delivery of x ounces of silver in May 2003, awaits a change in the futures price, and closes out the loss position. At that point, the other position will have registered gain in approximately an equal amount.85 If the position is held open, the unrealized gain, i.e., the amount that would be recognized if the position were closed out (since no gain is recognized by virtue of the mark to market payments received from the clearing organization) could evaporate. By entering into a new offsetting futures contract, replacing or succeeding the loss position closed out, however, this gain is effectively locked in. At this point, the taxpayer, prior to the ERTA rules, has a recognized loss which can be set off against any unrelated short-term gain even though there has not been any true economic loss. Whichever way the market moves, any payments due the clearing organization will be offset by payments received from the offsetting position.
85Due to the marking to market system, the gain will have been paid out by the clearing organization and will have been repaid to the organization with respect to the loss position; closing out the gain position will not result in any additional payment to the holder where there has been no convergence or divergence of the differential between the Mar. and May futures prices. However, there usually will be some degree of change in the differential resulting in a relatively small net gain or loss from the closing of both positions. It was to accommodate professional traders seeking to profit from futures price differentials that the exception to the short sales rules described above was included in the rules.
The second straddle (original gain position and successor to the loss position) may then be held until January of Year 2 at which time both positions are closed out. This will result in recognition of the locked in gain.86 In this manner, tax on the unrelated short-term gain offset by closing out the loss position in Year 1 will have been deferred for one year. Economically, the taxpayer will realize a benefit equal to the present value of the tax liability discounted for one year at the prevailing interest rate for short-term loans; the Treasury will have sustained a detriment in approximately the same amount.87
86Approximately, since, as explained, the futures price differential may expand or diminish. In any event, net overall net gain or loss from the series of transactions will be negligible when compared to the tax benefit enjoyed.
87An example of this kind of straddle transaction is set forth in Rev. Rul. 77-185, 1977-1 C.B. 48, in which the IRS ruled that no loss was allowable upon the disposition of the loss position in Year 1 since there had been no "closed and completed transaction." IRS attempts, prior to the enactment of ERTA, to defeat this kind of abusive manipulation of straddles are discussed below.
Variations of the tax avoidance stratagem outlined above took many forms. All of which, no matter how intricate or complex, involved the same basic pattern, i.e., disposition of the loss position(s) of a commodity futures spread position while simultaneously locking in unrealized gain from the offsetting position by acquiring a successor to the position disposed of.
Another, somewhat different, stratagem for obtaining recognition for tax purposes of a "loss" that had not been sustained in an economic sense was the so-called "cash-and-carry" straddle. This was based on the fact that the futures price for any commodity is equal to the spot price on the date the contract is entered into plus the interest and carrying charges (insurance, storage, transportation, etc.) that would be incurred were the commodity to be purchased with funds borrowed for that purpose and held to the delivery date called for in the futures contract. If the taxpayer, after entering into a short futures contract, finances the purchase of and holds the commodity needed to make delivery under the contract, absent the ERTA provisions he could deduct currently from ordinary income88 the interest and carrying charges incurred while recognizing capital gain upon delivery.89 The tax benefits consisted not only of being able to convert ordinary income to long-term capital gain, but, where delivery was effected in the year following the establishment of the straddle, the interest deductions were taken currently whereas the offsetting capital gain was postponed for one year.
88Under the 1954 Code, which allowed unlimited deductions for personal interest and up to $10,000 of investment interest over and above net investment income. See pre-1986 TRA §163(d).
89This is because the futures contract price will almost always exceed the spot price paid for the commodity when the futures contract is entered into, irrespective of the commodity's price when the futures contract matures. See Johnson, "An Introduction to Options," Salomon Bros., 1987, at p.3. The same stratagem may be used with forward contracts which, as is pointed out elsewhere, are economically identical to futures but are not standardized or exchange traded; margin requirements are discretionary with the parties to the transaction.
These were foremost among the abuses Congress sought to curtail by enacting the so-called tax straddle rules of §§263(g), 1092, 1234A, and 1256, which are described below. The complexities of the rules arise principally from the awareness of Congress that straddle transactions play a legitimate, profit oriented role in many business operations. While an attempt was made to structure the rules to permit taxpayers to enter into such non-abusive straddles without adverse tax consequences, this was only partially successful, as will be seen, and such adverse consequences may result from faulty tax planning with respect to non-tax motivated transactions entered into by taxpayers who lack thorough familiarity with these rules.
Note: The Revenue Reconciliation Act of 1993 (1993 RRA), §13206(a), added §1258, which provides that a portion of the income derived from certain "conversion transactions" must be treated as ordinary income rather than as capital gain. A conversion transaction generally is a transaction where substantially all of the taxpayer's return is attributable to the time value of the taxpayer's net investment in the transaction. Conversion transactions include: (1) holding property and entering into a contract to sell the property at a price determined in accordance with the contract, where the property was acquired and the contract was entered into on a substantially contemporaneous basis; (2) applicable straddles; and (3) any other transaction which is marketed or sold as producing capital gains. The term "applicable straddle" means any straddle within the meaning of §1092(c).90 Section 1258 applies to conversion transactions entered into after April 30, 1993.91
90§1258(d)(1), as amended by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888(c)(2), effective for positions established on or after Oct. 22, 2004. For positions established on or before Oct. 21, 2004, pre-2004 AJCA §1258(d)(1) provided that "applicable straddle" meant any straddle within the meaning of  §1092(c), except that the term "personal property" included stock.
911993 RRA, §13206(a)(3).
Section 1258(a) treats as ordinary income a portion of the amount of gain recognized on the disposition or termination of any position which was held as part of a conversion transaction. Gain is treated as ordinary to the extent that it does not exceed the "applicable imputed income amount."92 The "applicable imputed income amount" equals: (1) the amount of interest that would have accrued on the investment at a rate equal to 120% of the applicable rate;93 minus (2) the amount treated as ordinary income under §1258(a) with respect to any prior disposition or termination of a position that was held as a part of the transaction.94
92§1258(a).
93Generally, the applicable federal rate as defined in §1274(d). §1258(d)(2).
94§1258(b).
Section 1258 may create a character mismatch, however, because it focuses only on the gain recognized on the transaction. For instance, if a taxpayer separately disposes of the positions of a conversion transaction, the taxpayer's inability to net losses on the position against gains could result in the characterization of gain in excess of the time value element.
The Treasury issued regulations to provide relief from this potential character mismatch in certain circumstances.95 Regs. §1.1258-1 allows taxpayers to net gains and losses on the positions of certain conversion transactions for purposes of §1258. To be eligible, the taxpayer must identify, before the close of the day on which the positions become part of the conversion transaction, all the positions that are part of the conversion transaction.96 In addition, all positions must be disposed of within a 14-day period that is within a single taxable year.97 Regs. §1.1258-1(c) provides special rules for losses on positions of conversion transactions, preventing the netting of built-in loss against gain. The rules also treat certain losses that arise during the term of a conversion transaction as built-in losses.
95Regs. §1.1258-1.
96Regs. §1.1258-1(b).
97Id.
B. Straddle: Definition
A straddle is defined as "offsetting positions with respect to personal property."98
98§1092(c)(1).
1.	Position
A "position" is defined in §1092(d)(2) as an "interest (including a futures or forward contract or option) in personal property." Thus, a position includes any right or obligation or interest with respect to personal property, including ownership of such property. Importantly, the obligation of the grantor of an option is deemed to be a "position" with respect to the optioned property. A binding contract to purchase or sell actively traded property would also qualify as a "position" with respect to the property, as is the holding of a debt obligation by a U.S. person denominated in any actively traded currency other than U.S. dollars. Whether the obligor on such an instrument holds an interest in personal property would be unclear without the statutory special rule providing that an obligor's interest in a nonfunctional currency denominated debt obligation is treated as a position in the nonfunctional currency.99
99§1092(d)(7)(A). For the definition of functional currency, see §985. Section 1092(d)(7)(B) adds that a foreign currency for which there is an active interbank market is presumed to be actively traded. Note that this is not restricted to currencies with respect to which futures contracts are available on a qualified board or exchange. There is no IRS pronouncement defining what currencies are considered to be actively traded. However, a position denominated in Polish zlotys would almost certainly be ruled not to be a position in "property" for purposes of §1092(c). This statutory rule applies notwithstanding the general rule set forth in In re State Tax on Foreign-Held Bonds, 82 U.S. 179 (1873): "[D]ebts owing by corporations, like debts owing by individuals, are not property of the debtors in any sense, they are obligations of the debtors, and only possess value in the hands of the creditors. With them they are property. . . . To call debts property of the debtors is simply to misuse terms. All the property there can be in the nature of things in debts of corporations, belongs to the creditors, to whom they are payable."
2.	Personal Property
Note: Final regulations were published setting forth rules for the timing of income and deductions from notional principal contracts. These are discussed below at VII, E. With these regulations, there were also published final regulations under §1092(d) defining "actively traded" and the circumstances under which notional principal contracts are to be treated as actively traded personal property.100 The provisions of Regs. §1.1092(d)-1 are set forth below substantially verbatim since any abbreviated or abstracted version would be of little assistance to the practitioner.
100T.D. 8491, 1993-2 C.B. 215.
"Personal property" means any personal property of a type which is actively traded.101 "Actively traded" personal property includes any personal property for which there is an "established financial market."102 An "established financial market" is defined103 as: 
(i) A national securities exchange that is registered under §6 of the Securities Exchange Act of 1934;104
(ii) An interdealer quotation system sponsored by a national securities association registered under §15A of the Securities Exchange Act of 1934;
(iii) A domestic board of trade designated as a contract market by the Commodities Futures Trading Association;
(iv) A foreign securities exchange or board of trade that satisfies analogous regulatory requirements under the law of the jurisdiction in which it is organized (such as the London Financial Futures Exchange, the Marche a Terme International de France, the International Stock Exchange of the United Kingdom and the Republic of Ireland, Limited, the Frankfurt Stock Exchange, and the Tokyo Stock Exchange);
(v) An interbank market;
(vi) An interdealer market; and
(vii) Solely with respect to debt instruments, a debt market.105 
101§1092(d)(1).
102Regs. §1.1092(d)-1(a). Cf. the definition of "traded on an established market" in Regs. §1.1273-2(f), employing much of the language of Regs. §1.1092(d)-1(b), below.
103Regs. §1.1092(d)-1(b)(1).
10415 USC §78f.
105Regs. §1.1092(d)-1(b)(1).
The definitions of "interdealer market" and "debt market" are as follows:
An interdealer market is characterized by a system of general circulation (including a computer listing disseminated to subscribing brokers, dealers or traders) that provides a reasonable basis for determining fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of recent transactions. An interdealer market does not include a directory or listing of brokers, dealers or traders for specific contracts (such as yellow sheets) that provides neither price quotation nor actual prices of recent transactions.106
106Regs. §1.1092(d)-1(b)(2)(i).
A debt market exists with respect to a debt instrument if price quotations for the instrument are readily available from brokers, dealers, or traders. A debt market for an instrument does not exist if:
(A) No other outstanding debt instrument of the issuer (or of any person who guarantees the debt instrument) is traded on an established financial market, as defined above (other traded debt);
(B) The original stated principal amount of the issue that includes the debt instrument does not exceed $25 million;
(C) The conditions and covenants relating to the issuer's performance with respect to the debt instrument are materially less restrictive than the conditions and convenants included in all of the issuer's other traded debt (e.g., the debt instrument is subject to an economically significant subordination provisions whereas the issuer's other traded debt is senior); or
(D) The maturity date of the debt instrument is more than three years after the latest maturity date of the issuer's other traded debt.107
107Regs. §1.1092(d)-1(b)(2)(ii).
Regs. §1.1092(d)-1(c) addresses the status of notional principal contracts (NPCs).
An NPC (as defined by Regs. §1.446-3(c)(1), discussed below at VII, E) constitutes personal property of a type that is actively traded if: (1) contracts based on the same or substantially similar specified indices are purchased, sold, or entered into on an established financial market, as defined above; and (2) the rights and obligations of a party to an NPC are rights and obligations with respect to personal property and constitute an interest in personal property.108
108Regs. §1.1092(d)-1(c)(1),  (2).
The preamble to the final §1092 regulations states that these provisions were based on the conclusion that the term "actively traded" under §1092 was intended to cover financial instruments that are liquid or easily offset, even when such instruments are not traded on an exchange or in a recognized secondary market. It is sufficient under the definitions above that there be a system of general circulation through which prices are disseminated either in the form of recent quotations of one or more brokers, dealers or traders or in the form of actual prices of recent transactions. The preamble also states that the definition of actively traded and the characterization of NPCs as personal property or interests in personal property clarifies the interaction of these rules with §1234A. Finally, the preamble notes that the IRS will consider applications for relief in instances where the proposed regulations have been changed and a taxpayer detrimentally relied on the proposed regulations.
Comment: These rules make it clear that a debt instrument and a swap (or other NPC) that hedges it can make up a straddle if both are actively traded, since a debt instrument is clearly personal property in the hands of the holder. Where the holder of a debt instrument hedges it with an NPC, he must be sure to identify the hedge position under §1256(e)(2) if the loss deferral rule of §1092(a) is to be avoided, even though NPCs are not §1256 contracts. What of the obligor of a debt instrument who hedges his position with an NPC? Here the answer is less clear. The obligor does not hold "property" as that term is normally used. It is for this reason that §1092(d)(7)(A) expressly provides that the obligor's interest in a nonfunctional currency denominated debt obligation is treated as a position in the nonfunctional currency.
Observation: While the preamble to the §1092 regulations states that a straddle of which an NPC makes up a part may constitute a conversion transaction within the meaning of §1258, it is difficult to imagine such a situation.
The similarity of the rules for determining whether property is actively traded under Regs. §1.1092(d)-1(b) and  (c) and those for determining whether a debt instrument is publicly traded under Regs. §1.1273-2(f) has been noted. The former rules were drafted after receipt of public comments on the proposed version of the latter rules. The rules under §1273 have no application to NPCs, however, since it seems clear that an NPC is not a "debt instrument," since it has neither an issue price nor a stated principal amount.
For positions established on or after October 22, 2004, the stock exception is repealed,109 and, thus, stock is considered personal property only if:
(1) such stock is of a type which is actively traded and at least 1 of the positions offsetting such stock is a position with respect to such stock or substantially similar or related property,110 or
(2) such stock is of a corporation formed or availed of to take positions in personal property which offset positions taken by any shareholder.111
109§1092(d)(3), as amended by the 2004 American Jobs Creation Act, P.L. 108-357, §888(a). See also H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 757 (2004) (noting that the 2004 AJCA "eliminates the exception from the straddle rules for stock (other than the exception relating to qualified covered call options)" and "[t]hus, offsetting positions comprised of actively traded stock and a position with respect to substantially similar or related property generally constitute a straddle.").
110§1092(d)(3)(A)(i), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
111§1092(d)(3)(A)(ii), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
For positions established on or before October 21, 2004, personal property did not, as a general rule, include stock, except in certain circumstances. 112 For positions established on or before October 21, 2004, personal property did include "any interest in stock,"113 which presumably meant that the exception for stock did not operate to except straddles consisting contracts or options to buy or sell stock. Thus, the holding of an executory contract to purchase actively traded stock and a put option on the same stock was a straddle under pre-2004 AJCA §1092(d)(3)(A).
112Pre-2004 AJCA §1092(d)(3)(A). See also PLR 9640023 (ruling, prior to the repeal of the stock exception by the 2004 AJCA, that stock of foreign corporations which is not actively traded is not considered personal property and foreign currency forwards are not substantially similar or related property to the stock).
113Pre-2004 AJCA §1092(d)(3)(A).
For positions established on or before October 21, 2004, stock was considered personal property where it was part of a straddle at least one or more of the offsetting positions of which was: 
(1) An option on such stock or on substantially identical stock or securities;114 or
(2) a securities futures contract 115 with respect to such stock or substantially identical stock or securities;116
(3) Under regulations, a position with respect to substantially similar or related property (other than stock).117
114Pre-2004 AJCA §1092(d)(3)(B)(i)(I).
115As defined in §1234B.
116Pre-2004 AJCA §1092(d)(3)(B)(i)(II).
117Pre-2004 AJCA §1092(d)(3)(B)(i)(III). The 1984 legislative history of pre-2004 AJCA §1092(d) provided examples of pre-2004 AJCA straddles as follows: (1) stock offset by a convertible debenture of the same corporation where the price movements of the two are related; and (2) short position in a stock index RFC (or long put option on the RFC or on the index) offset by stock in an investment company the performance of whose principal holdings mimics the index, or ownership of a portfolio of stocks whose performance mimics the performance of the stocks in the index. See 1984 Bluebook at 309. In FSA 200150012 (issued pre-2004 AJCA), the Chief Counsel's Office examined the situation where a corporation held shares of a second corporation and issued an instrument that was exchangable for shares of the second corporation on a sliding scale contingent on the value of the second corporation's stock at the maturity date. The Chief Counsel's Office concluded that the holding of the shares and the issuing of the instrument resulted in a straddle.
For positions established both before and after the 2004 AJCA, personal property includes stock of a corporation formed or availed of to take positions in personal property which offset positions held by its shareholders.118
118§1092(d)(3)(A)(ii); pre-2004 AJCA §1092(d)(3)(B)(ii). The 1984 Blue Book at 308-09 states that all members of an affiliated group (as defined in §1504(a)) are treated as one corporation for purposes of applying the hedging exemption (discussed below) when a corporation is formed or availed of to take offsetting positions.
Example: X Corp. is the parent of subsidiary Y, which is engaged in the manufacture of various products that include chocolate in one form or another, and subsidiary Z, which purchases cocoa on the world markets for resale to Y. Z also enters into cocoa futures contracts as a form of risk insurance and to insure it of predictable prices. These futures contracts offset cocoa inventories held by Y. The futures contracts are hedging transactions exempted from the straddle rules.119 However, if the only shareholders of Z were individual investors or traders who speculated in cocoa futures, positions of Z offsetting positions of its shareholders could cause their stock in Z to be treated as positions in personal property offsetting positions held by them individually.
119§§1092(e), 1256(e).
3.	"Substantially Similar or Related Property" (SSRP) and "Personal Property": Regs. §1.246-5, §1.1092(d)-2 and Prop. Regs. §1.1092(d)-2"
a.	Introduction
Section 246(c)(1) disallows the dividend received deduction to which a corporate shareholder would otherwise be entitled under §243: (1) unless the corporation has held the dividend-paying stock for more than 45 days during the 91-day period beginning on the date that is 45 days before the date on which such stock becomes ex-dividend with respect to such dividend, or (2) to the extent the taxpayer is under an obligation (whether under a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. Section 246(c)(4) contains provisions tolling the required 46-day holding period. Among these is §246(c)(4)(C), under which the period is tolled for any period during which, "under regulations prescribed by the Secretary, a taxpayer has diminished his risk of loss by holding one or more other positions with respect to substantially similar or related property."120
120For more discussion of the treatment of dividends, as well as the treatment of certain preference dividends, see 764 T.M., Dividends -- Cash and Property.
Regs. §1.246-5 defines the meaning of "substantially similar or related property" and "diminished risk of loss" for purposes of §246(c)(4)(C). At the same time such regulations were issued, Treasury also issued Regs. §1.1092(d)-2, which provides that, for purposes of the rule under pre-2004 AJCA §1092(d)(3)(B)(i)(III), the term "substantially similar or related property" is defined in Regs. §1.246-5 (other than Regs. §1.256-5(b)(3) defining "position" which, under §246(c)(4)(C) may also include stock).121  Thus, Regs. §1.246-5 governs the definition of the phrase "substantially similar or related property" (hereinafter referred to as SSRP) as used in the provisions of pre-2004 AJCA §1092(d)(3)(B)(i)(III) set forth above.122 Its definition of "diminished risk of loss" is also relevant to the interpretation of §1092(d), since §1092(c)(2)(A) states that the taxpayer holds "offsetting positions with respect to personal property" (the definition of a straddle provided by §1092(c)(1)) if "there is a substantial diminution of the 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 (whether or not of the same kind)."
121Regs. §1.1092(d)-2 was promulgated before the removal of §1092(d)(3)(B)(i)(III) by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888(a), effective for positions established on or after Oct. 22, 2004. However, presumably, Regs. §1.1092(d)-2 remains relevant in the case of positions established on or before Oct. 21, 2004. The phrase "substantially similar or related property" also is defined as it is in Regs. §1.246-5 when that phrase is applied retroactively to positions established before Mar. 17, 1995, under the effective date rule in Regs. §1.1092(d)-2(b)(2). See TAM 200033004. See also TAM 200049006 (advising that, for purposes of Regs. §1.1092(d)-2(b)(2), such an option on a stock index is limited to options on stock indexes on which there are regulated futures contracts, and does not apply to private "custom" stock indexes).
122Like Regs. §1.1092(d)-2, Regs. §1.246-5 was promulgated before the removal of §1092(d)(3)(B)(i)(III) by the 2004 AJCA, P.L. 108-357, §888(a), effective for positions established on or after Oct. 22, 2004. However, presumably, Regs. §1.246-5 remains relevant in the case of positions established on or before Oct. 21, 2004.
Note: As noted in footnotes above, §1092(d)(3)(B)(i)(III) was removed by the 2004 American Jobs Creation Act (2004 AJCA). The regulations relating to this section have not been amended, and, presumably, continue to apply to situations relating to positions established on or before October 21, 2004.123
123See 2004 AJCA, P.L. 108-357, §888(a) (removing §1092(d)(3)(B)(i)(III)), effective for positions established on or after Oct. 22, 2004.
In May 1995, proposed regulations were issued under §1092(d)124 clarifying the definition of "personal property" under §1092(d)(1) as it applies to stock. Prop. Regs. §1.1092(d)-2 incorporates, with certain modifications, Regs. §1.1092(d)-2, which it expands.
124FI-21-95, 60 Fed. Reg. 21482 (5/2/95).
This section of the portfolio first analyzes those provisions of Regs. §1.246-5 that are applicable to Regs. §1.1092(d)-2 and Prop. Regs. §1.1092(d)-2. Next, Prop. Regs. §1.1092(d)-2, is analyzed, with emphasis on its provisions stating that an equity swap may be treated as SSRP that diminishes the risk of loss from the taxpayer's stockholdings and the implications of these new provisions.
About two years before the publication of Regs. §§1.246-5 and 1.1092(d)-2, the Treasury Department published a set of proposed regulations addressing the same subjects.125 Public comments caused Treasury to reconsider certain aspects of the proposed rules. The final regulations omit several examples that were in the proposed regulations but retain, with some minor modifications, the definition of SSRP and diminished risk of loss. The final regulations also provide new mechanical rules for determining the extent to which a position that reflects the values of a portfolio of stocks is, with respect to stock held by the taxpayer, SSRP. While, as stated above, the provisions of the regulations under §246(c) are to be applied, generally, to §1092(d), this can be done only by taking into account the different objectives of the statutory provisions involved. Certain of the rules of Regs. §1.246-5, which carry out the objective of restricting the dividend received deduction, obviously do not apply to the straddle rules, whose objectives are quite different.
12558 Fed. Reg. 45080 (5/27/93).
b.	Substantially Similar or Related Property (SSRP); Diminished Risk of Loss: Basic Rules
Regs. §1.246-5(b)(1) provides that the term SSRP is applied according to the facts and circumstances in each case. However, the final regulation does provide following general, basic rules.
Property is substantially similar or related to stock when:
(i) The fair market values (FMVs) of the stock and the property primarily reflect the performance of --
(A) A single firm or enterprise;
(B) The same industry or industries; or
(C) The same economic factor or factors such as (but not limited to) interest rates, commodity prices, or foreign currency exchange rates; and
(ii) Changes in the FMV of the stock are reasonable expected to approximate, directly or inversely, changes in the FMV of the property, a fraction of the FMV of the property, or a multiple of the FMV of the property.
Similar broadly phrased basic rules were set forth in the proposed regulations.
Regs. §1.246-5(b)(2) further provides that a taxpayer has diminished its risk of loss on its stock by holding positions with respect to SSRP if changes in the FMV of the stock and the positions are reasonably expected to vary inversely.
Finally, under the final regulations, "reasonable expectations" are those of a reasonable person based on all the facts and circumstances on the later of the time the stock is acquired or the positions are entered into, and include all explicit or implicit representations made with respect to the marketing or sale of the positions.126
126Regs. §1.246-5(b)(4).
Thus, the rules interpreting §246(c)(4)(C) and pre-2004 AJCA §1092(d)(3)(B)(i)(III)127 address the same issues regarding a position held by the owner of stock; namely, (1) Is the position one with respect to substantially similar or related property? and (2) Does the position diminish the risk of loss on the stock? The sole difference between the two Code sections is that, for purposes of pre-2004 AJCA §1092(d)(3)(B)(i)(III),128 the position must be a position other than stock. Thus, as the legislative history of §1092(d)(3) points out, where a taxpayer holds stock and enters into a short sale of the same or substantially identical stock, he is not considered to hold a straddle as defined by §1092(c) even though his holding period for the stock is tolled under §246(c)(4).129
127The 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888, removed §1092(d)(3)(B)(i)(III), effective for positions established on or after Oct. 22, 2004.
128The 2004 AJCA, P.L. 108-357, §888, removed §1092(d)(3)(B)(i)(III), effective for positions established on or after Oct. 22, 2004.
129See Joint Comm. on Tax'n, General Explanation of the Tax Provisions of the Deficit Reduction Act of 1984, at p. 309: "[s]tock offset by another position (other than an option) in substantially similar or related stock, which may result in a reduction in a corporate taxpayer's holding period for purposes of the dividend received deduction does not constitute a straddle."
Comment: As will be explained below, it cannot be concluded as axiomatic, given the definition of SSRP set forth above, that any property the changes in the value of which can reasonably be expected to approximate those of the stock held by the taxpayer must be SSRP. Changes in the fair market value of a diversified portfolio of stocks can be expected, under some circumstances, to approximate changes in the value of a broadly based stock index. However, this does not, ipso facto, make the index SSRP to the stock portfolio. On the other hand, once it is established that a given position is SSRP to the stock held by the taxpayer, a short position with respect to such position automatically diminishes the risk of loss from the stockholdings.
If one excludes short sales, there are very few positions in property other than stock that fulfill the above requirements for SSRP. Two positions that do meet the requirements to be SSRP are mentioned in the legislative history, above. The first, a convertible debt instrument, qualifies only if its fair market value (FMV) is unaffected by factors (such as market interest rates) other than changes in the FMV of the stock. This may be true of some convertible instruments but not true of others. The second possibility is a short position with respect to a stock index. This, however, gives rise to problems discussed below. There is a third possibility raised in the 1993 proposed regulations, which contained an example of a taxpayer holding nonparticipating, fixed-term preferred stock offset by a short position in interest rate futures (based on Treasury securities). The example concluded that fluctuations in interest rates could reasonably be expected to affect the values of the two positions inversely in approximately the same amounts. The example was withdrawn from the final regulations, however, after commentators pointed out that, in some cases, the FMV of the preferred stock could be affected by factors other than interest rate fluctuations (e.g., changes in the issuer's credit rating). The preamble to the final regulations cautions, however, that in this situation the interest rate futures position may or may not be SSRP depending on the facts and circumstances.130 Taxpayers should, therefore, be advised that the IRS will carefully scrutinize any positions in instruments that are technically equity interests but which have substantial debt-like characteristics that are offset by short interest rate futures.
13060 Fed. Reg. 14636, 14637 (3/20/95).
c.	Special Rules
Probably the most difficult interpretative issue in applying these rules is the extent to which short positions in respect to stock indexes are considered to fulfill the requirements to be SSRP. Fluctuations in the value of the stock of any corporation reflect both the risks that are inherent in the business operations of that particular corporation and also risks that are relatively common to all business entities. Thus, a given company's profits may rise (or fall) dramatically during a period in which the major widely based stock indices (Dow, S & P 500, NYSE Composite) are relatively stable. There are two categories of risks that may affect the value of a stock or a portfolio of stocks. First, there are risks that reflect those factors to which a given corporation is peculiarly sensitive. These are termed "nonsystematic," as distinguished from the "systematic" risk which reflects factors that affect the performance of the stock market considered as a whole. Nonsystematic risk can be reduced through diversification. Studies have shown that significant nonsystematic risk reduction can be achieved by holding a portfolio with as few as ten stocks issued by unrelated issuers.131 A taxpayer, the value of whose stock holdings reflects nonsystematic risk, will, generally, not be able to hedge such risk effectively by acquiring a short position in any stock index RFC. Futures trading in stock indexes are limited to those which are broadly based (e.g., MMI, S & P 500, NYSE Composite), fluctuations in the value of which reflect only systematic risk. There are available, however, exchange-traded options on more narrowly based indices. In addition, an investor can obtain, in the over-the-counter market, short positions on indices that are limited to the stocks of corporations in a particular industry.
131For a discussion of modern portfolio and capital asset pricing theory, see Malkiel, A Random Walk Down Wall Street (1990 ed.), at pp. 215-237.
The preamble to the final regulations notes that commentators suggested that the general rule of the proposed regulations that two portfolios of stock are SSRP solely by reason of the fact that changes in their FMVs are reasonably expected to approximate each other did not give effect to the statement in the legislative history of the relevant statutory provisions that the SSRP standard is not satisfied merely because the taxpayer is an investor with diversified holdings and acquires a RFC or option on a stock index to hedge general market (i.e., systematic) risk.132 It was suggested that even if changes in value of the two position are expected to approximate each other, the SSRP standard should be met only if the portfolios substantially overlap. This suggestion was adopted in drafting the final regulations, and is embodied in the new "Special Rules" of Regs. §1.246-5(c)(1)(i) through  (iv).
13260 Fed. Reg. 14636, 14637 (3/20/95).
If a taxpayer holds stock in B, C, D, and E corporations and also holds a short position in an index whose value reflects predominantly the values of stocks C, D, and E, the short position would seem clearly to be SSRP; not only will changes in the values of the taxpayer's stockholdings in such a case reasonably be expected to approximate, inversely, changes in the value of the index, there is substantial overlap between stocks C, D, and E. However, if the taxpayer also has substantial investments in half a dozen more stocks whose values are not represented in the index, it may be less clear, even if changes in the values of the stock held and the index position approximate each other due to their sensitivity to certain economic factors, that the index position meets the SSRP test. The IRS and Treasury concluded that this problem cannot be resolved by examples, but only by some clearly stated rules of general application.
The regulations accomplish the objective described, above by applying a mechanical test. In the following discussion, the stockholdings of the taxpayer are referred to as the SP (shareholder's position) and the stock whose value is represented in the index is referred to as the IP (index position). A list is drawn up of all the stock in the SP with the fair market value (FMV) of each holding; (e.g., ABC Corp. 500 shares $100 - $50,000). A similar list is made of all of the stock represented in the IP with the FMV of each stock so represented, (e.g., ABC Corp. 250 shares $100 - $25,000). Then, there is composed a "Subportfolio" which contains a list of each stock if it is both held by the taxpayer and is represented in the IP followed by the lower of the FMV of the SP or that of the IP; (e.g., ABC Corp. - $25,000) using the figures presented above. Where a stock in the SP is not represented in the IP, it is not listed in the Subportfolio, and vice versa (stock is represented in the IP that is not in the SP). In applying this test, the IP must represent the values of at least 20 stocks of unrelated issuers.
(1)	Portfolios (Indices) Representing the Values of 20 or More Stocks
A position reflecting the value of a portfolio of stocks is SSRP to the stocks held by the taxpayer only if the position and the taxpayer's holding substantially overlap as of the most recent "testing date."133 The latter term means any day on which the taxpayer buys or sells any stock if the FMV of the stock or the FMV of the SSRP is reflected in the position, any day on which the taxpayer changes the position, or any day on which the composition of the position changes.134 Note that the term "position" refers to the property other than stock for purposes of §1092(d) (stock index, for purposes of this discussion). A position may be SSRP to a taxpayer's entire stockholdings or a portion of the stockholdings.
133Regs. §1.246-5(c)(1)(ii).
134Regs. §1.246-5(c)(1)(iv).
To determine whether "substantial overlap" exists, once the stocks and values listed in the Subportfolio, described above, has been determined, the ratio of the value of the Subportfolio to the value of the stocks represented in the IP is determined. If this ratio equals or exceeds 70%, there is substantial overlap and, accordingly, the IP is SSRP with respect to the SP. If this calculation shows that no substantial overlap exists, the values represented in the IP are reduced by a percentage and a new Subportfolio value is determined. If the Subportfolio/IP ratio is 70% or more, there is substantial overlap to the extent of the 100% less the percentage reduction described.
Example: SP contains holdings of the stocks of corporations C through V, with the exceptions of K and Q, (18 stocks in all), with a FMV of $4,200. The IP represents the values of the stock of all the corporations C through V (20 stocks in all) with a FMV of $6,750. The Subportfolio, with 18 stocks represented, has a FMV of $4,100. The ratio 4,100/6750 is only 60.74% and the substantial overlap test is, thus, not satisfied. Next, the values of all the stocks represented in the IP are reduced by 20%, and a revised Subportfolio is calculated.135 Here, the FMV of the stocks in the IP is $5,400 (i.e., $6,750 less 20%) and of those represented in the Subportfolio is $3,780. The Subportfolio/IP ratio is now exactly 70%. Thus, the IP is SSRP with respect to 70% of the taxpayer's stockholdings. Obviously the ideal manner in which to carry out these calculations, that is, to determine by exactly what percentage the values of stocks represented in the IP must be reduced to produce a 70% overlap, is by means of a computer spreadsheet or similar program.
135The regulations, in what the author suggests is an overly convoluted and confusing explanation of this procedure, provide that "[t]he largest percentage of the position that results in a substantial overlap is substantially similar or related to the Subportfolio determined with respect to that percentage of the position." Regs. §1.246-5(c)(1)(iii).
Note: These rules determine the percentage of the taxpayer's stockholdings considered to be offset by the short index position. Where this was less than 100%, regulations were to be issued under pre-2004 AJCA §1092(c)(2)(B)136 to provide rules for determining the application of the straddle rules. These regulations were never issued and in 2004, the 2004 AJCA revoked this regulatory authority.
136The 2004 AJCA, P.L. 108-357, §888(a), removed §1092(c)(2)(B), effective for positions established on or after Oct. 22, 2004.
The explanation of the special rules applicable to index positions representing 20 or more stocks is taken from the regulations.137 In view of the considerable diversification of the stock position (18 issues) and of the stocks represented in the index, it can be assumed that changes in value of each will reflect general market (systematic) risk to a considerable degree. In this situation, the taxpayer would be well advised to select another index with a comparable degree of diversification to hedge his stockholdings. There is no reason to become needlessly entangled in the straddle rules. Finally, the important point made by these special rules is that even if changes in the value of a stock portfolio and an index can reasonably be expected to approximate each other, this does not automatically make the index property SSRP to the stock unless there is substantial overlap. Thus, systematic risk can be effectively hedged without the stock and index positions being treated as a straddle.
137Regs. §1.246-5(d), Ex. 3.
(2)	Index Positions Representing Less Than 20 Stocks
A rule is supplied for nonportfolio (i.e., with fewer than 20 stocks represented) positions. A position that represents the value of more than one, but less then 20, stocks is treated as a separate position with respect to each of the stocks the value of which the position reflects.138 In other words, assume the taxpayer holds shares of corporations X, Y, and Z and the nonportfolio (narrowly based index) position reflects the values of stocks Y, Z, and M. The degree of overlap is presumably determined solely on the basis of the FMV of the shares held and of the stocks represented in the index on a stock-by-stock basis. If the taxpayer holds 100 shares of Y but the index position reflects the value of only 10 shares of Y, the index position is SSRP with respect to 10% of the Y stock held by the taxpayer.
138Regs. §1.246-5(c)(1)(v).
d.	Anti-abuse Rule
As has become the Treasury Department's usual practice, the §246 regulations contain an "anti-abuse" rule under which, notwithstanding the mechanical special rules explained above, a position that reflects the value of more than one stock is SSRP to "an appropriate part of the taxpayer's holdings," if: 
(A) Changes in the value of the position or the stocks reflected in the position are reasonably expected to virtually track (directly or inversely) changes in the value of the taxpayer's stock holdings, or any portion of such holdings and other positions of the taxpayer,139 and
(B) The position is held or acquired as part of a plan principal purpose of which is to obtain tax savings (including deferral) the value of which is significantly in excess of the expected pre-tax economic profits from the plan.
139Regs. §1.246-5(c)(1)(vi)(A).
Note: As Regs. §1.246-5(d), Ex. 3, from which the discussion of the "substantial overlap" special rules is drawn, indicates, the percentage of overlap derived by applying the formula under the special rules may be overridden (increased) by application of the anti-abuse rule, where appropriate.140
140Regs. §1.246-6(c)(1)(vi)(B).
e.	Options, Stacking Rule, Guarantees, and Hedges
Apart from the special rules set forth above, the regulations provide a number of other general rules. 
(1) A substantially out-of-the money option to sell does not diminish the taxpayer's risk of loss on its stock "unless the option is held as part of a strategy to substantially offset changes in the FMV of the stock."141 The regulations do not indicate, however, what such a strategy might be. Thus, an example would be helpful.
(2) Notwithstanding the definitions of SSRP and "diminished risk of loss" set forth above, the regulations provide that the following transactions involving convertible preferred or convertible debentures are treated as diminishing the taxpayer's risk of loss by its holding of SSRP:142
(i) A short sale of common stock while holding convertible preferred of the same issuer and the price changes of the convertible preferred and the common stock are related.143
(ii) A short sale of a convertible debenture while holding convertible preferred stock into which the debenture is convertible144 or common stock;145 or
(iii) A short sale of convertible preferred stock while holding common stock.
(3) The regulations also provide a "stacking rule." Under this rule, if the taxpayer diminishes its risk of loss by holding a position in SSRP with respect to only a portion of the shares held of a particular stock, the holding period of the shares having the shortest holding period is reduced.146
(4) The regulations also provide the somewhat obvious rule that a guarantee, surety agreement or similar arrangement that will substantially offset decreases in the FMV of the taxpayer's stock is treated as a position in SSRP to the stock.147
(5) Hedges are counted only once under the regulations. The regulations state that a position (position H) established as a hedge of one outstanding position transaction or obligation (position P) is not treated as diminishing the risk of loss from another position (position P2) held by the taxpayer. While no identification requirements are provided to determine which positions are position P and position H, it is stated that deference will be given to the "relationships established in [the taxpayer's books and records at the time the position is entered into.]"148
141Regs. §1.246-5(c)(2)(i).
142Regs. §1.246-5(c)(2)(ii).
143Note, however, that §1092's legislative history makes it clear that a position with respect to SSRP (other than stock) does not include direct ownership of stock or a short sale of stock. Thus, the above rule would seem to apply only for purposes of §246(c).
144Is this a typographical error? Shouldn't the reference be to preferred stock into which the debenture is convertible; a debenture convertible into convertible preferred makes little sense.
145Shouldn't this also be common into which the debenture is convertible? In the legislative history on which these rules are based, the convertible debenture language reads quite clearly as follows: "a short sale of a convertible debenture while holding stock into which the debenture is convertible . . . ." See Joint Comm. on Tax'n, General Explanation of the 1984 TRA, at p. 143.
146Regs. §1.246-5(c)(3).
147Regs. §1.246-5(c)(4).
148Regs. §1.246-5(c)(5).
f.	Use of Related Persons or Pass-Through Entities
The regulations provide that positions of a party related to the taxpayer (within the meaning of §§267(b) and 707(b)(1)) are treated as held by the taxpayer if they are held with a view to avoiding the application of these regulations. Further, a taxpayer is treated as diminishing its risk of loss by holding SSRP if it holds an interest in, or is the beneficiary of, a pass-through entity, intermediary, or other arrangement with a view to avoiding the application of these regulations.149
149Regs. §1.246-5(c)(6). Regs. §1.1092(d)-2(a) provides that this rule does not narrow the related party rule of §1092(d)(4), discussed below.
g.	Notional Principal Contracts
The payments that are due from the counterparties to a notional principal contract (NPC) are usually netted (see general discussion at V, II, B, below). Regs. §1.246-5(c)(7) provides that, for purposes of these regulations, payments under NPCs are considered separately. Hence, if a taxpayer is treated as receiving payments under a NPC when the FMV of the taxpayer's stock declines, there is a diminution of risk of loss from holding a position in SSRP regardless of the netting of payments. This provision is further clarified in Prop. Regs. §1.1092(d)-2, which is discussed below.150
150FI-21-95, 60 Fed. Reg. 21482 (5/2/95).
h.	Examples
Some of the examples provided in Regs. §1.246-5 relate only to the provisions of §246. They will not be discussed herein.
The examples in the regulations clarify that changes in the value of the stock of an automobile manufacturer are, as a general rule, not reasonably expected to approximate those of the stock of another, independent automobile manufacturer, since numerous factors other than the general level of growth in the automotive industry play a significant role in stock values.151 However, where the value of the stock of two corporations reflects preponderately the value of a commodity (two corporations that hold gold as their principal asset, for example), the stock of one is SSRP to the stock of the other.152 In another example, taxpayer X hedges its $100 million portfolio of stocks by entering into a $100 million short stock index RFC on January 15, 1996, with a March delivery date. The stock portfolio would substantially overlap with the index RFC. On January 15, 1996, X also enters into a $75 million long position with respect to the same index RFC with a June delivery date. It is established from X's books and records from an entry made on January 15 that the long and short index RFCs were intended to offset one another. Under these circumstances, $75 million of the short index RFC is not treated as diminishing the risk of loss from the stock portfolio. Instead, the long and short RFC positions are treated as a straddle or hedging transaction, as appropriate, with respect to the $75 million long position and $75 million of the short position. Of the short index RFC, $25 million is treated as diminishing the risk of loss on the portfolio by holding a position in SSRP. The special rules of Regs. §1.246-5(c) are then applied to determine the overlap percentage, as explained above.
151Regs. §1.246-5(d), Ex. 1.
152Regs. §1.246-5(d), Ex. 4.
i.	Prop. Regs. §1.1092(d)-2
On May 1, 1995, proposed regulations were issued clarifying Regs. §1.1092(d)-2 153 under which, in turn, the rules of Regs. §1.246-5 are applied, generally, to determine whether an offsetting position is a position with respect to SSRP (other than stock) within the meaning of pre-2004 AJCA §1092(d)(3)(B)(i)(III).154 These rules are explained above.
153FI-21-95, 60 Fed. Reg. 21482 (5/2/95).
154The 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888(c), removed §1092(d)(3)(B)(i)(III), effective for positions established on or after Oct. 22, 2004. Regs. §1.1092(d)-2 was promulgated removal of §1092(d)(3)(B)(i)(III) by the 2004 AJCA. However, presumably, Regs. §1.1092(d)-2 remains relevant in the case of positions established on or before Oct. 21, 2004.
Prop. Regs. §1.1092(d)-2(a) clarifies the meaning of "personal property" as defined by §1092(d)(1). It includes any actively-traded stock, where such stock is part of a straddle at least one of the offsetting positions of which is an option with respect to the stock (or substantially identical stock or securities) or is a position with respect to SSRP (other than stock).155 Personal property also includes any stock, whether or not actively traded, of a corporation formed or availed of to take positions in personal property, as defined by §1092(d)(1), that offset positions taken, directly or indirectly, by any shareholder.156
155Prop. Regs. §1.1092(d)-2(a)(1).
156Prop. Regs. §1.1092(d)-2(a)(2).
Comment: These provisions more or less restate the statutory provisions with the significant clarification (based on the legislative history) that even where offset by SSRP, stock is not personal property unless actively traded (aside from the rule relating to stock of a company availed of to take positions offsetting those of a shareholder).
The proposed regulations then restate the provisions of Regs. §1.1092(d)-2(a) that, for purposes of pre-2004 AJCA §1092(d)(3)(B)(i)(III),157 the term SSRP is defined in Regs. §1.246-5 (other than §1.246-5(b)(3)) and that the related party rule of Regs. §1.246-5(c)(6) does not narrow the related party provisions of §1092(d)(4).158
157The 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888(c), removed §1092(d)(3)(B)(i)(III), effective for positions established on or after Oct. 22, 2004. Regs. §1.1092(d)-2 was promulgated removal of §1092(d)(3)(B)(i)(III) by the 2004 AJCA. However, presumably, Regs. §1.1092(d)-2 remains relevant in the case of positions established on or before Oct. 21, 2004.
158Prop. Regs. §1.1092(d)-2(b). These points were covered in the discussion of Regs. §1.1246-5, above.
In addition, the proposed regulations clarify that a position with respect to SSRP (other than stock) does not include direct ownership of stock or a short sale of stock, but does include any other position with respect to SSRP.159
159Prop. Regs. §1.1092(d)-2(c).
As was indicated in the discussion of Regs. §1.246-5(c)(7), a notional principal contract (NPC) can be a position that is SSRP with respect to stock held by the taxpayer. There appear to have been brought to the attention of the the Treasury Department some well advertised securities transactions that might permit avoidance of the straddle rules. These were so-called "executive equity swaps." An equity swap is an agreement between two parties, the "equity payor" (EP) and the "floating-rate payor" (FLP)160 under which the EP agrees to make periodic payments to the FLP in an amount equal to: (1) all dividends paid on the stocks contained in notional portfolio during the period preceding the payment date, and (2) any appreciation in the FMV of such stocks during this period. In return, the FLP agrees to make payments to EP in an amount equal to: (1) an agreed rate of interest (usually a rate based on some publicly announced interest index, such as LIBOR, the federal yield curve, etc.) multiplied by the value of the notional portfolio; and (2) depreciation during the period in the FMV of the stocks in the portfolio. Payment dates may be quarterly, semiannually, annually, or at such other periods agreed on. Usually, the value of the notional portfolio is adjusted to its FMV at each payment date. The payments, as in the case of other types of swaps, are netted. The resulting position of the FLPs is the same as if the FLP had made a leveraged purchase of the stocks in the notional portfolio.
160For an analysis of equity swap transactions, see, Kleinbard, "Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System," 69 Tex. L. Rev. 1319 (1991).
Swaps of this kind (some of which provide for FLP payments based on various financial data including, perhaps, even the yield of another notional stock portfolio) have been popular with to corporate executives holding large blocks of stock in their employer who seek either to achieve the effect of diversification or to realize cash with which to make alternative investments. The latter is facilitated by the willingness of the investment banker, playing the role of the FLP swap counterparty, to make a loan secured by the executive's interest in the swap.161
161For a discussion of "executive equity swaps," see Sheppard, "Equity Swaps: The Other Shoe Drops," 67 Tax Notes 721 (5/8/95).
As stated above, a stockholder entering into an equity swap is protected against any diminution in the FMV of his portfolio (provided the stocks are those that make up the notional portfolio), but, in return, forfeits any dividends and capital gains. Thus, the shareholder's position is, from an economic standpoint, almost the same as if he had sold his stockholding short against the box.
Prop. Regs. §1.1092(d)-2(d) provides an example that sets forth the rules and interpretative justification for the treatment of equity swaps entered into by a taxpayer who holds stock reflected in the notional portfolio. 
Taxpayer [B], on September 29, 1995, holds 10,000 shares of actively-traded X stock with a FMV of $1 million. On that date, he enters an equity swap agreement with unrelated counterparty C. [B] is the EP and C the FLP. The notional portfolio is 10,000 shares of X stock. Payment dates are quarterly. The interest payable by FLP on the FMV of the notional portfolio is three month LIBOR.
The issue posed by these facts is whether the position of B constitutes a straddle. A straddle is defined by §1092(c) as offsetting positions in personal property. The regulations conclude that because holding the swap substantially diminishes B's risk of loss from holding X stock, the X stock and swap are "offsetting positions" within the meaning of §1092(c). But B holds a straddle only if both the stock and the swap are positions in personal property. It is first determined whether the swap position is personal property, and next whether the stock position is also personal property.
For positions established on or after October 22, 2004, the stock exception is repealed, however, for positions established on or before October 21, 2004, while the definition of personal property provided by pre-2004 AJCA §1092(d)(3)(A) generally excluded stock, its second sentence provided that this general rule did not apply to "an interest in stock" (other, as has been seen, than direct ownership or a short sale of stock). The example, citing this exception to the general rule, concludes that an equity swap is an "interest in stock," and that it, thus, is "personal property."
Prior to the 2004 AJCA, which, as noted above, repealed the stock exception, there remained the problem of whether the stock was also personal property. As stated above, under pre-2004 AJCA §1092(d)(3)(B), stock was personal property only in certain circumstances. One of these was stock that was part of a straddle at least one of the positions of which was a position with respect to SSRP (other than stock), the rule of pre-2004 AJCA §1092(d)(3)(B)(i)(III). The example in the proposed regulations concludes that this provision applies. The swap contract is a position in property that is SSRP to the X stock because Bis entitled to payments attributable to a decline in the FMV of the X stock.
Finally, pre-2004 AJCA §1092(d)(3)(C) provided that for purposes of subparagraph (B), subsection (c) was applied as if stock described in clause (i) of subparagraph (B) were personal property.
On the basis of this somewhat convoluted interpretative reasoning from the statutory provisions, it is concluded that the X stock and equity swap constitute a straddle since both positions are positions in personal property and the swap position offsets the stock position.
One commentator 162 has suggested that essentially the same end sought by entering into an executive equity swap can be achieved by a short sale against the box. This would probably involve more transaction costs and use of the sale proceeds is restricted for most investors.
162Id.
C. Section 1256 Contracts Defined
The two major prongs of the tax straddle rules consist of: (1) the rule that all "§1256 contracts" be "marked to market" at year end,163 and (2) the loss deferral rule of §1092. Since the term "§1256 contract" is used throughout the straddle rules, the meaning of this term is discussed before the straddle rules are analyzed.
163See §1256(a)(1).
 A "§1256 contract" is any regulated futures contract (RFC); any foreign currency contract; any nonequity option; any dealer equity option; or any securities future contract.164
164§1256(b)(1) through  (5).
1.	Regulated Futures Contract
The definition of an RFC and the system of marking to market are discussed above at III, C. An RFC is a contract "with respect to which the amount to 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."165 As explained above, this definition includes all commodity futures contracts traded in domestic exchanges and on those foreign exchanges which the IRS determines have rules adequate to carry out the purposes of §1256.
165§1256(g)(1). See, e.g., FSA 200041006 (investor's regulated futures contracts fit the category of "on or subject to" under §1256(g)(1) and should be treated as sold at fair market value on the last business day of the year). The meaning of "qualified board or exchange" was discussed in III, B, 1, b, above.
Comment: Although it is common to refer to the acquisition of a long futures position as "buying" and a short position as "selling" a contract or contracts, the entering into a futures contract does not constitute the purchase or sale of property. Nevertheless, except in the case of a hedging transaction,166 the termination of the holder's rights and obligations under a futures contract by acquiring an offsetting contract, mediated by a clearing organization, was held to constitute the sale or exchange of a capital asset long before the straddle rules were enacted.167
166See §1256(e). The meaning of this term is discussed in V, F, 3, below.
167See Covington v. Comr., 120 F.2d 768 (5th Cir. 1941). Under §1234A, gain or loss from the cancellation or termination of: (1) any right or obligation with respect to property which is (or on acquisition would be) a capital asset, or (2) a §1256 contract which is a capital asset is treated as capital gain or loss from the sale of a capital asset. The cited case law and statute overcome the problem posed by the fact that the holder of a futures contract actually has no basis in the contract. When the contract is closed out, the holder's rights and obligations under it are terminated. Gain or loss will have been realized by virtue of the daily marking to market. The initial margin posted is recovered (less any amount applied to cover commissions and payments due the clearing organization).
2.	Foreign Currency Contract
The definition of a foreign currency contract (referring primarily to forward purchases or sales of foreign currency)168 contains three elements. First, the contract must require the delivery of (or the settlement of which depends on the value of) a foreign currency which is a currency in which positions are also traded through RFCs.169 Thus, a forward contract to purchase or sell Italian lire is not a §1256 contract.
168Forward sales of foreign currency, while sometimes entered into for speculation only, are almost exclusively a means of hedging exposure to foreign exchange rate fluctuation by various business concerns and financial institutions issuing or receiving debt instruments denominated in currencies other than the U.S. dollar. Foreign currency futures may also be used as hedges, but because of the standard contract terms are usually unsuitable for this purpose. In the 1980s, currency exchange hedging was effected to a large extent by swap agreements which offer a number of advantages over straight forward sales/purchases. Notably, they are not considered §1256 contracts. See FSA 200041006 (foreign currency contracts that were traded "over-the-counter" were not traded "on or subject to" an exchange); PLR 8818010.
169§1256(g)(2)(A)(i). Note that this definition excludes forward contracts with respect to a number of actively traded currencies for which RFCs are not available. For example, in 1989 foreign currency RFCs were traded only with respect to Australian and Canadian dollars, Sterling, West German marks, Swiss francs and Yen. RFCs were also traded in ECUs (European Currency Units), whose value is based on a basket of European currencies.
Second, the contract must be "traded in the interbank market."170
170§1256(g)(2)(A)(ii).
Comment: The meaning of this phrase is unclear. Foreign currencies are traded in this market, but a party's rights and obligations under a forward contract are not generally subject to assignment without the consent of the other party. Nevertheless, it is clear that a forward contract in any of the currencies for which RFCs are traded qualifies as a foreign currency contract under the definition.
Third, the contract must be entered into at arm's length at a price determined by reference to the price in the interbank market.171
171§1256(g)(2)(A)(iii). The reference here appears clearly to be to the interest rates established by the various central banks and financial institutions to the currencies involved. A forward contract, like a futures contract, is based on the spot rate for the currency plus the cost of carry (interest) to maturity. §1256(g)(2)(B) authorizes regulations to carry out the purposes of this definition which may exclude contracts falling within its literal terms if its application would be inconsistent with such purposes. It should be noted that §1256 applies to so-called foreign exchange swaps (not to be confused with foreign currency swaps) which consist of two forward contracts entered into at the same time with the same counterparty. These transactions are discussed in Spooner, "Tax Consequences of Trading Foreign Currencies in the Spot, Forward, Future and Swap Markets," 2 J. Bank Tax'n 19 (1988).
Note: While collateral is sometimes required by the bank or other financial institution engaging in a forward sale or purchase of foreign currency, and the arrangement between the bank and its customer may include the posting (and right to withdraw) amounts similar to the variance margin applicable to RFCs, this is not strictly required by any regulatory body similar to the clearing organization of a futures exchange.
Of course, a regulated futures contract for any foreign currency qualifies as a §1256 contract under §1256(g)(1).
3.	Nonequity Option; Dealer Equity Option
The meaning of nonequity option is discussed above at III, B, 2. Examples are listed options on commodities, commodity futures, foreign currencies, financial instruments and broad based stock indexes. However, unlisted options, i.e., options other than those traded on or subject to the rules of a "qualified board or exchange," are not §1256 contracts.
Note: Certain offsetting foreign currency contracts constitute "listed transactions" under Regs. §§1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112-1(b)(2).172 Where a taxpayer claims a loss upon the assignment of a §1256 contract (a foreign currency contract consisting of a put and a call option on a foreign currency traded through regulated futures contracts) to a charity but fails to report the recognition of gain when the taxpayer's obligation under an offsetting non-§1256 contract (a put and a call option on a foreign currency not traded through regulated futures contracts) terminates, the IRS and Treasury have concluded that such transactions are tax avoidance transactions. Accordingly, taxpayers must make the disclosures required for listed transactions under §§6111 and 6112.173
172Notice 2004-67, 2004-41 I.R.B. 600 (identifying these transactions as listed effective Dec. 4, 2003). For a discussion of required disclosures for listed transactions, see 634 T.M., Civil Tax Penalties.
173Notice 2004-67, 2004-41 I.R.B. 600.
A dealer equity option is an equity option granted or purchased by an options dealer (defined above in the discussion of option trading) in the course of the dealer's activity as a market maker or specialist in listed options.174 An options dealer can, of course, grant or acquire equity options in the course of trading outside of his market making activities, e.g., for investment purposes; these are not §1256 contracts.
174§1256(g)(4). A dealer equity option must be listed on the qualified board or exchange on which the dealer is registered. Id.
4.	Dealer Security Futures Contract
A "dealer security futures contract" is a securities futures contract 175 and any option on such contract, which is entered into by a dealer in the normal course of his activity of dealing in such contracts or options, as the case may be, and is traded on a qualified board or exchange.176 Securities futures contracts are discussed in greater detail in 188 T.M., Taxation of Equity Derivatives.
175As defined in §1234B.
176§1256(g)(9)(A). See also Rev. Rul. 2004-95, 2004-38 I.R.B. 492 (Category 1 and 2 OneChicago LLC Market Makers that satisfy certain market maker and dealer qualification quotation requirements specified in revenue ruling perform functions similar to options dealers and, thus, qualify as dealers in securities futures contracts within the meaning of §1256(g)(9)(B)); Rev. Rul. 2004-94, 2004-38 I.R.B. 491 (Tier 1, Tier 2, and Tier 3 NQLX Market Makers that satisfy certain market maker and dealer qualification quotation requirements specified in revenue ruling perform functions similar to options dealers and, thus, qualify as dealers in securities futures contracts within the meaning of §1256(g)(9)(B)); PLRs 200448036 and 200448034.
D. The Loss Deferral Rule of §1092(a)
1.	General: Statutory Provisions
As noted above, the straddle rules are constructed around two principal pillars: the loss deferral rule of §1092 and the mark-to-market rule of §1256. This section analyzes the loss deferral rule.
Section 1092(a) provides that any loss realized from the disposition of one or more positions of a straddle is taken into account for any taxable year only to the extent that the amount of such loss exceeds the "unrecognized gain" (if any) with respect to one or more positions which were offsetting positions with respect to one or more positions from which the loss arose.177
177§1092(a)(1)(A). The technical definition of the term "straddle" is discussed above, at V, B.
"Unrecognized gain" is defined in §1092(a)(3)(A)(i) as the amount that would be taken into account if the position were sold on the last business day (trade date) of the taxable year for its fair market value, even though such gain would not be realized until settlement.
Comment: In the case of the grantor of an option, "unrecognized gain" means the amount of gain which would be recognized if the grantor had entered into a closing purchase transaction on such last business day. In the case of a futures contract, it means the amount of gain which would be recognized if the contract were closed out through acquisition of an offsetting contract and both were assigned to the clearing organization on such last business day. In the case of a forward sale or purchase, it means the amount of gain which would be recognized if the holder of the contract were to assign his rights and obligations to a third person or to the counterparty for value.
Note: Gain that has been realized with respect to a position but is not recognized for tax purposes is also "unrecognized gain."178
178§1092(a)(3)(A)(ii).
A loss disallowed under this rule is carried over to the succeeding taxable year, where it is treated as having been realized from the disposition of the straddle position in that year. It will be allowed if at the end of that year the taxpayer holds no offsetting positions with unrecognized gain.179
179§1092(a)(1)(B). These rules are refined and expanded in Regs. §1.1092(b)-1T, discussed in detail in VI, below.
Example: On Mar. 15 of Year 1, B purchases 100 shares of XYZ stock at a price of $50 per share. On June 20 the stock price has advanced to $60 per share. On that date, B grants, for a premium of $20 per share, a call option to purchase XYZ with an exercise price of $40 per share. (B thus receives a total receiving premium of $2,000.) On Nov. 12, the stock price has declined to $45. On that date, B sells the stock sustaining a loss of $500. On Dec. 31, the stock price remains $45 and the call option has not been exercised. To terminate his obligation under the option, B would have to make payment of $600 (to purchase a $40 call). There is, thus, $1,400 of unrecognized gain from the call option. Since the loss from the sale of the stock ($500) does not exceed this amount, it may not be taken into account for Year 1. Assume that in Year 2, the option expires unexercised. In that year (provided B enters into no other transactions involving XYZ stock), B will recognize a $2,000 short-term capital gain from the option180 and may deduct the short-term capital loss of $500 carried over from Year 1.
180See §1234(b).
A straddle is made up of one or more long positions (LgPs) offset by one or more short positions (ShPs). A LgP is a position the value of which will increase as the value of the actively traded personal property to which it relates increases (and will decrease as the value of the property decreases). A ShP is one the value of which will increase as the value of the actively traded personal property to which it relates decreases (and vice versa). (The examples below illustrating straddle principles employ the symbols LgP and ShP.)
Regulations coordinating the wash sale and loss deferral rules are described in detail in VI, below. Briefly, the regulations extend these rules to deal with situations in which a position of a straddle is disposed of at a loss and a second, successor, position is acquired within 30 days before or after the date of the disposition of the loss position. A modified wash sale is first applied to disallow the loss sustained on the loss position provided the successor position is in "substantially identical" property. If the wash sale rule is inapplicable, then a modified loss deferral rule applies if there is unrecognized gain at year end in either the successor or its offsetting position.
With the exception of positions which are included in an identified straddle or which are property held in inventory or for sale to customers or depreciable property used in a trade or business, the holder must report in his tax return for the year all positions181 with respect to which there is unrecognized gain as of the close of the year and the amount thereof.182
181Referring to "positions" as defined above, i.e., interests in actively traded personal property. This would not include e.g., stock (unless part of a straddle) or securities denominated in U.S. dollars.
182§1092(a)(3)(C)(ii), as redesignated by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888(a), effective for positions established on or after Oct. 22, 2004.
This reporting requirement does not apply if no loss on any position (including an RFC) was sustained during the taxable year or if the only losses sustained were with respect to positions which were inventory or depreciable business property.183
183Id.
Section 1092 does not apply to any position which is part of a "hedging transaction," as that term is defined in §1256(e).184 The hedging transaction exception should not be confused with the rules relating to identified straddles.
184§1092(e). What constitutes a hedging transaction is discussed in detail below.
2.	Identified Straddles
a.	Positions Established On or After October 22, 2004
For positions established on or after October 22, 2004, the 2004 American Jobs Creation Act (2004 AJCA) substantially revised the identified straddle rules.185 Under the post-2004 AJCA Code, taxpayers generally are permitted to identify the offsetting positions that are components of a straddle at the time the taxpayer enters into a transaction that creates a straddle, including an unbalanced straddle.186
185See 2004 AJCA, P.L. 108-357, §888(a).
186See §1092(a)(2)(B)(i), as amended by the 2004 AJCA, P.L. 108-357, §888(a), effective for positions established on or after Oct. 22, 2004. However, to the extent provided by regulations, taxpayers are not permitted to identify offsetting positions of a straddle if the fair market value of the straddle position already held by the taxpayer at the creation of the straddle is less than its adjusted basis in the hands of the taxpayer. See id.
For positions established on or after October 22, 2004, an identified straddle is defined as any straddle:
(1) which is clearly identified on the taxpayer's records as an identified straddle before the earlier of: (i) the close of the day on which the straddle is acquired, or (ii) such time as the Secretary may prescribe by regulations.
(2) to the extent provided by regulations, the value of each position of which (in the hands of the taxpayer immediately before the creation of the straddle) is not less than the basis of such position in the hands of the taxpayer at the time the straddle is created, and
(3) which is not part of a larger straddle.187
187See §1092(a)(2)(B), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
If there is a loss with respect to any identified position that is part of an identified straddle, the general straddle loss deferral rules do not apply to such loss.188 Instead, the basis of each of the identified positions that offset the loss position in the identified straddle is increased by an amount that bears the same ratio to the loss as the unrecognized gain (if any) with respect to such offsetting position bears to the aggregate unrecognized gain with respect to all positions that offset the loss position in the identified straddle.189 Any loss with respect to an identified position that is part of an identified straddle cannot otherwise be taken into account by the taxpayer or any other person to the extent that the loss increases the basis of any identified positions that offset the loss position in the identified straddle.190
188See §1092(a)(2), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
189See §1092(a)(2)(A)(ii), as amended by the 2004 AJCA, P.L. 108-357, §888(a). For this purpose, "unrecognized gain'' is the excess of the fair market value of an identified position that is part of an identified straddle at the time the taxpayer incurs a loss with respect to another identified position in the identified straddle, over the fair market value of such position when the taxpayer identified the position as a position in the identified straddle. §1092(a)(3)(B), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
190See H.R. Rep. No. 755, 108th Cong., 2d Sess. 756-757 (2004).
In addition, the Code provides the Secretary authority to issue regulations that would specify (1) the proper methods for clearly identifying a straddle as an identified straddle (and identifying positions as positions in an identified straddle), (2) the application of the identified straddle rules for a taxpayer that fails to properly identify the positions of an identified straddle,191 and (3) provide an ordering rule for dispositions of less than an entire position that is part of an identified straddle.192
191For example, although the provision does not require taxpayers to identify any positions of a straddle as an identified straddle, it may be necessary to provide rules requiring all balanced offsetting positions to be included in an identified straddle if a taxpayer elects to identify any of the offsetting positions as an identified straddle. See H.R. Rep. No. 755, 108th Cong., 2d Sess. 757, n.866 (2004).
192See §1092(a)(2) (flush language), as amended by the 2004 AJCA, P.L. 108-357, §888(a).
As in the case of positions established on or before October 21, 2004, for positions established on or after October 22, 2004, where all the positions of a straddle are §1256 contracts, the loss deferral rule does not apply to the straddle.193 If an all-§1256 contract straddle is designated as an identified straddle,194 the loss deferral rule is not applied to defer recognition of a loss sustained from the disposition of one or more positions outside the straddle by reason of the fact that one or more of the positions of the identified straddle is offsetting to such outside loss position(s).195
193§1256(a)(4). Section 263(g) (providing interest and carrying charge capitalization rules), discussed below, also does not apply. However, in the case of a straddle at least one (but not all) of the positions of which are §1256 contracts, both of these sections apply to any §1256 contract and any other positions making up the straddle. §1092(d)(5)(A). See §263(g)(1).
194As provided by §1092(a)(2).
195Section 1092(d)(5)(B) provides that such a straddle made up entirely of §1256 contracts, when properly identified under §1092(a)(2), "will not cause [§]263(g) or [§]1092(a) to apply to any position by treatment of part or all of such straddle as also including positions not part of the identified straddle." The language of this provision is somewhat obscure. It seems clearly intended to carry out the intent, set forth in the 1984 Bluebook at 311, that the identified straddle rules are to be extended to all-§1256 contract straddles.
b.	Positions Established On or Before October 21, 2004
As previously mentioned, one of the problems confronting the framers of the straddle rules was to avoid imposing tax penalties on legitimate, profit seeking transactions based on investment strategies involving straddle positions. For positions established on or before October 21, 2004, to permit such transactions to be effected, the Code exempted from the loss deferral rule of §1092(a)(1) positions of an "identified straddle."196 Further, any loss with respect to such straddle was treated as sustained no earlier than the date on which all positions of the straddle were disposed of.197
196See pre-2004 AJCA §1092(a)(2)(A)(i).
197Pre-2004 AJCA §1092(a)(2)(A)(ii). This rule applied where, for example, §1256 contract positions of the straddle were marked to market for a loss exceeding unrealized gain from the offsetting positions.
For positions established on or before October 21, 2004, an identified straddle was a straddle meeting these requirements: (1) all of the positions of the straddle were required to be acquired on the same day; (2) all the positions of the straddle were clearly identified in the taxpayer's records as an identified straddle no later than the end of day on which the straddle was acquired (or such earlier time as may be prescribed by regulations); (3) all positions of the straddle were either: (i) disposed of on the same day, or (ii) held on the last day of the taxable year; and (4) none of the positions were part of a larger straddle.198
198Pre-2004 AJCA §1092(a)(2)(B)(i)-(iii). A commonly utilized straddle technique involves a "butterfly" spread consisting of two long positions and two offsetting short positions (typically, the center positions are either both short or both long, and the "wings" are the offsetting positions) with different expiration (or delivery) dates. Sometimes, several pairs of offsetting positions may be acquired. For positions established on or before Oct. 21, 2004, one could not select two offsetting positions of such a spread and identify them as an identified straddle since they were part of a larger straddle.
For positions established on or before October 21, 2004, once a straddle had been properly identified, it was isolated from the taxpayer's other transactions and treated as a unit. Thus, as illustrated above, where the taxpayer also held one or more positions that offset positions of the identified straddle, the loss deferral rule did not apply to such "outside" positions solely because they offset one or more positions of the identified straddle.199 Likewise, where a loss was sustained from the disposition of a position of an identified straddle,200 the loss deferral rule did not apply by reason of unrecognized gain from an offsetting position not included in the straddle. Finally, unrecognized gain with respect to an outside position had no effect on recognition of a net loss sustained where all of the straddle positions were liquidated on the same date.
199See pre-2004 AJCA §1092(c)(2)(C). (Section 1092(c)(2)(C) was redesignated as §1092(c)(2)(B) by the 2004 AJCA, P.L. 108-357, §888(a)(4)). In the absence of regulations under pre-2004 AJCA §1092(c)(2)(B), the IRS had ruled that a taxpayer could identify the shares of stock that are part of a straddle and the shares that are used as collateral for loans by using appropriately versions of the methods of Regs. §1.1012-1(c)(2) and  (3) and Regs. §1.1012-3T(d)(4). PLR 199925044.
200Although no identified straddle position could be disposed of separately, a loss could occur where a position was marked to market at year end under the rules of §1256(a).
Example: On Aug. 20, 2002, T acquired a straddle made up of LgP and ShP. The positions were identified on T's records as an identified straddle before the close of Aug. 20 (or such earlier time as regulations may require). Subsequently, T acquireed position ShP2 which offset LgP. Prior to the end of the year, T disposed of position ShP2 at a loss. At the close of the year, T retained the identified straddle. Assume that there was unrecognized gain with respect to position LgP at that time. The loss from the disposition of ShP2 was allowed since the positions of the identified straddle were not taken into account for purposes of applying the loss deferral rule.201 Similarly, if both positions of the straddle were disposed of and ShP2 which had appreciated in value were held as of year end, it would have no effect on any loss allowed with respect to LgP (which would be offset, in whole or in part, by the gain realized from depositing of ShP).
201See pre-2004 AJCA §1092(a)(2)(A)(i).
As in the case of positions established on or after October 22, 2004, for positions established on or before October 21, 2004, where all the positions of a straddle were §1256 contracts, the loss deferral rule did not apply to the straddle.202 If an all-§1256 contract straddle was designated as an identified straddle,203 the loss deferral rule was not applied to defer recognition of a loss sustained from the disposition of one or more positions outside the straddle by reason of the fact that one or more of the positions of the identified straddle was offsetting to such outside loss position(s).204
202§1256(a)(4). Section 263(g) (providing interest and carrying charge capitalization rules), discussed below, also did not apply. However, in the case of a straddle at least one (but not all) of the positions of which are §1256 contracts, both of these sections applied to any §1256 contract and any other positions making up the straddle. §1092(d)(5)(A). See §263(g)(1).
203As provided by pre-2004 AJCA §1092(a)(2).
204Section 1092(d)(5)(B) provides that such a straddle made up entirely of §1256 contracts, when properly identified under pre-2004 AJCA §1092(a)(2), "will not cause [§]263(g) or [§]1092(a) to apply to any position by treatment of part or all of such straddle as also including positions not part of the identified straddle." The language of this provision is somewhat obscure. It seems clearly intended to carry out the intent, set forth in the 1984 Bluebook at 311, that the identified straddle rules are to be extended to all-§1256 contract straddles.
3.	Qualified Covered Calls
The identified straddle exception discussed above was enacted to permit profit seeking straddle transactions to proceed without entanglement in rules designed to prohibit abusive manipulation. Congress also exempted from the straddle rules a commonly encountered transaction consisting of the granting of a call option by the owner of the stock subject to the option. Such a "covered" call serves two legitimate investment purposes: (1) it offers a degree of protection against a downward price movement (resembling, to this extent, a "married put"), and (2) if the stock is not called away, the grantor realizes enhanced yield from the stock in the form of the premium received. Congress concluded that where such a call is granted with an exercise price not substantially less than the price of the stock at the time the option is granted, the potential for abuse is so negligible that no purpose would be served in attaching adverse tax consequences to the transaction. Thus, if all the offsetting positions of a straddle consist of one or more "qualified" covered call options, and the stock to be purchased from the taxpayer under such options, and the straddle is not part of a larger straddle,205  the straddle is not treated as a straddle for purposes of the loss deferral rules.206
205The existence of a larger straddle is determined on a stock-by-stock basis rather than for a porfolio of stocks in the aggregate. See TAM 200033004. See also Rev. Rul. 2002-66, 2002-45 I.R.B. 812 (providing discussion of what constitutes "part of a larger straddle").
206§1092(c)(4)(A). Section 263(g), which is discussed below, is also not applicable. See also Rev. Rul. 2002-66, 2002-45 I.R.B. 812 (ruling on effect of certain collar transactions on exemption from straddle treatment for qualified covered calls).
Such a "qualified covered call" must meet five conditions: 206.1
(1) It must be granted more than 30 days prior to its expiration date,
(2) It may not be granted by an options dealer in the course of his business of dealing in options,
(3) Gain or loss from such option must not be ordinary income or loss,
(4) The option must be traded on an SEC regulated exchange, and
(5) It must not be "deep-in-the-money."
206.1§1092(c)(4)(B).
A deep-in-the-money option is an option having a strike price lower than the "lowest qualified benchmark," a term meaning, generally, the highest available strike price which is less than the "applicable stock price." 207
207§1092(c)(4)(C) and  (D).
From the discussion of options in III, B, above, recall that where the strike price of a call option is less than the prevailing stock price, it is "in the money," that is, it has some intrinsic value. Where, for example, the stock price is $75, and the call option has a strike price of $60, the option is $15 in the money. It will have a value of at least $15 plus any time value it may also have. A straddle consisting of a covered call which is deep in the money is potentially abusive:
Example: T holds 100 shares of XYZ having a value of $100 per share. For a premium of $5,000, he grants a call option with a strike price of $50. The stock price advances to $125. T closes out his option position for a loss of $2,500. He then locks in the $2,500 gain from the stock position either by purchasing a put or by granting another deep in the money call. The stock and the offsetting position are both disposed of in the following year. This stratagem would not be feasible if T were to grant a call with a strike price of $100, since the premium would reflect only the time value of the option. This would be basically true also even if the option had a strike price of, say, $95. As the strike price decreases below $95, however, the potential for abuse increases.
The term "benchmark" refers to the practice of options exchanges in setting the price ranges for which options may be traded. When an option is listed for trading, it is available for strike prices above or below the price at which the stock is quoted on the stock exchange in multiples of $2.50, $5 or $10, for stocks priced, respectively at $25 or less, from $25 to $199, and $200 or more. Thus, where the stock price is $763/8, options may be available at $70, $75, $80, $85, etc. Where the stock price is $211, however, options may be available at strike prices of $200, $210, and $220, etc.208
208The dollar "jump" of benchmarks has changed since the qualified covered call provisions were enacted (formerly, $10 jumps started at a price of $150). However, §1092(c)(4)(H) authorizes regulations reflecting changes in exchange rules. The rules outlined below assume that the exchange rules in effect in Jan. 1990 are applicable in determining whether a call is deep-in-the-money.
The rules set forth above relating to the "applicable stock price" are somewhat complex, but may be summarized as follows: For stock whose "applicable price" (the price as of the close of the previous day's trading or, where 110% of such price, the opening price of the stock on the day the option is granted) is:

• Less than $25, the option cannot be more than $2.50 in the money;
• Greater than $25 but less than $200, the option cannot be more than $5 in the money; and
• $200 or more, the option cannot be more than $10 in the money.209
209See §1092(c)(4)(D). These figures are based on CBOE Rule 5.5, Interpretation .01 (Apr. 10, 1985).
A special year-end rule is provided in §1092(c)(4)(E) to insure that no undue tax advantage be taken under the qualified covered call exception. In the case of such a straddle, (1) if either side (the option or the stock) is disposed of at a loss, and (2) the other side is disposed of at a gain less than 30 days after the disposition of the loss position and (3) such gain is included in income of a year following the year in which the loss was sustained, then for purposes of the loss deferral rule of §1092(a), but for no other purposes, the qualified covered call is treated as a straddle.
Finally, rules similar to the short sale rules apply to qualified covered calls with a strike price lower than the applicable stock price. Under these rules, where such a qualified covered call is granted and, subsequently, the option is closed out at a loss, the loss is treated as a long-term capital loss if the covered stock was held longterm at the time the loss was realized.210 Further, the holding period of the stock is suspended while the option is outstanding.211
210§1092(f)(1).
211§1092(f)(2).
In April 2002, the Treasury issued regulations211.1 addressing the eligibility of equity options with flexible terms (FLEX options), standardized options with terms longer than one year, and over-the-counter (OTC) options for qualified covered call treatment.
211.1T.D. 8990, 67 Fed. Reg. 20896 (4/29/02).
Examining FLEX options, the final regulations provide that the availability of strike prices established by equity options with flexible terms does not affect the determination of the lowest qualified benchmark, as defined in §1092(c)(4)(D), for an equity option with standardized terms.211.2
211.2Regs. §1.1092(c)-2(b), as redesignated and revised by T.D. 8990, 67 Fed. Reg. 20896 (4/29/02), effective for equity options with flexible terms entered into on or after July 29, 2002. Regs. §1.1092(c)-2(d)(2).
The final regulations further provide that FLEX options are qualified covered call options not subject to the straddle rules if:
• The option meets the requirements of §1092(c)(4)(B), i.e., is exchange traded, has more than 30 days before expiration, is not deep-in-the-money, is not granted by a dealer in connection with his dealing activities, and gain or loss from the option is not ordinary income or loss.
• The only payments permitted with respect to the option are a single fixed premium paid not later than five business days after the first day the option is granted, and a single fixed strike price211.3 stated as a dollar amount that is payable entirely at (or within five business days) of exercise;
• An equity option with standardized terms is outstanding for the underlying equity; and
• The underlying security is stock in a single corporation.211.4
211.3Regs. §1.1092(c)-4(d) defines a single fixed strike price as a strike price that is fixed, determinable, and stated as a dollar amount on the date the option is written. An option will not fail to have a single fixed strike price if, after the date the option is written, the strike price is adjusted to account for the effects of a dividend, stock dividend, stock distribution, stock split, reverse stock split, rights offering, distribution, reorganization, recapitalization, or reclassification with respect to the underlying security, or a merger, consolidation, or liquidation of the issuer of the underlying security. Regs. §1.1092(c)-4(d) is applicable to equity options entered into on or after July 29, 2002. Regs. §1.1092(c)-4(g)(2).
211.4Regs. §1.1092(c)-2(c)(1), applicable to equity options with flexible terms entered into on or after July 29, 2002. Regs. §1.1092(c)-2(d)(2).
For purposes of applying the general rules, the benchmarks would be the same as for an equity option with standardized terms on the same stock having the same applicable stock price. 211.5An example is provided for determining whether a FLEX option is deep-in-the-money.
211.5Regs. §1.1092(c)-2(c)(2)(i), applicable to equity options with flexible terms entered into on or after July 29, 2002. Regs. §1.1092(c)-2(d)(2).
Example: T owns stock in Corporation X. T writes an equity call option with flexible terms on Corporation X stock through a national securities exchange for a term of not more than 12 months. The applicable stock price for Corporation X stock is $73.75. Using the bench marks for an equity option with standardized terms with an applicable stock price of $73.75, the highest available strike price less than the applicable stock price is $70, and the second highest strike price less than the applicable stock price is $65. Therefore, an equity call option with flexible terms on Corporation X stock with a term of 90 days or less will not be deep in the money if the strike price is not less than $70. If the term is greater than 90 days, an equity call option with flexible terms on Corporation X will not be deep in the money if the strike price is not less than $65.211.6
211.6Regs. §1.1092(c)-2(b), Ex. 1.
The final regulations also consider standardized options with terms greater than one year. The regulations allow a qualified covered call option to have a term as long as 33 months, the longest term currently being used for exchange traded options. If an option has a term longer than 12 months, the use of an adjusted stock price211.7 is required to determine whether the option meets the requirements in §1092(c)(4) for a QCC.211.8 The following examples are provided to assist in determining if a standardized option with a term greater than one year is deep-in-the-money.
211.7Regs. §1.1092(c)-4(e) defines adjusted applicable stock price as the applicable stock price as defined in §1092(c)(4)(G), adjusted for time. To determine the adjusted applicable stock price, the applicable stock price, which is determined in accordance with the rules of §1092(c)(4)(G), is multiplied by an adjustment factor, provided in the tables in Regs. §1.1092(c)-4(e). Regs. §1.1092(c)-4(e), applicable to equity options entered into on or after July 29, 2002. Regs. §1.1092(c)-4(g)(2).
211.8Regs. §1.1092(c)-1(b)(1), applicable to QCC options entered into on or after July 29, 2002. The Treasury has stated that it may issue additional guidance regarding the maximum term limit of option exchanges begin to trade equity options with terms longer than 33 months. The Treasury further noted that if longer-term QCC options are used to achieve inappropriate risk reductions, it may reconsider the issue of term limits for the QCC options. See Preamble, T.D. 8990, 67 Fed. Reg. 20896 (4/29/02).
Example: T owns stock in Corporation X. T writes an equity option with standardized terms on Corporation X stock through a national securities exchange with a term of 21 months. The applicable stock price for Corporation X stock is $100. The bench marks for a 21-month equity option with standardized terms with an applicable stock price of $100 will be based upon the adjusted applicable stock price. Using the table provided in Regs. §1.1092(c)-4(e), the applicable stock price of $100 is multiplied by the adjustment factor 1.12, resulting in an adjusted applicable stock price of $112. Using the bench marks for an equity option with standardized terms with an adjusted applicable stock price of $112, the highest available strike price less than the adjusted applicable stock price is $110, and the second highest strike price less than the adjusted applicable stock price is $105. Therefore, a 21-month equity call option with standardized terms on Corporation X stock will not be deep in the money if the strike price is not less than $105.211.9
211.9Regs. §1.1092(c)-1(b)(2)(ii), Ex. 1.
Example: T owns stock in Corporation Y. T writes an equity option with standardized terms on Corporation Y stock through a national securities exchange with a term of 21 months. The applicable stock price for Corporation Y stock is $13.25. The bench marks for a 21-month equity option with standardized terms with an applicable stock price of $13.25 will be based upon the adjusted applicable stock price. Using the table provided in Regs. §1.1092(c)-4(e), the applicable stock price of $13.25 is multiplied by the adjustment factor 1.12, resulting in an adjusted applicable stock price of $14.84. Using the bench marks for an equity option with standardized terms with an adjusted applicable stock price of $14.84, the highest available strike price less than the adjusted applicable stock price is $12.50. However, under §1092(c)(4)(D), the lowest qualified bench mark can be no lower than 85% of the applicable stock price, which for Corporation Y stock is $12.61 (85% of the adjusted applicable stock price of $14.84). Thus, because the highest available strike price less than the adjusted applicable stock price for an equity option with standardized terms is lower than the lowest qualified bench mark, the lowest strike price at which a qualified covered call option can be written is the next higher strike price, or $15.00. Therefore, a 21-month equity call option with standardized terms on Corporation Y stock will not be deep in the money if the strike price is not less than $15.211.10
211.10Regs. §1.1092(c)-1(b)(2)(ii), Ex. 2.
The final regulations also deal with qualified over-the-counter (OTC) options. A qualifying OTC option is a qualified covered call option under this regulation if it meets the requirements of Regs. §1.1092(c)-1 after substituting "qualifying over-the-counter option" for "equity option with flexible terms." A qualifying OTC option is deemed to have satisfied the requirements of §1092(c)(4)(B)(i) (i.e., requiring a qualified covered call to be an exchange traded option).
A qualifying OTC option is an equity option if it is:
• Not traded on a national exchange registered with the SEC; and
• Is entered into with (1) a broker-dealer, acting as a principal or agent, who is registered with the SEC as a broker-dealer under §15 of the Securities Act of 1934 and the regulations thereunder; or (2) an alternative trading system under 17 CFR 242.300 et seq.; or (3) a person, acting as a principal or agent who must comply with the recordkeeping requirements for securities transactions described in 12 CFR 12.3, 12 CFR 208.34, or 12 CFR 344.4.211.11
211.11Regs. §1.1092(c)-4(c). Regs. §1.1092(c)-4(c) makes the rule applicable to banks, a change from the 2001 proposed regulations.
Accordingly, a qualified OTC option is eligible for qualified covered call treatment under the final regulations if it meets the aforementioned requirements as well as the same requirements for qualified covered call treatment that apply to equity options with flexible terms.211.12
211.12Regs. §1.1092(c)-3(a), applicable to qualifying OTC options entered into on or after July 29, 2002. Regs. §1.1092(c)-3(c).
4.	Long Stock Position and Offsetting Short Security Futures Contract
For a detailed discussion of futures contracts, including discussion of security futures contracts, see 188 T.M.., Taxation of Equity Derivatives.
5.	Physically Settled Positions
The 2004 American Jobs Creation Act (2004 AJCA) clarified the straddle rules with respect to taxpayers that settle a position that is part of a straddle by delivering property to which the position relates.211.13 Specifically, §1092(d)(8) clarifies that the straddle loss deferral rules of §1092(a)(2) treat as a two-step transaction the physical settlement of a straddle position that, if terminated, would result in the realization of a loss. With respect to the physical settlement of such a position, the taxpayer is treated as: (1) having terminated the position for its fair market value immediately before the settlement, and then (2) as having sold at fair market value the property used to physically settle the position.211.14
211.13§1092(d)(8), added by the 2004 AJCA, P.L. 108-357, §888(b), effective for positions established on or after Oct. 22, 2004. See also H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 757 (2004); S. Rep. No. 192, 108th Cong., 1st Sess. (2003) (noting that the Senate Finance Committee believes "that the present-law treatment of physically settled positions under the straddle rules require[d] clarification").
211.14§1092(d)(8).
E. Interest and Carrying Charges
1.	Background
As explained above, the futures (or forward) price of any given commodity (including financial instruments) is, generally, the spot price of the commodity plus the cost of carry (interest, insurance, storage, etc.) to the delivery date. Where the futures price is greater than the spot price plus the estimated cost of carry, a profit may be realized by buying the commodity and entering into a short futures contract. If the futures price falls below this amount (spot plus cost of carry), a profit can be realized by selling the commodity short (where possible) and entering into a long futures contract. These are generally referred to as "cash and carry" transactions. Aside from such non-tax motivated arbitrage transactions, taxpayers, prior to the enactment of the straddle rules in 1981, could reap substantial tax benefits from cash and carry straddles.
Example: A quantity of the commodity, preferably one not subject to waste or spoilage and with minimal storage costs, such as a precious metal, is purchased with borrowed funds. At the same time, a contract to sell the commodity at a future date would be entered into in the form of a short futures position, irrespective of whether the futures price was sufficient to produce any arbitrage profit (aside from tax benefits). Interest on the borrowed funds was deductible against ordinary income.212 When delivery was made under the contract, the price received was sufficient to recoup at least a substantial portion of (if not more than) the interest and other costs incurred, but the excess of such futures price over the taxpayer's basis in the property was long-term capital gain.212.1 In this manner, ordinary income could be converted into long-term capital gain.
212Restrictions on the deduction of investment interest were not so strict as under the 1986 Code §163(d).
212.1Actually, where the futures contract was an RFC, the difference between the price on the delivery date and the price provided in the contract would be reflected in the daily marking to market credits and/or debits to the holder's account, as explained above. One interesting variation of the cash and carry straddle is designed to convert interest expense to a capital loss through the short sale of a physical commodity coupled with a long future position in the same commodity. The taxpayer borrows 100 ounces of gold and sells the gold. A long future contract for a similar quantity of gold is entered into. The gold is sold and the contract is held to maturity at which time the taxpayer takes delivery of the gold at the contract price which will be higher than the price received from the sale of the borrowed gold. This loss may be set off against capital gain. The device may be used to circumvent the restrictions on the deduction of personal interest, or to avoid the allocation and apportionment of interest expenses required by Regs. §1.861-8. Regs. §1.861-8T(b)(1) requires that the capital loss, as an "interest equivalent," be treated as interest for purposes of the rules relating to the allocation and apportionment of interest expense. See Regs. §1.861-9T(b)(1)(ii), Ex. (1). This does not appear technically to be a "straddle" unless the obligation to return the borrowed gold is considered to be an interest in personal property. However, even if it were, the straddle rules would have no practical effect except to the extent that the futures contract, if it is an RFC (i.e., traded on a "qualified exchange"), is subject to the rules of §1256.
Congress decided that in the case of such cash and carry straddles, the costs of carry should be capitalized to prevent this kind of unwarranted tax benefit.
2.	Statutory and Other Provisions
Section 263(g) provides that no deduction is allowed with respect to "interest and carrying charges properly allocable to personal property which is part of a straddle (as defined in §1092(c))." Such disallowed expenses are capitalized and added to the taxpayer's basis in the property.212.2
212.2§263(g)(1); Prop. Regs. §1.263(g)-1(a). The IRS will not provide rulings as to whether a loan was incurred or continued to purchase or carry stock used in connection with a costless collar. Such a ruling would require the IRS to determine whether the loans were "incurred or continued to purchase or carry" stock used in the costless collar. Because this language is the same as that used in §265(a)(2), the IRS has refused to provide rulings in a §263(g) context. PLR 199925044. Under Rev. Proc. 2005-3, 2005-1 I.R.B. 118, §4.01(20), the IRS will not issue rulings on whether, in a §265(a)(2) context, indebtedness is incurred to purchase tax-exempt obligations.
Section 263(g)(2) defines the costs to be capitalized as (1) interest on indebtedness incurred or continued to purchase or carry the personal property plus (2) all other costs incurred to carry the personal property (insurance, storage, transportation, etc.).
Note: Regs. §1.163-8T (providing rules for the allocation of interest expenses for purposes of applying the passive loss and nonbusiness interest limitations) provides that any limitation on the deductibility of an item (other than the passive loss and nonbusiness limitations) applies without regard to the manner in which the indebtedness is allocated under the regulations.212.3 However, the regulations further provide that capitalization provisions (which include §263(g)) do not apply to any interest expense allocated to any personal expenditure under the rules of these regulations.212.4 Note also that the statute provides that "interest" includes any amount paid in connection with personal property used in short sale.212.5
212.3Regs. §1.163-8T(m)(2)(i).
212.4Regs. §1.163-8T(m)(2)(ii). In the case of an individual's borrowing in connection with a cash and carry straddle, if the loan proceeds are traced to the acquisition of the property (which will be true in most cases, even though under the tracing rules the fact that the loan is collateralized by the property is irrelevant) the debt, and, consequently, the interest expense, will probably be allocated to an investment expenditure rather than to a personal expenditure. Thus, the interest expense is capitalized and the tracing rules will no longer apply to it; once capitalized the expense is not taken into account as interest for any taxable year for purposes of applying the passive loss and nonbusiness interest limitations. Regs. §1.163-8T(m)(1)(iv).
212.5§263(g)(2), last sentence. The statute thus clearly contemplates that while short sales are generally subject to the rules of §1233, they are also subject to the straddle rules, at least to the extent of §263(g). While a "regular" short sale of stock would not appear to constitute a straddle, §263(g) would appear to apply to a situation wherein the holder of stock purchases a put option treated as a short sale under §1233(b). The short sale of securities such as Treasury bills and notes would appear to be the type of short sale to which §263(g) will typically apply.
Under §263(g)(2)(B), the following items are deducted from the costs to be capitalized:
(1) Any interest (including original issued discount) includible in income for the year with respect to the personal property; 213
(2) Any amount includible in income under §§1271(a)(3)(A), 1276, or 1281(a) (all relating to discount treated as interest);
(3) Any dividends with respect to the property (as reduced by any dividend received deduction); and
(4) Any amount received by and includible in the incomeof the lender of securities (referring principally to securities to be used in a short sale).
213This would apply where the property is a debt instrument; the offsetting position will usually be some type of financial futures contract or option (T-bill or GNMA, for example).
The statute also provides, as do all of the statutory provisions relating to straddles, that its provisions do not apply to "hedging transactions." 214
214As defined in §1256(e), discussed in V, F, below. See §263(g)(3).
3.	Proposed Regulations
a.	Introduction and Background
In January 2001, the Treasury published proposed regulations which radically expand the scope of the straddle rules.215
215REG-105801-00, 66 Fed. Reg. 4746-4751 (1/18/01).
One major proposed change is to add new Prop. Regs. §1.1092(d)-1(d) 215.1 defining the circumstances in which a debt instrument can be treated as a "position" in personal property. In addition, the proposed regulations would add new Prop. Regs. §1.263(g)-1 through -5, as follows:
• Prop. Regs. §1.263(g)-1, providing general rules for the disallowance of certain interest and carrying charges in the case of straddles;
• Prop. Regs. §1.263(g)-2, defining "personal property" for purposes of §263(g);
• Prop. Regs. §1.263(g)-3, defining interest and carrying charges for purposes of §263(g), §1092, and Regs. §1.1092(d)-4T (relating to mixed straddle accounts);
• Prop. Regs. §1.263(g)-4, providing rules governing the capitalization of amounts to which §263(g) applies; and
• Prop. Regs. §1.263(g)-5, setting forth effective dates.
215.1Existing Regs. §1.1092(d)-1(d) (effective dates) would be redesignated as subsection -1(e).
For most of the 20 years after they were enacted, the provisions of §263(g) were generally understood to apply only to cash and carry straddles like the one described in V, E, 1, above.  However, new financial products were introduced in the 1990s which were perceived as producing many of the abuses of straddles but which did not appear to fall within the statutory language. Proposals were made in the budget submitted for 2001 to amend the straddle rules to meet the concerns of the Treasury and the IRS. In the meantime, the Treasury decided that it had sufficient authority to achieve the same ends by regulations.
These provisions are somewhat intricate and involve interpretations of the statutory language of §§1092 and 263(g), which may prove controversial. Hearings to be held in May 2001 may result in some changes.
b.	The DECs Problem
For many years, beginning in the early 1990s, the Treasury, IRS and commentators sought, without any success, to analyze and determine the proper tax treatment of the issuers and holders of what purported to be debt instruments of the kind referred to as DECs.215.2 While there were several variations, the typical DEC 215.3 is issued by a corporation holding a block of appreciated stock. Each DEC is issued for a price equal to a share of such stock and purported to be a debt instrument. Interest at a rate exceeding the dividend rate is payable until maturity which is generally about three years.  At maturity, if the value of the referenced stock has not appreciated, the noteholder receives a share or cash equal to its fair market value. If it has appreciated, the investor receives a fraction of a share (or cash equivalent) such that the issuer shares in a portion of the appreciation. In other words, the issuer has eliminated all downside risk from holding the stock but has retained an opportunity to enjoy some portion of any appreciation. While the rights and obligations of the issuer of a DEC can be viewed as basically the same as under a collaterialized or prepaid forward sale of the stock, there is no constructive sale since under §1259(d)(1), a "forward contract" is defined as a contract to deliver a substantially fixed amount of property for a substantially fixed price. A DEC can also be viewed as a short-term loan coupled with a collar since the issuer has a long put position and a short call. The interest rate paid on the issue price takes into account the net premium for the collar and is thus slightly below the market rate (but will always exceed the dividend rate on the stock).
215.2The first DEC was issued by American Express in 1993. The acronym stands for Debt Exchangeable for Common. These were three-year notes bearing stated interest at close to a market rate and issued for the same price as a single common share of First Data Corp., an American Express 21% owned subsidiary. At maturity, the holder was to receive a share of First Data.  In addition, if the stock had appreciated by more than 22%, the noteholder was to receive .82 share at maturity. For a complete discussion of equity-linked securities, see 188 T.M., Taxation of Equity Derivatives.
215.3DEC is one securities firm's trade name. ACES, PRIDES, PEPS are other essentially identical types of equity-linked securities.
It was apparent that a DEC issuer could effectively monetize its stock holding without recognizing gain. Analysis of these transactions led to a number of conclusions. Representatives of the issuers took the position that while a DEC did not constitute an obligation to pay a sum certain at maturity, they were still debt instruments entitling the issuer to deduct the payments characterized as interest.  This contention was based on the theory that the issue price paid by the investor was prepayment of its obligation under the forward contract, a deposit which at maturity was returned by the issuer after payment of any amount due the issuer and increased by any amount due the investor under the forward contract. In time, many variations of the DEC were issued. Most investment banks issued similar instruments that referenced stock issued by unrelated corporations and which was acquired by the issuer at the time of issuance of the security solely to hedge the issuer's obligation.
As observed above, the issuer of a DEC has effectively entered into a collar, that is, has purchased an at-the-money put financed in part by granting an out-of-the-money call. While the collar is too "loose" for §1259 to apply (since the issuer will participate to a limited extent in any appreciation), the collar is an offsetting position to the long stock position. Is this a straddle within the meaning of §1092(c)? This question to date has never required an answer because whatever happens to the stock price, there is no §165(a) loss to be deferred under §1092(a). And there would appear to be no reasonable interpretation of §263(g) that would permit the disallowance of deductions by the issuer for its interest payments; these might be disallowed, however, on the as yet untried theory that the DEC is not a debt instrument.215.4
215.4For a discussion of the applicability of the straddle rules to DECs, see Kleinbard, "Everything I Know About New Financial Products I Learned From DECS," 457 PLI/Tax  1171 (1999), hereinafter "Kleinbard on DECS."
Since a principal purpose of a DEC is the monetization of appreciated stock, 215.5 there is usually no loss to be deferred under §1092(a) when the stock is ultimately sold (or exchanged in satisfaction of the issuer's obligation) at maturity, and most commentators agree that interest payments on the DEC cannot properly be characterized as deferrable losses. Next, the language of §263(g) makes it extremely difficult without the regulatory provisions proposed to disallow deductions by the issuer for payments characterized as interest to the holders since the purported indebtedness was not incurred or continued to acquire or carry the long stock position, nor is the debt secured by the stock.
215.5A number of investment banks have issued similar instruments referencing stock of an unrelated corporation shares of which are acquired by the bank at the time of issuing the instrument solely as a hedge. The principal function of these is, as is the case for collar transactions, to earn a profit from the net premium.  These "equity linked" instruments are traded under various acronyms. DECs type instruments referencing the issuer's own stock have also been issued. DECs are discussed in greater detail in 186 T.M., Financial Instruments: Special Rules.
c.	Contingent Payment Monetization Securities (CPMs)
Possibly out of apprehension that the IRS could effectively challenge the characterization of the DEC holder's rights as debt and thus the periodic payments by the issuer as interest, there appeared in the later 1990s a somewhat different type of appreciated stock monetization instrument under the terms of which the holder pays an issue price equal to a share of appreciated referenced stock held by the issuer, to be repaid at maturity (without regard to the value of the stock at that time). The instruments provide for periodic payments of interest at a rate substantially below market (e.g., an annual rate of 2%). If at maturity the price of the referenced stock exceeds a specified amount (typically 120% of the price on the date of issue), the holder is entitled to a percentage (e.g., 75%) of such excess. Thus, downside risk is not shifted to the holder. Products of this type will be referred to herein as CPMs (contingent payment monetizations). Analysis of this instrument for purposes of application of the straddle rules requires some appreciation of options pricing.
Assume the issuer holds appreciated stock of XYZ Corp. currently trading at $100 per share, the referenced stock. An investor will pay $100 per unit of this instrument and will receive a minimum of $100 at maturity. The issuer will pay interest on the $100 debt instrument at an annual rate of 2%. In addition, the issuer will pay at maturity 75% of the excess over $120 of the price on that date of a referenced share of XYZ.  The issuer has granted to the holder what in effect is a European style cash settled call option on 75% of a share of the referenced stock with a strike price of 120% of the issue date price of the stock. Assume a maturity date five years from the issue date. The value of a call option, European or American style, is equal to or more than the excess of the stock's price over the present value of the exercise price discounted at the risk-free interest rate in effect at the time the option is granted. 215.6 Thus, if on the date of issue the stock had a value of $100 per share, and if the risk-free interest rate for debt maturing in five years is 5%, the call would have a value equal to or greater than $6.54.215.7 If the stock is reasonably volatile, which is usually the case, say an annualized standard deviation of .30, the call is priced at approximately $19.215.8 Taking this into account, the five- year debt instrument has a yield of about 6.6%, 215.9 entitling the issuer to deduct accrued OID under the contingent payment debt instrument (CPDI) rules of Regs. §1.1275-4, in addition to the below market interest payments. Thus, the issuer has the use of the $100 issue price for five years at a 2% below market rate and is entitled to deduct an additional 4.6% in interest under the CPDI rules without any cash outlay. The benefits enjoyed by the issuer in return for granting the call were twofold: (1) use of the issue price paid in at a substantially below market interest rate; and (2) deduction of the "phantom" interest expense allowable under the CPDI rules. The value of these benefits can be seen to result in substantial reduction of any risk from the holding of the referenced stock.
215.6See Kolb, Futures, Options and Swaps 407-408 (Blackwell Business 1997).
215.7Using a risk-free rate of 5%, the present value of $120 is $120e-(.05)(5) = $93.46.
215.8Using options pricing software supplied with Kolb, Futures, Options and Swaps  (Blackwell Business 1997).
215.9Applying the rules of Regs. §1.1275-4(b) relating to contingent payment debt instruments, the comparable yield of such an instrument can be obtained by determining what it would cost the issuer to purchase a call option identical to that granted, a Regs. §1.1275-6 hedge, and determining the yield of the synthetic debt instrument created. If the option price is $19, as has been determined using a Black Scholes model, the synthetic instrument would have an issue price of $81, stated redemption price at maturity of $100, and yield of 6.58%.
In 1999, there were issued two instruments of the type just described given the tradename PHONES. 216 Among other features, the debt instruments matured in 30 years (extendable to 60 years in one issue if the referenced stock appreciated by 50% over the issue price over the 30-year period). The tax and economic benefits to the issuers, explained above, seem clear, but PHONES would appear an attractive investment only to certain institutional or tax exempt entities. Assuming current stock price of $100 and an exercise price of $120, and a risk-free interest rate of 6%, the present value of the exercise price of the call is $19.84 and the price of the call option is equal to or greater than $80.16. Thus theoretically, the price of a call on .75 of a share expiring in 30 years struck at $120 is equal to or greater than $60.12.216.1 It is the IRS's view that under this arrangement the issuer has substantially reduced any risk of economic loss from holding the referenced stock just as in the case where the holder of a long stock position writes a call (other then a qualified covered call). However, it was far from clear whether the straddle provisions of the Code, as currently formulated, could be applied to deny to the issuer the tax benefits described.
216Described and discussed in an article by Lee Sheppard at 83 Tax Notes 347 (4/19/99).
216.1The comparable rate for the CPDI , calculated as explained above, is 6.70% compounded annually, which entitles the issuer to deduct over the term of the debt instrument, in addition to the $60 payable in cash, contingent interest of $60.10.
d.	Legislative Proposals
For a number of years the IRS and the Treasury have supported legislation to revise and expand the operation of the straddle rules to deal with transactions which have been perceived as permitting abuses similar to those which prompted the rules. These transactions employ financial products which were largely unknown when the basic straddle rules of §§263, 1092 and 1256 were enacted in 1981 (and amended in 1984 and 1986 to provide a limited relaxation of the stock exclusion). Among the revenue provisions contained in the Clinton Administration's fiscal year 2001 budget proposal 216.2 were a number of amendments and additions to the straddle rules. It was proposed 216.3 that if a taxpayer issues a debt instrument calling for one or more payments linked to the value of personal property, the taxpayer's obligations under the debt instrument is an interest in personal property that may constitute a leg of a straddle. Thus, if a taxpayer holds a long position in actively traded stock and issues a debt instrument that contains an embedded short position in the same stock, the long position and the debt instrument could be offsetting positions in actively traded personal property and, therefore, would constitute a straddle. 
216.2See Joint Committee on Taxation, Description of Revenue Provisions Contained in The President's Fiscal Year 2001 Budget Proposal  (Comm. Print 2000) (hereinafter "JCT Description").
216.3JCT Description at 341.
Further, it was proposed that, for purposes of §263(g), interest is considered properly allocable to a straddle if the interest accrues on a "straddle related debt instrument." This latter term would include a debt instrument that is itself an interest in property that constitutes all or part of one leg of a straddle. 216.4
216.4JCT Description at 342.
With respect to the first of these proposals, note was taken 216.5 of the view that a taxpayer's obligation under a debt instrument cannot constitute a "position," as evidenced by the special rule of §1092(d)(7), which expressly characterizes a debt instrument denominated in a nonfunctional currency as a position in the currency, based on the conclusion that foreign currency borrowing creates the economic equivalent of a short position in the currency. However, proponents pointed out that to the extent a debt instrument calls for payments linked to the value of personal property, the obligor has an interest (generally the equivalent of a short position) in that personal property. Also noted was the contention that this proposal expands, rather than merely clarifies, present law in a way that, combined with the revised §263(g) rules, would adversely affect relatively common debt instruments that are exchangeable into common stock and would have the effect of raising the cost of capital for the issuers. The reference here is, of course, to DECs described above.
216.5JCT Description at 343
The proposals relating to the treatment of interest and carrying charges were based on the contention that it is inappropriate for a taxpayer to deduct expenses associated with one position in a straddle to the extent that there is unrecognized gain in the offsetting position, and that where a straddle includes a straddle-related debt instrument, the related interest expense should be viewed as a cost of the straddle. Opponents of the proposal argued that "there is sound legal theory under present law supporting the position that interest paid with respect to a straddle-related debt instrument that is not incurred to purchase or carry a long position in personal property does not have to be capitalized under §263(g)." The Joint Committee noted that the proposal changes this result and took note of the contentions by opponents of this change that giving it retroactive effect to apply to any outstanding debt instruments that are exchangeable into common stock held by the issuer would be unfair and unwarranted.216.6
216.6JCT Description at 348. It was noted with respect to the proposal to "clarify situations in which interest and carrying changes would be considered properly allocable to a straddle and, therefore, capitalized" that somewhat similar proposals were included in the President's tax simplification proposals released in April 1997 and in the Fiscal Year 2000 budget proposal.
e.	Proposed Regulations
It would seem that having failed to bring about legislative changes such as those discussed above to deny the issuers of DECs and CPMs (such as the PHONES) deductions for interest expense, the Treasury and the IRS turned to the authority granted by §1092(b)(1)216.7 and the general authority of §7805 to propose regulations which, if adopted, will accomplish most of the purposes sought in the legislative proposals. Most of these regulations relate to §263(g) (under which there are no current regulations).
216.7Section 1092(b)(1) grants authority to issue regulations "with respect to gain or loss on positions which are part of a straddle" appropriate to carry out the provisions of §§1092 and 263(g). But §263(g) denies deductions for interest and carrying charges, not losses.
(1)	Prop. Regs. §1.1092(d)-1(d)
The new rules relating to §263(g) that are aimed at straddle strategies employing financial products developed during recent years may be viewed as predicated in part on Prop. Regs. §1.1092(d)-1(d). Similar to the legislative proposal described above, this proposed regulation provides that if the taxpayer is the obligor under a debt instrument one or more payments under which are linked to the value of personal property or a position with respect to personal property, then the taxpayer's obligation under the debt instrument is a position with respect to personal property and may be part of a straddle. The rationale for this rule, as set forth in the preamble, is that where the taxpayer's obligation under the debt instrument changes as the value of the referenced property changes, the taxpayer's position as obligor functions as a position in the referenced property. 216.8
216.8The preamble also takes note of the contention, referred to above in discussing the JTC Description, that the issuer's obligations under a debt instrument cannot be considered a "position" as is evidenced by §1092(d)(7) which provides that an obligor's interest in a nonfunctional currency denominated debt instrument is a "position" in the currency would not have been necessary. It is pointed out that this argument has been rejected by the IRS and Treasury in Regs. §1.1275-4(b)(9)(vi) providing that increased interest expense on a CPDI issued by a taxpayer may be a straddle loss subject to §1092(a) deferral.
While this provision is intended to apply to straddles established on or after January 17, 2001, the preamble states that in "appropriate cases" the IRS may apply this rule to earlier established straddles if the debt instrument functioned economically as an interest in actively traded personal property.
The preamble notes that it is proposed to finalize both the regulation just discussed and Prop. Regs. §1.1092(d)-2 (published in May of 1995 216.9 and discussed above at V, B, 3, i) simultaneously. Under the latter provisions, it will be recalled:
(A) The second sentence of pre-2004 AJCA §1092(d)(3)(A) (providing that the stock exclusion rules did not apply to any interest in stock) sets forth a substantive rule to the effect that actively traded stock is "personal property" for purposes of testing whether an interest in the stock is a position with respect to personal property, and
(B) The language of pre-2004 AJCA §1092(d)(3)(B)(i)(III)217 is to be interpreted by reading the parenthetical (other than stock) to include as substantially similar or related property any interest in stock other than direct ownership or a short sale.217.1
216.9FI-21-95, 60 Fed. Reg. 21482 (5/2/95). Note that the proposed regulations do not reflect amendments to §1092(d) made by the 2004 American Jobs Creation Act (2004 AJCA), P.L. 108-357, §888, effective for positions established on or after Oct. 22, 2004. P.L. 108-357 eliminates the exception from the straddle rules for stock (other than the exception relating to qualified covered call options). Thus, offsetting positions comprised of actively traded stock and a position with respect to substantially similar or related property generally constitute a straddle.
217Section §1092(d)(3)(B)(i)(III) was removed by the 2004 AJCA, P.L. 108-357, §888, effective for positions established on or after Oct. 22, 2004.
217.1While the NYSBA in a 1995 report termed these interpretations "strained," a more recent report commenting on the 2001 budget proposals, referred to above, has backed off somewhat from this conclusion. NYSBA Report (3/17/00) at fn. 91.
(2)	Prop. Regs. §§1.263(g)-1 through 1.263(g)-5
Regarding the regulations under §263(g), it should be recalled that these provisions were enacted primarily, if not exclusively, to deny any tax benefits to taxpayers engaged in transactions referred to as "cash and carry" straddles. These are essentially forward sales of debt-financed personal property enabling the taxpayer to deduct currently interest on the debt which is recovered (usually in the subsequent taxable year) on the delivery date in the form of capital gain. 217.2 The provisions of §263(g)(1) require the capitalization of "interest and carrying charges properly allocable to personal property which is part of a straddle," and §263(g)(2) defines "interest and carrying charges" to include "interest on indebtedness incurred or continued to purchase or carry the personal property."
217.2In taxable years before the effective date of §1258 relating to conversion transactions.
Example: If taxpayer A borrows $1,000 to purchase a quantity of personal property P and enters into a contract to sell P forward for delivery on date D, the forward price will generally be the spot price of P compounded forward at the current risk-free rate to the delivery date.  Assume the contract is entered into on June 1, 2001 and provides for delivery of P on Nov. 1, 2002. Assume a risk-free annual rate of 5.2%. The forward price is $1,077. A will collect this in exchange for P on Nov. 1, 2002. The long position in P and the forward contract are offsetting positions in personal property.
Under current law, it is clear that §263(g) will apply to require capitalization of the interest paid on the $1,000 loan the proceeds of which were used to acquire P, in which case there will be no gain from the sale of P at the forward price if P is delivered to satisfy A's obligation under the contract. As of the date of the proposed §263(g) regulations, many, if not most commentators were of the opinion that the term "personal property" as used in §263(g) has the same meaning as under §1092(d), i.e., that it excludes direct ownership of stock. Thus, in the case of a forward sale of debt-financed stock, gain realized upon delivery of the stock may be recharacterized as ordinary income under the conversion transaction rules of §1258, discussed in 186 T.M., Financial Instruments: Special Rules, but §263(g) would not apply to require capitalization of the interest.217.3
217.3The tax treatment of newly introduced listed equity futures authorized by the CFTC is analyzed at III, D, above.
The proposed regulations broaden the scope of §263(g) to apply not only to conversion transactions but also to risk reduction and monetization strategies such as the DECs and CPMs described above.
Prop. Regs. §1.263(g)-1 reiterates the language of §263(g), stating that the purpose of §263(g) is to "coordinate the character and the timing of items of income and loss attributable to a taxpayer's positions that are part of a straddle to prevent payments or accruals related to a straddle transaction from giving rise to recognition of deductions or losses before related income is recognized and to prevent the items of loss and income from having a different character." This is effected by capitalizing the disallowed deductions for interest and carrying charges "properly allocable to personal property" that is part of a straddle.
It is then provided that §263(g) does not apply if none of the taxpayer's positions that are part of a straddle are not personal property, and that it does not apply to any hedging transactions (as defined by §1256(e)) or to securities as to which mark-to-market accounting applies under §475.
To deal with the anomaly resulting under current interpretations of §263(g) that prevent its application to conversion transactions involving stock, Prop. Regs. §1.263(g)-2(a) defines "personal property" as used in §263(g) as meaning any personal property whether or not actively traded, including stock, i.e. without regard to the definition of §1092(d). For this purpose, the proposed regulations state that a position in personal property may itself be property.
The preamble points out that if the term "personal property" is limited to property of a type that is actively traded, §263(g) would apply to a transaction in which the taxpayer borrows to purchase actively traded property that is part of a straddle, but not to a similar transaction in which the taxpayer borrows to purchase a derivative instrument that is not traded but which is a position in actively traded property.
Thus, under these proposed regulations, it is clear that an untraded OTC option or forward contract to sell listed stock would qualify as "personal property" for §263(g) purposes.
However, the proposed regulation 217.4 specifies that a position in personal property is not property of a taxpayer unless it confers or may confer substantial rights on the taxpayer. Thus, personal property includes ownership of stock or a debt instrument and either party's position under a forward contract or conventional swap, but does not generally include the debtor's position under a debt instrument. However, under Prop. Regs. §1.1092(d)-1(d), discussed above, the obligor on a debt instrument has a position in any personal property underlying it (i.e., stock the value of which affects one or more payments due under the instrument). Further, the obligations of the grantor of an option are not treated as property for §263(g) purposes.
217.4Prop. Regs. §1.263(g)-2(a)(1).
A somewhat complex example is provided illustrating these rules:
Example: A purchases an ounce of gold for $400 and transfers it to a trust that is treated as a partnership because it issues multiple classes of trust certificates. A receives two certificates that are not actively traded. One entitles A upon termination of the trust in four years to a payment of $489, the forward price of one ounce of gold. The other entitles A to payment on the same date of the amount by which the spot price of gold exceeds $489. In other words, A is in the same position as if he had sold the gold forward. A sells the second certificate and retains the first. The example states that the certificate retained by A is personal property for §263(g) purposes.
Note: The example does not attempt to analyze the tax consequences of these transactions. A forward sale contract is a combination of a short European style call and a long European style put which can be settled in cash on identical property with the same strike price and expiration date. Here A has sold the call and retained the put. If A has incurred interest on funds borrowed to purchase the gold, §263(g) may be applicable to deny a deduction for interest on the loan.
Prop. Regs. §1.263(g)-3 interprets the meaning of interest and carrying charges that a properly allocable to property that is part of a straddle.  As a general rule, there is disallowed only the excess of such amounts over the allowable income offsets.
Prop. Regs. §1.263(g)-3(b) explains that the interest and charges referred to are otherwise deductible amounts paid or accrued on indebtedness or other financing 217.5 incurred or continued to purchase or carry property that is part of a straddle and also otherwise deductible amounts paid or incurred to carry property that is part of a straddle, such as, storage, insurance, and transportation costs. Interest would include OID and accruals by the issuer of a contingent payment debt instrument under the noncontingent bond method of Regs. §1.1275-4(b).
217.5The term "or other financing" presumably is intended to include obligations that may or not constitute indebtedness within the strict meaning of the tax laws but which are treated as such by the taxpayer and the IRS (e.g., most equity linked and similar securities the payment at maturity on which is not an unconditional amount but depends in part or in whole on the value of specified property or a specified index.  Hereinafter, the term "indebtedness" used in this context includes such other financing.
Comment: Note the similarity of the statutory language of §263(g)(2)(A)(i), which describes the indebtedness as "incurred or continued to purchase or carry" the personal property, and §265(a)(2), which disallows interest on indebtedness "incurred or continued to purchase or carry" obligations the interest on which is tax-exempt. The determination of what interest meets this definition has often been the subject of considerable controversy and has been the subject of rulings and several cases. 217.6 The preamble notes that Rev. Proc. 72-18 217.7 sets forth rules for determining when this standard is met for §265(a)(2) purposes, requiring, generally, direct tracing, the use of the obligations as collateral, and a totality of facts and circumstances test under which it is met is there is a "sufficiently direct relationship" between the borrowing and the investment in the tax-exempt bonds. 217.8 It is noted that the proposed regulations provide that a sufficiently direct relationship exists between the indebtedness and personal property that is part of a straddle if payments on the indebtedness are determined by reference to the value of or change in value of the personal property, as is pointed out below.
217.6See, e.g., The Wisconsin Cheeseman, Inc. v. U.S., 388 F.2d 420 (7th Cir. 1968); Comr. v. Bagley & Sewall Co., 221 F.2d 944 (2d Cir. 1955); Investors Diversified Servs., Inc. v. U.S., 575 F.2d 843 (Ct. Cl. 1978).
217.71971-2 C.B. 40.
217.8Thus, the methodology of Regs. §1.163-8T does not apply for this purpose.
The regulations make clear that indebtedness (or other financing) incurred or continued to purchase or carry a straddle position includes indebtedness (or other financing) --
• the proceeds of which are used directly or indirectly to purchase personal property that is part of a straddle;
• that is secured directly or indirectly by personal property that is part of a straddle; and
• the payments on which are determined by reference to payments with respect to the personal property or the value of or the change in value of the personal property. 217.9 
217.9Prop. Regs. §1.263(g)-3(c).
With reference to the last of these items, financial instruments that are deemed part of a straddle or considered to carry part of a straddle include --
• a financial instrument that is part of a straddle;
• a financial instrument that is issued in connection with the creation or acquisition of a position in personal property if that position is part of a straddle;
• a financial instrument marketed as an arrangement involving a taxpayer's position in personal property that is part of the straddle and purports to result in either monetization of the property without current recognition of gain or a current tax deduction for payment of an expense that is economically offset by an increase in value that is not currently recognized or has a different character (e.g., interest expense that is offset by capital gain in a later period); and
• any other financial instrument "if the totality of facts and circumstances support a reasonable inference that the issuance, purchase, or continuation of the instrument was intended to purchase or carry personal property that is part of the straddle."  218 
218Prop. Regs. §1.263(g)-3(d)(1) through 1.263(g)-3(d)(4). See, e.g., FSA 200131015 (issuer's financial instruments were incurred to continue, and therefore carry, an investment in another company's stock; as part of a straddle, they are subject to the capitalization rules under §263(g)).
Comment: These rules appear to expand the scope of the straddle provisions enacted in 1981 (as subsequently amended in 1984 and 1986 to modify the stock exception) far beyond anything envisaged at the time.  The extent to which they are supported by the language of the statute, even given the broad regulatory authority, will be addressed in comments by the public in a hearing scheduled for May 2001.
Prop. Regs. §1.263(g)-3(e) enumerates the various allowable income offsets such as interest (included in gross income) with respect to the personal property. Both OID and market discount are taken into account as are dividends to the extent they exceed the dividends received deduction.  Included as an offset is any amount that is a receipt or accrual with respect to a financial instrument described in paragraph (d) to the extent it is entered into to buy or carry the personal property.
Prop. Regs. §1.263(g)-4 provides rules that allocate the disallowed interest and carrying charges in the following order:
• To personal property that is part of the straddle purchased directly or indirectly with proceeds of the indebtedness;
• To personal property that is part of the straddle and directly or indirectly secures the indebtedness; or
• If all or a portion of such interest and carrying charges are determined by reference to the value or change in value of personal property, to such personal property.218.1
218.1Prop. Regs. §1.263(g)-4(a)(1)(i), (ii), (iii).
The disallowed fees and expenses for storage, insurance, transportation, etc. of the straddle related personal property are all allocated to the property with respect to which these expenses were incurred.
Under a catch-all provision, in all other cases, allocation is effected in a manner that "under all the facts and circumstances is most appropriate." 218.2
218.2Prop. Regs. §1.263(g)-4(a)(2), (3).
The proposed regulations coordinate the allocation rules with other Code provisions.218.3 In the case of a short sale, the provisions of §263(h) (limiting the deduction allowable for "in lieu of" dividends or interest payments to the lender of the property sold short) are applied before §263(g). The Code's provisions relating to the taking into account of market discount and of OID on short-term debt instruments defer deductions for interest incurred or continued to purchase or carry such market discount bond or short-term instrument to the extent it does not exceed net interest income from the debt instrument.  These provisions are applied before application of §263(g). Finally, it is provided that capitalization under §263(g) applies before loss deferral under §1092, presumably in those cases where the same amount could be treated as either a loss under §165(a) or an otherwise deductible expense such as interest or as some other type of expenditure.
218.3Prop. Regs. §1.263(g)-4(b).
The rules set forth in the preceding proposed regulations are illustrated by a series of examples. 218.4
218.4Prop. Regs. §1.263(g)-4(c).
Example 1 involves a relatively simple cash and carry silver straddle (use of borrowed funds to purchase silver coupled with entering into a forward sale of the same amount of silver).
In Example 2, the same taxpayer is required to post variation margin as security for his obligation to deliver the silver when the market price of silver increases. Interest on money borrowed to pay such margin is treated as on debt incurred to continue or carry the holding of the silver (personal property that is part of a straddle) and must be capitalized into the silver.
Example 3 involves a CPDI. Taxpayer D sells forward x barrels of oil for a price of $y. Soon thereafter, D issues a debt instrument to F with stated principal of $z payable at maturity in two years. Interest is payable quarterly at a rate equal to LIBOR as adjusted by an index that varies inversely with changes in the price of oil; as oil prices increase, interest payments are decreased.  The example states that the changes in the aggregate interest paid due to the functioning of the index "approximates the concurrent change in the value of x barrels of fuel oil and, thus, the value of A's interest in the forward contract."
On these facts, it is concluded that the CPDI and the forward contract are offsetting positions with respect to the same personal property and constitute a straddle. Under Prop. Regs. §1.1092(d)-1(d), the CPDI is a position in personal property because one or more payments under the instrument are linked to the value of personal property a position with respect to personal property. The forward is also a position with respect to personal property under §1092(d)(2). The values of the two positions can be seen to vary inversely with the result that they are offsetting. Interest payments on the CPDI are thus treated as interest on indebtedness incurred or continued to carry a straddle position and are, therefore, properly allocable to the capital account for the forward contract. Among the regulations cited in support of this result is Prop. Regs. §1.263(g)-4(a)(1)(iii) which provides that interest on debt incurred to carry personal property that is part of a straddle is allocable to the personal property if all or a portion of the interest is determined by reference to the value or change in value of personal property that is part of the straddle.
In Example 4, the same facts are assumed as in Example 3 and, in addition, D enters into a two-year interest rate swap under which D pays a fixed rate (7% annually) and receives a floating rate (LIBOR) on a notional principal amount of $z.
It can be seen that if under the CPDI, D pays LIBOR adjusted to reflect the oil index and under the swap pays 7% in exchange for LIBOR, the effect is the same as if the debt instrument called for a 7% rate adjusted to reflect changes in the value of the oil index. The example concludes that the swap is a financial instrument that carries personal property that is part of a straddle with the result that net payments made by D under the swap are chargeable to the capital for the forward contract for the delivery of the oil, but net payments received by D are allowable offsets.
Example 5 involves a contingent payment debt instrument like the one discussed above and referred to herein as a CPM. G has held 100,000 shares of publicly traded XYZ stock for four years. On Jan. 1, 2002, when the stock has a value of $x (the example does not state whether the stock has appreciated while in G's hands), G issues a CPDI for an issue price of $100,000x maturing in five years. The instrument provides for coupon interest at an annual rate of 2% (which is presumably well below market) and stated redemption price at maturity of $100,000x. The instrument provides that if on the maturity date, the value of XYZ stock equals or exceeds $1.2x, there is payable at maturity 75% of 100,000 multiplied by such excess. Thus, if the value of XYZ stock on Jan. 1, 2002, is $100, and on Jan. 1, 2007, is $138, the holder of the CPDI will receive a payment at maturity (in addition to the coupon interest due) of $10,000,000 (the stated principal amount) plus an additional $1,350,000.
Example 5's analysis of this set of facts is as follows:
(1) The debt instrument is a position in XYZ stock under Prop. Regs. §1.1092(d)-1(d);
(2) The XYZ stock and the debt instrument are offsetting positions because aggregate payments under it vary directly with the value of the stock; any additional payment to the holder at maturity based on the formula described will be offset by appreciation in the value of the stock;
(3) The XYZ stock is personal property because it is part of a straddle the other leg of which is substantially similar or related property (the debt instrument) within the meaning of §1092(d)(3)(B)(i)(III) and Regs. §1.1092(d)-2(c); and
(4) The interest on the CPDI, both the coupon interest and accruals under the CPDI rules, are properly allocable to the capital account of the XYZ stock.
Comment: Commenting on legislative proposals similar to those in the proposed regulations, the NYSBA stated that if a taxpayer borrows money to purchase stock and writes an out-of-the-money call option on the stock with a reasonably short term to maturity (i.e., one that would have a premium approximating that for a qualified covered call under current law -- the NYSBA recommends eliminating the QCC exception), the taxpayer should not be viewed as having substantially reduced the risk of loss with respect to the stock and should not, therefore, be required to capitalize interest on the loan under §263(g). But, the report continues, there is a point where, because of the term of an optionally exchangeable debt instrument just as in the case of a long-term written call option, the premium for the embedded written call option would be so significant as a percentage of the current value of the cover stock that it should be viewed as substantially reducing the issuer's risk of loss on the stock. In these circumstances, it is reasonable to regard the cash component of the interest paid on the instrument, as well as the "phantom" deduction required by the CPDI rules as a cost of "carrying" the underlying property by monetizing its value and at the same time reducing its risk of loss.218.5
218.5NYSBA Report (3/17/00) at p. 29. See Tax Notes (1/31/00) at 587 (analysis of NYSBA Tax Section meeting of Jan. 24, 2000) and Tax Notes (1/22/01) at 440 (analysis of ABA Section of Taxation meeting of Jan. 12, 2001) addressing the proposed regulations about to be issued. The latter article is helpful to an appreciation of the extremely broad scope of the proposed regulations.
Example 6 is somewhat like Example 1. Taxpayer H borrows funds to purchase 100 ounces of gold for $u which he then transfers to a trust taxed as a partnership which issues to H two certificates. One certificate entitles H to a payment upon the termination of the trust in four years of an amount equal to the spot price of gold at that time up to a maximum of ($u + w). The other entitles H to a payment equal to the amount by which the spot price of gold at termination exceeds ($u + w). The first certificate is equivalent to the grant of a European style call option with a ($u + w) exercise price. The second certificate is equivalent to the acquisition of a European style call option with the same exercise price. After sale of the second certificate, H's position is the equivalent of holding a long (physical) position in the gold and writing a covered call. The forward sale is an offsetting short position. These two positions are personal property for §263(g) purposes and are also offsetting positions that constitute a straddle as defined by §1092(c) (since gold is actively traded). Under Prop. Regs. §1.263(g)-3(b)(1) and 1.263(g)-3(c)(1), above, the borrowing is considered indebtedness incurred to purchase personal property that is part of a straddle. The example posits that the partnership also incurred storage expenses for the gold. These are deemed incurred due to H's holding personal property that is part of a straddle. Therefore, both the interest on the loan and the storage expenses are allocated to the capital account for the partnership interest represented by the retained trust certificate.
In the final example, Example 7, taxpayer J purchases 100,000 (listed) shares of XYZ Four years later, on Dec. 31, 2001, at which time the stock traded for $x per share, J entered into a notional principal contract (NPC) with K. The NPC is a standard short total return equity swap under which J makes payment to K annually of an amount equal to dividends and appreciation on the XYZ stock and K makes an annual payment to J of one year LIBOR times $100,000x (as adjusted to reflect changes in value annually) plus the amount of any depreciation of the stock. Payments are netted. The example concludes that "J's aggregate payments on the NPC varied directly with the increase in value in the XYZ shares."
This same situation was addressed in Prop. Regs. §1.1092(d)-2, discussed above. Under that proposed regulation the long stock position and the taxpayer's position in the NPC are offsetting positions in personal property coming within the exception to the §1092(d)(2) stock exclusion rule provided by §1092(d)(3)(B)(i)(III) since the swap position is considered to be one with respect to substantially similar or related property.
The proposed regulation issued in 1995 contained no rules regarding the treatment of payments made under the swap. In the extensive criticism of the proposed regulation, the NYSBA 218.6 posed a number of questions regarding the application of §263(g) to a stock/total return swap straddle. The proposed regulations and the example leave some of these questions unanswered. What is meant by "J's aggregate payments on the NPC?" Does this refer to net payments? The example concludes that since the positions described constitute a straddle, "J's payments are interest and carrying charges properly allocable to personal property that is part of a straddle and they "should be allocated to the personal property that is part of the straddle in the manner that is most appropriate under all the facts and circumstances." In the case presented by the example, it is proposed that since the payments were incurred to carry the XYZ shares, they should be allocated to the capital account for the stock.
218.6The report was published in 69 Tax Notes 1271 (12/4/95).
(3)	Effective Dates
The proposed regulations under §263(g) apply to interest and carrying charges properly allocable to personal property that are paid, incurred or accrued after publication of final regulations for a straddle established on or after January 17, 2001.218.7
218.7Prop. Regs. §1.263(g)-5.
As noted above, Regs. §1.1092(d)-1(d) contains the effective dates of the regulations issued under §1092(d). It is proposed that these be shifted to subsection (e), and that Prop. Regs. §1.1092(d)-2 be inserted. The effective date for the latter (also to be contained in paragraph (e)) is for straddles established on or after January 17, 2001.
4.	Coordination with Other Code Provisions
The Code219 requires the capitalization, in certain circumstances, of "in lieu of dividend" payments made by the borrower of stock used in a short sale. In the case of a short sale, this capitalization rule is to be applied before the interest capitalization rule of §263(g).219.1
219§263(h).
219.1§263(g)(4)(A); Prop. Regs. §1.263(g)-4(b).
Section 263(g) is to be applied after the application of §§1277 and 1278 (calling for the deferral of interest attributable to the purchase or carrying of market discount and short-term debt instruments having acquisition or original issue discount).219.2
219.2§263(g)(4)(B); Prop. Regs. §1.263(g)-4(b).
Observation: These provisions would require the capitalization of interest paid to a broker where securities are purchased on margin and the taxpayer acquires an offsetting position with respect to such securities (a short futures position, for example), but if the same securities are loaned in connection with a short sale, "in lieu of interest" payments from the borrower would not be applied to reduce the amount required to be capitalized under §263(h) since they apply only to payments in lieu of dividends.
F. Section 1256: Mark to Market, "60/40" Rules, Hedging Exception
1.	Introduction: The Mark to Market and 60/40 Rules
The second major prong of the straddle rules is contained in the provisions of §1256(a). See A, above, for discussion of the abuse at which the rules were directed. Briefly, the taxpayer enters into a straddle composed of long and short futures contracts, one of which is closed out at a loss and replaced with another contract offsetting the retained contract to lock in the unrealized gain. Both are held until the following year at which time both are closed out for a net gain approximating the loss sustained in the previous year. The transaction is abusive because there has been no true economic loss; the loss sustained was counterbalanced by unrealized gain on the offsetting position, and this gain is frozen or preserved by entering into a new position offsetting the retained position.
In devising the 1981 anti-abuse provisions, Congress took note of the fact that all futures contracts are marked to market and the taxpayer in such transactions has available for withdrawal from the margin account all of the unrealized gain. Therefore, Congress concluded that this gain should be recognized even if the contract was not closed out at the end of the year. This income inclusion effectively counteracts any loss claimed from the disposition of offsetting positions during the year because the gain "locked in" under prior law is unlocked for tax purposes.
To accomplish this, the Code provides that each "Section 1256 contract" held by the taxpayer at the end of the year is treated as sold for its fair market value on the last business day of the year and any resulting gain or loss is taken into account for that year.220 When a position marked to market under the foregoing rule is subsequently disposed of, the taxpayer adjusts any gain or loss on disposition to reflect the gain or loss from marking to market.221
220§1256(a)(1). In Murphy v. U.S., 93-1 USTC ¶50,270 (9th Cir. 1993), the Ninth Circuit held that taxation of year-end gains on marked-to-market futures contracts under §1256 is constitutional because the unique accounting method governing futures contracts treats gains inherent in the contracts as constructively received. Under a marked-to-market system of accounting, a trader's equity in futures contracts is measured at the end of each trading day based on the net unrealized gain or loss on each open futures contract. Whether a trader actually receives the funds attributable to gain is determined entirely by the trader's own volition, because the trader constructively receives any gain as a matter of right each trading day. Id.
221§1256(a)(2).
Because straddles were not only used to defer tax liability but also to age holding periods, the statute also provides that 60% of any gain or loss with respect to a §1256 contract is treated as long-term gain or loss, and the remaining 40% is treated as short-term gain or loss.222 This is referred to herein as the "60/40 rule" or "60/40 treatment."
222§1256(a)(3).
Generally, noncorporate taxpayers may not carry back net capital losses. These losses are carried forward indefinitely under §1212(b). Congress, however, saw fit to enact a carryback election for the net §1256 contract losses of noncorporate taxpayers. Under §1212(c), a noncorporate taxpayer may elect to carry back for three years any "net section 1256 contract loss." This loss may only be used to offset "net section 1256 contract gain" recognized in the carryback years.
Under the formula provided in §1212(c), net §1256 contract loss for the loss year is segregated from the net capital loss for the year (if any). The carryback amount is the lesser of: (i) the net §1256 loss for the year; or (ii) the sum of short- and long-term capital losses that qualify for capital loss carryover under the general rule of §1212(b)(1).
When carried back, the net §1256 contract loss offsets net §1256 contract gain for the carryback year. Net §1256 contract gain is defined as the lesser of: (i) capital gain net income attributable solely to §1256 contracts; or (ii) the capital gain net income for the year.223 The portion of the loss carryback not absorbed by the third preceding taxable year is allowed first as a carryback to the second preceding year, and then to the first preceding year.224 In effect, §1212(c) combined with the §1212(b)(1) capital loss carryover provisions prevents any net §1256 contract loss allowed as a carryback from being included in the amount to be carried forward. As stated above, these provisions are elective for any taxable loss year.
223§1212(c)(5).
224§1212(c)(3).
Note: A §1256 net loss carried back under §1212(c) is a net capital loss for purposes of determining the amount of refund interest. In TAM 9145007, the taxpayers carried back a §1256 loss from 1989 to 1986. The loss was offset against §1256 gains realized in 1986, giving rise to an overpayment. In refunding the overpayment, the IRS paid interest only from the date the claim for refund was filed. According to the IRS, net §1256 contracts losses are "net capital losses" for purposes of computing interest under §6611(f)(1).
Finally, because these rules effectively prohibit the abusive manipulation of straddles composed entirely of §1256 contracts, §1256(a)(4) provides that in the case of such a straddle neither §1092 nor §263(g) applies. These sections, however, do apply to a straddle containing any position which is not a §1256 contract.225
225§1092(d)(5).
2.	Additional Mark-to-Market Rules
The mark-to-market and 60/40 rules also apply where the taxpayer's rights and obligations under a §1256 contract are terminated (or the contract itself is transferred 226 and the holder's rights and obligations are assumed by another): (1) by offsetting; (2) by taking or making delivery; (3) by exercise or being exercised (in the case of options), by assignment or being assigned; (4) by lapse; or (5) otherwise.227 If such a termination (or transfer) occurs, the §1256 contract is treated as if it were sold for its fair market value, and such amount is taken into account by the taxpayer in the year of termination.228
226Ordinarily, RFCs cannot be assigned, but if the holder dies, the rights and obligations pass to the personal representative. RFCs may be transferred to and from partnerships, and the legislative history of the 1982 Technical Corrections Act (P.L. 97-448) states that these provisions were intended to operate in these circumstances. Also, any rights are subject to claims of creditors (including the United States under a tax lien) and, in the case of bankruptcy, will pass to the trustee.
227§1256(c)(1). See also Greene v. U.S., 79 F.3d 1348 (2d Cir. 1996), rev'g 864 F. Supp. 407 (S.D.N.Y. 1994), in which the circuit court held that §1256 applies to donations of regulated futures contracts, and that such contracts should have been marked to market with gain recognized at the time of contribution. On remand in Greene v. U.S., 975 F. Supp. 273 (S.D.N.Y. 1997), aff'd, 185 F.3d 67 (2d Cir. 1999), the district court rejected the taxpayer's contention that that §1256(a)(2) required a "proper adjustment in the amount of any gain subsequently realized." Rather, the court found that the sole purpose of the "proper adjustment" was not to prevent taxation, but to prevent double taxation.
228§1256(c)(3). Note: Before TEFRA, taking delivery under a futures contract was not a taxable event. Section 1223(8) provided that the holding period of the commodity acquired included the period for which the futures contract was held. This paragraph of §1223 was amended in 1982 by P.L. 97-448, §105(c)(4), making the rule inapplicable to §1256 contracts.
Example 1: In 2003, T, a speculator, entered into a long futures contract calling for delivery in Sept. 2004 of 5,000 bushels of wheat at $2.75 per bushel. At the end of 2003, T still holds the contract and the September wheat futures price is $2.50. The contract is marked to market, and T recognizes a capital loss of $1,250,229 which is treated as long-term to the extent of $750 and short-term with respect to $500. On Mar. 12, 2003, when the Sept. wheat price has risen to $3.10, T closes out the contract by offset. The contract is again marked to market for a gain of $1,750 ($.35 × 5000). The gain, however, is adjusted to account for the loss previously allowed. As a result, T recognizes a capital gain of $3,000 in 1997, of which $1,800 is long-term and $1,200 is short-term.
229Under §1256(a)(1), the contract is treated as sold, i.e., closed out through the clearing organization, for its fair market value. In this case, T would have paid over to the clearing organization $1,250 in additional margin which would be retained when the contract is closed by offset and T's obligation terminated. At this time, T would be entitled to a capital loss.
Example 2: The facts are the same as above, except that instead of closing out the contract, T took delivery of the wheat in Sept. when the price was $2.80 per bushel. Again, the contract is marked to market.230 T's gain is $250, but it is adjusted to $1,500 to reflect the previous loss of $1,250. T's basis in the wheat is $2.80, the price paid. Note that a §1256 contract is subject to the mark-to-market and 60/40 rules without regard to whether it is part of a straddle.
230See §1256(c), discussed below.
As a general rule, the straddle rules may sometimes accelerate the recognition of income but will never accelerate the recognition of a loss.
Example: At the close of her taxable year, T holds a long non-§1256 contract position and an offsetting §1256 contract position. If the §1256 contract is marked to market for a gain of $10x, T must recognize the gain, notwithstanding that there is unrealized loss from the non-§1256 contract position. On the other hand, if marking to market the §1256 contract results in a loss, §1092(a) prevents the loss from being recognized to the extent of any unrecognized gain from the offsetting non-§1256 contract position.231
231This rule, which requires recognition of gain when marking to market a §1256 contract, but prevents recognition of the loss (if it is not matched by unrecognized gain from the offsetting position), can be avoided by making a "mixed straddle" election under §1256(d), explained below, at the cost of giving up 60/40 treatment of any gain realized.
If two or more §1256 contracts are part of a straddle (regardless of whether the straddle consists entirely of §1256 contracts) and the taxpayer takes delivery on or exercises one of the contracts, all other §1256 contracts in the straddle are treated as terminated at that time and marked to market.232
232§1256(c)(2). This rule was added by the Technical Corrections Act of 1982. The legislative history states that if a short futures contract is deemed terminated under this provision because the taxpayer takes delivery of property under a long futures contract, for purposes of making a §1256(d) mixed straddle election, the short contract is treated as newly acquired on that date. H.R. Rep. No. 794, 97th Cong., 2d Sess. 24 (1982). The §1256(d) election is discussed below.
Comment: As originally enacted, the mark-to-market rule was justified on the ground that it simply reflected the principle of constructive receipt. This, of course, cannot be said of the marking to market of such §1256 contracts as nonequity options and forward sales of foreign currency, neither of which is subject to daily credits or debits as are the margin accounts of the holders of futures contracts. As noted above, if an options dealer grants a call option and the option has not been exercised by the close of the year, the dealer is treated as if he or she had entered into a closing purchase transaction and must recognize any gain or loss which would have been realized.233 This is subject to the 60/40 rule as well. Under a special rule, however, if gains and losses attributable to dealer equity options or dealer securities futures contracts are allocable to limited partners, the 60/40 rule does not apply, and all gains and losses are treated as short-term capital gains and losses.234
233Despite the wording of the statute. The dealer has no interest in property that could be "sold for its fair market value."
234§1256(f)(4), as amended by the Community Renewal Tax Relief Act of 2000, P.L. 106-554, effective Dec. 21, 2000. The rule also applies to limited entrepreneurs within the meaning of §1256(e)(3), discussed below.
3.	Hedging Transactions
a.	Introduction
As explained at A, above, the straddle rules contain exceptions to accommodate certain types of transactions that Congress viewed as presenting little or no potential for abuse. The identified straddle and the qualified covered call are discussed at D, above. The most significant exceptions, however, are what are known as "hedging transactions."
Section 1256(e) excepts from §1256(a) certain financial products that would otherwise be §1256 contracts which have been properly identified by the taxpayer as hedging transactions. Likewise, §1092(e) excepts these transactions from the loss deferral rule of §1092(a), and §263(g)(3) excepts straddles that qualify as hedging transactions from §263(g)(1). Both §§1092(e) and 263(g)(3) cross refer to §1256(e) for the definition of hedging transactions.
The Joint Committee's General Explanation of §1256 235 noted that a hedging transaction is one that a taxpayer executes in the normal course of its trade or business primarily to reduce certain risks.235.1 This transaction results in ordinary income or loss and is properly identified as a hedging transaction. This portion of §1256 appeared to pose no particular problems for a number of years after its enactment. As is explained below, however, in 1988, the Supreme Court rendered a decision that was interpreted by the IRS as making the hedging transaction exception inapplicable to all but a very limited category of business related hedges -- in seeming contradiction of Congress' understanding of current law when §1256(e) was enacted. Except for this limited category, the IRS took the position that the hedging transactions defined in §1256(e) gave rise to capital gain and loss and the hedging transaction exception did not apply. The failure of these transactions to qualify under §1256(e) was only part of the problem created. Characterizing gain and loss as capital more often than not resulted in a mismatch of the character of income or loss from the hedges and that of the assets and liabilities being hedged.
2351981 Blue Book at 299.
235.1Note that the definition of a hedging transaction has since been expanded from transactions that reduce risk to transactions that manage risk. See §§1256(e) and 1221(b)(2), both as amended by the 1999 Tax Relief Extension Act, §532, and effective for any instrument held, acquired, or entered into, any transaction entered into on or after Dec. 17, 1999.
Although remedial legislation appeared to be called for, Congress, in the Conference Committee report accompanying the 1993 Budget Act, instead decided to call for a study by the Treasury Department on the tax treatment of hedging transactions. In response, the Treasury, in October 1993, published temporary regulations under which a substantial segment of the hedging transactions defined in §1256(e) were accorded ordinary income or loss treatment, permitting taxpayers to proceed with such transactions with the understanding that they would be excepted from the straddle rules and, equally as important, that gains and losses would be characterized in the same manner as the gains and losses of the items being hedged. The Treasury also issued proposed regulations relating to the identification of such transactions and to the timing of recognition of gains and losses.236 Due to the urgency of the need for guidance in this area, final regulations were published in July 1994 (hereinafter the "hedging regulations") on all of these subject matters. While there still remain a number of unresolved questions, especially in the area of the timing of realized gains and losses from hedging transactions, these regulations are a significant and helpful step toward the comprehensive legislation that most commentators believe is necessary.
236See Letter from Secretary Bentsen to Chairman of the Ways and Means Committee Rostenkowski (10/18/93) (outlining the scope of the regulations), reprinted in Tax Analysts' Daily Tax Highlights & Documents (11/5/93). Hereinafter, this publication is referred to as Daily Tax H & D.
Congress amended §1221 in 1999 to broaden the definition of "hedging transactions" from transactions that reduce risk to include transactions that manage risk.236.1 In March 2002, final regulations were issued to conform the hedging regulations with the amended statute.236.2
236.1See §1221(b)(2), as amended by the 1999 Tax Relief Extension Act, §532.
236.2See Regs. §1.1221-2, T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
The subject matter is far more complex than the drafters of §1256(e) could have imagined in 1981, due in large part to the proliferation and widespread use by all kinds of taxpayers of complex financial instruments and products that have been developed and marketed since then. Section 1256(e), the hedging regulations, and the 2001 proposed regulations are analyzed below after a discussion of the background essential to an understanding of them.
Hedging is an extremely complex topic and the discussion herein is limited to the tax aspects of some of the more common types of hedging activity. What persons engaged in business operations refer to as "hedges" embrace a broad universe of transactions. The variety and complexity of business hedging makes it extremely difficult to formulate a comprehensive set of tax accounting rules that are satisfactory over the entire range of this activity. An idea of the complexity of the subject matter can be gathered from books and articles discussing aspects of the use of "financial derivatives" for business related purposes as well as speculation.237
237See, e.g., Koziol, Hedging, Principles, Practices and Strategies of the Financial Markets (1990), Andersen, Currency and Interest Rate Hedging (2d ed. 1993), Kolb, Interest Rate Futures (1984), Kolb, Financial Derivatives (1993), and the various articles cited therein. See also Bierman, Johnson & Peterson, "Hedge Accounting: An Exploratory Study of the Underlying Issues," Financial Accounting Standards Board (1991).
As is well known, the futures and options markets (as well as the markets for over-the-counter derivatives of all kinds) are driven to a considerable extent by speculators and arbitrators. But a substantial portion of trading is attributable to hedging transactions entered into by producers and processors of various commodities and by corporations and financial institutions seeking to reduce risks resulting from the volatility of interest rates and currency exchange rates. In the final analysis, hedging transactions, as distinguished from speculation, all have as their objective the immunization, in whole or in part, of the hedger's business operations from market forces affecting prices, interest rates, and currency exchange fluctuations, enabling the hedger more accurately to predict and stabilize profit margins and future cash flows.
This portion of the portfolio discusses the transactions that are excluded from §§1256(a) and 1092(a) by virtue of §1256(e), and the rules governing the character and timing of income, deductions, gains, and losses from such transactions. The historical background presented first explains how the problems addressed by the hedging regulations developed, and the analysis of the final hedging regulations explains the rules for determining both the character and timing of gains and losses from hedging transactions. Finally, the final regulations issued in 2002 are discussed.
b.	Historical Background
As indicated above, Congress, in enacting §1256(e), clearly understood that under then-current law the sale or exchange of certain types of assets that, taken alone, appeared to fall within the general definition of capital assets in §1221, nevertheless could give rise to ordinary income or loss in certain circumstances. The types of assets referred to are those making up "hedging transactions."
Congress obviously did not anticipate any problems with excluding certain commonly employed hedging transactions, as it understood the term, from the mark-to-market and loss deferral rules of §§1256 and 1092. Also, as discussed in the context of the short sale rules, the exclusion of §1233 from hedging transactions in commodity futures238 has been in the Code since 1954 without having caused much in the way of comment or controversy regarding the meaning of hedging transaction as used therein.
238§1233(g).
(1)	Treatment of Hedging Transactions Before Corn Products
Before the Supreme Court decision in Corn Products Ref. Co. v. Comr.239 in 1955, a rule had developed, first articulated in 1936 in GCM 17322,240 that futures contracts,241 which are generally treated as capital assets, that are entered into for the sole purpose of insuring against the risks inherent in a taxpayer's business, should be considered a form of business insurance, and, consequently, losses on such contracts should be treated as ordinary business expenses. As a corollary, the GCM also treated gains from such contracts as ordinary income from the business. The contracts the GCM referred to were those insuring against price changes affecting what is referred to in hedging terminology as the taxpayer's long cash position. A taxpayer that invests in the production of goods held for sale to customers has a long cash position because any increase in the price for which the goods can be sold will result in an increase in gross profit; any decrease in price will have the opposite effect. If a party is found that agrees to purchase a specified quantity of the goods at a specified date in the future for a specified price, the producer can lock in a profit equal to the excess of the futures price over its costs of production, at the cost of forfeiting any additional profit that might have been earned if the contract had not been entered into. The producer of a commodity (e.g., a farmer or cattle rancher) can insure against a drop in current market prices by entering into a short futures contract242 which fixes the price for the commodity when brought to market, the typical and traditional type of hedge from which the futures market evolved. Hedges envisaged by the GCM included: 
(1) short futures positions acquired by the purchaser of raw materials used in its manufacturing to insure against a drop in the price of such raw materials and, hence, a drop in the price for which the manufactured goods can be sold; and
(2) long futures positions in the raw material components of goods produced by a manufacturer who has contracted for the future delivery of finished goods at a fixed price, acquired to insure against a rise in raw material prices.
239350 U.S. 46 (1955).
240XV-2 C.B. 151.
241The GCM would presumably also extend to any similar "derivatives," such as options, futures options, and forward sales or purchases had they been traded on established exchanges at the time.
242See 188 T.M., Taxation of Equity Derivatives, for a discussion of futures contracts.
The GCM warned, however, that futures contracts that are not hedges against spot transactions are speculative unless they are hedges against concurrent futures or forward sales or purchases. Thus, a hedge position can itself be hedged to reduce overall cost or reduce the coverage of the initial hedge. In the handful of cases concerning gains or losses from transactions assertedly falling within the scope of this hedging rule, the question arose whether the GCM applied to hedges that were not "true" hedges in that they did not result in an "even and balanced position."
In Comr. v. Farmers & Ginners Cotton Oil Co.,243 the producer of crude cottonseed oil, forced to sell its product when prices were what it considered artificially depressed, acquired long futures positions in refined cottonseed oil. The prices of the cottonseed oil closely tracked those of the crude and there were no crude oil futures available. The strategy behind these hedges was to enable the taxpayer, once prices had risen, to recoup the profits it would have earned had it been able to store the oil and sell it at a more opportune time. When prices fell, however, the futures had to be closed out at a loss. The losses from these futures were held to be capital on the ground that the hedges were not "true" hedges, within the meaning of GCM 17322, because they did not protect the taxpayer from a drop in the market prices for which its inventory could be sold.
243120 F.2d 772 (5th Cir. 1941), rev'g 41 B.T.A. 1083.
The hallmark of a hedge is that it must offset or counterbalance another position. To constitute a true hedge, a long futures contract must be offset by a short position, typically a contractual obligation to make delivery in the future at a fixed price. The taxpayer in Farmers & Ginners had no position, short or long, in either crude or refined oil. The fact that it was a producer, which seemed to sway the reversed Board of Tax Appeals was, essentially, irrelevant.
Under the "true" hedge theory, the hedge serves to insulate the taxpayer from the effects of price changes from the date the hedge is entered into because at that point the hedger is locked into that portion of the profit margin that is subject to control. This is the essence of all hedging, as distinguished from speculation. The transactions entered into by the taxpayer in Farmers & Ginners, from this standpoint, were speculative. To this extent, the case is a seminal one that remains valid as a statement of current law.
To the extent that GCM 17322 was interpreted as ruling that, in order to constitute business insurance, a hedge had to be "true" in the sense of leaving the taxpayer in a totally balanced position, it was considered by some as restricting too narrowly the use of business hedges. Many also thought that ordinary treatment of gains and losses from positions which were only partial, or what might be termed "quasi," hedges was also warranted. For example, if only a portion of the risk was insured against, if the futures position was in another product subject to similar price changes to the asset hedged, or if short futures positions were acquired by a farmer who had not yet planted his crop, it was contended that these hedges should be treated the same as "true" hedges.
This broader interpretation of hedging prevailed in Stewart Silk Corp. v. Comr.,244 where the taxpayer, a manufacturer of garments made from silk who anticipated a drop in silk prices due to competition from synthetic fabrics, sold raw silk futures to hedge its raw material inventory on hand and to be acquired. The court held that losses sustained on the hedges because of a sudden unanticipated rise in silk prices were ordinary, rejecting the IRS' argument that the hedges were not "true" because only a portion of the taxpayer's silk purchases were covered. The court stated that futures contracts representing hedges against price fluctuations in spot goods are not speculative transactions although they are not concurrent with the spot transactions. In other words, the taxpayer's hedges did not have to match precisely its purchases of raw silk to be treated as hedging transactions within the scope of GCM 17322. Further, in Kurtin v. Comr.,245 losses on short butter futures entered into by a cheese wholesaler to reduce risk of a decline in dairy product prices were held to be ordinary.
2449 T.C. 174 (1947).
24526 T.C. 958 (1956), acq., 1957-1 C.B. 4.
(2)	The Corn Products Decision
The Second Circuit's opinion in Corn Products 246 appeared to clarify the somewhat fragmentary and partially evolved principles regarding the character of gains and losses from hedging transactions entered into as a form of business insurance.
246215 F.2d 513 (2d Cir. 1954), aff'd, 350 U.S. 46 (1955).
The taxpayer in Corn Products manufactured various products, the principal ingredient of which was oil derived from processing raw corn. The products were sold to customers for delivery in 30 days for a specified price or, if the market price was lower, the market price. In setting the specified price, the taxpayer could not rely on the prices paid for corn on hand due to limited storage facilities. It was thus obliged to estimate its corn costs based on current prices plus cost of carry. A rise in the price of raw corn due to a poor harvest would, therefore, compel it to sell the finished products at either a lower profit or a loss; a drop in corn prices presumably would adversely affect its profit margin but not to the same extent. Having sustained losses in earlier years from sudden unanticipated shortages of corn that in increased corn prices, the taxpayer instituted, some years before those in issue, a program of buying futures contracts to insure an adequate supply of corn and to protect against price increases. The futures were acquired during or shortly after the harvest season. If no corn shortage appeared imminent, the taxpayer took delivery on some contracts and sold the rest. If shortages developed, it closed out its contracts as corn was purchased for grinding.
In the first two of the three years in issue, the taxpayer sustained losses from closing out its contracts. These losses were added to the cost of goods sold. In the third year, the taxpayer had substantial gains which it set off against the cost of goods sold. Inconsistently with its return position, the taxpayer contended that the futures did not constitute valid hedging transactions and that the character of the gains and losses should have been reported as capital. The taxpayer's principal argument was that acquisition of the futures contracts were not "true" hedges because they did not leave it in a balanced position. In view of the lower of fixed contract price or market sales contracts, it was protected only against increases in corn price. Further, the futures did not evenly match its anticipated corn purchases.
At the time this case was pending, the courts and commentators were considering whether the treatment of hedging transactions as set forth in GCM 17322 and the decisions applying it had created a common law of taxation exception to the provisions of §1221,247 namely, that an asset not specifically excepted from the general rule of §1221 by paragraphs (1) through (5) was, nevertheless, excluded from treatment as a capital asset if its acquisition served as a nonspeculative form of business insurance entered into in the course of the taxpayer's trade or business. The Second Circuit, affirming the Tax Court, appeared to reject this argument, but held that even though the futures were not "true" hedges because they did not insure against the risk of declining prices, they must nevertheless be recognized as hedging transactions giving rise to ordinary income and loss as they were used in exactly the same manner as true hedges--i.e., to stabilize inventory costs and protect profit. Furthermore, the court observed that the futures contracts were not speculative but rather part of the taxpayer's inventory purchase system. The court expressly denied that the tax treatment of hedges was based on a judicially created exception to §1221, stating that it was simply "a recognition by the courts that property used in hedging transactions properly comes within the exclusions of the section."248
247Actually, the Code section involved was the identically worded predecessor of §1221, §117(a) of the 1939 Code. Hereinafter, reference to "§1221" also refers, where appropriate, to its predecessor.
248215 F.2d at 516 (referring to §1221(1)).
The Supreme Court affirmed the Second Circuit, where, as one commentator put it, "the Commissioner prevailed under a rationale that squarely followed GCM 17322. . . and the extra-statutory exception school of analysis."249 The Court, which could have simply based its decision on the grounds articulated by the court of appeals, went well beyond these, remarking that the definition of capital asset in §1221 should not be so broadly applied as to defeat the purpose of Congress--i.e., that the profits and losses from the everyday operation of a business are ordinary in character--and that characterizing gains and losses from sales of capital assets as capital should be restricted to transactions that are not the normal source of business income.
249Kleinbard & Greenberg, "Business Hedges After Arkansas Best," 43 Tax L. Rev. 393 (1988).
(3)	The Corn Products Doctrine
The Supreme Court's language in Corn Products was widely interpreted to mean that for gain or loss from the sale of property to be treated as ordinary, it was not necessary for the property to come within one of the statutory exceptions to the general rule of §1221250 or to constitute a surrogate for or insurance against loss from such excepted property. It was sufficient to establish that the property in question was acquired and sold as part (sometimes referred to as "an integral part") of the taxpayer's business activities, as distinguished from an investment unrelated to such activities. Whether and the extent to which acquisition of the property served a hedging function no longer appeared to be significant. While this might be evidence of the purpose for which the property was acquired, other evidence could establish a business related purpose; the purpose was the paramount issue. This interpretation of the decision came to be known as the Corn Products doctrine.
250§1221(1)- (4); Section 1221(1) includes stock in trade, inventory, and goods held for sale to customers in the ordinary course of business, and §1221(4) includes accounts or notes receivable acquired in the ordinary course of business for services rendered or the sale of §1221(1) property.
What the IRS may have initially viewed as a victory (the taxpayer's gain, which far exceeded its losses, was characterized as ordinary) was soon seen as a major source of revenue loss. The Corn Products decision was cited as authority for characterizing as ordinary the losses from the sales of various types of property, without regard to whether they served a hedging function (broadly construed). This property included the stock of a subsidiary held by a holding company251 and stock acquired for various allegedly business related purposes, such as assuring a source of supply of goods used in the taxpayer's business or protecting and/or enhancing the taxpayer's reputation. The IRS, in Rev. Rul. 75-13, 1975-1 C.B. 67, ruled that in such cases the taxpayer's predominant motive in acquiring the stock or other property governed the character of loss from its sale. Later, following language adopted by the Tax Court in W. W. Windle Co. v. Comr.,252 the IRS in Rev. Rul. 78-94,253 took the position that, in order for gain or loss from the sale of property to be treated as capital, it must have been acquired pursuant to a "substantial investment motive."
251Campbell Taggart, Inc. v. U.S., 744 F.2d 442 (5th Cir.1984); Schlumberger Tech. Corp. v. U.S., 443 F.2d 1115 (5th Cir. 1971). See Javaras, "Corporate Capital Gains and Losses -- The Corn Products Doctrine," 52 TAXES 770 (1974).
25265 T.C. 694 (1976), appeal dism'd, 550 F.2d 43 (1st Cir.).
2531978-1 C.B. 58, revoking and superseding Rev. Rul. 75-13.
As might be expected, taxpayers realizing gains from the sale of assets that arguably came within the ambit of the doctrine simply reported the transactions as sales of capital assets, gambling that the IRS would not inquire too deeply into the taxpayer's purpose for acquiring the assets in question. When losses were sustained, however, they were claimed as ordinary if the taxpayer had any grounds for contending that the assets in question were not acquired with a "substantial investment motive."
It became well known among tax professionals that the Tax Division of the Department of Justice disagreed with the IRS's adoption of the Corn Products doctrine with its emphasis on the purpose for which the assets in question were acquired. It was the Tax Division's view that Corn Products should not be read as creating a nonstatutory exception to §1221, but rather as articulating the circumstances under which an asset that hedges property falling within one of the statutory exceptions to §1221 may be treated as falling within the same exception.254
254See GCM 38178(11/22/79).
(4)	Section 1256(e): "Hedging Transaction"
Such was the state of the law in 1981 when the provisions of §1256(e) were drafted and enacted. Section 1256(e) excludes "hedging transactions" from §1256. It was thought appropriate that such transactions be excluded from the mark-to-market and 60/40255 rules of §1256(a). Also, as indicated above, because of §1092(e), which cross refers to §1256(e), hedging transactions as defined by §1256(e) are excluded from the loss deferral straddle rules of §1092(a) and from the capitalization of expense requirement of §263(g).
255See V, F, 1, above.
Note: In defining "hedging transaction," Congress did not, and did not intend to, create any statutory exception to §1221. It limited the exclusion from §1256 to what it assumed were transactions that would normally be treated as giving rise to ordinary income or loss under Corn Products, unless entered into for investment or speculation unrelated to the taxpayer's business activities, and that would otherwise fall within the definition of §1256 transaction.
Section 1256(e)(2)(A), as enacted in 1981, defined a hedging transaction as a transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily --
(1) to reduce risk of price change or currency fluctuations with respect to property which is held or to be held by the taxpayer; or
(2) to reduce risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred by the taxpayer.256 Importantly, to qualify as a hedging transaction, gain or loss from the transaction must be treated as ordinary gain or loss.257 Note that this element of the definition does not make such gains and losses ordinary, but requires that they be so treated under established tax law principles if the transactions are to qualify as hedging transactions. Finally, hedging transaction treatment applies only if, before the close of the day on which the transaction was entered into, the taxpayer clearly identifies the transaction as a hedging transaction.258
256Note that in 1999 Congress broadened the definition of hedging transactions by amending §1256(e)(2) to include transactions that manage risk. See §§1256(e)(2) and 1221(b)(2)(A), both as amended by 1999 Tax Relief Extension Act, §532, and effective for instruments held, acquired or entered into on or after Dec. 17, 1999.
257§1256(e)(2)(B).
258§1256(e)(2)(C).
Note: Identification is the most effective whipsaw preventative. In 1976, a bill was introduced adding a new §1254 to the Code, under which any security acquired as other than a nonbusiness related investment had to be identified as such with 30 days of its acquisition if loss from its sale or exchange was to be characterized as ordinary. Gain from any security so identified was ordinary. The bill259 was never enacted.
259H.R. 10902, 94th Cong., 2d Sess., reprinted in H.R. Rep. No. 13160, 94th Cong., 2d Sess. 6-7 (1976).
This definition does not extend hedging transaction status to all transactions that would pass muster under the broad reach of the Corn Products doctrine. The definition reflects the view that a hedging transaction need not necessarily result in a balanced position as long as it reduces risk. It must be entered into in the "normal course" of the taxpayer's business activities, thus excluding speculative transactions. As noted above, it must reduce price change or currency fluctuations with respect to property held by the taxpayer. "Property" presumably refers to property falling within one of the exceptions to §1221, although this limitation is not provided.
Section 1256(e)(2)(A)(ii) clearly recognizes "liability hedges," as well as anticipatory hedges -- i.e., hedges that reduce the risk of loss with respect to current obligations and anticipated obligations -- which, at the time the statute was enacted, had not ever been specifically considered by a court but which the drafters apparently concluded came within the Corn Products doctrine.
(5)	Arkansas Best
The Supreme Court's decision in Arkansas Best Corp. v. Comr.,260 dealt a death blow to the Corn Products doctrine as described above and to any theory that based the determination of whether an asset fell within a statutory or judicial exception to § 1221 solely on the taxpayer's purpose in acquiring the asset. The taxpayer in Arkansas Best was a diversified holding company that had acquired a 65% stock interest in a bank. Because of the 1970 amendments to the Bank Holding Company Act, the taxpayer had to commit to divestiture of the bank stock over a ten-year period. In 1972, the bank was classified as a "problem" by the Federal Reserve. Shareholders were called upon to make additional contributions to capital to prevent the collapse of the bank and, presumably, the stock's becoming worthless. In 1975, the taxpayer sold most of the additional stock acquired (the post-problem stock) together with the other shares (pre-problem stock) at a loss, which the taxpayer characterized as ordinary under the Corn Products doctrine, claiming that the stock had not been acquired as an investment.
260108 S. Ct. 971 (1988).
The Tax Court261 held that the sales of the pre-problem stock generated capital losses because these shares had been acquired with a substantial investment motive. As to sales of the post-problem stock, however, the court allowed ordinary loss on the ground that these shares had been acquired and held solely for the business related purpose of protecting the taxpayer's reputation by fending off the bank's failure. On appeal, the Eighth Circuit262 reversed the Tax Court as to the latter sales, stating that it had never accepted the "misbegotten" Corn Products doctrine and holding that there was no legal basis for any exception to §1221under which capital stock can be treated as anything other than a capital asset (unless included in inventory by a dealer).263 One was left to ponder whether this opinion essentially held that there were no exceptions to §1221 other than those enumerated in the statute, or whether the holding applied only to capital stock.
26183 T.C. 640 (1984), aff'd in part and rev'd in part, 800 F.2d 215 (8th Cir. 1986), aff'd, 108 S. Ct. 971 (1988).
262800 F.2d 215 (8th Cir. 1986), aff'd, 108 S. Ct. 971 (1988).
263800 F.2d at 221.
The Supreme Court, on certiorari, affirmed the court of appeals. It observed that, to the extent Corn Products had been interpreted as holding that ordinary asset treatment was authorized for any asset acquired and held for business rather than for investment purposes, such interpretation was in error. The Court concluded that Corn Products must be interpreted "as standing for the narrow proposition that hedging transactions that are an integral part of a business' inventory-purchase system fall within the inventory exclusion of [§] 1221."264 Because that was clearly not the case in Arkansas Best, loss from sale of the stock was held to be a capital loss.
264108 S. Ct. at 976-77. See also Pike v. U.S., 88 F.3d 54(1st Cir. 1996), in which the First Circuit cited Arkansas Best in rejecting an individual's assertion that the bank stock that he accumulated was §1221(1) inventory because it embodied the "raw material" from which he intended to build a bank holding company. The court noted that the individual did not hold the bank shares as "stock in trade" for sale to his customers. In the wake of the Supreme Court's Arkansas Best decision, the court explained, the determination of whether property qualifies for exclusion from capital gains treatment under the §1221(1) inventory exception turns on the property owner's ability to demonstrate that it acquired the assets in connection with an inventory-purchase system.
This decision, which appeared to upset what had been considered settled law for almost 30 years, was widely commented on. Its implications were both unclear and unsettling. The IRS issued Notice 87-68,264.1 suspending all published guidelines relying on or applying the business motive test. The holding, as it applied to stock whose acquisition could not be considered a hedging transaction under the most liberal interpretation of that term, was not overly troubling. But the implication that, to qualify for ordinary income or loss treatment, any asset acquired and held as a hedge must either be property described in §1221(1)- (4) or, as was the case in Corn Products as interpreted by the Court, a substitute or "surrogate" for such excepted property, appeared to disqualify a wide range of hedging transactions commonly entered into by various businesses.
264.11987-2 C.B. 378.
It was quickly perceived that if these implications were acted on by the IRS, many, if not most, of the hedging transactions described in §1256(e)(2)(A) would fail to meet the §1256(e)(2)(B) requirement that gain or loss from them be treated as ordinary income or loss. Perhaps the most significant of these were so-called liability hedges. A very common type of liability hedge is the acquisition of an interest rate futures (or, sometimes, option) contract to protect the taxpayer against adverse interest rate fluctuations affecting anticipated borrowings.
Example: T funds the acquisition of a one-year debenture bearing annual interest of 12% by issuing a nine-month note bearing interest at an annual rate of 10%. The principal amount of both instruments is $20,000,000. T realizes that at maturity of the nine-month note, $20 million of principal plus $1,500,000 of interest will be due. To fund this, T must borrow $21,500,000 for three months, at the end of which period T will receive $22,400,000 from the 12-month debenture. To break even, T calculates that it can pay no more than 16.75% interest on the three-month refinancing, determined by the following calculation:
$22,400,000 - $21,500,000 = $900,000;
($900,000/$21,500,000) / .25 = .16744
To protect itself against the risk that short-term rates will have risen above the breakeven 16.75% rate nine months hence, T sells T-note futures for a price that will lock in a lower rate. Assume that on the date the one-year debenture was acquired, T enters into a futures contract, the terms of which require it to deliver in nine months a T-bill maturing in 90 days at a price reflecting an annual yield of 9.2%. If interest rates on the T-bill rise by 6.5% (a rather unlikely assumption, of course), the rate that the taxpayer will have to pay on its short-term notes will have risen commensurately (although not precisely; the "locked-in" rate is the Treasury component only). This means that under each T-bill contract, T would be entitled to deliver a bill worth $964,200 for a price of $978,238. The contract can thus be closed out for profit of $14,038. T issues its three-month notes at a rate of 17%. The net interest expense for each $1,000,000 in face amount of such notes is approximately $24,452 ($38,490 - $14,038), reflecting a rate of about 10.04%. Had rates dropped, the loss from the futures contracts would have been offset by the lower interest payable on T's debt issuance. Note that this is a hedge of the anticipated borrowing, not of the debenture held by T.
Although hedging transactions such as those described in the example appear to come clearly within §1256(e)(2)(A)(ii), the IRS took the position in the wake of Arkansas Best that gain or loss from hedging transactions described in that clause ((A)(ii)) is not ordinary gain or loss because such interest rate futures are assets not described in any of the exceptions to the general rule of §1221. Therefore, they could not be described as surrogates for, or as reducing the risk with respect to, any property that is so excepted. Admittedly, this is a narrow reading of the decision, but not an implausible one. Liability hedges were not the only transactions affected, of course, but they presented perhaps the sorest problems.
Not only did this narrow interpretation of Arkansas Best threaten to bring about mismatches in the character of gain and loss resulting from hedging transactions, it also had the effect of making many, if not most, commonly employed hedges subject to §§1256 and 1092 in seeming direct contradiction to the legislative intent.
If these consequences were not bad enough, many taxpayers were caught in the trap of §1256(f)(1), whereby any gain is ordinary if a hedging transaction is identified as such, regardless of whether it satisfies the definition of §1256(e)(2)(A) and  (B). On the other hand, if the IRS concludes that the identified transaction does not satisfy the definition, §1256(f)(1) is no impediment to characterizing any loss as capital. This rule could be especially devastating to taxpayers that irrevocably identified hedging transactions before Arkansas Best.
Congress heard numerous pleas for remedial legislation because it was unclear at best the extent to which the Arkansas Best decision could be administratively overridden or modified. Although the IRS unofficially let it be known that it would refrain from applying §1256(f)(1) in cases involving bona fide pre-Arkansas Best hedging transaction identification, the status of hedging transactions that were not clearly surrogates for property described in §1221(1)- (4) remained under a heavy cloud. 
(6)	FNMA
The Tax Court considered the character of gain or loss from the disposition of liability hedges in Federal Nat'l Mortgage Ass'n v. Comr. (referred to herein as FNMA), 264.2 but in a context that limited the precedential value of the holding. The taxpayer was the principal participant in the secondary market for residential mortgages, purchasing such mortgages from the originators and holding them until retirement.264.3 The mortgages acquired were typically long-term fixed rate instruments, but their acquisition was funded by issuing short- and mid-term debentures which had to be refinanced from time to time. During the late 1970s and early 1980s, rising interest rates caused the spread between the rates on the long-term mortgages and the rates payable on the short-term debt incurred to hold the mortgages to narrow. In some instances, the latter rates exceeded the former causing net losses, termed net "interest margin" losses (reflecting the excess of its borrowing costs over its interest income from the mortgages) in each year for the period 1981-84. FNMA sought to ameliorate this situation by purchasing adjustable rate mortgages and issuing longer term debt. It continued to be confronted with interest rate risk of two kinds, however.
264.2100 T.C. 541 (1993).
264.3The recent trend is to pool the mortgages and transfer them to a REMIC, shifting interest rate risk to the REMIC interest holders.
Due to the regulations under which it operated, FNMA could not issue debt obligations whenever rates seemed favorable. There was, therefore, the risk of a rise in interest rates between the dates new issuances were planned and the dates as of which the debt could be issued. Due to the same regulations, FNMA entered into contractual agreements or commitments to purchase mortgages from lenders for specified prices based on the yields of the instruments. Here the risk was that rising interest rates would cause the fair market value of the mortgages to fall before settlement, with the result that the asset-liability gap would be further widened.
FNMA established a committee to plan hedging strategies to reduce these risks. The hedges decided on covered only a small amount of anticipated borrowings and a substantial portion of the mortgage commitments. They were in the form of short interest rate futures, options, and short sales of Treasury securities. In 1984 and 1985, when interest rates fell, these short hedges were closed out at losses, which FNMA claimed as ordinary losses. The IRS, relying on Arkansas Best, characterized the losses as capital.
The IRS made a number of arguments. It contended that under Arkansas Best ordinary gain or loss with respect to a hedging position was restricted to long hedges of inventory (or other ordinary property statutorily excepted from §1221) held or to be held. The mortgages did not qualify under the inventory exception or under any other statutory exception. Further, not only were the asserted hedges partial only (and thus not "true hedges"), they related to property (Treasury securities) other than the kind of property hedged (the mortgage portfolio).
The Tax Court dismissed these arguments and found for the taxpayer. It concluded that the short hedges locking in interest rates with respect to anticipated borrowings were entered into as an integral part of the taxpayer's business of acquiring and carrying the mortgages. The same reasoning applied to the short hedges fixing the yields of mortgages the taxpayer was committed to acquire. These hedges, the court ruled, were so closely related to the acquisition and carrying of the mortgages that they could be viewed as substitutes or surrogates for the mortgages. As to the latter, the court took note of a case decided in 1964, Burbank Liquidating Corp. v. Comr.,264.4 in which it held that mortgage loans made by an S&L in the ordinary course of its business are notes receivable acquired for services rendered within the meaning of §1221(4) -- i.e., the making of the loans. The court then accepted FNMA's argument that its mortgage portfolio should be treated the same, the services in its case being the provision of stability to the secondary mortgage market. As a result of this reasoning, the court held that FNMA's losses were ordinary in accordance with Corn Products as interpreted by Arkansas Best.
264.439 T.C. 999 (1963), aff'd in part, rev'd in part, 335 F.2d 125 (9th Cir. 1964).
It is noteworthy that the Tax Court left "to another case on another day" the issue of whether there are any nonstatutory exceptions to the general rule of §1221, seeming to conclude that this issue was not foreclosed by Arkansas Best.264.5
264.5FNMA v. Comr., 100 T.C. 541, 574-75. The court also found it unnecessary to consider other arguments raised by FNMA, such as the contention that the losses should be treated as additional interest expenses and that in enacting §1256(e)(2), Congress intended that liability hedges be accorded ordinary gain or loss treatment.
Comment: Although the issue presented in FNMA can be described as a very narrow one, and its holding confined to hedges entered into by a small class of taxpayers in whose hands debt instruments, the purchase and holding of which is hedged, are noncapital (e.g., by reason of §582(c)), it was generally believed to be significant in that it did hold that liability hedges, such as those described in §1256(e)(2)(A)(ii),264.6 qualified for noncapital treatment even though they related to property of an entirely different kind than the property being hedged.
264.6In fact, the court stated that it "strikes this Court as odd that Congress would provide an exception to the marked to market regime that would effectively serve no purpose, if, as respondent claims, property serving to hedge a borrowing were not excepted under §1221." FNMA v. Comr., 100 T.C. 541, 577.
c.	The Hedging Regulations
(1)	Introduction
In March 2002, the Treasury Department promulgated new regulations under §1221,265 necessitated by the amendment to §1221 under the Ticket to Work and Work Incentives Improvement Act of 1999,266 discussed below. Prior to amendment in 1999, §1221 generally defined a capital asset as property held by the taxpayer other than: (1) stock in trade or other types of assets includible in inventory; (2) property used in a trade or business that is real property or property subject to depreciation; (3) certain copyrights (or similar property); (4) accounts or notes receivable acquired in the ordinary course of a trade or business; and (5) U.S. government publications.
265T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
266P.L. 106-170, §532(a).
In 1994, prior to the amendment of §1221, the Treasury Department issued the 1994 regulations under §1221, which provided for ordinary character treatment for certain business hedges. The 1994 regulations were generally applicable to transactions that reduced risk with respect to ordinary property, ordinary obligations, and borrowings of the taxpayer and that met certain identification requirements.266.1
266.1See generally 1994 Regs. §1.1221-2.
On December 17, 1999, §1221 was amended by the Ticket to Work and Work Incentives Improvement Act of 1999 to provide ordinary gain or loss treatment for hedging transactions and consumable supplies. Section 1221(a)(7) provides ordinary treatment for hedging transactions that are clearly identified as such before the close of the day on which they were acquired, originated, or entered into.266.2
266.2See also §1221(b)(2).
Under amended §1221, a hedging transaction is defined as a transaction entered into by the taxpayer in the normal course of business primarily to manage risk of interest rate, price changes, or currency fluctuations with respect to ordinary property, ordinary obligations, or borrowings of the taxpayer.266.3 Further, the Code grants the Secretary the authority to provide regulations to address the treatment of nonidentified or improperly identified hedging transactions, and hedging transactions involving related parties.266.4 
266.3§1221(b)(2)(A)(i) and  (ii).
266.4§1221(b)(2)(B) and  (b)(3).
Congress intended that the hedging rules be the exclusive means through which the gains and losses from hedging transactions are treated as ordinary. Further, Congress thought a "risk management" standard better reflected modern hedging practices and, thus, Congress's amendment to the Code was intended to broaden the standard to risk management from the previously more narrow risk reduction standard.266.5
266.5S. Rep. No. 201, 106th Cong., 1st Sess. 24-25 (1999).
In 2001, proposed regulations were published by the Treasury Department.266.6 On May 16, 2001, the IRS held a public hearing on the proposed regulations. Written comments responding to the notice of proposed rulemaking were also received. In response to these comments, the proposed regulations were modified and adopted as the final regulations. The provisions of the final regulations are discussed below.
266.6REG-107047-00, 66 Fed. Reg. 4738 (1/18/01).
Regs. §1.1221-2(h) provides that the rules of the final regulations apply to transactions entered into on or after March 20, 2002. However, the preamble to the final regulations states that the IRS will not challenge any transaction entered into on or after December 17, 1999, and before March 20, 2002, that satisfies the provisions of either former Prop. Regs. §1.1221-2 or the provisions of the final regulations.266.7
266.7Preamble, T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
(2)	General
Several key changes were effected by the promulgation of the final regulations. Perhaps the most significant change is the change from a risk reduction to a risk management standard. In response to comments on the proposed regulations, the final regulations have been restructured to implement the risk management standard. While no definition of risk management is provided, the rules do characterize a variety of classes of transactions as hedging transactions because they manage risk. Risk reducing transactions still qualify as one class of hedging transactions, but there are also others. In addition, the final regulations specifically provide for the recognition of additional types of qualifying risk management transactions through published guidance or private letter rulings. Under the final regulations, as under the proposed regulations, transactions entered into for speculative purposes do not qualify as hedging transactions.266.8
266.8See S. Rep. No. 201, 106th Cong., 1st Sess. 24 (1999).
In addition to the change in standard, the final regulations effect a change in the way a taxpayer can determine if a transaction manages risk. The proposed regulations provided that a taxpayer had risk of a particular type only if it was at risk when all of its operations were considered, i.e., risk must have existed on a "macro basis." Under the proposed regulations, a taxpayer was required to show that hedges of particular assets or liabilities, or groups of assets or liabilities, were reasonably expected to reduce the overall risk of the taxpayer's operations. Responding to comments that this entity-based approach to hedging was no longer uniform business practice, the final regulations permit the determination of whether a transaction manages risk to be made on a business unit basis provided that the business unit is within a single entity or consolidated return group that adopts the single-entity approach.266.9
266.9Regs. §1.1221-2(c)(4).
Further, in response to comments on the proposed regulations, the final regulations have also been restructured to separately separately address interest rate hedges and price hedges. Responding to comments that that the rules in the proposed regulations provided insufficient guidance in that it stated only that fixed-to-floating interest rate or price hedges may be hedging transactions, the Treasury Department, in the final regulations, provides that a transaction that converts an interest rate from a fixed rate to a floating rate or from a floating rate to a fixed rate manages risk. With respect to fixed-to-floating price hedges, the final regulations adopt the proposed rules without change.266.10
266.10Regs. §1.1221-2(d)(iv).
In addition to the above discussed changes to the regulations, the final regulations also clarify that certain transactions are not entered into primarily to manage risk and comment on "gap" hedges.266.11 These changes are discussed in further detail, below.
266.11T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
(3)	The Character Rules: "Hedging Transaction"
Regs. §1.1221-2(a) is substantially identical to the proposed rules and provides that, notwithstanding the provisions of Regs. §1.1221-2(g)(2), the term "capital asset" does not include property that is part of a "hedging transaction" as defined in Regs. §1.1221-2(b). It also provides, as did the proposed regulations, that Regs. §1.1221-2 governs the character of gain or loss from a short sale or option that is part of a hedging transaction. The final regulations provide that the character of gains and losses from short sales and acquired or options, respectively, that are (or are identified as being) part of a hedging transaction are determined under Regs. §1.1221-2.
The final regulations, under the heading "Exclusivity," make it clear that unless a transaction satisfies the definition of "hedging transaction" in Regs. §1.1221-2(b) (substantially identical to the definition under the proposed regulations), the character of gain or loss is not made ordinary on the ground that the property involved in the transaction is a surrogate for a noncapital asset, that the transaction serves as insurance against a business risk, or that it serves a hedging purpose, or a similar function or purpose.266.12
266.12Regs. §1.1221-2(a)(3).
Regs. §1.1221-2 does not apply to gains and losses realized in §988 transactions or realized with respect to any qualified fund as defined in §988(c)(1)(E)(iii), but does apply to transactions or payments that would have been subject to §988 but for the date entered into or made.266.13 While the proposed regulations provided that except to the extent provided in regulations issued under §§864(e) and 954(c), the definition of "hedging transaction" in  -2(b) did not apply for purposes of §§864(e) and 954(c),266.14 the final regulations contain no such provision. Subsequent regulations will specify the extent to which the rules relating to hedging transactions that are contained in the §1221 regulations will be applicable for purposes of those other regulations and related Code sections.
266.13Regs. §1.1221-2(a)(4).
266.14Former Prop. Regs. §1.1221-2(a)(4)(ii).
Note: In May 2002, the Treasury Department issued proposed regulations,266.15 offering guidance as to how the rules in the §1221 regulations apply for purposes of §954(c). In January 2003, final regulations 266.16 were issued, adopting, without significant change, the proposed regulations. These regulations are discussed in more detail in 927 T.M., CFCs -- Foreign Personal Holding Company Income.
266.15REG-154920-01, 67 Fed. Reg. 31995 (5/13/02).
266.16T.D. 9039, 68 Fed. Reg. 4916 (1/31/03).
Note: Under §988(c)(1)(B)(iii), entering into or acquiring any forwards contract, futures contract, option, or similar financial instrument (which includes virtually all derivatives including swaps) is a §988 transaction if the amount the taxpayer is entitled to receive or is required to pay by reason of the transaction is denominated in or determined by reference to a nonfunctional currency. Under §988(b)(3), any gain or loss from the transactions described in §988(c)(1)(B)(iii) is treated as foreign currency (i.e., ordinary) gain or loss. Under §988(c)(1)(D)(i), §988(c)(1)(B)(iii) applies to regulated futures contracts and nonequity options which would be marked to market if held on the last day of the year. But the taxpayer may make an election (revocable only with IRS consent) to have this clause not apply to contracts held during the year of election and all subsequent years. Although the character of gains and losses from §988 transactions is determined under §988, that section has no application in determining whether a §988 transaction is a hedging transaction for purposes of §1256(e)(2). Thus, a futures contract or forward contract which is a §988 transaction may nevertheless be subject to the provisions of §§1256(a) and 1092(a) unless it satisfies the risk management function defined by §1256(e)(2) and is properly identified. Further, Regs. §1.1256(e)-1, providing rules for identifying a hedging transaction for purposes of §1256(e)(2), incorporates the rules of Regs. §1.1221-2(f).
The key term in the final regulations is "hedging transaction." It is defined in Regs. §1.1221-2(b) as a transaction that the taxpayer enters into in the normal course of the taxpayer's trade or business primarily:
(i) to manage risk of price changes or currency fluctuations with respect to ordinary property (as defined in Regs. §1.1221-2(c)(2)) that is held or to be held by the taxpayer; or
(ii) to manage 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
(iii) to manage such other risks as the Secretary may prescribe in regulations.
Ordinary property and ordinary obligations are defined in Regs. §1.1221-2(c)(2). Property is ordinary property to a taxpayer only if a sale or exchange of the property by the taxpayer cannot produce capital gain or loss, irrespective of the taxpayer's holding period at the time of the sale or exchange. An obligation is an ordinary obligation if performance or termination of such obligation by the taxpayer could not produce capital gain or loss. For purposes of Regs. §1.1221-2(c)(2), termination has the same meaning as under §1234A.
The final regulations clarify that "normal course" means a transaction entered into in furtherance of the taxpayer's trade or business even if the risk to be managed related to the expansion of an existing business or the acquisition of a new trade or business.266.17
266.17Regs. §1.1221-2(c)(1).
Thus, under the final regulations, a hedging transaction must, therefore, manage risk with respect only to property in the form of noncapital assets held or to be held. Thus, transactions that manage risk with respect to any asset that is not excepted from §1221(a)(1)- (8) (or treated as if it were under §582(c)) does not qualify.
(4)	Rules of Application
(a)	General
Regs. §1.1221-2(c) provides the general rules regarding the application of Regs. §1.1221-2.
(b)	Risk Management
Regs. §1.1221-2(c)(4)(i) provides the general rule that whether a transaction manages risk is determined on the basis of the facts and circumstances involved, and that a primary factor is the taxpayer's hedging strategies and policies as reflected in its minutes or other records.
Changing the proposed regulations, the final regulations also provide that whether a transaction manages a taxpayer's risk may be determined on a business unit by business unit basis (for example, by treating particular groups of activities, including the assets and liabilities attributable to those activities, as separate business units), provided that the business unit is within a single entity or consolidated return group that adopts the single-entity approach.266.18 In addition, Regs. §1.1221-2(c)(4)(ii) specifically states that except as determined by published guidance or private letter ruling, a transaction that is not treated as a hedging transaction under Regs. §1.1221-2(d) does not manage risk. Further, the final regulations clarify that a transaction undertaken for speculative purposes is not treated as a hedging transactions.226.19
266.18Regs. §1.1221-2(c)(4)(i).
226.19Regs. §1.1221-2(c)(4)(ii).
(c)	Risk Reducing Transactions
The final regulations provide that a transaction that is entered into to reduce a taxpayer's risk generally manages risk.
Comment: The final result of this circular drafting is that for a transaction to be considered a hedging transaction, it must manage risk, and to manage risk, it must reduce risk (the former standard for what constituted a hedging transaction) unless it is described in Regs. §1.1221-2(d)(2) or the taxpayer obtains a private letter ruling.
The final regulations modify the proposed regulations, specifically enumerating certain transactions that manage risk through risk reduction. 266.20
266.20Regs. §1.1221-2(d).
(i)	"Micro" and "Macro" Hedges
 The first of these specifically identified transactions are micro and macro hedges. Under the final regulations, risk is generally determined on a "macro" basis. The final regulations state that " [a] taxpayer has risk of a particular type only if it is at risk when all of its operations are considered."266.21 As a general rule, a taxpayer's risk is to be analyzed on an overall company basis, rather than by looking at the effect of each individual hedging transactions on the specific item being hedged. However, Regs. §1.1221-2(c)(4)(i) provides that a taxpayer may instead opt to determine its hedging activity with reference to the separate business units within a single taxpayer.
266.21Regs. §1.1221-2(d)(1)(ii)(A).

In addition, some micro risk reducing transactions are permitted: (1) "a hedge of a particular asset or liability generally will be respected as reducing risk if it reduces the risk attributable to the asset or liability and if it is reasonably expected to reduce the overall risk of the taxpayer's operations;" 266.22 and (2) "hedges [of] particular assets or liabilities, or groups of assets or liabilities, [where] the hedges are undertaken as part of a program that, as a whole, is reasonably expected to reduce the overall risk of the taxpayer's operations." 266.23 The final regulations provide the following example regarding micro and macro hedges:
266.22Id.
266.23Id.
Example: Corporation X manages its business operations by treating particular groups of activities, including the assets and liabilities attributable to those assets, as separate business units. A separate set of books and records is maintained with respect to the activities, assets and liabilities of separate business unit y. As part of a risk management program that Corporation X reasonably expects to reduce the overall risks of its business operations, Corporation X enters into hedges to reduce the risks of separate business unit y. Corporation X may demonstrate that the hedges reduce risk by taking into account only the activities, assets and liabilities of business unity.266.24
266.24Regs. §1.1221-2(d)(1)(ii)(B).
These rules should not be confused with the rules relating to hedges of the taxpayer's aggregate risk. The final regulations include in the definition of hedging transaction, a transaction that manages the aggregate risk of interest rate changes, price changes, and/or currency rate fluctuations, but only if all of the risk, or all but a de minimis amount of the risk, was with respect to ordinary property, or ordinary obligations and borrowings.266.25
266.25Regs. §1.1221-2(c)(3).
(ii)	Written Options
The second category of transaction specifically identified as managing risk through risk reduction is written options. 266.26 The regulations provide an example, stating that, in appropriate circumstances, a written call option with respect to assets held by the taxpayer or a written put option with respect to assets to be acquired by a taxpayer may be hedging transactions.
266.26Regs. §1.1221-2(d)(1)(iii).
(iii)	Fixed-to-Floating Price Hedges
The third and final category of transactions identified as managing risk through risk reduction by the final regulations is fixed-to-floating price hedges. As provided in Regs. §1.1221-2(d)(1)(iv), a transaction that economically converts a price from a fixed price to a floating price may reduce risk. The final regulations provide, for example, that a taxpayer with a fixed cost for its inventory may be at risk if the price at which the inventory can be sold varies with a particular factor. Thus, the final regulations provide that for such a taxpayer, a transaction that converts its fixed price to a floating price may be a hedging transaction.
(d)	Other Transactions That Manage Risk
Additional transactions, other the ones identified above, also manage risk, as stated by the final regulations. These additional transactions are explored below.
(i)	Interest Rate Conversions
 While the proposed regulations recognized that a transaction that economically converted an interest rate or price from a fixed rate or price to a floating rate or price may manage risk, commentators suggested that this rule provided insufficient guidance in that it stated only that fixed-to-floating interest rate or price hedges may have qualified as hedging transactions. In response to these comments, the final regulations were restructured to separately address interest rate hedges and price hedges.266.27
266.27T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
Commentators commenting on the proposed regulations suggested that in the case of interest rate conversions, a taxpayer may choose to convert from a floating to a fixed rate to fix the amount payable on the obligation. However, these commentators also observed that a taxpayer could also elect to convert from a fixed to a floating rate to insure that the value of the liability remained relatively constant. In response to these comments, the final regulations provide that a transaction that converts an interest rate from a fixed rate to a floating rate or from a floating rate to a fixed rate manages risk.266.28
266.28Id.; Regs. §1.1221-2(d)(2).
(ii)	Counteractive Hedging
Pursuant to Regs. §1.1221-2(d)(3), if a transaction is entered into primarily to offset all or any part of the risk management effected by one or more hedging transactions, the transaction is a hedging transaction. These transactions are also referred to as "un-hedging hedges." The final regulations provide, for example, if a written option is used to reduce or eliminate the risk reduction obtained from another position such as a purchased option, then it may be a hedging transaction.
(iii)	Recycled Hedges
The final regulations provide that a taxpayer may enter into a hedging transaction by using a position that was a hedge of one asset or liability as a hedge of another asset or liability (recycling). This recyling is a transaction that manages risk.266.29 Thus, for example, a long futures hedge reducing risk of price change with respect to ordinary property (inventoriable items) to be acquired could be maintained after the property has been purchased if, at that time, additional purchases of the same or similar property were anticipated. It still retains its status as a hedging transaction. A single forward sale of foreign currency may be retained to cover multiple anticipated payments in that currency over the course of an accounting period before being terminated.
266.29Regs. §1.1221-2(d)(4).
(iv)	Partial Hedges
Pursuant to Regs. §1.1221-2(d)(7)(i), a taxpayer may hedge all or any portion of its risk for all or any part of the period which it is exposed to such risk.
(v)	Multiple Hedges
The final regulations recognize the fact that a taxpayer frequently enters into and terminates positions (even if done on a daily or more frequent basis). Regs. §1.1221-2(d)(7)(ii) provide that is not relevant to whether these transactions are hedging transactions. Thus, the final regulations provide, for example, a taxpayer hedging the risk associated with an asset or liability may frequently establish and terminate positions that hedge that risk, depending on the extent the taxpayer wishes to be hedged. Similarly, the final regulations provide that if a taxpayer maintains its level of risk exposure by entering into and terminating a large number of transactions in a single day, its transactions may nonetheless qualify as hedging transactions.266.30
266.30Regs. §1.1221-2(d)(7)(ii).
(vi)	Hedges of Other Risks
Regs. §1.1221-2(d)(6) provides that the Commissioner may, by published guidance, determine that hedging transactions include transactions entered into to manage risks other than interest rate or price changes, or currency fluctuations. The Treasury Department, in the preamble to the 2002 regulations, notes that the expansion of the scope of operation of the hedging rules is not being proposed at this time. The 2002 preamble notes, however, that the IRS is continuing to consider whether to expand the definition of hedging transactions to cover hedges of such other risks.
Comment: Under Regs. §1.1221-2(d)(6), the regulations delegate the authority to the Commissioner through published guidance. Some suggest this will be guidance in the form of revenue rulings or notices, rather than PLRs.
(e)	Transactions Not Entered to Manage Risk
The proposed regulations provided that the purchase or sale of certain assets did not qualify as a hedging transaction if the assets were not acquired primarily to manage risk. This rule was illustrated by the example of a taxpayer that had an interest rate risk from a floating rate borrowing and that acquired debt instruments bearing a comparable floating interest rate. Although the taxpayer's interest rate risk from the floating rate borrowing may have been reduced by the purchase of the floating rate debt instruments, the proposed regulations provided that the acquisition of the debt instruments was not made primarily to reduce risk and, therefore, was not a hedging transaction.226.31
226.31Former Prop. Reg. §1.1221-2(c). See also  Preamble to T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
The preamble to the final regulations states that the IRS and the Treasury Department understand that some employers may invest in assets (such as shares of a mutual fund) that are used as a reference investment for purposes of computing their liability to employees under a nonqualified deferred compensation plan. Further, they recognize that a question may arise whether such an investment may constitute a hedging transaction and, if so, whether income from the investment may be deferred by the employer until payments of deferred compensation are made to employees.266.32
266.32Preamble to T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
As a result of this information, the rule has been restated in the final regulations to refer specifically to investments in debt instruments, equity securities, and annuity contracts so as to provide greater certainty in its application. For this purpose, certain transactions in instruments that are not themselves debt instruments may include a debt investment.226.33 Further, the final regulations provide that the IRS may identify by future published guidance specified transactions that are determined not to be entered into primarily to manage risk.226.34 The following examples have been added to the final regulations at  -2(d) to illustrate the rule stated in this section.
226.33Regs. §1.1221-2(d)(5)(i).
226.34Id.
Example 1: Taxpayer borrows money and agrees to pay a floating rate of interest. Taxpayer purchases debt instruments that bear a comparable floating rate. Although taxpayer's interest rate risk from the floating rate borrowing may be reduced by the purchase of the debt instruments, the acquisition of the debt instruments is not a hedging transaction, because the transaction is not entered into primarily to manage the taxpayer's risk.
Example 2: Taxpayer undertakes obligations to pay compensation in the future. The amount of the future compensation payments is adjusted as if amounts were invested in a specified mutual fund and were increased or decreased by the earnings, gains and losses that would result from such an investment. Taxpayer invests funds in the shares of the mutual fund. Although the investment in shares of the mutual fund reduces the taxpayer's risk of fluctuation in the amount of its obligation to employees, the investment was not made primarily to manage the taxpayer's risk. Accordingly, this transaction is not a hedging transaction.
Example 3: Taxpayer provides a nonqualified retirement plan for employees that is structured like a defined contribution plan. Based on a schedule that takes into account an employee's monthly salary and years of service with the taxpayer, the taxpayer makes monthly credits to an account for each employee. Each employee may designate that the account will be treated as if it were used to pay premiums on a variable annuity contract issued by the M insurance company with a value that reflects a specified investment option. M offers a number of investment options for its variable annuity contracts. Taxpayer invests funds in M company variable annuity contracts that parallel the investment options selected by the employees. The investment is not made primarily to manage the taxpayer's risk and is not a hedging transaction.
(f)	Gap Hedges
The status of so-called gap hedges was not separately addressed in the proposed regulations and is not covered in the final regulations.266.35 The final regulations provide, for example, that insurance companies sometimes hedge the gap between their liabilities and the assets that fund them. Under the final regulations, a hedge of those assets would not qualify as a hedging transaction if the assets are capital assets. Whether a gap hedge qualifies as a liability hedge is a question of fact and depends on whether it is more closely associated with the liabilities than with the assets.266.36
266.35Preamble to the final regulations, T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
266.36Id.
(5)	Identification Requirements
(a)	Introduction
For a transaction to qualify as a hedging transaction under §1256(e) (and §1092(e)), the transaction must be identified as such on or before the close of the day on which it was entered into. The same rule is provided for hedging transactions within the ambit of Regs. §1.1221-2(b).
(b)	Hedging Transactions
Regs. §1.1221-2(f) provides the identification and recordkeeping requirements that must be met for a transaction to have been treated as a hedging transaction. 266.37
266.37Regs. §1.1221-2(f)(1).
(c)	Item(s) Hedged
Identification of the hedged item(s) "generally involves identifying a transaction that creates risk, and the type of risk that the transaction creates."266.38 The final regulations provide as the sole example the situation in which the hedged item is June purchases of corn inventory, and the risk was described as price movements in the market where the taxpayer bought the corn.
266.38Regs. §1.1221-2(f)(2)(i).
Section 1221(a)(7), and the regulations thereunder, state that a taxpayer entering into a hedging transaction must identify such transaction as a hedge, before the close of the day on which the transaction is entered into or any other time as the Secretary may by regulations prescribe. However, the Secretary, as promulgated in the final regulations, has decided that identification of the hedged item(s) (or aggregate risk), not the hedge itself, as above, would be sufficiently timely if made "substantially contemporaneously" with the identification of the hedging transaction -- i.e., within 35 days.266.39
266.39Regs. §1.1221-2(f)(2)(ii).
(d)	Specific Situations
In addition to the above rules, there exist more detailed rules regarding identification of certain hedging transactions. These more detailed rules, as finalized, are discussed in this section. Specific rules apply to the types of hedges discussed herein.
(i)	Anticipated Acquisition of Assets
If the transaction relates to the anticipated acquisition of assets, the identification is required to include the expected date or dates of acquisition and the amounts expected to be acquired.266.40
266.40Regs. §1.1221-2(f)(3)(i).
(ii)	Purchase or Sale of Inventory
If the hedging transaction relates to the purchase or sale of inventory, the identification is required to specify the type or class of inventory to which the transaction relates. If it relates to specific sales or purchases, it is required to include the expected dates thereof and the amounts of inventory involved.266.41
266.41Regs. §1.1221-2(f)(3)(ii).
Comment: The final regulations are phrased in terms of "inventory." It would be helpful if the final regulations clarified that this term included inventoriable costs of all kinds.
(iii)	Existing Debt of Taxpayer
Identification of hedges of existing debt of the taxpayer, if related to accrual or payments under an issue of debt, are required to specify the issue and, if the hedge is for less than the adjusted issue price or full term of the debt, to specify the amount and term of the hedge.266.42
266.42Regs. §1.1221-2(f)(3)(iii)(A).
(iv)	Debt to Be Issued
In the case of debt to be issued, the identification is required to specify the expected date of issuance, expected maturity or maturities, and the expected interest provisions. If the hedge is for less than the full amount or term of the expected issuance, the identification is also required to specify the portion of each hedged. The final regulations recognized that such information could have been somewhat inexact, in which case ranges of terms, dates, and amounts were permitted. As an example, the taxpayer may identify a hedge of the yield of an anticipated issuance of fixed rate debt during the second half of its fiscal year in an amount between $75 million and $125 million and an anticipated term of between 20 and 30 years.266.43
266.43Regs. §1.1221-2(f)(3)(iii)(B).
(v)	Aggregate Risk
If the taxpayer hedges aggregate risk, the identification is required to describe the risk and the program under which the hedging transaction is entered. This requirement is satisfied by placing a description of the program in the taxpayer's records and by establishing a system under which individual transactions are identified as being part of the hedging program.266.44
266.44Regs. §1.1221-2(f)(3)(iv)(A).
(e)	How to Identify Hedging Transactions
In providing rules for the manner in which identification should be effected, the final regulations first provide that the identification required by Regs. §1.1221-2(f) must be made on and retained as part of the taxpayer's books and records, and that the presence or absence of identification for purposes of this provision must be unambiguous. Identification for financial accounting or regulatory purposes does not automatically satisfy the final regulations' requirements unless the books and records clearly indicate that the identification is being made for tax purposes as well. Thus, the taxpayer's records are required to indicate that individual hedges or a class or classes of hedges identified for financial accounting or regulatory purposes is also being identified as hedging transactions for purposes of Regs. §1.1221-2.266.45
266.45Regs. §1.1221-2(f)(4)(i),  (ii).
Although identification on a transaction by transaction basis can be made, the final regulations permit the taxpayer to establish a system under which identification is indicated by the type of transaction (e.g., all T-bill futures and options on such futures; all long positions and all swaps relating to heating oil) or by the manner in which the transaction was consummated or recorded (e.g., all financial derivatives entered into through the XYZ brokerage firm; all options contracts recorded in ledger 234-AZ). Under this system, an identification is made at the later of the time the system is established or the time the transaction satisfies the terms of the system by being entered or by being consummated or recorded in the designated fashion.266.46
266.46Regs. §1.1221-2(f)(4)(iii).
For example, the taxpayer can set up an account identified as containing only hedges of a specified item (or specified aggregate risk). Second, the taxpayer can record a statement in the books and records that all future transactions in a specified derivative product are hedges of a specified item, items, or aggregate risk. Third, the taxpayer can place a designated mark on a record of the transaction (trading ticket, purchase order, or trade confirmation) or use a designated form or a record that contains a designated legend.266.47
266.47Regs. §1.1221-2(f)(4)(iv).
Note: These examples are not exclusive. They indicate that the IRS is flexible in accepting any reasonably designed identification method that is unambiguous and provides the examining agent with the information needed to apply the final regulations.
(f)	Consistency with §1256(e)
The final regulations provide that any identification for purposes of §1256(e)(2) is also an identification for purposes of Regs. §1.1221-2(f)(1).266.48
266.48Regs. §1.1221-2(f)(6).
(g)	Failure to Identify and Inadvertent Identification
Under §1256(f)(1) (the "whipsaw rule"), the §1256(e)(2) identification of a transaction as a hedging transaction is binding on the taxpayer. Any gain from this transaction is ordinary income. The IRS is not so bound, however, and may characterize any loss on the transaction as capital if either the transaction does not qualify as a hedging transaction or the identification is defective.
A similar rule applies for purposes of Regs. §1.1221-2. If a transaction is identified as a hedging transaction for purposes of Regs. §1.1221-2(f)(1), the identification as such is binding with respect to gain regardless of whether the identification requirements of Regs. §1.1221-2(f)(1) are satisfied. If, however, the transaction is not in fact a hedging transaction as defined in Regs. §1.1221-2(b), Regs. §1.1221-2(a)(1) and  (2) (treating a hedging transaction as a noncapital asset) do not apply, and the character of any loss is determined without reference to whether the transaction serves a hedging function. (This is referred to as the "reverse whipsaw rule.") Thus, identification of the transaction does not alone make a loss from the transaction ordinary.266.49
266.49Regs. §1.1221-2(g)(1)(i).
Except as provided by the inadvertent error exception, explained below, the absence of adequate identification under the rules of Regs. §1.1221-2(f)(1) is binding on the taxpayer and establishes that a transaction was not a hedging transaction. Thus, subject to the inadvertent error exception, the general rules of Regs. §1.1221-2(a)(1) and  (2) do not apply and the character of any gain or loss is determined without reference to whether the transaction serves a hedging function.266.50
266.50Regs. §1.1221-2(g)(2).
Example: U.S. taxpayer T holds stock of X Corp., a foreign corporation that pays its dividends in FCRs, a nonfunctional currency of T. T expects to receive quarterly dividends from X over the next year. To hedge against any drop in the value of the FCR, T sells FCR futures contracts and identifies these transactions as hedging transactions under Regs. §1.1221-2(f)(1). Subsequently, T sells one contract at a gain and another at a loss. Because these transactions are not hedging transactions within the meaning of Regs. §1.1221-2(b), the gain is characterized as ordinary income and the loss as capital loss without regard to the fact that the futures contracts serves a hedging function.
On the other hand, if the taxpayer entered into a transaction that is a hedging transaction within the meaning of Regs. §1.1221-2(b), but failed to make a proper identification under Regs. §1.1221-2(f)(1), the failure to identify the transaction is binding, and the transaction is treated as if it served no hedging function.266.51
266.51Regs. §1.1221-2(g)(2)(i).
There is an exception to the above rules. If the taxpayer fails to make an identification that complies with Regs. §1.1221-2(f)(1), gain or loss from the transaction may be treated as ordinary under Regs. §1.1221-2(a)(1) and  (2) only if: 
(1) the transaction is a hedging transaction as defined by Regs. §1.1221-2(b); 
(2) the failure to identify the transaction is due to inadvertent error; and
(3) all of the taxpayer's hedging transactions in all open years are being treated on original or, if necessary, amended returns as provided under Regs. §1.1221-2(a)(1) and  (2) (i.e., excluded from capital asset status).266.52
266.52Regs. §1.1221-2(g)(2)(ii).
The final regulations contain a provision granting relief from inadvertent identification. If the taxpayer identified a transaction as a hedging transaction for purposes of Regs. §1.1221-2(f), the character of the transaction is determined as if the transaction had not been identified, if: 
(1) the transaction is not a hedging transaction;
(2) the identification is inadvertently made; and
(3) all of the taxpayer's transactions in all open years are being treated on either original, or, if necessary, amended returns in a manner consistent with the principles of Regs. §1.1221-2.266.53
266.53Regs. §1.1221-2(g)(1)(ii).
Finally, under an anti-abuse rule, the final regulations provide that if the taxpayer fails to make an identification that satisfies the requirements of Regs. §1.1221-2(f)(1), but has no reasonable basis for treating the transaction as other than a hedging transaction, gain from the transaction is ordinary. Thus, a taxpayer cannot elect to treat gain or loss from a transaction as capital merely by failing to identify it as a hedging transaction. The reasonableness of the taxpayer's failure is determined by taking into account not only the requirements of Regs. §1.1221-2(b), but also the taxpayer's treatment of the transaction for financial accounting or other purposes and the taxpayer's identification of similar transactions as hedging transactions.266.54
266.54Regs. §1.1221-2(g)(2)(iii). Note that under Rev. Rul. 2003-127, 2003-52 I.R.B. 1245, even if the taxpayer fails to identify the transaction under Regs. §1.1221-2(f), if the transaction satisfies the definitions of a hedging transaction in §1221(b)(2)(A) and Regs. §1.1221-2(b), the taxpayer must account for the transaction using a method of accounting that is permissible under Regs. §1.446-4.
(6)	The Timing Regulations: Regs. §1.446-4
(a)	Introduction
On the same date that the former 1994 character regulations were published, the Treasury Department published T.D. 8554 containing final regulations, Regs. §1.446-4, which provide methods for taking into account gains and losses realized from business hedging transactions. These are sometimes referred to as the "timing regulations." They adopt with a few technical and clarifying changes most of the 1993 proposed regulations relating to timing.266.55 Some new provisions dealing with specific situations are added.
266.55See FI-54-93, 58 Fed. Reg. 54077 (10/20/93).
As noted in the preamble, these rules apply to business hedges described in Regs. §1.1221-2(b), regardless of whether the character of gain or loss from the transactions was determined under Regs. §1.1221-2.266.56 The reference here is primarily, if not exclusively, to hedging transactions that are also §988 transactions, gain or loss from which is ordinary foreign currency gain or loss under §988(b), in which case character is determined under §988 rather than by Regs. §1.1221-2.
266.56Explanation of Provisions, 59 Fed. Reg. at 36356. For an illustration of how Regs. §1.446-4 is applied, see FSA 200221008 (Chief Counsel's Office characterized a forward Treasury rate-lock agreement as a cash-settled forward contract on interest rates subject to Regs. §1.446-4 rules for hedging transactions).
Formulating rules for the timing of gains and losses from many hedging transactions presents extremely complex problems, especially in view of the proliferation of a wide variety of financial derivatives that can be used as hedges. How gains and losses, whether or not realized, from these instruments should be taken into account has for some time been under intense study by the Financial Accounting Standards Board.266.57 Although some interim standards have been adopted by the accounting profession, there are considerable differences of opinion yet to be resolved. For this reason, in promulgating the timing regulations, the IRS's position has been that general financial accounting rules that have been adopted will in many, if not most, cases satisfy the clear reflection of income standard of §446. Until rules have been fully developed by the FASB, however, there is a need for specific tax accounting rules to insure application of that standard.
266.57See Daily Tax Report (BNA) 174 (9/12/94).
Thus, the timing regulations provide a general clear reflection of income principle, requiring that, with respect to each identified hedging transaction, the taxpayer's books and records must contain a description of the accounting method used in sufficient detail to indicate whether this principle has been complied with. This information is required in addition to the information required under Regs. §1.1221-2(f)(1).
Note: Some commentators have questioned whether the IRS has the regulatory authority to make the character of gain or loss from a given transaction depend on whether the taxpayer's books contain a description of the accounting method used and whether the timing of recognition of gain or loss under such described method meets the clear reflection of income standard.
Rather than providing a set of specific rules, these regulations set forth the basic clear reflection of income principle with which taxpayers are expected to make a reasonable attempt to comply. The absence of specific examples is deliberate because "the identification that is needed depends on the method of accounting being used and the types or items or risk being hedged."266.58
266.58Explanation of Provisions, 59 Fed. Reg. at 36356.
Comment: This reason is somewhat difficult to accept; a specific example could have provided these elements as assumptions. Taxpayers in many cases are left to cope with somewhat vaguely described "guidelines," and would seem to have little recourse to accounting principles other than those adopted from time to time by the developing GAAP in this area. Of particular concern are the rules deemed appropriate for adopting and identifying methods appropriate to so-called "global" or "aggregate" hedges. None were proposed, but the final regulations offer some suggestions. Here, one or two specific examples, even though they may require a number of assumed circumstances, would have been helpful.
The timing regulations do, however, rule out some methods that were suggested. In the final analysis, the timing regulations emphasize the principle of matching hedge income or loss with income, loss, or deductions attributable to the item(s) hedged.
(b)	The Regulations: Clear Reflection of Income
Regs. §1.446-4(a) sets forth the general rule that the method of accounting used for a hedging transaction (as defined by Regs. §1.1221-2(b)) must clearly reflect the taxpayer's income regardless of whether Regs. §1.1221-2 governs the character of gain or loss on the transaction. Regs. §1.446-4 does not apply to hedges of capital assets, but it does apply to foreign currency hedges for which §988 and the regulations thereunder provide character but not timing rules. It overrides any other regulation that provides inconsistent rules for the timing of income, deductions, gain, or loss.266.59 Regs. §1.446-4 applies to hedging transactions entered into on or after October 1, 1994.266.60
266.59Regs. §1.446-4(a).
266.60Regs. §1.446-4(g).
Regs. §1.446-4 does not apply to cash basis taxpayers if, for all prior years ending on or before the date of final regulations, the taxpayer met the $5 million gross receipts test of §448(c) (or would have met the test if it were a corporation or partnership).266.61 It does not apply to transactions to which §475 (dealer mark-to-market rules) applies or to those whose timing rules are governed by Regs. §1.988-5 (or an advance ruling described in Regs. §1.988-5(e)) relating to the integration of certain hedges of exposure to foreign currency fluctuations and the underlying transactions. Nor does it apply in determining the issuer's yield on an issue of tax-exempt bonds for purposes of the arbitrage restrictions to which Regs. §1.148-4(h) applies.266.62
266.61Regs. § 1.446-4(a)(1). Such exempted taxpayers may, however, use an accounting method consistent with these regulations if they elect to do so.
266.62Regs. §1.446-4(a)(2).
Comment: It should be clearly understood that Regs. §1.446-4 does not call for the integration of a hedging transaction and the item(s) hedged. The IRS at present has no statutory or other authority to impose an integration regime (as it does under §988(d)). In prescribing rules for the timing of income, deductions, gains, and losses from hedging transactions, it is understood that the hedging transaction is separate and distinct from the assets, liabilities, and other items hedged.
As noted above, the principal rule set forth in Regs. §1.446-4 is that the method of accounting used for a hedging transaction must clearly reflect the taxpayer's income. To do so, it must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction to the timing of these items from the item or items being hedged.266.63
266.63Regs. §1.446-4(b).
Taking gains or losses into account in the period in which they are realized may, in some instances, clearly reflect income in the case of some hedging transactions -- e.g., where the hedge and the item being hedged are disposed of in the same taxable year. In other cases, however, taking gain or loss from the hedging transaction into account in the year realized does not result in the matching required by these regulations.266.64
266.64Id.
The regulations clarify that, for a given hedging transaction, there may be more than one method of accounting that satisfies the clear reflection of income requirement. Regs. §1.446-4(c), however, relating to hedges of certain assets and liabilities, provides some restrictions and limitations on the choice of method. Different methods may apply to different types of hedges or hedging transactions of different types of items.266.65 Once a method has been selected, it cannot be changed without consent of the IRS.266.66
266.65Regs. §1.446-4(c).
266.66Id. See also Rev. Rul. 2003-127, 2003-52 I.R.B. 1245 (even where taxpayer uses impermissible method of accounting for hedging transaction, taxpayer must obtain consent before changing to permissible method under Regs. §1.446-4).
(c)	Specific Assets and Liabilities
Regs. §1.446-4(e) provides the following "guidance" in determining whether the taxpayer's accounting method reflects income. Even if these guidelines are satisfied, however, the taxpayer's method must result in the matching of income, deductions, gains, and losses that is essential to the clear reflection of income.
First, Regs. §1.446-4(e) requires that the method used for hedges of aggregate risk comply with the above matching requirements. Even though the taxpayer may not be able to associate the particular hedging transaction to any particular item or items being hedged, the matching principle must nevertheless be applied. Thus income, deduction, gain, or loss from the hedging transaction must be matched with income, deduction, gain, or loss from the hedged items.266.67
266.67Regs. §1.446-4(e)(1)(i).
Comment: As "guidance," this language seems of very little real help. It states, essentially, that the matching principle of Regs. §1.446-4(b) applies to hedges of aggregate risk. The problem, however, is that such hedges generally do not relate to any single item -- e.g., they might relate to both outstanding and anticipated borrowings or inventoriable property on hand and to be acquired. The regulations offer this example. If a notional principal contract (NPC) hedges aggregate risk, then taking income and deductions under the NPC into account as provided under Regs. §1.446-3 266.68 may clearly reflect income.
266.68Id. Regs. §1.446-3 is discussed at VII, E, below.
Query: Under what circumstances would taking NPC income and deductions into account otherwise clearly reflect income? Although Regs. §1.446-4(a) provides that Regs. §1.446-4 controls in any case where other regulations provide inconsistent rules, it would be interesting to see an example with a set of facts under which income and deductions under a swap hedging aggregate risk should not be taken into account under Regs. §1.446-3.
Although the IRS considered and rejected several of the suggested methods for matching income or loss from hedges of aggregate risk with the item(s) hedged, it did agree that the mark-and-spread method would be acceptable. Under this method, the hedging transactions are periodically marked to market, at least quarterly (provided the taxpayer has adequate data). Any income, deduction, gain, or loss realized from such marking to market is, in the words of the regulations, "taken into account over the period for which the hedging transactions are intended to reduce risk."266.69 Again, the regulation provides no examples.
266.69Regs. §1.446-4(e)(1)(ii).
Second, Regs. §1.446-4(e) provides that marking a hedge to market reflects income where the hedged asset is also marked to market.266.70
266.70Regs. §1.446-4(e)(2).
Third, hedges of the purchase of inventory may be accounted for, generally, by treating realized gain or loss on the hedging transaction as if it were an adjustment to the cost of the corresponding inventory. Hence, gain or loss from the hedge of anticipated purchases of inventory is taken into account in the same period in which it would have been taken into account if it had been an adjustment to the cost of the inventory. And gain or loss from the anticipated sales of inventory is taken into account in the same period in which it would have been taken into account if it had been an adjustment to the sales price.266.71
266.71Regs. §1.446-4(e)(3).
Note: Again, it must be understood that these regulations do not integrate the hedges and transactions hedged.
Example: If an item of inventory is purchased for $10x and the taxpayer realizes gain from the related hedge of $2x, the inventory item has a cost basis of $10x. The $2x gain from the hedge is not included in cost of goods sold and is not taken into account until the hedged item(s) are sold, whether at a gain or a loss, at which time the gain from the hedge is included in income. If 1,000 such items are purchased in 2003 and 500 are included in closing inventory, the taxpayer recognizes $1,000 of the hedging gain in 2003, deferring the remaining $1,000 to 2004 and subsequent periods in which the items are sold.
This example assumes that the hedging transaction and the specific items hedged can be identified which, obviously, may not be the case. For example, if 500 identical (or closely similar) items (or units of a commodity) were on hand before the hedge was entered into, 1,000 were purchased while the hedge was open, and another 500 were purchased after the hedge was closed out at a gain, it may not be possible to identify physically each of the hedged items. In such a case, as may well be more often encountered than not, the regulations advise that, as in the case of hedges of aggregate risk, use of the mark-and-spread technique explained above is acceptable.266.72 They add that the gain or loss that is spread to each period must be taken into account when it would be if it were an element of cost incurred (purchase hedges) or an element of sales proceeds received (sales hedges) during that period.
266.72Regs. §1.446-4(e)(3)(i).
A purchase hedge is generally a long position reducing the risk of a rise in prices of inventory to be purchased; a sales hedge is generally a short position reducing risk of a drop in the prices that can be realized. However, there are many types of purchase and sales hedges varying with the taxpayer's circumstances, market conditions, etc. Forward purchases (or sometimes long futures or options positions) of foreign currency needed to fund anticipated acquisitions of inventory are purchase hedges; forward sales of foreign currency that the taxpayer anticipates receiving from sales of goods are typical sales hedges.
Comment: Again, one or two specific examples would be very helpful. Usually, the required identification of the hedging transaction (under either Regs. §1.1221-2(f)  or Regs. §1.446-4) should contain an explanation of how its terms were calculated. For example, if 12 feeder cattle futures were bought calling for November delivery, and another six calling for delivery the following January, a brief explanatory note should indicate how the taxpayer arrived at the number of contracts and the delivery dates.
The timing regulations also provide for "simpler, less precise methods" than those outlined above in accounting for gains and losses from inventory hedges, as long as the taxpayer complies with the clear reflection of income standard.266.73 The regulation provides two examples.
266.73Regs. §1.446-4(e)(3)(ii).
Example 1: The taxpayer takes into account realized gains and losses on both hedges of inventory purchases and hedges of inventory sales when they would be taken into account if the gains and losses were elements of inventory cost incurred during the period realized. This method does not clearly reflect income, however, if LIFO is used to value inventory.
Example 2: The taxpayer marks hedging transactions to market with immediate recognition of any gain or loss. This may clearly reflect income even though the inventory hedged is not marked to market, but only if the inventory is not valued under LIFO or the lower of cost or market, and only if inventory items are held for a short time before sale.266.74
266.74Id. Some commentators suggested that taxpayers be allowed to set up a hedging account, similar to the mixed straddle account under the §1092(b) regulations (see VI, C, 3, below) which would be marked to market daily. See ABA Commentary, Daily Tax H&D (4/7/94). This was rejected because it would entail a corresponding marking to market of the hedged items for which the IRS believed there existed questionable authority in any event.
Fourth, Regs. §1.446-4(e) requires that the timing of gain or loss from a transaction that hedges a debt instrument be accounted for by reference to the terms of the instrument and the period(s) to which the hedge relates. Constant yield principles are usually required for the hedge of a debt instrument that provides for a fixed or qualified floating rate.266.75 Thus, as the regulations explain, assuming that a fixed or qualified floating rate instrument remains outstanding, hedging gain or loss is taken into account in the same periods in which it would be taken into account if it were used to adjust the yield of the instrument over the term to which the hedge relates.
266.75Regs. §1.446-4(e)(4). See also PLR 9706002 (income or loss from the hedging of interest rates with Treasury Lock agreements is accounted for under Regs. §1.446-4(e)(4)).
Example: T anticipates issuing a 10-year debenture with a stated principal amount of $5,000,000 in three months. The T-note futures quotations indicate that T can contract to deliver in three months a note maturing in five years for a price of 103 and 10/32d/s, indicating a yield of 7.2%. The taxpayer purchases 30 contracts ($3,000,000 face amount of T-notes) as a partial hedge against a rise in interest rates. At the end of three months, when the taxpayer is ready to issue its debt, the spot T-note price is 102.5, a yield increase of 19 basis points. The futures contract is closed out for a gain of $24,375. The taxpayer issues its five-year note bearing a coupon of 8.75% payable semiannually at par. The $24,375 gain is amortized over the term of the instrument on a constant yield basis, that is, as if the bond had been issued for a price of $4,975,625 with $24,375 of OID. While the hedge gain does not directly reduce the interest deductible under §163, the amount of the gain allocable to each accrual period is calculated as if it were OID and taken into income as it accrues.
Hedging floating rate debt raises some problems since gain or loss from the hedge must be compared with a change in the present value of the payments due over the remaining term of the instrument hedged.
Fifth, Regs. §1.446-3 relates to the timing of amounts paid and received under notional principal contracts. Under Prop. Regs. §1.446-4, the alternative methods for amortizing nonperiodic payments made and received in respect of swaps and caps/floors were the only methods deemed clearly to reflect income in any case where the notional principal contract hedges a debt instrument.266.76
266.76Regs. §1.446-4(e)(5).
Sixth, if an item is hedged, the item is disposed of, and the hedge position is not terminated within a reasonable time, Regs. §1.446-4(e) requires that the taxpayer "appropriately match the built-in gain or loss on the hedging transaction to the gain or loss on the disposed item." To meet this requirement, the taxpayer must mark the hedge to market at the time it disposes of the hedged item. If the taxpayer intends to dispose of the hedging transaction within a reasonable time, however, it may be appropriate to match the realized gain or loss on the hedging transaction with the gain or loss on the hedged item disposed of. But if the hedging transaction is not disposed of within a reasonable period, the taxpayer must match gain or loss from the hedging transaction at the end of the reasonable period with the gain or loss of the hedged item disposed of. For purposes of these rules, a "reasonable period" is generally seven days.266.77
266.77Regs. §1.446-4(e)(6).
Seventh, if a hedging transaction is entered into by recycling a hedge of a particular item to hedge risk with respect to a different item, built-in gain or loss on the hedge as of the date of recycling must be taken into account and matched with gain or loss on the item(s) or aggregate risk originally hedged. Gain or loss from the hedge attributable to the period after the recycling is then matched with gain or loss from the new hedged item(s) or aggregate risk.266.78
266.78Regs. §1.446-4(e)(7).
Eighth, in the case of an anticipatory hedge, if the anticipated borrowing, acquisition of property, or obligation is not consummated, income, gain, deduction, or loss from the hedging transaction is taken into account when realized.266.79 For purposes of this rule, an anticipated transaction is consummated upon the occurrence (within a reasonable interval around the expected time of the anticipated transaction) of either the transaction or a different but similar transaction for which the hedge reasonably serves to reduce risk.266.80
266.79Regs. §1.446-4(e)(8)(i).
266.80Regs. §1.446-4(e)(8)(ii).
(d)	Recordkeeping Requirements
The taxpayer's books and records must describe the accounting method used for each type of hedging transaction and show that the clear reflection of income requirements have been satisfied.266.81 In addition to the identification required by Regs. §1.1221-2(f), these records must contain whatever more specific identification of the transaction is necessary to verify that the proper accounting method has been used with respect to it. This identification may relate to the hedging transaction or to the item(s) or aggregate risk being hedged, and must have been completed at the time specified in 2002 Regs. §1.1221-2(f). It must be retained as part of the taxpayer's books and records.266.82
266.81Regs. §1.446-4(d)(1).
266.82Regs. §1.446-4(d)(2). Note that under Rev. Rul. 2003-127, 2003-52 I.R.B. 1245, if a transaction satisfies the definitions of a hedging transaction in §1221(b)(2)(A) and Regs. §1.1221-2(b), the taxpayer must account for the transaction using a method of accounting that is permissible under Regs. §1.446-4, even if the taxpayer fails to identify the transaction under Regs. §§1.1221-2(f) and 1.446-4(d)(2).
The identification and recordkeeping requirements of Regs. §1.1221-2(f) must be satisfied in the case of §988 transactions (as defined by §988(c)(1)) or a qualified fund (as defined by §988(c)(1)(E)(iii)), even though the character of gain or loss from these transactions is not determined under Regs. §1.1221-2(c).266.83
266.83Regs. §1.446-4(d)(3). Except to the extent of transactions (or payments) that would have been subject to §988 but for the date they were entered into (or made). This identification requirement must be met if the transactions are treated as hedging transactions for purposes of §1256(e). See Regs. §1.1256(e)-1(b) (identification under §1256(e)(2) must satisfy the requirements of Regs. §1.1221-2(f)(1)).
(e)	Type and Character of Income
Regs. §1.446-4 governs the timing of income on hedging transactions, but does not affect the character of gain, loss, income, or expense produced by the transaction. This rule clarifies that these accounting provisions do not call for the integration of a hedging transaction and the item or items hedged. It does not, therefore, affect the computation of the cost of goods sold or sales proceeds for a taxpayer that hedges inventory purchases or sales. Similarly, this rule does not increase the interest income or expense of a taxpayer that hedges a debt instrument.
(7)	Hedging Transactions by Consolidated Group Members
(a)	Introduction
As discussed below, the final regulations relating to hedging transactions by consolidated group members are very similar to the proposed regulations. However, there is one major change which is worthy of comment. The proposed regulations provided that a taxpayer had risk of a particular type only if it was at risk when all of its operations were considered. That is, risk must have existed on a "macro" basis. For this purpose, under the proposed regulations, a taxpayer had to show that hedges of particular assets or liabilities, or groups of assets or liabilities, were reasonably expected to reduce the overall risk of the taxpayer's operations.266.84
266.84Preamble to the final regulations, T.D. 8985, 67 Fed. Reg. 12863 (3/20/02).
The preamble to the final regulations notes that commentators pointed out that this entity-based approach to hedging is no longer a uniform business practice. Instead, these commentators stated that businesses often conduct risk management on a business unit by business unit basis. In response to these comments, the final regulations permit the determination of whether a transaction manages risk to be made on a business unit basis, provided that the business unit is within a single entity or consolidated return group that adopts the single-entity approach.266.85
266.85Id.
(b)	General Rule
Regs. §1.1221-2(e)(1) provides that, for purposes of Regs. §1.1221-2, the risk of one member of a consolidated group is treated as the risk of the other members as if all of the members of the group are divisions of a single corporation. Thus, if one member hedges the risk of another by entering into a contract with an unrelated person, that transaction may potentially qualify as a hedging transaction. Under this general rule, intercompany transactions are not hedging transactions because they are treated as transactions between divisions of a single corporation and do not reduce the risk of the group.266.85
266.85Regs. §1.1221-2(e)(1).
(c)	Separate Entity Election
Instead of the treatment specified above, a consolidated group may be able to elect separate entity treatment of its hedges.266.86 If a group makes this election, the following rules apply: 
• The risk of one member is not treated as the risk of any other member;
• An intercompany transaction or obligation is a hedging transaction with respect to a group member only if it meets the following requirements:
(1) The position of the member in the intercompany transaction or obligation would qualify as a hedging transaction if that member entered into the transaction with an unrelated party; and
(2) The position of the other member (the marking member) in the transaction is marked to market under the marking member's method of accounting.266.87
266.86Regs. §1.1221-2(e)(2).
266.87Regs. §1.1221-2(e)(2)(ii).
An intercompany transaction or obligation that is a hedging transaction under the above rules is treated as follows: 
• Neither the hedging transaction nor any intercompany obligation with respect to that transaction is treated as an intercompany transaction or obligation for purposes of §1502 and the regulations thereunder, and
• Except as provided in Regs. §1.1221-2(g)(3), the character of the marking member's gain or loss from the transaction is ordinary.266.88
266.88Regs. §1.1221-2(e)(2)(iii).
The separate entity election is made by attaching to the electing group's tax return for the first year the election applies a separate statement indicating the date as of which the election is to be effective. It applies to all transactions entered into on or after the effective date specified in the election statement.266.89 The terms "consolidated group," "member of a consolidated group," "intercompany transaction," and "intercompany obligation" have the same meaning as in §1502 and the regulations thereunder.266.90
266.89Regs. §1.1221-2(e)(2)(iv). A consolidated group was not thereafter allowed to revoke its election may without the IRS's consent.
266.90Regs. §1.1221-2(e)(3).
(d)	Identification Requirements
The identification rules of Regs. §1.1221-2(f) apply to hedges under the general (single entity) rule as if they were entered into by a corporation with respect to risks of its divisions. The hedging member is required to identify the transaction as a hedging transaction. It is also required to identify the item(s) or aggregate risk hedged substantially contemporaneously, as under Regs. §1.1221-2(f) discussed above, even if such risk related to other members of the group.266.91 If the group members use intercompany transactions or obligations to transfer risks within the group, identification of the item(s) or aggregate risk being hedged can be effected by identifying such transactions or obligations as hedges or hedged items, as may be appropriate. The final regulations provide, as an example, that if a member transfers risk in an intercompany transaction, it may identify under the rules of Regs. §1.1221-2(f) both its position in that transaction and the item, items, or aggregate risk being hedged. The member that hedges the risk outside the group may identify under the rules of Regs. §1.1221-2(f) both its position with the third party and its position in the intercompany transaction.266.92
266.91Regs. §1.1221-2(f)(5)(i).
266.92Regs. §1.1221-2(f)(5).
Example: O and H are members of the same consolidated group. O's business operations give rise to interest rate risk "B," which O wishes to hedge. O enters into an intercompany transaction with H that transfers the risk to H. O's position in the intercompany transaction is "C," and H's position in the transaction is "D." H enters into position "E" with a third party to reduce the interest rate risk it has with respect to its position D. E would be a hedging transaction with respect to risk B if O's risk B were H's risk. O's risk B is treated as H's risk, and therefore E is a hedging transaction with respect to risk B. Thus, the character of E is determined under the rules of this section, and the income, deduction, gain, or loss from E must be accounted for under a method of accounting that satisfies Regs. §1.446-4. The intercompany transaction C-D is not a hedging transaction and is taken into account under Regs. §1.1502-13.
If the group makes the separate entity election, however, each member of the group that enters into an intercompany hedging transaction with a marking member must satisfy the identification requirements of Regs. §1.1221-2(f).266.93
266.93Regs. §1.1221-2(f)(5)(ii).
Regs. §1.1221-2(g) relates to consequences of the failure to identify properly a hedging transaction, of identification of a transaction as a hedging transaction, of inadvertent failure to identify, and of unreasonable failure to identify a hedging transaction. These provisions apply to hedging transactions entered into with unrelated third parties under the general rule (but not to intercompany transactions).266.94 If the separate entity election is made, then the following additional rules apply: 
(1) If an intercompany transaction is identified as a hedging transaction but does not meet the requirements of Regs. §1.1221-2(e)(2)(ii)(A) or  (B), then both parties to the transaction are subject to Regs. §1.1221-2(g)(1) (treating any gain as ordinary income and providing that any loss may be characterized as capital) as if both had incorrectly identified their positions as hedging transactions, notwithstanding §1502.266.95
(2) If the intercompany hedging transaction satisfies Regs. §1.1221-2(e)(2)(ii)(A) or  (B), and both are not identified, both parties are subject to Regs. §1.1221-2(g)(2) (providing that the transaction will not be respected as a hedging transaction or, at the IRS's discretion, will be deemed identified if there was no reasonable basis for the failure to identify it).266.96
266.94Regs. §1.1221-2(g)(3)(i).
266.95Regs. §1.1221-2(g)(3)(ii)(A).
266.96Regs. §1.1221-2(g)(3)(ii)(B).
(e)	Timing Provisions
The basic clear reflection of income rules for recognition of gain or loss from hedging transactions entered into by a member of a consolidated group are generally the same as for other such transactions. Under the general rule, a member that hedges the risk of another member must account for its hedging transactions as if all group members were divisions of a single corporation. The timing of gain, loss, income, or deductions from the hedge must match the timing of these items from the item(s) being hedged rather than with an intercompany transaction.266.97
266.97Regs. §1.446-4(e)(9)(i).
If a separate entity election is made, each group member must account for its hedging transactions (including intercompany transactions) in accordance with the clear reflection of income principles in Regs. §1.446-4(b) -- i.e., as if it were a separate, nonaffiliated corporation.266.97
266.97Regs. §1.446-4(e)(9)(ii).
4.	The Mixed Straddle Election
Any straddle made up of non-§1256 contracts and at least one §1256 contract can have at least two significant tax consequences: 
(1) As was pointed out in the discussion of the mark to market rule at V, F, 2, above, if at year end the §1256 position is marked to market for a gain, such gain must be recognized without taking into account any unrecognized losses from any offsetting non-§1256 contract positions. On the other hand, where the marking to market of the §1256 contract results in a loss, it will be disallowed under the §1092 loss deferral rule if there is any unrecognized gain with respect to offsetting non-§1256 positions.
(2) Without regulatory provisions calling for a different result, the mixed straddle can convert short-term gain to 60/40 gain where the disposition of a non-§1256 position of the straddle results in a loss which is applied to offset short-term gain from transactions unrelated to the straddle. This situation and the regulatory provisions prescribed to deal with its perceived potential for tax abuse are examined in detail in VI, below.
The potentially adverse tax consequences noted in (1), above, can be avoided by making a mixed straddle election.267 Where all of the positions of such a straddle are identified by the taxpayer before the close of the day (or such earlier time as may be provided by regulations) on which the first §1256 contract included in the straddle is acquired, the taxpayer may elect to have the mark to market and 60/40 rules not to apply to all §1256 contracts in the straddle.267.1 The mixed straddle election applies on a straddle by straddle basis.
267The "killer rule" can also be avoided by making the elections provided by Regs. §§1.1092(b)-3T and  -4T, explained below at VI, C, 2 and 3.
267.1§1256(d) (referred to as the "§1256(d) election"). The election is irrevocable without the consent of the IRS. Technically, under the statutory definition, the term "mixed straddle" means a straddle with respect to which such identification and election has been made, but the term is used here (and in the §1092(b) regulations) to mean any straddle qualifying for such election whether or not it has been so identified. Identification is presumably made in a manner similar to the identification required under §1236 for securities acquired by a dealer to be treated as held for investment.
Note: No action need be taken to identify non-§1256 contract positions before the acquisition of the first §1256 contract position of the straddle. Thus, an options dealer may include in the mixed straddle election a stock position that was acquired at some previous date. In order for the previously acquired stock to be included in the election, identification must be made before the end of the day on which an offsetting dealer equity option position is acquired of both the stock position and the option position as being the positions of the §1256(d) mixed straddle. Note that an election under §1256(d) cannot be made if the §1256 contract position is acquired before the non-§1256 position is acquired, unless both positions are acquired on the same day. 
Observation: A §1256(d) mixed straddle 268 may also be identified under §1092(a)(2). In the case of such an identified §1256(d) mixed straddle, not only do the mark to market and 60/40 rules not apply to any of the §1256 contracts in the straddle (due to the §1256(d) election), but the loss deferral rules do not apply to any positions in the straddle or to any other positions held by the taxpayer outside the straddle by reason of their being offsetting to positions which are part of the identified straddle, as explained above at V, D, 2.
268Under the language of the Code, a straddle in which at least one, but not all, of the positions of which is a §1256 contract does not become a "mixed straddle" until a valid election has been made under §1256(d). However, in the regulations discussed in VI, below (the "§1092(b) regulations"), the term refers to those straddles eligible for the §1256(d) election as well as to those not eligible because the §1256 contract position was first acquired. This different use of the term should be kept in mind.
[Footnotes 269-294 reserved.]
Comment: Whether to make a mixed straddle election involves deciding whether forfeiting 60/40 treatment of gain realized from §1256 contract positions is outweighed by not having to mark such positions to market. Where there is no tax rate differential between long- and short-term gains or between capital gain and ordinary income, there is, obviously, no advantage to 60/40 treatment of gain. In view of the fact that any losses from marking to market will probably be deferred, at least in part, under §1092(a), if the §1256 contract remains part of a straddle, making the election will avoid accelerating gain recognition from marking gain positions to market at year end. It will also avoid the other somewhat complex rules relating to marking to market set forth above. Note that once an election not to have §1256 apply to a §1256 contract is made under §1256(d), the position remains exempt from the §1256 rules even though the other positions of the straddle have been disposed of.
G. Pre-ERTA Straddles
For a discussion of straddles, including a discussion of the evolution of the straddle rules, see 188 T.M., Taxation of Equity Derivatives.
H. Conversion Transactions: §1258 For a detailed discussion of conversion transactions, including which transactions are targeted, the consequences of a conversion transaction, and the scope of §1258, see 186 T.M., Financial Instruments: Special Rules.
I. Security Futures Contracts
For a detailed discussion of futures contracts, including discussion of security futures contracts, see 188 T.M., Taxation of Equity Derivatives.
VI. The §1092 Regulations
A. Introduction
As part of the loss deferral rules of §1092 as enacted in 1981, Congress in §1092(b) directed the Secretary of the Treasury to prescribe regulations with respect to gain or loss on positions which are part of a straddle as are appropriate to carry out the purposes of §1092, and that to the extent consistent with such purposes the regulations were to include rules applying the principles §1091(a) and  (d), (the wash sale rule)295 and of §1233(b) and  (d) (the short sale rules).296
295Section 1091(a) is the general loss disallowance rule; subsection  (d) is the provision calling for an adjustment to the basis of the acquired property to reflect the disallowed loss. See 186 T.M., Financial Instruments: Special Rules.
296Section 1233(b) provides the rule converting what would have been long-term to short-term gain; subsection  (d) provides the rule converting what would have been short-term loss to long-term loss. Both are discussed in 188 T.M., Taxation of Equity Derivatives.
In enacting 1984 amendments to extend the straddle rules to positions made up of stock and offsetting options on substantially identical stock, and to make dealer equity options subject to §1256,297 Congress was made aware that the regulatory extension under §1092(b) of the principles of §1233(d) to straddle transactions would create a situation that was perceived by many taxpayers to be unduly harsh. This is explained below. To deal with this problem, Congress expanded §1092(b) by redesignating it as §1092(b)(1) and adding a new paragraph, §1092(b)(2), which specifies that the regulations prescribed under §1092(b)(1) are to provide "elective provisions in lieu of Section 1233(d) principles." As explained in the 1984 Bluebook,298 "The regulations prescribed by the Act will permit taxpayers to avoid the loss recharacterization rule that results from applying Section 1233(d) principles299 while retaining favorable treatment for mixed straddle net gains from Section 1256 contracts." Briefly, the regulations were to provide rules for the treatment of straddles: (1) at least one, but not all, of the positions of which is a §1256 contract; (2) with respect to which the taxpayer has not made an election under §1256(d); 300 and (3) as to which the taxpayer has made an election on the basis of (i) straddle by straddle identification, or (ii) the establishment of a mixed straddle account. Under either of these mutually exclusive elections (i.e., straddle by straddle identification or a mixed straddle account), gains or losses from §1256 contract positions are netted against gains and losses from non-§1256 contract positions. The net gain or loss is then accorded 60/40 treatment only if attributable to the §1256 contract position(s).301
297Prior to the 1984 TRA amendments, §1256 applied only to RFCs; the term "§1256 contract," which includes also nonequity options, foreign currency contracts and dealer equity options, was introduced into the Code by the 1984 TRA amendments.
298At p. 317.
299This rule is explained below.
300See §1092(b)(2)(C), referring to §1256(d)(4).
301See §1092(b)(2)(A)(ii).
The discussion of the §1092(b) regulations 302 is divided into two major subdivisions: the §1092(b)(1) regulations and the §1092(b)(2) regulations.
302Temporary regulations under §1092(b)(1) and  (2) were issued on Jan. 1, 1985. T.D. 8007.
B. The §1092(b)(1) Regulations 1.	General
The regulations issued under the directives of §1092(b)(1) may be divided into two parts. 
(1) The first part, Regs. §1.1092(b)-1T,303 provides a regulatory wash sale rule applicable only to losses arising from the disposition of straddle positions. It also coordinates wash sale and the loss deferral principles governing the extent to which a loss sustained from the disposition of a straddle position must be deferred. This section of the temporary regulations applies to dispositions of loss positions on or after January 24, 1985.304
303As amended by T.D. 8070.
304Regs. §1.1092(b)-1T(f).
Regs. §1.1092(b)-1T does not apply305 to dispositions of the positions of a hedging transaction,306 positions included in a mixed straddle account,307 or positions of a straddle made up entirely of §1256 contracts.308
(2) The second part, Regs. §1.1092(b)-2T, sets forth rules based on principles similar to those underlying the short sale rules of §1233(b) and 1233(d) relating, respectively, to the treatment of holding periods and the characterization of losses sustained with respect to straddle positions.
305See Regs. §1.1092(b)-1T(d)(1)(i),  (ii), and  (iii).
306As defined by §1256(e), discussed above. See Regs. §1.1092(b)-5T(b).
307Established in accordance with the regulations prescribed under the directive of §1092(b)(2). See Regs. §1.1092(b)-4T, discussed below.
308Since all such positions are marked to market at year end, there is no need for the loss deferral rules to prevent the recognition of non-economically sustained losses.
Regs. §1.1092(b)-3T and  4T provide the rules carrying out the directive of §1092(b)(2) to provide elective alternatives to the provisions of the §1092(b)(1) regulations applying §1233(d) principles to recharacterize losses from the disposition of mixed straddle positions. These regulations, Regs. §§1.1092(b)-3T and  -4T (discussed in VI, C, below), are referred to in this discussion as the "§1092(b)(2) regulations." 309
309The §1092(b)(2) regulations were issued as T.D. 8008 on Jan. 18, 1985. Regs. §1.1092(b)-5T contains definitions of terms used throughout all of the foregoing regulations.
2.	The Wash Sale "(a)(1)" Rule
The regulations provide a wash sale rule, referred to in the regulations as the " (a)(1) rule,"310 apply to "[a]ny loss sustained from the disposition of shares of stock or securities that constitute positions of a straddle." Under this rule, the loss is not to be taken into account if, within 30 days before or after the date of disposition the taxpayer has acquired (by purchase or fully taxable exchange), or has entered into a contract or option so to acquire, substantially identical stock or securities. This language is similar to the statutory wash sale rule.311
310This term is used because the rule is set forth in Regs. §1.1092(b)-1T(a)(1).
311§1091(a). Note that the regulation does not reflect the TAMRA amendment to §1091(a) extending the meaning of the term "stock or securities" to options or contracts to buy stocks or securities. See 186 T.M., Financial Instruments: Special Rules.
The regulations provide that this rule supersedes the statutory wash sale rule in any case where the regulatory rule applies (i.e., losses from dispositions of straddle positions)312 and is to be applied before applying the other provisions of subsection  (a) of Regs. §1.1092(b)-1T, referred to as the " (a)(2)" rules.313
312Regs. §1.1092(b)-1T(e).
313Regs. §1.1092(b)-1T(a).
Comment: As under the statutory rule, the regulatory rule applies only where the "substantially identical" criterion is satisfied. As has been seen, this will seldom be the case where attempts are made to manipulate straddle positions; "substantially identical" is far more restrictive than "offsetting."
The  (a)(1) wash sale rule, like the statutory wash sale rule, does not apply to losses sustained by a securities dealer in the course of such dealer's business activities as a dealer in securities.314
314Regs. §1.1092(b)-1T(d)(2).
3.	The "(a)(2)" Rules a.	Background: Purpose of Rules
The  (a)(2) rules apply wash sale principles to the loss deferral rules. They are best understood by considering the following example:
Example: Taxpayer B on Feb. 20 of Year 1 acquires offsetting positions LgP and ShP.315 On Apr. 15, B disposes of LgP at a loss of $10. Under the statutory loss deferral rule of §1092(a), if B retains ShP on the last day of the taxable year, the $10 loss is disallowed to the extent of any unrecognized gain with respect to ShP. Assume, however, that at the time LgP is disposed of, B acquires new LgP2 locking in the unrealized gain from ShP.316 This means that whatever price changes may take place, B will realize a net gain of approximately $10 upon liquidating both positions. Thus, if at the close of the year there is no unrecognized gain with respect to ShP, there will be unrecognized gain of $10 with respect to LgP2. Similarly, if the value of ShP declines to the point where unrecognized gain is $5, LgP2 will also have unrecognized gain of $5 -- this reflects the locking in of the unrealized $10 gain on ShP when LgP2 is acquired. For the loss deferral rule to be effective, it must apply with respect to any portion of the gain locked in by acquiring a new LgP2 offsetting the ShP.
315As noted above, the symbols "LgP" and "ShP" are used to represent "long position" and "short position." 
316This assumes that acquisition of the new position does not trigger the regulatory wash sale rule.
The wash sale principle is applied by treating gain as being locked in where the successor position317 to the loss position is acquired within 30 days before or after the date the loss position was disposed of. If such position is acquired within the 61-day period, the wash sale principle applies if the new position offsets the retained gain position;318 it does not have to be a position in property substantially identical to that of the position disposed of. However, if the loss position disposed of was stock or securities (within the meaning of that term under §1091(a)) and the successor position acquired within the 61 day period consists of stock or securities substantially identical to the those disposed of at a loss, then the wash sale rule of the (a)(1) rule applies, superseding the loss deferral (a)(2) rule.
317In this general introduction, the term has its normal meaning; the technical definition of "successor position" provided by the statute is discussed below.
318"Gain position" means the position which offset the loss position disposed of. Actually, such position could become a loss position within the 61-day period if the market is volatile.
b.	Definition of Terms Used
The (a)(2) rules contain two critical terms: (1) "disposing, disposes or disposed," and (2) "successor position." 319
319See Temp. Regs. §1.1092(b)-5T(a),  (n).
The term "disposing, disposes or disposed" includes the sale, exchange, cancellation, lapse, expiration or other termination of a right or obligation with respect to personal property (as defined in §1092(d)(1)).320 Disposition would include, for example: 
(1) A closing purchase transaction entered into by the grantor of an option or performance of the option upon its exercise by the holder where this triggers realization of loss (as, for example, exercise of an option with respect to a §1256 contract).
(2) The closing out of a futures contract either by offset (i.e., acquiring a short position to close out a long position) or by making or accepting delivery under the contract.
(3) The termination of the holder's obligations under a forward sale or purchase contract by payment to the counterparty cancelling the contract or by entering into an offsetting contract.
320Temp. Regs. §1.1092(b)-5T(a). For the definition of "personal property," see discussion above at V, B, 2.
The second key term employed in (a)(2) rules is "successor position." This is defined in Temp. Regs. §1.1092(b)-5T(n) as a position ("P") that is or was at any time offsetting to a second position if -- 
(1) The second position was offsetting to any loss position disposed of; and
(2) P is entered into during the period commencing 30 days prior to and ending 30 days after the date of the disposition of the loss position.
Other terms employed by the regulations (e.g., straddle, offsetting positions, hedging transaction, identified or mixed straddle, §1256 or non-§1256 contract, etc.) have the same meanings as the same terms used in the statutory provisions discussed above.
c.	The Basic Wash Sale/Loss Deferral Rule
The basic (a)(2) rule is that, except as otherwise provided in the regulations, if the taxpayer disposes of one or more, but less than all, the positions of a straddle, any loss sustained from the position(s) disposed of "shall not be taken into account" to the extent that the amount of unrecognized gain321 as of the close of the taxable year in one or more of three enumerated positions exceeds any loss disallowed under the (a)(1) (wash sale) rule. The three enumerated positions (with an example illustrating each) are: (1) successor positions; (2) offsetting positions to the loss position; and (3) offsetting positions to any successor position.
321This term has the same meaning as it has under the provisions of §1092(a)(1).
(1)	Illustrations
The following example illustrates successor positions.
Example: Taxpayer T enters into a long position (LgP) and an offsetting short position (ShP) on the same date. In this example, and in all the examples to follow in this section, the positions described are the only positions held by T either directly or through a passthrough entity or related person. Assume that the value of LgP declines. There will usually be an increase in the value of ShP corresponding, more or less, to the decline in the value of LgP. T disposes of LgP at a loss of $20. Within 30 days before or after such disposition, T acquires new LgP2 which offsets the retained ShP. LgP2 is a successor position. If at year end LgP2 is still held and there is $10 of unrecognized gain with respect to LgP2, at least $10 of the $20 loss is disallowed without regard to (a) whether or not the ShP has been disposed of, or (b) if the ShP is still held, the amount of unrecognized gain with respect to ShP. If there is $8 of unrecognized gain with respect to ShP, the remaining $10 of loss is disallowed to this extent.
The following example illustrates offsetting positions to the loss position.
Example: Assume the same facts as in the above example except that there is no replacement of the LgP disposed of and T has retained ShP at the close of the year. The $20 loss is disallowed to the extent there is unrecognized gain with respect to ShP. This, of course, applies the loss deferral rule of §1092(a)(1) where there is no successor position.
The following example illustrates offsetting positions to any successor position.
Example: Assume the same facts as in the first example, with the difference that after acquiring LgP2, T disposes of ShP (whether at a gain or loss is irrelevant). Subsequently, and before the end of the year, T acquires ShP2 which offsets LgP2, the successor position to the loss position. At the end of the year, there is $5 of unrecognized gain with respect to LgP2. The $20 loss is disallowed to this extent under the first rule. Also, there is $8 of unrecognized gain with respect to ShP2. This calls for an additional disallowance of $8 of the remaining $15 of loss. Thus, the unrecognized gains on both LgP2 and ShP2 totalling $13 must be applied to reduce the $20 loss from LgP; only $7 of this is allowed for the year.
(2)	Rules Relating to Disallowed Losses
Where a loss is disallowed under the provisions of the (a)(1) or (a)(2) rules, it is not permanently disallowed but is carried over and treated as sustained in the subsequent year.322 It may be deducted in that year subject to the application in that year of the same (a)(1) and (a)(2) rules. The regulations point out, as an example, that a loss disallowed under the (a)(1) wash sale rule in Year 1 is not allowed in Year 2 unless the substantially identical stock or securities, the acquisition of which caused the loss to be disallowed in Year 1, are disposed of during Year 2 and paragraphs (a)(1) and (a)(2) do not apply in Year 2 to disallow the loss.323
322Temp. Regs. §1.1092(b)-1T(b). This is consistent with the statutory wash sale and §1092 loss deferral rules.
323Temp. Regs. §1.1092(b)-1T(b).
Comment: Under the statutory wash sale rule (which applies only where a loss stock or securities position which is not part of a straddle is disposed of and replaced by substantially identical stock or securities within the 61-day period) the disallowed loss is effectively added to the basis of the replacement property and is therefore taken into account when the property is disposed of. See §1091(d). In contrast, the regulatory wash sale rule (notwithstanding the direction in §1092(b)(1) to adopt principles similar to those of §1091(d)) operates differently, as explained above, by permitting the disallowed loss to be carried over.
An additional regulatory rule324 deals with the treatment of disallowed losses allowed in a subsequent year. Under this rule, if the disallowed loss would have been a short or long-term capital loss (e.g., where the position disposed of was an equity option), or would have been treated as 60% short-term/40% long-term capital loss (e.g., where the position disposed of was a §1256 contract), the character of the loss is retained when it is allowed in a subsequent year. This rule is applied even though the loss, when allowed, arises from the disposition of a successor position which, in the absence of this rule, would give rise to an ordinary loss.
324Temp. Regs. §1.1092(b)-1T(c).
4.	Rules Based on Short Sale Principles
a.	Introduction
Regs. §1.1092(b)-2T carries out the directive to prescribe regulations applying the principles of the short sale rules of §§1233(b) and  (d) to straddle positions.
Subsection (a) of the regulations contains rules applying the principles of §1233(b);325 subsection (b) contains rules applying the principles of §1233(d).326
325See Temp. Regs. §1.1092(b)-2T(a).
326See Temp. Regs. §1.1092(b)-2T(b). Subsections (b) and (d) of §1233 are discussed in 188 T.M., Taxation of Equity Derivatives.
These rules apply to all straddle positions except positions that: 
(1) Constitute part of a hedging transaction,
(2) Are included in a straddle consisting only of §1256 contracts,
(3) Are included in a mixed straddle account (as defined in Regs. §1.1092(b)-4T(b), discussed below).327
327Temp. Regs. §1.1092(b)-2T(c)(1). In addition, the rules of §1.1092(b)-2T(a)(2) and  (b)(2), applying the principles of §1233(d), do not apply to straddles as to which the straddle by straddle election has been made under Temp. Regs. §1.1092(b)-3T.
For all purposes of the rules discussed in this section, the term "mixed straddle" means a straddle (not part of a larger straddle) all of the positions of which are capital assets, and at least one (but not all) of which is a §1256 contract; it excludes any straddle with respect to which a mixed straddle election has been made.328
328Temp. Regs. §1.1092(b)-5T(e). See V, F, 4, supra, for the rules relating to mixed straddle elections.
b.	Rules Applying §1233(b) Principles
Except as otherwise provided in the regulations, the holding period of any position of a straddle329 does not begin earlier than the date on which the taxpayer no longer holds directly or indirectly (through a related person or pass-through entity) any offsetting position.330 There is one exception: this rule does not apply to any straddle position that has been held long-term before the establishment of the straddle. The general rule applies in determining whether the exception is applicable, i.e., whether a position was held long-term at the time the straddle was entered into.331
329These rules apply only to positions of a straddle as defined by §1092(c). Hence, they do not apply to a qualified covered call, which is not treated as a straddle for purposes of §1092 or §263(g). §1092(c)(4)(A). Qualified covered calls with a strike price below the applicable stock price are subject to a special holding period suspension rule provided by §1092(f), explained above at V, D, 3.
330Regs. §1.1092(b)-2T(a)(1). This rule is similar to the "(b)(2)" short sale rule discussed in 188 T.M., Taxation of Equity Derivatives.
331Temp. Regs. §1.1092(b)-2T(a)(2).
Example: T acquires offsetting LgP and ShP. On Nov. 20 of Year 1, he disposes of ShP and retains LgP. On Mar. 12, Year 2 (when the long-term holding period is 6 months) A acquires ShP #2 offsetting the retained LgP. Since the holding period of LgP began on Nov. 20 of Year 1, the date ShP was disposed of, it was not held long-term on the date the second straddle was established by acquiring ShP #2. Therefore, the holding period for LgP will not begin earlier than the date T no longer holds a straddle that includes LgP.
c.	Rules Applying §1233(d) Principles
The regulations provide two "modified" short sale rules incorporating §1233(d) principles.
Under the first rule, applicable to mixed straddles or straddles made up entirely of non-1256 positions, loss (but not gain) from the disposition of a straddle position is characterized as long-term where: (1) at the time the loss position was acquired the taxpayer held (directly or indirectly) one or more offsetting positions; and (2) all gain or loss from one or more of such offsetting positions straddle would have been treated as long-term gain or loss if such position had been disposed of on the date the loss position was acquired.332
332Temp. Regs. §1.1092(b)-2T(b)(1).
Note: In applying this rule, it should be kept in mind that in the case of a §1256 position, only 60% of any loss sustained is treated as long-term, irrespective of how long the position was held before it was disposed of.
Example: On Mar. 20, Year 1, T has held stock in ABC Corp. for more than one year. On that date, T grants a call option on the same quantity of ABC stock. The option is not a qualified covered call.333 T, therefore, holds a straddle composed entirely of non-§1256 positions. The price of ABC stock increases, and on August 10, Year 1, T enters into a closing transaction terminating his obligation under the call option, sustaining a loss of $1,000. The loss, §1234(b) notwithstanding, is a long-term capital loss since gain or loss from the sale of the stock on March 20, Year 1, the date on which the straddle was established, would have been long-term.
333Also, the short sale rules of §1233 do not apply to this straddle.
Example: A has held a §1256 contract for more than one year at the time an offsetting non-§1256 contract position is entered into. In this case, the rule does not apply since gain or loss from the disposition of the §1256 contract held at the time the straddle was established would not be long-term capital gain by reason of the 60/40 rule of §1256(a)(3).
The second rule applying §1233(d) principles applies only to mixed straddles, as defined above; in Regs. §1.1092(b)-5T(e), discussed supra at V, F, 4, it does not apply to any straddle as to which the mixed straddle election of §1256(d) has been made.
The purpose of §1233(d), as explained in 188 T.M., Taxation of Equity Derivatives, is to prevent the conversion of long-term loss to short term loss. The regulatory rule adopting "Section 1233(d) principles" operates in a somewhat similar manner but has a quite different effect: it prevents the conversion of short-term capital gain to long-term gain. Without the regulatory rule, the following tax consequences could occur:
Example: Assume that a taxpayer holds a mixed straddle composed of one §1256 contract and one non-§1256 position.334 The taxpayer has realized $100 of unrelated short-term capital gain. The non-§1256 straddle position is closed out for a loss of $100. This loss offsets the unrelated gain. The §1256 position is closed out for a gain of $100, subject to 60/40 treatment. Consequently, the taxpayer reports $60 of long-term gain and $40 of short-term gain for the year. As can be seen, while economically the straddle positions offset each other, unrelated short-term gain has been converted into 60/40 gain.
334In the discussion below, the terms "Section 1256 position" and "non-Section 1256 position" dispense with the word "contract" after "Section 1256."
Note that if, on the other hand, the §1256 position in the above example is the loss position, the result is adverse. Assume again that there is $100 of unrelated gain. If the gain is long-term, disposition of both sides of the straddle ($100 of short-term gain from the non-§1256 position; $60 of long-term loss and $40 of short-term loss from the §1256 position) will leave the taxpayer with $60 of short-term gain and $40 of long-term gain; thus $60 of the long-term gain has been converted to short-term gain.
The regulations, focusing on the conversion of short-term gain to 60/40 gain, apply the principles of §1233(d) by treating any loss sustained with respect to the non-§1256 contract position of a mixed straddle as if it were sustained with respect to a §1256 contract, that is, by characterizing it as 60% long-term and 40% short-term loss.335 In this manner, the loss from the non-§1256 position offsets gain from the §1256 position (which is accorded 60/40 treatment under the statutory rules), leaving items of unrelated short-term gain unaffected.336 The rule applies to mixed straddles only if: (1) gain or loss from the disposition of any §1256 contract position would be treated as from the sale of a capital asset; (2) long-term capital loss would not result from the disposition of any position of the straddle, and (3) no election has been made with respect to the straddle to account for gains and losses under Temp. Regs. §1.1092(b)-3T or  -4T (the straddle by straddle or straddle account elections discussed below).337
335Temp. Regs. §1.1092(b)-2T(b)(2). Since §1233(d) applies only to recharacterize losses from closing short sales, the IRS presumably did not have authority to provide a similar rule recharacterizing gain from a non-§1256 position as 60/40 gain.
336Of course, gains and losses from straddle positions will usually not match each other exactly; but to the extent they are offsetting, they will effectively cancel each other out since both receive 60/40 treatment under the regulatory rule.
337Temp. Regs. §1.1092(b)-2T(b)(2). This rule is the only provision of the §1092(b)(1) regulations that does not apply to straddles as to which a straddle by straddle election has been made under Temp. Regs. §1.1092(b)-3T. All of the other rules of Temp. Regs. §§1.1092(b)-1T and 1.1092-2T apply to such straddles.
As has been noted, where the non-1256 contract position of the mixed straddle is the gain position, the regulations do not provide for recharacterization even though the loss from the §1256 contract position is given 60/40 treatment under the normal statutory rule. Thus, the non-§1256 contract position gain is treated as all short-term gain.338 Because of the potentially adverse tax consequences, illustrated in the previous example, where the non-§1256 straddle position is the gain position, this second rule has been referred to, especially by taxpayers, such as options dealers who acquire and dispose of large quantities of mixed options, as the "killer" rule. The operation of this rule is further illustrated in the following example.
338It cannot be long-term due to the holding period suspension rule discussed above.
Example: The taxpayer holds a mixed straddle composed of a long non-§1256 position and a short §1256 position. The taxpayer has realized $100 of short-term capital gain during the same taxable year. The non-§1256 position was not held long-term at the time the straddle was established. There has been no mixed straddle election.
Situation (1): Both straddle positions are disposed of. There is a $100 loss from the non-§1256 position and $100 of gain from the §1256 position. As already shown in the preceding example, absent the regulatory rule described above, the loss from the non-§1256 position would offset the unrelated short-term gain, leaving the taxpayer $60 of long-term gain and $40 of short-term gain. However, under the regulatory rule, gains and losses from the straddle positions offset each other; the taxpayer is left with $100 of short-term gain.
Situation (2): Both straddle positions are disposed of. There is gain of $100 from the non-§1256 position and a $100 loss from the §1256 position. Result: There is a total of $200 of short-term capital gain offset by $60 of long-term loss and $40 of short-term loss. Assuming the pre-1986 Code rate differential, only $30 of the longterm loss can be offset against the short-term gain. The taxpayer is left with $130 of short-term gain. The tax disadvantage is even greater where the unrelated gain is long-term. In that case, where all straddle positions are disposed of, the result is $40 of long-term gain and $60 of short-term gain. Thus, $60 of the unrelated long-term gain has been converted to short-term.
Where the taxpayer acquires and disposes of many straddle positions during the year, the cumulative effect of the "killer" rule could be very severe. The only way to escape it would be to make mixed straddle elections with respect to all straddles, in which case all gains and losses would be short-term. This alternative, however, forfeits 60/40 treatment of gains from §1256 positions. To relieve taxpayers whose business activities involved straddle positions the acquisition of which was not motivated by the abusive stratagems targeted by the straddle rules, Congress directed the IRS to issue regulations under which such taxpayers who adopt certain methods of accounting for gains and losses from straddle positions prescribed by regulations339 would not be subject to the "killer" rule. These regulations are discussed below.
339What these regulations were to provide was spelled out in great detail in the Conference Committee report. See 1984 Bluebook (containing the Conference Committee's directions word for word) at pp. 316-321.
d.	Effective Dates
The modified short sale rules described above apply, generally, to positions in a straddle established after June 23, 1981, in taxable years ending after that date.340 However, the rule of Temp. Regs. §1.1092(b)-2T(b)(2) recharacterizing losses from the disposition of non-§1256 contract positions of mixed straddles to 60/40 losses applies to positions of a mixed straddle established on or after January 1, 1984.341
340Temp. Regs. §1.1092(b)-2T(e)(1).
341Temp. Regs. §1.1092(b)-2T(e)(2).
C. The §1092(b)(2) Regulations
1.	Introduction
While the rules applying short sale principles to straddle positions were being considered, various groups of taxpayers, primarily options dealers, whose business operations typically involve mixed straddles, were concerned about the potential dilemma of either opting for the §1256(d) election342 thereby forfeiting 60/40 treatment for any gains realized on §1256 contracts, or risking the adverse tax consequences described immediately above resulting from operation of the "killer" rule. They persuaded Congress to require Treasury to issue regulations offering a compromise solution under which the use of mixed straddles to obtain unwarranted tax benefits would be prevented while permitting the taxpayers to enjoy 60/40 treatment of §1256 contract gains in appropriate circumstances.
342The election is available, as discussed above, only where identification of the straddle can be made no later than the close of the day ion which the §1256 contract position is entered into. See V, F, 4, supra.
Accordingly, as part of the 1984 legislative amendments to the loss deferral rules, the Secretary was directed to issue regulations providing elective provisions under which such "killer" rule could be avoided.343 They are to provide, generally, that the taxpayer may offset gains and losses from positions which are part of mixed straddles: (1) as to which a straddle-by-straddle election has been made; or (2) "by the establishment (with respect to any class of activities) a mixed straddle account for which gains and losses would be recognized (and offset) on a periodic basis."344 Further, under either method, such offsetting is to take place before the application of §1256, the 60/40 rule will apply only to gain/loss attributable to §1256 positions, and the above described regulatory §11233(d) loss recharacterization principle will not apply to any straddle positions identified under a straddle by straddle election or made part of a mixed straddle account.345
343See §1092(b)(2).
344§1092(b)(2)(A)(i)(I) and  (II).
345§1092(b)(2)(A)(ii) and  (iii).
These regulations, thus, offer two elective regimes for the treatment of mixed straddles.346 A taxpayer may elect to identify and elect application of the rules of Temp. Regs. §1.1092(b)-3T as to any particular straddle. In addition, the taxpayer may elect under the provisions of Temp. Regs. §1.1092(b)-4T to set up an account or accounts in which may be included mixed straddles, other than those for which the straddle by straddle election has been made, relating to the same class of property.
346As indicated above, the term "mixed straddle" as used in these §1092(b)(2) regulations refers to any straddle at least one, but not all, of the positions of which is a §1256 contract, irrespective of whether the §1256 contract position was acquired before or after the non-§1256 contract position, and with respect to which no §1256(d) election has been made. See Temp. Regs. §1.1092(b)-5T(e).
Comment: The mixed straddle account election will usually be made by taxpayers acquiring and disposing of a large volume of straddle positions; while not specifically restricted to options dealers, it will probably be made almost exclusively by them.
Under either of these elections, 60/40 treatment will apply to net gain or loss from straddle transactions to the extent attributable to §1256 contracts; gain or loss attributable non-§1256 positions will be short-term capital gain or loss. The rules implementing these two methods are somewhat complex, and were obviously intended for use by relatively sophisticated taxpayers with adequate accounting support.
2.	The "(b)(2)IMS": Straddle by Straddle Identification Election
Under the first straddle by straddle election, the taxpayer must "clearly" identify "on a reasonable and consistently applied economic basis"347 the positions of the straddle as to which the election applies before the close of the day on which the straddle is established.348 Once this identification is properly made, the straddle is known as a "Section 1092(b)(2) identified mixed straddle," hereinafter referred to as a "(b)(2)IMS." A straddle qualifies for treatment as a (b)(2)IMS irrespective of whether the §1256 position is acquired before the non-§1256 position. Thus, if a §1256 position is acquired on June 20, and on August 12, while the first position is still held, an offsetting non-§1256 position is acquired, the straddle by straddle election may be made with respect to the resulting straddle so long as it is identified as a (b)(2)IMS before the close of the day on which the non-§1256 position was acquired.349 The same rule applies, of course, where the first position acquired is the non-§1256 position.
347The legislative history indicates that if this is done, "the determination by the taxpayer of what constitutes a mixed straddle generally will be accepted by the IRS." See 1984 Bluebook at 317.
348Regs. §1.1092(b)-3T(d)(1). These terms are defined in Regs. §1.1092(b)-3T(d), discussed at f, below.
349In contrast, the mixed straddle election under §1256(d) cannot be made where the §1256 contract position was acquired on any day prior to the date on which the non-§1256 position was acquired; identification must be made before the close of the day on which the first §1256 contract forming part of the straddle is acquired. §1256(d)(4)(B).
a.	Where All Straddle Positions Are Disposed of on Same Day
Where all of the positions of a (b)(2)IMS are disposed of (or deemed disposed of) on the same day: (1) gains and losses from all §1256 positions are netted; (2) gains and losses from non-§1256 positions are netted; (3) net §1256 position gain or loss is netted against net non-§1256 position gain or loss; and (4) the resulting net gain or loss is subject to 60/40 treatment if attributable to the §1256 positions or is treated as short-term gain or loss if attributable to the non-§1256 positions.350
350Temp. Regs. §1.1092(b)-3T(b)(2).
Example: On November 12, Year 1, T enters into a (b)(2)IMS composed of a short §1256 position and a long non-§1256 position. On December 15, T acquires a short non-§1256 position that is offsetting to the long non-§1256 position. On December 31, T disposes of the long non-§1256 position at a gain of $2,000. On that date the short §1256 position is marked to market for a loss of $2,200. Also, on that date, there is $200 of unrecognized gain on the short non-§1256 position. There is a net $200 loss from the (b)(2)IMS which is attributable to the §1256 position; it is therefore characterized as 60/40 loss. However, the short non-§1256 position is a "successor position" under the loss deferral and wash sale rules of Temp. Regs. §1.1092(b)-1T, discussed supra.351 Temp. Regs. §1.1092(b)-3T(c), requires that its rules are to be applied before the loss deferral and wash sale rules. Thus, the $200 net loss resulting from the (b)(2)IMS is disallowed because it is offset by the $200 unrecognized gain from the short non-§1256 successor position.352
351This is because the position was offsetting to a second position (the long non-§1256 position), such second position was offsetting to the §1256 loss position deemed disposed of, and the short non-§1256 position was entered into within 30 days of the date such second position was disposed of. See Temp. Regs. §1.1092(b)-5T(n).
352See Example (6) of Temp. Regs. §1.1092(b)-3T(b)(2).
b.	Where All of the Non-§1256 Positions Are Disposed of on the Same Day
Where all of the non-§1256 positions are disposed of on the same day (and one or more of the §1256 positions are retained), what may be referred to as the (b)(3) rule353 applies. This rule provides: (1) the realized net gain/loss from the non-§1256 positions is determined; (2) realized (with respect to the positions disposed of on that day) and unrealized (with respect to positions retained) gain/loss from the §1256 contracts is also determined; (3) the net non-§1256 contract gain/loss is then set off against the net §1256 contract gain/loss and the result is the net gain or loss from the straddle that day; (4) any net gain/loss attributable to the non-§1256 position(s) is recognized on that day as short-term gain/loss; (5) if there is net gain/loss attributable to realized gain/loss from the §1256 contracts, this is recognized on that day and is subject to the 60/40 rule; (6) if any unrealized gain/loss from the §1256 contracts was applied as an offset in making these computations, it is to be taken into account in adjusting any gain/loss subsequently realized from such contracts when they are disposed of or deemed disposed of (i.e., marked to market).
353Because provided under Temp. Regs. §1.1092(b)-3T(b)(3).
Example 1: Assume a mixed straddle made up of two non-§1256 positions and two §1256 contract positions. On June 3, the non-§1256 positions are disposed of for a net gain of $1,000. In addition, one of the §1256 contract positions is disposed of on the same day for a loss of $300. There is unrealized loss of $500 with respect to the §1256 contract position retained. The realized and unrealized losses from the §1256 contract positions, $800, are offset against the $1,000 gain from the non-§1256 positions resulting in a net short-term loss of $200, which is treated as realized from the straddle on June 3. Since the gain is attributable to non-§1256 positions, it is short-term gain. When the retained §1256 contract position is disposed of (or deemed disposed of), the $500 loss taken into account as an offset against the non-§1256 gain will be taken into account and the gain or loss sustained adjusted accordingly.
Example (2): Assume the same straddle configuration (two non-§1256 positions and two §1256 positions) as in Example (1). The non-§1256 positions are disposed of for a net gain of $500. One §1256 position is disposed of for a loss of $1,000. There is unrealized gain of $300 on the retained §1256 position. Thus, there is (1) net non-§1256 gain of $500 and (2) net §1256 loss if $700. Consequently, there is net loss from the straddle that day of $200. Since this loss is attributable to the realized loss from the §1256 position disposed of, it is recognized and treated as 60/40 loss. The unrealized $300 gain from the retained §1256 position (which offset, and thus reduced, the loss from the §1256 position disposed of) will subsequently be taken into account to decrease any gain or increase any loss subsequently realized when this position is disposed of (or deemed disposed of).
If a gain of $300 had been realized from the §1256 position disposed of and there was $1,000 of unrealized loss from the §1256 position retained, there would be a net straddle loss of $200 ($500 of net non-§1256 gain offset by net $700 §1256 loss) attributable to the retained §1256 position. However, because this net straddle loss is attributable to the retained §1256 position, no gain or loss is realized from the straddle on that day. Since only $800 of the unrealized $1,000 loss from the retained §1256 position was applied to offset straddle gains, any gain subsequently realized upon the disposition (or deemed disposition) of this position is increased and any loss subsequently realized is decreased by $800.
c.	Where All of the §1256 Contract Positions Are Disposed of on the Same Day
Where all of the §1256 contract positions of a (b)(2)IMS are disposed (or deemed disposed) of on the same day, another set of rules, the "(b)(4)" (Temp. Regs. §1.1092(b)-3T(b)(4)) rules apply: (1) gains and losses realized from the §1256 positions disposed of are netted; (2) both realized and unrealized gains and losses from non-§1256 positions are netted on the same day the §1256 were disposed of; (3) the net §1256 position gain or loss is treated as short-term to the extent of any offsetting non-§1256 position gain or loss, and as 60/40 gain or loss to the extent of the remainder (if any).
Thus, if there is $1,000 of net §1256 position gain and $800 on net non-§1256 position loss, there is treated as realized $800 of short-term gain and $200 of 60/40 gain. If there were $1,000 of net §1256 position loss and $800 of net gain from the non-§1256 positions, there would be $800 of short-term loss and $200 of 60/40 loss subject to the loss deferral rule of §1092; this loss would be allowable only to the extent it exceeded unrecognized gain from any offsetting retained non-§1256 positions held at year end.354
354See Temp. Regs. §1.1092(b)-3T(b)(4), Example (4). Deferral of loss under §1092(a)(1) is not applicable in the (b)(3) situation because the only straddle positions that might be on hand at year end are §1256 contracts which are deemed disposed of for fair market value (marked to market) at that time; there is thus no unrecognized gain.
d.	Where One or More, but Not All, Straddle Positions Are Disposed of on the Same Day
Where one or more positions of a (b)(2)IMS are disposed of on the same day, but at least one non-§1256 position and one §1256 position are retained, the net gain or loss from the non-§1256 positions disposed of is determined as is the net gain or loss from the §1256 positions disposed of.
It is then necessary to determine whether the principles of the (b)(3) or the (b)(4) rules are to be applied. See Temp. Regs. §1.1092(b)-3T(b)(5).
If the net gain or loss is attributable to the non-§1256 contracts, the (b)(3) rules (discussed at b, supra) apply. If the net gain or loss is attributable to the §1256 contracts, the (b)(4) rules (discussed at c, supra) apply.
Where, however, there was either a net gain or net loss on both §1256 and non-§1256 contracts (i.e., both amounts are either positive or negative), the (b)(3) rules apply to the net gain or loss from the §1256 contracts and the (b)(4) rules apply to the net gain or loss from the non-§1256 contracts.
Example: On July 15 of Year 1, T enters into a (b)(2)IMS made up of four §1256 contracts and four non-§1256 positions. On July 20, T disposes of one non-§1256 position for an $800 gain and one §1256 contract for a loss of $300. On that day, there is $400 of unrealized net loss on the retained §1256 contracts and $100 of unrealized net loss on the retained non-§1256 positions. In these circumstances, the $300 loss on the §1256 contract disposed of is set off against the $800 gain from the non-§1256 position disposed of, resulting in $500 of net gain attributable to the non-§1256 position. In this case, then, the (b)(3) rule applies.355 Thus, the net loss of $700 on the §1256 contracts is offset against the net gain of $800 from the non-§1256 position disposed of. Finally, the net gain of $100 resulting is characterized as short-term gain because it is attributable to the non-§1256 positions. When any gain or loss is subsequently realized from the §1256 contracts, it will be adjusted to reflect the unrealized loss of $400 that was offset against the $800 gain from the non-§1256 position disposed of.356
355If net gain were attributable to the §1256 contract position(s), the (b)(4) rule would be applied.
356See Regs. §1.1092(b)-3T(b)(5), Example (1).
e.	Marking Previously Acquired Positions to Market
Where the straddle by straddle election is made under Temp. Regs. §1.1092(b)-3T, any position of the (b)(2)IMS which was held on any day prior to the day identification is effected is treated as if it were sold for its fair market value at the close of the last business day preceding the day on which the (b)(2)IMS is identified, and any unrealized gain or loss with respect to such position must be taken into account.357 If such previously held position is a §1256 contract, the gain or loss is subject to 60/40 treatment; if it is a non-§1256 contract position, the gain or loss is long or short-term depending on the holding period. Such recognized gain or loss is then taken into account (by an adjustment to basis or otherwise) in determining the amount of any gain or loss subsequently realized when the position is disposed of (or deemed disposed of).358 Where the previously held position is marked to market under these rules, the regulations note that the loss deferral and wash sale rules, as well as the rules relating to the treatment of holding periods and losses with respect to such position, will apply.359
357Temp. Regs. §1.1092(b)-3T(b)(6).
358Temp. Regs. §1.1092(b)-3T(b)(6). If the mixed straddle is held at year end, the §1256 positions are marked to market under the normal rules of §1256(a). Positions marked to market are deemed disposed of.
359Temp. Regs. §1.1092(b)-3T(b)(6); the rules of Temp. Regs. §1.1092(b)-1T do not apply, however, to positions of straddles included in straddle accounts under Temp. Regs. §1.1092(b)-4T. See 3, infra.
Example: On June 2, Year 1 (a business day), T has held a non-§1256 position long-term. On June 3, Year 1, T acquires an offsetting §1256 position and identifies the straddle as a (b)(2)IMS. At the close of June 2, Year 1, there is $500 of unrealized gain with respect to the non-§1256 position. T recognizes $500 of long-term gain with respect to the non-§1256 position on the day the straddle is identified. However, if the previously held position was a §1256 contract, the gain recognized is treated as 60/40 gain. The same rule applies to any unrealized loss with respect to the previously acquired position. If the position marked to market is subsequently disposed of (or deemed disposed of in the case of a §1256 contract), the unrealized gain/loss taken into account under the above rule is applied to adjust any gain/loss realized upon such disposition.
f.	Other Miscellaneous (b)(2)IMS Provisions
As stated above, the taxpayer must clearly identify on a "reasonable and consistently applied economic basis" each position that is part of a (b)(2)IMS before the close of the day on which established. If one of the positions of such straddle is disposed of before the end of the day on which it is established (which may easily occur in the case of an options dealer), identification must be made before such position is disposed of. In the case of an individual, the close of the day is midnight (local time) in the place of taxpayer's residence, and in the case of other taxpayers, it is midnight (local time) in the location of the taxpayer's principal place of business. Only a person or entity that directly holds all positions of a straddle may make the (b)(2)IMS election.360
360Temp. Regs. §1.1092(b)-3T(d)(1).
The regulations provide that a taxpayer will be presumed to have identified a (b)(2)IMS within the time prescribed if the taxpayer receives independent verification of such identification.361 Such verification may be made by a broker, futures commission merchant or other such person: (1) in books or records maintained by him in an account labeled "Section 1092(b)(2) identified mixed straddle account," in which entries are made identifying all such positions and the dates entered into; or (2) by written confirmation from such broker, FCM, etc., or the party from whom the position was acquired, setting forth the date the position was acquired and the other positions in the IMS.362
361Temp. Regs. §1.1092(b)-3T(d)(2).
362Temp. Regs. §1.1092(b)-3T(d)(4).
3.	The Mixed Straddle Account
a.	General
The second alternative elective method for avoiding the short sale loss recharacterization rule of Temp. Regs. §1.1092(b)-2T generally follows the statutory directive described above under which the taxpayer may elect to set up one or more mixed straddle accounts.363 In addition, the statute364 provides that where the mixed straddle account election is made by the taxpayer, in no event may: (1) more than 50% of the net gain from the account for any taxable year be treated as long-term gain; and (2) more than 40% of the net loss from the account for any taxable year be characterized as short-term loss. As already indicated, the taxpayer is free to make straddle by straddle elections with respect to identified mixed straddles not included in any mixed straddle accounts.
363See §1092(b)(2)(A)(II). See PLR 9722028 (extension of time to file mixed straddle account elections granted).
364§1092(b)(2)(B).
b.	Basic Rules
Under the regulations, a taxpayer electing the mixed straddle account method for any taxable year must designate each "class of activities" for which an account is to be maintained. Temp. Regs. §1.1092(b)-4T(b)(1). A separate account must be maintained for each class of activities,365 and the positions to be included in the account are those which a reasonable person would consider to be offsetting.366 While there are no hard and fast rules, the designation must be reasonable and is subject to adjustment by the IRS if found not to carry out the purposes of the regulations.367 Thus, an options dealer who makes a market in options on ABC stock and XYZ stock and who also holds positions in the stock will be required to set up separate accounts for equity option/stock straddles with respect to each of these stocks.
365Temp. Regs. §1.1092(b)-4T(b)(1).
366Regs. §1.1092(b)-4T(b)(2).
367Temp. Regs. §1.1092(b)-4T(b)(4).
The regulations contemplate that there may be gains and losses from positions that a reasonable person would treat as offsetting other positions in more than one account. In such a case, allocation of such gains and losses is called for. See Temp. Regs. §1.1092(b)-4T(b)(3).
Note: The example in the regulation illustrates this situation by a taxpayer holding stock in corporations A, B, and C and short option positions on a broad based stock index (nonequity options) in circumstances where a reasonable person would treat the stock positions as offsetting the option position. The taxpayer must designate three separate classes of activities, one for each stock and maintain three separate mixed straddle accounts.
Comment: It would be interesting to have a more detailed example, using identified corporations, together with further discussion of the basis for treating the positions as offsetting. It is not at all clear, that a taxpayer holding stock in IBM and a short option position on the S & P 500 index holds a straddle.
Temp. Regs. §1.1092(b)-4T(b)(4) grants the IRS broad authority to remove positions from accounts where it is determined that their inclusion is inappropriate, or, where the positions in one account reflect more than one class of activities to assign them to two or more accounts, and to make other adjustments that may result in positions being removed from mixed straddle accounts. Positions thus removed if they are offsetting to other positions outside the account are thus subject to the rules of Temp. Regs. §1.1092(b)-1T and  -2T, including the loss recharacterization (killer) rule.368
368Regs. §1.1092(b)-4T(b)(4)(iii).
c.	Computing Annual Net Gain or Loss from Each Mixed Straddle Account
Briefly, all transactions in each mixed straddle account are tallied on a daily basis. Gains and losses from positions disposed of are recorded and the positions not disposed of at the close of each day are marked to market. Non-§1256 position gains and losses are netted as are those from §1256 positions. Net gain or loss for the day is then computed and attributed to the non-§1256 or the §1256 positions or to both, as the case may be. The taxpayer then records for that day the amount of gain or loss and the character thereof, short-term or long term. See Temp. Regs. §1.1092(b)-4T(c)(1).
Example: Assume that for August 23, there is net non-§1256 gain of $200 and net §1256 gain of $600. For the day, there is net gain of $800. Of this, $200 is short-term gain attributable to the non-§1256 positions, another $240 (40% of $600) of short term gain attributable to the §1256 contracts and $360 (60% of $600) of long term gain also attributable to the §1256 contracts. On August 24, there is net non-§1256 loss of $600 and net §1256 gain of $200. For the day, there is a net loss of $400 which is short-term since it is attributable to the non-§1256 positions. If it were attributable to the §1256 positions, the taxpayer would record $240 of long-term loss and $160 of short-term loss. If on August 25, there is $300 of net gain from non-§1256 positions and net gain of $400 from §1256 contract positions, the taxpayer records $460 ($300 + $160) of short-term gain and $240 of long-term gain.
On the last business day of the taxable year, the taxpayer computes the "annual account net gain or loss" from all transactions in each account. Temp. Regs. §1.1092(b)-4T(c)(2). That is, all long-term gains and losses are netted. All short-term gains and losses are netted. If there is net long-term gain and net short-term loss (or vice versa), these are netted. However, it is more likely that there will be annual net long-term gain and net short-term gain, or net long-term loss and net short-term loss. In any event, each account will have overall gain or overall loss.
d.	Interest and Carrying Charge Capitalization
The next step is to determine with respect to each account the interest and carrying charges369 "properly allocable" to such account.370 These include interest and carrying charges (less certain items of income discussed at V, E, supra)371 incurred with respect to all mixed straddle positions in the account. Such expenses may not be deducted but must be capitalized and applied to reduce annual net account gain or increase annual account net loss, as the case may be. The total amount of such expenses is then allocated between the annual account net long-term and short-term gain or loss on a pro rata basis.372
369As defined by §263(g)(2).
370Temp. Regs. §1.1092(b)-4T(c)(2). The regulations do not provide any guidance as to how this is to be done.
371As provided in §263(g).
372Temp. Regs. §1.1092(b)-4T(c)(3).
Example: If for a given account, net annual long-term gain is $40,000 and net short-term gain is $50,000, and if the interest and carrying charges to be capitalized total $2,800, $1,244.44 ($40,000/$90,000 × $2,800) is applied to reduce the long-term gain to $38,755.56, and $1,555.56 ($50,000/$90,000 × $2,800) is applied to reduce the short-term gain to $48,444.44.
e.	Application of §1092(b)(2)(B) Limitations
After the annual account net gains and/or losses from each mixed straddle account have been determined (after application of the interest and carrying charge capitalization rule, as explained above), they are combined to obtain the "total annual account net gain or loss." That is, annual account net long-term gains are netted against annual account net long-term losses, and annual account net short-term gains are netted against annual account net short-term losses. The result may be all long-term or all short-term gain or loss, a combination of long and short-term gain, or a combination of long and short-term loss. See Temp. Regs. §1.1092(b)-4T(c)(2).
Example: Assume that the taxpayer has two mixed straddle accounts. Account 1 has an annual account net gain of $5,000 short-term gain resulting from netting $5,000 of long-term loss against $10,000 of short-term gain. Account 2 has an annual account net loss of $2,000 resulting from netting $3,000 of long-term loss against $1,000 of short-term gain. The total annual account net gain is $3,000 short-term gain ($5,000 short-term gain from Account 1 netted against $ 2,000 loss from Account 2).373
373See Regs. §1.1092(b)-4T(c)(6), Example (6).
In the case where the result is total annual account net gain, no more than 50% may be treated as long-term gain.374 Thus, if the total annual account net gain were made up of $100,000 of long-term gain and $20,000 of short-term gain, $40,000 of the long-term gain would be recharacterized as short term (i.e., only $60,000 of the total gain of $120,000 can be characterized as long-term). Also, no more than 40% of total annual account net loss can be treated as short-term.375 Thus, if the total annual net loss were made up of $40,000 of long-term loss and $60,000 of short-term loss, $20,000 of the short-term loss would be recharacterized as long-term loss (i.e., only $40,000 of the total loss of $100,000 can be characterized as short-term). If there were total annual net gain of $60,000 short-term gain, there would be no recharacterization, but if it were $60,000 of long-term gain, $30,000 would be recharacterized as short-term gain.
374§1092(b)(2)(B)(i), noted above. The statute seems to require that the limitation be applied to each account before the accounts are combined to obtain total annual account nets, but the regulations provide that the limitation is to be applied to the total annual account nets. Temp. Regs. §1.1092(b)-4T(c)(4).
375§1092(b)(2)(B)(ii), noted above. Again, although the statute suggests that the limitation is applied to each account before determining the total annual net amounts, the regulations apply the limitation to the total annual net. Temp. Regs. §1.1092(b)-4T(c)(4).
In Roberts v. U.S., 1990-1 USTC ¶50,196 (N.D. Ill. 1990), the court held that the loss from a -4T mixed straddle account qualifying for 60/40 treatment by reason of its being attributable to §1256 contracts may be carried back under §1212(c) to offset net §1256 gain for prior years, just as would be the case for any other net §1256 loss. See discussion of §1212(c) at V, F, 1, supra.
Note: The above rules were intended to apply to equity options dealers. There has been enacted a new category of §1256 contract, a dealer security futures contract, which is to be treated much the same as a dealer equity option. Regulations will define this term, but for the present a security futures dealer is a person carrying on activities similar to those of an options dealer. The mixed straddle accounting rules will apply to such dealers. See the discussion at V,I, above.
D. Mixed Straddles Resulting from §988(c)
As discussed in more detail in VII, infra, foreign currency related options, futures, forward contracts and similar financial instruments are "Section 988 transactions," the gain or loss from which is separately computed and treated as ordinary income or loss.376 Under amendments made to §988 by P.L. 100-647 (TAMRA), §6130(b), effective, generally, as to instruments entered into or acquired after October 21, 1988, RFC's and nonequity options are excluded from §988 transaction status if they would be marked to market if held on the last day of the year.377 Thus, if the taxpayer should enter into a §988 transaction such as a forward purchase or sale of foreign currency and hedges the obligation thus incurred by an RFC or nonequity option, the result is a mixed straddle, the gain or loss from one leg of which is capital gain or loss (subject to the 60/40 rule), and gain or loss from the other leg is ordinary.
376See generally §988(a)(1)(A); §988(c)(1)(B)(iii).
377§988(c)(1)(D)(i). The taxpayer may, however, elect not to have this rule apply. §988(c)(1)(D)(ii).
The Conference Committee report378 relating to the TAMRA amendments states that the conferees intended that such straddles be subject to the mixed straddle regulations under §1092(b) "with appropriate modifications," to take into account the different character of gains and losses from the two legs described above. Under such regulations, it is intended that the rules set forth in the discussion of straddle-by-straddle and mixed straddle account elections apply, with 60/40 treatment to be accorded to any net gain or loss from the straddle attributable to the §1256 contracts and ordinary gain or loss treatment to net gain or loss attributable to the non-§1256 positions. In addition, no more than 50% of net gain is to be characterized as 60/40 gain and no more than 40% of net loss is to be characterized as (ordinary) foreign currency loss.
378H.R. Rep. No. 1104, 100th Cong., 2d Sess. 194 (1988).
Note: Options and futures that are not traded on a qualified board or exchange and forward contracts are not excluded from §988 transaction status. Forward contracts calling for delivery of or settlement in currencies not actively traded on the interbank market (generally, with respect to which RFCs are not traded) are not §1256 contracts under the definition of §1256(g)(2).
VII. Exotics, Notional Principal Contracts, International Aspects
A. Introduction
A host of new financial instruments were developed following the last substantive amendments to the tax straddle rules (1986 TRA).379 Almost all of these instruments were designed to serve financial goals unrelated to tax avoidance. In addition, corporations employing innovative financing techniques have issued financial instruments containing various restrictions, rights, and contingencies. Many of these instruments contain features that would justify characterizing them as equity interests. The rights and obligations created by many of these instruments do not fit easily into any of the categories formulated by the tax laws.
379Numerous provisions of the 1986 TRA, such as the restrictions on the deduction of personal and investment interest and the passive loss rules, together with the elimination of preferential rates for capital gains, had a very substantial indirect effect in making virtually obsolete whatever stratagems may have been devised to avoid these rules.
Given the complexities of the problems involved, the IRS, Treasury, and Congress have not been able fully to respond to these developments. The tax consequences attaching to transactions involving these instruments are therefore to a large degree still speculative, although some complex instruments may, upon careful analysis, be broken down into their component parts permitting application of the rules discussed in the previous parts of this Portfolio.
Example: Rev. Rul. 88-31,379.1 discusses the tax consequences to the issuer and holder of investment units consisting of one share of the issuer's common stock and a certain right (the Right). The units were issued for a price of $10 each on a date when the quoted market price of the stock (which was widely held and publicly traded) was $8. The Right, separately tradable after the lapse of a short period of time, entitled the holder to a one-time payment, two years from the issue date of the unit, of an amount equal to $11 minus the value of the share on that date, subject to a maximum payment of $7.33 (if the stock value dropped to $3.67 or lower). A minimum payment of $0.10 was also provided.
In determining the tax consequences to the holder, the IRS ruled that the Right is the economic equivalent of a cash-settlement put option, whose value varies inversely with that of the stock between the values of $3.67 and $10.90, and for which the holder paid a premium of $2 (the $10 issue price less the $8 allocable to the stock). From this, the IRS concluded that the character and timing of any gain or loss with respect to the Right are governed by §1234(a) and  (c) and §1234A. The IRS further ruled that since the option position diminishes the risk of loss from the stock position, a share of the stock and the Right, if held simultaneously, constitute a straddle (as defined by §1092(c)) with the consequence that a holder of both positions is subject to the loss deferral rule of §1092(a) and to the modified short-sale rules of Regs. §1.1092(b)-2T, and that such rules also apply to a holder of the stock only who subsequently purchases a Right, or the holder of a Right only who subsequently purchases a share of the stock. The IRS ruled that the issuing corporation, while the grantor of the economic equivalent of an option, did not recognize any gain or loss either from the receipt of the $2 premium for the Right or the making of any payments with respect to the Right, by virtue of §1032(a).
379.11988-1 C.B. 302.
In PLR 9235053, "Rights" that were issued by a corporation in exchange for a target corporation's common stock were ruled to be §1234(c) cash settlement put options. A Right entitled the holder to receive a specified amount of the excess over the current market price of the target corporation's stock, subject to a cap. The target corporation issued Rights to its shareholders but the Rights issued to its principal shareholder differed in both the trigger price and the amount of the cap. The corporation later redeemed the Rights. The IRS found the Rights very similar to the contingent payment rights in Rev. Rul. 88-31. It stated that the Rights are characteristic of cash settlement put options because (1) the amount paid at maturity on the Rights was based on the value of the target corporation common stock, (2) the amount of the payment and the value of the Rights varied inversely with the value of the target corporation common stock, and (3) the Rights called for the payment of cash rather than the delivery of the underlying target corporation common stock at maturity. As in Rev. Rul. 88-31, the ceiling on payments does not affect this characterization. Further, §483 and the original issue discount rules under §§1271-1275 do not apply to the Rights. The IRS also ruled that the loss, realized on redemption of the Rights, is treated as a loss from the sale or exchange of a §1234(b) capital asset held for not more than one year.
Comment: The instrument described in Rev. Rul. 88-31 has a distinct equity flavor. Other equity-flavored instruments were issued in the 1980s in connection with leveraged acquisitions and buy-outs. These instruments contain provisions that more nearly resemble equity interests than the rights usually accruing to holders of straight debt instruments. Among these are instruments bearing yields to maturity substantially higher than investment grade bonds and that provide for the deferral of interest payments until five or more years after the issue date, sometimes until maturity (e.g., zero coupon bonds).
Congress amended the Code in 1989, adding provisions that deny interest deductions for original issue discount on such instruments. In the case of corporate holders, a portion of the OID, when taken into income under the rules of §1272, is treated as a dividend to the extent of the issuer's earnings and profits, thereby entitling the holder to a dividend received deduction.380
380See §163(e)(5)(B) and  (i), as amended by the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239), applicable to corporation issued instruments (generally, after July 10, 1989) with terms exceeding five years and yields equal to or exceeding the AFR (as defined by §1274(d)) plus five percentage points and having "significant" OID. These provisions are discussed in 535 T.M., Time Value of Money: OID and Imputed Interest.
Other types of instruments devised to satisfy various financial goals and needs of the issuer (and, perhaps even more often, to attract potential investors willing to assume the risks involved) include so-called compounding principal obligations that provide for the payment, at the issuer's option, of interest in the form of obligations or cumulative redeemable preferred stock of the issuer (or a related party). These also are subject to the high-yield discount obligation rules noted above. Debt instruments with terms conditioning payments on the economic performance (or appreciation of the assets) of the issuer raise familiar debt/equity problems; if treated as debt, they may be subject to the contingent payment rules of Regs. §1.1275-4, as are debt instruments providing for payments tied to the values of stock indexes, commodities, and the like.381
381The proposed regulations under §1275 were criticized by various commentators; e.g., Land, "Contingent Payments and the Time Value of Money," 40 Tax Lawyer 237 (1987); Hariton, "The Taxation of Complex Financial Instruments," 43 Tax L. Rev. 731 (1988). For a concrete example of how these regulations may produce somewhat bizarre tax consequences, see Walter and Balcerzak, "A/S Eksxportfinans 14 1/2 Percent Gold Indexed Notes: Heaven and Hell Bonds," 67 TAXES 680 (1989). These and other aspects of exotic financial instruments are discussed in Kleinbard, "Beyond Good and Evil Debt (and Debt Hedges): A Cost of Capital Allowance System," 67 TAXES 943 (1989). A full discussion of the technical aspects of most of the exotic financial instruments referred would involve, to a large extent, a discussion of timing and measurement concepts based on the time value of money, a topic discussed in 535 T.M., Time Value of Money: OID and Imputed Interest.
Of particular significance among the financial products developed during the 1980s are the so-called notional principal contracts, primarily interest rate and foreign currency swaps. As of 1989, approximately a trillion dollars in notional principal amount contracts were outstanding.382 While some swap transactions may be engaged in for speculation, these products are used almost exclusively to hedge against exposure to interest and currency rate fluctuations. In this respect, they displaced to a large extent the use of options, futures, and forward contracts for hedging.
382Quint, "Eliminating Risk of Rising Rates," The New York Times, July 31, 1989 at D-1, cited in the New York State Bar Association Tax Committee on Financial Instruments Report on Tax Accounting for National Principal Contracts, fn. 6 (Sept. 28, 1989), hereinafter referred to as "NYSBA Report." See also News Release of International Swap Dealers Association, New York City, July 26, 1989, reporting a survey by Andersen Consulting showing that as of Dec. 31, 1988, the notional principal amount of swaps exceeded $1.3 trillion, with interest rate swaps accounting for $1 trillion of this and currency swaps, the remainder. The survey also reported that derivative products such as caps, floors and "swaptions," (options on swap positions) contributed an additional $327 billion to the total swap and derivative market outstanding. These instruments are discussed below.
Note: The problems created by the Arkansas Best decision in devising effective interest and currency rate hedges are analyzed in the discussion of §1256, above.
Hedging is a vital and virtually indispensable part of most business operations that involve transactions subject to the risks posed by the extremely volatile interest and foreign exchange rates of recent years. Treasury and the IRS appear to recognize this.383 The most interesting regulatory developments have come about in connection with §988;384 these regulations permit the integration of hedging transactions and transactions giving rise to foreign currency gains and losses.
383For instance, see the regulations issued under §446, relating to notional principal contracts and the timing of income and deductions, discussed below at VII, E.
384Section 988 was one of the Code provisions enacted in 1986 relating to the treatment of foreign currency gains and losses. See generally §§985-989 inclusive.
Comment: IRS spokesmen have indicated that the approaches developed in the regulations may eventually be extended to all kinds of hedging transactions. The following discussion focuses primarily on notional principal contracts, perhaps the most widely used hedging devices employed to diminish the risk of loss from interest and foreign exchange rate movements. It also covers §988 hedging transactions in general and the rules developed under the authority of §988(d) that permit the integration of hedges and the positions hedged.
B. Notional Principal Contracts: General
Financial institutions and corporate treasurers responsible for managing financial assets and liabilities need to manage the risks that are incident to fluctuating interest and foreign currency exchange rates. Part of the definition of "hedging transaction" is a transaction entered into primarily to manage the risk of price change or currency fluctuations with respect to property which is held or to be held by the taxpayer, or to manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer.385
385§1256(e)(2)(A)(i) and  (ii), as amended by the 1999 Tax Relief Extension Act, §532. Prior to amendment, hedging transactions were transactions that reduce risk. "Risk management" is meant to be a broader standard than "risk reduction." H.R. Rep. No. 106-478 (1999). The amendments are effective for instruments held, acquired or entered into on or after the date of enactment of the 1999 Act. In 2002, the Treasury issued the final hedging regulations regarding character of gains and losses from hedging transactions. These final regulations incorporate the statutory language "to manage risk" into the definition of hedging transactions. See Regs. §1.1221-2.
After the Supreme Court's decision in Arkansas Best (i.e., property of the taxpayer not falling within one of the exceptions to the general rule of §1221 is a capital asset), many, if not most, transactions fail to qualify as §1256(e) hedging transactions because they do not satisfy the additional requirement that "the gain or loss on such transaction is treated as ordinary income or loss."386 Thus, many hedging transactions in the form of options, futures contracts, and forward contracts would appear to be subject to §1256 and/or the loss deferral rules of §1092(a).387 They fail to satisfy the requirements of §1256(e) and, hence, those of §1092(e).388 This situation is exacerbated by the rule contained in §1256(f)(1) requiring, in effect, ordinary income characterization of gain from the disposition of any position which has been identified as part of a hedging transaction.389
386§1256(e)(2)(B). See the discussion of Arkansas Best at V, F, 3, b, above.
387Unless the positions constitute interests in U.S. dollars.
388Which exempts from the provisions of §1092 positions which are part of a hedging transaction as defined by §1256(e).
389While this may not entrap taxpayers aware of the implications of Arkansas Best and who, accordingly, have ceased to identify as hedges positions that cannot be excluded from the general §1221definition of capital asset, there are many positions outstanding entered into prior to the Arkansas Best decision (which is not limited as to retroactivity) which were so identified and as to which loss will be characterized as capital while gains will be treated as ordinary. See Kleinbard and Greenberg, "Business Hedges After Arkansas Best," 43 Tax L. Rev. 393, 424 (1988).
While these developments alone explain only partially the popularity of notional principal contracts, whose flexibility makes them preferable to futures and forward contracts in most instances, they gave such contracts considerable impetus as hedging devices that are seemingly immune to §1256 and, where no foreign currencies are involved, to §1092.
The two most commonly employed notional principal contracts are interest rate and foreign currency swap agreements. While the foreign currency swap technique was developed first, interest rate swaps are the more common of such agreements.
C. Interest Rate Swaps
1.	General
An interest rate swap is an agreement between one party and another, referred to as the counterparty, under the terms of which each will make payments to the other of amounts equal to the interest accruing on a hypothetical debt of a specified amount, the notional principal. In the typical swap, one of the parties will make payments based on a floating or adjustable rate tied to one or more interest rate indexes. Examples of such indexes include the prime rate of a specified bank, LIBOR,390 or the rate of a specified Treasury obligation (e.g., 90-day T-bills or T-notes with five or three years remaining to maturity, etc.). The counterparty will make payments based on a fixed annual percentage rate. Typically, but not necessarily, payments become due on the same dates and are offset, with one of the parties making the net payment called for.
390The London Interbank Offered Rate, the average rate offered by five major London area banks for Eurodollar deposits for terms of from three months to one year, quoted daily.
One advantage of swaps over parallel or back to back loans (which they have almost completely replaced, especially in cross border transactions) is that the default of one party terminates the continuing obligation of the other.
In some instances, one party to the agreement will grant to the other the right to terminate the agreement -- this is sometimes referred to as a "put" right or a callable swap -- in exchange for a lump sum premium or in consideration of an upward adjustment to the interest rate payable by the party acquiring such right. Swap agreements usually provide that the rights and obligations of either party may not be assigned to another person without the consent of the counterparty; swaps are, therefore, usually not negotiable or tradable.
Interest rate swaps, like forward contracts, are privately negotiated between the parties without the intermediation of an exchange. The interest rates involved depend, as in the case of debt instruments, on market rates and the credit worthiness of the respective parties. In time, the widespread use of such agreements resulted in a network of swap dealers who developed a standardized contract form, leaving open only such provisions as the period of the agreement, the timing of payments due, and the interest rates. The dealers act somewhat in the same fashion as an exchange, becoming the intermediary party guaranteeing the obligations of and succeeding to the rights of each end-user swap party. Through the dealer network a secondary market in swap positions has been formed allowing a party to transfer, terminate or otherwise liquidate its swap position where deemed advisable due to changes in the nature of the party's balance sheet, changes in the party's outlook on interest rates, or a party's desire to recognize a profit or loss.391 Quotes on swap terms are usually available from the dealers.
391See Rogers, "Interest Rate and Currency Swaps: The Secondary Market," Interest Rate and Currency Swaps 1988 B4-6832 Practicing Law Institute (hereinafter referred to as "Swaps 1988") at p. 23. The collection of papers in this PLI course handbook contains a valuable bibliography of articles dealing with various aspects of swap transactions, as does the PLI's handbook for 1989, "Interest Rate and Currency Swaps 1989," which contains an excellent, concise explanation of the economic dynamics and technical aspects of interest rate swaps, Taylor, "Understanding Interest Rate Swaps and Contracts," at p. 69.
To illustrate, assume a party obligated (or contemplating undertaking an obligation) on a debt instrument providing for floating rate interest indexed to LIBOR who wishes to swap into a fixed rate. A dealer can offer a swap matching the desired rate exchange, taking a number of basis points as his commission. There is, in effect, a going market in which fixed rates are deemed exchangeable against LIBOR (or some other index).
Example: ABC Corporation is a well known and highly rated entity able to borrow long term at 10%. Its financial assets, however, yield a floating rate return. XYZ Corporation will normally have to pay 12% for long term funds. ABC can borrow at LIBOR flat, whereas XYZ would have to pay LIBOR plus 1 percentage point. A swap would be advantageous to both. ABC can borrow at a 10% fixed rate and then enter into a swap with XYZ under which the latter pays a 10.5% fixed rate. XYZ borrows at LIBOR plus 1 and receives LIBOR flat under the swap from ABC. XYZ's all-in cost is thus 10.5% plus 1% = 11.5%, a saving of 500 basis points. ABC, on the other hand, pays a floating rate matching its floating rate asset return, and receives profit of 500 basis points on the fixed rate side.
The swap provides the participants with several advantages. First, cash flows from each party's portfolio can be more closely matched; if income from financial assets is based on floating rates, floating rates can be substituted for fixed rates on liabilities, and vice versa. Swaps can also provide a management tool for the party with long-term liabilities and rolled over short-term assets. Second, as illustrated by the example, a swap permits a party that can borrow at low rates to, in effect, sell this advantage to a party unable to access the market on such favorable terms, and to permit the party with the lower credit rating to borrow funds at a lower effective fixed rate than would otherwise be available. Thus, the swap serves to alter the party's all-in costs of borrowing and permits the party to substitute exposure to the risks of fixed rate borrowing to those of a floating rate (and vice versa) that may more closely match the character of its cash flows.
Of course, as interest rates change, a swap may, in much the same way as an option or futures contract, become a valuable in-the-money asset that can be assigned for value ("above-water"), or on the other hand, may become an out-of-the-money burden ("below-water") which the holder of the adversely affected position will be willing to pay another party to assume.
Example: In the previous example, if LIBOR should increase to a point where a dealer can offer a 12.5% fixed rate versus LIBOR swap flat, ABC's swap position would be out-of-the-money (under-water). ABC may be willing to pay a dealer to assume its rights and obligations under its position. The dealer could either negotiate with XYZ to terminate the swap or find another counterparty to agree to a LIBOR versus 10.5% fixed rate swap position in exchange for a premium paid by the dealer. Likewise, XYZ might be willing to assign its swap position in exchange for a premium, leaving it free to enter into a new swap. None of these transactions would alter in any way the obligations owed by ABC or XYZ to their respective lenders.
In the case of standardized dealer mediated swaps, the dealer will, in effect, find an assignee. In some instances, a swap party may desire to unbundle the position and assign only one of the legs (usually the obligation leg). This can also be arranged by a dealer. Since swap terms generally require consent of the counterparty for any assignment of an obligation thereunder, however, such consent must be obtained before any assignment can be made. Where the dealer is the counterparty, this usually poses no difficulties.392 Of course, the right to receive a stream of fixed interest rate payments can easily be sold just as an installment obligation may be factored. This would not appear to require the consent of the obligor, but the seller's obligation to make payments to the counterparty is in no way affected.
392In this sense, a swap resembles a forward contract the rights and obligations under which can be terminated only by assignment, cancellation or entering into an offsetting contract.
Swap dealers are not regulated by any government agency and swaps are not traded on any exchange. They therefore do not appear to fall within any of the definitions of §1256 contract contained in §1256(b).393 Further, if the agreement is denominated in U.S. dollars (or in a foreign currency that is not actively traded), it is not treated as a position with respect to personal property within the meaning of §1092(c), even though its primary function may be to diminish the risk of loss from the holding of an interest bearing asset.
393Cf. PLR 8818010, relating to foreign currency swap agreements, discussed below.
The principal tax problems arising from interest rate swaps do not involve the application of the straddle rules. Rather, they relate to the questions of the timing, character and source of income and loss from swap agreements. The IRS has issued relatively little guidance other than the notices and regulations discussed below, much of which relates to international aspects.
There seems little question, however, that payments received under an interest rate swap are ordinary income under the broad inclusory rule of §61(a). How such income is to be classified (interest, compensation for services, etc.) for the purposes of other Code sections is unclear. Further, there is no Code section that clearly authorizes deductions for payments made under a swap agreement. Again, this depends on the classification of such payments, but it does not seem unreasonable to assume that the IRS will treat them as a deductible expense notwithstanding the fact that neither party to an interest rate swap is obligated with respect to the notional principal amount. The extent to which such expense will be treated as interest or interest-equivalent remains to be seen.394
394See Cragie, "Interest in the Rate Swap: Will Old Colony Die Hard?" 18 Tax Mgmt. Int'l J. 65 (1989), for a discussion of how swap payments should be characterized. See also PLR 9834026, TAM 9730007 (payment or receipt of periodic payments under interest-rate swap is ordinary income or expense; but not interest). But see FSA 200037034 (service fees, payments made pursuant to notional principal contracts, and commitment fees paid to obtain a line of credit should not be treated as interest for purposes of §265(a)(2)).
One may assume that the IRS will view the assignment for value (whether to a dealer or new counterparty) of both legs of an above-water swap position395 as the sale of a capital asset since the position would appear to be "property" not falling within any of the exceptions to §1221.396 On the other hand, it is not clear how payment to an assignee for the latter's agreement to assume the position would be treated by the assignor. Pre-1997 Act §1234A397 applies only to a loss attributable to the cancellation of an obligation with respect to personal property within the meaning of §1092(d)(1), but, assuming that the swap payments are denominated in U.S. dollars, U.S. dollars are not treated as personal property for §1092 purposes.398 The only authority that appears applicable to this transaction is the line of cases holding that the extinguishment or termination of a burdensome contractual obligation is not a sale or exchange, with the result that gain or loss from such a transaction is ordinary.399 There is no statutory counterpart to §1234(b) or §1234A applicable to gains or losses from the termination of a party's rights/obligations under a swap agreement. The amount received by an assignee in consideration of its assumption of the rights and obligations of the assignor of an under-water swap position would seem to come within the provisions of Notice 89-21,399.1 discussed below, requiring amortization over the remaining term of the swap agreement.400
395That is, both the assignor's rights and obligations are assigned, although it is possible to assign only the right to receive payments or the obligation to make them separately, as discussed below.
396See discussion of Arkansas Best at V, F, 3, b, above.
397Effective for terminations after Sept. 4, 1997, the Taxpayer Relief Act of 1997, P.L. 105-34, amended §1234A by replacing in §1234A(1) the term "personal property (as defined in Section 1092(d)(1))" with the term "property." The provision treats the cancellation, lapse, expiration, or other termination of a right or obligation (other than a §1234B securities futures contract) with respect to property which is (or would be upon acquisition) a capital asset in the hands of the taxpayer to all types of property as a "sale or exchange." This removes the effective ability of a taxpayer to elect the character of gains and losses from certain transactions. The new provision was seen as necessary due to a deficiency in pre-1997 Act law in which: (1) similar economic transactions were taxed differently; (2) some, but not all, taxpayers could make an election as to how an item would be taxed; and (3) the lack of certainty made the tax laws unnecessarily difficult to administer.
398See V, B, 2, above. Of course, if the obligation were denominated in a currency other than the U.S. dollar, §1234A may apply. This is but one of the many anomalies encountered in this area.
399See, e.g., Comr. v. Pittston Co., 252 F.2d 344 (2d Cir. 1958); Comr. v. Starr Bros., 204 F.2d 673 (2d Cir. 1953). It was this principle, reflected in former Regs. §1.1234-1(b) and private letter rulings issued to the CBOE concluding that gain or loss realized from a closing transaction entered into by the grantor of an option was ordinary income or loss, that led Congress to enact §1234(b) providing for capital treatment for such gain or loss. See 1976 Bluebook at pp. 673-678.
399.11989-1 C.B. 651.
400That is, the present value of five payments of $10, to be made at the end of each year, using a discount rate of 10%.
2.	Lump-Sum Payments: Pre-December 13, 1993 Contracts
Note: The Treasury issued final regulations under §446 relating to the timing of income and deductions with respect to notional principal contracts (NPCs).401 The discussion of Notice 89-21 below is relevant only for notional principal contracts entered into before December 13, 1993.
401See T.D. 8491, 1993-2 C.B. 215, which is discussed in VII, E, below.
The IRS issued, in 1989, administrative guidance on one of the most pressing tax problems encountered in this area,401.1 namely, determining the proper treatment of payments made in one taxable year with respect to a notional principal contract where a payment relates to the obligation to make a payment or payments in other taxable years under the contract. This situation can occur in the following ways:
401.1See Notice 89-21, 1989-1 C.B. 651. In TAM 9730007, the National Office cited Notice 89-21 in advising that commodity swaps are notional principal contracts and that amounts paid by the taxpayer to a bank and amounts received from the bank by the taxpayer constituted ordinary income and expense, not capital gain and loss.
Example (1): Party A enters into a swap with Party B under which A is to pay B semiannually interest on a notional principal of $1,000,000 at 6 month LIBOR plus 2% and is to receive from B semiannual payments based on a fixed annual rate of 10% on the same principal. The agreement has a term of eight years. B, in lieu of making the 16 semiannual payments called for, makes payment to A at settlement in cash the present value of 16 semiannual payments of $50,000 which equals $541,888. This may be termed an accelerated fixed-rate payment.
Example (2): Assume the same facts as in Example (1) except that B makes no payment to A in satisfaction of its obligation, but that A, after settlement assigns to Party C its right to receive the 16 semiannual payments from B in consideration of a payment by C to A of $541,888. A remains liable to make the payments called for in the swap agreement to B.
Example (3): In a so-called zero coupon swap, the fixed rate payor agrees to pay, at the end of a specified term (say, five years), the interest accrued at a specified rate on the notional principal amount. In exchange, this party will receive periodic payments of interest at the corresponding floating rate. Thus, the floating rate payor receives nothing until the close of the agreement's term. This swap will afford the purchaser of a zero coupon bond with a current floating rate cash flow. The issuer of a zero coupon bond might also enter into such a swap in which the issuer would become the payor of periodic floating rate interest and receive, in exchange, at the end of the term, from the fixed rate counterparty, funds with which to finance the interest payment due at maturity.
Example (4): Assume that for an eight year notional principal obligation of $1,000,000 the swap market calls for an 8% annual fixed rate versus six month LIBOR. A, the fixed rate payor under a swap agreement, agrees to make 8 annual payments based on the 10% rate ($100,000) in consideration of a premium paid by the counterparty who will pay six month LIBOR. The premium is an amount equal to the present value (using a discount rate of 8%) of 8 payments of $20,000, the amount by which the annual fixed rate payments agreed to exceeds fixed rate payments based on an 8% rate, or $114,932. This is paid to A at settlement.
The IRS became aware that swap agreements fitting the patterns of these examples (accelerated fixed rate payments and "premium" swaps) were sometimes being used to generate income in the taxable year of settlement to offset expiring net operating losses or otherwise unusable losses.402
402See Sheppard, "Safe Harbor Leasing Revisited: Using Swaps to Avoid NOL Limitations," 41 Tax Notes 486 (1988). Generation of such income was also used to increase foreign source income for tax credit purposes.
In Notice 89-21, the IRS ruled that "[i]n the case of a payment received during one taxable year with respect to a notional principal contract where such payment relates to the obligation to make a payment or payments in other taxable years under the contract, a method of accounting that properly recognizes such payment over the life of the contract clearly reflects income." (emphasis supplied). The Notice specifies that "the accounting method prescribed in cases such as Schlude v. Comr.,403 and American Automobile Association v. U.S.403.1 does not clearly reflect income in the case of notional principal products."403.2 Thus, the IRS rejects the position that the types of prepayments described above are includible in income in the year of payment.
403372 U.S. 128 (1963) .
403.1367 U.S. 387 (1961).
403.2In each case the Court held that payments received in one taxable year as consideration for services to be performed (if and when called for under the contracts involved) in later years must be included in the year of receipt, and established the principle that amounts received without restriction as to use in one taxable year must be included in income of that year irrespective of the fact that such payment is compensation for the performance of services in later years whose costs can be accurately estimated based on a reliable statistical sampling method. The authority for requiring amortization of payments is that granted by §446(b) to require a taxpayer to use a method of accounting that clearly reflects its income. See RCA Corp. v. U.S., 664 F.2d 881, 886 (2d Cir. 1981), cert. denied, 457 U.S. 1113 (1983).
The Notice provides no specific method for amortizing such payments, nor does it address directly the proper tax accounting treatment by the person making them. Presumably, if such payments are characterized as deductible expenses (whether as interest equivalents or otherwise), the provisions of §461(h) will apply to require some form of amortization over the life of the contract.404 The Notice further states that deferring the entire amount of such payment to the termination of the contract (as in the zero coupon swap illustrated in Example (3) above) is not acceptable.
404Section 461(h) provides that in determining whether an amount has been incurred with respect to an item for any taxable year, the "all events" test (which governs the timing of an item of expense of an accrual basis taxpayer) is not treated as having been met with respect to such item of expense until the year in which "economic performance" with respect to the item takes place. The Notice is not applicable to transactions the IRS characterizes as loans. An agreement under which one party receives a payment of cash in exchange for which it undertakes to make periodic payments of the amount received plus interest is economically indistinguishable from a loan, but the characterization of swap contracts as loans would introduce more problems than such a position would resolve, including the question of withholding in the case of cross-border swaps.
In Notice 89-21, the IRS promised to issue regulations under §§61, 446(b), 451, 461 and 988404.1 to provide specific rules for taking such lump sum payments into account by both the recipient and the payor, including similar rules governing the treatment of payments made or received in connection with the assignment of the right to receive future payments where there is no assumption by the assignee of the obligation to make payments under the contract, as in Example (2), above. While the regulations to be issued will, generally, be prospective only, Notice 89-21 has no effective date; it is retroactive to all open years. As to such years, the method used for amortizing lump sum payments made or received prior to the effective date of these regulations over the life of the contract will be accepted if "reasonable."
404.1Treasury partially fulfilled the IRS's promise by issuing proposed regulations under §446 relating to the timing of income and deductions with respect to notional principal contracts (NPCs). See FI-16-89, 56 Fed. Reg. 31350 (7/10/91). The proposed regulations also allow dealers and traders in derivative financial instruments to elect mark-to-market tax accounting (provided certain conditions are met). The purpose of these regulations is to prescribe accounting methods intended to reflect the economic substance of NPCs without creating unnecessary complexity. They are cross-referenced in Regs. §§ 1.61-14(b)(7), 1.162-1(b)(8), 1.451-1(f), and Prop. Regs. §1.1275-4(i). The proposed regulations are to be effective, generally, for NPCs entered into after publication of final regulations. For NPCs entered into before that effective date, Notice 89-21continues to apply. The effective date for the mark-to-market election is the taxable year ending on or after the date that final regulations are published. In addition, final §988 regulations were issued. See T.D. 8400, 57 Fed. Reg. 9172 (3/17/92), and T.D. 8860, 65 Fed. Reg. 2026 (1/13/00), and the proposed amendments to Regs. §§1.988-1,  -2,  -5 in INTL-15-91, 57 Fed. Reg. 9217 (3/17/92), and REG-116567-99, 65 Fed. Reg. 2084 (1/13/00).
The Notice also indicates that the IRS is considering a mark-to-market rule with respect to swap dealers. These proposed regulations were finalized in T.D. 8517, 1994-2 C.B. 38, generally effective for debt instruments issued on or after April 4, 1994. Note that Regs. §1.1275-5 makes several changes to the treatment of variable rate debt instruments.
Comment: In September 1989, the New York State Bar Association Tax §(NYSBA) issued a report (NYSB report)405 discussing certain tax accounting issues that the IRS must address in drafting the implementing regulations contemplated by Notice 89-21. The report focuses, generally, on matters relevant to end-users of notional principal contracts designed to manage interest rate exposure. While it does not deal directly with the more complex issues arising with respect to foreign currency hedges, many of its observations are clearly relevant to such issues. Although the authors of the report disavow any intention of advising taxpayers which accounting methods will be considered "reasonable" for purposes of Notice 89-21, its recommendations regarding the conceptual basis for forthcoming regulations present an analysis that will probably be very useful in formulating and justifying such methods for the period prior to the effective date of such regulations. Some of the valuable analytical insights contained in this report are drawn on in the following discussion.
405Perhaps in response to the NYSB report, Treasury proposed regulations under §446, relating to notional principal contracts and the timing of income and deductions. For a discussion of these regulations, see VII, E, below.
The NYSB report suggests that the rules relating to the timing of cash flows under notional principal contracts follow as closely as is permissible under generally applicable tax law the results that would obtain under a "static" mark-to-market regime. Thus, ignoring changes in interest rates and volatility assumptions occurring after the date a given position was entered into, the amortization of lump sum payments should be based on the basic principles applied in the measurement of income and expense in connection with debt instruments and other financial products. Thus, for example, for purposes of timing the recognition of income and expense, a swap agreement may be regarded as the exchange of two debt instruments with the same issue price, one bearing interest at a fixed and the other at a floating rate. Under this analysis, the principles contained in the proposed regulations under §§163(e), 1272-1273 and 1275 (the "OID regulations") can be applied to measure income and expense. These proposed regulations were finalized in December 1994.405.1
405.1See T.D. 8517, 59 Fed. Reg. 4799 (2/2/94), which is generally effective for instruments entered into after April 1994. Note that Regs. §1.1275-5 makes several changes to the treatment of variable rate debt instruments.
Example: T enters a swap under which T will make annual payments of 10% on a notional principal amount of $100 for a five year term406 in exchange for the counterparty's annual payments of interest based on 6 month LIBOR, reset annually. T should report and deduct the fixed rate payments as if they were interest payable on a 5 year debt instrument with an issue price and stated redemption price of $100. Likewise, T should report and include in income the floating rate payments as if they were paid with respect to a debt instrument issued by the counterparty with the same issue and stated redemption prices. The floating rate payments would be treated as made with respect to a variable rate debt instrument (VRDI), as defined in Regs. §1.1275-5.407 The counterparty would report income and deductions on the same principal, i.e., as if he were the holder of a debt instrument with a $100 issue price on which interest is payable at the annual rate of 10%, and deduct the floating rate payments as if the counterparty were the obligor issuer of a VRDI with a $100 issue price providing for a stated redemption price at maturity of $100.
406Swap contracts provide for the settlement date, the counting convention to be used in computing interest (e.g., a 30 day month and 360 day year) payment frequency, reset frequency for the floating rate and pricing date.
407The hypothetical VRDI has no OID since the issue price and stated redemption price at maturity are both $100. Problems might be encountered if the floating rate formula does not qualify under the somewhat restricted rules of the regulations.
Following conventional time value of money principles, if T and the counterparty agree to an up-front payment by T on the settlement date (discharging T's obligations under the swap) of the present value of T's fixed rate payments, $37.91,408 a reasonable method for the amortization of such payment by the counterparty (consistent with Notice 89-21) would be to include in income each year the present value of $10 discounted to the issue date of the hypothetical obligation using a 10% annual rate. Thus, the counterparty would include in income for the five year term the respective amounts of $9.09, $8.26, $7.51, $6.83, and $6.21.409 Under §461(h), the IRS will probably take the position that the $37.91 payment by T is deductible only to the extent of the amounts set forth in the amortization schedule above. Of course, more complex agreements410 would require more complex computations.
408That is, the present value of five payments of $10, to be made at the end of each year, using a discount rate of 10%.
409This can perhaps be seen more clearly by considering that if T were to pay $9.09 in satisfaction of T's obligation to make a $10 payment at the end of one year, the agreement would reflect an interest rate of 10%. Conceivably, Notice 89-21 could be satisfied by a straight line amortization of the $37.91, but this seems very doubtful.
410For example, one variation might be an agreement under which the fixed rate payor defers a portion of the interest payments from one accrual period to another or to maturity. Possibly, the fixed rate payor could make a lump sum payment to the floating rate payor, but this is rarely, if ever, done. In the case of a "basis" swap, i.e., each party to make floating rate payments based on two different indexes, there would presumably be no rational basis for accelerated payments of this kind.
In the situation just described, if either party wished to assign his swap position, the accelerated payment must be taken into account. Without such lump sum payment, each party has a zero basis in his swap position. However, after the payment described, T would have a basis in his swap position of $37.90. This would decrease by the amounts deductible411 by T for each taxable year. Assume that at the end of one year, interest rates fall to the point where the swap market called for a fixed rate of 8% (down from 10%) versus 6 month LIBOR. If T had not prepaid his fixed rate obligation, his position would be under-water. T, having satisfied his fixed rate liability, retains the right to receive the floating rate payments. At the beginning of the second year, T's basis is equal to the as yet unamortized portions of his $37.91 payment,412 that is, $28.81. His right to receive the remaining four floating rate payments has a value of $26.50 (the present value of four annual payments of $8 using the 8% rate). Assignment of the position would net T a loss of $2.31 ($28.81 - $26.50) which should be recognized in the year of assignment since T has no further continuing rights or obligations under the swap.413 Since T's obligation to the counterparty has been satisfied, the counterparty has nothing to assign; he has only an obligation to fulfill. Presumably, a third party or dealer will assume this obligation in consideration of payment of $26.50. The result here, although less clear, would appear to be that upon the assignment, the counterparty would have to include in income the unamortized portion of the lump sum payment but could offset the $26.50 payment made to the party assuming his obligations under the agreement.
411Assuming that a deduction is allowable; otherwise, the amounts taken into account by T in amortizing his expenditure, whether or not deductible, would nevertheless decrease T's basis.
412Which it will be assumed has been deducted for Year 1.
413Presumably, based on the argument set forth above, the loss is properly characterized as capital loss. But Notice 89-21, as already stated, does not address questions of characterization.
In amortizing a premium payment, the amounts includible in income by the recipient (and taken into account as expense by the payor) may be determined by applying a constant interest rate to such premium in much the same fashion as bond premium should be amortized.414 The computation is basically the same as set forth above for amortizing lump sum payments made in satisfaction of the obligation to make periodic fixed rate payments, since bond premium is measured by the present value of interest payments to be made in the future in excess of the rate at which the bond could be marketed at par.415
414While §171 provides for economic accrual of bond premium by the holder, there are no Code or regulatory rules for amortization of premium by the issuer other than Regs. §1.61-12(c)(2) which calls for proration or amortization over the life of the instrument without setting forth any particular method or requiring economic accrual. See NYSB Report, supra, fn. 383, for examples illustrating the accrual of premium on a constant interest basis.
415For additional discussion of the implications of Notice 89-21, see Cantrell, Hanna and Kurtz, "Notice 89-21 Crashes the Interest Rate Swap Party," 45 Tax Notes 337 (1989); Klein and Donaldson, "Swap and Cap Premiums: Recent Notice Offers Answers, But Raises Questions," 2 J. of Bank Tax'n 11 (1989); Letter to Kenneth Gideon, Assistant Secretary for Tax Policy from Feldgarden, Adams and McCarty of Lee, Toomey & Kent, Tax Analysts Daily Tax Highlights and Documents, Vol. 15, 1806 (Nov. 29, 1989) (pointing out that in the case of the payment by a swap party to a third party in consideration of the latter's assumption of a below-water position, Notice 89-21 requires the recipient of the payment to amortize it over the remaining life of the swap, but appears to permit the payor to deduct such payment in the year made (as a payment in termination of a burdensome contract; see, discussion above) opening the door to tax sheltering by reason of this disparate treatment.)
A "zero coupon swap," in which the fixed rate payor will make a single payment at maturity of interest computed by compounding the fixed annual rate over the term of the swap, in exchange for periodic floating rate payments (more fully described below), the same time value of money analysis may be applied to determine the timing of income and expense, applying the original issue discount rules of §§1272 and 1273. See generally 535 T.M., Time Value of Money: OID and Imputed Interest.
Comment: Some dealers (and nondealers as well) offer "swaptions," options to enter into a swap agreement with specified terms (the strike price). Thus, in consideration of a premium, a dealer may offer the optionee the right exercisable for a limited period (expiration date) to enter into a swap at a specified fixed versus floating rate based on a specified notional principal amount. The IRS has not issued any guidance on the tax treatment of such contracts. Presumably, payment of the premium, as in the case of options on other property, is not a realization event for either party. Since a swap position is a capital asset (as broadly defined by §1221), the option is a capital asset in the holder's hands under the principles of §1234(a). If the option is exercised, the option holder presumably acquires a basis in the swap position equal to the amount of the premium paid. Possibly, this amount may be amortized over the life of the swap on a straight-line or some other reasonable basis. If the option expires unexercised, the premium is presumably treated as a capital loss under the principles of §1234(a). If the option is exercised, the grantor, under this analysis, would acquire an amortizable basis in its swap position. Since §1234(b) (concerning stock, securities, commodities, etc.) does not literally apply to such an option, the grantor could claim ordinary loss if the option were closed out (repurchased from the option holder) at a loss. On the other hand, the grantor's gain (option expires unexercised or closed out for a gain) may be characterized by the IRS as ordinary income, as is the gain from any option relating to property other than that to which §1234(b) applies. Whether or not the grantor is a swap dealer may have some bearing on the timing and character of gain or loss from granting the option. These matters should be addressed in regulations.
Also, so-called "forward swaps" have been developed under the terms of which both swap parties agree to enter a swap agreement on some specified future date. If, as is unusual, one party pays a premium (in consideration for an "off market" leg) at the time of the agreement, the NYSB report (see fn. 383, supra) suggests that it could be treated as a loan prior to settlement with the imputed interest treated as earned by the payor and incurred by the recipient. However, a loan analysis entails sourcing (hence, withholding) problems, and the report opts for the inclusion in income (or deduction) of the premium by the parties on an amortization basis over the entire life of the transaction (including the period prior to settlement).
3.	Caps, Floors and Collars
Caps and floors are hedging transactions entered into by obligors and obligees of floating rate debt instruments. Assume, for example, that a person is the obligor of a $1,000,000 note maturing in five years and providing for interest at a variable rate based on a rate index plus a specified number of basis points. Another example might be an obligor on a fixed interest rate note who has swapped into a floating rate obligation. In either case, the obligor bears the risk of an increase in interest rates. Many swap dealers, banks and financial institutions will agree, for a lump sum premium paid in advance, to pay the obligor on the dates interest payments are due: the difference (if any) between the amount of interest due under the floating rate index and a given fixed rate. Thus, if the obligor desires to protect itself against floating rates in excess of 12%, the cap contract will be written to this rate. Similarly, the obligee of a floating rate instrument (or of a fixed rate instrument who has swapped into a floating rate) may desire to insure that the interest payable does not fall below a given rate. In this case a floor agreement can be obtained under which the counterparty will pay the difference (if any) between the interest due under a specified minimum rate and the floating rate, if lower.
A "collar" is an agreement under which the first party makes payments to a counterparty where the designated floating rate goes above the agreed on ceiling and the counterparty makes payments to the first party where the floating rate goes below the designated floor rate. Here, the party purchasing the cap can recoup a portion (or perhaps all) of the premium by writing the floor side of the contract. Of course, a party can purchase a cap from one entity and write a floor for a different entity with the same net result. The principles discussed below apply to all such contracts, caps, floors, and collars.
The treatment of premiums paid by the party obtaining cap or floor protection involves computations quite different from those outlined above. A cap, for example, is economically and functionally similar to a cash settlement put option on a short-term obligation.
Example: T borrows $100 and agrees to pay interest semiannually at a rate equal to the 6 month LIBOR rate plus 2 percentage points. The term of the loan is five years. At the time of the loan, the LIBOR rate is 8% (annual percentage rate). T enters into a cap agreement with bank B under which B will make payment to T if the interest payable on T's note exceeds an annual percentage rate of 14%. B also grants to T a series of put options on 6 month certificates of deposit redeemable for $107 with a strike price of $100 (reflecting a 14% annual rate). The options expire at six month intervals over the next five years (10 options in all) and may be exercised (European style) only on the expiration date. If short term interest rates increase to, say, 16%, T can exercise the put by purchasing a certificate for $99.00, realizing a gain of $1.00. If the option were settled in cash, this is the amount that would be payable to the option holder. Under the swap, if on the first payment date, the floating rate is equal to 16%, B must pay to T $1.00 under the cap agreement.416
416Difference between interest for 6 months on $100 at an annual rate of 14% and at an annual rate of 16 is $1.00.
The premium that the writer or grantor of the cap will demand will usually be based on the same options pricing models referred to in III, B 1, above. Since the risk of the grantor increases as the time to expiration is extended, the longer the option's term, the greater its time value and, hence, the premium demanded. Applying a commonly used pricing computation to a $600 premium received for a three year cap on a floating rate payable annually417 the premium is allocated to each of the hypothetical put options: $55 to the option expiring at the end of the first year, $225 to the option expiring at the close of the second year, and $320 to the option expiring at the end of the third year.418 At the end of Year 1, $320 of the premium must be amortized, since on that date, the premium for the same coverage for the remaining two years is $280 ($55 + $225). It can thus be argued that this is the amount that should be taken into income by the grantor (offset, of course, by any payment due under the cap) and treated as an expense by the purchaser of the cap (offset, of course, by any payment received under the cap), applying the principles governing the tax treatment of options set forth in III, B, supra.
417Namely, the Black Scholes formula, mentioned above in the discussion of options.
418These figures are taken from the example set forth in the NYSBA Report, above, fn. 383, at 794. See also Letter of March 4, 1988 from Simpson Thacher & Bartlett to Associate Chief Counsel (Technical and International) Kevin Dolan, proposing rules for the tax treatment of interest rate caps on the basis of the cash settlement option equivalency explained herein.
Comment: The foregoing analysis goes only to the timing of the recognition of gain or loss. Their character poses other problems. Arguably the purchaser of the cap should apply the net amount realized (premium amortized offset by any payment received) against its net cost of the borrowed funds for the year in determining any deduction under §163. The cap writer arguably should, like the grantor of an option relating to stock or securities under §1234(b), recognize short-term capital gain or loss on the net amount realized (premium taken into income under the amortization schedule set forth above offset by any payment required under the cap agreement). A similar analysis may be applied to the tax treatment of floors, which are functionally equivalent to the writing of call options on short term obligations. The proposed treatment of the premiums paid and received for caps and floors is only one of several that might be deemed "reasonable." The payment could be amortized by deducting in the first year the premium allocable to the hypothetical option expiring in year one, thus reversing the proposed treatment to allocate $320 of the total to the last year. Conceivably, a straightline amortization would be acceptable. Finally, applying the principles underlying §467, the $600 premium could be looked at as a prepayment for the option coverage and thereby treated as the present value of the premiums applicable to the options expiring at the end of each succeeding year; under this approach, the $600 payment is treated as a lending transaction, and the payor's deductions for the amortized premium payments are offset by the interest accruing on the indebtedness incurred. The writer of the cap (floor) would be entitled to a corresponding interest deduction. While this theory has some appeal from a technical aspect, it seems unlikely to be adopted by the IRS in view of the fact that it departs from the well established rules for the treatment of option premiums.
Dealers may be required (or given the option) to mark caps and floors to market.
D. International Aspects of Financial Instruments
1.	Introduction
The financial products and instruments discussed thus far in the portfolio play a major role in international transactions, including: (1) the purchase of property (stock, equipment, merchandise, etc.) from foreign entities where payment is to be made in foreign currencies; (2) the borrowing (or lending) of units of a foreign currency requiring payments to be made in such currency; and (3) speculation in various financial products denominated in foreign currencies. Such transactions are commonplace, but it was not until 1986 that Congress enacted statutory provisions governing how gain or loss from such transactions attributable solely to exchange rate fluctuations were to be taken into account. These provisions are contained in §§985-989 (Foreign Currency Transactions). They are discussed below to the extent they are relevant in determining the tax consequences of transactions in financial instruments denominated in foreign currencies and related hedging transactions.
U.S. taxpayers may, for numerous reasons, borrow (or lend) units of foreign currency, and may enter into transactions resulting in payables or receivables denominated in units of such foreign currency. Where exchange rates fluctuate, the taxpayer may realize gain or loss from the standpoint of the U.S. dollar. If 200 units of a foreign currency (FCU) are borrowed on a date when the spot exchange rate is $1 = 2 FCUs, the taxpayer has acquired currency worth $100 (which he can immediately exchange for dollars or not, as he wishes). If at the time repayment is due the exchange rate is $1 = 2.5 FCUs, the taxpayer can purchase the 200 FCUs required to satisfy his obligation for $80, thus realizing a gain just as if the FCUs were property sold short for $.50 each and the sale were closed by delivery of FCUs purchased for $.40 each. For many years prior to the enactment of subpart J of the Code in 1986, where foreign currency gain or loss occurred in connection with business undertakings, it was unclear whether (and how) gain or loss from the business transactions themselves were to be taken into account separately from gain or loss resulting solely from exchange rate fluctuations. Subpart J, comprising §§985-989 of the Code, portions of which are discussed briefly below, is an attempt to resolve these problems by subjecting foreign currency gain and loss to a separate tax regime.
2.	Section 988 Transactions
a.	General
Section 988(a) provides the general rule that any foreign currency gain or loss attributable to a "Section988 transaction" must be computed separately and treated as ordinary income or loss (as the case may be).419 Such gain or loss may occur only where the transaction involves a "nonfunctional" currency, i.e., a currency other than the "functional" currency of the taxpayer, defined by §985(b) as the dollar or, in the case of a "qualified business unit" (branch, subsidiary, etc.), the currency of the "economic environment" in which a "significant part" of such unit's activities are conducted. See §988(c)(1)(A). A foreign currency gain is any gain from a §988 transaction to the extent it does not exceed gain realized by reason of changes in exchange rates on or after the "booking date" and before the "payment date." Foreign currency loss is defined in the same way, substituting "loss" for "gain."420
419§988(a)(1)(A).
420§988(b)(1) and  (2).
Translated in terms relevant to this discussion, this means that if U.S. taxpayer T borrows 100 units of a foreign currency (FCUs), or otherwise accrues an obligation to make payment of 100 FCU at some date in the future, at a time when the exchange rate is $1 (USD) = 1 FCU, and if at the time of repayment of the 100 FCU debt, the exchange rate has changed, the amount by which the value of the FCU needed to make such repayment is less than or exceeds $100 gives rise to a foreign currency gain or loss to be taken into account without regard to whether gain or loss resulted from the business transaction for which the currency was used. Thus, if the FCUs were used to purchase inventory which was sold at a gain, this would have no effect on any foreign currency gain realized when the 100 FCU debt was paid. These rules do not apply to "personal transactions" if the amount of gain is $200 or less. Otherwise, a transaction is not a personal one if the individual who enters into it is able to claim allocable expenses that are deductible under §162 (other than §162(a)(2) traveling expenses) or are deductible under §212 (other than expenses incurred in connection with taxes).421
421§988(e). The $200 threshold (as well as the §162(a)(2) limitation) was added by the Taxpayer Relief Act of 1997 (P.L. 105-34), applicable to tax years beginning after Dec. 31, 1997.
Section 988(c)(1)(A) defines a "Section 988 transaction." It is any transaction (described in subparagraph (B)) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of the transaction is denominated in terms of a nonfunctional currency (or determined by reference to one or more nonfunctional currencies). Clauses (i), (ii) and (iii) of subparagraph (B) then enumerate the three categories of §988 transactions: 
(i) The acquisition of or becoming the obligor under a debt instrument.
(ii) Accruing (or otherwise taking into account) any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued (or taken into account).
(iii) Entering into or acquiring any forward contract, futures contract, option or similar financial instrument.
The regulations make it clear that the term "similar financial instrument" includes a notional principal contract only if the payments required to be made or received under the contract are determined with reference to a nonfunctional currency.422
422Regs. §1.988-1(a)(2)(iii)(B). This rule does not apply to any forward contract, futures contract, option, warrant, or similar financial instrument entered into or acquired on or before October 21, 1988, if such instrument would have been marked to market under §1256 if held on the last day of the taxable year. See Regs. §1.988-1(a)(2)(iii)(C).
As to category (iii), §988(a)(1)(B) provides that, except as provided in regulations, a taxpayer may elect to treat any foreign currency gain or loss attributable to a forward contract, futures contract or option described in (iii), above, which is a capital asset in the taxpayer's hands and which is not part of a straddle (as defined by §1092(c)), as capital gain or loss; the election must be made and the position identified before the close of the day on which it is acquired. Obviously, this election cannot be made if the position hedges the risk of currency loss from another position, and both the position hedged and the hedging transaction are positions with respect to personal property (i.e., relate to actively traded currencies other than the U.S. dollar).
If the election just described is not or cannot be made, there results a situation involving the interplay between the straddle rules and some commonly employed hedging transactions (other than swaps). This situation is discussed immediately below.
b.	Hedging Transactions Other Than Notional Principal Contracts
If a U.S. taxpayer enters into an option, futures contract or forward contract to hedge against exposure to either interest rate or foreign exchange rate fluctuations with respect to his interest as obligor or obligee under a debt instrument denominated in a foreign currency, such positions, since they constitute interests in personal property423 and diminish the risk of loss from the position hedged and the hedged foreign currency transaction, are straddles within the meaning of §1092(c). They are thus potentially subject to the rules of §§263(g) and 1092.
423See §1092(d)(7), under which an obligor's interest in a nonfunctional currency denominated debt obligation is treated as a position in the nonfunctional currency and is, hence, a position in personal property, provided there is an active interbank market for the currency (in order to meet the "actively traded" requirement of §1092(d)(1)). Currencies for which there is an interbank market include many which are not treated as regulated futures contracts as defined in §1256(g)(1). However, for a forward contract to qualify as a §1256 contract, it must be for the purchase or sale of a currency with respect to which RFCs are traded. See §1256(g)(2). It would appear that a forward contract to purchase or sell an actively traded currency (French franc, for example, or Italian lire) for which RFCs are not available may be considered a "position in personal property" for §1092 purposes even though it is not a §1256 contract.
As noted above, §988(c)(1)(B)(iii) includes among the enumerated §988 transactions: "Entering into or acquiring any forward contract, futures contract, option or similar financial instrument." Prior to its amendment by TAMRA, §6130(a), effective as to instruments entered into or acquired after October 21, 1988, this clause contained the words "if such instrument is not marked to market at the close of the taxable year under section 1256." This excluded RFCs, nonequity options and foreign currency contracts. Such excluded instruments thus retained their status as capital assets. While this rule suited the needs of traders in such instruments, corporate finance managers objected to it because capital gain/loss treatment resulted in a mismatch with gains and losses from the financial assets hedged. TAMRA eliminated the quoted exception and provided in a new subparagraph (D) that §988(c)(1)(B)(iii) does not apply to any RFC or nonequity option "which would be marked to market under section 1256 if held on the last day of the taxable year."424 The statute grants an election (inserted to meet the needs of corporate financial managers) not to have this rule apply to the taxpayer; the election applies to all contracts held at any time during the taxable year for which such election is made and all subsequent years (unless consent to revoke is granted by the IRS).425 If this election, referred to herein as the "(D) election," is made, RFCs and nonequity options used to hedge foreign currency borrowings (or foreign currency debt instruments held by the taxpayer) come under the §988 regime and, as a result, gains and losses from such contracts are ordinary.
424§988(c)(1)(D)(i). Note that this provision does not exclude from §988 transaction status forward contracts, futures or options not traded on a qualified board or exchange, or a position as to which a §1256(d) mixed straddle election has been made. As noted above, foreign currency gains and losses from all of the above are ordinary and such instruments are potentially subject to the rules of §§263(g) and 1092.
425§988(c)(1)(D)(ii)(I). The procedure for making the election is set forth in Regs. §1.988-1(a)(7)(iii).
Under a special rule, any gain or loss from any of the transactions described in §988(c)(1)(B)(iii), above, are treated as foreign currency gains or losses.426 Thus, if an option or futures contract is closed out, gain or loss is ordinary income or loss.
426Section 988(b)(3), added by TAMRA §1012(v)(3)(A), effective as if enacted by the 1986 TRA.
Note: The statute uses the term "described," and thus applies to RFCs and nonequity options whether or not a (D) election has been made. It seems clear that it was not intended that this special rule apply to such positions that are not §988 transactions by virtue of the taxpayer's failure to make a (D) election.
RFCs and nonequity options for which the (D) election has been made, as well as any forward contracts, may be identified as parts of a hedging transaction under §1256(e) without regard to the effect of Arkansas Best, which continues to invalidate §1256(e) elections with respect to similar hedges involving U.S. dollar denominated financial instruments. Foreign currency contracts, even if they satisfy the description set forth in §1256(g)(2) and, in consequence, must be marked to market under §1256(a), are treated as §988 transactions and no (D) election is needed as to them.
A taxpayer who is obligor or obligee under a foreign currency denominated debt instrument who has entered into a §1256 contract (RFC or nonequity option or forward contract) to hedge exposure to interest and/or currency exchange rate changes holds a straddle position (as defined by §1092(c)). The position is also eligible for the mixed straddle election of §1256(d). If the election is made, §1256 ceases to apply to the §1256 positions, and no (D) election is needed for them to qualify as §988 transactions.
Where a futures contract, option, forward contract or other similar instrument that is used to hedge a lending or borrowing in a foreign currency cannot be validly identified as a hedge under §1256(e), the straddle is subject to the loss deferral rule of §1092. However, if a valid election under §1256(e) can be made, §1092 does not apply to the straddle by virtue of §1092(e).
A diagram showing the interplay of §988 transactions and the straddle rules is included in the Worksheets.
3.	Foreign Currency Swaps
The basic concepts and structure of interest rate swaps were derived from foreign currency swap techniques developed to meet the financial goals and needs of persons who had incurred indebtedness in nonfunctional currencies. While a currency swap is a notional principal contract, it may involve actual exchanges of the principal amount either at the termination of the agreement or both at the beginning and at termination.
The principal purpose of a currency swap is to hedge against risk of loss from foreign exchange rate movements, although it, like an interest rate swap, can also be entered into for speculation.
Example: U.S. corporation A is able to borrow Swiss francs at an attractive rate. On a date when $1 = 1.4775 Swiss Francs (SFRs), A issues its note to the Swiss lender with a principal amount of SFR 147,750,000 (the equivalent of $100,000,000 U.S. dollars.). It calls for semiannual payments of interest at a fixed rate and matures in 10 years. On the same day, A enters into a currency swap agreement with Swiss entity B427 under the terms of which B will make periodic payments to A equal to the interest called for under the SFR note and a payment of the SFR 147,750,000 principal at maturity, and A will make payments to B in U.S. dollars (USDs) on the same days B's payments to A come due of amounts equal to what the fixed rate interest payments would be on a $100,000,000 note issued on the Eurodollar market on that date, and a payment of $100 million at the swap's maturity in 10 years. B could be a bank, a corporation or a dealer. B may have borrowed $100 million in a related transaction and will use A's payments to service its indebtedness. Corporation A may need the SFRs borrowed for use in its business, or it may exchange the borrowed SFRs for USDs in a transaction with either B or on an unrelated third-party (it makes no difference). As a consequence of the swap, A is not relieved of its indebtedness to the Swiss lender, but has effectively converted the SFR debt into a synthetic USD denominated debt, hedging its exposure to fluctuations in USD/SFR exchange rates. If it is so desired, A could also enter into an interest rate swap with a U.S. entity with A as the floating rate payer, converting its bond market position from short to long.
As an alternative, A and B could agree to exchange only the interest payments due, A making the USD payments and B the payments in SFRs. This would be only a partial hedge, however, since A would remain exposed to risk of an adverse change in the USD/SFR exchange rate on the date the payment of principal comes due; A would have created a synthetic USD obligation only to the extent of the interest payments.
427The swap may well be intermediated by a dealer who is counterparty to both A and B.
These are all notional principal contracts in that A never becomes obligated with respect to B's indebtedness, nor does B with respect to A's indebtedness. The rights and obligations assumed by each party are completely independent of whatever obligations might be owed by such party to third persons.
Of course, a U.S. taxpayer with branch operations in country X generating income in X currency may enter into an interest rate swap in connection with a borrowing in such currency. Both a currency swap such as that described in the example and such a nonfunctional currency denominated interest rate swap are "similar financial products" within the meaning of §988(c)(1)(B)(iii). They are, therefore, §988 transactions, and thus both subject to the §988 regulations.427.1
427.1See T.D. 8400, 57 Fed. Reg. 9172 (3/17/92), and T.D. 8860, 65 Fed. Reg. 2026 (1/13/00), and the proposed amendments to Regs. §§1.988-1,  -2 and  -5 in INTL-15-91, 57 Fed. Reg. 9217 (3/17/92), and REG-116567-99, 65 Fed. Reg. 2084 (1/13/00). For transactions entered into before the effective date of the §988 regulations, see Notice 89-21, discussed in VII, C, 2, above. See Regs. §1.988-2(e)(6).
In addition to the interest rate and currency swaps described above, there are so-called "cross currency" swaps that provide the hedging and other functions of both kinds of swaps.
Example: U.S. Corporation ABC borrows 14,300,000 Yen from a Japanese entity on a date when the spot rate is $1 = 143 Yen. ABC issues a bond maturing in five years that calls for periodic interest payable in Yen at a fixed rate. ABC enters into a swap with a five year term under the terms of which: (1) ABC pays to the swap dealer 143,00,000 Yen on the swap settlement date, (2) ABC agrees to pay the dealer interest on a notional $1 million principal based on 6 month LIBOR, and (3) ABC will pay the dealer $1 million on the termination date of the swap. In exchange, the dealer will: pay to ABC $1 million on the swap settlement date, (2) pay to ABC Yen at the fixed rate needed to service ABC's Yen obligation, and (3) pay to ABC upon termination of the swap the 143,00,000 Yen needed to pay the Yen denominated bond.
The net value of ABC's swap position will be affected by changes in either interest rates or currency exchange rates. Any increase in the value of the US dollar, with respect to the Yen, and any increase in prevailing interest rates applicable to the Yen, will improve the taxpayer's position as creditor and will decrease the value of the hedge (swap) position.
Assume that on the swap settlement date, LIBOR is 9% and the coupon rate on the Yen bond is 4.2%. The bond and swap are both settled on January 1 of Year 1. On the first semiannual interest payment date, June 31, there is due 3,003,000 Yen on the bond. This is paid by the issuer, ABC. Under the swap, ABC receives an equal amount of Yen and pays to the counterparty $45,000, the LIBOR rate. The same exchange of payments occurs on December 31. If there are no changes to the Yen exchange rate or the 6 month LIBOR rate, ABC will deduct interest for Year 1 in the amount of $42,000 (two payments of 3,003,000 Yen). There is a net dollar payment under the swap of $48,000.
Comment: Had ABC hedged currency rate exposure by a forward purchase of the Yen needed to pay the interest, using the same assumed rates set forth above, the Yen needed to make the first payment would have cost $21,494 and for the second payment $21,999 (reflecting forward rates of 139.71 and 136.51 Yen to the dollar respectively). Based on these forward rates, the Yen needed to pay the principal at the end of one year would cost $1,047,565. The forward cost would be amortized on a constant interest basis. If the forward contracts were entered into as part of a §988 hedging transaction, as defined in Notice 87-11, discussed below at D, 4, b, (3), they would not be subject to the straddle rules. If they were not (e.g., if the loan was only partially hedged) these rules would apply, but gain or loss on the contracts would be treated as ordinary income or loss under §988. If RFCs or nonequity options were used as hedges, however, and the taxpayer made no (D) election, apparently capital gain or loss would result since they would appear clearly not to constitute hedging transactions under §1256(e) due to the Arkansas Best decision.
4.	Integration of Hedges and Positions Hedged
a.	General
Where a taxpayer uses one of the financial instruments discussed herein to hedge financial liabilities or assets the taxpayer holds, under general tax principles the tax treatment of gain or loss from the hedge position is determined separately from any gain or loss realized from the positions hedged (without regard to whether the transactions involve nonfunctional currency). In the case of an interest rate hedge, one may argue that gains and losses from the hedging transactions should, in some fashion, be applied to adjust interest income or expense from the positions hedged. In the case of a foreign currency hedge, it can likewise be argued that to the extent the hedge neutralizes any risk from exchange rate movements, there should be no foreign currency gain or loss recognized from the hedge or the position hedged. In either event, whether or not the transactions are integrated, it appears appropriate to provide consistent tax treatment to both transactions, that is, there should be consistency between the rules governing the timing and character of gain or loss from the position hedged and the hedging transaction. Congress appeared to be receptive to these arguments insofar as §988 transactions are concerned, as discussed below.
The validity of these arguments has been recognized to a very limited extent by the IRS in regulations relating to the determination of the amount of interest expense required to be allocated and apportioned to foreign source gross income in determining taxable income from sources without the United States, a factor in computing the foreign tax credit limitation under §904.428 In addition, the integration of hedges and positions hedged has been given a degree of recognition in the regulations relating to the computation of foreign personal holding income for purposes of Subpart F.429 Discussion of these regulations is beyond the scope of this portfolio.430
428See generally Regs. §1.861-9T(a).
429See Regs. §1.954-2(h)(3), T.D. 8618, 60 Fed. Reg. 46500 (9/7/95), relating to the treatment of income from certain notional principal contracts as income equivalent to interest includible in foreign personal holding company income for subpart F purposes.
430See generally Augustyn, "Tax Treatment of Notional Principal Contracts and Financial Products," 45 Tax Notes 1353 (Dec. 11, 1989).
The position taken by the IRS in its regulations under §988, however, merits some detailed discussion since it may indicate the ultimate resolution of many of the numerous problems relating to the timing and character of gains and losses from notional principal contracts (and other hedging transactions) not falling within the ambit of §988.
b.	Integration Theory as Applied under §988(d)
(1)	Statutory Authority
Section 988(d) was enacted to deal with a number of legal and technical problems, including the application of the straddle rules, that could arise in cases where a U.S. taxpayer seeks to hedge its position as obligor or obligee under a foreign currency denominated debt instrument (which would include payables and receivables). Under this provision, to the extent provided in regulations, if any §988 transaction is part of a "Section 988 hedging transaction," all transactions which are part of such hedging transaction are to be integrated and treated as a single transaction or otherwise treated consistently. Further, whether a transaction qualifies as a §988 hedging transaction is determined without regard to whether it would otherwise be marked to market under §1256.431 Neither §1092 nor §1256 applies to a §988 hedging transaction.432
431The term does not include, however, any option, futures contract or forward contract that is a capital asset and not part of a straddle as to which the taxpayer has made an election under §988(a)(1)(B). §988(d)(1).
432§988(d)(1).
Note: These rules must be prescribed by regulations; the statute itself is not self-executing. Thus, the rules are effective only for the periods and to the extent provided in the regulations. Further, a futures contract is to be treated as a part of a hedging transaction without regard as to whether a §988(c)(1)(D) election has been made with respect to it. See §988(d)(1).
The definition of §988 hedging transaction is any transaction entered into433 primarily to reduce risk of currency fluctuations with respect to property held or to be held by the taxpayer, or to reduce risk of currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred by the taxpayer. Further, such a hedging transaction must be identified by the taxpayer or by the IRS as being a §988 hedging transaction.434
433There is no requirement that it be entered into in the course of the taxpayer's trade or business as under §1256(e).
434§988(d)(2).
Note: Thus, where a taxpayer incurs a liability (issues a debt instrument) denominated in a nonfunctional currency and enters into an interest rate swap that effectively alters its cost of borrowing (but does not reduce risk from exchange rate fluctuations), this is not a "Section 988 hedging transaction" within the meaning of §988(d)(2). However, an interest rate swap denominated in a foreign currency is a §988 transaction.435 The regulations issued under the authority of §988(d) are discussed below.
435See Regs. §1.988-1(a)(6), Ex. (10).
(2)	Nonintegrated Hedges
A discussion of the regulations issued under §988(d) should be prefaced by considering how typical hedging transactions are treated where there is no integration. The rules applied herein are derived from Regs. §1.988-1 through  -3, applicable, generally, to taxable years beginning after December 31, 1986.
Example: U.S. taxpayer ABC borrows 100 foreign currency units (FCUs) on a date when the exchange rate is $1 = 1 FCU. The loan has a term of three years and calls for interest to be paid currently at the end of each year at an annual rate of 5%. The interest rate for the dollar is 10%. To hedge against exchange rate fluctuations, ABC enters into forward contracts to purchase the FCU needed to service the loan. Due to the differences in the interest rates, the forward prices of the FCU required are: 
                          FCU needed                                   
                        at end of year              Forward price      
  Year 1:                                  5                     $ 5.24
  Year 2:                                  5                     $ 5.49
  Year 3:                                105                    $120.72

Alternatively, ABC could enter into a currency swap. Under the swap, ABC would make payments to the counterparty at the end of each year of the three year term in the respective amounts of $10, $10 and $110. The counterparty would make payments to ABC of 5 FCU, 5 FCU and 105 FCU.
Without integration, ABC in the first situation (using a forward contract hedge) would be confronted with a number of tax problems. First, since the forward contracts are all §1256 contracts, they must all be marked to market at the close of each year. While there are various methods for doing this, the simplest is to refer to the current market prices for forward sales as of the end of the year. Foreign currency gain or loss would then be recognized,436 since the contracts are §988 transactions under §988(c)(1)(B)(iii). When each forward contract is closed by taking delivery of the FCU, the foreign currency gain or loss must again be computed.437 This will be adjusted by any gain or loss taken into account by marking the contracts to market.438 Since the forward contracts are all straddle positions, recognition of any losses realized by reason of the year-end marking to market must be deferred to the extent there is unrecognized gain from the offsetting (debt) position. However, it is difficult to see how there can be any "unrecognized gain" from the taxpayer's position as debtor, even if interest rates rise. In any event, the marking to market will require recognition of any gain from the forward contract positions. Note that even if the exchange rates do not change, there may be gain due to the amortization of forward premium, and this is foreign currency gain.439
436See Regs. §1.988-2(d)(2).
437Id.
438See §1256(a)(2).
439See examples set forth in Regs. §1.988-2(d)(2)(iv). Likewise, amortization of forward discount will give rise to a loss.
Marking to market could be avoided in either of two ways. One, the taxpayer could identify the forward contracts as hedging transactions under §1256(e); this would also eliminate any loss deferral problem under §1092 due to §1092(e). Also, the taxpayer could make a mixed straddle election under §1256(d) which would take the forward contracts out of §1256. There will be foreign currency gain or loss to be taken into account, however, as each forward contract is closed by taking delivery of the FCU.
Finally, the taxpayer may deduct as interest expense the FCU paid to the holder of the FCU denominated debt instrument. If the taxpayer is an accrual basis taxpayer, foreign currency gain or loss must be determined with respect to this transaction. The spot rate for the FCU on the date of payment is compared with the average exchange rate during the one year accrual period and gain or loss computed accordingly.440 Of course, the repayment of principal is also a §988 transaction and may give rise to foreign currency gain or loss if the exchange rate differs from that of the spot rate on the instrument's booking date (settlement date).441
440See Regs. §1.988-2(c)(4).
441Regs. §1.988-2(b)(6).
If the taxpayer hedges with a currency swap, the computations are as follows. Since a swap is not a §1256 contract, there is no mark-to-market problem. However, since it is a §988 transaction (as a "similar financial instrument") foreign currency gain or loss may be recognized as payments are made under the agreement. Regs. §1.988-2(e) sets forth the rules relating to the realization, recognition and amount of foreign currency gain or loss with respect to currency swap contracts (but not relating to the source or character of such gains or losses). These rules apply to currency swap contracts as defined in Regs. §1.988-2(e)(2)(ii) (hereinafter regulatory swap contracts) for purposes of these rules as well as the rules of Regs. §1.988-5, discussed below, relating to integration. A regulatory swap contract is one involving two or more currencies under which two parties agree to: 
(1) Exchange periodic interim payments at the swap exchange rate on or before maturity of the contract; and
(2) Exchange the swap principal amount upon maturity of the contract. The contract may also call for an exchange of the swap principal amount upon commencement of the agreement.
Comment: Commentators to the temporary regulations pointed out a flaw in the definition of a currency swap, which required that the periodic interim payments be exchanged at the "swap exchange rate." This requirement unintentionally prevented cross currency interest rate swaps from qualifying as a currency swap, the preamble to the final regulations stated. Accordingly, the definition of a currency swap was amended to delete this requirement when the regulations were finalized.
The U.S. dollar Swiss franc currency swap discussed above meets the requirements of this definition. Note that this definition would appear to exclude any zero coupon swaps (where only one party makes periodic interim payments). It does accommodate cross currency swaps, however.
Under the rules of Regs. §1.988-2(e)(2)(iii), the timing of realization and recognition of exchange gain or loss is determined by treating: 
(1) Payments made under the swap as payments made pursuant to a hypothetical debt instrument issued by the payor denominated in the currency in which such payments are to be made under the swap; and
(2) Payments received under the swap as payments received pursuant to a hypothetical debt instrument issued by the counterparty and held by the person receiving the payments denominated in the currency in which the payments are received under the swap.
Note: If the taxpayer is a U.S. person and the hypothetical debt instrument under which payments are to be made or received is a dollar denominated instrument, there is no foreign currency gain or loss recognized with respect to any of the swap payments (or on the exchanges of swap principal). See §988(c)(1). Of course, a U.S. taxpayer could borrow Swiss francs and swap into West German marks, creating a mark denominated hypothetical debt instrument. In this case, exchange gain or loss would be recognized as payments were made (or received) under the hypothetical instrument, since the taxpayer would have a U.S. dollar functional currency.
The hypothetical issue price of these hypothetical debt instruments is the swap principal amount, and the hypothetical stated redemption price at maturity of such instruments is the sum of all payments due (excluding any exchange of swap principal upon commencement of the contract) other than qualified periodic interest.441.1
441.1Regs. §1.988-2(e)(2)(iii).
Comment: The terms "issue price," "stated redemption price at maturity," and "qualified periodic interest" are technical terms defined in the regulations under §§1272 and 1273 (part of the OID rules). For a full discussion of their meaning and significance in the timing and measurement of interest expense, see 535 T.M., Time Value of Money: OID and Imputed Interest. They also appear in the discussion of Regs. §1.988-5.
Applying these rules, the timing and amount of foreign currency gain or loss realized by reason of payments made or received under the swap agreement that are denominated in a nonfunctional currency is determined as if these payments were payments of interest and principal with respect to the reciprocally issued hypothetical debt instruments. The regulations, however, make it clear that no inference should be drawn that the swap payments are to be treated as interest for any other purposes of the Code.441.2
441.2Regs. §1.988-2(e)(2)(i),  (ii).
Under the currency swap contract set forth in the example, the taxpayer is treated as if it had issued a debt instrument to the counterparty with an issue price of $100, calling for annual interest payments of $10 and the repayment of the $100 principal at maturity. The taxpayer is also treated as having purchased a debt instrument with an issue price of 100 FCU, calling for annual payments of interest of 5 FCU and a payment of principal at maturity of 100 FCU. The amount treated as exchange gain or loss with respect to the periodic swap payments for the year is the amount of hypothetical interest income and exchange gain or loss attributable to such income from the hypothetical borrowing less the amount of hypothetical interest expense and exchange gain or loss attributable to such expense from the hypothetical loan for such year.441.3
441.3Regs. §1.988-2(e)(2)(iii)(A).
Thus, the taxpayer in the example for the first year would have interest expense of $10 and interest income of the dollar equivalent of 5 FCU. Whether exchange gain or loss is realized upon receipt of the 5 FCU payment depends on whether the taxpayer is an accrual basis taxpayer under the principles explained above. Assuming no exchange rate fluctuations, the taxpayer is deemed to have a foreign currency loss of $5 for the year. This is ordinary loss, but its character (interest or some other classification) is still an unsettled matter.
Note: The regulations provide rules for the amortization of premium or discount in the case of "off market" currency swaps (e.g., in the example above, the U.S. counterparty may be willing to pay the taxpayer a premium for agreeing to make U.S. dollar payments at an interest rate above 10% or to make interest payments in FCUs based on a rate in below of 5%, or if the taxpayer were willing to enter into the swap on the basis of a rate of $1 = 1.15 FCU). Here, the general rule is that the present values of the payments due by each party are compared, and the premium (or discount) will generally be equal to the amount needed to make such present values equal. If the taxpayer pays a premium or receives a discount, the payment is to be amortized in such a manner as to place the taxpayer in the same position as it would be in had the present values been equal.442
442Regs. §1.988-2(e)(3).

(3)	Initial IRS Position
The directive to issue regulations under §988(d) was first implemented by Notice 87-11 ("Notice").443 The Notice, effective as to transactions entered into after December 31, 1986, applies to "qualified hedging transactions" (QHTs), defined as an "integrated economic package" consisting of a "qualifying transaction" and a "section 988 hedge."443.1 A qualifying transaction is a borrowing under a debt instrument or the purchase of a debt instrument if the entire amount which the taxpayer is required to pay or is entitled to receive is denominated in terms either of a functional or a nonfunctional currency -- thus, dual or multiple currency debt instruments do not qualify.443.2 A §988 hedge (hereinafter "hedge") is defined as a spot contract,443.3 a swap agreement443.4 or agreements, forward contract, series of forward contracts, or combination thereof that fixes the cost or return with respect to a qualifying transaction (or transactions) in terms of a currency other than that in which the qualifying transaction is denominated, such that the cost or return is not affected by movements in exchange rates after the trade date.443.5
4431987-1 C.B. 423. Notice 87-11 is discussed in McCawley, "International Aspects of the Original Issue Discount Regulations," 17 Tax Mgmt. Int'l J. 231 (1988).
443.1Notice 87-11, §2(a)(1).
443.2Notice 87-11, §2(b).
443.3I.e., a contract for the purchase or sale of currency which requires delivery in two business days or less. Notice 87-11, §2(e)(6).
443.4This is defined in the Notice simply as a contract under which two parties agree to exchange simultaneously one currency for another at a predetermined rate, in which each party's obligation to perform is contingent upon the performance of the other party. Notice 87-11, §2(e)(5).
443.5Notice 87-11, §2(c).
If a transaction is a QHT, properly identified as such in the books and records of the taxpayer as required by the Notice no later than the close of the trade date,443.6 neither the qualifying transaction nor the hedge making up the QHT is subject to §§263(g), 1092 or 1256.443.7
443.6This was the date on which the interest rate (floating or fixed) on the qualifying debt instrument is set and the exchange rates on the hedge are fixed. Notice 87-11, §2(e)(7). This was a somewhat troublesome requirement, eliminated in the §988 regulations discussed below. Under it, to be fully hedged, the borrower would have to hedge the amount to be received at settlement for the period between the trade and settlement dates, usually by a forward sale of the loan proceeds.
443.7Notice 87-11, §4(a)(1).
The rules set forth in the Notice contemplated that where the qualifying transaction is denominated in currency A and the hedge is denominated in currency B, a synthetic debt instrument denominated in currency B was created.443.8 The qualifying transaction had to be fully hedged on the trade date and remain so throughout its entire term. Thus, using the currency A and B example, the A currency proceeds had to be converted to B currency at settlement. The parties to a QHT (both the qualifying transaction and the hedge) had to be unrelated.443.9 The Notice contemplated (and required) that the taxpayer on the trade date be able to calculate the yield to maturity of the synthetic borrowing or lending created by the QHT.444 Assuming for purposes of this discussion a U.S. taxpayer (with U.S. dollar as its functional currency) and a foreign currency denominated qualifying transaction that the U.S. taxpayer issues (or acquires a foreign currency denominated debt instrument), the synthetic dollar denominated debt instrument resulting from the hedge is then treated as if it had been a dollar denominated instrument issued or acquired by the taxpayer, and any resulting OID or bond premium is taken into account under the relevant Code and regulatory rules.444.1 This requires, among other things, that the payment dates under a swap agreement be exactly matched. Note that these conditions cannot be met by a hedge in the form of an option. The qualifying hedge can be in the form of a futures contract, forward contract444.2 or currency swap. Examples illustrating qualified hedging transactions and their tax treatment are provided below in the discussion of Regs. §1.988-5, which superseded Notice 87-11.
443.8See generally Notice 87-11, §2(d)(3).
443.9Notice 87-11, §2(d)(2)(ii).
444Notice 87-11, §2(d)(2)(i).
444.1See Notice 87-11, §4(b)(1). The Notice extends to a borrowing or lending in one nonfunctional currency and a QHT creating a synthetic borrowing or lending in another nonfunctional currency; neither the qualifying transaction nor the hedge need be denominated in the taxpayer's functional currency. See Notice 87-11, §2(d)(3)(ii).
444.2A forward contract is in all essential economic features identical to a futures contract but is not exchange-traded or standardized and the posting of initial and variance margin will vary from transaction to transaction depending on the parties involved.
(4)	Regulations
(a)	General
Regs. §1.988-5445 further implements §988(d). The regulations have, for the most part, liberalized the requirements of Notice 87-11 and thus expanded integrated treatment to cover a wider range of hedged debt transactions. These regulations apply to qualified hedging transactions entered into on or after September 21, 1989, even if the transaction being hedged (e.g., the debt instrument) was entered into or acquired before that date.446 An additional transitional rule states that if the taxpayer entered into any hedging transaction before September 21, 1989 that satisfied the requirements of Notice 87-11, then such transaction also will be deemed to satisfy Regs. §1.988-5(a).447
445See T.D. 8400, 57 Fed. Reg. 9172 (3/17/92) and the proposed amendments to Regs. §1.988-5 in INTL-15-91, 57 Fed. Reg. 9217 (3/17/92).
446Regs. §1.988-5(g).
447Regs. §1.988-5(a)(10).
Comment: Notice 87-11 (the predecessor to Regs. §1.988-5(a)) sets forth the integration rules for debt instrument hedging transactions entered into after December 31, 1986 and before September 21, 1989. The IRS and Treasury apparently drafted the latter transition rule because Notice 87-11 applies by its terms only until regulations are issued. Therefore, the transition rule allows Notice 87-11 transactions to continue to enjoy integrated treatment and presumably subjects such transactions to the additional consequences detailed under Regs. §1.988-5(a), including the provisions addressing the consequences of legging out. The requirements of Notice 87-11 are addressed below to the extent such requirements differ from Regs. §1.988-5(a).
Under the regulations, integrated treatment is permitted for a "qualified hedging transaction" (QHT), defined as an integrated economic transaction consisting of a qualifying debt instrument and a Regs. §1.988-5(a) hedge.448 If the transaction constitutes a QHT, neither the qualifying debt instrument nor the §988 hedge are subject to §§263(g), 1092, or 1256 for the period that the transaction is a QHT.449 The proposed §988 regulations would also provide integrated treatment for hedges of certain qualified payments. A qualified payment is defined as: (1) a declared but unpaid dividend denominated in a currency other than the functional currency of the recipient, or (2) an unaccrued rent or royalty payment denominated in a nonfunctional currency, the amount of which is fixed on the date the hedge is entered into.449.1
448Regs. §1.988-5(a)(1).
449Regs. §1.988-5(a)(9)(i)(A).
449.1Prop. Regs. §1.988-5(d)(1) and  (2)(iii).
The regulations define a qualifying debt instrument as a debt instrument described in Regs. §1.988-1(a)(2)(i), regardless of whether denominated in, or determined by reference to, nonfunctional currency (including dual currency debt instruments, multi-currency debt instruments and contingent payment debt instruments). However, a qualifying debt instrument does not include accounts payable, accounts receivable or similar items of expense or income.449.2
449.2Regs. §1.988-5(a)(3)(i).
Note: A commentator to the temporary regulations suggested that the integration rules be extended to partial hedges of debt instruments. Although this suggestion was rejected, the final regulations added a rule to allow proportional hedging of debt instruments where the integrated yield with respect to such proportion is determinable.449.3
449.3See Regs. §1.988-5(a)(3)(ii).
The final regulations define a Regs. §1.988-5(a) hedge (hereinafter referred to as a "hedge") as a spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap contract, similar financial instrument, or series or combination thereof, that when integrated with a qualifying debt instrument permits the calculation of a yield to maturity (under principles of §1272) in the currency in which the synthetic debt instrument is denominated (as determined under Regs. §1.988-5(a)(9)(ii)(A)).449.4
449.4See Regs. §1.988-5(a)(4)(i). Taxpayers may apply the definition of currency swap contract in Regs. §1.988-2(e)(2)(ii) in lieu of the definition of swap agreement in Notice 87-11, §2(e)(5), for transactions entered into after December 31, 1986 and before September 21, 1989. Regs. §1.988-5(a)(4)(ii).
The regulations provide that a qualifying debt instrument and a hedge are an integrated economic transaction if the following requirements are satisfied:450 
(i) All payments to be made or received under the qualifying debt instrument (or amounts determined by reference to a nonfunctional currency) are fully hedged on the date the taxpayer identifies the transaction as a qualified hedging transaction such that a yield to maturity (under principles of §1272) in the currency in which the synthetic debt instrument is denominated can be calculated. Any contingent payment features of the qualifying debt instrument must be fully offset by the hedge such that the synthetic debt instrument is not classified as a contingent payment debt instrument.
(ii) The hedge is identified on or before the date the acquisition of the financial instrument (or instruments) constituting the hedge is settled or closed.
(iii) None of the parties to the hedge are related.
(iv) In the case of a qualified business unit with a residence, as defined in §988(a)(3)(B), outside of the United States, both the qualifying debt instrument and the hedge are properly reflected on the books of the qualified business unit throughout the term of the qualified hedging transaction.
(v) Subject to the limitations of Regs. §1.988-5(a)(5), both the qualifying debt instrument and the hedge are entered into by the same individual, partnership, trust, estate, or corporation. With respect to a corporation, the same corporation must enter into both the qualifying debt instrument and the hedge whether or not the corporation is a member of an affiliated group of corporations that files a consolidated return.
(vi) With respect to a foreign person engaged in a U.S. trade or business that enters into a qualifying debt instrument or hedge through such trade or business, all items of income and expense associated with the qualifying debt instrument and the hedge (other than interest expense that is subject to Regs. §1.882-5), would have been effectively connected with such U.S. trade or business throughout the term of the qualified hedging transaction had these rules not applied.
450See Regs. §1.988-5(a)(5).
Comment: The most important distinctions between the regulations and Notice 87-11 are the provisions in the regulations that: (1) allow for and address the treatment of transactions in which the hedge is closed out before, or entered into after, the debt instrument;451 (2) do not require that the transaction be identified on the "trade date" (that is, the calendar day on which both the interest rate or rate of return on the qualifying transaction is set and all exchange rates on the hedge are fixed);451.1 and (3) allow for the hedged transaction, but not the hedge, to be with a related party.451.2
451See Regs. §1.988-5(a)(6).
451.1See Regs. §1.988-5(a)(5)(ii) and  (a)(8).
451.2See Regs. §1.988-5(a)(5)(iii).
For a detailed discussion of the §988 regulations, see 921 T.M., Tax Aspects of Foreign Currency [Foreign Income Series].
(b)	Tax Consequences of a Qualified Hedging Transaction: Examples and Commentary
The operation of the regulations may be illustrated by reference to the transactions in the examples provided in (2) above.
Example: Assume that U.S. taxpayer A borrows 100 FCUs and fully hedges the borrowing with forward contracts under which it will purchase for U.S. dollars the FCU needed to service the debt (principal and interest). This is a QHT.452 The loan calls for interest payable annually at the rate of 5% and matures at the end of the third year. To service this debt, A must make payment of 5 FCU at the end of each year and 100 FCU at maturity. Assume that A elects to purchase the FCU forward from bank B, and that the prevailing interest rate for the U.S. dollar is 10% (the rate paid by the bank executing the forward sale of FCU). Since the FCU interest rate is lower than the U.S. dollar rate, A must pay a premium. Assume that on the date the loan is settled and the forward contract is entered into $1 = 1 FCU. The prices payable per FCU at the end of each of the three years are, respectively, $1.05, $1.10 and $1.15. [To have 5 FCU on hand at the end of Year 1, the bank must invest 1.05E-1 × 5 = 4.76; at the prevailing rate, these will cost $4.76. The bank borrows this amount to purchase the FCU. At the end of the year, the bank must pay 1.1 × 4.76 = $5.24 (reflecting a 10% interest rate). 5.24/5 = 1.05. Similar computations may be made for each forward transaction.] Thus, A must make payments to the bank at the end of each year in the respective amounts of $5.24, $5.49 and $120.72 to purchase the FCU needed to service the FCU loan.
452This assumes the transaction is properly identified. The procedure for identification is set forth in Regs. §1.988-5(a)(8). The taxpayer must establish a separate record containing the date the qualifying debt instrument (QDI) and hedge were entered into; the date on which the QDI and hedge were identified as constituting a QHT; the amount, if any, to be deferred if the hedge is being legged in (see explanation below) and the source and character of the deferred amount; a description of the QDI and the hedge; and a summary of the cash flows called for under the QHT. Note that, unless the legging-in rules apply, the identification must take place no later than the close of the date the hedge is entered into. The IRS is authorized to postpone this deadline for individuals serving in U.S. Armed Forces, individuals serving in support of U.S. Armed Forces in a combat zone or in a qualified deployment in a contingency operation, or taxpayers affected by a Presidentially declared disaster. In order for taxpayers to be entitled to a postponement, the IRS generally will publish guidance providing relief with respect to a specific combat zone or Presidentially declared disaster or terroristic or military action. Rev. Proc. 2005-27, 2005-20 I.R.B. 1050.
Viewing this as a dollar denominated debt instrument, and applying the OID principles of Regs. §§1.1272 and 1.1273, this instrument has an annual accrual period and a yield to maturity of 10%. Of each payment, qualified stated interest (as defined in Regs. §1.1273-1(c)(1) is $5.24. Under OID principles, the instrument's stated redemption price at maturity is the sum of all payments due other than qualified stated interest, that is, $115.73. Since this exceeds the $100 issue price by $15.73, the instrument has OID in this amount.453
453See McCawley, above, fn. 443, for a detailed explanation of the application of the OID rules to a QHT using forward contracts.
OID accrues at the rate of the instrument's yield to maturity, 10%. Thus, for the first period, the OID is $10 less the qualified stated interest = $4.76. This is added to the $100 issue price. For the next period, the OID is (104.76 × .1 = 10.48, less qualified stated interest of $5.24) $5.24. For the final period, the OID is $5.76 [The $.03 discrepancy is due to rounding decimals to two places.]
Since the tax consequences are based on the synthetic dollar instrument, A may deduct for each of the three years under §163(e) payments of qualified stated interest plus the accrued OID. This give a total interest deduction of $10 for each year, the same amount as if A had borrowed dollars at the prevailing 10% rate. There is no currency gain or loss, and, provided the §988 hedge is not itself part of a straddle, §§263(g), 1092 and 1256 do not apply to either position.
Note: If the synthetic debt instrument were in a nonfunctional currency, currency gain or loss would have to be computed with respect to the OID using the average rate for the accrual period.
Where a currency swap is used to hedge the 100 FCU borrowing, the taxpayer is treated as having issued a debt instrument with an issue price of $100, providing for annual payments of qualified stated interest of $10, and a stated redemption price at maturity of $100. There is no OID calculation needed to determine the tax consequences.
Note: As under the rules of Notice 87-11, the legs of a QHT may both be in a nonfunctional currency. It is necessary only that the issue price, yield to maturity and stated redemption price at maturity of the synthetic debt instrument created by the hedging transaction be established on the identification date and will in no way be affected by any movements in the exchange rate while the QHT is in existence. The temporary regulations did not permit integrated treatment for partial hedges of qualifying debt instruments, although such treatment was accorded to partially hedged executory contracts. Regs. §1.988-5(a)(3)(ii), however, was added to provide that if a debt instrument satisfies the requirements of Regs. §1.988-5(a)(3)(i) and all principal and interest payments are hedged in the same proportion, then the portion so hedged may be treated as a qualifying debt instrument subject to the rules of Regs. §1.988-5(a). Regs. §1.988-5(a)(10)(iii) specifies that the new partial hedging rule for qualifying debt instruments is effective for transactions entered into after March 17, 1992.
(c)	Legging In and Out
Regs. §1.988-5 goes considerably beyond Notice 87-11 in that it permits, and provides rules for, the legging in and legging out of a QHT. It also provides rules governing two types of hedging transactions other than fully hedged borrowings and lendings, namely hedged executory contracts and hedges of certain publicly traded securities transactions entered into by cash basis taxpayers.
"Legging in" to integrated treatment means that a hedge is entered into after the date the qualifying debt instrument is entered into or acquired, and the requirements of Regs. §1.988-5(a) are satisfied on the date the hedge is entered into (the "leg in date").453.1 If a taxpayer legs into integrated treatment, the following rules apply: (A) exchange gain or loss is realized with respect to the qualifying debt instrument determined solely by reference to changes in exchange rates between (1) the date the instrument was acquired by the holder, or the date the obligor assumed the obligation to make payments under the instrument, and (2) the leg in date; (B) the recognition of the gain or loss is deferred until the date the qualifying debt instrument matures or is otherwise disposed of; and (C) the source and character of the gain or loss is determined on the leg in date as if the qualifying debt instrument was actually sold or otherwise terminated by the taxpayer.453.2
453.1Regs. §1.988-5(a)(6)(i).
453.2Regs. §1.988-5(a)(6)(i)(A),  (B),  (C).
Note: The final regulations eliminated the need to obtain valuations of debt instruments that are part of a QHT when the taxpayer is legging into integrated treatment. If a taxpayer legs into integrated treatment by entering into a hedge after the qualifying debt instrument is issued or acquired, the final regulations provide that only gain or loss from movements in exchange rates up to the leg in date is realized (and deferred).453.3
453.3See Preamble to T.D. 8400, 57 Fed. Reg. 9172 (3/17/92).
With respect to a qualifying debt instrument and hedge that are properly identified as a QHT, "legging out" of integrated treatment means that the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or hedge before maturity of the QHT, or the taxpayer changes a material term of the qualifying debt instrument (e.g., exercises an option to change the interest rate or index, or the maturity date) or hedge (e.g., changes the interest or exchange rates underlying the hedge, or the expiration date) before maturity of the QHT.453.4 In contrast to Notice 87-11, which did not allow for integrated treatment where the taxpayer had legged out of the hedging transaction, the final regulations permit the taxpayer to dispose of or terminate either leg of a properly identified QHT before maturity. A taxpayer that disposes of or terminates a QHT (i.e., disposes of or terminates both the qualifying transaction and the hedge on the same day) is considered to have disposed of or otherwise terminated the synthetic debt instrument rather than as legging out.
453.4Regs. §1.988-5(a)(6)(ii).
If a taxpayer legs out of integrated treatment, the following rules apply: (A) the transaction is treated as a QHT during the time the requirements of Regs. §1.988-5(a) were satisfied; (B) if the hedge is disposed of or otherwise terminated, the qualifying debt instrument is treated as sold for its fair market value on the date the hedge is disposed of or otherwise terminated (the "leg-out date"), and any gain or loss (including gain or loss resulting from factors other than movements in exchange rates) from the identification date to the leg-out date is realized and recognized on the leg-out date;453.5 (C) if the qualifying debt instrument is disposed of or otherwise terminated, the hedge is treated as sold for its fair market value on the date the qualifying debt instrument is disposed of or otherwise terminated (the "leg-out date"), and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date;454 (D) except as provided in Regs. §1.988-5(a)(8)(iii) (regarding identification by the IRS), that part of the QHT that has not been terminated (i.e., the remaining debt instrument in its entirety even if partially hedged, or the hedge) cannot be part of a QHT for any period after the leg-out date; and (E) if a taxpayer legs out of a QHT and realizes a gain with respect to the terminated instrument, then Regs. §1.988-5(a)(6)(ii)(B) or  (C), as appropriate, will not apply if during the period beginning 30 days before the leg-out date and ending 30 days after that date the taxpayer enters into another transaction that hedges at least 50% of the remaining currency flow with respect to the qualifying debt instrument which was part of the QHT (or, if appropriate, an equivalent amount under the Regs. §1.988-5 hedge which was part of the QHT).455
453.5The spot rate on the leg-out date is used to determine exchange gain or loss on the debt instrument for the period beginning on the leg-out date and ending on the date such instrument matures or is disposed of or otherwise terminated. Proper adjustment to the principal amount of the debt instrument must be made to reflect any gain or loss taken into account. The netting rule of Regs. §1.988-2(b)(8) applies. Regs. §1.988-5(a)(6)(ii)(B).
454The spot rate on the leg-out date shall be used to determine exchange gain or loss on the hedge for the period beginning on the leg-out date and ending on the date such hedge is disposed of or otherwise terminated. Regs. §1.988-5(a)(6)(ii)(C).
455Regs. §1.988-5(a)(6)(ii)(A) through  (E). The last two rules are antiabuse rules for taxpayers that leg out of a QHT.
Comment: If the qualifying debt instrument is a borrowing, i.e., the taxpayer is the obligor, and the hedge is disposed of, what is meant by treating the debt instrument as if sold for its fair market value? In Example (4) of Regs. §1.988-5(a)(9)(iv), U.S. taxpayer X has borrowed 100 FCU on January 1, 1990, when the spot rate is 1 FCU = $1.50. The hedge is a currency swap. On January 1, 1991, the swap is disposed of. On that date, the spot rate is 1 FCU = $1.60. The example assumes that there was no change in the FCU interest rates, thus the fair market value of the taxpayer's debt in FCU had not changed. The example concludes that X has a currency loss of $10 that is recognized on January 1, 1991. X is treated as if the spot rate at the time the debt was incurred was 1 FCU = $1.60 for purposes of determining any exchange gain or loss when the bond is paid.
Query what would be the result if the FCU interest rate had increased (with the result that the bond's fair market value in FCU decreased)? Would X have to recognize gain? Of course, the sale of X's bond by the holder would have no effect on X.
If X had purchased a 100 FCU bond and entered into a currency swap (paying FCUs and receiving dollars), and there was an increase in the FCU interest rate, the drop in value of the bond would apparently have to be recognized as a loss on the leg-out date. Where the debt instrument is disposed of in a leg-out, there is no problem, since the swap position is either in or out-of-the-money. Probably the answer is that the obligor of a debt instrument where the hedge is disposed of is treated as recognizing gain or loss (aside from exchange gain or loss) as if the obligee were willing to agree to the termination of the obligation for its fair market value (i.e., if interest rates had increased, the bond holder would be willing to agree to prepayment of the instrument at a discount; if they had decreased a premium would be required). An example illustrating this situation where there is also a change in the exchange rate would be helpful.
These rules can be summarized by treating the leg-out as a hypothetical sale of the QHT as a package and a re-establishment of the retained leg for its fair market value.
Example: Assume U.S. taxpayer X borrows 100 FCU for three years with 5% interest payable annually. The schedule of payments in FCU is 5, 5, and 105. The spot rate is $1 = 1 FCU. The dollar interest rate is 10%. A currency swap is entered into as the hedge. Payments due from X under the swap in dollars are 10, 10 and 110. At the end of Year 1, the FCU interest rate has increased to 6%, and the exchange rate has changed to $1 = .67 FCU (1 FCU = $1.50). What result? The present value of the remaining FCU payments due is 98.17 FCU. The swap would thus have a net value of $47.26. On the other hand, to pay the 100 FCU obligation would require $150. Disposing of the package, therefore, would entail a net loss of $2.74. If the spot rate of the FCU at maturity moved to 1 FCU = $.50, there would be an additional loss of $17 when the FCU note was paid, since the principal amount of the FCU note is adjusted to reflect a rate of 1 FCU = $.67 on the leg-out date.
(d)	Hedged Executory Contracts
The regulations provide separate rules for hedged executory contracts. For purposes of these rules, an executory contract is an agreement entered into before the accrual date to pay nonfunctional currency in the future for: (1) the purchase of property used in the ordinary course of the taxpayer's business or the acquisition of a service (or services) in the future; or (2) to receive nonfunctional currency in the future with respect to property used or held for sale in the ordinary course of such business or the performance of a service (or services) in the future.456
456Regs. §1.988-5(b)(2)(ii). The final regulations provide that a contract to buy or sell stock shall be considered an executory contract, effective for contracts to buy or sell stock entered into after March 17, 1992. (Thus, for example, a contract to sell stock of an affiliate is an executory contract for this purpose.) Id.
A hedged executory contract 457 is one subject to a hedge (as defined below) but only where:
• The contract and hedge are properly identified before the close of the day the hedge is entered into.458
• The hedge is entered into on or after the date the contract is entered into and before the accrual date. Where the hedge is in the form of a bank deposit, the nonfunctional currency must be acquired and deposited within this period.
• The contract must be hedged (fully or partially) from the identification date to a date after the accrual date, but not after the payment date.
• The parties to the hedge may not be related within the meaning of §§267(b) or 707(b)(1).
• In the case of a qualified business unit residing outside the U.S., both contract and hedge must be properly reflected on its books.
• Both must be entered into by the same individual, partnership, trust, estate or corporation (even if the corporation is a member of an affiliated group).
• With respect to a foreign person engaged in a U.S. trade or business that enters into an executory contract or hedge through such trade or business, all items of income and expense associated with the executory contract and the hedge would have been effectively connected with such U.S. trade or business throughout the term of the hedged executory contract had Regs. §1.988-5(b) not applied.
457Regs. §1.988-5(b)(2)(i)(A) through  (G). The definition of executory contract excludes §988 transactions. Regs. §1.988-5(b)(2)(ii)(B). Moreover, since accounts payable and receivable are not qualified debt instruments, they cannot be included in a qualified hedged transaction. See Regs. §1.988-5(b)(2)(ii)(A) and  (B).
458See Regs. §1.988-5(b)(3) for identification rules. The IRS is authorized to postpone this deadline for individuals serving in U.S. Armed Forces, individuals serving in support of U.S. Armed Forces in a combat zone or in a qualified deployment in a contingency operation, or taxpayers affected by a Presidentially declared disaster. In order for taxpayers to be entitled to a postponement, the IRS generally will publish guidance providing relief with respect to a specific combat zone or Presidentially declared disaster or terroristic or military action. Rev. Proc. 2005-27, 2005-20 I.R.B. 1050.
A hedge can be in the form of a deposit of nonfunctional currency, a forward or futures contract, or combination thereof, that reduces the risk of exchange rate fluctuations by reference to the taxpayer's functional currency with respect to nonfunctional currency payments made or received under the executory contract.459 Special rules are provided permitting a series of rolling hedges (provided that the new hedge is entered into within one business day after the date the old hedge is terminated), and historical rate rollovers extending the hedge's maturity date prior to the accrual date; no interest income or expense is accrued so long as the term of the new forward contract does not exceed 183 days.460
459Regs.  §1.988-5(b)(2)(iii)(A).
460Regs. §1.988-5(b)(2)(iii)(B) and  (C).
A deposit of nonfunctional currency in a bank account is within the definition of a hedge; pre-accrual date interest is treated as part of the hedge, but interest is included in gross income (under  §61) without regard to the deposit's status as a hedge.461
461Regs. §1.988-5(b)(2)(iii)(D) and  (E).
Example: On January 1, A contracts to purchase an item of equipment for 1,000 FCU. On that date, $1 = 2 FCU. Delivery and payment are to be made on December 31. The FCU interest rate is 8%. A purchases 926 FCU (the present value of 1,000 FCU payable in one year) for $463 which are deposited in an interest bearing bank account that pays 8% compounded annually. The deposit is properly identified as a §988 hedge. For the period January 1-December 31, A receives 74 FCU in interest that is included in A's gross income. Assume that A is a cash basis taxpayer and the spot rate of the FCU on the date the interest is available for withdrawal is $1 = 1.5 FCU. A realizes $50 of interest income, and $50 is A's basis in the 74 FCU of interest. When the equipment is delivered, A withdraws the deposit (principal and interest) and makes payment of 1,000 FCU. A's basis in the equipment is $513 (A's basis in the principal, $463, plus A's basis in the interest, $50). There is no currency gain or loss.
Where an executory contract is hedged as described, amounts paid or received under the hedge are treated as paid or received under the contract, and no foreign currency gain or loss is recognized on the hedge or on the payable or receivable.462 Furthermore, §§263(g), 1092 and 1256 do not apply to either the contract or the hedge (but they may apply if the hedged contract is part of a straddle). These rules apply to the portion of a contract hedged where the hedge is partial.463
462Regs. §1.988-5(b)(4)(i).
463Regs. §1.988-5(b)(4)(ii) and  (v).
If a hedged contract is terminated or disposed of before the accrual date, the hedge is treated as sold for its fair market value on the date of such disposition, and any resulting gain or loss is realized and recognized on that date. The spot exchange rate on that date is then used to determine any additional gain or loss on the hedge position. If the hedge is disposed of before the accrual date, any resulting gain or loss realized is not recognized but is taken into account to adjust income from, or expense incurred for, services performed or received under the contract, or the amount realized or basis of the property sold or purchased under the contract.464
464Regs. §1.988-5(b)(4)(iii)(A).
Example: Assume that U.S. taxpayer X enters into a contract on Jan. 1 to purchase an item of equipment for 100 FCUs. The spot rate at that time is 1 FCU = $.50. On July 1, on which date the exchange rate is 1 FCU = $1, the equipment is delivered and taxpayer accrues the 100 FCU liability as $100. Payment is made on Dec. 31, on which date the rate is 1 FCU = $1.50. There is no interest differential between the two currencies at any time during the year. Assume that to reduce risk from exchange rate fluctuations, X on July 1 contracts to purchase 100 FCUs on Dec. 31 for $100. This does not qualify as an executory contract hedge since the hedge was not entered into until the accrual date. As a result, each transaction is booked separately. Since the transaction was booked when 1 FCU = $1, X realizes a $50 exchange loss on the payment date. As to the forward contract, there is an exchange gain of $50. The loss and gain offset each other. X has a $100 basis in the equipment.
If, on the other hand, on Jan. 1, X had contracted to purchase 100 FCU on Dec. 31 for $50 and properly identified the hedge under Regs. §1.988-5(b), the effect of integrating the contract and hedge is to treat the amount accrued on July 1 as the amount of dollars payable under the forward contract on Dec. 31 to acquire the 100 FCU due, $50. Thus, when payment is made, the amount accrued on X's books ($50) is the basis of the equipment in X's hands. There is no exchange gain or loss; the result reflects the fact that X paid $50 for the FCU necessary to make payment for the equipment.
If in a series of hedges the new hedge is not entered into within one day after the date the old hedge is disposed of, the hedged contract is treated as if terminated, and the rules set forth immediately above apply; in such a case, a new hedge cannot be entered into with respect to the subject contract.464.1
464.1Regs. §1.988-5(b)(4)(iii)(B).
To address concerns of the IRS regarding disposition of a hedge or an executory contract before the accrual date in a transaction between related persons, a new rule was added to the final regulations. This rule provides that if an executory contract is between related persons,464.2 and the taxpayer disposes of the hedge or terminates the executory contract before the accrual date, the IRS may redetermine the timing, source, and character of gain or loss from the hedge or the executory contract if it determines that a significant purpose for disposing of the hedge or terminating the executory contract before the accrual date was to affect the timing, source, or character of income, gain, expense, or loss for federal income tax purposes.464.3
464.2As defined in §§267(b) and 707(b).
464.3Regs. §1.988-5(b)(4)(iii)(C).
If the hedge is disposed of on or after the accrual date, no gain or loss is recognized on the hedge, and the booking date of the hedged contract is the date the hedge is disposed of, for purposes of determining foreign currency gain or loss under the general rules of §988.465
465Regs. §1.988-5(b)(4)(iv).
Although of very limited scope, Regs. §1.988-5(c) extends the rules applicable to executory contract hedges to provide for the integration of an exchange rate hedge with a contract entered into by a cash basis taxpayer to purchase publicly traded stock and securities, where the hedge protects the taxpayer against risk of loss for the period between the trade date and the settlement date.
5.	Debt-Equity Swaps and Conversions
There are various types of debt-equity swaps in the foreign area and their taxation depends on the type of transaction entered into. In G.M. Trading Corp. v. Comr.,465.1 the U.S. taxpayer company entered into a Mexican debt-equity swap transaction. The type of Mexican debt-equity swap transaction that was at issue in G.M. Trading involved the transfer or surrender to the Mexican government by a U.S. company or by its Mexican subsidiary corporation of previously issued U.S. dollar-denominated debt (which debt represented a direct liability of the Mexican government to the U.S. company or a liability of a Mexican company to the U.S. company that is guaranteed by the Mexican government) in exchange for the transfer by the Mexican government of Mexican pesos into a restricted account with the Mexican Treasury in favor of the Mexican subsidiary of the U.S. company. The Mexican subsidiary must use Mexican pesos transferred into its restricted Treasury account to make investments and expand its business operations in Mexico. In such transactions, the U.S. dollar-Mexican peso exchange rate that is utilized to compute the number of Mexican pesos to be credited to the Mexican Treasury account of the Mexican subsidiary is extremely favorable to the U.S. corporation and its Mexican subsidiary corporation participating in the swap.
465.1103 T.C. 59 (1994), supplemented by106 T.C. 257 (1996), rev'd, 121 F.3d 977 (5th Cir. 1997).
Also, as part of the debt-equity swap transaction, the new Mexican subsidiary corporation effectively transfers 100% of newly issued class B restricted stock to the Mexican government which, in turn, transfers such stock to the U.S. parent corporation.
In general, U.S. companies participated in debt-equity swaps in order to expand their business operations through terms that were financially favorable. Through debt equity-swaps, U.S. companies could receive significantly more Mexican pesos with which to fund their business expansion in Mexico than they could receive, for the same price, by directly buying Mexican pesos with U.S. dollars on the open foreign exchange markets.
For the years at issue in G.M. Trading, U.S. dollar-denominated debt obligations of (or guaranteed by) the Mexican government were sold at a steep discount (approximately 50% of the principal amount of the debt) because of a general uncertainty regarding the government's ability to repay its debt obligations.
By participating in debt-equity swaps, the U.S. companies and their Mexican subsidiaries could purchase from other U.S. companies, at the prevailing steep discount rate, U.S. dollar-denominated debt that was owed or guaranteed by the Mexican government and then sell or exchange such debt with the Mexican government for Mexican pesos at a significantly reduced discount of some percentage of the principal amount of the debt. The discount rates were established on a case-by-case basis and generally were dependent upon the benefit of each proposed investment.
In G.M. Trading, the taxpayer formed a Mexican subsidiary corporation to participate in a debt-equity swap transaction and contributed capital for the purpose of having the subsidiary construct and operate a processing plant in Mexico. The subsidiary recorded the amounts credited to its Treasury account as a result of the debt-equity swap as a contribution to its capital, reflecting no discount or reduction in the amount or value of the pesos due either to the restrictions applicable to the pesos or to some of its stock. The taxpayer did not report any gain with respect to the debt-equity swap on its tax return. The IRS, however, cited Rev. Rul.87-124465.2 in determining that the taxpayer realized a taxable gain on the difference between the cost of participating in the transaction and the alleged fair market value of the pesos received in the transaction.
465.21987-2 C.B. 205. But see G.M. Trading v. Comr., 121 F.3d 977 (5th Cir. 1997), rev'g 106 T.C. 257 (1996), which found Rev. Rul. 87-124 erroneous as a matter of law.
The taxpayer argued that the step transaction doctrine should apply and that, thereunder, the exchange of the U.S. dollar-denominated debt for the Mexican pesos that occurred in this case should be disregarded and subsumed as just one part of a larger "debt-for-equity" transaction with respect to which the taxpayer realized no gain. According to the taxpayer, the substance of the transaction was merely a contribution of capital by the taxpayer to the subsidiary, followed by a purchase of the Mexican debt by the subsidiary, followed in turn by an exchange between the subsidiary and the Mexican government of the Mexican debt for the restricted Mexican pesos having a fair market value, due to restrictions on pesos and certain shares of the subsidiary's stock, equal to the taxpayer's initial contribution to the subsidiary. Alternatively, the taxpayer argued that if any gain was realized, it was realized by the subsidiary and should be treated, under §118, as a nontaxable contribution of capital by the Mexican government to the subsidiary.
The Tax Court, in a decision subsequently reversed (see discussion below), disagreed and found that the substance of the transaction was an exchange by the taxpayer, either directly or indirectly, of the U.S. dollar-denominated Mexican debt that the taxpayer had purchased for the Mexican pesos. In addition to providing capital, the taxpayer also purchased the debt which was converted into pesos. The Tax Court held that the taxpayer was taxable on any gain on the exchange of the debt for the pesos. Section 118 did not apply because the Mexican government received specific, direct, and quantifiable benefits in exchange for the transfer to the subsidiary of the pesos.
The Tax Court relied on its decision in G.M. Trading in Norwest Corp. v. Comr.465.3 In Norwest, the taxpayer owned blocked deposits at the Central Bank of Brazil (CB) consisting of principal repayments of dollar-denominated loans previously made to Brazil in the ordinary course of the taxpayer's banking business. CB prevented the taxpayer from repatriating these deposits because Brazil had insufficient hard currency (U.S. dollars) to make payments on the loans. The taxpayer was permitted to exchange its blocked deposits for an equity interest in a Brazilian company. In order to reduce its blocked deposits and decrease its foreign debt exposure, the taxpayer entered into a debt-equity conversion transaction in which the blocked deposits were exchanged for Brazilian cruzados and simultaneously the cruzados were exchanged for a stock interest in a Brazilian company. The taxpayer applied the step-transaction doctrine and determined that its equity investment in the Brazilian company was worth less in the secondary market than its blocked deposits. Consequently, the taxpayer took a loss for the difference on its tax return.
465.3108 T.C. 265 (1997).
Citing G.M. Trading, the Tax Court held that the taxpayer did not realize a loss on the debt-equity conversion because the taxpayer simply exchanged its blocked deposits for cruzados worth the same amount. The step-transaction doctrine was not applicable because the steps had independent significance. The exchange of the blocked deposits for the cruzados and the conversion of the cruzados into stock was not merely a transitory step but rather a substantive  and significant element of the conversion. Any loss would be measured by the difference between the taxpayer's basis in the blocked deposits and the market value of the cruzados received. No loss was realized because the basis of the blocked deposits and the fair market value of the cruzados were identical on the date of the transaction.
The court did, however, conclude that the 12-year repatriation restriction imposed on the taxpayer's investment warranted a 15% discount on the fair market value of the cruzados received, leaving the taxpayer a reduced loss for the tax year at issue.
In September 1997, the Fifth Circuit reversed the Tax Court's decision in G.M. Trading466 and held that G.M. Trading had no taxable gain on the transaction. The court determined that G.M. surrendered to the Mexican government a debt worth exactly what G.M. had paid for the debt. The property received in exchange for this debt was worth the amount paid for the debt and any excess value of that property was a nontaxable contribution to capital under §118(a).
466G.M. Trading v. Comr., 121 F.3d 977 (5th Cir. 1997).
The Fifth Circuit examined the plain language of §118 and found the use of the word "any" in §118(a) to be significant. According to the plain terms of the statute, anything that qualifies as a contribution to capital is nontaxable. Thus, the statute mandates bifurcation by requiring that any, rather than some, contributions to capital be excluded from income. Both the IRS and Tax Court theories required that a multi-part payment not be bifurcated but instead looked at as a whole. The Fifth Circuit found this to be plainly inconsistent with the statute. Additionally, the court found no support for either the IRS's or Tax Court's position and determined that the Tax Court's ruling and Rev. Rul. 87-124 were erroneous as a matter of law.
In conclusion, the Fifth Circuit cited U.S. v. Davis467 for the proposition that when property with a readily ascertainable value is exchanged for property without one, the latter property is presumed to be equal in value to the former. G.M. surrendered a certain amount of debt to the Mexican government in exchange for an unknown amount of restricted pesos, each worth an unknown amount. This was an arms-length transaction with real economic substance. Absent a readily-ascertainable value for the amount and worth of the pesos exchanged for that debt extinguishment, the value received for the debt is assumed to the same as the value of the debt. Any excess value of that property is a nontaxable contribution to capital under §118(a).
467370 U.S. 65 (1962).
In FSA 199904012, the Chief Counsel's Office, dismissed the Fifth Circuit holding in G.M. Trading Corp., advising that a U.S. corporation does recognize taxable gain on a transaction similar to that undertaken inG.M. Trading Corp. In the FSA, the taxpayer (T) was planning on investing in a plant in a foreign country (Z). In order to obtain Z's currency at the lowest cost possible, T purchased sovereign debt from a commercial bank at the prevailing secondary market value for the debt. In exchange for surrender of the sovereign debt, Z credited T's subsidiary (S) with an amount of restricted foreign currency that could only be used for the purposes specified under the agreement between T and Z. The Chief Counsel's Office did not determine whether T or S exchanged the debt for the currency. The Chief Counsel's Office cited the Tax Court for the position that the value of the foreign currency promised by the foreign government should not be reduced because of the restrictions on its use, and for the position that the gain was taxable, and not a §118 nontaxable capital contribution by the foreign government. The Chief Counsel's Office dismissed the Fifth Circuit opinion because (1) the taxpayer in the FSA was in an appellate venue other than the Fifth Circuit and (2) the Chief Counsel's Office found the Fifth Circuit's reasoning incorrect. Further, the Chief Counsel's Office advised that §367 would apply to trigger gain recognition on the value of the zero-basis foreign currency T negotiated with X and transferred to S. Alternatively, if T contributed the sovereign debt to S prior to its exchange with the foreign government, then §367(a) would again result in gain recognition because of the favorable exchange agreement T negotiated with X caused the debt to appreciate in value.468
468See also FSA 200123008, citing G.M. Trading Corp. and Rev. Rul. 87-124 (domestic corporation should recognize gain when its foreign subsidiary receives restricted foreign currency after parent pays U.S. dollars to retire debt of foreign country).
In CMI Int'l, Inc. v. Comr.,469  the Tax Court held in that a U.S. corporation does not recognize taxable gain on a transaction similar to that undertaken in G.M. Trading Corp. In CMI Int'l, a U.S. corporation purchased dollar-denominated Mexican government debt. The U.S. corporation transferred the debt to its Mexican subsidiary. The debt was then cancelled, and the Mexican government deposited Mexican pesos into an account on behalf of the Mexican subsidiary. The use of the funds in the account was restricted to the purchase of goods or services from Mexican residents. Finally, the Mexican subsidiary issued shares of class B stock to the parent U.S. corporation. The Tax Court, in reaching a conclusion similar to the Fifth Circuit's conclusion in G.M. Trading Corp., relied on Regs. §1.367(a)-1T(b)(3)(i), stating that the gain recognized under §367(a) is not to be more than the gain that would be recognized on a taxable sale of those items of property if sold individually. The Tax Court reasoned that whether or not the debt was worth more than the U.S. corporation paid for it, the amount of recognized gain under §367(a) is limited to zero.
469113 T.C. 1 (1999).
[Footnotes 470-517 reserved.]
E. Regulations Relating to Notional Principal Contracts
For a complete discussion of notional principal contracts (NPCs) and the rules relating to the timing, character, and source of income from such NPCs, see 188 T.M., Taxation of Equity Derivatives.
F. Conduit Transactions Using "Fast-Pay" or "Step-Down Preferred" Stock
1.	General Background
In an effort to curb tax avoidance, the Treasury issued regulations that recharacterize certain multiple-party transactions that use fast-pay stock of a conduit entity to allocate income artificially to tax-exempt participants.518 The parties to these transactions typically include: (1) a sponsor seeking financing, (2) investors who are willing to provide financing and who are typically not subject to federal income tax, and (3) a conduit entity, normally a corporation that is subject to income tax only at the shareholder level. The conduit entity issues a class of self-amortizing stock (the fast-pay stock) to the investors and another class of stock (the benefited stock) to the sponsor. The transactions are structured so that at first the fast-pay stock pays substantial and relatively certain dividends, while the benefited stock pays insignificant dividends. After the initial period, the dividend rate of the fast-pay stock and its effective redemption value decline.
518T.D. 8853, 65 Fed. Reg. 1310 (1/10/00). The final regulations exercise the Secretary's authority under §7701(l) to recharacterize any multiple-party financing transaction, in this case fast-pay arrangements. The regulations finalize with certain modifications proposed regulations (REG-104072-97, 64 Fed. Reg. 805 (1/6/99)). The Treasury announced its intention to issue regulations dealing with fast-pay stock transactions in Notice 97-21, 1997-1 C.B. 407. The regulations deviated significantly from the treatment originally suggested in Notice 97-21; under the regulations, fast-pay stock is treated as a debt instrument issued by the benefited shareholders, while Notice 97-21 suggested treating the fast-pay shareholders as acquiring the assets of the corporation.
The following simplified example provides a basic outline of the typical features of a fast-pay stock arrangement:
 Example 1: A sponsor (S), a U.S. taxpayer, organizes a conduit entity (C), in this case a RIC, to which it contributes $100,000 in exchange for 100 shares of C's stock. C issues to foreign investor (FI) 1000 shares of preferred stock for $1,000 per share. C invests its $200,000 capital in a 10-year Treasury note bearing a 7% coupon payable semiannually. Under the arrangement with FI, the preferred is to receive semiannual dividends of $65 per share for a period of 10 years, at the end of which the semiannual dividend on the preferred shares drops to $5.30. At that time, C may acquire the preferred for $15 per share. C will distribute to S semi-annual dividends of $5.00 per share for the initial 10-year period, at the end of which S intends to cause C to redeem the preferred. At that time, C's assets will total $185,000 ($200,000 - 15,000). S can then liquidate C and recognize capital gain of $85,000.
The fast-pay stock functions economically as a self-amortizing debt instrument because the distributions made with respect to the fast-pay stock are not only a return on the investor's investment, but also a return of their investment. In substance, the fast-pay shareholders finance the sponsor's investment in the conduit entity. Although nominally shareholders in the conduit entity, the investors have a limited, diminishing claim to the entity. The sponsor's claim, in contrast, is residual and long-term. Thus, a fast-pay transaction is a leveraged arrangement in which the sponsor uses untaxed income from the conduit entity to repay the investors.
In contrast to this economic reality, the parties characterize the fast-pay stock distributions entirely as dividends (that is, entirely as a return on investment) for tax purposes. Consequently, the investor's reported taxable income, in the form of overstated dividend income followed by an overstated capital loss on disposition of the fast-pay stock, fails to reflect clearly their economic income. Correspondingly, the fast-pay arrangement understates the income on the benefited stock for tax purposes during the initial period. Instead of receiving dividends attributable to its share of the conduit entity's income, the sponsor's economic income takes the form of an increasing ownership interest in the conduit entity, because each distribution reduces the investor's claim on the conduit entity, while increasing the sponsor's claim.
The regulations identify as a fast-pay arrangement, any financing arrangement in which a corporation has fast-pay stock outstanding for any part of its taxable year.519 Under the regulations, certain fast-pay arrangements are characterized as arrangements directly between the holders of the fast-pay stock and the corporation's other shareholders (the benefited shareholders). The regulations also impose withholding and reporting requirements on certain corporations with outstanding fast-pay stock and on certain shareholders that participate in fast-pay arrangements. The reporting requirements apply to all fast-pay arrangements, whether or note they are subject to recharacterization.
519Regs. §1.7701(l)-3(b)(1). Under the proposed regulations, a fast-pay arrangement was to have been a financing arrangement in which a corporation had two or more classes of outstanding stock, one of which was fast-pay stock. Former Prop. Regs. §1.7701(l)-3(b)(1). The final regulations simplified the definition of fast-pay arrangement to confirm that a fast-pay arrangement can be set up with only one class of stock, as class is defined in state corporate law. T.D. 8853, 65 Fed. Reg. 1310 (1/10/00).
2.	Regulatory Scheme
a.	Fast-Pay Stock and Benefited Stock Defined
Under the regulations, fast-pay stock is stock that is structured to provide for dividends that economically represent a return, in whole or in part, of the holder's investment rather than only a return on the holder's investment. Stock is presumed to be fast-pay stock if it has, by design, a dividend rate that is reasonably expected to decline, or an issue price that exceeds the amount at which the holder can be compelled to dispose of the stock.520
520Regs. §1.7701(l)-3(b)(2)(i).
Stock is determined to be fast-pay stock based on all the facts and circumstances, including any related agreements such as options or forward contracts. A related agreement includes any direct or indirect agreement or understanding, oral or written, between the holder of the stock and one or more other shareholders in the corporation. Stock is examined both when it is issued and when there is a significant modification in its terms or the related agreements or a significant change in the relevant facts and circumstances.521
521Regs. §1.7701(l)-3(b)(2)(ii).
Stock is not fast-pay stock solely because a redemption is treated as a dividend by §302 unless there is a principal purpose of achieving the same economic and tax effect as a fast-pay arrangement.522  In adding this rule, Treasury agreed with those commentators on the proposed regulations who found it inappropriate to treat every arrangement in which a redemption of stock produces dividend income under §302 as a fast-pay arrangement. The commentators gave a variety of reasons why §302 redemption should not trigger fast-pay stock arrangement treatment. First, §302 already recharacterizes certain redemptions of stock, which indicates Congress has determined the appropriate tax treatment of these transactions. Second, applying the fast-pay regulations to arrangements involving redemptions might have a chilling effect on common, non-abusive transactions. Finally, any changes affecting the application of §302 should be accomplished by issuing new regulations under §302.
522Id.
The regulations define benefited stock by reference to fast-pay stock; with respect to a class of fast-pay stock, all other stock in the corporation, including any other class of fast-pay stock, is benefited stock.523  For a fast-pay arrangement in which there is more than one class of benefited stock, the parties must apply the general recharacterization rules among the different classes as appropriate to match the arrangement's economic substance.524
523Regs. §1.7701(l)-3(b)(3).
524Preamble to REG-104072-97, 64 Fed. Reg. 805 (1/6/99). Note that the final regulations incorporate the proposed regulations without modifying the definition of benefited stock, so the discussion of benefited stock in the preamble to the proposed regulations still has pertinence.
b.	Transactions Subject to Recharacterization
If a corporation with outstanding fast-pay stock is either a regulated investment company (RIC) or a real estate investment trust (REIT), the fast-pay arrangement is automatically recharacterized.525  If the corporation is neither a RIC nor a REIT, the Commissioner may, at his or her discretion, recharacterize the fast-pay arrangement in cases where the Commissioner determines that a principal purpose for the structure of the fast-pay arrangement is the avoidance of tax, whether the parties acquired their interests as part of an initial offering or later (by purchase or other transfer).526  If the Commissioner determines that tax avoidance was a principal purpose behind the arrangement, the recharacterization applies to all parties to the arrangement, including transferees.
Note: The regulations use "a principal purpose" rather than "the principal purpose" as the standard under which the Commissioner may recharacterize a fast-pay stock arrangement. A fast-pay arrangement may be recharacterized even though it may have a valid business purpose, as long one of its principal purposes was tax avoidance.
525Regs. §1.7701(l)-3(c)(1)(i). See, e.g., FSA 200034010 (REIT with two stock classes, one paying most of its original cost back as dividends in the first four years, is a fast-pay stock arrangement subject to recharacterization as a financing arrangement directly between two classes of shareholders).
526Regs. §1.7701(l)-3(c)(1)(ii).
c.	Treatment of Recharacterized Transactions
A recharacterized fast-pay arrangement is deemed an arrangement directly between the benefited shareholders and the fast-pay shareholders.527  The recharacterization treats that the benefited shareholders or sponsors as issuing financial instruments (the deemed financing instruments) directly to the fast-pay shareholders or investors in exchange for cash equal to the fair market value of the fast-pay stock at the time of issuance, taking into consideration any related agreements.528 The deemed financing instruments have the same payment terms as the fast-pay stock with the result that the timing and amount of the payments under the deemed financial instruments deemed issued to the fast-pay stockholder always match the timing and amounts of the distributions made under the fast-pay stock. Under the recharacterization, the benefited shareholders are treated as having contributed to the corporation the cash deemed received for issuing the deemed financial instruments.529 Any distributions made by the corporation with respect to the fast-pay stock are treated as distributions made by the corporation with respect to the benefited shareholders' benefited stock. The benefited shareholders are then deemed to have used the distributions to make payments on the deemed financing instruments. The corporation is treated as a paying agent on the financing instruments with no other relationship to the fast-pay shareholders.529.1
527Regs. §1.7701(l)-3(c)(2).
528Regs. §1.7701(l)-3(c)(2)(i).
529Regs. §1.7701(l)-3(c)(2)(ii).
529.1Regs. §1.7701(l)-3(c)(2)(iii).
The character of the deemed financing instrument (equity or debt) is determined under general tax principles, depending on all the facts and circumstances.529.2
529.2Regs. §1.7701(l)-3(c)(3)(i).
Example 2: Assuming the same facts as in Example 1 above, S is deemed to have issued to FI for fair market value in cash an instrument calling for 20 semiannual payments of $6,500 and a payment at maturity of $15,161 or, with the reduced dividend, a residual value of the same amount. The present value (and fair market value) of this stream of payments discounted at the interest rate payable on the assets backing the payments, a Treasury note, is $100,000. S is further deemed to have contributed the $100,000 to C. S thus has a basis in its stock of $200,000. The semiannual $6,500 distributions to FI are characterized as made to S and constitute ordinary income S. S is then deemed to have made payments to FI under the terms of the financing agreement. Assuming that under general tax principles the financing instrument would be deemed debt, the amounts deemed paid would be based on an amortization table for a debt instrument issued for $100,000 (the stated principal amount), which provides for 20 semiannual payments of $6,500 and a payment at maturity of $15,000. Interest is calculated to be 6.8% compounded semiannually as follows:
    Payment            Principal           Interest            Balance
                                                                      
       1                  $3,008             $3,492            $96,992
       2                   3,113              3,387             93,878
       3                   3,222              3,278             90,656
       4                   3,334              3,166             87,322
     ****                 ******             ******             ******
      18                   5,392              1,108             26,354
      19                   5,580                920             20,775
      20                   5,775                725             15,000

Under the recharacterization model provided in the regulations, S must report and take into account as ordinary interest income, presumably under its regular method of accounting, the semiannual distributions to FI (i.e., $6,500 in this case), but is entitled to deduct, as issuer of the financing instrument, the interest component of the payments as shown in the amortization table.
If there is more than one class of benefited stock, the recharacterization rules apply among the different classes "as appropriate to match the economic substance of the fast-pay arrangements." 529.3
529.3Regs. §1.7701(l)-3(c)(3)(ii).
d.	Disposition of Benefited Stock
At the time of the sale of benefited stock, the seller is treated as receiving, in addition to any consideration actually received, the amount necessary to terminate its position with respect to the financing instruments at fair market value.529.4 If the deemed financing instrument is characterized as debt under general tax principles, the amount necessary to terminate a position in the financing instrument would be the instrument's outstanding balance plus any accrued interest to the date of sale. The purchaser of the benefited stock is deemed to issue financing instruments to the fast-pay shareholders in the same amount needed to terminate the seller's position.529.5
529.4Regs. §1.7701(l)-3(c)(3)(iii)(A)(1).
529.5Regs. §1.7701(l)-3(c)(3)(iii)(A)(2).
Example 3: Assume the same facts as in Examples 1 and 2. S sells the benefited stock three months after the end of the third period (i.e., one year and nine months after the issue date of the instrument). Referring to the amortization table in Example 2, the outstanding principal balances at the beginning of each semiannual payment period are as follows:
        Period                        Adjusted Issue Price              
                                                                        
           1                                $100,000                    
           2                                 96,992                     
           3                                 93,878                     
           4                                 90,656                     
         ****                              *********                    
          18                                 31,745                     
          19                                 26,354                     
          20                                 20,775                     

The interest accrues at the stated rate (in this case 6.8% compounded and payable semiannually) during each period. Thus at the time of the sale of the benefited stock, the amount necessary to terminate the seller's position would be $90,656 plus interest of $1,541,530  a total of $92,197. This amount is added to whatever other consideration is received by S for the benefited stock. Assume S sells the stock for $115,000 to an unrelated buyer (B). S is deemed to have realized $207,197 on the sale. S has gain of $7,197 (amount realized less the $200,000 basis in the C stock). B is deemed to issue financing instruments to FI in exchange for the amount necessary to terminate S's position, $92,197. B's basis in the C stock is therefore equal to the amount realized by the seller, $207,197.
530Stated coupon interest payable on the principal balance is 6.8% payable semiannually. Thus, interest accrued is $90,656 × (.034/2) = $1,541. The interest accrues ratably within each six month payment period.
e.	Anti-Abuse Rule Prohibits Affirmative Use of Recharacterization

The regulations prohibit a taxpayer from affirmatively using the automatic recharacterization rules if a principal purpose for using the rules is the avoidance of any tax imposed by the Code. With respect to such a taxpayer, the Commissioner may depart from the automatic recharacterization rules and treat the fast-pay arrangement in accordance with its form or its economic substance.530.1 Thus, if a foreign person acquires fast-pay stock in a REIT (in which case recharacterization is automatic under the general rule) with a principal purpose of reducing U.S. withholding tax by applying the recharacterization rules,530.2 the Commissioner may for purposes of determining that foreign person's U.S. tax consequences (namely, withholding tax) depart from the regular recharacterization rules and treat the foreign person as holding stock in the REIT. This anti-abuse rule applies on a taxpayer-by-taxpayer basis.
530.1Regs. §1.7701(l)-3(d).
530.2Foreign withholding on dividends is normally 30% (or lower treaty rate), while there is, as a general rule, no withholding on interest received from portfolio debt instruments. See §871(h).
3.	Reporting and Withholding Requirements
a.	General Reporting Requirement forConduit Corporations

In general, a corporation that has fast-pay stock outstanding at any time during the taxable year must attach a fast-pay stock disclosure statement to its federal income tax return for that taxable year.530.3 This rule does not apply to a §957 controlled foreign corporation (CFC), a §552 foreign personal holding company (FPHC), or a §1292 passive foreign investment company (PFIC). Instead, certain shareholder (and officers and directors of FPHCs) of those corporations must attach a disclosure statement to their returns.530.4
530.3Regs. §1.7701(l)-3(f)(2) details the information required in the disclosure statement. The statement must say "This fast-pay stock disclosure statement is required by §1.7701(l)-3(f) of the income tax regulations." The statement must identify the name of the corporation that has the fast-pay stock outstanding, and must recite the terms of the fast-pay stock and the date on which the fast-pay stock was issued. In addition, to the extent the filing persons knows or has reason to know such information, the statement must contain the names and the taxpayer identification numbers of the shareholders of any class of stock that is not traded on an established securities market as described in Regs. §1.7704-1(b).
530.4Regs. §1.7701(l)-3(f)(1).
b.	Reporting Requirements for Holders of Interests in CFCs, FPHCs and PFICs
In the case of a §957 CFC that has fast-pay stock outstanding during any part of its taxable year (during which it was a CFC), each controlling U.S. shareholder (within the meaning of Regs. §1.964-1(c)(5)) must attach a fast-pay stock disclosure statement (providing the same information as that filed by an issuing U.S. corporation to the extent the shareholder knows or has reason to know such information) to the shareholder's Form 5471 for the CFC's taxable year. The provisions of §6038 and the regulations thereunder apply to such statements.531.3
531.3Regs. §1.7701(l)-3(f)(1)(ii).
The same fast-pay disclosure statement requirement applies to each U.S. citizen or resident who is an officer director or 10% shareholder of a former §552 FPHC that has fast-pay stock outstanding at any time during a taxable year during which it was a FPHC. The provisions of §§6036 and 6679 and the regulations thereunder apply to such statements.531.4
531.4Regs. §1.7701(l)-3(f)(1)(iii). The 2004 American Jobs Creation Act, P.L. 108-357, §413(a), repealed the foreign personal holding company provisions (former §§551-558), effective for taxable years of foreign corporations beginning after 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end. The regulations have not been amended to reflect this repeal.
Any shareholder that has elected to treat a §1297 PFIC as a qualifying electing fund must comply with the same reporting requirement, if the shareholder knows or has reason to know that the PFIC has fast-pay stock outstanding for any part of its taxable year during which it was a PFIC. The statement must be attached to the Form 8621 for the PFIC's taxable year. Each shareholder owning at least 10% of a PFIC's  shares (vote or value) is presumed to know whether the PFIC has issued fast-pay stock. The provisions of §§1295 and 1298 and the regulations thereunder (including Regs. §1.1295-1(f)(2)) apply to any disclosure statement required by this rule.531.5
531.5Regs. §1.7701(l)-3(f)(1)(iv).
c.	Withholding Requirements
A corporation that issues fast-pay stock is a withholding agent for payments deemed made under a fast-pay arrangement.531.6 Generally, if a fast-pay arrangement is recharacterized under the automatic recharacterization ruled, a withholding agent must withhold in accordance with the transaction as recharacterized. A different rule applies, however, if the withholding agent knows or has reason to know that any taxpayer entered the fast-pay arrangement with a principal purpose of using the recharacterization rules to avoid tax under §§871(a) or 881. In that case, for each payment deemed made to such taxpayer under the arrangement, the withholding agent must withhold under §§1441 or 1442 the higher of: (1) the amount of withholding that applies to such payment determined under the form of the arrangement, or (2) the amount of withholding that applies to such payment determined under the recharacterization rules.532 When the withholding agent knows or has reason to know that the Commissioner has exercised the discretion to depart from the automatic recharacterization rules for a taxpayer, the withholding agent must withhold on payments made (or deemed made) to that taxpayer in accordance with the characterization of the fast-pay arrangement determined by the Commissioner.532.1 The withholding agent's liability to withhold on payments to foreign individuals is described in Regs. §1.1441-7(g).
531.6Regs. §1.1441-10(a).
532Regs. §1.1441-10(b).
532.1Regs. §1.1441-10(a).
d.	Reporting Requirements for Tax Shelter Organizers and Promoters
Fast-pay arrangements532.2 are "listed transactions" for purposes of the tax shelter rules under §6011.532.3 As a result, promoters (or other persons responsible for registering tax shelter transactions) may need to register such transactions with the Treasury. In addition, under Regs. §301.6112-1,533 promoters must maintain lists of investors with respect to these listed transactions. As a listed transaction, a fast-pay arrangement meets the "significant purpose of tax avoidance or evasion" prong of the test for determining whether a transaction is a tax shelter requiring reporting by the promoter or organizer. Registration will be required if the transaction is offered to potential participants under conditions of confidentiality and if the promoters receive fees in excess of $100,000. For further discussion of the tax shelter registration and reporting requirements, see 634 T.M., Civil Tax Penalties.
532.2As defined in Regs. §1.7701(l)-3(b).
532.3Notice 2004-67, 2004-41 I.R.B. 600; Regs. §1.6011-4(b)(2).
533T.D. 9046, 68 Fed. Reg. 10161 (3/4/03).
4.	Effective Date
The §7701(e) regulations are effective February 27, 1997, and generally apply to taxable years ending after February 26, 1997.533.1 The reporting requirements under Regs. §1.7701(l)-3(f) apply to taxable years (of the taxpayer required to file the statement) ending after January 10, 2000.533.3
533.1Regs. §1.7701(l)-3(g)(1).
533.3Regs. §1.7701(l)-3(g)(4).
5.	Transitional Rules
a.	Rule of Preserving Gain from Taxable Years Ending Before February 27, 1997
Because the regulations do not apply to amounts accrued or paid in taxable years ending before February 27, 1997 (pre-effective years), a benefited shareholder will have economic income, but not taxable income, attributable to pre-effective years if the form of a fast-pay arrangement is respected for those years. This economic income is unrealized gain in the benefited stock. To preserve the unrealized gain resulting from the economic income attributable to pre-effective years, the regulations special basis adjustment rule provides that after taking into account any basis increase under the general rule, a benefited shareholder must decrease its basis in its benefited stock by the amount (if any) that (1) its taxable income attributable to the fast-pay arrangement for pre-effective years, computed by recharacterizing the fast-pay arrangement under the regulations, exceeds (2) its taxable income attributable to the fast-pay arrangement for pre-effective years, computed without applying the recharacterization rules of the regulations.533.4
533.4Regs. §1.7701(l)-3(c)(3)(iv).
Example 4: In the case of the fast-pay arrangement described in Examples 1 - 3 above, assume S reports income on a calendar year basis and that the fast-pay stock was issued on Jan. 1, 1996. Dividends are payable on July 1, and Jan. 1 of each year, beginning with July 1, 1996 Assume that S is an accrual basis taxpayer. The dividends paid to the fast-pay shareholder are includible in S's income in the year paid. On the other hand, it would appear that interest on the financing instrument deemed issued to the fast-pay shareholders accrues during the six-month period between the deemed payment on the financial instrument.
Gross income attributable to the benefited stock for calendar year 1996 is $6,500 (the dividend paid on the fast-pay stock) plus the $500 dividend paid to S, a total of $7,000. Interest is deductible, however, in the total amount of $6,879.533.5 Thus, taxable income attributable to the benefited stock for taxable years ending before Feb. 26, 1997 is $121. This is less than income attributable to the stock without the recharacterization rules, $5000. No adjustment to basis would be called for in this case.
If dividends (on both the fast-pay and benefited stock) were payable on July 1, and Dec. 31, however, taxable income attributable to the benefited stock would be $7,121 under the recharacterization rules and $1,000 without application of these rules. A deduction in basis by $6,121 would be required.534.1
533.5That is, $3,492 for the period ending 7/1/96 and $3,387 for the period ending 12/31/96.
534.1Based on Regs. §§1.7701(l)-3(c)(3)(iv) and - 3(e), Ex. 5, it is unclear whether basis reduction is the excess of income attributable to the benefited stock solely by reason of the recharacterization rules over income attributable to this stock without application of the rules, or whether the first quantity refers to income attributable to the benefited stock including income resulting from recharacterization. The latter seems the correct interpretation.
b.	Election to Apply Recharacterization Modelof Notice 97-21

The effective date of the recharacterization relates to the February 26, 1997 issue date of Notice 97-21,534.2  which described a different recharacterization scheme. For periods after February 26, 1997, and before April 1, 2000, a taxpayer may ameliorate the effects of these changes by electing to limit its taxable income attributable to the fast-pay arrangement to the lesser of (1) taxable income that would result if the fast-pay arrangement were recharacterized under Notice 97-21, or (2) taxable income that would result if the fast-pay arrangement were recharacterized under Regs. §1.7701(l)-3(c), computed by assuming the financing instruments are debt. Any amount excluded by using the Notice 97-21 calculation must be included as an adjustment to taxable income in the shareholder's first taxable year that includes April 1, 2000.
534.21997-1 C.B. 407.
Notice 97-21 stated that under the then expected regulations:
The sponsor will be treated as having engaged in a transaction directly with the other parties to the debt instruments, leases or other assets held by the conduit entity, and the holders of the self-amortizing interests in the conduit entity will be treated either as having engaged in the transactions directly with the other parties or as having engaged in an income "stripping" transaction with the sponsor.
Assuming the facts set out in Example 1 above, under the Notice's recharacterization model, S and FI would be treated as having acquired an interest in the Treasury note purchased by C.  Moreover, if a sponsor had issued of the debt instrument held by a conduit, the sponsor would be treated as having issued one or more instruments directly to the holders of the conduit's fast-pay stock.
Neither Notice 97-21 nor the final regulations explicitly detailed the Notice 97-21 recharacterization method, though the final regulations describe with two examples such recharacterization and their use as a limit on taxable income.534.3 The first example deals with the fast-pay arrangement recharacterization of a REIT holding third-party debt. The example suggests that one way to recharacterize the fast-pay arrangement under Notice 97-21 is to treat the fast-pay shareholders and the benefited shareholders as if they jointly purchased the note from the issuer with the understanding that over the five-year term of the note the benefited shareholders would use their share of the interest to buy the fast-pay shareholders' portion of the note. The example then describes the tax consequences of such a recharacterization. The second example assumes that a corporation that holds 80% of the benefited stock is the issuer of the note. The example states that the fast-pay arrangement is recharacterized under Notice 97-21 as an arrangement in which the corporation issuing the note is treated as having issued debt instruments directly to the fast-pay shareholder and the other benefited shareholders. The example then describes the tax consequences of such a recharacterization.
534.3Regs. §1.7701(l)-3(g)(2)(iii).
G. Forward-Based Products Designed as Investment Units (Feline PRIDES)
For a complete discussion of forward-based products, including Feline PRIDES, see 188 T.M., Taxation of Equity Derivatives.
A recent innovation in the world of forward-based financial products is an instrument that typically links a forward purchase contract that obligates the holder to purchase shares of the issuer's common stock within (typically) three years of the issue date with a (typically) five-year debt instrument issued by the same issuer. These instruments are often referred to as Feline PRIDES (preferred redeemable increased dividend equity securities). See generally Kleinbard & Nijenhuis, "Everything I Know About New Financial Products I Learned From DECS," Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2000, 484 PLI/Tax 265 (2000). For a sample prospectus for a Feline PRIDES offering, see MCN Energy Group, SEC File No. 333-21175, dated 3/19/97, available at www.sec.gov. Feline PRIDES was the name given to these instruments by Merrill Lynch when first offered in 1997. They are also referred to as ACES Units and Upper DECS.
Rev. Rul. 2003-97, 2003-34 I.R.B. 380, considers the tax consequences of Feline PRIDES. In Rev. Rul. 2003-97, a corporation issues investment units consisting of instruments in the form of a five-year note and a three-year forward contract. In the ruling, the corporation, issues units on August 18, 2003, consisting of instruments in the form of a three-year forward contract to purchase a quantity of the corporation's common stock and a five-year note issued by the corporation. The purchase contract requires the holder to purchase, and the corporation to sell, on August 18, 2006, a quantity of X's common stock that is determined by reference to the market price of the stock on the settlement date. The note has a maturity date of August 18, 2008.
In Rev. Rul. 2003-97, the IRS ruled that issuers of the above described investment units, commonly referred to as Feline PRIDES, could deduct interest on the debt component of the PRIDE under §163(a) and such deduction is not disallowed by §163(l). In reaching this conclusion, the IRS delineated a three-step analysis, considering: (1) whether the note is separable from the associated purchase contract; (2) if the note is separable from the purchase contract but is not, in fact, separated from the purchase contract, whether the note qualifies as debt; and (3) if the note does qualify as debt, whether §163(l) prevents the corporation from deducting the interest that accrues on the note.
In the first prong of its analysis, the IRS addressed whether the note can be separated from the associated purchase contract. The IRS concluded that the note and purchase contract were separate contracts when issued, noting the legal right of the lender to separate the unit and the ability of the lender to actually separate the unit. Rev. Rul. 2003-97, 2003-34 I.R.B. 380. See also Chock Full O'Nuts v. U.S., 453 F.2d 300 (2d Cir. 1971) (in bond-warrant investment unit, where bonds and warrants separately tradeable, bond and warrant properly treated as separate instruments); Rev. Rul. 88-31, 1988-1 C.B. 302 (share of common stock and contingent payment right issued together as investment unit are separate items of property for federal income tax purposes because separately tradable on national securities exchange shortly after issuance). The IRS notes that, had the note and purchase contract been treated as a single unit, interest would not be deductible. Rev. Rul. 2003-97, 2003-34 I.R.B. 380.
Contemplating whether the note qualifies as debt, if it is separable from the purchase contract but is not, in fact, separated from such purchase contract, the IRS concluded that the note would qualify as debt. Considering several debt characteristic in reaching its conclusion, the IRS focused on the fact that the holder has creditor's rights in bankruptcy. Rev. Rul. 2003-97, 2003-34 I.R.B. 380.
Reaching the third prong of its analysis, the IRS considered whether §163(l) prevents the corporation from deducting the interest that accrues on the note. Ruling that §163(l) does not prevent the corporation from deducting the interest associated with the note, the IRS identified four critical factors that led to its conclusion. They are as follows:
1. The holder has the unrestricted legal right to convert investment unit and the holder is not economically compelled to keep the unit unseparated;
2. The purchase contract terminates upon the corporation's bankruptcy, the associated note or zero-coupon Treasury security are released to the holder, and, the holder of the investment unit would be treated as a creditor in the bankruptcy proceeding;
3. The notes will remain outstanding after remarketing for a significant period of time; and
4. It is substantially certain that a remarketing of the notes will succeed, since the reset rate is not capped. Rev. Rul. 2003-97, 2003-34 I.R.B. 380.

Rev. Rul. 2003-97 provides that for investment units issued on or before August 22, 2003, the IRS has announced that such revenue ruling will not be applied adversely with respect to a unit that was issued on or before August 22, 2003, provided that interest accruing on the unit would be deductible under this revenue ruling if: (1) factor 2, above, required only that, under the transaction documents, in the event of the issuer's bankruptcy, the purchase contract will terminate and the associated note or Treasury security will be released to the holder; and (2) factor 4, above, required only that the issuer of the unit undertook a legal obligation to attempt to cause a remarketing to succeed and reasonably believed that a remarketing would succeed. Rev. Rul. 2003-97, 2003-34 I.R.B. 380.
The IRS and the Treasury Department are considering issuing regulations under §163(l) to address policy issues raised by the above described investment unit. Rev. Rul. 2003-97, 2003-34 I.R.B. 380.
VIII. Investment Incentives Related to Ownership of Stock
In recognition of the importance of small businesses to economic growth and job creation, the Clinton Administration's revenue proposals included the extension of preferential tax treatment to long-term commitments of capital to small business. In furtherance of that objective, the 1993 RRA added §1044 to the Code. Section 1044 provides an elective rollover of gain realized on the sale of publicly traded securities if the taxpayer purchases a stock (or a partnership) interest in a specialized small business investment company within 60 days of the sale. Because the taxpayer is required to reduce the basis in the small business investment company to the extent of the gain excluded, §1044 provides only a deferral of gain.
A. Rollover of Securities Gain Upon Investment in Small Business Investment Companies
1.	Overview
Section 1044 provides for an elective rollover of gain from the sale of publicly traded securities where the taxpayer uses the proceeds to purchase a common stock or partnership interest in a "specialized small business investment company" (SSBIC) within 60 days of the sale of the securities.534.4 Estates, trusts, partnerships, and S corporations are not eligible for the election. In the case of individuals, a $50,000 annual and $500,000 lifetime limitation applies. In the case of corporations, a $250,000 annual and $1,000,000 "lifetime" limitation applies. The basis in the stock or partnership interest in the SSBIC must be reduced by the amount of gain not recognized by virtue of the rollover election.
534.4The provision is effective for sales of securities on or after Aug. 10, 1993.
2.	Sale of Publicly Traded Securities
An election to roll over gain may be made by an individual or C corporation which realizes gain from the sale of "publicly traded securities." 534.5 Partnerships, S corporations, trusts, and estates are not eligible to elect roll-over treatment.535 Publicly traded securities are defined as securities which are traded on an established securities market.535.1 The election, which is revocable with the IRS's consent, must be made on or before the due date (including extensions) for the income tax return for the year in which the publicly traded securities were sold by reporting the entire gain on the sale on Schedule D of the return and attaching a statement that describes the circumstances of the sale and rollover.535.2
534.5§1044(a).
535§1044(c)(4).
535.1§1044(c)(1).
535.2Regs. §1.1044(a)-1.
3.	Purchase of Interest in SSBIC
In order to roll over gain on the sale of publicly traded securities, the taxpayer must purchase either common stock or a partnership interest in an SSBIC during the 60-day period beginning on the date of the sale.535.3 A taxpayer is considered to purchase the interest in the SSBIC if he takes a cost basis in the interest.535.4
535.3§1044(a)(1).
535.4§1044(c)(2).
A SSBIC is defined as a partnership or corporation which is licensed by the Small Business Administration under §301(d) of the Small Business Investment Act of 1986.536 That legislation was enacted to stimulate and supplement the flow of private equity capital and loans to small businesses.537 Pursuant to that mandate, the Small Business Administration licenses and regulates small business investment companies, whose purpose is to invest in small business concerns and facilitate business ownership by persons who may face social or economic disadvantages in their attempts to participate in the free enterprise system.538 Regulations issued by the Small Business Administration specify the manner in which SSBICs may provide debt financing, equity capital, and loan guarantees to eligible small businesses. SSBICs generally are prohibited from engaging in the active conduct of a trade or business, but may provide management services.539
536§1044(c)(3).
537See 15 USC §661.
538See 15 USC §681(d) (codification of §301(d) of the Small Business Investment Act of 1958, P.L. 85-669).
53913 CFR §§107.1 through 107.1202. The statute and the regulations use the term "small business investment company," rather than the term "specialized small business investment company" used in §1044.
4.	Computation of Gain Recognized
a.	In General
If a taxpayer purchases an interest in an SSBIC within the 60-day period, gain realized on the sale of the publicly traded securities is recognized only to the extent that it exceeds the cost of the interest in the SSBIC.540 However, the rollover is subject to limitations discussed below.
540§1044(a)(1).
b.	Limitation on Individuals
An individual may exclude no more than $50,000 under §1044(a) in a taxable year. In addition, an individual is subject to a $500,000 lifetime maximum exclusion of gain.541
541§1044(b)(1). A yearly limitation of $25,000 and a lifetime limitation of $250,000 apply to a married individual who files a separate return. On joint returns, the amount of the excluded gain must be allocated equally between the spouses for purposes of applying the lifetime limitation to later years. §1044(b)(3).
c.	Limitation on C Corporations
A C corporation may exclude no more than $250,000 under §1044(a) in a taxable year. In addition, a C corporation is subject to a $1,000,000 "lifetime" maximum exclusion of gain.542 For purposes of the limitation, C corporations which are members of the same controlled group of corporations are treated as one taxpayer. Any gain excluded by a predecessor of a C corporation (e.g., a party to a merger or reorganization) is treated as having been excluded by the C corporation.543
542§1044(b)(2).
543§1044(b)(4).
d.	No Exclusion of Ordinary Income
The rollover of gain under §1044 does not apply to gain from the sale of publicly traded securities that is treated as ordinary income.544 Thus, a dealer in securities is not entitled to rollover treatment.
544§1044(a) (last sentence).
5.	Basis of Interest in SSBIC
a.	In General
Any gain that is not recognized by virtue of §1044 must be applied to reduce the taxpayer's basis in the common stock or partnership interest in the SSBIC. If the taxpayer acquires more than one interest in an SSBIC, the basis reduction is applied in the order of acquisition.545
545§1044(d).
b.	Coordination with §1202 Exclusion
The last sentence of §1044(d) provides that the basis reduction "shall not apply for purposes of Section 1202." §1202, also added by the 1993 RRA, provides for an exclusion of 50% of the gain realized on the sale of "qualified small business stock" held for more than five years.546 No basis reduction is required under §1202; unlike the deferral of gain under §1044, §1202 provides a true exclusion of gain. The conference report states in connection with the reference to §1202 in §1044(d): "Basis in common stock of a corporate SSBIC is not reduced for purposes of calculating the gain eligible for the 50% exclusion for qualified small business stock under new §1202 as provided in the House bill."547 The apparent purpose of this provision is to coordinate the application of §§1202 and 1044 in the case of a sale of qualified small business stock with respect to which the taxpayer makes an election under §1044.548 In that situation, the §1202 exclusion should be applied first, with respect to the basis in the stock immediately before the sale, with the remainder of the gain eligible for rollover treatment under §1044. The basis reduction is required only with respect to the gain excluded under §1044.
546For a discussion of §1202, see 501 T.M., Gross Income: Overview and Conceptual Aspects.
547H.R. Rep. No. 213, 103d Cong., 1st Sess. 529 (1993).
548Although SSBICs are prohibited from engaging in the active conduct of business, an SSBIC can qualify as a qualified small business under an exception to the active business requirement in §1202(c)(2)(B).
B. SBA Assistance to Small Business Investment Companies
The Small Business Administration (SBA) provides financial assistance to small business investment companies (SBICs) which in turn provide venture capital to disadvantaged and other small business concerns. One program of SBA assistance to SBICs is a participating security program funded by federal appropriations. Under the program, an SBIC seeking to raise capital issues a participating security to the SBA. Acting through underwriters, the SBA transfers to a trust created by statute a portion of its distribution rights in the participating security and promises that a defined level of payments will be maintained. On the basis of that promise, the trust issues certificates to underwriters who may sell them to investors.
In PLRs 9544032, 9621020, 9626036, and 9644029, the IRS ruled that the participation rights, issued pursuant to the SBA participating security program and held by trusts in connection with the issuance of certificates, are primary obligations of the SBA that are secured by the SBA's interest in distributions from the SBICs. In determining whether a party is a guarantor or a primary obligor, some of the key factors outlined by the IRS in the rulings were: the extent to which the party's duty to make payments depends on the failure by another obligor to meet a legally binding obligation; the extent to which the party expects at the outset to be called upon to make payments; and the nature of the party's right to be reimbursed for any payments. Based on these factors, the IRS concluded that the participation rights are not ownership interests in the SBIC preferred limited partnership interests held by the SBA but instead represent a primary obligation of the SBA that is secured by the SBIC distributions.
The IRS ruled similarly in Rev. Rul. 97-3.548.1 At issue in the ruling was whether the SBA was the primary obligor and therefore beneficial owner of certain payment rights created and guaranteed under its participating security program. The IRS ruled that, while a trust held a group of rights, these rights were, in substance, primary obligations of the SBA and the trust certificate holders merely owned SBA debt.
548.11997-1 C.B. 9.
IX. Backup Withholding Requirements
Section 3406 imposes backup withholding requirements in four situations. First, backup withholding under §3406(a)(1)(A) applies if a payee fails to provide a taxpayer identification number (TIN) in the required manner (the A trigger or certification). Second, backup withholding under §3406(a)(1)(B) applies if the IRS or a broker notifies a payor that a payee provided an incorrect TIN (the B trigger). Third, backup withholding under §3406(a)(1)(C) applies if the IRS or a broker notifies a payor that a payee is subject to notified payee underreporting, i.e., the payee has failed to report and pay tax on reportable interest and dividends (the C trigger). Fourth, backup withholding under §3406(a)(1)(D) applies if a payee fails to certify, when required, that the payee is not subject to backup withholding under §3406(a)(1)(C) (the D trigger).
Generally, if backup withholding is required under §3406 on a reportable payment, the payor must withhold at the time it makes the payment to the payee or to the payee's account that is subject to withholding.549 Amounts are considered paid when they are credited to the account of, or made available to, the payee.550 Amounts posted but not actually credited to the payee's account are not considered paid.551
549Regs. §31.3406(a)-4(a).
550Id.
551Id.
The following is a discussion of the various backup withholding provisions which apply to financial instruments.
A. Window Transactions
A window transaction refers to a payment of interest with respect to any of the following obligations: 
(1) an interest coupon in bearer form that is subject to taxation;
(2) a U.S. savings bond; or
(3) a discount obligation having a maturity at issue of one year or less, including commercial paper and bankers' acceptances that are in definitive form but not including short-term government obligations (as defined in §1271(a)(3)(B)).552
552Regs. §31.3406(b)(2)-3(b).
Withholding under §3406 applies to window transactions only if the payee does not furnish a taxpayer I.D. number to the payor either orally or in writing at the time that the window transaction occurs or furnishes an obviously incorrect number.553 Withholding does not apply even though the IRS notifies the payor of the payee's incorrect I.D. number or underreporting under §3406(a)(1)(B) or  (C).554 The payee is not required to certify, under penalties of perjury, that the taxpayer identification number provided is correct.555
553Regs. §31.3406(b)(2)-3(a) and  (c). There is an exception for certain minimal payments. See Regs. §31.3406(b)(4)-1.
554Regs. §31.3406(b)(2)-3(b).
555Regs. §31.3406(b)(2)-3(c).
B. Sales of Securities or Commodities by Brokers
The amount of a §3406 reportable payment subject to withholding with respect to broker reporting is the amount of gross proceeds of the transaction.556
556Regs. §31.3406(b)(3)-2(b)(1). Gross proceeds are defined in Regs. §1.6045-1(d)(5).
If a customer is subject to withholding with respect to a forward contract (including a foreign currency contract) or a regulated futures contract, or with respect to an account through which those contracts are disposed of or acquired, the broker must withhold on the following amounts: 
(1) all cash or property withdrawn from the account during the year; and
(2) the amount of cash in the account available for withdrawal by the customer at the relevant year-end (including both gross proceeds and variation margin).557
557Regs. §31.3406(b)(3)-2(b)(2).
In the case of a security sale made through a margin account, the amount subject to withholding is the gross proceeds of the sale. The amount required to be withheld with respect to the sale, however, is limited to the amount of cash available for withdrawal by the customer immediately after the settlement of the sale.558
558Regs. §31.3406(b)(3)-2(b)(3).
The amount subject to withholding with respect to a short sale of securities is the gross proceeds of the short sale. At the option of the broker, however, the amount subject to withholding may be the gain upon the closing of the short sale so that the obligation to withhold can be deferred until the closing transaction. This alternative method may only be used if at the time the short sale is initiated, the broker expects that the amount of gain realized upon the closing of the short sale will be determinable from the broker's records. If, due to unforeseen events when the sale is initiated, the broker is unable to determine the basis for the property used to close the short sale, the property must be assumed for this purpose to have a basis of zero.559
559Regs. §31.3406(b)(3)-2(b)(4)(i).
The determination of whether a short seller is subject to withholding is made on the date of the initiation or closing or on the date that the initiation or closing is entered on the broker's books and records.560
560Regs. §31.3406(b)(3)-2(b)(4)(ii).
A broker is not required to withhold with respect to a sale of a fractional share of stock resulting in less than $20 of gross proceeds.561
561Regs. §31.3406(b)(3)-2(b)(5).
If the IRS or another broker, notifies a payor-broker that a payee is subject to withholding due to notified payee underreporting, the payor must: 
(1) identify any accounts of the payee under the rules of Regs. §31.3406(c)-1(c)(3); and
(2) notify the payee and withhold on interest or dividend payments made with respect to any identified account under the rules of Regs. §31.3406(c)-1(d) and  (e).562
562Regs. §31.3406(c)-1(c)(1). Generally the payor-broker is not required to identify any account other than the account identified in the notice. Regs. §31.3406(c)-2(c)(3).
Additionally, a broker must notify the payor of a readily tradable instrument that the payee of the instrument is subject to withholding due to notified payee underreporting if: 
(1) the broker receives a notice from the IRS that a payee is subject to withholding due to notified payee underreporting and the broker is required to identify an account of the payee;
(2) the payee subsequently acquires the instrument from the broker through the same account; and
(3) the acquisition563 of the instrument occurs after the close (or earlier) of the 30th business day after the date that the broker receives the notice.564
563An acquisition includes a transfer of an instrument out of street name into the name of the registered owner (i.e., the payee). Regs. §31.3406(c)-1(c)(2)(ii).
564Regs. §31.3406(c)-1(c)(2)(i).
C. Special Rules for Readily Tradable Instruments Acquired Through a Broker
If a readily tradable instrument is acquired through a post-1983 brokerage account 565 and the broker is not a broker holding a security (including stock) for a customer in street name,566 the broker must: 
(1) obtain with respect to each account the certifications described in Regs. §31.3406(d)-2(a),  -1(b)(3) and  (c)(2) from the payee;
(2) furnish the payee's taxpayer I.D. number to the payor; and
(3) notify the payor to impose withholding if the payee fails to make either of the required certifications to the broker or if the broker has been notified by the IRS before the acquisition of the instrument that the payee is subject to withholding due to notified payee underreporting under §3406(a)(1)(C) or that the payee is subject to withholding because the payee's taxpayer I.D. number is incorrect.567
565As defined in Regs. §31.3406(d)-1(c)(2).
566As defined in Regs. §31.3406(a)-2(b)(3). Note, however, that an amendment to Regs. §31.3406(a)-2(b)(3) proposed in Oct. 2000 removes brokers from the list of persons treated as payors. See REG-246249-96, 65 Fed. Reg. 61292 (10/17/00). The amended regulation is proposed to be applicable for payments made on or after the beginning of the first calendar year that begins after the proposed regulations are published as final regulations in the Federal Register. Prop. Regs. §31.3406(a)-2. Regs. §31.3406(d)-4(a)(1), as amended by T.D. 9010, 67 Fed. Reg. 48754 (7/26/02).
567Regs. §31.3406(d)-4(a)(1). Certain additional requirements are listed in Regs. §31.3406(d)-4(a)(2).
Special rules are also provided for transactions entered into through a brokerage account that is not a post-1983 brokerage account.568
568Regs. §31.3406(d)-4(a)(3).
D. Special 30-day Rule for Certain Electronic Transmission Payments
In the case of an account established directly with, or a readily tradable instrument acquired directly from, the payor by means of electronic transmission (i.e., telephone or wire instruction) or by mail, the payor may permit the payee to furnish the certifications required under Regs. §31.3406(d)-1(b)(3) and  -2 within 30 days after the establishment or acquisition without subjecting the account to withholding during the 30 days. This applies only if the payee furnishes a taxpayer identification number (TIN) to the payor at the time of the establishment or acquisition, and the payee does not withdraw more than 69% of a reportable interest or dividend payment before the certifications are received within the 30 days.569
569Regs. §31.3406(d)-3(a). See Regs. §31.3406(d)-3(b) for special rules for sales through a post-1983 brokerage account and Regs. §31.3406(d)-3(c) for rules relating to foreign payees.
If the payee does not provide the required certifications within 30 days of the establishment or acquisition, the payor must withhold a tax equal to the product of the fourth lowest rate of tax applicable under §1(c) and such payment.570
570§3406(a)(1), as amended by the 2001 Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), P.L. 107-16, §101(c)(10), effective for taxable years beginning after Dec. 31, 2000.
An account is considered acquired directly from the payor if the instrument was acquired by the payee without the assistance of a broker or the instrument was acquired directly from a broker who holds the instrument as nominee for the payee (i.e., in street name) and who is considered a payor under Regs. §31.3406(a)-2.571
571Id. Note, however, that an amendment to Regs. §31.3406(a)-2(b)(3) proposed in Oct. 2000 removes brokers from the list of persons treated as payors. See REG-246249-96, 65 Fed. Reg. 61292 (10/17/00). The amended regulation is proposed to be applicable for payments made on or after the beginning of the first calendar year that begins after the proposed regulations are published as final regulations in the Federal Register. Prop. Regs. §31.3406(a)-2.

WORKING PAPERS
Table of Worksheets
FLOWCHART
Worksheet 1		Analysis of Currency Forwards, Futures, Options and Similar Financial Instruments: §§988, 1256(a), 1092(a).
IRS PUBLICATION
Worksheet 2		Excerpt from IRS Publication 550, Investment Income and Expenses.
PRACTICE AID
Worksheet 3		How Interest Rate Swaps Can Be Used to Hedge Bond Positions.
Worksheet 3A		Sample §1256(e)(2) Identification of a Hedging Transaction.
SELECTED LEGISLATIVE MATERIALS
Worksheet 4		Tax Reform Act of 1976, P.L. 94-455.
 • General Explanation of the Tax Reform Act of 1976 (Tax Treatment   of Grantor of Certain Options).
Worksheet 5		Economic Recovery Tax Act of 1981, P.L. 97-34.
 • General Explanation of the Economic Recovery Tax Act of 1981   (Tax Straddles).
Worksheet 6		Technical Corrections Act of 1982, P.L. 97-448.
 • House Report -- H.R. Rep. No. 794, 97th Cong., 2d Sess. (1982)   (Tax Straddles).
 • Senate Report -- S. Rep. No. 592, 97th Cong., 2d Sess. (1982) (Tax   Straddles).
 • Conference Report -- H.R. Rep. No. 986, 97th Cong., 2d Sess.   (1982) (Tax Straddles).
Worksheet 7		Tax Reform Act of 1984, P.L. 98-369.
 • General Explanation of the Tax Reform Act of 1984 (Tax Straddles).
Worksheet 8		Tax Reform Act of 1986, P.L. 99-514.
 • Explanation of Technical Corrections to the Tax Reform Act of 1984   and Other Recent Tax Legislation (Tax Straddles).
 • General Explanation of the Tax Reform Act of 1986 (Tax Straddles).

Worksheet 1
Analysis of Currency Forwards, Futures, Options and Similar Financial Instruments
Click to view the following graphic illustration:

"Analysis of Currency Forwards, Futures, Options and Similar Financial Instruments"
Worksheet 2
Excerpt from IRS Publication 550
Investment Income and Expense
Click to view graphic illustration
Worksheet 3
How Interest Rate Swaps Can Be Used to Hedge Bond Positions.
Swap positions:

• Fixed rate payer (FXR) is long the swap and short the bond market

• Floating rate payer (FLR) is short the swap and long the bond market
Effect of interest rate movement on swap positions:
  If interest rates increase        FXR position increases in value     
                                    FLR position decreases in value     
                                                                        
  If interest rates decrease        FXR position decreases in value     
                                    FLR position increases in value     

Discussion:

The obligor under a fixed rate debt instrument is short the bond market; if interest rates increase, the debt can be repaid at a discount. A FLR swap position will offset this bond position; the FLR swap position will decrease in value as interest rates increase.

The obligor under a floating rate debt instrument is long the bond market. If interest rates increase, his borrowing costs increase (the present value of future interest payments due based on the current rates increases). The offsetting swap hedge is, therefore, the FXR position whose value will increase.

Similarly, the holder of a fixed rate debt instrument is long the bond market and, to hedge this position, will enter into a FXR swap position. And the holder of a floating rate debt instrument, short the bond market, will hedge this position with a FLR swap position.

The above described hedged bond positions are economically straddle positions. Assuming that the swap notional principal amounts equal the principal amounts of the bond positions, where changes in interest rates result in unrealized gain with respect to the bond position, there will be unrealized loss with respect to the offsetting swap position.

Note: Unless the IRS is successful in contending that swap positions qualify as "actively traded" personal property, Section 1092 will not apply to the bond/swap straddles. Swap positions can in no event be treated as Section 1256 contracts under the Code definition. The IRS is considering whether dealer mediated swap positions can be characterized as actively traded property on the basis of the well developed secondary market.
Worksheet 3A
Sample Identification of a Hedging Transaction

Editor's Note: Section 1256(e) provides that the §1256(a) mark-to-market rules do not apply to certain hedging transactions that are entered into, in the ordinary course of a trade or business, to manage the risk of price changes, currency fluctuations, or interest rate changes. However, to escape the mark-to-market rules, §1256(e)(2) requires a taxpayer to unambiguously identify the hedging transaction before the close of the day on which the taxpayer entered into the transaction. See Regs. §1.1221-2(e)(4)(ii). Moreover, the identification must be made on (and retained as part of) the taxpayer's books and records. Regs. §1.1221-2(e)(4)(i). In addition, under Regs. §1.1221-2(e)(2)(ii), the taxpayer must "substantially contemporaneously" (i.e., within 35 days of entering into the transaction) identify the item(s) or aggregate risk that the transaction is hedging.

The following examples from Regs. §1.1221-2(e)(4)(iv) illustrate some of the means by which a taxpayer may identify a hedging transaction: (1) a taxpayer may designate a hedging transaction for (or place it in) an account that has been identified as containing only hedges of a specific item(s) (or specified aggregate risk); (2) a taxpayer may include and retain in its books and records a statement that designates all future transactions in a specified derivative product as hedges of a specified item(s) or aggregate risk; or (3) a taxpayer may place a designated mark on a record of the transaction (e.g., trading ticket, purchase order, or trade confirmation) or use a designated form or record that contains a designated legend.

For a discussion of hedging transactions, including the identification requirements, see the Detailed Analysis beginning at V, F, 3.
Sample Entry to Midwest Soybean Hedge Identification Account

March 15, 20xx--Purchased a contract on the Chicago Board of Trade for November 20xx delivery of 10,000 bushels of soybeans as a hedge against Autumn price increases in the Midwest soybean market. 
Worksheet 4
Tax Reform Act of 1976, P.L. 94-455
General Explanation of the Tax Reform Act of 1976
(H.R. 10612, 94th Congress; Public Law 94-455)
[Prepared by the Staff of the Joint Committee on Taxation]
December 29, 1976
[Excerpts]
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36. Tax Treatment of Grantor of Certain Options (sec. 2136 of the Act and sec. 1234 of the Code)
Prior Law

The tax treatment of puts and calls under prior law was based largely on several widely publicized private letter rulings issued to the Chicago Board of Options Exchange (CBOE) in which the Internal Revenue Service interpreted the application of Internal Revenue Code sections 1233 (relating to short sales) and 1234 (relating generally to options to buy or sell), the regulations under those sections and previously published revenue rulings to option transactions. The rulings assume that options are capital assets in the hands of their
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holders, and that the securities which would underlie or would be acquired in connection with options are also capital assets in the hands of the holders or writers (sec. 1234(a)). One aspect of the private rulings, the tax treatment of closing transactions, has significant tax planning potential. In a closing transaction, the writer (seller) of an option cancels his obligation under that option by purchasing from the exchange an option with terms identical to the option he had previously written. Under the Service's ruling, the difference between the amount paid in the closing transaction and the premium originally received by the option writer is ordinary income or loss. The Service has also ruled that premium income from the lapse of an option is ordinary income to the option writer (see reg. Section 1.1234-1(b)).
Reasons for change

Since the decision of whether or not to enter a closing transaction is usually within the discretion of the taxpayer, the revenue ruling described above has resulted in an opportunity for some taxpayers to plan tax strategies (described in more detail below) under which they realize ordinary loss on one part of a transaction, while realizing long or short term capital gain on another related transaction involving the same stock or securities.

Assume, for example, that a taxpayer in the 50 percent tax bracket purchases 100 shares of IBM for $200 a share; he also writes a call on the stock at a striking price of $200 per share, for a premium of $2,500. If the value of the stock rises to $250 per share, and the taxpayer has held his stock for more than 6 months, he may sell the stock, realizing a long-term capital gain of $5,000 on which he owes $1,250 tax. He also enters a closing transaction with respect to his call by purchasing a call on IBM at a striking price of $200 per share; he would pay a premium of about $5,000 under these circumstances, and the resulting loss of $2,500 (determined by subtracting the premium the taxpayer received for the call he wrote from the premium he paid for the call he purchased) would be ordinary loss which could be offset against ordinary income for a tax saving of $1,250. The net result is that the taxpayer pays no tax on transactions producing a net economic income of $2,500.

To prevent this situation from occurring in the future, the Act, in effect, reverses the private ruling with respect to closing transactions by providing that gain or loss from a closing transaction is to be treated as short-term capital gain or loss.1
1 This provision is virtually identical with H.R. 12224. The Ways and Means Committee Report on that provision is House Report 94-1102. For a further discussion of reasons for change in this area, see that report at pages 5-8.
Explanation of provisions

The Act provides that gain or loss from a closing transaction would be taxed as short-term capital gain or loss rather than as ordinary income. The effect of this change would eliminate the feature of existing law which permits conversion of ordinary income into capital gain.

Under the Act, any loss on a closing transaction would be treated as a short-term capital loss which would have to be netted against the
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taxpayer's capital gains.2Thus, in the example described above, the $2,500 short-term capital loss would be subtracted from the $5,000 long-term capital gain, leaving a net long-term capital gain of $2,500. A taxpayer in the 50-percent bracket would pay a tax of $625 on this amount.
2Under the tax law, a taxpayer's short-term capital losses are nettled against his short-term capital gains, if any. The net short-term capital loss is then netted against his long-term capital gains. The remaining net loss, if any, may then be deducted against ordinary income to the extent of $1,000 per year, but under section 1401 of the Act, this is increased to $2,000 for taxable years beginning in 1977 and to $3,000 for years beginning after 1977. 

Options covered under the rules of the Act include options (and privileges) in stock and securities (including stock and securities dealt with on a "when issued" basis) and options in commodities and commodity futures.

Treatment of income from lapsed options.--Under the ruling issued to the CBOE, premium income from a lapsed option is treated as ordinary income to the option writer. In some cases this rule can result in a serious hardship for some investors.

Under the tax law, a person who has substantial capital losses may not offset those losses (except to a very limited extent) against premium income, even if the capital losses result from transactions in stock underlying covered options. Thus, for example, assume that X purchases 1,000 shares of IBM at $200 per share and writes a call on the stock at that price, receiving a premium of $10,000. If the stock declines to 190, the call will lapse (because it is worthless), and under present law, X will have ordinary income of $10,000. If he sells the IBM stock, he will also have a $10,000 capital loss but, under prior law, only $1,000 of this amount could be offset against the income from writing the call.

The Act deals with this problem by providing that income from a lapsed option is to be treated as short term capital gain. Thus, in the example set forth above, the $10,000 gain from writing the option could be offset against the $10,000 capital loss which the taxpayer experienced with respect to the sale of the stock.

Treatment of broker-dealers.--Under the Act, the rules just outlined with respect to closing transactions and option lapse income are not to apply in the case of options written by the taxpayer in the ordinary course of his trade or business. Gain or loss from the transactions in options written in the ordinary course of the taxpayer's trade or business would continue to be treated as ordinary income or loss. This rule is consistent with the provisions of the tax law generally concerning the tax treatment of broker-dealers in stock or securities. It is possible, of course, that some taxpayers may write certain options in the ordinary course of their trade or business, and may write other options in connection with their investment activities. In such cases, the new rules would apply to options written in connection with the taxpayer's investment activities. The determination as to whether an option is written in the ordinary course of a taxpayer's trade or business, or as an investment, is to be determined under principles similar to those which apply the tax law in the case of a broker-dealer in securities. Generally, it is anticipated that persons who are treated as writers of options in the ordinary course of their trade or business will be those who "make a market" with respect to a particular option.
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Trading in options by regulated investment companies.--Under the tax law, regulated investment companies are treated in many respects as a conduit to their shareholders; that is, the mutual fund itself is not subject to tax on income which it distributes to shareholders. Instead, the shareholders are taxed, and the income received by the shareholders generally has the same character in their hands (long or short term capital gain, dividends, interest, etc.) as it would have had if the shareholders had made the underlying portfolio investments directly, rather than through the mutual fund. The purpose of these rules is to give the average investor an opportunity to participate in a diversified portfolio.

However, regulated investment companies are also subject to a number of rules and restrictions with respect to their operations. Among these rules is a requirement that at least 90 percent of gross income must be derived from dividends, interest, and gains from the sale of "stock or securities" (sec. 851(b)(2) of the Code). The purpose of these and other requirements is to help ensure that the regulated investment company is essentially engaging in passive investment activities, and is not operating as a normal business corporation.

The Service has ruled in Rev. Rul. 63-183, 1963-2 C.B. 285, that amounts derived by a regulated investment company from writing put and call options which lapse do not constitute gains from the sale or other disposition of stock or securities within the meaning of section 851(b)(2).3 Accordingly, a corporation under prior law would not qualify as a regulated investment company if more than 10 percent of its gross income consisted of premiums from the writing of puts and calls which lapse.
3 If a call is exercised the premium would be treated as income received by the mutual fund on the underlying stock.

Under the provisions of the Act, options are to be treated as capital transactions. Options are often written in connection with a taxpayer's transactions in stock or securities underlying the options and can, in many cases, be a means of protecting a taxpayer's gains or minimizing his risks in the securities market. Moreover, income from the writing of options would appear to be the kind of passive investment income which a regulated investment company is intended to receive.

Thus, there would appear to be no reason why income from the lapse of a covered or uncovered put or call should not be treated as qualifying income for purposes of the income source test which regulated investment companies are required to meet under section 851(b)(2) of the Code. Accordingly, the Congress intends that such income is to be treated as income from the sale or other disposition of a stock or security within the meaning of that test. In addition, it is intended that income from a closing transaction in options, as well as income from the lapse of an option, is to be treated as qualifying income.

Also, under section 851(b)(3) of the Code, less than 30 percent of the gross income of a regulated investment company can be derived from the sale or other disposition of stock or securities held for less than 3 months. The Congress intends that for purposes of this rule, the holding period of the option which the regulated investment company writes is to be treated as commencing on the date when the option
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is written. For purposes of section 851(b)(4), the "issuer" of an option is the corporation whose stock or securities underlie the option (even though the option may be written by an options exchange, for example.).

Also, under the tax law, exempt organizations are generally subject to tax only on their "unrelated business income." In the case of most exempt organizations, capital gains are excluded from the unrelated business income tax. Since income from the lapse of options and from closing transactions was treated as ordinary income under prior law, this income was not excluded from the unrelated business income tax base. Under the Act, these items of income would be treated as short term capital gains, and therefore income from the lapse of a covered or uncovered option, from a closing transaction in a covered or uncovered option, would not be treated as unrelated business income.4
4 Those interested in this area should be aware of Public Law 94-396, which amends section 512(b)(5) of the Code to provide that income from the lapse of an option or from a closing transaction is not to be treated as unrelated business income. That Act applies to options which lapse, or which are the subject of a closing transaction, which occurs on or after January 1, 1976.

Tax Treatment of Foreign Option Writers.--The tax law provides, in general, that interest, dividends and other similar types of income of a nonresident alien or a foreign corporation are subject to a 30-percent tax on the gross amount paid if the income or gains are not effectively connected with the conduct of a trade or business within the United States (secs. 871(a) and 881). This tax is generally collected through withholding by the person making the dividend, interest or other payment to the foreign recipient of the income (secs. 1441 and 1442).

Nonresident alien individuals are only subject to tax on their non-effectively connected capital gains if they are present in the United States for 183 days or more during the taxable year. Those capital gains which are subject to tax (because of the 183 days rule) are subject to a 30-percent tax on the net amount of the gains and losses for the year. Also, corporations are not subject to tax on their noneffectively connected capital gains. Any income or gain of a foreign person which is effectively connected with the conduct of a trade or business within the United States is subject to the regular individual or corporate tax rates as the case may be (sec. 871 or 881 or 882). However, the trading in stocks or securities by a foreign investor for his own account is not to be deemed engaging in a trade or business within the United States. The rules under prior law dealing with the tax treatment of income derived by a foreign person from the writing of an option were not clear in all situations. For example, if a call option written by a foreign investor is exercised, then the premium is considered as part of any gain realized by the foreign investor from the sale of the underlying stock and the investor is only subject to U.S. tax on the gain if he is present in the United States for 183 days or more, or if the gain was effectively connected with the conduct of a trade or business within the United States. In no case is a 30-percent withholding tax on the gross amount of the premium from writing the option imposed. A tax would either be imposed at a 30-percent rate on the net amount of gain for the entire year (by reason of the 183 day rule), or at the
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applicable individual or corporate rates (in the event of effectively connected capital gains). On the other hand, the tax treatment under prior law with respect to gain or loss realized on the lapse of an option or in a closing transaction is unclear. Some concluded that the premium was subject to the 30-percent tax on the gross amount while others concluded that the premium was not subject to this tax.

Under the Act, since option lapse income and income or loss from closing transactions is to be treated as short term capital gain or loss, the result is that gain from the lapse of an option or from a closing transaction is exempt from U.S. tax in most instances. The Congress believes that this is a sound result since it is not administratively feasible to impose a 30-percent withholding tax on the amount of the premium because when the premium is paid it is not known whether the option will be exercised, will be allowed to lapse, or will be subject to a closing transaction.5
5 Also. It is the Congress' intention that trading in options is to be treated in the same way as trading in the underlying stock, securities, or commodities for purposes of section 864(b)(2) of the code.

The Congress understands that a question exists under the tax law as to whether a corporation realizes income when warrants to purchase the corporation's stock expire unexercised. This issue was not considered by the Congress in connection with this revision, and no inference is intended (for the past or for the future) with respect to whether the expiration of warrants issued by a corporation for its own stock should, or should not, result in recognition of taxable income to the corporation.

Effective date.--The amendments made by the act are to apply to options granted after September 1, 1976.
Revenue effect

It is estimated that this revision will result in a revenue gain of $3 million in fiscal year 1977, and $10 million in fiscal year 1977, and $10 million per year thereafter.
Worksheet 5
Economic Recovery Tax Act of 1981, P.L. 97-34
General Explanation of the Economic Recovery Tax Act of 1981
(H.R. 4242, 97th Congress; Public Law 97-34)
[Prepared by the Staff of the Joint Committee on Taxation]
December 29, 1981
(Excerpts)
(279)
TITLE V--TAX STRADDLES
1. Postponement of recognition of certain straddle losses (sec. 501 of the Act and secs. 1091 and 1233 and new sec. 1092 of the Code)1
1 For legislative background of the Title V provisions, see: H.J. Res. 266, as reported by the Senate Finance Committee, secs. 501-508; S. Rep. No. 97-144 (July 6, 1981), pp. 143-171; Senate floor amendments, 127 Cong. Rec. S8214-17 and S8265-67 (daily ed. July 23, 1981); H. R. 4242, as reported by the House Ways and Means Committee, secs. 501-507; H. Rep. No. 97-201 (July 24, 1981), pp. 197-214; H. R. 4242, as passed by the House (July 29, 1981), secs. 501-507; H. Rep. No. 97-215 (August 1, 1981), pp. 258-260 (Joint Explanatory Statement of the Committee of Conference); and S. Con. Res. 30, 127 Con. Rec. S9270 (Aug. 3, 1981) and H5993 (Aug. 4, 1981) (daily ed.).
Prior Law
In general

Prior to amendment by the Act, the Internal Revenue Code did not contain express statutory rules dealing specifically with straddle transactions. Two Code provisions preclude (1) loss recognition until a taxpayer's investment in certain types of property is terminated and (2) conversion of short-term capital gain into long-term capital gain. These wash-sale and short-sale rules either did not apply to positions in commodities and commodity futures contracts or did not significantly affect tax straddle transactions. The Internal Revenue Service interprets general principles of tax law as prohibiting tax straddle shelters; however, this interpretation has been challenged by some taxpayers. In adding specific statutory rules in the Act to govern the taxation of straddle transactions, the Congress has supplemented the prior law, generally without changing or reinterpreting those rules which remain in effect.
Recognition of gain or loss

Under the tax law existing prior to the Act and generally continuing in effect now, gain or loss on property is recognized by the taxpayer at the time of a sale or other disposition of the property, unless there is specific statutory provision for nonrecognition (sec. 1001). However, losses of individuals are allowable only if incurred in a trade or business, incurred in a transaction entered into for profit, or resulting from casualty or theft (sec. 165(c)). Further, losses are recognized only if from a closed and completed transaction.
Wash sales

The Code includes a wash-sale rule providing for nonrecognition of certain losses from the sale or exchange of stock and securities if the taxpayer has not terminated his investment in the loss property (sec. 1091).

The wash-sale rule disallows any loss from the disposition of stock or securities where substantially identical stock or securities (or an option or contract to acquire such stock or securities) are
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acquired by the taxpayer during the period beginning 30 days before the date of sale and ending 30 days after such date. This provision prevents a taxpayer from selling stock which has declined in value in order to establish a loss for tax purposes, but then immediately reacquiring substantially identical stock, because the sale and reacquisition together do not significantly alter the taxpayer's position in that stock.

This wash-sale rule applies with respect to the disposition of stock or securities only. Commodity futures are not treated as stock or securities (Rev. Rul. 71-568, 1971-2 C.B. 312).
Capital gains and losses

Certain gains and losses from the sale or exchange of a capital asset1.1 are eligible for special treatment. In the case of individuals, only 40 percent of the excess of net long-term capital gain over net short-term capital loss for the taxable year is included in the taxpayer's adjusted gross income (sec. 1202). In addition, capital losses of individuals are deductible in full against capital gains and against up to $3,000 of ordinary income each year (sec. 1211(b)). Only 50 percent of the net long-term capital losses in excess of net short-term capital gains may be deducted from ordinary income. Capital losses in excess of this limitation may be carried over to future years indefinitely, but may not be carried back to prior years (sec. 1212(b)).
1.1 Sec. 1221. Capital assets generally include all property held by the taxpayer other than inventory, depreciable or real property used in a trade or business, certain taxpayer-created property, and certain receivables. Prior to the Act, certain short-term government obligations were treated as ordinary income property. Section 505 of the Act reclassifies these obligations as capital assets.
For this purpose, commodity futures contracts may not qualify as inventory. However, they are not allowed capital gains treatment if used as an integral part of the taxpayer's business, such as in farming or food processing. Corn Products Refining Co. v. Comm'r, 350 U.S. 46 (1955).

In the case of a corporation, the net capital gain is taxed at an alternative rate of 28 percent (sec. 1201). Capital losses are allowed only against capital gains (sec. 1211(a)). Any excess loss may be carried back three years and forward five years (sec. 1212(a)).

Generally, in order for gains or losses on a sale or exchange of capital assets to be considered long-term capital gains or losses, the assets must be held for one year or more.2 In the case of futures transactions in any commodity subject to the rules of a board of trade or commodity exchange, the required holding period was six months.3 (This special six-month holding period continues to apply to any futures contract which is part of a mixed straddle which is not marked-to-market under the new section 1256, added by the Act.)
2 Generally, options held for investment are governed by the same Code provisions as are other capital assets. However, sec. 1233(c) exempts certain options to sell property from the short sales rules if the option was acquired on the same day as the property and the option, if exercised, is exercised through the sale of the property. Section 1234 provides that gain or loss from the sale or exchange of an option has the same character as gain or loss from the sale or exchange of the property underlying the option, if the property were in the hands of the taxpayer. Gain or loss from closing transactions in options is treated as short-term capital gain or loss.
3 Sec. 1222.
Short sales

In the case of a "short sale" (i.e., where the taxpayer sells borrowed property and later closes the sale by repaying the lender with identical property), any gain or loss on the closing transaction
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is considered gain or loss from the sale or exchange of a capital asset if the property used to close the short sale is a capital asset in the hands of the taxpayer (sec. 1233(a)), but the gain ordinarily is treated as short-term gain (sec. 1233(b)(1)).4 Entering into a contract to sell is treated as a short sale for purposes of these rules.5
4 However, if on the date of a short sale, the taxpayer has held substantially identical property for over a year, a loss on the closing of the short sale will be treated as a long-term capital loss (sec. 1233(d)).
5 Thus, in any commodity futures contract transaction prior to the Act, or any such transaction which occurs after the Act but which involves contracts not marked-to-market under new section 1256, the person holding the obligation to sell generally may recognize only short-term capital gain or loss from that position (sec. 1233(b)(1).

The Code contains several rules which were intended to eliminate specific devices in which short sales could be used to transform short-term gains into long-term gains. Under these rules, if a taxpayer holds property for less than the long-term holding period and sells short substantially identical property, any gain upon the closing of the short sale is considered short-term gain, and the holding period of the substantially identical property is generally considered to begin on the date of the closing of the short sale (sec. 1233(b)). These rules preclude the taxpayer from "aging" his holding period so as to convert short-term capital gain into long-term capital gain where the taxpayer is free of any significant risk of loss. Also, if a taxpayer has held property for more than one year and sells substantially identical property short, any loss on the closing of the short sale is considered long-term capital loss (sec. 1233(d)). This rule prevents the conversion of long-term capital loss into short-term capital loss.

For purposes of these rules, property includes stock, securities, and commodity futures (sec. 1233(e)(2)(A)), but commodity futures are not considered substantially identical if they call for delivery of the commodity in different calendar months (sec. 1233(e)(2)(B)). In addition, these rules do not apply in the case of hedging transactions in commodity futures (sec. 1233(g)).
Straddles

Prior to the Act, the Code did not contain any special rules dealing with straddles in commodities or commodity futures contracts.6 In the case of the typical straddle in commodities (i.e. the acquisition of a contract to buy a commodity in one month and the acquisition of a contract to sell the same commodity in a different month), neither the wash sale rule applicable to stocks or securities (sec. 1091), nor the special short sales rules preventing conversion of short-term gain to long-term gain or long-term losses to short-term losses (secs. 1233 (b) and (d)), apply.
6 Section 1222 provides a six-month holding period for regulated commodity futures contracts. Section 465 contains rules limiting losses from an activity to amounts which certain taxpayers have "at-risk" in that activity. These rules are generally applicable to all activities, other than real estate, in taxable years beginning after 1978. It is unclear whether the section 465 rules limit deductions for losses related to straddles.

However, the Internal Revenue Service had ruled that the loss from certain silver futures contracts constituting part of a straddle was not deductible because the taxpayer "had no reasonable expectation of deriving an economic profit from the transactions" (Rev. Rul. 77-185, 1977-1C.B. 48).7 The ruling also stated that the loss
7 In the transaction described in the Revenue Ruling, the taxpayers on August 1, 1975, simultaneously sold silver futures contracts for July delivery and purchased an identical number of silver futures contracts for March delivery. Three days later, the March contracts were sold for a loss and an identical number of May contracts were purchased on February 18 of the following year, the taxpayer simultaneously sold the May contracts and purchased July contracts to cover the short position. The taxpayer reported a loss from the sale of the March silver contracts in 1975 which reduced its short term gain from the sale of real estate and reported a net long-term gain in the next year from the sale of the futures contracts.
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claimed on the disposition of one leg of the straddle was not a loss from a closed and completed transaction. This ruling has been the subject of controversy and the Revenue Service is litigating the deductibility of certain losses claimed in straddle transactions.
Reasons for Change

The possibility that certain transactions called spreads or straddles might afford taxpayers an opportunity to defer income and to convert ordinary income and short-term capital gain into long-term capital gain had been recognized by the investment industry for decades. In the last ten to fifteen years, the use of such tax shelters in commodity futures had extended beyond investment professionals to significant numbers of taxpayers, individual and corporate, throughout the economy. The tax advantages of spread transactions, especially those structured in commodity futures contracts, were touted in commodity manuals, tax services, and financial journals. Brokerage firms promoted tax spreads or straddles to their clients. Domestic and offshore syndicates advertised tax straddles shelters for which purchasers paid a fee in an amount equal to a percentage of their desired tax loss.

Simple commodity tax straddles generally had been used to defer tax on short-term capital gain from one tax year to the next tax year and, in many cases, to convert short-term capital gain realized in the first year into preferentially taxed long-term capital gain in a later year. However, in some cases straddles were used to defer tax on ordinary income and convert that income into short- or long-term capital gain (see discussion of straddles in Treasury bill futures contracts, below). A simple commodity straddle is constructed by taking equal long and short positions in futures contracts in the same commodity with different delivery dates. The two positions, called "legs," are expected to move in opposite directions but with approximately equal absolute changes. Thus, for example, if one leg of a straddle in futures contracts increase $500 in value, the other leg can be expected to decrease in value by about the same amount. By maintaining balanced positions, the risks of the transaction are minimized.

Four considerations motivated the Congress to take action at this time. First, the use of tax straddles already had received substantial public attention. The result was that a broad perception already had arisen that it was possible--indeed, perhaps legitimate--to pay no tax at ordinary income rates. The Congress recognized the adverse effects of such a perception and believed that an immediate response to taxpayer attempts to achieve conversion and deferral through commodity transactions was necessary.

Second, the Congress believed that the revenue loss might grow substantially because of the low transaction costs and significant leverage available in many commodity futures transactions. Thus, the revenue loss from a failure to act would have been substantial.

Third, the widespread tax sheltering activity threatened substantial disruption in the commodity markets. The tax benefits allegedly available through commodity transactions were leading many taxpayers to engage in transactions that were otherwise uneconomic, with a resulting distortion of supply and demand curves. The percentage of tax-motivated transactions in certain markets was already very substantial. The marked increase in the number of demands for delivery on Treasury bill futures contracts, noted in recent Decembers, had been linked to tax-motivated transactions and had been blamed for causing some distortion of the market.

Fourth, taxpayers confronted unnecessary uncertainty in ascertaining the tax consequences of transactions in the area of futures and forward contracts. Greater simplicity in the rules governing such transactions and greater certainty about the results of common transactions appeared essential.

The Congress believed that commodity futures markets play an important role in the economy. These markets provide a valuable means for farmers to reduce their risks in the production of crops and for bulk consumers to hedge their risks of price shifts. There has been explosive growth in the futures market over the past decade, and there is good evidence that such growth will continue. Because of the importance of the commodities markets, particularly in the agricultural and commercial sectors, the Congress considered it critical that the efficiency of these markets be preserved and the liquidity of these markets maintained. Thus, for example, the Congress created an exception to the new rules for hedging transactions.

The Congress believed that the changes which it made affirm general principles of present law. Fundamentally, the new rules require that commodity futures transactions be taxed on their economic substance.
Explanation of Provision
Loss deferral rule
General rules

The Act provides rules to prevent deferral of income and conversion of ordinary income and short-term capital gain into long-term capital gain on straddle transactions. Generally, the deduction of losses on positions which are part of a straddle is limited to the amount by which such losses exceed unrealized gains on any offsetting positions. As described in detail below, straddles subject to these rules are offsetting positions consisting of actively traded personal property other than stock, positions in such personal property, and certain stock options. In addition, the Act authorizes the Treasury Department to prescribe regulations applying to straddle gains and losses rules similar to those in subsections (a) and (d) of section 1091 (relating to wash-sales) and those in subsections (b) and (d) of section 1233 (relating to short sales).

Under the Act, a taxpayer's straddle losses are deferred to the extent the taxpayer has unrealized gains in offsetting positions. If a taxpayer realizes a loss on the disposition of one or more positions in a straddle, the amount of loss which may be deducted is the excess of the loss over the unrealized gain (if any) in positions 
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which offset the loss positions and which were acquired before the taxpayer disposed of the loss position. Losses on positions in straddles which the taxpayer properly identifies as identified straddles, within the definition in section 1092(a)(2)(B), are not subject to this loss deferral rule, but only if all positions in the identified straddle remain open at the end of the taxable year or all such positions are disposed of on the same day. Losses on identified straddles are treated as sustained no earlier than the day on which all positions in the identified straddle are closed.

Losses deferred under the loss deferral rule are carried forward to the succeeding year and are subject to the application of the deferral rule in that succeeding year. Deferral losses are recognized in the first taxable year in which there is no unrealized appreciation in offsetting positions acquired before the disposition of the loss position.

Allocation of losses.--The Treasury will have to prescribed regulations to deal with the situation in which the realized loss on the loss legs of a straddle exceeds the unrealized gain on the gain legs. These regulations will provide rules for allocating the losses among the unrealized gain positions and determining which of the losses will be deductible and which will be deferred. The Congress intended that allocation of losses to unrealized gain positions be done in a consistent manner that does not distort income. It is expected that regulations issued under this Act will provide that one dollar of unrealized appreciation at the end of any year defers at most only one dollar of realized loss.
Identified straddles Under the Act, identified straddles are exempted from the loss deferral rules and are taxed under special rules. Further, since

positions which are part of an identified straddle do not offset any positions not included in the identified straddle, no position within an identified straddle will defer losses or require capitalization of carrying costs as to any position not included in the identified straddle. Losses on positions which make up an identified straddle are treated as sustained not earlier than the day on which the taxpayer disposes of all positions comprising such a straddle.

To be treated as an identified straddle, the straddle must be clearly marked as an identified straddle on the taxpayer's records before the close of the day it is acquired. All of its positions must be acquired on the same day, and it must either have all of its positions closed of the same day during the taxable year or it must have no positions closed before the end of the taxable year. If a successor or substitute position replaces an original position in the straddle (including a case where a loss is disallowed because of the wash-sale rule under sec. 1092(b)), the straddle ceases to qualify as an identified straddle. Thus, for example, if a taxpayer disposes of a position that is part of an identified straddle at a loss and the loss is disallowed under the wash-sale rule because the position is replaced, other losses sustained on positions not part of the identified straddle may be disallowed because of unrealized gain on positions within the identified straddle. In addition, an identified straddle cannot constitute part of a larger straddle (for example, a butterfly).
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Straddles in regulated future contracts

A straddle comprised entirely of regulated futures contracts is not subject to the loss deferral rule. Such straddles will be taxed under the mark-to-market system (described below).
Mixed straddles

If a straddle is composed partially of regulated futures contracts and partially of other positions (called a "mixed straddle"),8 losses from positions that are part of the straddle will be subject to the loss deferral rule or to the rule relating to identified straddles. The mixed straddle will be subject to the loss deferral rule, if it is not an identified straddle, whether or not the taxpayer elects that the regulated futures contracts in the straddle be on or off the mark-to-market system under section 1256(d). Thus, the taxpayer will have essentially three choices in the case of a mixed straddle. First, he may choose that the regulated futures contracts be marked-to-market, in which case the straddle will be subject to the loss deferral, wash-sale, and short-sale rules. Second, if the taxpayer designates the positions as a mixed straddle, the regulated futures contracts will be excluded from the mark-to-market system but subject to the loss deferral, short-sale, and wash-sale rules. Third, if the straddle otherwise satisfies the conditions of an identified straddle, and if the taxpayer designates the straddle as a mixed straddle and further elects that it be an identified straddle under the identified straddle rules, the regulated futures contracts will be exempted from the mark-to-market rules, and the straddle will be exempted from the loss deferral rules but subject to the identified straddle, wash-sale, and short-sale rules. In this connection, a mixed straddle as discussed in this explanation may include positions acquired on different days. As stated above, a taxpayer may not elect to treat positions acquired on different days as an identified straddle.
8 In new section 1256(d)(4), the term "mixed straddle" is defined, for purposes of subsection (d), to refer only to straddles designated as mixed straddles. In this explanation, however, the term "mixed straddle" refers to all straddles composed partly of regulated futures contracts and partly of other positions, whether or not they are identified as straddles by the taxpayer.
Unrealized gain

In determining whether a taxpayer has deductible losses, the unrealized gain taken into account for a straddle position held by the taxpayer at the close of the taxable year shall be equal to the amount of gain which would be realized if the position were sold or otherwise liquidated at its fair market value on the last business day of the taxable year.9 In the case of regulated futures contracts, fair market value is determined by the final settlement prices set by the futures exchanges for each contract on the final trading day of the year. In the case of a mixed straddle in which the taxpayer has not elected out of mark-to-market treatment for the regulated futures contract, losses exceeding unrealized gains not marked to market are deductible without diminution by reason of gains taken into account by virtue of the mark-to-market system. The settle-
9The deferral of straddle losses is intended to preclude the deduction of losses until offsetting gains are taken into account for tax purposes. Accordingly, if by the close of the taxable year the taxpayer has economically disposed of both a loss position and an offsetting gain position that is not taken into account until the following year, the loss will not be allowed until the following year under the loss deferral rule.
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ment price applicable in the case of positions that are not regulated futures contracts will normally be dispositive of fair market value as well.
Disclosure of unrealized gains

To verify the amount of loss deductible by the taxpayer, the taxpayer's unrealized gains must be disclosed. The Act requires taxpayers to disclose all their positions which have unrealized gain at the close of the taxable year and the amount of unrealized gain in each of the positions. Positions with unrealized gain must be disclosed whether or not the positions are part of a straddle.

Taxpayers will not be required to file disclosure reports on unrealized gains if they have sustained no loss on any position (including regulated futures contracts) during the taxable year, or if the only loss sustained was a loss on inventory or depreciable trade or business property described in paragraph (1) or (2), respectively, of section 1221. No disclosure report is required for any positions which are part of an identified straddle. Further, taxpayers who sustain losses from the disposition of long positions and who have neither disposed of nor hold any short positions, whether as options, regulated futures contracts, forward sales, or otherwise, generally would not hold offsetting positions and would not be expected to report unrealized gain.

A taxpayer whose loss from a disposition of a short position in a prior year was deferred under section 1092 may have offsetting positions in the current year as a result of the carryover of such loss under section 1092(a)(1)(B) and therefore would be required to report unrealized gains. Additionally, a taxpayer is not required to report unrealized gain in inventory positions or in depreciable trade or business property, or in hedging transactions (as defined by this Act in Code sec. 1256L(e)). The Treasury is authorized to issue regulations prescribing the time, manner and form required for disclosure of such unrealized gains. The Congress intended that such disclosure be made on taxpayers' returns.
Wash sales; short sales

The Act requires that the Treasury issue regulations applying to straddle positions rules similar to certain provisions of the wash-sale rule (sec. 1091(a) and (d)) and of the short-sale rule (sec. 1233 (b) and (d)). It is intended that the wash-sale rule be applied in appropriate cases to disallow losses in certain straddle transactions prior to the application of the loss deferral rule of new section 1092, and that the time period applicable under the existing wash-sale rule (from 30 days before to 30 days after the date of sale) would be the appropriate time interval under these new rules.

In the typical tax-shelter straddle transaction, for example, the taxpayer, after disposing of the loss leg, immediately replaces it in order to remain in a balanced position and protect the unrealized gain. In this case, the modified wash-sale rule to be prescribed by regulations will prevent deduction of the loss. Thus, the loss deferral rule of section 1092(a) does not apply to this loss because section 1092(a) defers losses only if they are otherwise allowable. Any loss subsequently sustained on either leg of the reconstituted straddle may be deferred by application of new section 1092. Of course, an
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adjustment must be made to the replacement leg analogous to the basis adjustment made under section 1091(d). Thus, in most cases, the disallowance of losses under the section 1091 rule will operate merely to defer the loss.

Under section 1233(b), gain on closing a short position generally results in short-term gain. In addition, the holding period of property held by the taxpayer which is substantially identical to the property sold short and not used to close the short sale does not commence until the short position is closed (unless the long-term holding period requirement was already satisfied for such property when the short position was created).

However, the holding periods of properties not satisfying the substantially identical standard of section 1233 were unaffected by its holding period rule under prior law even if they would constitute offsetting positions subject to the loss deferral rule of new section 1092. Section 1233(b) did not affect, for example, the typical tax-shelter commodity straddle because futures contracts calling for delivery in different calendar months were defined as not substantially identical (sec. 1233(e)(2)(B)). As a result, there was a possibility that a short-term gain could be converted into a long-term gain by creating a straddle if the "long leg" increased in value by holding the straddle for enough time to satisfy the long-term holding period requirement.

To prevent this result, the Act authorizes the Treasury to prescribe regulations adopting rules comparable to section 1233(b), and to apply such rules so that the holding period for property that is part of a straddle subject to the new rules of section 1092 is terminated and does not begin anew until the offsetting position or positions is disposed of. Thus, for example, if a taxpayer enters a short forward contract at a time when he has held an offsetting long position for less than 12 months, the holding period for such long position will be terminated and will not commence until the offsetting short position is disposed of. For purposes of these regulations, a futures contract to sell a commodity is equivalent to the short sale of a long futures contract for the same commodity or the short sale of the commodity itself. The regulations are also to adopt a rule comparable to section 1233(d), to prevent converting a long-term capital loss into a short-term capital loss.

Generally, the rules developed under the Act's delegation of regulatory authority to develop rules comparable to sections 1091 and 1233 will supplement and will have broader application than the original statutory rules in the two sections. In the new regulations, the concept of offsetting positions is to be substituted for the concept of substantially identical property. The application of the new regulatory rules under sections 1091 and 1233 is to supercede any application (or restriction on the application) of those sections in situations where both the new regulations and the original statutory law appear to apply.
Definition of straddle

The Act defines straddles as offsetting positions with respect to personal property. A taxpayer is treated as holding offsetting positions with respect to personal property if there is a substantial reduction in the taxpayer's risk of loss from holding any position in
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personal property because the taxpayer holds one or more other positions with respect to personal property.

Although the concept of offsetting positions is not narrowly defined in the statute, certain cases fall outside its scope. For example, risk reduction through mere diversification usually would not be considered to substantially diminish risk for purposes of this Act, if the positions are not balanced. Thus a taxpayer holding several types of securities but holding not short positions generally would not be considered to be holding offsetting positions.

Positions in personal property may be treated as offsetting whether or not the underlying property is the same kind. Thus, a straddle can consist of two futures contracts, one to take delivery and the other to make delivery of silver, a long futures contract for silver and a short forward contract for silver coins, or a long futures contract for soybean meal and a short futures contract for soybean oil. A straddle also may consist of two positions which are not the same type of interest in property. A straddle may be made up of a cash position in silver, i.e., holding the physical commodity itself, and of a futures contract to sell the same amount of silver. It may also be made up of an option to acquire a long futures contract and a short futures contract.

In cases where one or more positions offset only a portion of one or more other positions, they should be treated as offsetting and subject to the rules in section 1092 only to the extent of the portion of the position or positions which is balanced. The Act authorizes the Treasury to issue regulations prescribing the method for determining the portion of a position which is to be taken into account as offsetting. In appropriate cases, therefore, only part of the loss from a single position may be treated as subject to the loss deferral rules. However, no position which is not a part of an identified straddle may be treated as offsetting with respect to any position which is part of an identified straddle.

Also, under the Act, taxpayers are presumed to hold offsetting positions in certain specified circumstances. The first presumption provides that positions in the same personal property, whether in the physical commodity itself or in a contract for the commodity, are considered offsetting positions, provided the values of the positions vary inversely with each other. Generally, values vary inversely if the value of one position decreases when the value of the other position increases. A straddle in silver futures contracts or forwards, or a straddle in cash silver and a futures contract to sell silver, falls within this presumption.

The second presumption covers positions in the same personal property, even though the property may be in a substantially altered form, provided the values of the offsetting positions ordinarily vary inversely with respect to each other.

The third presumption covers positions in debt instruments of similar maturities if the positions ordinarily vary inversely in value in relation to each other. Generally, debt instruments are considered to be of a similar maturity if the scheduled maturities are in sufficiently close proximity to each other that a change in value of one instrument will correspond substantially to a change in value of the other. The Treasury may prescribe regulations describing other types of positions in debt instruments which will
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be presumed to be offsetting, provided the inverse variation test is passed.

The fourth presumption treats positions which are sold or marketed as offsetting positions as straddles. the presumption does not depend on the positions being labelled by any particular name, such as straddle, spread, or butterfly.

The fifth presumption provides that positions are presumed offsetting if the aggregate margin requirement for such positions ordinarily is lower than the sum of the margin requirements for each of the positions, if held separately. Thus, if the value or amount of the deposit, pledge, payment, security, or other requirement for holding two or more positions together ordinarily is less than the cost of holding each alone, this presumption applies. Generally, the lower margin for the aggregate holdings is evidence that there is less economic risk associated with holding the combined positions than with holding each of the positions separately.

The Act also authorizes the Treasury to issue regulations prescribing other factors, including subjective or objective tests, to establish a presumption that positions are offsetting. The values of positions presumed offsetting under this regulatory authority ordinarily must vary inversely. This authority enables the Treasury to develop presumptions which treat complex or innovative types of straddles as offsetting positions. The Act makes clear that such regulations may describe factors to be applied in determining whether positions are offsetting or may prescribe categorical tests for such determination.

Any presumptions established under the Act's specific rules or under the regulatory authority provided by the Act can be rebutted by the taxpayer or by the Government.
Definitions and special rules

The Act defines personal property as any personal property, other than stock, of a type which is actively traded. A position is an interest in personal property, including a futures contract, a forward contract, or an option. In addition to corporate stock, the Act does not apply to real property or to property which is not actively traded. U.S. currency does not constitute personal property as defined since only property or interests in property that may result in gain or loss or their disposition are subject to the straddle limitations. Further, a futures contract, forward contract, option (other than a stock option) or other interest, while constituting a position in other property, is also personal property as defined in the act if it is actively traded. Thus, for example, a debt instrument is a contractual right entitling its holder to an amount of cash on a future date and also constitutes personal property if it is actively traded. Similarly, a futures contract that does not require delivery of personal property but calls for a cash settlement predicated on the future price of deposits, obligations, stock, securities, or other assets is itself personal property if actively traded. In order to be treated as actively traded, property need not be traded on an exchange or in a recognized market.

The term "position" includes options to buy or sell stock if such stock is actively traded, provided either that the period during which the option may be exercised exceeds the period required for
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long-term capital gain treatment or that the options are not traded on a domestic or designated foreign exchange. Thus, the Act's major rules apply to offsetting positions in stock options which can be held for more than 12 months. The definition of position excludes, and thus the major rules are inapplicable to, stock options traded on United States exchanges or similar foreign exchanges designated by the Secretary, if the options have an exercise period less than the minimum time required to hold a capital asset to produce long-term capital gain or loss.

An attribution rule treats positions which are held by a person related to the taxpayer as positions held by the taxpayer. Persons related to the taxpayer are the taxpayer's spouse and a corporation which files a consolidated return with the taxpayer under section 1501. In addition, certain positions held by flow-through entities, such as trusts, partnerships, or subchapter S corporations, are treated as held by the taxpayer. If part or all of the gain or loss from a position held by a flow-through entity would be properly taken into account in determining the taxpayer's own Federal tax liability, the position is treated as held by the taxpayer, unless the regulations provide otherwise.

New section 1092(a) providing for deferral of certain losses and the regulations to be issued under this Act to apply wash-sale (sec. 1091) and short-sale (sec. 1233) principles to straddle transactions do not apply to hedging transactions. The hedging transactions excepted from these rules also are excepted from the Act's mark-to-market and capitalization rules (see below.) Hedging is defined in the mark-to-market provisions (sec. 1256(e)) and refers to certain risk-limiting transactions conducted in the normal course of the taxpayer's trade or business which produce ordinary income or ordinary loss. A transaction qualifies for the exception only if it is clearly identified by the taxpayer as being a hedging transaction before the close of the day on which the transaction is executed. It is expected that taxpayers, such as banks or securities dealers, which may conduct thousands of hedging transactions to hedge property held or to be held in their accounts, may identify such accounts as hedged accounts without marking individual items as hedges or hedged property, provided such accounts deal only with ordinary income (or loss) items.
Penalty for failure to disclose gains

Under the Act, taxpayers who without reasonable cause fail to report all of their unrealized gains are subject to a penalty, if they have a tax deficiency attributable in whole or in part to the denial of a loss deduction because they hold an offsetting position with unrealized gain. The penalty for the failure to report unrealized gain is treated as a penalty attributable to negligence or intentional disregard of rules and regulations (but without intent to defraud) in section 6653(a). The penalty assessed is the amount equal to five percent of the underpayment. In addition, a penalty equal to 50 percent of the interest payable under section 6601 on that portion of the underpayment attributable to the negligence or intentional disregard is also imposed under section 6653(a)(2), as added by the Act. The period for computing this additional penalty commences
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on the date prescribed for payment of the underpayment and ends on the date of assessment.

Thus, for example, if a taxpayer who does not report all unrealized gain positions has an underpayment because the taxpayer is determined to have held an offsetting unrealized gain position, the taxpayer must pay the penalty, even if the taxpayer obtained a counsel's opinion that the unrealized gain did not offset the loss. To avoid the penalty, a taxpayer claiming a deduction for the loss may rely on the opinion, but the taxpayer also must disclose all unrealized gain positions and must indicate that none of the disclosed gain positions is considered an offsetting position.
Effective Date

The changes made by this provision generally apply to property acquired and positions established by the taxpayer after June 23, 1981.
Election

Taxpayers may elect under section 508 of the Act to apply the new rules governing the taxation of straddles, including the provisions of both sections 1092 and 1256, to all positions held on June 23, 1981, for the periods after that date. The election must cover all positions, whether in regulated futures contracts or in other property, held by the taxpayer on that date. (This and other elections under Title V of the Act are discussed in more detail below.)
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2. Capitalization of certain interest and carrying charges (sec. 502 of the Act and sec. 263 of the Code)
Prior Law

Under prior law, carrying charges, such as storage, insurance, and interest on indebtedness incurred or continued to purchase or carry a commodity held for investment, were deductible as an expense paid or incurred for the management, conservation, or maintenance of property held for the production of income (secs. 163 and 212), notwithstanding that the taxpayer held an offsetting position to minimize risk and may have claimed long-term capital gain on the sale of the commodity.

However, a limitation was imposed under section 163(d) on interest on investment indebtedness. This limitation was not changed by the Act and remains in effect. Generally, the deduction for such interest is limited to $10,000 per year plus the individual taxpayer's net investment income. Any remaining amount can be carried over to future years.
Reasons for Change

The Congress believed that the use of certain straddles which were executed with deductible financing and carrying charges, to defer ordinary income and to convert it into long term capital gain, had become a serious tax-avoidance problem threatening substantial revenue losses. The Congress decided to discourage these transactions, sometimes called "cash and carry" shelters, in this legislation.

"Cash and carry" tax shelters usually involved the purchase of a physical commodity, such as silver, and the acquisition of a futures contract to deliver (sell) an equivalent amount of the same commodity more than twelve months in the future. The taxpayer financed the purchase with borrowed funds, and deducted the interest expense, storage, and insurance costs in the first year. These ordinary deductions offset ordinary investment income, e.g., interest and dividends.

Because the price differential between the current (or spot) price of the physical commodity and the price of the futures contract for a distant month is largely a function of interest and other carrying charges, the futures contract has a contract price approximately equal to the total payment for the physical commodity plus interest and carrying costs.

A taxpayer executing a cash and carry shelter acquired the silver and the offsetting contract in one year and held them into the next year. When the 12-month holding period qualifying the physical commodity for long-term treatment had elapsed, the silver could be delivered to satisfy the taxpayer's obligation under the futures contract, thereby realizing a gain on the silver. If the price of silver had increased, the taxpayer could sell the silver, producing long-term capital gain, while closing out the short futures position, creating a short-term capital loss. In either event, the net gain on the two positions was about equal to the interest and carrying charges paid during the period the commodity was held, but was reported as long-term capital gain. Thus, in 1979, for example, investment income taxable at rates as high as 70 percent, might have been deferred for a year and converted into capital gains taxable at maximum rates no higher than 28 percent. (The Act also reduced the maximum rate on investment income from 70 to 50 percent in 1982, which results in the reduction of the maximum long-term capital gains rate from 28 to 20 percent.)

Because the Congress recognized that certain legitimate business transactions, such as hedging, which result only in ordinary income or loss, lack significant tax avoidance potential, it exempted such activities from the Act's rules on "cash and carry" transactions.
Explanation of Provision

The Act requires taxpayers to capitalize certain otherwise deductible expenditures for personal property if the property is held as part or all of an offsetting position belonging to a straddle. Such expenditures must be charged to the capital account of the property for which the expenditures are made. Thus, these expenditures will reduce the gain or increase the loss recognized upon the disposition of the property.

Expenditures subject to this capitalization requirement are interest on indebtedness incurred or continued to purchase or carry the property, as well as amounts paid or incurred for insuring, storing or transporting the property. The amount of expenditures, called carrying charges, to be capitalized is reduced by any interest income from the property (including original issue discount) which is includible in gross income for the taxable year, and any amount of ordinary income acquisition discount (new sec. 1232(a)(4)(A)) includible in gross income for the taxable year.

The capitalization requirements do not apply to any identified hedging transactions (sec. 125(e)) or to any position which is not part of a straddle. Thus, for example, a farmer still can deduct currently the costs of financing crops. Similarly, securities dealers' expenses for financing their inventory and trading accounts which generate ordinary income or loss remain deductible currently.
Effective Date

The provision applies to property acquired and positions established by taxpayers after June 23, 1981, in taxable years ending after that date.
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3. Regulated futures contracts market to market and certain elections (secs. 503 and 509 of the Act and new sec. 1256 of the Code)
Prior Law

Prior to the Act, the Code did not contain any special rules dealing with straddles in commodities or in futures contracts for commodities. In the case of the typical straddle in commodity future contracts (i.e. the holding of a contract to buy a commodity in one month and the holding of a contract to sell the same commodity in a different month), neither the wash-sale rule applicable to stocks or securities (sec. 1091), nor the special short sales rules preventing conversion of short-term gain to long-term gain or long-term losses to short-term losses (secs. 1233(b) and (d)), apply.

However, the Internal Revenue Service ruled that the losses on certain dispositions of silver futures contracts comprising part of a straddle were not deductible because the taxpayer "had no reasonable expectation of deriving an economic profit form the transactions". (Rev. Rul. 77-185, 1977-1 C.B. 48) This ruling has been the subject of controversy, and the Revenue Service is litigating the deductibility of certain losses claimed in straddle transactions.

Tax rules of general application which affect the taxation of transactions in commodity futures contracts are discussed in section 1., above.
Reasons for Change

Because of the rapid, significant growth in the use of tax straddles, especially those structured in commodity futures contracts, by high-and middle-income individuals as well as corporate taxpayers, the Congress believed it necessary to enact specific and simple statutory rules to prohibit any further attempts to use straddles in futures contracts for tax sheltering. The increase in tax sheltering through the use of commodity futures straddles threatened to undermine the integrity of the United States self-assessment system and to create substantial revenue losses. The seriousness of these dangers made it unwise to wait for a final judicial resolution of taxpayer-government disputes about the proper tax treatment of those transactions and imperative to eliminate any uncertainty about the tax rules for the future.

The Congress intended to prevent taxpayers from claiming the tax benefits which were alleged obtained by using a futures straddle as a tax shelter.

A taxpayer using a simple futures straddle as a tax shelter would establish a position in contracts with contract prices of
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about, say, $10,000 each. The two contracts, one to buy, the other to sell, were identical in every respect, except for their delivery months. Because the taxpayer's position was a straddle, his margin deposit was very low--as little as one percent of the value of the position ($200). The taxpayer would wait for the market to move, so that one leg of the straddle showed a loss, e.g., $500, and the other leg showed an almost identical gain. The taxpayer would liquidate the loss by entering into the opposite futures contract for the same month. (A contract to sell December wheat, for example, is liquidated by executing a contract to buy December wheat.) In order to maintain a balanced, minimal-risk position, the taxpayer would replace the liquidated leg with a contract which is identical, except for its delivery month. (The replacement contract would have a contract price of about $9,500, if the original long leg was liquidated at a loss, or a contract price about $10,500, if the original short leg was liquidated at a loss.)

The taxpayer would claim the decrease in value in the liquidated leg as a $500 short-term capital loss incurred in the year of liquidation thereby eliminating a $500 short-term gain for the tax year. At the same time, the taxpayer would continue to hold the other leg, which had an unrealized gain approximately equal to his "realized loss," that is, about $500. However, the taxpayer would not have made any payment on the liquidated leg because his account reflecting both long and short positions would show no net loss. In addition, because the taxpayer had maintained a balanced position, he ordinarily would not be required to deposit any additional margin into his margin account.

The taxpayer would hold the two legs into the following year. In the second year, the taxpayer would close out the two positions. Assuming the holdover contract would increase another $500 in value, the taxpayer would recognize a total gain of about $1,000 on the original leg and a loss of about $500 on the replacement leg. If the gain was on the long (buy) position and that position was held for over six months, the taxpayer would report a $1,000 long-term capital gain on the position and a $500 short-term capital loss on the short position. If he had no other capital transactions for the year, he would report the $500 difference between these legs as long-term capital gain. (His margin, less commissions, would be returned.) Thus, he ostensibly succeeded in deferring his short-term capital gain for one year and converting it to a long-term capital gain. If the gain was in the short (sell) position, the gain would be short-term capital gain. In this case, the taxpayer ostensibly obtained a one-year deferral, but no conversion.

The Congress believed that the enactment of tax rules, based on the actual operations of futures trading, would end this use of futures for tax-avoidance purposes, would establish an accurate method determining a taxpayer's futures income (or loss), and would ease tax administration and paperwork for both Government officials and taxpayers.

The United States commodity futures exchanges employ a unique system of accounting for every futures contract's gain or loss in cash on a daily basis. Even though a futures trader does not close out a position but continues to hold it, the trader receives any gain on the position in cash as a matter of right each trading day.
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If a trader's position has increased in value during the day, the net increase in the position is computed and transferred to the trader's account before the beginning of trading the next day. The trader has the right to withdraw the full amount of such gains immediately every trading day. However, if a trader's position decreases in value, the trader will have to meet a margin call, that is, deposit additional funds, before the next business day. Money paid on position losses is paid into the exchange clearing association which transfers such amounts to accounts which gained during the trading day. This daily accounting which includes the determination of contract settlement prices and margin adjustments to reflect gains and losses is called "market-to-market."

Marking-to-market requires daily cash adjustments through the exchange clearing association to reconcile exchange members net gains and losses on their positions. At the close of trading each day, every member must mark all customer accounts to the settlement prices (current market value) for the day. Gains and losses are immediately deposited into or withdrawn from the customer accounts. Customers in turn are entitled to withdraw their gains, or are required to deposit any margin required because of losses in their accounts, at the close of every day under this marking-to-market system.

The Act adopts a marking-to-market system for the taxation of commodity futures contracts. This rule applies the doctrine of constructive receipt to gains in a futures trading account at year-end. The application of this elsewhere in the tax law generally means, for example, that taxpayers must include in their income any interest which has accrued in their savings account during the year, even though they may not have withdrawn the interest. Because a taxpayer who trades future contracts receives profits as a matter of right or must pay losses in cash daily, the Congress believed it appropriate to measure the taxpayer's futures' income on the same basis for tax purposes.
Explanation of Provision
General rule

Under the Act, gain and loss from all regulated commodity futures contracts must be reported on an annual basis under a market-to-market rule. This tax rule corresponds to the daily cash settlement, mark-to-market system employed by commodity futures exchanges in the United States for determining margin requirements. Straddles which are composed solely of futures contracts and which are not part of a larger straddle are subject to the new mark-to-market rules and are excepted from the loss deferral rule (new sec. 1092), the regulations authorized to adapt wash-sale and short-sale principles and apply them to straddle positions, and the capitalization rule (sec. 263(g)).

All futures contracts must be marked-to-market at year end. Each regulated futures contract held by a taxpayer is treated as if it were sold or otherwise liquidated for fair market value on the last business day of the year. Ordinarily, the settlement prices determined by an exchange for its futures contracts on the year's last business day are to be considered the contract's fair market
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value. Any gain or loss on the contract is taken into account for the taxable year, together with the gain or loss on other futures contracts which were held during the year but closed out before the last business day. Thus, taxpayers' net gain or loss is approximately equal to the aggregate net amount which is credited to their margin accounts as variation margin, or which they had to pay into their accounts as variation margin, during the year.

If a taxpayer holds futures contracts at the beginning of a taxable year, any gain or loss subsequently realized on these contracts must be adjusted to reflect any gain or loss taken into account with respect to these contracts in a prior year.

Any capital gain or capital loss on a regulated futures contract which is marked-to-market is treated as if 40 percent of the gain or loss is short-term capital gain or loss, and as if 60 percent of the gain or loss is long-term capital gain or loss. For 1982 and later years, this allocation of capital gain between short-term and long-term results in a top rate of tax of 32 percent on such gains. Regulated futures contracts continue to constitute capital assets in all cases in which they would have constituted capital assets under prior law. Treatment of gains and losses as partially short-term and partially long-term is not intended to affect the character of such contracts as capital assets nor to eliminate the holding period requirements applicable to assets which are not regulated futures contracts. Any ordinary income or loss items on the mark-to-market system continue to be taxed at the regular tax rates applicable to such income. Thus, for example, gain or loss on a post ion not identified as a hedging transaction under section 1256(e) that is treated as an ordinary income asset under the rule of the Corn Products decision will constitute ordinary income or loss and is not subject to the 60/40 rule.

Adaptation of the mark-to-market system to the determination of taxable gain or loss from regulated futures contracts requires that the marked-to-market settlement price of every position held at any time during the taxable year be determined on each relevant --ate as necessary to include in taxable income all regulated futures contract gains and losses from such positions. Accordingly, the mark-to-market rules, including the allocation between long-term and short-term capital gain or loss, apply to any termination of a taxpayer's obligation with respect to a regulated futures contract whether the termination is executed by offsetting, by taking or making delivery, by transfer of the taxpayer's interest in the contract, or in some other manner. These mark-to-market rules apply to a transfer notwithstanding that nonrecognition of gain or loss would result from the application of any other provision of the Code. Gain or loss upon termination is determined on the basis of the contract's fair market value at the time of termination, ordinarily the actual price received or paid if the termination is a closing transaction.
Regulated futures contracts

Unless specifically excepted, all regulated futures contracts are subject to the mark-to-market rules.

A regulated futures contract means a contract (1) which requires delivery of personal property or an interest in personal property,
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as defined in new section 1092(d)(1); (2) which is marked-to-market under a daily cash flow system of the type used by United States commodity futures exchanges to determine the amount which must be deposited, in case of losses, or the amount which may be withdrawn, in the case of gains, as a result of price changes with respect to the contract during the day; and (3) which is traded on or subject to the rules of a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or of any board of trade or exchange which the Treasury determines operates under rules adequate to carry out the purposes of the mark-to-market provisions.
Mixed straddles

The Act provides special rules for the taxation of straddles composed of at least one position in regulated futures contracts and one or more positions in interests in property which are not regulated futures contracts. If the taxpayer clearly identifies each position in such a straddle as belonging to the straddle by the close of the day of the position's acquisition, the straddle herein is called an identified mixed straddle.1
1 New sec. 1256(d)(4) uses the term "mixed straddle" to describe what is here termed "identified mixed straddle."

The taxpayer may elect to exclude all positions in regulated futures contracts which belong to an identified mixed straddle from the mark-to-market rules; in that case, they will be subject to the loss deferral, wash sale, and short sale rules. The taxpayer's election is permanent and may be changed only with the consent of the Treasury. If a regulated futures contract is taken off the mark-to-market system pursuant to an election, it may not subsequently be switched back onto it. A taxpayer may not elect to bring any positions that are not regulated futures contracts onto the mark-to-market rules.

If a taxpayer fails to identify the positions constituting a mixed straddle, or if a taxpayer does not elect to remove futures positions in an identified mixed straddle from the mark-to-market rules, the amount of any gain or loss on futures contracts in the straddle is determined under the mark-to-market rules. Gain or loss on other positions in the straddle is determined under the regular tax rules. All positions in the straddle, both futures contracts and other property, are subject to the loss deferral and other rules in section 1092, and the capitalization rule in section 263(g). The application of section 1092 to such unidentified mixed straddles will result in the deferral of all losses with respect to which there is offsetting unrealized gain. However, gain taken into account under the mark-to-market rules is not treated as unrealized and will not defer the deduction of losses. Therefore, losses sustained in excess of offsetting unrealized gain, if any, on positions that are not regulated futures contracts in such a straddle will not be deferred because of gains marked-to-market on the offsetting regulated futures contracts. Conversely, losses otherwise allowable on the regulated futures contracts on the mark-to-market system will be deferred to the extent of unrealized gain on the offsetting positions that are not regulated futures contracts.
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Hedging exemption

The mark-to-market rules do not apply to hedging transactions. For purposes of the mark-to-market rules, a hedging transaction means a transaction which the taxpayer executes in the normal course of his or her trade or business primarily to reduce certain risks, which results in only ordinary income or ordinary loss and which is properly identified by the taxpayer as a hedging transaction. Hedging transactions are varied and complex. They may be executed in a wide range of property and forms, including options, futures, forwards, and other contract rights and short sales.

A hedging transaction may be executed to reduce the risk of price change or of currency fluctuations with respect to property which is held or to be held by the taxpayer and which, if disposed of at a gain, whether by sale, exchange, lapse, cancellation, or otherwise, produces ordinary income. Also, a hedging transaction may be executed to reduce the risk of price or interest rate changes, or currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer, provided all income or gain on such borrowings or obligations is treated as ordinary income. Gain or loss on dispositions both of the hedged property and of the hedge itself must be ordinary.

Transactions which result in capital gains or capital losses do not qualify for the hedging exemption. Speculation in commodity futures contracts, for example, does not qualify for this exemption whether a trader takes outright long or short positions, or whether a trader speculates in spreads, because futures speculation always produces only capital gains or capital losses.
Special rule for banks

The Act provides a special definition of "hedging transactions" for banks (as defined in section 581). For a transaction conducted by a bank to qualify as a hedging transaction, it must be entered into by the bank in the normal course of the bank's trade or business, the gain or loss on the transaction must be treated as ordinary income or loss, and it must be properly identified by the bank as a hedging transaction. The bank's transactions need not fulfill the primary purpose requirements of clauses (i) and (ii) of section 1256(e)(2)A, which specify certain types of risk reducing activities with respect to price, interest rate, and currency fluctuations. This special rule is intended to allow certain business activities which are conducted regularly by banks, but which may not be conducted primarily for risk reduction (for example, foreign currency trading), to qualify for the hedging exemption.
Identification requirements

For a transaction which constitutes one of the activities treated as hedging under section 1256 and which generates ordinary income or loss under normal tax principles to qualify as a hedging transaction under the definition in section 1256(e)(2), the transaction also must be clearly identified in the taxpayer's records as being part of a hedging transaction before the close of the day on which the taxpayer entered the transaction.
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Regulations should allow taxpayers to minimize bookkeeping identification requirements in as many cases as practicable. In situations where hedging transactions are numerous and complex, but opportunities for manipulation of transactions to obtain deferral or conversion of income are minimal, it generally is unnecessary to require taxpayers to keep records which identify and match particular hedging transactions with particular hedged properties.

In certain hedging transactions (for example, those conducted by banks), it may be extremely difficult to match a hedging contract with a specific hedged property. In such cases, it may be sufficient for this identification requirement to mark an entire account, such as the bank's securities trading account, as a hedged account. If the bank's securities trading account, which produces only ordinary income or loss, is managed and recorded independently and separately from the bank's investment account (and any other capital asset account), there is little danger of manipulation for conversion. Moreover, because Federal regulatory agencies impose certain standard accounting practices on banks, their deferral opportunities too are limited. Thus, detailed identification or matching of such hedging activities ordinarily would serve no useful purpose.

However, in cases where taxpayers do not maintain and manage their ordinary income transactions separately from their capital transactions and where other factors indicate a danger of manipulation, more detailed identification records may be required.

If personal property (as defined in section 1092(d)(1)) has ever been identified by the taxpayer as being part of a hedging transaction, gain from the sale or exchange of the property may never be treated as capital gain but must be reported as ordinary income. The term personal property, as defined in section 1092(d)(1), covers any personal property of a type which is actively traded, but specifically excludes stock. Thus, if a taxpayer holding a stock position and a balancing position (say, in forward contracts) identified the positions as a hedging transaction, this rule would not apply. Any gain on the stock (or forwards) would not become ordinary, if it otherwise would be capital. The taxpayer's positions would not constitute a straddle, because the positions, though they may be offsetting, are not both positions in personal property.

In no event is the provision of this hedging exemption to be interpreted as precluding the Commissioner of Internal Revenue from exercising his present law authority to require that taxpayers employ accounting methods which clearly reflect their income.

Prior law rules characterizing as ordinary the gain or loss on transactions constituting an integral part of a taxpayer's trade or business continue to apply so that ordinary income or loss may result from transactions that are not within the hedging exemption.
Syndicate rule

In order to prevent possible manipulation of the hedging exemption by tax shelters structured as limited partnerships, the exemption for hedging transactions does not apply to transactions entered into by syndicates. Thus, unless excluded as mixed straddles, a syndicate's transactions in futures contracts are taxed under the mark-to-market rules. A syndicate's transactions in mixed strad-
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dles, whose futures positions are taken off the mark-market-system, as well as straddles in other property are subject to the loss deferral rule in section 1092, the modifications of the wash sale and short sale rules, and the capitalization rule in section 263(g).

A syndicate means any partnership or other entity (other than a corporation that is not a subchapter S corporation), if more than 35 percent of the entity's losses during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of sec. 464(e)(2)).
Certain interests not counted

The Act provides that in five situations, certain interests held by limited partners or by limited entrepreneurs (within the meaning of sec. 464(e)(2)), are not to be treated as limited or passive interests counted in applying the test for 35 percent of losses in determining whether an entity is a syndicate.

First, an interest is not to be treated as held by a limited partner or limited entrepreneur for any period if during the period the interest is held by an individual who actively participates at all times during the period in the management of the entity.

Similarly, second, an interest held by the spouse, children, grandchildren, or parents of an individual who actively participates in the management of the entity will not be treated as a limited or passive interest. A legally adopted child is to be treated as a child by blood.

Third, an interest held by an individual who actively participated in the management of the entity for at least 5 years is not to be treated as a limited interest.

Fourth, an interest held by the estate of an individual who actively participated in the management of an entity for at least five years, as well as interests held by the estate of the spouse, children, grandchildren or parents of such an individual, are not to be treated as limited interests.

Fifth, the Act delegates to the Treasury the authority to determine whether certain other interests should be treated as active interests. The Treasury may allow an interest to be treated as an active interest if it determines that an interest should be treated as held by an individual who actively participates in the management of the entity and that neither the entity nor the interest are used (or will be used) for tax-avoidance purposes.
Elections
General rule

The Act provides that the mark-to-market rules apply to property acquired and positions established by the taxpayer after June 23, 1981, in taxable years ending after that date. However, the mark-to-market rules may be applied to futures contracts held on or before that date under either of two elections provided by the Act.

Under section 508(c) of the Act, taxpayers may elect the new rules governing the taxation of straddles, including the mark-to-market rules, for positions which they held on June 23, 1981, for periods after that date. The election must cover all positions held by the taxpayer on that date.
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Taxpayers holding regulated futures contracts may avail themselves of an alternative election with respect to such contracts under section 509 of the Act for the taxable year which includes June 23, 1981.
Futures held on June 2 1981

A taxpayer who held regulated futures contracts on June 23, 1981, may elect under section 508(c) of the Act to apply the mark-to-market rules to all regulated futures contracts held on that date, regardless of the date of their acquisition. If this election is made, gain or loss on all futures held on June 23, 1981 (and later in the taxable year which includes June 23,1981) would be taxed under the mark-to-market rules. Any gain or loss on futures contracts disposed of before June 23, 1981, would be unaffected by the election. Such gain or loss would be measured at the time of the contracts' dispositions and would be treated as long-term or short-term, according to the actual holding period for the contract.

If the election under section 508(c) is made, any gains on regulated futures contracts held on June 23, 1981, would be 60 percent long-term taxed at a maximum rate of 20 percent in 1981 and later years. 40 percent of such gains subject to short-term treatment would be taxed at a maximum rate of 70 percent in 1981 and 50 percent in later years.

Gains and losses on regulated futures contracts disposed of before June 23,1981 (if the sec. 508(c) election is made), and at any time for futures positions created on or before June 23 if no election is made, are taxed at the rates applicable to the disposition of capital assets other than regulated futures contracts. Thus, long-term gains on futures contracts held by individual speculators would be taxed at a maximum rate of 28 percent, if liquidated on or before June 9, 1981, and at a maximum rate of 20 percent if disposed of after June 9, 1981. The top marginal tax rate on short-term gains on contracts which were liquidated during 1981 would be 70 percent and 50 percent for contracts liquidated in later years. Any election under section 508(c) of the Act must apply both to futures positions and positions in property other than futures held on June 23, 1981. Thus, an electing taxpayer must apply the provisions of new code section 1092 to all straddles other than straddles wholly in regulated futures contracts, if such positions were held on June 23, 1981.
Five-year payment

General rule.--In lieu of any election under section 508(c) of the Act, a taxpayer may elect under section 509 to have the mark-to-market rules apply to all regulated futures contracts held by the taxpayer during the taxable year which includes June 23, 1981. If a taxpayer makes this full year election under section 509 of the Act, all regulated futures contracts held by the taxpayer at any time during the taxable year must be marked-to-market; net gains on such contracts will be taxed at the rates applicable to taxable years beginning in 1982 determined as the difference between tax liability without regard to credits computed at 1982 rates on 1981 taxable income including net gains on regulated futures contracts and on 1981 taxable income reduced by such net gains; and any tax liabili-
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ty for 1981 which is attributable to appreciation which occurred in such contracts prior to the beginning of the taxable year may be paid in two to five equal annual installments. The first installment must be paid on or before the due date for filing the return for the taxable year which includes June 23, 1981. For calendar year taxpayers, the first installment would be due on April 15, 1982. Subsequent installments would become due with interest annually thereafter.

Amount payable in installments.--Under the Act, the maximum amount of tax which may be paid in installments pursuant to the section 509 election is computed by determining the tax liability for the year, calculated under section 509(a)(2) by applying the mark-to-market rules and special rate to all futures contracts held during the year, and reducing that liability under section 509(a)(3)(B)(ii) by the amount of tax which would be due, if only the gains and losses actually attributable to changes in the contracts' value during the taxable year were taken into account. The amount of gain (or loss) attributable to the taxable year which includes June 23, 1981, is determined by treating all regulated futures contracts which were held by the taxpayer on the first day of the taxable year and which were acquired by the taxpayer prior to that day, as if the contracts were purchased or entered into for their fair market value (generally their settlement price) on the last business day of the preceding taxable year.

Date for installment payment.--Taxpayers who elect full-year mark-to-market treatment for their 1981 taxable year and choose to make installment payments under section 509 of the Act must pay the first installment of the tax with respect to gains rolled into 1981 from prior years on or before the due date for filing their 1981 tax return. For calendar year taxpayers, the first installment would be due on April 15, 1982. Succeeding installments, plus interest on these outstanding liabilities computed at the statutory rate, would be due on or before April 15 annually thereafter.

The Act protects the Treasury's right to recover these liabilities in the event that a taxpayer becomes bankrupt. If any bankruptcy case or insolvency proceeding involving the taxpayer begins before the final installment is paid, the total amount of any unpaid installments is treated as due and payable on the day preceding the commencement date of such case or proceedings.

Interest.--Interest is charged on any unpaid installments of tax which are attributable to gains rolled forward from prior years into 1981 and which are still outstanding after the due date for the first installment. Thus, calendar year taxpayers would be liable for interest on installments unpaid after April 15, 1982. Interest would be computed at the statutory rate prescribed for underpayments by section 6601.

Form of election.--An election under section 509 of the Act must be made no later than the time prescribed for filing the tax return for the 1981 taxable year affected by the election and must be made in the manner and form required by regulations prescribed by the Treasury.

In making the election, the taxpayer must report the amount of tax liability determined to be attributable to appreciation in prior years and the number of installments to be paid. The taxpayer also
304

must report each regulated futures contract held on the first day of the 1981 taxable year and the date of acquisition of each of these regulated futures contracts, whether or not the contract was acquired on the first day of the 1981 taxable year or prior to that date. The election also must set forth the settlement price for each reported regulated futures contract for the last business day of the preceding taxable year. The election must contain any additional information required by regulations for carrying out these provisions.
Effective Date

The changes made by the provision generally apply to property acquired and positions established by taxpayers after June 23, 1981, in taxable years ending after such date.

The identification requirement for hedging transactions in section 1256(e)(2)(C) applies to property acquired by taxpayers after December 31, 1981, in taxable years ending after that date.
(305)
4. Carryback of losses from regulated futures contracts to offset prior gains from such contracts (sec. 504 of the Act and sec. 1212 of the Code)
Prior Law

Under prior law, taxpayers could carry ordinary losses which are net operating losses back to each of the three taxable years preceding the taxable year in which such losses were sustained and forward to each of the seven subsequent taxable years.1 Corporations generally could carry capital losses back to the three preceding taxable years and forward to the five subsequent taxable years. Individual taxpayers could carry capital losses forward, but prior to the Act could not carry any capital losses back to prior years.
1 This Act generally allows a 15-year carryforward of net operating losses

Individual taxpayers with significant increases in income could qualify to average their income over a five-year period which includes the four preceding taxable years (secs. 1301-1305). However, significant decreases in income do not entitle taxpayers to benefit from the provisions for income averaging.
Reasons for Change

Investors in commodity futures contracts bear substantial risks and sometimes incur very significant losses because of the volatility of many futures markets. The Congress recognized the significance of these risks, and the unique nature of futures contracts which are marked-to-market daily for both trading and tax purposes, even though an investor may continue to hold the same position. The Congress believed that the possible economic distortions in income tax liability which might result from these factors might not be adequately mitigated by capital loss carry forwards or the income averaging rules and should be alleviated; therefore, the Congress provided a three-year carryback for losses on futures contracts taxed under the mark-to-market rules.
Explanation of Provision
Election to carry back losses

The Act permits an election under which net commodity futures capital losses may be carried back three years and applied against net commodities futures capital gains during such period.2
2 The carryback election is not available to an estate or trust

The carryback is available only if, after netting regulated futures contracts and other positions subject to the marked-to-market rule of
306

section 1256 with capital gains and losses from other sources, there is a net capital loss for the taxable year which, but for the election, would be a capital loss in the succeeding year under section 1212(b). The lesser of such net capital loss or the net loss resulting from the application of the marked-to-market rule of section 1256(a) constitutes the "net commodity futures loss" which may be carried back.

The amount carried back may be applied only against net gains resulting from application of the marked-to-market rule of section 1256(a) in the carryback year. Such gains must be reduced by any net capital loss to which section 1256(a) did not apply in the carry-back year, so that only to the extent the taxpayer had a net capital gain in the carryback year would any portion of the loss be allowed.
Treatment of carryback losses

Amounts carried back under the election are to be treated as if 40 percent of the losses are short-term capital losses and 60 percent are long-term capital losses. Such losses must be absorbed in the earliest year to which they may be carried back and any remaining amount is then carried forward to the next year in the same proportions of 40 and 60 percent. Losses are not allowable to the extent they would create or increase a net operating loss for the carryback year.

Amounts against which losses may be applied in the carryback year (i.e., "net commodities futures gain"), are determined without regard to "net commodity futures loss" for the loss year or any year thereafter. Because the marked-to-market system begins in 1981 and no taxpayer has net marked-to-market capital gains for a prior year, 1981 is the earliest year to which net commodity futures capital losses can be carried back.

Losses absorbed in carryback years under the election are treated as capital gains for the loss year in the 40-percent short-term and 60-percent long-term proportions for the purpose of determining the amount of any net capital loss to be carried forward to a succeeding year under section 1212(b)(1). If capital losses are carried forward under section 1212(b), to the extent they were determined under the marked-to-market rule of section 1256(a), they continue to be treated as losses from regulated futures contracts in the year to which they are carried.
Illustration

The capital loss carryback election for regulated futures contracts may be illustrated by the following example.

Assume that the taxpayer in 1985 has net losses of $100,000 from regulated futures contracts under the marked-to-market rule of section 1256(a). In addition, the taxpayer has a $3,000 short-term capital loss and $50,000 long-term capital gain. Under section 1211, the taxpayer's capital losses are applied against the $50,000 of long-term capital gain and $3,000 of other income, leaving a $50,000 loss. If the carryback election under section 1212(c) is not made, the $50,000 loss may be carried to 1986 under section 1212(b). Initially, the $100,000 net loss from regulated futures contracts is treated as $40,000 of short-term loss and $60,000 of long-term loss under the marked-to-market rule. Since the taxpayer has $50,000 of long-term gain from other sources, only $10,000 of long-term loss remains, which, along with the $40,000 short-term loss, is carried to 1986 and treated as losses from regulated futures contracts in that year.
307

If the taxpayer makes the section 1212(c) election, net losses from regulated futures contracts are carried back to 1982 but only to the extent of the net capital loss which would otherwise become a capital loss in 1986 under section 1212(b), i.e., $50,000. The amount carried back is treated as 40-percent short-term loss and 60-percent long-term loss in the carryback year. Thus, the $50,000 carried back will be treated as $20,000 of short-term loss and $30,000 of long-term loss from regulated futures contracts in 1982. The amount carried back may be applied only against gains from regulated futures contracts in the carryback year and only to the extent the taxpayer had a net capital gain in such year.

Assume that the taxpayer in 1982 had a net gain of $50,000 from regulated futures contracts and a long-term capital loss from other sources of $30,000. The gains subject to section 1256 were $20,000 short-term, and $30,000 long-term which was absorbed by the $30,000 of unrelated long-term loss, leaving a net short-term gain of $20,000 to be offset by $20,000 of the $50,000 loss carried back from 1985. If the taxpayer has no net gains or losses from regulated futures contracts in 1983 or 1984, the $30,000 of unused losses would be carried forward to 1986 under section 1212(b) and would be treated as losses from regulated futures contracts in that year.

For purposes of determining the capital losses which may be carried forward under section 1212(b), any losses from regulated futures contracts absorbed as carryback losses under the new rules are treated as capital gains in the 40-percent short-term, 60-percent long-term ratios in the loss year. Thus, assume that a taxpayer has $50,000 of losses from regulated futures contracts in 1985 and a $50,000 long-term capital loss from other sources plus an additional $3,000 short-term loss absorbed against other income under sec. 1211. If $20,000 of the losses from futures contracts were absorbed as carryback losses as illustrated above, $80,000 of losses would remain to be carried forward to 1986 under section 1212(b), $68,000 of which would be long-term and $12,000 would be short-term. Of the long-term loss, $18,000 would be treated as a loss from regulated futures contracts in 1986 and all of the short-term loss would be so treated. This result is obtained by treating the $20,000 absorbed as carryback losses as though the taxpayer had gains in that amount from regulated futures contracts in 1985, leaving $18,000 and $12,000 of long-term and short-term losses, respectively, to be carried forward as regulated futures losses to 1986 and leaving the $50,000 long-term loss from other sources to be carried forward to 1986 unaffected by the carryback.
Effective Date

The provision applies to property acquired and positions established by taxpayers after June 23, 1981, in taxable years ending after that date. Losses may be carried back to taxable years no earlier than taxable years ending in 1981.

* * *
(311)
6. Prompt identification of securities by dealers in securities (sec. 506 of the Act and sec. 1236 of the Code)
Prior Law

Under prior and present law, gains and losses from property held primarily for sale to customers in the ordinary course of business are taxed as ordinary gains or losses. Gains and losses from property held for investment are taxed as capital gains and losses.

Gains and losses from the sale of property of a type held by a person primarily for sale are generally ordinary. However, the prior law contained a rule (sec. 1236) to allow a securities dealer to identify and segregate certain of its assets as held for investment.

In order to receive capital gains treatment, a security held by a dealer had to be "clearly identified" on the dealer's records as held for investment within 30 days following the date of acquisition and became ineligible for such treatment if it was thereafter held primarily for sale to customers. If a security was at any time clearly identified as held for investment, ordinary loss treatment was denied. The term "security" means any share of corporate stock, any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in, or right to subscribe to, any of the above.
Reasons for Change

Because a dealer could wait 30 days to identify securities held for investment, the dealer might wait the 30 days to determine which securities increased in value. The dealer might choose to identify these appreciated securities as held for investment in the expectation that this appreciation would hold or continue and be eligible for preferential treatment as long-term capital gain upon disposition of the security. Also, the dealer might want to treat any securities which have declined in value as held primarily for sale to customers in order to treat losses from these securities as fully deductible ordinary losses.

Some taxpayers considered securities dealers' unique tax-planning opportunities so significant that they established themselves as broker-dealers solely to exploit these opportunities. Large broker-dealer partnerships passed these tax benefits through to hundreds of partners. Many of these broker-dealer partnerships sold shares in their operations for fees which were based on a percentage, usually ten percent, of the tax loss sought by the investor.

The Congress believed that requiring dealers to identify securities held for investment on their date of acquisition would end most abuse of the broker-dealer role. Because computers are used commonly now and because prudent investors, including dealers, know the purpose of their transactions when executed, delay in identification is unnecessary and unwise. In view of their special
312

responsibilities with respect to the stock for which they are registered, floor specialists are allowed seven business days to designate their specialist stock which is held for investment.
Explanation of Provision

The Act requires a dealer in securities to identify a security as held for investment not later than the close of business on the date of the security's acquisition. No security which is part of an offsetting position may be treated as clearly identified in the dealer's records as a security held for investment unless all securities be longing to the offsetting position are properly identified in a timely manner. The Act, while changing the identification requirement applicable to securities which the taxpayer treats as held for investment, does not otherwise change rules of prior law applicable in determining whether gain from the disposition of securities is capital gain.

A special rule is provided for floor specialists. A floor specialist on a national securities exchange is allowed seven business days after the date of acquisition of stock in which the specialist is registered with the exchange to identify such stock which is held for investment. This exception applies only with respect to acquisitions of stock in connection with the specialist's duties as a specialist in the stock on the exchange where the specialist is so registered. The Act defines a floor specialist as a person who is a member of a national securities exchange, is registered as a specialist with the exchange, and meets the requirements for specialists established by the Securities and Exchange Commission.
Effective Date

The provision applies to property acquired and positions established by taxpayers after December 31, 1981, in taxable years ending after that date. Property acquired or positions established by taxpayers after June 23, 1981, but before January 1,1982, must be identified as held for investment by the close of business on the first day after the day the security was acquired.
(313)
7. Treatment of gain or loss from certain terminations (sec. 507 of the Act and new sec. 1234A of the Code)
Prior Law

The definition of capital gains and losses in section 1222 requires that there be a "sale or exchange" of a capital asset. Court decisions prior to the Act interpreted this requirement to mean that when a disposition is not a sale or exchange of a capital asset, for example, a lapse, cancellation, or abandonment, the disposition produces ordinary income or loss.1 This interpretation applied even to dispositions which were economically equivalent to a sale or exchange of a capital asset.
1See The Comm'r. 260 F. 2d 489 (9th Cir., 1952), and Comm'r Pittsion Co., 252 F. 2d 344(2d Cir.), cert. denied, 357 U.S 919 (1958)
Reasons for Change

The Congress believed that the change in the sale or exchange rule was necessary to prevent tax-avoidance transactions designed to create fully deductible ordinary losses on certain dispositions of capital assets, which if sold at a gain, would have produced capital gains. These transactions already have caused significant losses to the Treasury.

Some taxpayers and tax shelter promoters attempted to exploit court decisions holding that ordinary income or loss results from certain dispositions of property whose sale or exchange would produce capital gain or loss. These decisions rely on the definition of capital gains and losses in section 1222, which requires that there be a sale or exchange of a capital asset.

As a result of these interpretations, losses from the termination, cancellation, lapse, abandonment and other dispositions of property which were not considered sales or exchanges of the property, were reported as fully deductible ordinary losses instead of as capital losses, whose deductibility was restricted. However, if such property increased in value, the taxpayer sold or exchanged it so that capital gains were reported as long-term gains when the holding period requirements were met.

Some of the more common of these tax-oriented ordinary loss and capital gain transactions involved cancellations of forward contracts for foreign currency or for securities.

The Congress considered this ordinary loss treatment inappropriate if the transaction, such as settlement of a contract to deliver a capital asset, was economically equivalent to a sale or exchange of the contract. For example, a taxpayer might have simultaneously entered into a contract to buy German marks for future delivery and a contract to sell German marks for future delivery with very little risk. If the price of German marks thereafter declined, the taxpayer sold his contract to sell marks to a bank or other institu-
314

tion for a gain equivalent to the excess of the contract price over the lower market price and canceled his obligation to buy marks by payment of an amount in settlement of his obligation to the other party to the contract. The taxpayer treated the sale proceeds as capital gain but treated the amount paid to terminate his obligation to buy as an ordinary loss.
Explanation of Provision

In order to insure that gains and losses from transactions economically equivalent to the sale or exchange of a capital asset obtain similar treatment, the Act adds a new section 1234A to the Code providing that gains or losses attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property shall be treated as gains or losses from the sale of a capital asset. Property subject to this rule is any personal property (other than stock) of a type which is actively traded (sec. 1092(d)(1)) and which is, or would be on acquisition, a capital asset in the hands of the taxpayer.
Effective Date

The provision applies to property acquired and positions established by taxpayers after June 23, 1981.
Worksheet 6
Technical Corrections Act of 1982, P.L. 97-448
Excerpts from Legislative History
House Report to Accompany H.R. 6056
H.R. Rep. No. 794, 97th Cong., 2d Sess. (1982)
(1)
TECHNICAL CORRECTIONS ACT OF 1982
SEPTEMBER 8, 1982.--Committed to the Committee of the Whole House on the State of the Union and ordered to be printed
Mr. ROSTENKOWKSI, from the Committee on Ways and Means, submitted the following
REPORT
[To accompany H.R. 6056]
[Including cost estimate of the Congressional Budget Office]

The Committee on Ways and Means, to whom was referred the bill (H.R. 6056) to make technical corrections relating to the Economic Recovery Tax Act of 1981, the Crude Oil Windfall Profit Tax Act of 1980, and the Installment Sales Revision Act of 1980, having considered the same, reports favorably thereon with amendments and recommend that the bill as amended do pass.

The amendments are shown in the reported bill, with the matter proposed to be stricken in line type and the matter proposed to be inserted-shown in italic type.
I. SUMMARY

In general, the bill contains technical, clerical, conforming, and clarifying amendments to provisions enacted by the Economic Recovery Tax Act of 1981 and certain other 1980 tax legislation. These amendments were developed as a result of a review of the application of the tax law changes made by the tax legislation, taking into account comments submitted to the committee from the Treasury Department, the Internal Revenue Service, the staff, tax practitioners, and others from the public. In addition to written statements submitted to the committee, the committee received public testimony on April 27, 1982, on H.R. 6056 as introduced. The committee approved several amendments on May 11, 1982, as a result of the testimony and comments received.

* * *
(22)
E. Amendments Relating to Tax Straddle Provisions
1. Postponement of recognition of certain straddle losses (sec. 105(a) of the bill and sec. 1092 of the Code)
Present law

ERTA requires the deferral of losses from positions constituting part of a straddle where there are unrealized gains on offsetting positions (sec. 1092(a)(1). Unrealized gains on offsetting positions are defined as gains which would be taken into account if the positions were sold on the last day of the taxable year at their fair market value (sec. 1092(a)(3)(A)). Under tax accounting rules, gains from sales of property by a taxpayer on the cash method of accounting are not taken into account until the sale proceeds are actually or constructively received. In the case of year-end sales, consummation of the sales contract and receipt of the sales proceeds may not take place until the following year. Losses, however, are generally taken into account for tax purposes on the date the sales contract is executed. Prior to ERTA, these tax accounting rules permitted losses to be taken into account in one year and offsetting gains to be deferred into the following year in some cases. ERTA was intended to preclude this possibility.
Explanation of provision

The bill clarifies that the loss deferral rules of section 1092 will apply where there is unrecognized gain on offsetting positions, whether or not the gain is realized.

The bill deletes certain language of sections 1092(a)(1)(A) and 1092(d)(4) as redundant.
Effective date

The provision generally applies to property acquired after June 23, 1981.
2. Regulated futures contracts (sec. 105(b) of the bill and sec. 1256 of the Code)
Present law

In general.--ERTA adopted the marked to market system of domestic exchanges to determine the tax consequences of holding regulated futures contracts (sec. 1256). Gains and losses reflected in such contracts held by the taxpayer at the close of his or her taxable year and which constitute capital assets are treated as short-term gain or loss to the extent of 40 percent of gains and losses and as long-term gain or loss to the extent of 60 percent of gains and losses. Section 1256(c) requires gains and losses to be taken into account at other relevant dates during the taxable year, such as the date a contract is closed by making or taking delivery under a regulated futures contract.

Holding period.--Section 1223(8) includes the period a commodity futures contract was held in determining the holding period of a commodity acquired by performance of the contract. Prior to ERTA, taking delivery under a futures contract was not a taxable event.
23

Mixed straddles.--Mixed straddles are straddles composed in part of regulated futures contracts and in part of other positions. Taxpayers may elect, under section 1256(d), to exclude the regulated futures contracts forming part of such straddles from the treatment provided by section 1256. Each position forming part of such a straddle must be identified as being part of such straddle before the close of the day on which it is acquired. If the regulated futures contract is acquired and identified before other positions included in such a straddle, failure to identify the subsequently acquired positions results in a failure to satisfy the definition of a mixed straddle in section 1256(d)(4).

Cash settlement contracts.--Regulated futures contracts the tax treatment of which is governed by section 1256 are defined to include only contracts that require the delivery of personal property (as defined in sec. 1092(d)(1)). Since the enactment of ERTA, the Commodity Futures Trading Commission has authorized trading in several market-to-market future contracts that call for cash settlement only and do not require the delivery of personal property.

Foreign currency contracts.--Trading in foreign currency for future delivery is conducted through regulated futures contracts, and is also conducted through contracts negotiated with any one of a number of commercial banks which comprise an informal market for such trading (bank forward contracts). Bank forward contracts differ from regulated futures contracts in that they are private contracts in which the parties remain entitled to performance from each other. They further differ from regulated futures contracts in that they do not call for daily variation margin to reflect market changes, and in that the interbank market has no mechanism for settlement terminating a taxpayer's position prior to the delivery date. Prior to ERTA, taxpayers who used both the futures exchanges and the interbank market to conduct short-term trading in foreign currency were subject to substantially comparable tax treatment for both types of contract. Although bank forward contracts differ from regulated futures contracts, the volume of trading through forward contracts in foreign currency in the interbank market is substantially greater than foreign currency trading on futures exchanges, and prices are readily available. Such contracts are economically comparable to regulated futures contracts in the same currencies and are used interchangeably with regulated futures contracts by traders.

Syndicates.--Hedging transactions are excepted from the marked to market treatment of section 1256(a), as well as the rules of section 1092 and section 263(g). Certain syndicates, losses from which flow to limited partners or limited entrepreneurs, are excluded from the hedging exception (sec. 1256(e)(3)). The Treasury is authorized to determine that certain interests will not be treated as limited interests under these rules where it determines that an interest is held by an individual actively participating in management and where neither such interest nor the entity are used for tax-avoidance purposes. It is not clear whether this authority may be exercised through the promulgation of regulations or must be exercised on a case-by-case basis.
Explanation of provisions

Under the bill, the termination rules of section 1256(c) are amended in two respects. The bill requires that gains and losses be taken into
24

account when a taxpayer's rights in a regulated futures contract are transferred by the taxpayer.4 The bill also requires, if a straddle includes two or more regulated futures contracts, that all the contracts will be treated as terminated on the date the taxpayer takes delivery under any of such contracts. Thus section 1256(a) will apply when transfers of regulated futures contracts are made to and from partnerships and other flow-through entities, and to all regulated futures contracts constituting part or all of a straddle when the taxpayer takes delivery under any of such contracts.
4This rule does not apply to the transfer of contracts of third party taxpayers between commission merchants.

The bill clarifies that the holding period rule of section 1223(8) will be inapplicable to commodities acquired through satisfaction of a regulated futures contract to which section 1256 applies.

The bill amends section 1256(d)(4) defining mixed straddles to require identification of all positions constituting such straddle not later than the close of the day on which the first regulated futures contract forming part of the straddle is acquired. This amendment clarifies that an election as to whether section 1256 will apply to a regulated futures contract included in a mixed straddle may not be deferred beyond the date that contract is acquired. For this purpose, when a short regulated futures contract is treated as terminated on the date the taxpayer takes delivery under a long regulated futures contract (under the straddle amendment to section 1256(c)), the short position will be treated as a new regulated futures contract acquired on that date.

The bill deletes the provision that a contract must require the delivery of personal property to be considered a regulated futures contract. Cash settlement contracts otherwise satisfying the definition of a regulated futures contract will be subject to the rules of section 1256 under the bill.

The bill treats certain foreign currency contracts as regulated futures contracts. Foreign currency contracts mean contracts traded through the interbank market that involve currencies which are also traded through regulated futures contracts. The Secretary of the Treasury is authorized to prescribe rules to determine the fair market value of any such foreign currency contract. For this purpose, any terms in a contract which preclude the determination of a readily ascertainable valuation may be disregarded.

Finally, the bill provides expressly that the Treasury may prescribe regulations to determine that interests will not be treated as held by limited partners or limited entrepreneurs in applying the syndicate rule.
Effective date

The provision generally applies to property acquired after June 23, 1981. However, the amendment relating to bank forward contracts in certain foreign currencies applies to contracts entered into after May 11, 1982.
3. Clerical amendment to straddle provisions

a. Code section 6653(g) is redesignated as section 6653(f).

b. A reference in code section 1092(c)(2) to subsection (a)(2)(B) is corrected.

c. Section 509(b)(3) of ERTA is clarified.
Senate Report to Accompany H.R. 6056
S. Rep. No. 592, 97th Cong., 2d Sess. (1982)
TECHNICAL CORRECTIONS ACT OF 1982
SEPTEMBER 27 (legislative day, September 8), 1982.--Ordered to be printed
Mr. Dole, from the Committee on Finance, submitted the following
REPORT
[To accompany H.R. 6056]

The Committee on Finance, to which was referred the bill (H.R. 6056) to make technical corrections related to the Economic Recovery Tax Act of 1981, the Crude Oil Windfall Profit Tax Act of 1980, and the Installment Sales Revision Act of 1980, having considered the same, reports favorably thereon with amendments and recommends that the bill as amended do pass.

The amendments are shown in the reported bill, with the matter proposed to be stricken in linetype and the matter proposed to be inserted shown in italic type.
I. SUMMARY

In general, the bill contains technical, clerical, conforming, and clarifying amendments to provisions enacted by the Economic Recovery Tax Act of 1981 and certain other tax legislation. These amendments were developed as a result of a review of the application of the statutory changes made by such legislation, taking into account comments submitted to the committee from the Treasury Department, the Internal Revenue Service, the staff, and tax practitioners, and others from the public. The committee approved several amendments on September 24, 1982, as a result of the comments received.
25
E. Amendments Relating to Tax Straddle Provisions
1. Postponement of recognition of certain straddle losses (sec. 105(a) of the bill and sec. 1092 of the Code)
Present law

ERTA requires the deferral of losses from positions constituting part of a straddle where there are unrealized gains on offsetting positions (sec. 1092(a)(1)). Unrealized gains on offsetting positions are defined as gains which would be taken into account if the positions were sold on the last day of the taxable year at their fair market value (sec. 1092(a)(3)(A)). Under tax accounting rules, gains from sales of property by a taxpayer on the cash method of accounting are not taken into account until the sale proceeds are actually or constructively received. In the case of year-end sales, consummation of the sales contract and receipt of the sales proceeds may not take place until the following year. Losses, however, are generally taken into account for tax purposes on the date the sales contract is executed. Prior to ERTA, these tax accounting rules permitted losses to be taken into account in one year and offsetting gains to be deferred into the following year in some cases. ERTA was intended to preclude this possibility.
Explanation of provision

The bill clarifies that the loss deferral rules of section 1092 will apply where there is unrecognized gain on offsetting positions, whether or not the gain is realized.

The bill deletes certain language of sections 1092(a)(1)(A) and 1092(d)(4) as redundant.
Effective date

The provision generally applies to property acquired after June 23, 1981.
2. Regulated futures contracts (sec. 105(c) of the bill and sec. 1256 of the Code)
Present law

In general.--ERTA adopted the market system of doing domestic exchanges to determine the tax consequences of holding regulated futures contracts (sec. 1256). Gains and losses reflected in such contracts held by the taxpayer at the close of his or her taxable year and which constitute capital assets are treated as short-term gain or loss to the extent of 40 percent of gains and losses and as long-term gain or loss to the extent of 60 percent of gains and losses. Section 1256(c) requires gains and losses to be taken into account at other relevant dates during the taxable year, such as the date a contract is closed by making or taking delivery under a regulated futures contract.

Holding period.--Section 1223(8) includes the period a commodity futures contract was held in determining the holding period of a commodity acquired by performance of the contact. Prior to ERTA, taking delivery under a futures contract was not a taxable event.
26

Mixed straddles.--Mixed straddles are straddles composed in part of regulated futures contracts and in part of other positions. Taxpayers may elect, under section 1256(d), to exclude the regulated futures contracts forming part of such straddles from the treatment provided by section 1256. Each position forming part of such a straddle must be identified as being part of such straddle before the close of the day on which it is acquired. If the regulated futures contract is acquired and identified before other positions included in such a straddle, failure to identify the subsequently acquired positions results in a failure to satisfy the definition of a mixed straddle in section 1256(d)(4).

Cash settlement contracts.--Regulated futures contracts the tax treatment of which is governed by section 1256 are defined to include only contracts that require the delivery of personal property (as defined in sec. 1092(d)(1). Since the enactment of ERTA, the Commodity Futures Trading Commission has authorized trading in several market-to-market future contracts that call for cash settlement only and do not require the delivery of personal property.

Foreign currency contracts.--Trading in foreign currency for future delivery is conducted through regulated futures contracts, and is also conducted through contracts negotiated with any one of a number of commercial banks which comprise an informal market for such trading (bank forward contracts). Bank forward contracts differ from regulated futures contracts in that they are private contracts in which the parties remain entitled to performance form each other. They further differ from regulated futures contracts in that they do not call for daily variation margin to reflect market changes, and in that the interbank market has no mechanism for settlement terminating a taxpayer's position prior to the delivery date. Prior to ERTA, taxpayers who used both the futures exchanges and the interbank market to conduct short-term trading in foreign currency were subject to substantially comparable tax treatment for both types of contract. Although bank forward contracts differ from regulated futures contracts, the volume of trading through forward contracts in foreign currency in the interbank market is substantially greater than foreign currency trading on futures exchanges, and prices are readily available. Such contracts are economically comparable to regulated futures contracts in the same currencies and are used interchangeably with regulated futures contracts by traders.

Syndicates.--Hedging transactions are excepted from the market to market treatment of section 1256(a), as well as the rules of section 1092 and section 263(g). Certain syndicates, losses from which flow to limited partners or limited entrepreneurs, are excluded from the hedging exception (sec. 1256(e)(3)). The Treasury is authorized to determine that certain interests will not be treated as limited interests under these rules where it determines that an interest is held by an individual actively participating in management and where neither such interest nor the entity are used for tax-avoidance purposes. It is not clear whether this authority may be exercised through the promulgation of regulations or must be exercised on a case-by-case basis.
27
Explanation of provisions

Under the bill, the termination rules of section 1256(c) are amended in two respects. The bill requires that gains and losses be taken into account when a taxpayer's rights in a regulated futures contract are transferred by the taxpayer.4 The bill also requires, if a straddle includes two or more regulated futures contracts, that all the contracts will be treated as terminated on the date the taxpayer takes delivery under any of such contracts. Thus section 1256(a) will apply when transfers of regulated futures contracts are made to and from partnerships and other flow-through entities, and to all regulated futures contracts constituting part or all of a straddle when the taxpayer takes delivery under any of such contracts.
4This rule does not apply to the transfer of contracts of third party taxpayers between commission merchants.

The bill clarifies that the holding period rule of section 1223(8) will be inapplicable to commodities acquired through satisfaction of a regulated futures contract to which section 1256 applies.

The bill amends section 1256(d)(4) defining mixed straddles to require identification of all positions constituting such straddle not later than the close of the day on which the first regulated futures contract forming part of the straddle is acquired. This amendment clarifies that an election as to whether section 1256 will apply to a regulated futures contract included in a mixed straddle may not be deferred beyond the date that contract is acquired. For this purpose, when a short regulated futures contract is treated as terminated on the date the taxpayer taxes delivery under a long regulated futures contact (under the straddle amendment of section 1256(c)), the short position will be treated as a new regulated futures contract acquired on that date.

The bill modifies the provision that a contract must require the delivery of personal property to be considered a regulated futures contract. Cash settlement contracts which require the delivery of an amount of cash determined by reference to the value of any property or index based on that value will meet the delivery of personal property requirement. Thus such a contract which otherwise satisfies the definition of a regulated futures contract will be subject to the rules of section 1256 under the bill.

The bill treats certain foreign currency contracts as regulated futures contracts. Foreign currency contracts mean contracts traded through the interbank market that involve currencies which are also traded through regulated futures contracts. The Secretary of the Treasury is authorized to prescribe rules to determine the fair market value of any such foreign currency contract. For this purpose, any terms in a contract which preclude the determination of a readily ascertainable valuation may be disregarded.

Finally, the bill provides expressly that the Treasury may prescribe regulations to determine that interests will not be treated as held by limited partners or limited entrepreneurs in applying the syndicate rule.
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Effective date

The provision generally applies to property acquired after June 23, 1981.

The amendment relating to bank forward contracts in certain foreign currencies applies to contracts entered into after May 11, 1982. The taxpayer may elect (within 90 days of enactment of the bill) to have that amendment apply to property held during 1981 and thereafter as though sections 508 and 509 (other than secs. 509(a)(3) and (4)) of ERTA applied with respect to such amendment. Alternatively, the taxpayer may elect to have such amendment apply to positions held on May 11, 1982 for taxable years ending after such date. The special deferred payment provisions of ERTA will not apply to these contracts. The House bill did not contain this election.
3. Capitalization of certain interest and carrying charges (sec. 105(b) of the bill and sec. 263(g) of the Code)
Present law

ERTA required taxpayers to capitalize certain otherwise deductible expenditures for personal property if the property is held as part or all of an offsetting position belonging to a straddle. Interest on indebtedness incurred or continued to purchase or carry such property was required to be capitalized.
Explanation of provision

Under the provision, charges for the temporary use of personal property borrowed in connection with a short sale must be capitalized to the same extent that interest must be capitalized.

The House bill did not contain this provision.
Effective date

The provision is effective for property acquired, and positions established, by the taxpayer after September 22, 1982.
4. Prompt identification by dealers in securities (sec. 105(d) of the bill and sec. 1236 of the Code)
Present law

ERTA required a dealer in securities to identify a security as held for investment, and thus eligible for capital gain treatment, not later than the close of business on the day of the security's acquisition.
Explanation of provision

Under the provision, any security acquired by a dealer in connection with the exercise of an option may be treated as held for investment only if the dealer, before the close of the day on which the option was acquired, clearly identified the option on his records as held for investment.

The House bill did not contain this provision.
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Effective date

The provision applies to securities acquired after September 22, 1982.
5. Clerical amendments to straddle provisions

a. Code section 6653(g) is redesignated as section 6653(f)

b. A reference in Code section 1092(c)(2) to subsection (a)(2)(B) is corrected.

c. Section 509(b)(3) of ERTA is clarified.
Conference Report to Accompany H.R. 6056
H.R. Rep. No. 986, 97th Cong., 2d Sess. (1982)
TECHNICAL CORRECTIONS ACT OF 1982
CONFERENCE REPORT
24
10. REGULATED FUTURES CONTRACTS
a. Bank forward contracts

Present law.--Contracts providing for the future delivery of foreign currency may be entered into with certain commercial banks comprising an informal interbank market or as regulated futures contracts which are taxed under the mark-to-market rules. Contracts traded in the interbank market are not assignable without the consent of the bank, and therefore, as in the case of regulated futures contracts, are not includable in inventory.

House bill.--The House bill would place foreign currency contracts traded through the interbank market under the mark-to-market rules applicable to regulated futures contracts. This treatment would apply only to contracts involving those currencies which are also the subject of trading on regulated futures exchanges. The Secretary of the Treasury would be authorized to prescribe rules to determine the value of contracts and to disregard the terms of a contract which preclude the determination of readily ascertainable value. The bill would apply to contracts entered into after May 11, 1982.

Senate amendment.--The Senate amendment is the same as the House bill with modifications to permit certain taxpayer elections. Taxpayers may elect to have the amendment apply to positions held on and after May 11, 1982. In addition, the amendment provides that taxpayers may elect to extend the amendment to positions held in 1981. Taxpayers so electing would have 90 days after the date of enactment of this bill to have certain ERTA elections apply to 1981 positions.

House amendment.--The amendment revises and clarifies the rules applicable in determining whether a position will be treated as a foreign currency contract subject to mark-to market treatment. The amendment provides that these contracts must be entered into at arm's length at a price determined by reference to the price in the interbank market and authorizes the issuance of regulations necessary or appropriate to carry out the purpose of the amendment, including regulations which would exclude from mark-to-market treatment contracts, or types of contracts, which are inconsistent with the purpose of the amendment.

Thus, for example, terms which attempt to make the contracts transferable in such a way to allow them to be held as inventory (which would make them unlike futures contracts) could cause them to be ineligible for mark-to-market treatment.

Contracts traded in the interbank market generally include not only contracts between a commercial bank and another person but also contracts entered into with a futures commission merchant who is a participant in the interbank market. A contract between two persons neither of whom is a futures commission merchant or other similar participant in the interbank market is not a foreign currency contract under the provision. If there is a change in the parties to a foreign currency contract under the relevant non-tax law, the transaction resulting in such change will be treated as a termination of the contract with respect to the original parties and the entering into of a new contract which, in order to be treated as a foreign currency contract subject to mark-to-market treatment, must independently qualify as such under the rules.

It is contemplated that, under the regulatory authority provided in the bill, the Internal Revenue Service may publish periodic rulings or similar statements (i) that provide guidance as to whether a price is determined by reference to the interbank market and (ii) that specify a type of contract or identify specific contracts that are excluded from the definition of foreign currency contract. In general, a price is determined by reference to the price in the interbank market if it is a price that would be obtainable from a bank that is a substantial participant in the interbank market. In making this determination, proper adjustments may be made for differences attributable to variations in the contracts customary in the interbank market, such as provisions relating to reasonable and customary commissions, the amount of currency under the contract, and the credit worthiness of the parties.

Significant price fluctuations may occur rapidly, frequently within a period of several hours, in the commodities markets and similar markets, including the interbank market. Present law provides generally that a dealer in securities must identify a security as held for investment by the close of the day on which it is acquired and a similar identification requirement applies to positions constituting hedges excluded from mark-to-market rules and other limitations on commodities straddles. Identification does not establish a taxpayer's purpose in holding a position but merely provides a statutory condition in addition to satisfying, as a matter of fact, that such position is held for investment, as inventory, or as a hedge. A taxpayer's purpose with respect to a position generally is formed quickly, frequently before the position is acquired. Thus, characterization of a position on a taxpayer's books several hours after the position was acquired may have little or no probative value in supporting the taxpayer's claim that such characterization is the correct one.
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The amendment modifies the 1982 election to permit a taxpayer to apply the amendment to positions held at any time during their 1982 taxable year.

Conference agreement.--The conference agreement generally follows the House bill and the House amendment with a clarifying modification. Under the modification, a taxpayer who held a foreign currency contract during 1981 and before June 24, 1981, who elects to have the amendment apply to foreign currency contracts held in 1981, may make a new election under either section 508(c) or section 509(a) of ERTA. For an electing taxpayer, any election under section 508(c) or 509(a) of ERTA must be applied to all regulated futures contracts, including foreign currency contracts.

Revenue effect.--This provision will reduce fiscal year budget receipts by $18 million in 1983.
b. Cash settlement contracts

Present law.--Regulated futures contracts taxed under the mark-to-market rules are defined to include only contracts that require the delivery of personal property. Since the enactment of ERTA, trading has commenced in a number of mark-to-market futures contracts calling only for cash settlement. Some contracts provide for cash settlement as an alternative to the delivery of personal property.

Settlement or other termination of a contract results in capital gain or loss notwithstanding the absence of a sale or exchange only if the contract is with respect to personal property that would be a capital asset in the hands of the taxpayer.

House bill.--The House bill deletes the provision that a contract must require the delivery of personal property to be treated as a regulated futures contract subject to mark-to-market treatment.

Senate amendment.--The Senate amendment retains the present law definition of a regulated futures contract but provides that cash settlement contracts requiring the delivery of an amount of cash determined by reference to the value of any property or index based on that value will meet the delivery of personal property requirement.

House amendment.--The House amendment retains the original House provision and adds an amendment providing that capital gain or loss will result from termination of a contract which does not require delivery of personal property even though there is no sale or exchange, if the contract itself is a capital asset in the hands of the taxpayer.

Conference agreement.--The conference agreement follows the House bill amendment.
Worksheet 7
Tax Reform Act of 1984, P.L. 98-369
General Explanation of the Tax Reform Act of 1984
(H.R. 4170, 98th Cong.; Public Law 98-369)
[Prepared by the Staff of the Joint Committee on Taxation]
December 31, 1984
(Excerpt)
(301)
H. Provisions Relating to Tax Straddles
(Secs. 101-108 of the Act, and secs. 263, 1091, 1092, 1234, 1234A, 1236, 1256, 1362, 1374, and 1402 of the Code)1
1 For legislative background of the provisions relating to straddles, see: H.R. 4170, committee amendment approved by the House Committee on Ways and Means on March 1, 1984, secs. 101-105; H. Rep. No. 98-432, Pt. 2 (March 5, 1984), pp. 1262-1273; "Deficit Reduction Act of 1984" as approved by the Senate Committee on Finance on March 21, 1984, secs. 75-81; S. Rep. No. 98-169, Vol. II (April 2, 1984), pp. 284-297; H. Rep. No. 98-861 (June 22, 1984), pp. 898-917 (Conference Report); and H. Con. Res. 328, 130 Cong. Rec. S944 (June 29, 1984), H7525 (June 29, 1984).
Prior Law

The Internal Revenue Code as amended by the Economic Recovery Tax Act of 1981, (ERTA) provides specific rules to prevent the use of straddles to defer income or to convert ordinary income and short-term capital gain to long-term capital gain. In general, the deduction of losses from straddle positions involving actively traded personal property (other than stock) is deferred except to the extent such losses exceed unrecognized gains on offsetting positions (sec. 1092). Gains and losses on regulated futures contracts ("RFCs") are reported under a mark-to-market rule that corresponds to the daily cash settlement system employed by U.S. commodity futures exchanges to determine margin requirements (sec. 1256).
Taxation of stock options

The straddle rules, including the loss-deferral rule, did not apply to stock or to domestic exchange-traded stock options under prior law (sec. 1092(d)). An option is considered an open transaction. The party that acquires property upon the exercise of an option to buy (a "call") or an option to sell (a "put") recognizes no gain or loss because the option and its exercise are, together, viewed as a purchase of the property. Both the holder of a call and the grantor of a put treats the premium paid or received as an adjustment to the purchase price of the underlying property. The party that sells the underlying property recognizes gain or loss. The holder of a put or the grantor of a call treats the premium paid or received as a reduction or increase of the amount realized on the sale of the underlying property.

Gain or loss from the sale or exchange of an option by an option holder is considered gain or loss from the sale or exchange of property that has the same character as the property to which the option relates has or would have, in the hands of the holder (sec. 1234(a)). For purposes of applying this rule, if a loss is attributable to failure to exercise an option, the option is deemed to have been sold or exchanged. Thus, if the property to which the option relates would be a capital asset in the hands of the holder, capital gain or
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loss would result. The capital gain or loss would be long-term or short-term depending upon the holding period of the option. These rules apply to options to buy or sell property.

In the case of a grantor of an option, gain or loss from a closing transaction with respect to the option, or the lapse of the option, is treated as short-term gain or loss (sec. 1234(b)). Because the rules of sections 1234(a) and 1234(b) apply to options in property, it was unclear under prior law whether these rules apply to options that settle in (or could be settled in) cash. In addition, it was not clear whether gains and losses from transactions in cash settlement options are accorded capital gain or loss treatment under the rule (sec. 1234A) providing for such treatment on the termination of certain contracts.
Treatment of professional options traders

Historically, gain or loss from transactions in options granted or acquired in the ordinary course of a taxpayer's trade or business of granting options was treated as ordinary income or loss. In cases where a taxpayer grants or acquires options in the course of a trade or business and also holds options in connection with investment activities, the rules prescribed by section 1234 apply to the options granted or acquired as investments. Although, under prior law, the matter was not free from doubt, it appears that taxpayers who "make a market" with respect to a particular option were treated as granting or acquiring options in the course of a trade or business.
The short-sale rule

In the case of a "short sale" (i.e., where the taxpayer sells borrowed property and later closes the sale by buying identical property and returning the same to the lender), any gain or loss on the closing transaction is considered gain or loss from the sale or exchange of a capital asset if the property used to close the short sale is a capital asset in the hands of the taxpayer (sec. 1233(a)). The Code contains several rules designed to eliminate specific devices in which short sales could be used to transform short-term gains into long-term gains. Under these rules, if a taxpayer holds property for less than the long-term holding period and sells short substantially identical property, any gain upon the closing of the short sale is considered short-term gain, and the holding period of the substantially identical property is generally considered to begin on the date of the closing of the short sale (sec. 1233(b)). These rules prevent a taxpayer from "aging" his holding period so as to convert short-term capital gain into long-term capital gain where the taxpayer has materially reduced his risk of loss. Also, if a taxpayer has held property for more than the long-term holding period and sells short substantially identical property, any loss on the closing of the short sale is considered long-term capital loss (sec. 1233(d)). This rule is intended to prevent the conversion of long-term capital loss into short-term capital loss.

For purposes of these rules, property includes stock, securities, and commodity futures (sec. 1233(e)(2)(A)), but commodity futures contracts are not considered substantially identical if they call for delivery of the commodity in different calendar months (sec.
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1233(e)(2)(B)). In addition, these rules do not apply in the case of hedging transactions in commodity futures (sec. 1233(g)).

For purposes of the short-sale rules, the acquisition of a put is treated as a short sale, and the exercise or failure to exercise such an option is considered as a closing of the short sale (sec. 1233(b)).
Application of wash-sale rule

The wash-sale rule disallows certain losses from the disposition of stock or securities where substantially identical stock or securities (or an option to acquire such property) are acquired by the taxpayer during the period beginning 30 days before the date of sale and ending 30 days after such date (sec. 1091). Commodity futures are not treated as stock or securities for purposes of this rule. Rev. Rul. 71-568, 1971-2 C.B. 312. Losses incurred in a trade or business were not disallowed by sec. 1091 under prior law except that, in the case of a corporate taxpayer, losses were disallowed other than those sustained in the ordinary course of business of a dealer in stocks or securities. The basis of the substantially identical stock or securities is adjusted to include the disallowed loss (sec. 1091(d)).
Loss deferral rule

If a taxpayer realizes a loss on the disposition of one or more positions in a straddle, the amount of the loss that can be deducted is limited to the excess of the loss over the unrecognized gain (if any) in offsetting positions. Positions are offsetting if there is a substantial diminution in the risk of loss from holding one position by reason of holding one or more other positions in personal property. Deferred losses are recognized in the first year in which there is no unrecognized gain in offsetting positions.
Exception for identified straddles

The loss-deferral rule does not apply to losses on positions in an identified straddle. To qualify as an identified straddle, all of the positions in the straddle must be acquired on the same day, the straddle must have all its positions closed on the same day or have no positions closed at the end of the taxable year, and the straddle must not be part of a larger straddle. An identified straddle must be clearly marked as such on the taxpayer's records before the close of the day on which it is acquired.

Losses on positions in an identified straddle are treated as sustained not earlier than the day on which the taxpayer disposes of all the positions comprising the straddle.
Hedging exemption

The loss-deferral rule does not apply to hedging transactions. A hedging transaction is a transaction that is executed in the normal course of a trade or business primarily to reduce certain risks, and that results in only ordinary income or loss. To prevent manipulation of the hedging exemption by tax-shelter syndicators, the exemption was made inapplicable to syndicates. A syndicate is defined as any partnership or other entity (other than a corporation that is not an S corporation), if more than 35 percent of the entity's losses during any period are allocable to limited partners or limited
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entrepreneurs. A hedging transaction must be clearly identified before the close of the day the transaction is entered into.
Treatment of mixed straddles

In general, a straddle composed of both RFCs and positions that are not RFCs is subject to the loss deferral rule, and the RFC positions of the straddle are subject to the mark-to-market rule. However, the RFC positions in a mixed straddle are excluded from the mark-to-market rule if the taxpayer designates the positions as a mixed straddle by the close of the day on which the first RFC included in the straddle is acquired. If a designated mixed straddle also qualified as an identified straddle, the mixed straddle is exempt from the loss deferral rule.

Because the RFC positions and the non-RFC positions of a mixed straddle are taxed at different rates (and, possibly, at different times), a mixed straddle presents opportunities to defer tax and to convert long-term capital loss to short-term capital loss or short-term capital gain to long-term capital gain. However, under regulations authorized under prior law mixed straddles are subject to rules similar to the rules relating to short sales (described above), regardless of whether the straddle is designated as a mixed straddle or qualifies as an identified straddle (sec. 1092(b)). The statute contemplates that, under these rules, recognized losses will be recharacterized in appropriate cases.

Uncertainty in determining whether positions are included in or excluded from a particular straddle and the designation requirement applicable to mixed straddles limited the ability, under the regulatory authority of prior law, to develop rules effectively dealing with mixed straddles.
Capitalization of interest and carrying charges

Taxpayers are required to capitalize certain otherwise deductible expenditures for property that is held as part of an offsetting position, and for charges for the temporary use of property borrowed in connection with a short sale constituting part of a straddle (sec. 263(g)). Expenditures subject to this requirement ("carrying charges") are interest on indebtedness incurred or continued to purchase or carry property, as well as amounts paid or incurred for temporary use of the property in a short sale, or for insuring, storing or transporting the property. The amount of carrying charges required to be capitalized is reduced by any interest income from the property (including original issue and acquisition discount), which is includible in gross income for the taxable year. The capitalization requirement does not apply to hedging transactions (as defined above for purposes of the similar exemption from the loss-deferral rule).
Mark-to-market rule

Each RFC held by a taxpayer at year-end is treated as if it were sold for its fair market value on the last business day of the year (sec. 1256(a)(1)). Ordinarily, the settlement price determined by an exchange for its RFCs on the year's last business day is considered to be the RFC's fair market value. Any gain or loss on the RFC is taken into account for the taxable year, together with the gain or 
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loss on other RFCs that were closed out before the end of the year. If a taxpayer holds RFCs at the beginning of a taxable year, any gain or loss subsequently realized on these contracts is adjusted to reflect any gain or loss taken into account with respect to the contracts in a prior year (sec. 1256(a)(2)). The mark-to-market rule is inapplicable to hedging transactions.

Historically, under case law, commodity futures traders have been treated as buying or selling capital assets (unless the taxpayers came within a nonstatutory hedging exemption). By statute, any gain or loss with respect to an RFC that is subject to the mark-to-market rule is treated as if 40 percent of the gain or loss is short-term capital gain or loss, and as if 60 percent is long-term gain or loss. This allocation of capital gain results in a maximum rate of tax of 32 percent for investors other than corporations.
Definition of an RFC

An RFC is a contract that (1) is marked to market under a daily cash settlement system of the type used by U.S. futures exchanges to determine the amount that must be deposited due to losses, or the amount that may be withdrawn in the case of gains, as the result of price changes with respect to the contract during the day, and (2) is traded on or subject to the rules of a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission ("CFTC"), or any board of trade or exchange that Treasury determines to have rules that are adequate to insure compliance with the mark-to-market rules (sec. 1256(b)). Cash settlement futures contracts are included in the definition of an RFC.

Certain foreign currency contracts are treated as RFCs (sec. 1256(g)). For purposes of this rule, a foreign currency contract is defined as a contract that (1) requires delivery of a foreign currency that is also traded through RFCs, (2) is traded in the interbank market, and (3) is entered into at arm's length at a price determined by reference to the price in the interbank market.
Treatment of losses from pre-1981 straddles

Prior to the adoption of rules relating to straddles and marking RFCs to market by ERTA, it was unclear whether a claimed loss was allowable on the disposition of a position in a straddle where offsetting unrecognized gain on another position or positions included in the straddle was deferred. In Rev. Rul. 77-185, 1977-1 C.B. 48, the Internal Revenue Service ruled that a loss claimed on disposing of legs of a silver futures straddle where the straddle was continued was not deductible because there was no closed and completed transaction and the disposition represented no real economic change. Similar arguments were rejected by the Tax Court in Smith v. Commissioner, 78 T.C. 350 (1982), although the loss found to have been incurred in that case was disallowed because, under the facts of the case, it was not incurred in a transaction entered into for profit. The Internal Revenue Service has continued to litigate the allowability of pre-1981 straddle losses in accordance with the position adopted in Rev. Rul. 77-185 and has challenged such losses where claimed by commodity dealers as well as by investors with isolated transactions such as those involved in the Smith case.
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Reasons for Change

Taxpayers have attempted to exploit the exemption from the loss-deferral rule for exchange-traded stock options to defer tax on income from unrelated transactions. If effective, these straddles in stock options defer gains from one year to the next by creating a recognized loss on an option that is matched by an unrecognized gains on an offsetting option. A typical abusive straddle involves the acquisition of "deep-in-the-money" offsetting option positions. (A call is in-the-money to the extent the exercise price (or strike price) is less than the market value of the stock when the option is granted; a put is in-the-money to the extent the strike price exceeds the stock's value.) Regardless of whether the value of the underlying stock increases or decreases, one option position will result in a loss that can be realized for tax purposes, while the other position results in a gain or approximately equal size that can be deferred until the next year. The unrealized gain can be preserved by adopting a new offsetting position to replace the loss position that is disposed of. Although the Internal Revenue Service may be successful in challenging these transactions under rulings and case law, the law in this area applicable to transactions covered by prior law is unclear. The Congress believed that tax-motivated straddling in stock options is just as objectionable as the straddling in other actively trades property that occurred prior to enactment of the loss-deferral rule in ERTA.

One widely used investment strategy involves writing call options on stock owned by the taxpayer. The Congress believed that an exemption from the straddle rules should be provided for these transactions where they are undertaken primarily to enhance the taxpayer's investment return on the stock and not to reduce the taxpayer's risk of loss on the stock.

The Congress was also concerned about the disparity in the tax treatment of options market makers on securities exchanges and professional traders on commodity exchanges. Although the trading activities of these taxpayers are in some respects similar, under the case law, professional commodity traders were traditionally viewed as realizing capital gains or losses on futures transactions. In contrast, it appears that options market makers trading on securities exchanges were treated as realizing ordinary income or loss with respect to their options transactions. Moreover, an options dealer was considered to be a dealer in property subject to the option. As a result of the ordinary income or loss treatment that may have been available to options professionals, tax-shelter syndicates purporting to be market makers attempted to pass through ordinary losses on stock-option straddles to limited partners.

Another area of concern was that taxpayers might take inconsistent positions regarding the application of prior law to new investment products that were not traded when the tax straddle rules were enacted in 1981. For example, the treatment of exchange-traded options that settle only in cash was uncertain. Taxpayers with losses on cash-settlement options might claim ordinary loss treatment, while taxpayers with gains might claim capital gain treatment under the rules of prior law generally applicable to options. The Technical Corrections Act of 1982 revised the definition
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of RFCs to expressly include cash-settlement futures contracts. The Congress concluded that the status of cash-settlement options should be clarified. In addition, options on RFCs ("commodity options") are traded on domestic futures exchanges. Some taxpayers took the position that transactions in commodity options qualified under prior law for the 32-percent maximum rate of tax on gains provided by the statutory mark-to-market rule. (The Treasury Department disputed this interpretation of prior law.) However, taxpayers with losses might claim that, under prior law, they were subject to the general tax rules for options and treat their losses as wholly short-term.

The question of the proper tax treatment of other new investment products raised a broader issue regarding whether competing investment products traded on different exchanges should be taxed under the same tax regime. For example, as noted above, some taxpayers were claiming that options on broad-based stock index futures were subject to the mark-to-market rules while direct options on broad-based indexes were subject to the general tax rules governing options. A related concern was the proliferation of mixed straddles between products that are subject to a 32-percent maximum rate of tax and products that are taxed at a 50-percent maximum rate. The Congress believed that the number of mixed straddles should be limited where possible.

The Congress determined that the regulatory authority granted to Treasury under prior law to prescribe rules for mixed straddles was not sufficient to insure the promulgation of rules that are effective.

The wash sale rule of prior law did not preclude the allowability of losses from short sales of stock in certain cases where the taxpayer closes a short sale and within a brief period before or after the closing, again sells substantially identical stock or sells the stock short.

For example, taxpayers may attempt to defer income by entering into a short sale of stock against the box (a short sale is referred to as being "against the box" if the seller holds stock that is identical to the stock sold short). If the value of the stock increases before the short sale is closed, the seller would acquire additional stock at the higher current price in order to close the short sale, generating a short-term capital loss. In this case, the rule that a short sale is deemed consummated on the date it is closed (Treasury reg. sec. 1.1233-1(a)(1)) would make the closing date the relevant date for applying the 61 day wash sale rule. The taxpayer could attempt to defer income by closing the short sale before year-end (offsetting unrelated income with the resulting short-term capital loss), and selling the retained stock after the beginning of the next taxable year. Even if the transactions occurred within a 30-day period, the prior law wash-sale rule would not apply if the stock held by the taxpayer was not acquired within the 30-day period preceding the close of the short sale. Thus, the taxpayer could take the position that the short-term capital loss is deductible, even though there is no economic loss (because the loss would be offset by an equal amount of unrealized gain in the stock). Alternatively, the taxpayer could replace the closed short position by entering into a new
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short sale after the beginning of the next taxable year, in order to claim a tax loss, essentially without terminating his position.

The Congress concluded that a more liberal exemption from the wash sale rule for individual investors who sustained securities losses in connection with a trade or business than that applicable to corporate taxpayers was not appropriate.

The hedging exemption, the mixed straddle election, and the identified straddle rule are subject to a requirement that the taxpayer identify the position or positions before the close of the day on which it is acquired. A similar identification requirement applies to securities dealers seeking capital asset treatment with respect to their securities holdings. The identified straddle rule also requires the identification to be made on the taxpayer's records. Because of the volatility of price movement in some positions, the "end of the day" identification requirement may not operate to preclude taxpayers from claiming beneficial treatment with respect to built-in losses or built-in gains resulting from price movement during the day, contrary to the purpose of such requirement.

The Congress concluded that it was inappropriate to prolong the uncertainty and attendant litigation as to claimed losses from straddle positions for periods prior to 1981.
Explanation of Provisions
1. Overview

The Act repeals the blanket exceptions from the straddle rules for exchange-traded stock options and certain other interest in stock. More limited exceptions are provided. In addition, the mark-to-market rule and the 32-percent maximum rate of tax are extended to certain exchange-traded options held by investors and to all listed options held by options market makers. Commodity options are also made subject to the mark-to-market rule and accorded the 32-percent maximum rate of tax. Positions subject to mark-to-market are renamed "section 1256 contracts".
2. Repeal of exception for certain stock and stock options
Exchange-traded stock options

In general, the straddle rules, including the loss deferral rule, are extended under the Act to straddles involving exchange-traded stock options. An exception is provided for a straddle the positions of which consist of stock and a qualified covered call option.
Stock

The Act extends the straddle rules to stock offset by an option with respect to such stock or substantially identical stock or securities, to stock of a corporation formed or availed of to take positions in personal property that offset positions held by any shareholder, and to stock that is part of a straddle one of the offsetting positions of which, under regulations, is a position with respect to substantially similar or related property (other than stock). All members of an affiliated group, as defined in section 1504(a), are to be treated as one taxpayer for purposes of applying the hedging exemption
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when a corporation is formed or availed of to take offsetting positions.

Application of the straddle rules to actively traded stock and exchange-traded stock options applies to positions established after December 31, 1983. However, the Congress intends that the regulations defining positions that are substantially similar or related to stock held by the taxpayer will apply to straddles described in the following paragraph only for positions established on or after March 1, 1984, and for positions not described in the following paragraph only on a prospective basis.

A straddle consisting of stock and substantially similar or related property includes offsetting positions consisting of stock and a convertible debenture of the same corporation where the price movements of the two positions are related. It also includes a short position in a stock index RFC (or alternatively an option on such an RFC or an option on the stock index) and stock in an investment company whose principal holdings mimic the performance of the stocks included in the stock index (or alternatively a portfolio of stocks whose performance mimics the performance of the stocks included in the index). Identical results will be applicable under the provision reducing the holding period of stock held by a corporation for purposes of the dividend received deduction where the taxpayer has diminished its risk of loss by holding another position in substantially similar or related property. However, stock offset by another position (other than an option) in substantially similar or related stock, which may result in a reduction in a corporate taxpayer's holding period for purposes of the dividend received deduction, does not constitute a straddle.
Qualified covered call options

A covered call option is one that is written with respect to stock that is held by the taxpayer (or acquired by the taxpayer in connection with the granting of the option). The granting of a covered call option does not substantially reduce a taxpayer's risk of loss with respect to the underlying stock unless the option is deep-in-the-money. The Act contemplates that taxpayers can continue to write at-the-money and non-deep-in-the-money covered calls, without running afoul of the straddle rules.

In general, a qualified covered call option is an exchange-traded option (1) the gain or loss with respect to which is not ordinary income or loss, (2) the term of which is more than 30 days, (3) which is not deep-in-the-money and (4) which is not granted by an options dealer in the ordinary course of his options writing activity. The term "deep-in-the-money option" is defined as an option that has a strike price lower than the lowest qualified benchmark. Generally, the "lowest qualified benchmark" is the highest available strike price that is less than the "applicable stock price" (defined below). In the case of an option with a term of more than 90 days and a strike price exceeding $50, the lowest qualified benchmark is the second highest available strike price that is less than the applicable stock price.

Exchange rules currently provide for strike prices on options at five-dollar intervals (or "benchmarks") for options on stock trading at prices under $100. For stock trading at prices over $100, there
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are $10 benchmarks. The lowest strike price currently authorized is $10. Thus, for example, with respect to stock trading at $50, an exchange-traded call option with a strike price of $45 or more would qualify for the exception.

The above rules are subject to the following limitations. First, if the applicable stock price is $25 or less, the lowest qualified benchmark is limited to 85 percent of the applicable stock price. Second, if the applicable stock price is $150 or less, the lowest qualified benchmark otherwise determined is limited to the amount which is $10 below the applicable stock price.

The term "applicable stock price" is generally defined as the closing price of the optioned stock on the most recent day on which such stock was traded before the date on which the option was granted. However, if the opening price of the optioned stock on the day the option is granted is greater than 100 percent of the closing price on the last previous trading date, then the opening price of the stock is treated as the applicable stock price.

In general, a qualified covered call option must be written on a national securities exchange registered with the Securities and Exchange Commission ("SEC"). The Secretary may designate other exchanges or markets qualifying for this treatment if the exchange or market has rules adequate to carry out the purposes of the exception to the straddle rules for qualified covered calls. The Act contemplates that, as a condition of designating and exchange or market, the Secretary could require that trades on the exchange or market be subject to information reporting under section 6045 (relating to reports by brokers).

The Secretary is granted broad regulatory authority to modify the provisions of the Act (e.g., to take account of changes in the practices of options exchanges or to prevent tax avoidance). The Congress contemplates that the Secretary will prescribe rules for the determination of the applicable strike price if the options exchanges modify their benchmarks.

For purposes of the loss deferral rule, but not for purposes of the limitations on interest and carrying costs (sec. 263(g)) and the short sale and wash sale rules in section 1092, a covered call option will not be treated as qualified if gain from the disposition of the stock to be purchased under such option is included in gross income in a taxable year subsequent to the year in which the option is closed and the stock is not held for more than 30 days following the date on which the option is closed. In determining whether this holding period requirement is satisfied, rules similar to those applicable in determining whether a taxpayer is eligible for the dividend received deduction under section 246(c)(3) and (4) will apply. Under those rules, the replacement of the terminated call position by the granting of a new qualified covered call will not cause a suspension of the 30-day holding period.

Under the Act, any loss realized from a qualified covered call option granted by the taxpayer which has a strike price below the applicable stock price will be long-term capital loss if gain from a sale or exchange of the stock at the time such loss is realized would be long-term. In addition, the holding period for the stock subject to such option will not include any period during which the taxpayer is the grantor of the option. It is anticipated that stock option 
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losses and the holding period of stock will also be subject under regulations to section 1233(b) and (d) principles as applied to straddles consisting of stock and stock options. However, straddles consisting of stock and qualified covered call options to which the straddle rules are inapplicable will be affected only by the statutory rules under discussion. The tolling of the holding period of stock while the taxpayer is the grantor of a covered call option does not apply for purposes of section 851(b)(3), limiting the portion of the income of a regulated investment company that may be derived from the disposition of stocks and securities held for less than 3 months. No inference is intended that the lack of a specific statutory exclusion requires the application of section 1233 principles in applying section 851(b)(3).
3. Identified straddle rule

The Act extends the identified straddle rules of section 1092(a)(2) to straddles consisting entirely of section 1256 contracts. Thus, such a straddle which satisfies the definition of an identified straddle under section 1092 as amended by the Act will not cause section 263(g) or section 1092(a) to apply to any position by treatment of part or all of such straddle as also including positions not part of the identified straddle.
4. Transitional rule for hedging exemption

The identification requirement applicable to the hedging exemption does not apply to transactions in stock or stock options until September 16, 1984 (60 days after the date of enactment).
5. Extension of mark-to-market rule

The Act extends the mark-to-market rule (including the 60/40 treatment that results in a 32-percent maximum tax rate) to nonequity listed options and dealers' equity options. Rules are provided to prevent limited partners (or entrepreneurs) of an options dealer from recognizing gain or loss from equity options as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss.
Definition of listed option contract

The Act defines a listed option as any option (other than a right to acquire stock from the issuer) that is traded on (or subject to the rules of) a qualified board of trade or exchange. A qualified board or exchange is a national securities exchange registered with the SEC, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market, that the Secretary determines has rules adequate to carry out the purposes of the relevant statutory provisions. The Act contemplates that, as a condition of designating an exchange, board or trade, or other market, the Secretary may require information reporting consistent with the rules of section 6045 (relating to returns of brokers).

Several stock index options are currently traded for which there has been no designation by the CFTC for futures trading in the same index. These options held by investors are not subject to
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mark-to-market and 60/40 treatment until the Secretary of the Treasury determines that they meet the requirements of law for such a CFTC designation. The Congress expects such designations will have prospective effect only. Thus, the Congress urges the Treasury Department to take prompt action to determine the status of these options. The Act provides for the extension of mark-to-market and 60/40 treatment, as well as the covered call exception, to options traded on a market other than a board of trade or exchange if the Secretary of the Treasury determines that such market has rules adequate to carry out the purposes of the provisions governing the treatment of section 1256 contracts. The Secretary is also to determine whether persons trading in such market qualify as options dealers.
Equity listed options

An equity option is defined to mean any option to buy or sell stock, and any other option the value of which is determined by reference to an index of stock of the type that is ineligible to be traded on a commodity futures exchange (e.g., an option contract on a sub-index based on the price of nine hotel-casino stocks). The definition of equity option excludes options on broad-based stock indexes (such as the Standard & Poor's 500 index) and options on stock index futures; thus, these options fall within the definition of nonequity options (discussed below). Holders of equity options (other than dealers) remain subject to the general rules for the taxation of options, including the loss-deferral rule.
Nonequity listed options

A nonequity option is defined as any listed option that is not an equity option. Under the Act, any holder of a nonequity option (whether an options dealer or an investor) is treated as if the option were disposed of at year-end for a price equal to its fair market value, and any gain or loss is taxed as if it were 60-percent long-term and 40-percent short-term (just as the holders of RFCs are treated). All options on RFCs are, by definition, nonequity options under the bill.
6. Treatment of dealer options

The Act changes the claimed present-law treatment of options market makers and codifies present law with respect to professional commodity traders bare treated as buying and selling capital assets, except to the extent that an option or future is acquired to hedge property or obligations that would generate ordinary loss to the taxpayer (including property to be acquired or obligations to be incurred, to the extent the same result was obtained under prior law). An options dealer is defined as any person who is registered with an appropriate national securities exchange as a market maker or specialist in listed options. Under the Act, an options dealer will not recognize ordinary income or loss with respect to his stock and securities transactions, unless the taxpayer is a dealer in stock and securities under general Federal income tax rules (determined without regard to whether options in such property produce ordinary
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income or loss). Further, it is intended that the capital gain or loss status of options traded in the normal course of an option dealer's activity in trading options is to be determined without regard to the identification requirement of section 1236.

In addition to nonequity options, which are marked-to-market in the hands of all holders, equity options held by options dealers are also subject to the mark-to-market rule and 60/40 treatment. To prevent dealers from passing through 60/40 treatment of equity options to limited investors, the Act provides that 60/40 treatment does not apply to gain or loss on dealer equity options that is allocable to limited partners or limited entrepreneurs (regardless of the percentage of such gain or loss that is so allocated). Instead such gain or loss is treated as short-term capital gain or loss.
7. Treatment of gains and losses of options and commodities dealers as earned income and for certain subchapter S purposes

Under the Act, gains and losses derived in the ordinary course of trading in section 1256 contracts and property related to such contracts (e.g., stock used to hedge options) are defined as earnings from self-employment for purposes of applying the tax on self-employment income and the rules relating to contributions to self-employment plans. This treatment is extended only to options dealers, and commodity dealers, as defined in the Act. A commodity dealer is any person registered with a domestic board of trade designated as a contract market by the CFTC who buys or sells options or RFCs subject to the rules of such board. This treatment applies to taxable years beginning after the date of enactment except that for options dealers electing 60/40 and mark-to-market rules for the taxable year which includes the date of enactment, it applies for such taxable year. Commodity dealers may also elect such treatment for the taxable year which includes the date of enactment. No inference is intended as to whether options dealers and commodity dealers are to be viewed as engaged in a trade or business in connection with their transactions in section 1256 contracts as a result of the application of self-employment taxes to such persons.

A tax is imposed on corporations making a subchapter S election in certain cases where net capital gain exceeds 50 percent of the corporation's taxable income. Further, when an election is made by a corporation which has subchapter C earnings and profits, it may be taxable on a portion of its passive investment income and, in certain cases, the election may be terminated. To facilitate subchapter S elections by options and commodities dealers, the Act excepts gains and losses with respect to section 1256 contracts and related property derived in the normal course of an options or commodities dealer's transactions in options or commodities from net capital gain subject to to tax under section 1374 and from passive investment income as defined in section 1362(d)(3).

The Act provides that an election to be an S corporation made by a commodities dealer or options dealer within 75 days after the date of enactment of the Act (October 1, 1984) will be effective for the taxable year which includes the date of enactment, without regard to the requirement in section 1362(b) requiring the election to be made by the 15th day of the third month of the year. The Act
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provides that when this election is made, the taxpayer will be treated as having adopted a taxable year beginning on the first day during 1984 that it is a small business corporation as defined in section 1361(b) and ending on the date determined under section 1378. The Act also permits its extension of 60/40 and mark-to-market treatment to be applied at the taxpayer's election to positions held during the full taxable year which includes the date of enactment (sec. 102(g)(2)), and to pay any resulting increase in tax in 2 to 5 annual installment (sec. 102(h)). The S election, if it were interpreted to preclude the application of the full year election and installment payment of tax for any portion of the taxable year including the date of enactment (as determined without regard to the S election) would make those relief provisions unavailable to gains that qualify for such relief but for the S election.

It is intended that the elections under section 102(g)(2) and sec. 102(h) of the Act will apply to the taxable year determined without regard to the S election and will apply to a short taxable year ending before the date of enactment when such short year is created as a result of the S election, whether or not the electing corporation is a C corporation or an S corporation for such short year. It is also intended that an S election made pursuant to the Act will apply (for the taxable year including the date of enactment as determined without regard to the election) commencing with the beginning of such year or, if later, the first day of the period which includes the date of enactment for which the corporation has been continuously a small business corporation, and ending with the date prescribed pursuant to section 1378. It is intended that such S taxable year may include a taxable year commencing in 1983 as well as one that terminates before the date of enactment as a result of the application of section 1378. The Treasury Department has adopted temporary regulations construing the S election as well as the section 102(g)(2) and section 102(h) elections to provide such rules, reg. sec. 18.1362-1(c) (49 Fed. Reg. 38920, October 1, 1984). It is intended that a technical correction will clarify and confirm that the S election produces these results.
8. Hedging exemption

In general, the hedging exemption under prior law remains available. However, the Act limits the ability of limited partners and limited entrepreneurs to deduct losses from hedging transactions against unrelated income where the hedging exemption is claimed.

Under the Act, an options dealer who is a dealer in the underlying property is treated the same as a commodity trade who is a dealer in the cash commodity. Thus, neither the loss-deferral rule nor the mark-to-market rule applies to an option or an RFC that is identified as a hedging transaction where gain or loss on both the option or the RFC and the underlying property would be ordinary income or loss (as determined under the Act).

For limited partners and limited entrepreneurs the Act limits the deductibility of any loss on a hedging transaction to the taxable income (determined without regard to such loss) derived from the conduct of the trade or business to which the hedging transaction
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relates. Taxable income as so determined is to be separately computed for partners and S corporation shareholders with such limited interests. The Congress intends that this rule be applied broadly so that, for example, a hedging loss sustained by a securities firm in its municipal bond operations may be deducted against profits from its other securities operations. However, limited partners may not deduct such loses against, for example, their dividend income. This provision is intended to prevent the passthrough of ordinary losses to limited investors from hedging transactions engaged in by traders who qualify as dealers in the underlying property.

The limitations on the deductibility of hedging losses allocable to limited partners and limited entrepreneurs apply to the following taxpayers: (1) any taxpayer who enters into a hedging transaction relating to stock or securities, (2) any individual, and (3) any corporation if at any time during the last half of the taxable year more than 50 percent in value of its outstanding stock is owned by five or fewer individuals. The term "hedging loss" is generally defined as the excess of (1) the allowable deductions for the taxable year attributable to hedging transactions (determined without regard to the rule limiting hedging losses), over (2) income received or accrued by the taxpayer during such taxable year from such transactions. However, an exception to the limitation on losses is provided for cases in which an overall economic loss occurs. The Act provides that the limitations do not apply to a hedging loss to the extent that the hedging loss for the year exceeds the aggregate unrecognized gains from hedging transactions (including gains from hedged property) as of the close of the taxable year. Hedging gains for this purpose include only those relating to the same trade or business in which the hedging losses were incurred. The "aggregate unrecognized gain" is defined as that term is used for purposes of the straddle rules: (1) the amount of gain that would be taken into account with respect to property if such property were sold on the last business day of such taxable year at fair market value, plus (2) in the case of any position with respect to which, as of the close of the taxable year, gain has been realized but not recognized, the amount of gain so realized.
9. Cash-settlement options

For cash-settlement options that are not subject to the market-to-market rule (e.g., narrow-based options on sub-indexes of stock), the Act amends section 1234 to clarify that gain or loss on the sale, exchange, lapse, or exercise of the option is capital gain or loss with respect to grantors or holders. For purposes of the Act, a cash-settlement option is defined as any option which on exercise settles in (or could be settled in) cash or property other than the underlying property. As under prior law, the receipt of cash on exercise of a cash-settlement option is a taxable event.
10. Options on section 1256 contracts

The Act provides that gain or loss is recognized on the exercise of an option on a section 1256 contract. Under this provision, if an option on a section 1256 contract is excluded from mark-to-market and 60/40 treatment as a result of a mixed straddle election, the
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treatment of gain or loss resulting from exercise of the option will be determined under the rules of section 1234(a) and (b). Under these rules, options holders will have long-term or short-term gain or loss, depending on their holding period for the option and grantors will have short-term gain or loss.
11. Capitalization of interest and carrying costs

Interest and carrying costs of a straddle position that are required to be capitalized are reduced, under the Act, by dividends on stock included in a straddle. The reduction is limited to the portion of the dividend included in income after allowance of the dividends received deduction. The Act also provides for additional reductions with respect to market discount and acquisition discount included in income under sections 1276 and 1281 as added by the Act. New section 263(h) added by the Act, which disallows the deduction of short sale expenses in certain cases, section 1277 added by the Act, which requires the deferral of net direct interest on indebtedness with respect to market discount bonds, and section 1282 as added by the Act, which requires the deferral of interest on indebtedness with respect to short-term obligations, are to be applied before the application of the rule requiring the capitalization of costs with respect to straddle positions.
12. Technical amendment clarifying the treatment of market discount on residential mortgage securities

Section 1234A provides that gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property is treated as capital gain or loss. Property subject to this rule is any personal property of a type that is actively traded and that is (or would be on acquisition) a capital asset in the hands of the taxpayer.

Section 1234A was enacted in 1981 to prevent certain straddles abuses,2 and was not intended to change the long-standing tax treatment of market discount on residential mortgage investments and other obligations of natural persons as ordinary income. See section 1271(b). The amendment (sec. 102(e)(9) of the Act) merely clarifies that the same result is obtained when the holder's interest is an indirect one, such as a security in a fixed investment trust investing in residential mortgage.
2 See, for example, the description of a transaction involving offsetting positions in foreign currency. S. Rep. No. 97-144 (July 6, 1981), p. 171.
13. Mixed straddle regulations

The Act extends the regulatory authority, with respect to mixed straddles, to include as a mixed straddle positions not described as such in present law section 1256(d)(4). In addition the regulatory authority is extended to provide rules governing the capitalization of interest and carrying costs with respect to straddle positions (sec. 263(g)).

In addition, the Act prescribes that the regulations will provide rules that will apply in lieu of the application of section 1233(d)
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principles to mixed straddles if the taxpayer so elects. Under these rules, a taxpayer may either (1) offset gains and losses from positions which are part of mixed straddles by separately identifying each mixed straddle to which such treatment applies or (2) establish a mixed straddle account with respect to a class of activities for which gains and losses will be recognized and offset on a periodic basis. These two new elections will be in addition to the mixed straddle election of present law. Under either of the new alternatives, 60/40 treatment will apply only to net gain or loss from the straddle transactions and only to the extent attributable to section 1256 contracts. Under the rules applicable to a mixed straddle account, not more than 50 percent of any net gain may be treated as long-term capital gain and not more than 40 percent of any net loss may be treated as short-term capital loss.

It is intended that regulations adopting the principles of section 1233(d), authorized under prior law for straddles, will result in recharacterizing short-term losses realized from mixed straddle positions not subject to section 1256 as 60/40 losses in the case of mixed straddles that are not either identified or subject to the account described in the preceding paragraph. A mixed straddle may also produce 60/40 losses on the section 1256 contracts and short-term gain on the other positions included in the mixed straddle, effectively converting long-term gain realized from transactions unrelated to the straddle to short-term. Taxpayer can avoid this result by making a mixed straddle election foregoing marking-to-market and 60/40 treatment for their section 1256 contracts including in a mixed straddle.

The regulations prescribed by the Act will permit taxpayers to avoid the loss recharacterization rule that results from applying section 1233(d) principles while retaining favorable treatment for mixed straddle net gains derived from section 1256 contracts.
Straddle-by-straddle identification

It is intended that, in applying the regulations to separately identified mixed straddles, the determination by the taxpayer of what constitutes a mixed straddle generally will be accepted by the Internal Revenue Service if the taxpayer has adopted a reasonable and consistently applied method of identifying straddle positions which clearly reflects income in the absence of circumstances indicating that the taxpayer has not properly identified straddles pursuant to such method.

The present law election to exclude section 1256 contracts from 60/40 and mark-to-market treatment may be exercised only if all positions included in a mixed straddle are identified not later than the day on which the first section 1256 contract so included in acquired. It is intended that the offset for gains and losses from mixed straddles under the regulations may apply in cases where the taxpayer holds either section 1256 contracts or other positions before a mixed straddle is established. In such cases it is intended that the regulations will require the pre-straddle gains and losses accrued at the time the mixed straddle is created to be recognized at such time. Such gain or loss from positions not subject to sec. 1256 will be short-term or long-term, depending on the taxpayer's holding period when the mixed straddle is created, and gain or loss
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from pre-existing section 1256 contracts will receive 60/40 treatment. In all such cases, appropriate basis adjustments will be made to exclude such pre-existing gains and losses from the mixed straddle offsetting rules.

If a mixed straddle is terminated without disposing of all positions, it is contemplated that the regulations will require recharacterization of gains and losses from some closed positions. Such recharacterization will involve recharacterizing 60/40 gains and losses as short-term rather than vice versa. For example, if the taxpayer closes a section 1256 contract at a loss of $10 which is offset by an unrealized gain of $10 on an offsetting position not subject to section 1256, the loss will be recharacterized as short-term and will be deferred under section 1092 to the extent there continues to be unrecognized gain on the offsetting position at year-end. Under the offsetting position rules, if the loss on the section 1256 contract in this example were $12, the additional $2 that is not offset by unrealized gain would receive 60/40 treatment and would be recognized, assuming it is not offset by unrecognized gain in the offsetting position at year-end. Similarly, if the taxpayer realized at $12 gain on closing a section 1256 contract offset by an unrealized $10 loss on an open offsetting position not subject to section 1256, the rule would recharacterize $10 of such gain as short-term, which would be recognized currently since section 1092 does not defer gains. The remaining gain of $2 would also be recognized and receive 60/40 treatment. The taxpayer could avoid tax on the $10 gain converted to short-term by closing out the offsetting position at a $10 loss before year-end.

If a mixed straddle is terminated by closing out positions other than the section 1256 contracts, it is contemplated that the gain or loss will be offset by the loss or gain with respect to the section 1256 contracts as of the time such positions are closed and any net gain or loss attributable to the positions other than section 1256 contracts will be short-term. Losses from closing positions other than section 1256 contracts generally will not be deferred by sec. 1092 but instead will be netted against any offsetting gain on the section 1256 contracts included in the mixed straddle to the extent of such gain at the time the loss position is terminated. Adjustments to subsequent gain or loss with respect to section 1256 contracts included in a mixed straddle and retained following its termination will be made as under section 1256(a)(2) to reflect the portion of such gain or loss absorbed under the offsetting position rules. For example, if the taxpayer closes a position other than a section 1256 contract at a $12 gain and, on the date of disposition, there is a $10 loss determined by marking-to-market the offsetting section 1256 contract, the taxpayer will have a $2 short-term gain. If the taxpayer retains the section 1256 contract at year-end and it is marked-to-market at the same price that resulted in the offsetting $10 loss, no further gain or loss is recognized.

The holding period of positions other than section 1256 contracts included in a mixed straddle will not commence until the mixed straddle is terminated. In this regard, all post-straddle period gain or loss, as to amount and treatment as short-term or long term, is to be determined without regard to gain and loss attributable to the straddle period.
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For mixed straddles with respect to which both section 1256 contracts and offsetting positions remain open at year-end, gain and loss attributable to positions that are not section 1256 contracts are not recognized currently. However, gains on section 1256 contracts are recognized under section 1256 and, to the extent offset by unrecognized losses on positions that are not section 1256 contracts, will be recharacterized as short-term gains under the regulations. Similarly, year-end losses on open section 1256 contracts, to the extent offset by unrecognized gains on positions that are not section 1256 contracts, will be recharacterized as short-term losses and will be deferred under section 1092.
Mixed straddle account election

The mixed straddle account rules will accommodate taxpayers who with respect to a class of trading activities, have such a large volume of transactions that identification of specific mixed straddles is impractical. The account rules will accommodate, for example, market makers in options on XYZ company stock who also have long and short non-option positions in XYZ company stock in substantial volume. If the taxpayer is also a market maker in options on ABC company stock, it is intended that a second account be established with respect to such options and the underlying stock. It is intended that the Treasury have considerable flexibility in determining the nature of those accounts, and in specifying the classes of activities for which separate accounts must be established.

All gains and losses on positions in the account are to be determined and offset on a periodic basis which may be a daily or less frequent basis. Those positions not closed during the period are to be marked-to-market as of the close of the period and adjusted (as to both options and non-option position) in the manner described in sec. 1256(a)(2) in order to avoid duplicating gain or loss on positions carried into the subsequent period. In determining how frequently positions in the account are to be marked-to-market and gains and losses are to be netted, the Secretary is to take account of recordkeeping and other administrative burdens that would be imposed on taxpayers.

Gains and losses from positions that are not section 1256 contracts are to be netted for the period and gains and losses from section 1256 contracts for the period are separately netted. The gain or loss from the positions that are not section 1256 contracts are then offset against the loss or gain from the section 1256 contracts. Overall net gain or loss for the period attributable to positions not subject to section 1256 constitutes short-term gain or loss. Overall not gain or loss for the period attributable to section 1256 contracts constitutes 60/40 gain or loss. The account net short-term gain or loss and the account net long-term gain or loss for the taxable year is to be determined by netting the aggregate gains and losses for the separate periods as so determined before any account gains or losses are applied against losses and gains from non-account sources. If, as a result of applying these rules, over 50 percent in the aggregate of the account net gain for the taxable year is long-term, the excess over 50 percent will be converted to short-term gain. Similarly, if over 40 percent in the aggregate of the account
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net loss for the taxable year is short-term, the excess over 40 percent will be recharacterized as long-term loss.

For example, assume that A, a market maker in stock options, has elected to adopt an account with respect to his market-making activities in XYZ corporation stock and (for illustrative purposes only) that mark-to-market accounting is required as of the close of each quarter so that the taxable year consists of four periods for which separate netting of section 1256 contracts (in this case, options) and non-section 1256 contracts (in this case, stock) is required with respect to A's positions in XYZ corporation stock. For the first quarter. A's gains from stock positions exceed losses by $5,000, and option losses exceed option gains by $6,000. The second quarter activity results in a net stock loss of $7,000 and net option gain of $8,000; the third quarter results in net stock gain of $1,000 and net option gain of $2,000; and the fourth quarter results in net stock loss of $2,000 and net option gain of $7,000. The taxable year result is tabulated as follows: 
                                                                        Net for period 
  Period                    Stock      Option        Net       Treat-     Long    Short
                        positions   positions                    ment     term     term
  1........                $5,000    ($6,000)   ($1,000)        60/40   ($600)   ($400)
  2........              ($7,000)      $8,000     $1,000        60/40      600      400
  3........                $1,000      $2,000     $3,000    (1)$1,000                  
                                                            (2)$2,000    1,200    1,800
  4........              ($2,000)      $7,000     $5,000        60/40   $3,000    2,000
  Cumulative result                                                     $4,200   $3,800
  for all periods                                                                      
  Limitation (only 50                                                   $4,000   $4,000
  percent of account                                                                   
  net gain may be                                                                      
  long-term)                                                                           

(1)1
1Short term.

(2)2
260/40.

If, in the above example, the results for periods 1 and 2 were the same but for period three, there was an excess of option net gain
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over net loss from stock positions of $1,000 and for the fourth period there was an excess of stock net loss over option net gain of $5,000, the result would be $600 of net long-term gain and $400 of net short-term gain for period three and a net short-term loss of $5,000 for period four. The cumulative result (periods one and two in the aggregate resulting in no net gain or loss) would be a $600 net long-term capital gain and a $4,600 net short-term capital loss. Without regard to characterization the account results in a net loss of $4,000 for the taxable year, only 40 percent of which may be characterized as short-term. As a result, only $1,600 of A's losses from the account may be treated as short-term in applying such losses against gains derived from transactions outside the account.

Gains and losses with respect to positions entering the account that have accrued as of the date the account is established will be recognized at that time and treated as long-term or short-term depending on the taxpayer's holding period as of that date, or as 60/40 gain or loss for section 1256 contracts. Appropriate basis adjustments will be made to reflect such gains and losses. Similar rules will apply where positions are transferred to and from the account

It is intended that, under the regulatory rules prescribed by the Act the Treasury will have broad authority to place positions held by the taxpayer in the account and to exclude positions from the account, and otherwise to prescribe standards with respect to the account to insure that income is clearly reflected, and the purpose of the mixed straddle rules is carried out.
Effective date of regulations

The Act precludes application of the regulations under section 1092(b) applying sec. 1233 principles to mixed straddles established prior to January 1, 1984. The Act requires that the initial regulations under section 1092(b) (including regulations relating to mixed straddles) are to be prescribed within 6 months after the date of enactment (i.e., by January 18, 1985). It is intended that the regulations providing for netting of identified mixed straddles and for a mixed straddle account will apply to any taxable year, if the taxpayer elects, to the extent that the amendments applicable to section 1256 contracts under the Act apply for such taxable year under the effective date provisions of section 102(f) and (g) of the Act.
14. Wash sale rules to apply to losses on certain short sales and other transactions

The Act extends the wash sale rule to a loss realized on the closing of a short sale if, within 30 days before or after such closing, the taxpayer sells, or enters into another short sale of, substantially identical stock or securities.

Under prior law, the wash sale rule did not apply, in the case of taxpayers other than corporations, if the loss was incurred in a trade or business while, in the case of a corporation, it was inapplicable only if the taxpayer was a dealer in stocks or securities and the loss was sustained in a transaction made in the ordinary course of such business. Thus, the wash sale rule did not apply to noncorporate taxpayers who were in a trade or business of trading in
322

stocks or securities. Under the Act, the wash sale rule is inapplicable only if the taxpayer is a dealer in stocks or securities and the loss is sustained in a transaction made in the ordinary course of the taxpayer's business of dealing in stocks and securities. Thus, the exemption applicable to noncorporate traders has been terminated.
15. Time for identification by taxpayers of certain transactions

The Treasury is authorized under the Act to impose earlier identification deadlines under certain provisions requiring identification of a position by the close of the day on which the position is acquired. This requirement is to be imposed by regulation and applies to the hedging exemption, the mixed straddle selection, identified straddles, and, in the case of securities dealers, the identification of securities held for investment. It is contemplated that any additional identification requirements for the hedging exemption that may be imposed under the regulations will be consistent with the intended application of the identification rule for the hedging exemption expressed in the report of the Senate Finance Committee in 1981 as follows:

Taxpayers, such as banks or securities dealers, who may conduct thousands of hedging transactions to hedge property held or to be held in their accounts, may identify such accounts as hedged accounts without marking individual items as hedges or hedged property, provided such accounts deal only if ordinary income (or loss) items. S. Rept. No. 144, 97th Cong., 1st Sess. 151 (1981).

Treasury would have the authority to require earlier identification only for particular classes of taxpayers, like tax shelters, or to exempt particular classes of taxpayers, like bona fide government securities dealers.
16. Treatment of losses from pre-1981 straddles

The Act provides that a loss on the disposition of a position entered into before 1982 will be allowed, except to the extent nonrecognition its required under any applicable provision, if the position is part of a transaction entered into for profit. This treatment applies where the position is part of a straddle as defined in section 1092 as in effect on the day after the date of enactment of ERTA (as well as a straddle consisting entirely of RFCs), and is one to which the provisions of Title V of ERTA did not apply. The loss generally will be allowed for the taxable year in which the position is disposed of. Rules affecting the period within which the loss is recognized, and its treatment as long-term or short-term, other than section 1233 or section 1234, are to be applied without regard to the fact that the position is part of a straddle.

In determining whether a position is part of a transaction entered into for profit, it is intended that the provision be applied by treating the condition as satisfied if there is a reasonable prospect of any profit from the transaction.

In the case of commodity dealers and persons actively engaged in investing in RFCs, the provision is to be applied by presuming that
323

the position is held as part of a transaction entered into for profit unless the Internal Revenue Service establishes to the contrary. The presumption does not apply to a syndicate, as defined in section 1256(e)(3)(B). In determining whether a taxpayer is actively engaged in trading in RFCs with an intent to make a profit, a significant factor will be the extent of transaction costs. If they are sufficiently high relatively to the scope of the taxpayer's activities that there is no reasonable possibility of a profit, the presumption will be unavailable. RFCs for purposes of applying the presumption are regulated futures contracts as defined in section 1256(b) before its amendment by the Act.

For purposes of the provision, the term "commodities dealer" has the same meaning as such term in the amendments by the Act providing for application of the self-employment income tax to such persons.
Effective Dates
General rules

In general, the provision repealing the exempt ion from the straddle rules for stock options and certain stock applies to positions established after December 31, 1983. The identification requirement under the hedging exemption will not apply with respect to stock and stock options acquired or entered into within 60 days after the date of enactment. However, the application of the straddle rules to offsetting position stock is effective for positions established on or after May 23, 1983. The rule characterizing certain qualified covered call losses as long-term and suspending the holding period of stock for the period the taxpayer is the grantor of such options applies to positions established after June 30, 1984. The extension of the identified straddle rule to straddles consisting entirely of section 1256 contracts applies to positions established after the date of enactment.

The provisions extending the mark-to-market rule to nonequity options and dealer equity options generally apply to positions established after the date of enactment. However, with respect to commodity options, the amendments made by the bill apply to positions established after October 31, 1983.

The provisions clarifying the treatment of cash-settlement options and requiring recognition of gain or loss on exercise of commodity options apply to options purchased or acquired after October 31, 1983. The amendments to the hedging exemption apply to taxable years beginning after December 31, 1984. The amendments relating to the time for identification of certain transactions apply to items identified after the date of enactment.

The application of the wash sale rules to certain short sales applies in the case of short sales entered into after the date of enactment. The limitation of the exemption from the wash sale rule to losses sustained in the ordinary course of the taxpayer's business as a dealer in stocks or securities applies to sales after December 31, 1984.
324
Elections

The mark-to-market rules may be applied to nonequity options and dealer equity options on or before the general effective dates under either of two elections provided by the Act.

Positions held on the date of enactment.--Taxpayers can elect to apply the mark-to-market rule to nonequity options or dealer options that they held on the date of enactment. The election must cover all such positions held by the taxpayer on the date of enactment.

Positions held on or before the date of enactment.--In lieu of the election described above, taxpayers can elect to apply the mark-to-market rule to all positions held by the taxpayer during the taxable year that includes the date of enactment (the "transition year"). If the taxpayer makes this full-year election, all nonequity listed options and dealer equity options held at any time during the transition year must be marked-to-market.

With respect to stock options and stock that is ordinary income or loss property (to the extent offset by such options), any tax liability for the transition year which is attributable to appreciation in such options and such stock can be paid in two to five equal annual installments. This election applies with respect to gain from stock and options which would be ordinary income if the stock and options were disposed of by the taxpayer on the last day of the taxable year preceding the taxable year which includes the date of enactment. Interest is charged on any unpaid installments of tax that are still outstanding after the due date for the first installment.
Revenue Effect

The provisions relating to straddles are estimated to increase fiscal year budget receipts by $22 million in 1984, $427 million in 1985, $152 million in 1986, $70 million in 1987, $58 million in 1988, and $45 million in 1989.
Worksheet 8
Tax Reform Act of 1986, P.L. 99-514
Explanation of Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation
(Title XVIII of H.R. 3838, 99th Congress; Public Law 99-514)
[Prepared by the Staff of the Joint Committee on Taxation]
May 13,1987
(Excerpt)
(3)
TITLE XVIII OF THE TAX REFORM ACT OF 1986: TECHNICAL CORRECTIONS PROVISIONS1
1 For legislative background of these provisions, see H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, title XV; H. Rep. 99-426, pp. 877-1065; H.R 3838, as reported by the Senate Committee on Finance on May 29, 1986, title XVII; S. Rep. 99-313, pp. 893-1114; and H. Rep. 99-8411, Vol. II (September 18, 1986), pp. 841-860 (Conference Report).
I. TECHNICAL CORRECTIONS TO THE TAX REFORM ACT OF 1984

* * *
42
8. Tax Straddle Provisions
a. Treatment of Subchapter S corporations (sec. 1808(a) of the Act)
Prior Law

The 1984 Act extended the mark-to-market and sixty percent long-term, forty percent short-term capital gain and loss treatment
43

applicable to commodities dealers to dealers in exchange-traded options, provided elections to adopt this treatment for positions carried forward from earlier taxable years into the taxable year including the date of enactment and to pay any increase in tax liability resulting from this election over 5 years, and permitted qualified incorporated commodities dealers and options dealers to elect S corporation status without regard to the requirement of prior law that the election be made by the 15th day of the third month of the taxable year for which it is effective,
Explanation of Provision

The Act makes clarifying amendments to ensure that S corporation taxable year limitations do not affect the elections relating to adoption of mark-to-market treatment for positions carried forward from earlier years, and to properly coordinate those elections with the S corporation election with respect to taxable years commencing before January 1, 1984 in the manner provided by regulation.14
14 See Treas. Reg. sec. 18.1362-1, 49 Fed. Reg. 38920 (October 1. 1984).
b. Treatment of amounts received for loaning securities (sec. 1808(b) of the Act and sec. 263(g) of the Code)
Prior Law

The prior law requirement that interest and other carrying costs incurred to carry personal property constituting part of a straddle must be capitalized, as amended by the 1984 Act, limits the requirement to the excess of these costs over interest, discount income and dividend income with respect to the property that is subject to tax during the taxable year. A lender of securities to be used in a short sale may receive compensation from the borrower to replace interest, dividends, and other compensating amounts with respect to the loaned property and may also incur interest and other carrying costs with respect to the property that are subject to the capitalization requirement.
Explanation of Provision

The Act provides for the inclusion of compensating payments to a lender of securities used in a short sale in those taxable amounts that reduce interest and other costs required to be capitalized under section 263(g) of the Code.
c. Clarification of the exception for straddles consisting of stock (sec. 1808(c) of the Act and sec. 1092(d) of the Code)
Prior Law

The 1984 Act extended the straddle rules to straddles involving exchange-traded stock options. Exceptions were provided for a straddle consisting of stocks, or stock and a qualified cover call.
44
Explanation of Provision

The Act clarifies that the exception for stock does not operate to except straddles involving exchange traded stock options (other than qualified covered calls that offset stock).
d. Treatment of losses from pre-1981 straddles (sec. 1808(d) of the Act and sec. 108 of the 1984 Act)
Prior Law

Unlike taxpayers who conducted isolated straddle transactions prior to the effective date of ERTA solely for tax purposes, taxpayers in the trade or business of trading commodities conducted numerous straddle transactions in the normal course of their business. Section 108 was intended to clarify the treatment of losses claimed with respect to straddle positions entered into and disposed of prior to 1982 by taxpayers in the trade or business of trading commodities. It provided a profit-motive presumption in section 108(b) for such taxpayers because of the inherent difficulty in distinguishing tax-motivated straddle transactions from profit-motivated straddle transactions when the taxpayer was in the trade or business of trading in commodities.
Explanation of Provision

The Act makes clear that subsection (b) treatment is limited to those taxpayers in the business of trading commodities. The determination of whether a taxpayer is in the business of trading commodities is based upon all the relevant facts and circumstances. Under the statute as clarified by the technical correction, generally a taxpayer engaged in the business of investment banking who regularly trades in commodities as part of that business would be considered in the trade or business of trading commodities. If a person qualifies as a commodities dealer, the subsection (b) treatment applies with respect to any position disposed of by such person. It would, for example, apply without regard to whether the position was in a commodity regularly traded by that person, whether it was traded on an exchange on which the dealer was a member, or whether an identical position was reestablished on the same trading day or subsequently. If an individual owns a seat on a commodities exchange, such individual will be treated as a "commodities dealer." Further, if a trading firm also regularly trades commodities in connection with its business, then the commodities trading will be deemed to be part of its trade or business. The latter rule applies only to the securities trading firm itself; it does not apply to separate individual trading of its partners, principals, or employees, nor to partnerships or other organizations formed for the principal purpose of marketing tax straddles.

The Act also clarifies that subsection (b) treatment is available not only with respect to a loss incurred directly by a commodities dealer, but also to a loss allocable to a commodities dealer in determining such person's income with respect to an, interest in a partnership, S corporation, or trust. For example, in determining the tax liability of a commodities dealer who was a shareholder in an S corporation, a loss incurred by the corporation in the trading of
45

commodities would be treated as a loss incurred by the commodities dealer. Of course, whether an individual is a commodities dealer is no way indicated merely because such individual has an interest in a partnership, S corporation or trust engaged in the trading of commodities.

In the case of trades on a domestic exchange described in Code section 1402(i)(2)(B), the identification of positions disposed of shall be as provided in exchange procedures, and records of the exchange or clearinghouse shall be controlling in the absence of proof that rules were violated. A taxpayer who does not satisfy the indicia of trade or business status, such as the taxpayer in Miller v. Commissioner (84 T.C. No. 55 (1985)), would not be considered in the trade or business of trading commodities. Further, the presumption would not be available in any cases where the trades were fictitious, prearranged, or otherwise in violation of the rules of the exchange in which the dealer is a member. The subsection (b) treatment is only for purposes of subsection (a), and no inference should be drawn that a loss is incurred in a trade or business for any other purpose, such as for purposes of section 162, 163(d) or 172.

Section 108 also restated the general rule that losses from the disposition of a position in a straddle are only allowable if such position was part of a transaction entered into for profit. A majority of the United States Tax Court in Miller interpreted section 108 as providing a new, less stringent profit standard for losses incurred with respect to pre-1981 commodity straddles. It was not the intent of Congress in enacting section 108 to change the profit-motive standard of section 165(c)(2) or to enact a new profit motive standard for commodity straddle activities. This technical correction is necessary to end any additional uncertainty created by the Miller case.

Further, the Congress intends that the Internal Revenue Service bring all outstanding pre-ERTA straddle litigation to a speedy resolution, so that the large docket of cases on this issue may be cleared, in a manner consistent with this legislation.
General Explanation of the Tax Reform Act of 1986
(H.R. 3838, 99th Congress; Public Law 99-514)
[Prepared by the Staff of the Joint Committee on Taxation]
May 4, 1987
(Excerpt)
(186)
D. Tax Straddles (Sec. 331 of the Act and Sec. 1092 of the Code)6
6 For legislative background of the provision, see: H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 422; S.Rep. 99-313, pp. 172-173 and H.Rep. 99-841, Vol. II (September 18, 1986), p. 108 (Conference Report).
Prior Law

In general, if a taxpayer realizes a loss on the disposition of one or more positions in a straddle, the amount of the loss that can be deducted is limited to the excess of the loss over the unrecognized gain (if any) in offsetting positions (sec. 1092). An exception to the loss deferral rule applies to a straddle consisting of stock that is offset by a qualified covered call. For purposes of this exception, a call option is not treated as qualified if gain from the disposition of the underlying stock is included in gross income in a taxable year subsequent to the year in which the option is closed, and the stock is not held for more than 30 days following the date on which the option is closed. This rule is intended to prevent taxpayers from using covered call options to defer tax on income from unrelated transactions (by realizing a loss on the option in one year, and deferring realizing any gain on the related stock until the next year.'.
Reasons for Change

Under prior law, the exception to the loss deferral rule for qualified covered call options applies even where the straddle is used to defer tax on income from unrelated transactions. Such deferral may occur where gain from closing the option is included in gross income in a taxable year subsequent to the year in which the stock is disposed of at a loss. The Act amends the definition of a qualified covered call to exclude a covered call option in these circumstances.
Explanation of Provision

Under the Act, the qualified covered call exception to the loss deferral rule is denied to a taxpayer who falls to hold a covered call option for 30 days after the related stock is disposed of at a loss where gain on the option is included in the subsequent year.
Effective Date

The provision applies to positions established after December 31 1986.
Revenue Effect

This provision is estimated to increase fiscal year budget receipts by less than $5 million in each of fiscal years 1987 through 1991.

BIBLIOGRAPHY
OFFICIAL
Statutes:
IRC Sections 263(g), 988, 1091, 1092, 1233, 1234, 1234A, 1236, 1256, 1259, 1402(i).
Legislative History:
H.R. Rep. No. 97-794, 97th Cong., 2d Sess. (1982).
H.R. Rep. No. 99-426, 99th Cong., 1st Sess. (1985).
H.R. Rep. No. 99-841, 99th Cong., 2d Sess. (1986).
Treasury Regulations:
See the regulations promulgated under the above-cited IRC provisions.
Treasury Rulings:
Rev. Proc. 97-43, 1997-39 I.R.B. 12.
Rev. Rul. 56-406, 1956-2 C.B. 523.
Rev. Rul. 56-452, 1956-2 C.B. 525.
Rev. Rul. 60-231, 1961-1 C.B. 402.
Rev. Rul. 61-97, 1961-1 C.B. 394.
Rev. Rul. 62-140, 1962-2 C.B. 181.
Rev. Rul. 62-153, 1962-2 C.B. 186.
Rev. Rul. 63-65, 1963-1 C.B. 142.
Rev. Rul. 65-31, 1965-1 C.B. 365.
Rev. Rul. 67-436, 1967-2 C.B. 266.
Rev. Rul. 70-344, 1970-2 C.B. 50.
Rev. Rul. 70-627, 1970-2 C.B. 59.
Rev. Rul. 71-30, 1971-1 C.B. 226.
Rev. Rul. 71-123, 1971-1 C.B. 227.
Rev. Rul. 71-520, 1971-2 C.B. 311.
Rev. Rul. 71-568, 1971-2 C.B. 312.
Rev. Rul. 72-198, 1972-1 C.B. 223.
Rev. Rul. 72-521, 1972-2 C.B. 178.
Rev. Rul. 73-329, 1973-2 C.B. 302.
Rev. Rul. 73-403, 1973-2 C.B. 308.
Rev. Rul. 74-218, 1974-1 C.B. 202.
Rev. Rul. 75-13, 1975-1 C.B. 67.
Rev. Rul. 77-185, 1977-1 C.B. 48.
Rev. Rul. 78-94, 1978-1 C.B. 58, revoking Rev. Rul. 75-13.
Rev. Rul. 78-182, 1978-1 C.B. 265.
Rev. Rul. 85-72, 1985-1 C.B. 286.
Rev. Rul. 85-87, 1985-1 C.B. 268.
Rev. Rul. 86-7, 1986-1 C.B. 295.
Rev. Rul. 86-8, 1986-1 C.B. 295.
Rev. Rul. 87-124, 1987-2 C.B. 205.
Rev. Rul. 88-31, 1988-1 C.B. 302.
Rev. Rul. 93-76, 1993-2 C.B. 234.
Rev. Rul. 93-84, 1993-2 C.B. 225.
Rev. Rul. 94-63, 1994-2 C.B. 188.
Rev. Rul. 97-3, 1997-2 I.R.B. 5.
Rev. Rul. 97-39, 1997-39 I.R.B. 4.
Notice 87-11, 1987-1 C.B. 423.
Notice 89-21, 1989-8 I.R.B. 23.
Notice 97-37, 1997-27 I.R.B. 8.
Cases:
Alling v. Comr., 102 T.C. 323 (1994).
American Automobile Ass'n v. U.S., 367 U.S. 387 (1961).
Appleby v. Comr., 31 B.T.A. 533 (1934), nonacq., XIV-1 C.B. 23, appeal dism'd (2d Cir. 1935).
Arkansas Best Corp. v. Comr., 83 T.C. 640 (1984), aff'd in part, rev'd in part, 800 F.2d 215 (8th Cir. 1986), aff'd, 108 S.Ct. 971 (1988).
Berry Petroleum Co. v. Comr., 104 T.C. 584 (1995).
Bohrer v. Comr., 945 F.2d 344 (10th Cir. 1991).
Booth Newspapers, Inc. v. U.S., 303 F.2d 916 (Ct. Cl. 1962).
Boswell v. Comr., 91 T.C. 151 (1988).
Brown v. Comr., 85 T.C. 968 (1985).
Campbell Taggart, Inc. v. U.S., 552 F. Supp. 355 (N.D. Tex. 1982), aff'd, 744 F.2d 442 (5th Cir. 1984).
Cenex, Inc. v. U.S., 97-2 USTC Para.50,523 (Fed. Cl. 1997).
Cherin v. Comr., 89 T.C. 986 (1987).
Circle K Corp. v. U.S., 91-2 USTC Para.50,382 (Cl. Ct. 1991).
Concord Instruments Corp. v. Comr., T.C. Memo 1994-248.
Convergent Technologies, Inc. v. Comr., T.C. Memo 1995-320.
Cook v. Comr., 90 T.C. 975 (1988).
Corn Products Refining Co. v. Comr., 350 U.S. 46 (1955).
Covington v. Comr., 120 F.2d 768 (5th Cir. 1941), cert. denied, 315 U.S. 822 (1942).
Cumberland Pub. Serv. Co., U.S. v. 338 U.S. 451 (1950).
DeMartino v. Comr., T.C. Memo 1986-263.
Dial, U.S. v., 757 F.2d 163 (7th Cir. 1985).
Doyle v. Comr., 286 F.2d 654 (7th Cir. 1961).
Enrici v. Comr, 85 T.C. 127 (1985), aff'd per curiam, 813 F.2d 293 (9th Cir. 1987).
Estroff Est. v. Comr., T.C. Memo 1983-666.
Ewing v. Comr., 91 T.C. 396 (1988).
Farmers and Ginners Cotton Oil Co., Comr. v. 120 F.2d 772 (5th Cir. 1941), rev'g 41 B.T.A. 1083.
Federal National Mortgage Assoc. v. Comr., 100 T.C. 541 (1993).
Forseth v. Comr., 85 T.C. 127 (1985), aff'd sub nom., Enrici, 813 F.2d 293 (9th Cir. 1987), aff'd, 845 F.2d 746 (7th Cir. 1988).
Fox v. Comr., 82 T.C. 1001 (1984).
Frank Lyon Co. v. U.S., 435 U.S. 561 (1978).
Freytag v. Comr., 89 T.C. 849 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd, 501 U.S. 868 (1991).
Fried, Helvering v., 299 U.S. 175 (1936).
Furer v. Comr., T.C. Memo 1993-65, aff'd per curiam, 33 F.3d 58 (9th Cir. 1994).
G.M. Trading Corporation v. Comr., 103 T.C. 59 (1994), supplemented by 106 T.C. 257 (1996), rev'd, 121 F.3d 977 (5th Cir. 1997).
Gantner v. Comr., 91 T.C. 713 (1988).
Gardner v. Comr., 92-1 USTC Para.50,079, 954 F.2d 836 (2d Cir. 1992), cert. denied, 60 USLW 3780 (1992).
Glass v. Comr., 87 T.C. 1087 (1986),.
Greene v. U.S., 79 F.3d 1348 (2d Cir. 1996), rev'g 864 F. Supp. 407 (S.D.N.Y. 1994) cert. denied, 117 S.Ct. 582 (1996), on remand, No. 94 CV 0617 (S.D.N.Y. 1997).
Gregory v. Helvering, 293 U.S. 465 (1935).
Groetzinger v. Comr., 107 S.Ct. 980 (1987).
Hall v. Comr., 92 T.C. 3712 (1989).
Hanlin v. Comr., 38 B.T.A. 811 (1938), nonacq., 1939-1 C.B. (Part 1) 55, aff'd, 108 F.2d (3d Cir. 1939).
Hart v. Comr., T.C. Memo 1997-11.
Higgins v. Comr., 312 U.S. 212 (1941).
Hoover Co. v. Comr., 72 T.C. 206 (1979), nonacq., 1980-2 C.B. 2.
Horn v. Comr., 92-2 USTC Para.50,328 (D.C. Cir. 1992).
Israel Est. v. Comr., 108 T.C. 208 (1997).
Julien v. Comr., 82 T.C. 492 (1985).
Katz v. Comr., 90 T.C. 1130 (1988).
King v. Comr., 87 T.C. 1213 (1986).
King v. Comr., 89 T.C. 445 (1987), acq., 1988-2 C.B. 1.
Krumhorn v. Comr., 103 T.C. 29 (1994).
Kurtin v. Comr., 26 T.C. 958 (1956), acq. 1957-1 C.B. 4.
Landreth v. Comr., 50 T.C.M. 728 (1985), aff'd, 845 F.2d 828 (9th Cir. 1988) (withdrawn), aff'd, rev'd, & rem'd, 859 F.2d 643 (9th Cir. 1988).
Lerman v. Comr., 939 F.2d 44 (3d Cir. 1991), cert. denied, 112 S.Ct. 590 (1991).
Levin v. U.S., 597 F.2d 760 (Ct. Cl. 1979).
Liang v. Comr., 23 T.C. 1040 (1955), acq., 1955-1 C.B. 4.
Marcus v. Comr., T.C. Memo 1988-3.
Marrin v. Comr., T.C. Memo 1997-24.
Mayer v. Comr., T.C. Memo 1994-209.
Mayer v. U.S., 94-2 USTC Para.50,509 (Fed. Cl. 1994).
Miller v. Comr., 84 T.C. 827 (1985), rev'd, 836 F.2d 1274 (10th Cir. 1988).
Mitchell v. Comr., T.C. Memo 1990-617, aff'd in unpub. opinion, 992 F.2d 1219 (9th Cir. 1993).
Moller v. U.S., 83-2 USTC Para.9698 (Fed. Cir. 1983).
Mosher v. Comr., T.C. Memo 1987-231.
Murphy v. U.S., 93-1 USTC Para.50,270 (9th Cir. 1993).
Nestle Holdings, Inc. v. Comr., 94 T.C. 803 (1990).
1955 Production Exposition, Inc. v. Comr., 41 T.C. 85, 89-90 (1963).
Norwest Corporation v. Comr., 108 T.C. 265 (1997).
Padgett v. Comr., T.C. Memo 1987-130.
Paoli v. Comr., T.C. Memo 1988-23.
Pike v. U.S., 88 F.3d 54 (1st Cir. 1996), cert. denied, 117 S.Ct. 691 (1997).
Pittston Co. v. Comr., 252 F.2d 344 (2d Cir.), cert. denied, 357 U.S. 919 (1958).
RCA Corp. v. U.S., 664 F.2d 881 (2d Cir. 1981), cert. denied, 457 U.S. 1113 (1983).
Rice's Toyota World, Inc. v. Comr., 81 T.C. 184 (1983), aff'd in part, rev'd in part, and rem'd, 752 F.2d 89 (4th Cir. 1985).
Roberts v. U.S., 90-1 USTC Para.50,196 (N.D. Ill. 1990).
Ruml v. Comr., 83 F.2d 257 (2d Cir. 1936).
Schlude v. Comr., 32 T.C. 1271 (1959), rev'd, 238 F.2d 234 (8th Cir. 1960), vac'd, and rem'd, 367 U.S. 911 (1961), aff'd, 296 F.2d 721 (8th Cir. 1962), aff'd, rev'd, and rem'd, 372 U.S. 128 (1963), on remand, T.C. Memo 1963-307.
Schlumberger Technology Corp. v. U.S., 443 F.2d 1115 (5th Cir. 1971).
Seykota v. Comr., T.C. Memo 1991-234.
Smith v. Comr., 78 T.C. 350 (1982), aff'd without published opinion, 820 F.2d 1220 (4th Cir. 1987).
Spreckler v. Helvering, 315 U.S. 626 (1942).
Starr v. Comr., T.C. Memo 1991-610.
Starr Brothers v. Comr., 204 F.2d 673 (2d Cir. 1953).
State Tax on Foreign-Held Bonds, 82 U.S. (15 Wall.) 300 (1872).
Stein v. Comr., T.C. Memo 1989-489.
Stevens v. Comr., 78 F.2d 713 (2d Cir. 1935).
Stewart Silk Corp. v. Comr., 9 T.C. 174 (1947).
Stokes v. Rothensies, 61 F. Supp. 444 (E.D. Pa. 1945), aff'd, 154 F.2d 1022 (3d Cir. 1946).
Stoller v. Comr., T.C. Memo 1990-659, rev'd, 994 F.2d 855 (D.C. Cir. 1993).
Stoller v. Comr., (D.C. Cir. 1993), aff'g in part and rev'g in part T.C. Memo 1990-659.
Swartz v. Comr., 89-1 USTC Para.9354 (8th Cir. 1989).
Thomas Est. v. Comr., 84 T.C. 412 (1985).
Vickers v. Comr., 80 T.C. 394 (1983), appeal dism'd (6th Cir. 1984).
W.W. Windle Co. v. Comr., 65 T.C. 694 (1976), appeal dism'd, 550 F.2d 43 (1st Cir.), cert. denied, 431 U.S. 966 (1977).
Wehrly v. U.S., 808 F.2d 1311 (9th Cir. 1986).
Yeager Est. v. Comr., T.C. Memo 1988-264, aff'd, rev'd, and rem'd, 89-2 USTC Para.9633 (2d Cir. 1989).
Yosha v. Comr., 861 F.2d 494 (7th Cir. 1988).
UNOFFICIAL
Joint Committee Explanations:
General Explanation of the Economic Recovery Tax Act of 1981.
General Explanation of the Tax Equity and Fiscal Responsibility Act of 1982.
General Explanation of the Tax Reform Act of 1984.
General Explanation of the Tax Reform Act of 1986.
Explanation of Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation.
Books and Pamphlets:
Kolb, "Interest Rate Futures," (Reston Publishing Co., Inc., 1984) at 24-32.
Kramer, "Taxation of Securities, Commodities and Options," John Wiley & Sons (1987) at Section 5.4(c) and (d).
New York State Bar Association, Tax Section Committee on Financial Instruments, Report on Tax Accounting for Notional Principal Contracts.
Practicing Law Institute, Corporate Law and Practice Course Handbook Series: No. 564 Interest Rate and Currency Swaps 1987. No. 603 Interest Rate and Currency Swaps 1988. No. 638 Interest Rate and Currency Swaps 1989.
Walmsley, "The New Financial Instruments," John Wiley & Sons, Inc., 1988.
Periodicals:
Pre-1987
Black and Scholes, "The Pricing of Options and Corporate Liabilities," 81 J. Pol. Econ. 637 (1973).
Black, "Fact and Fantasy in the Use of Options," 31 Fin. Analysts J. 36 (July-Aug. 1975).
Freeman, "Recognition of Gain on Year-end Stock Sales," 30 Tax L. Rev. 197.
1987
Land, "Contingent Payments and the Time Value of Money," 40 Tax Law. 237.
1988
Hariton, "The Taxation of Complex Financial Instruments," 43 Tax L. Rev. 731.
Kleinbard & Greenberg, "Business Hedges After Arkansas Best," 43 Tax L. Rev. 393.
McCawley, "International Aspects of the Original Issue Discount Regulations," 17 Tax Mgmt. Int't J. 231.
Spooner, "Tax Consequences of Trading Foreign Currencies in Spot, Forward, Future and Swap Markets," 2 J. of Bank Tax'n 19.
1989
Cantrell, Hanna and Kurtz, "Notice 89-21 Crashes the Interest Rate Swap Party," 45 Tax Notes 337.
Cragie, "Interest in the Rate Swap: Will Old Colony Die Hard?" 18 Tax Mgmt. Int'l J. 65.
Klein and Donaldson, "Swap and Cap Premiums: Recent Notice Offers Answers, But Raises Questions," 2 J. of Bank Tax'n 11.
Kleinbard, "Beyond Good and Evil Debt (and Debt Hedges): A Cost of Capital Allowance System," 67 TAXES 943.
Muller, "Foreigner Currency Hedging Transactions Under the Section 988 Regulations," 30 Tax Mgmt. Memo 339.
Walter and Balcerzak, "A/S Eksxportfinans 14 1/2 Percent Gold Indexed Notes: Heaven and Hell Bonds," 67 TAXES 680.
Note, "Wash Sales and Stock Options: How Does the `Substantially Identical' Rule Apply?" 42 Tax Law. 1073.
1990
McCawley, "Tax Aspects of Interest and Currency Exchange Rate Hedging Transactions," 31 Tax Mgmt. Memo 19.
1991
Conlon, Connors, and Butch, "Contingent Debt Instruments are `Divided and Conquered' Under the New OID Proposed Regulations," 75 J. Tax'n 46 (July).
Dilworth, Harter, and O'Donnell, "New United States Source Rules for Notional Principal Contract Income," 69 TAXES 343 (June).
Klein, DeCarlo, and Fiest, "Sourcing Rules Applicable to Income from Notional Principal Contracts," 20 Tax Mgmt Int'l J. 388 (July).
1992
Breen et al., "Treatment of Notional Principal Contracts Further Complicated by Proposed Regulations," 76 J. Tax'n 154 (Mar.).
Weinrib, Driscoll, and Connors, "Final and Proposed Regulations Expand Available Foreign Currency Hedging Opportunities," 77 J. Tax'n 110 (Aug.).
1993
Norvell, "Dividends Received Deduction: The Effects of Hedging with In-the-Money Call Options in the Holding Period Requirement of Section 246: Progressive Corp. v. United States," 46 Tax Law. No. 2, 629.
1994
Beer, "The Taxation of Interest Swaps and the Financial Service Charge: Towards a Consistent Approach," 1 Fla. Tax Rev. No. 12, 729.
Carlisle and Swainston, "Commodities and Financial Futures: Defining Indebtedness That is `Directly Attributable' Under Section 246A," 11 J. Tax'n Invest. No. 2, 133.
Cartusciello, "Complying With the Mark-to-Market Rules for Securities Dealers Under RRA `93," 80 J. Tax'n 68 (Feb.).
1995
Calvin, "Mutual Funds: Using a `Call' Option Straddle to Maximize Cash Dividend Yield," 12 J. Tax'n Invest. No. 3, 244.
Willens, "Roadmap Through the Contingent Payment Debt Regulations," 66 Tax Notes 109.
1996
Harter, "Proposed Section 1259: Targeting `Shorts Against the Box' and What Else?" 37 Tax Mgmt. Memo., Spec. Ed. 1996-4: Corp. Tax and Bus. Plan. Rev. S-121.
Solway and Bothamley, "Treasury Centers, Hybrid Instruments, and Foreign Currency Strategies," 70 Tax Notes 883.
1997
Paul, "Constructive Sales Under New Section 1259," 76 Tax Notes 1467.
1998
Ulcickas, "Internal Revenue Code 1259: A Legitimate Foundation for Taxing Short Sales Against the Box or a Mere Makeover?" 39 Wm. & Mary L. Rev. 1355.
1999
Kess, "Investment Companies: Starting and Operating a Hedge Fund: Tax and Business Issues," 16 J. Tax'n Invs. 253.
2000
Carlisle and Lanning, "Commodities and Financial Futures: New Standards for `Hedging Transactions' and New Categories of Ordinary Assets Added to Code," 17 J. Tax'n Invs. 237.
Johnson, "Straddles: Analysis of the Tax Consequences of Holding Offsetting Positions," 17 J. Tax'n Invs. 257.
2001
Fichtenbaum, "Tax Law Changes to Cope with the Advent of Single-Security Futures Contracts," 18 J. Tax'n Invs. 237.
Schizer, "Tax Constraints on Indexed Options," 149 U. Pa. L. Rev. No. 6, 1941.