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

Tax Management Portfolio, Taxation of Equity Derivatives, No. 188-2nd, 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.

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, reverse convertibles, and negative coupon debt. The Portfolio also analyzes the tax consequences of recent forward-based products, such as variable prepaid forward contracts, exchange-traded notes and debt/forward contract investment units. The impact these transactions may have on a tax ownership analysis of the underlying equity is also discussed. The possible application of several statutory anti-abuse provisions to transactions involving both a position in the underlying equity and a position in a related derivative is also discussed, as well as the recent rules under §871(m) intended to prevent certain transactions involving underlying U.S. source dividends from escaping U.S. withholding tax.

The Portfolio considers special issues that arise when corporations take positions in their own stock under §1032. The Portfolio 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.

The Worksheets include 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 and Additional Resources also include relevant legislative history and IRS guidance relating to equity derivatives, including most recently, certain legislative history and IRS guidance related to Section 871(m).

This portfolio may be used in conjunction with Schizer, 186 T.M., Financial Instruments: Special Rules.

This portfolio may be cited as Chen and Kunkel, 188-2nd T.M., Taxation of Equity Derivatives.

Authors

Sam Chen

Sam Chen, Senior Manager in the Financial Institutions and Products group of KPMG LLP's Washington National Tax practice. His practice focuses on the taxation of financial products, debt, and leasing transactions. He has extensive experience with advising clients in the banking and capital markets space and in asset management with respect to their lending, investing, and market-making activities, and routinely advises multi-national corporations in a wide range of industries with respect to their debt issuances and re-financings, hedging strategies, and leasing transactions. He previously was an associate at Ropes & Gray, LLP. He has a J.D. from Cornell Law School, a B.S. in computer engineering from the University of Illinois, Urba-na-Champaign, and is a member of the New York State Bar. 

Paul J. Kunkel

Paul J. Kunkel, Director in the Financial Institutions and Products group of KPMG LLP's Washington National Tax practice. His practice focuses on the taxation of financial products and debt instruments. He has a J.D. from Northwestern University School of Law, a Ph.D. (Mathematics) from Northwestern University, a B.A. from Princeton University, and is a member of the Illinois State Bar.

Table of Contents

Detailed Analysis
I. Traditional and Modern Equity Derivatives
A. Introduction
B. Forward Contracts
1. General Description
2. Timing and Amount of Income/Deduction
a. General Timing Rules
b. Prepaid Forwards
c. Exceptions — Sales and 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. Equity Futures Subject to §1256
a. Overview of §1256
b. Timing and Amount of Income/Deduction
c. Character of Gain/Loss
d. Source of Gain/Loss
e. Effect of §1256 Futures Contracts on Tax Ownership
3. Equity Futures Not Subject to §1256
a. Timing and Amount of Income/Deduction
b. Character of Gain/Loss
c. Source of Gain/Loss
d. Effect of Non-§1256 Futures Contracts on Tax Ownership
D. Stock Loans/Short Sales
1. General Description
2. Treatment of Stock Lender
a. Gain/Loss on Initial Transfer
b. Basis
c. Substitute or In-Lieu of Payments
d. Fees
e. Noncompliance with §1058
3. Treatment of Short Seller (Stock Borrower)
a. Substitute Dividend Payments and Fees
b. Gain/Loss
c. Character of Gain/Loss
d. Source of Gain/Loss
E. Equity Swaps — Notional Principal Contracts
1. General Description
2. Tax Characterization of Equity Swaps — the §446 Regulations
3. General Timing and Amount of Income/Deduction
a. Periodic Payments
b. Termination Payments
c. Nonperiodic Payments — Overview
d. Noncontingent Nonperiodic Payments
e. Contingent Nonperiodic Payments
(1) In General
(2) Requests for Comments and Responses
(3) Rev. Rul. 2002-30 and Notice 2002-35
(4) 2004 Proposed Regulations
(a) Overview
(b) Proposed Noncontingent Swap Method
(c) Proposed Mark-to-Market Method
f. Straddle Issues
4. Character
a. In General
b. Periodic and Nonperiodic Payments
c. Termination Payments
d. Character Under 2004 Proposed Regulations
5. Source
F. Equity Options
1. General Description
a. Overview
b. Forms of Settlement
c. Over-the-Counter (OTC) and Exchange-Traded Options
2. Timing and Amount of Income/Deduction
a. General Timing Rules — Options Not Subject to §1256
b. Timing Rules for Options Subject to §1256
c. Section 1259 Constructive Sales
d. Section 1092 Straddle Rules
(1) Overview
(2) Equity Straddle Rules
(3) Qualified Covered Calls (QCC)
3. Character of Gain/Loss
a. Overview
b. Holders
c. Issuers
4. Source of Gain/Loss
5. Effect of Options on Tax Ownership
a. General Rules on Ownership and Dispositions
b. Section 1259 Constructive Sales
c. Basket Contract Guidance and Notices
G. Forward-Based Products
1. Variable Prepaid Forward Contracts
a. General Description
b. Tax Treatment — Generally
c. Effect on Tax Ownership
d. Revenue Ruling 2003-7
(1) Revenue Ruling 2003-7—The Facts
(2) Issues Raised by Revenue Ruling 2003-7
(a) Unrestricted Legal Right to Settle in Cash or Other Shares
(b) Economic Compulsion
(3) Issues Not Addressed in the Ruling
e. IRS Guidance Subsequent to Rev. Rul. 2003-7
f. Anschutz v. Commissioner
g. Straddle Issues
h. Estate of McKelvey v. Commissioner
2. Designed as an Investment Unit (Including Debt) to Access Capital Markets — “Feline PRIDES”
a. General Description
b. Tax Treatment
(1) Rev. Rul. 2003-97 — Overview
(2) Components of Feline PRIDES as Separate Instruments
(3) Maturity of the Notes
(4) Potential Application of §163(l)
(5) Contract Fees
H. Equity-Linked Debt — Convertible Debt and Beyond
1. Convertible Debt
a. General Description
b. Timing and Amount of Income/Deduction
c. Character and Source of Gain/Loss
d. Effect of Convertible Bonds on Stock Ownership
e. Cash Settlement and Net-Share Settlement
2. Reverse Convertible Securities
3. Zero-Coupon Convertibles — a.k.a. “LYONs”
a. General Description
b. Tax Treatment
4. Contingent Interest Convertible Notes — a.k.a. “Contingent LYONs”
a. General Description
b. Tax Treatment
(1) Adjustments to Projected Payment Schedule
(2) Adjustments on Cash Redemption for Accreted Value
(3) Adjustments on Conversion
(4) Section 163(l)
5. Negative Coupon Debt — “SQUARZ”
6. “Debt” Instruments with Contingent Payments at Maturity Based on Equity Value
II. Special Issues
A. Corporations Taking Positions in Their Own Stock — §1032
1. In General
2. Options
a. Granting a Call Option
b. Granting a Put Option
c. Buying a Call Option
d. Buying a Put Option
e. Selling a Purchased Option/Assigning the Obligation Under a Granted Option
f. Option Combinations — “Box Spreads”
g. Options Used to Hedge Convertible Debt Issuances
(1) General Description of Transactions
(2) Tax Treatment
3. Forward and Futures Contracts
a. In General
b. “Cash and Carry” Transactions
4. Convertible Debt
5. Equity Swaps
6. Potential Application of §1259
B. Section 871(m)
1. Background
a. Overview of §871(m)
b. 2012 Temporary and Proposed Regulations and the Aftermath
2. The Final Regulations and Temporary Regulations
a. Effective Dates of the Final Regulations
(1) Effective Date for NPCs Entered Into Before January 1, 2017
(2) Effective Date for Simple Contracts (NPCs and ELIs) that Are Delta-One Transactions
(3) Effective Date for Certain Identified ETNs
(4) Effective Date for Non-Delta-One Transactions and Complex Contracts
(5) Simplified Standard for Combined Transactions for Short Parties
(6) Phase-In Relief for Qualified Derivatives Dealers (“QDD”)
b. Instruments Covered by the Final Regulations
(1) Simple vs. Complex Contracts
(2) The Delta Test for Simple Contracts
(3) Complex Contracts and the Substantial Equivalence Test
(a) Overview
(b) Substantial Equivalence Test
(c) Complex Contract Calculations
(d) Determining the Change in Value for Both the Complex Contract and the Initial Hedge
(e) Testing Price
(f) Probability
(g) Benchmark Calculation
(4) Rules Relating to Derivatives that Reference Partnerships
(5) Rules Relating to Certain Corporate Acquisitions
c. Dividend Equivalent
(1) Definition
(2) Exceptions
(a) Dividends Not Subject to Tax
(b) Coordination with §305
(c) Due Bills
(d) Employee Compensation
(e) Annuities and Life Insurance
(f) Other Substantially Similar Payments
d. Payment of Dividend Equivalent
e. Amount and Timing of Dividend Equivalent
f. Qualified Index Exception
(1) General Requirements
(2) Safe Harbor for Non-U.S. Indices
(3) Purpose Provision
(4) Short Positions
(5) Indirect Positions
g. Combined Transactions
(1) General Rules
(2) Presumptions
(3) Ordering Rule
(4) Other Issues with Combining Transactions
h. Reporting and Recordkeeping Obligations
i. Withholding Rules
j. Qualified Derivatives Dealer Regime
k. Contingent Debt Instruments and Portfolio Interest
l. Anti-Abuse Rule
m. Notice 2016-76

 

Working Papers

Table of Worksheets
Worksheet 1 Diagram of DECS Forward Pricing Mechanism
Worksheet 2 List of Examples of “Modern” Equity Derivatives
Worksheet 3 Example of Proposed Noncontingent Swap Method
Worksheet 4 Example of Application of Substantial Equivalence Test to Complex Contract
Worksheet 5 Permanent Subcommittee on Investigations Staff Report Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends
Worksheet 6 Legislative History to §1259 (Constructive Sales)
Worksheet 7 Legislative History to §163(l) (Debt Payable in Equity)
Worksheet 8 Legislative History to Tax Provisions Relating to Single Stock Futures Contracts
Worksheet 9 Staff of Joint Committee on Taxation, Technical Explanation of the Revenue Provisions Contained in Senate Amendment 3310, The “Hiring Incentives to Restore Employment Act,” Under Consideration by the Senate