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Financial Instruments: Special Rules (Portfolio 186)

Product Code: TPOR40
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Financial Instruments: Special Rules, written by David M. Schizer, the Dean and Lucy G. Moses Professor of Law at the Columbia University School of Law, considers the taxation of financial instruments, which is especially challenging because it requires two levels of analysis. First, one must establish the tax treatment of a particular instrument in isolation. Once this threshold inquiry is conducted, a second analysis is needed because special rules apply when one instrument has a specified relationship to another.  There are, however, four special rules that override this usual treatment: the wash sale rules of §1091, the conversion transaction rules of §1258, the constructive sale rules of §1259, and the constructive ownership rules of §1260.  This Portfolio comprehensively addresses how these rules are applied and their own tax treatments and the problems that inspired Congress or the Treasury Department to promulgate the rules. Included is in-depth analysis on matching rules; acquisitions; double counting; forward contracts; securities futures; swaps; doubling up; hedging; dispositions of fungible property; dividend roll-up on common stock; derivatives based on managed accounts, on indices, and on compound derivatives; delta methodology; and much more. 

Key issues are highlighted in Financial Instruments: Special Rules, and examples illustrate nuances in the rules and frequently encountered issues of construction. In addition, there are discussions of various business and regulatory realities that feature prominently in these transactions, such as accounting rules, dynamic hedging, and more.   

Financial Instruments: Special Rules allows you to benefit from:

  • Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area
  • Invaluable practice documents including tables, charts and lists
  • Plain-English guidance from world-class experts
  • Real-world and in-depth analysis that lets you explore various options
  • Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more
  • Alternative approaches to both common and unique tax scenarios 

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which cover every federal tax topic with expert, in-depth analysis, and offer commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

Detailed Analysis

I. Wash Sales Under § 1091

Introductory Material

A. Targeted Transaction

B. Consequences of a Wash Sale

1. Loss Deferral

2. Basis Adjustment

3. Holding Period

4. Order of Shares Sold or Acquired

a. Multiple Wash Sales

b. Matching Rules When More (or Less) Property Is Sold than Acquired

c. Prevention of Double Counting

C. Scope of the Wash Sale Rules

1. Types of Loss Positions that Can Be the Subject of a Wash Sale

a. “Stock or Securities”

b. Options

c. Forward Contracts, Securities Futures, and Swaps

d. Short Sales

e. Dealer Positions

2. Acquisitions During the Window Period

a. The Window Period

b. Waiting or Doubling Up

c. Selling a Recently Acquired Position

d. What Is an “Acquisition”?

e. Doubling Up and Hedging

3. Relationship of Loss Position to Substitute Position: The “Substantially Identical” Standard

a. Same Issuer

b. Reorganizations and Process of Becoming Substantially Identical

c. Baskets of Stock and Securities

4. Contracts to Acquire, Options, and Other Derivatives

a. Forward Contracts

b. Options

c. Swaps

5. Short Sales

a. Inadequacy of § 1091(a) for Short Sales

b. Section 1091(e)

c. Short Sales, Options and Other Derivatives

(1) Put Option

(2) Short Call Option

(3) Short Securities Futures

(4) Over-the-Counter Forward Contracts and Swaps

6. Related Party Transactions and the Common Law of Wash Sales

a. Spouses

b. Other Family Relationships

c. Controlled Corporations

d. Trusts and Estates

II. Conversion Transactions Under § 1258

Introductory Material

A. Targeted Transaction: Interest Disguised as Capital Gain

B. Consequences of a Conversion Transaction

1. Recharacterized Amount

2. Built-in Losses and Built-in Gains

3. Netting

4. Interaction with § 263(g)

C. Scope of § 1258

1. Economic Return

a. “Substantially All” and the Time Value Test

b. Net Investment

2. Formal Context

3. Exception for Options Dealers and Commodities Traders

III. Constructive Sales Under § 1259

Introductory Material

A. Targeted Transaction

1. Taxpayer Motivations in Hedging

2. Tax Law Constraints on Hedging Prior to the Enactment of § 1259

a. Dispositions of Fungible Property

b. IRS Rulings on Hedging Transactions

c. Straddle Rules

d. Lending Securities to Hedging Counterparty

3. Enactment of § 1259

4. Overview

B. Consequences

1. Deemed Sale and Repurchase

2. Tax Ownership and Losses

3. Identification

4. Grandfathered Constructive Sales

C. What Positions Can Be Constructively Sold?

1. Appreciated Financial Position: Stock, Debt, Partnership Interests, and Actively-Traded Trust Interests

2. Nonqualified Stock Options

3. Straight Debt

4. Assets that Are Marked to Market

5. Forward Sale of Nonpublicly Traded Equities

6. Nonrecognition Transactions

D. How Long Must the Hedge Last?

1. Point in Time Analysis

2. Short-Term Safe Harbor

E. How Perfect Must the Hedge Be?

1. Substantial Is the Key

2. Hedging Only Upside or Downside

3. Some Upside, Some Downside

4. Periodic Payments

5. Variable Delivery Forward Contracts

6. Long-Dated Options and Optionally Exchangeable Debt Securities

7. Receipt of Cash Is Not Relevant

8. Credit Risk Is Not Relevant

9. Spread-Based Safe Harbor

10. Options Pricing

11. Delta Methology

12. Cash Proceeds Received

13. Special Rule for Collars?

14. The “Substantially Identical” Standard, Variations in the Underlying, and Mergers

F. Which Hedge and Which Appreciated Asset Should Be Considered?

1. Aggregation

a. Simple Aggregation

b. Series of Hedges

2. Bifurcation

a. Simple Bifurcation of the Hedged Asset

b. Simple Bifurcation of Hedge

c. Scheduled and Certain Transformations

d. Contingent Hedges

e. “Catch-ups” and Multipliers

3. Identification

G. What Business and Regulatory Issues Often Arise in Hedging Transactions?

1. Accepting Risk

2. Individuals with Positions Worth Less than $1 Million

3. Individuals with Positions Worth $1 Million to $75 Million

4. Individuals with Positions Worth More than $75 Million

5. Public Corporations with Stock in Unrelated Firms

IV. Constructive Ownership Under § 1260

Introductory Material

A. Targeted Transaction

1. High Tax Burden from Direct Investment in Hedge Fund

2. Hedge Fund Derivative: Law Before Enactment of § 1260

3. The Securities Dealer and the Key Role of § 475

4. What if the Hedge Fund Declines in Value?

5. Enactment of § 1260

B. What Happens if a Transaction Is Classified as a COT?

1. Conversion of Character

2. Interest Charge

3. Basis Step-Up

4. Physical Settlement

5. Mark to Market Election

6. Divergence from PFIC Rules

7. Interaction with Proposed Regulations for Contingent Swap

8. Effective Date

C. Does the Derivative Transaction Offer “Substantially All” of the Economic Return in the Underlying Asset?

1. Origins and Relevance of “Substantially All” Inquiry

2. Difficulty of Dynamic Hedging

3. Responses that Carve Out Portion of Economic Return

a. Call Option

b. Contingent Debt Instrument

c. Dealer Keeps Only Opportunity for Gain

d. Catch-up Structure

e. Inclusion of Third Party

D. Does the Subject Matter of the Derivative (the so-called “Underlying”) Qualify as a “Financial Asset”?

1. Evolution of “Financial Asset” Definition During Legislative Process

2. Short Positions Not Covered

3. Debt Instruments

4. Dividend Roll-up on Common Stock

5. Forward Contracts: Shifting Underlying, Investment Averaging, and Option-Like Terms

6. Derivative Based on Managed Account

7. Derivatives Based on Indices

8. Compound Derivatives

E. Does the Taxpayer Have One of the Enumerated Derivative Transactions or a Transaction Having “Substantially the Same Effect”?

1. In General

2. Nonrecourse Loan and Call Option

3. Offshore Corporate Wrapper

4. Variable Insurance or Annuity

5. Offshore Insurance Company

F. Is the Transaction Offering the Taxpayer Deferral and Conversion?

1. Exception for Mark to Market

2. Tax Exempts and Foreign Persons

Working Papers

Table of Worksheets

Worksheet 1 Section 1258 Legislative History

Worksheet 2 Section 1259 Legislative History

Worksheet 3 Section 1260 Legislative History

Bibliography

OFFICIAL

Internal Revenue Code:

United States Code:

Code of Federal Regulations

Treasury Regulations:

Public Laws

Legislative History:

Other Legislative Background:

Other:

Revenue Rulings and Revenue Procedures:

Cases:

UNOFFICIAL

URLs

Books:

Periodicals:

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David M. Schizer
David M. Schizer is the Dean and Lucy G. Moses Professor of Law at Columbia Law School, where he teaches courses on federal income taxation, the taxation of financial instruments, corporate tax, and the economics of transactions. His publications include: “Frictions and Tax-Motivated Hedging: An Empirical Exploration of Publicly-Traded Exchangeable Securities,” 56 National Tax J. 167 (Mar. 2003) (with William Gentry); “Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock,” 116 Harv. L. Rev. 874 (2003) (with Ronald Gilson); “Reducing the Tax Cost of Indexed Options,” 96 Tax Notes 1375 (9/2/02); “Frictions as a Constraint on Tax Planning,” 102 Colum. L. Rev. 1312 (2001); “Tax Constraints on Indexed Options,” 149 U. Pa. L. Rev. 1941 (2001); “Sticks and Snakes: Derivatives and Curtailing Aggressive Tax Planning,” 73 S. Cal. L. Rev. 1339 (2000); “Executives and Hedging: The Fragile Legal Foundation of Incentive Compatibility,” 100 Colum. L. Rev. 440 (2000); and “Realization as Subsidy,” 73 N.Y.U. L. Rev. 1549 (1998). Dean Schizer has also written several reports for the New York State Bar Association, where he serves on the executive committee and as co-chair of the Committee on Financial Institutions. Dean Schizer is also a member of the Tax Club and the Tax Forum. He served in the tax department at Davis Polk & Wardwell from 1995-98, and clerked for Justice Ruth Bader Ginsburg during the U.S. Supreme Court's October 1994 term. He is a graduate of Yale College and Yale Law School.