Taxation of Equity Derivatives analyzes the tax consequences of transactions involving equity derivatives.  It then turns to a discussion of special issues that arise when corporations take positions in their own stock.  Written by David H. Shapiro of PricewaterhouseCoopers LLP, this Portfolio examines “traditional” equity derivatives, including equity options, forward contracts, futures contracts, short sales, and convertible debt. For each type of transaction, you’ll get analysis on the timing rules applicable to the resulting income (or loss), as well as the character and source of the resulting income (or loss). Also addressed are the impacts these instruments may have on tax ownership of the underlying equity. 

This Portfolio examines a number of “modern” equity derivative transactions, including notional principal contracts, equity-linked debt products, and forward-based products. The Portfolio also analyzes the tax consequences of equity-linked debt products such as zero coupon convertibles, contingent interest convertibles, and negative coupon debt.  

Taxation of Equity Derivatives takes an in-depth look at the tax consequences of forward-based products, such as variable prepaid forward contracts and debt/forward contract investment units. The impact these transactions may have on tax ownership of the underlying equity is also discussed.

This Portfolio also considers special issues that arise when corporations take positions in their own stock under §1032. Taxation of Equity Derivatives explores the tax consequences of the use of options, forward contracts, futures contracts, convertible debt, and equity swaps by corporations taking positions in their own stock. 

Worksheets included with the Portfolio contain a diagram of a variable forward pricing mechanism and a list of public offering memoranda relating to the “modern” equity derivatives discussed in the Portfolio. The Worksheets also include relevant legislative history and IRS guidance relating to equity derivatives. 

Taxation of Equity Derivatives 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. Introduction

II. “Traditional” Equity Derivatives

A. Equity Options

1. General Description

2. Timing and Amount of Income/Deduction

a. General Timing Rules

b. Section 1256 Contracts

c. Section 1259 Constructive Sales

d. Straddle Rules

3. Character of Gain/Loss

a. Holders

b. Issuers

4. Source of Gain/Loss

5. Effect of Options on Tax Ownership

a. Common Law Ownership and Dispositions

b. Section 1259 Constructive Sales

B. Forward Contracts

1. General Description

2. Timing and Amount of Income/Deduction

a. General Timing Rules

b. Prepaid Forwards

c. Exceptions - Sales & Straddles

3. Character of Gain/Loss

a. In General

b. Conversion Transactions under 1258

4. Source of Gain/Loss

5. Effect of Forward Contracts on Tax Ownership

C. Futures Contracts

1. General Description

2. Timing and Amount of Income/Deduction

3. Character of Gain/Loss

4. Source of Gain/Loss

5. Effect of Futures Contracts on Tax Ownership

D. Stock Loans/Short Sales

1. General Description

2. Timing and Amount of Income/Deduction

a. Treatment of the Stock Lender

b. Treatment of the Stock Borrower/Short Seller

3. Character of Gain/Loss

4. Source of Gain/Loss

5. Effect of Short Sales on Stock Ownership

E. Convertible Debt

1. General Description

2. Timing and Amount of Income/Deduction

3. Character and Source of Gain/Loss

4. Effect of Convertible Bonds on Stock Ownership

III. “Modern” Equity Derivatives

A. Equity Swaps - Notional Principal Contracts

1. General Description

2. Timing and Amount of Income/Deduction

a. General Timing Rules

b. Contingent, Non-Periodic Payments

(i) In General

(ii) Rev. Rul. 2002-30 and Notice 2002-35

(iii) Proposed Regulations

c. Proposed Mark-to-Market Regime for Nonperiodic Payments

d. Straddle Issues

3. Character

a. In General

b. Proposed Regulations

4. Source

B. Equity-Linked Debt - Beyond the Standard Convertible Bond

1. Zero Coupon Convertibles - a.k.a. “LYONs”

a. General Description

b. Tax Treatment

2. Contingent Interest Convertible Notes - a.k.a. “Contingent LYONs”

a. General Description

b. Tax Treatment

c. Adjustments to Projected Payment Schedule

(i) Adjustments Upon Cash Redemption for Accreted Value

(ii) Adjustments Upon Conversion

d. Section 163(l)

3. Negative Coupon Debt - “SQUARZ”

4. “Debt” Instruments with Contingent Payments at Maturity Based on Equity Value

C. Forward-Based Products

1. Designed as a Monetization Strategy - Variable Prepaid Forward Contracts (VPFC)

a. General Description

b. Tax Treatment - Generally

c. Effect on Tax Ownership

d. Revenue Ruling 2003-7

(i) The Ruling

(ii) New Issues Raised By Ruling

(a) Unrestricted Legal Right to Settle in Cash or Other Shares

(b) Economic Compulsion

(iii) Issues Not Addressed in Ruling

e. Straddle Issues

2. Designed as an Investment Unit (Including Debt) to Access Capital Markets - “Feline PRIDES”

a. General Description

b. Tax Treatment

(i) Rev. Rul. 2003-97 - Generally

(ii) Components of Feline PRIDES as Separate Instruments

(iii) Maturity of the Note

(iv) Potential Application of 163(1)

(v) Contract Fees

IV. Special Issue: Corporations Taking Positions in Their Own Stock - 1032

A. In General

B. Options

1. Issuance of a Call Option

2. Issuance of a Put Option

3. Purchase of a Call Option

4. Purchase of a Put Option

5. Sale of a Purchased Option/Assignment of an Issued Option

6. Option Combinations -“Box Spreads”

7. Options Used to Hedge Convertible Debt Issuances

a. General Description of Transactions

b. Tax Treatment

C. Forward and Futures Contracts

1. In General

2. “Cash and Carry” Transactions

D. Convertible Debt

E. Equity Swaps

F. Potential Application of 1259

Working Papers

Table of Worksheets

Worksheet 1 Diagram of DECS Forward Pricing Mechanism

Worksheet 2 List of Examples of “Modern” Equity Derivatives

Worksheet 3 Legislative History to 1259 (Constructive Sales)

Worksheet 4 Legislative History to 163(l) (Debt Payable in Equity)

Worksheet 5 Legislative History to Tax Provisions Relating to Single Stock Futures Contracts

Worksheet 6 IRS Guidance with Respect to Contingent, Non-Periodic Payments in Notional Principal Contracts

Worksheet 7 IRS Guidance with Respect to Contingent Interest Convertible Debt Instruments

Worksheet 8 IRS Guidance with Respect to Variable Prepaid Forward Contracts

Worksheet 9 IRS Guidance with Respect to Feline PRIDES

Bibliography

OFFICIAL

Treasury Rulings:

Cases:

UNOFFICIAL

List of relevant treatises and portfolios:

Periodicals

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