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Taxation of Equity Derivatives (Portfolio 188)

Be a trusted advisor to your clients with Bloomberg BNA Tax Portfolios. In this portfolio, Premier tax experts analyze the tax consequences of transactions involving equity derivatives. After discussing “traditional” equity derivatives, the portfolio discusses more “modern” equity derivatives that have arisen in recent years. The portfolio then turns to a discussion of special issues that arise when corporations take positions in their own stock.

 

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DESCRIPTION

The Taxation of Equity Derivatives, No. 188, analyzes the tax consequences of transactions involving equity derivatives. After discussing “traditional” equity derivatives, the portfolio discusses more “modern” equity derivatives that have arisen in recent years. The portfolio then turns to a discussion of special issues that arise when corporations take positions in their own stock.
Specifically, the portfolio examines “traditional” equity derivatives, including equity options, forward contracts, futures contracts, short sales, and convertible debt. For each type of transaction, the portfolio analyzes the timing rules applicable to the resulting income (or loss), as well as the character and source of the resulting income (or loss). The portfolio also addresses the impact these instruments may have on a tax ownership analysis of the underlying equity.
The portfolio examines a number of “modern” equity derivative transactions, including notional principal contracts, equity-linked debt products, and forward-based products. The portfolio analyzes the tax consequences of equity-linked debt products such as zero coupon convertibles, contingent interest convertibles, and negative coupon debt. The portfolio also analyzes the tax consequences of recent forward-based products, such as variable prepaid forward contracts and debt/forward contract investment units. The impact these transactions may have on a tax ownership analysis of the underlying equity is also discussed.


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AUTHORS

Bloomberg BNA Portfolios are written by leading tax professionals who set the standard as leaders in their fields. The Taxation of Equity Derivatives, No. 188 portfolio was authored by the following attorneys.  

 

DAVID H. SHAPIRO

David H. Shapiro, Partner, Swick & Shapiro, has been litigating employment discrimination cases on behalf of plaintiffs since 1981. Mr. Shapiro represents employees in both the public and private sectors, and also represents some white collar criminal defendants  (particularly in matters concerning government ethics), commercial litigation, and legal malpractice defense.  His practice also includes serious personal injury work, including medical malpractice claims, and some major commercial and business torts work.

Before Mr. Shapiro joined Mr. Swick, he maintained an active trial, appellate and administrative practice, particularly in the areas of civil rights and employment law at the law firm of Kator, Scott & Heller.  His practice included primary responsibility for litigation of cases in federal and state trial and appellate courts.  Mr. Shapiro handled trials and appeals of both civil and criminal cases in several U.S. District Courts and U.S. Courts of Appeals, and in state trial and appellate courts, including those in and for the District of Columbia, Virginia, Maryland, California, Texas, Hawaii, Michigan, Missouri, Tennessee, South Carolina and New York.  In addition, he regularly handled arbitrations and administrative hearings before the U.S. Equal Employment Opportunity Commission, the D.C. Office of Human Rights and the U.S. Merit Systems Protection Board.  

Credentials / A.B., cum laude, Princeton University (1992); J.D., University of Virginia School of Law (1995); LL.M. (Taxation), New York University School of Law (1997). Editor, Virginia Tax Review (1994-95); Graduate Editor, Tax Law Review (1996-97). Adjunct Professor of Law, Georgetown University Law Center. Member: New York State Bar, District of Columbia Bar, American Bar Association (Tax Section) and District of Columbia Bar Association (Tax Section).


TABLE OF CONTENTS

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

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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