Taxation of Non-Equity Derivatives (Portfolio 187)

Tax Management Portfolio, Taxation of Non-Equity Derivatives, No. 187, reviews the U.S. federal income taxation of derivative transactions other than equity derivatives. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Tax Management Portfolio, Taxation of Non-Equity Derivatives, No. 187, reviews the U.S. federal income taxation of derivative transactions other than equity derivatives. The taxation of equity derivatives is reviewed in a separate portfolio. See 188 T.M., Taxation of Equity Derivatives. This Portfolio is divided into eight main parts.

Part I provides a general overview of derivatives as financial instruments under which the return is determined by reference to the value of some underlying property or index. A fundamental issue with respect to the taxation of derivatives is the degree to which the gain or loss on a derivative is taxed symmetrically with the gain or loss that would be earned on an investment in its underlying property. Part II provides a summary of the tax rules that apply to the major classes of underlying property referenced by derivatives.

Parts III through V discuss the tax regimes applicable to the major classes of derivative financial instruments. Part III reviews the tax treatment of securities lending transactions and sales and repurchase (“repo”) transactions. Part IV discusses the tax regimes that apply to forward and futures contracts and Part V discusses the regime applicable to option contracts. A separate portfolio is devoted to the taxation of notional principal contracts. See 189 T.M., U.S. Taxation of Notional Principal Contracts.

Part VI addresses the tax treatment of the most important use of derivatives by nonfinancial taxpayers — to hedge exposures with respect to currency, interest rate and commodity price fluctuations. Part VII discusses the straddle regime of §§1092 and 263(g), which prevents taxpayers from using combinations of offsetting positions to achieve inappropriate timing and character results. Finally, Part VIII summarizes other limitations on the ability of taxpayers to exploit the differing tax treatments of financially equivalent instruments.

This Portfolio may be cited as Harter, III, Lukacs, and Shurberg, 187 T.M., Taxation of Non-Equity Derivatives.


L.G. Harter, III, Esq.

Chip Harter is a principal in the PricewaterhouseCoopers LLP Washington National Tax Practice. His practice focuses on advising multinational corporations and financial institutions on international tax planning and on tax issues arising with respect to financing transactions and financial instruments. As a senior technical review partner within PwC's national tax office, he participates in the review of the tax provisions of many financial institutions and multinational corporations. Mr. Harter joined PricewaterhouseCoopers in 1999 after having practiced tax law with Baker & McKenzie for 18 years. From 1989 through 1994, he was an Adjunct Professor of Taxation in the Graduate Tax Program of IIT Chicago-Kent College of Law.

Mr. Harter is a past Chair of the Financial Transactions Committee of the American Bar Association Section of Taxation. His recent publications include: “The Devil is in the Details: Problems, Solutions and Policy Recommendations with Respect to Currency Translation, Transactions and Hedging,” Vol. 89, No. 3 TAXES, p. 199 (March 2011) (with John D. McDonald, Ira G. Kawaller, and Jeffry P. Maydew); “Inherently Hedgeable: Hedging Foreign Currency Exposures Arising From Branch Operations of a CFC,” Vol. 37, No. 5 International Tax Journal, p. 11 (Sept. – Oct. 2011) (with Rebecca Lee and David Shapiro); and “Hedges of Foreign Currency Risk Associated with Debt Instruments Held as Capital Assets,” Vol. 36, No. 6 International Tax Journal, p. 5 (Nov. – Dec. 2010) (with Michael J. Harper).

Mr. Harter earned a J.D. from the University of Chicago Law School in 1980, where he was Comments and Articles Editor of the University of Chicago Law Review, and he graduated magna cum laude from Harvard College in 1977. Following law school, Mr. Harter clerked for the Honorable Thomas R. McMillen, United States District Judge for the Northern District of Illinois.

Michael Lukacs, Esq.

Michael Lukacs is the Tax Leader for Regulatory Affairs with GE Capital, based in Norwalk, CT. In this capacity he is responsible all tax matters relating to GE Capital's status as a regulated financial institution. Prior to his current role, Michael was based in London, England and was the Global Tax Director for GE Capital's European Mortgage & Restructuring unit, and prior to that, a director in with GE Capital's Global Banking unit. Michael joined GE in 2007 as International Tax Counsel to General Electric Corporation's Corporate Treasury function. Prior to joining GE, he was with PricewaterhouseCoopers, as part of that firm's International Tax Services team in Washington, DC and Chicago, IL.

Michael received his LL.M. (Taxation) from the Georgetown University's Law Center in 1998, his J.D. from the University of Detroit-Mercy School of Law in 1997, and his B.A. from the University of Michigan (Ann Arbor) in 1993.

David Shurberg

David Shurberg is a partner in the Ernst & Young Transaction Advisory Services practice. He advises both domestic and international clients regarding tax issues arising with respect to investing in financial services businesses, including assessing historic and prospective tax risks, tax structuring, post-deal integration, as well as divesting. His practice includes advising domestic, inbound and outbound investors.

Mr. Shurberg serves both private equity and corporate clients considering investments in the banking and capital markets, asset management, and insurance sectors. His practice spans the life cycle of a corporation's capital raising and divesting activities, including public and private acquisitions, divestitures, stock offerings, corporate restructurings, leveraged buyouts, and financings. Mr. Shurberg also participates in the review of the tax treatment of financial transactions in connection with tax provisions for several large clients.

Mr. Shurberg earned an M.B.A. from Columbia Business School where he was elected to Beta Gamma Sigma, and he graduated summa cum laude from the Wharton School of the University of Pennsylvania. Mr. Shurberg is a Certified Public Accountant.

Table of Contents

Detailed Analysis
 I. Introduction
 II. Summary of Tax Treatment of Transactions in Major Categories of Underlying Property
 Introductory Material
 A. Taxation of Debt Instruments
 1. Timing of Income and Deductions
 2. Character of Income and Expense
 3. Character of Gains and Losses on Redemption or Disposition
 4. Source of Income, Gains, Losses and Deductions
 5. Withholding Tax Treatment
 6. Subpart F Treatment
 7. Section 1411 Treatment
 B. Taxation of Corporate Stock
 1. Timing of Gains, Losses and Dividends
 2. Character of Gains, Losses and Dividends
 3. Source of Gains, Losses and Dividends
 4. Withholding Tax Treatment
 5. Subpart F Treatment of Stock Gains and Dividends
 6. Section 1411 Treatment
 C. Foreign Currency and Foreign Currency Denominated Debt Instruments
 1. Scope of Section 988
 2. Source and Character of Foreign Currency Gains and Losses
 3. Withholding Taxation
 4. Subpart F Treatment of Foreign Currency Gains and Losses
 5. Section 1411 Treatment
 D. Taxation of Commodities and Other Tangible Personal Property
 1. Timing of Gains and Losses
 2. Character of Gains and Losses
 3. Source of Gains or Losses
 4. Withholding Tax Treatment
 5. Section 1411 Treatment
 E. Symmetry Between Taxation of Derivative and Underlying Property
 III. Securities Lending and Repo Transactions
 Introductory Material
 A. Economic and Commercial Terms
 1. Repos
 a. Repo Markets and Mechanics
 b. Structured Transactions
 2. Securities Lending Transactions
 a. The Market
 b. Mechanics
 B. Tax Characterization
 1. Repos
 a. Generally
 b. Retention of Economic Benefits and Burdens of Securities
 c. Free Transferability of Securities
 (1) Generally
 (2) Right to Pledge, Hypothecate, or Re-hypothecate Repo'd Securities
 d. Ability to Substitute Assets or Collateral
 e. Physical Delivery vs. Cash Settlement
 f. Other Factors
 2. Securities Loans and §1058
 a. Overview
 b. Tax Treatment of §1058 Transactions
 c. Definition of §1058 Transaction
 3. Danielson Issues
 C. Specific Tax Issues
 1. Taxation of Substitute Payments
 a. Overview
 b. Scope of Final Substitute Payment Regulations
 c. Validity of Final Substitute Payment Regulations
 d. Source Rules
 e. Character Rules
 f. Timing Rules
 g. Withholding Tax
 (1) Generally
 (2) Portfolio Interest
 (3) Cascading Withholding Tax: Notice 97-66
 h. Other Considerations
 (1) Subpart F Issues
 (2) Foreign Tax Credit Issues
 (3) Foreign Taxpayers
 (4) Section 1411 Treatment
 2. Taxation of Borrow Fees
 3. Loan Rebate Fees
 4. Overlap with Straddle Rules
 5. Interest Allocation
 IV. Forward and Futures Contracts
 A. Description of Forward Contracts and Futures Contracts and Their Economics
 1. Forward Contract
 2. Futures Contract
 3. Economics of Forward and Futures Contracts
 B. Taxation of Forward Contracts
 1. Timing of Gains and Losses on Forward Contracts
 a. Generally Realization Based
 b. Constructive Sales Treatment for Appreciated Financial Positions
 c. Mark-to-Market Regime for Foreign Currency Contracts Under §1256
 2. Character of Gains and Losses on Forward Contracts
 a. Generally Capital
 b. Application of §1234A to Terminations
 c. Effect of §1233 on Holding Period
 d. Ordinary Gains and Losses for Foreign Currency Forwards
 3. Source of Gains and Losses on Forward Contracts
 4. Withholding Tax Treatment: Gains Generally Not FDAPI
 5. Subpart F Treatment of Forward Contracts
 a. Foreign Currency Gain or Loss
 (1) General
 (2) Business Needs Exception
 (3) Two Alternative Elections are Provided for Transactions Producing Foreign Currency Gain or Loss
 b. Commodities Gain or Loss
 (1) General
 (2) Gains or Losses of Active Merchants Exception
 (3) Bona Fide Hedging Transactions by Active Merchants
 c. Gain or Loss from Certain Property Transactions
 d. Dealer Exception
 6. Section 1411 Treatment
 C. Taxation of Regulated Futures Contracts
 1. Mark-to-Market Regime of §1256: Timing and 60/40 Long-Term/Short-Term Splitting Rules
 a. In General
 b. Hedging Exception Under §1256(e)
 (1) In General
 (2) Hedging Transaction Loss Limitation
 (3) Exceptions
 (4) Carryforward of Disallowed Hedging Losses
 c. Section 1256 Inapplicable to §988(d) Hedging Transactions
 d. Section 1256 Inapplicable to All §1256 Contracts that Are Part of a Mixed Straddle
 e. Section 1256 Inapplicable to a Securities Futures Contract that Is Not a Dealer Securities Futures Contract
 f. Section 1256 Inapplicable to Futures Contracts Held by Dealers and Traders Electing §475
 g. Section 1259 Potentially Applicable to a Futures Contract
 2. Additional Gain/Loss Characterization Rules
 a. 60/40 General Rule and Exceptions
 b. Elective Ordinary Regime for Currency Futures
 3. Source of Gains or Losses on Regulated Futures Contracts
 a. Section 865 Rules for Non-Currency Futures
 b. Section 988 Rules for Currency Futures
 4. Withholding Tax Treatment: Gains Generally Not FDAPI
 5. Subpart F Treatment of Regulated Futures Contracts
 6. Section 1411 Treatment
 D. Securities Futures Contracts
 V. Option Contracts
 A. Introduction
 1. Option Terminology
 2. Market Overview
 3. Overview of Option Pricing
 B. General Tax Treatment of Options
 1. Timing and Amount of Income/Deduction
 a. Lapse
 b. Physical Settlement
 c. Cash Settlement
 d. Special Rules
 (1) Section 1256
 (2) Potential Application of Other Timing Rules
 2. Character of Gain/Loss
 a. Options on Property
 b. Treatment of Writers of Options on Stocks, Securities and Commodities
 c. Section 1256 Contracts
 d. Foreign Currency Options — Section 988
 3. Source of Gain/Loss
 4. Related Tax Issues: Beneficial Ownership and Limitation on Holding Periods
 5. Subpart F Treatment of Options
 6. Section 1411 Treatment
 VI. Use of Derivatives in Hedging Transactions
 A. Introduction
 1. Business Reasons for Hedging
 2. Impact of Qualifying as a Hedge for Tax Purposes — Overview
 a. Timing
 b. Character
 c. Source
 B. Background: Development of Hedging Law
 1. Introduction
 2. Case Law and IRS Pronouncements
 a. General Counsel Memorandum 17322
 b. The Corn Products Doctrine
 c. Arkansas Best and Its Implications
 d. Federal National Mortgage Association
 3. 1994 Final Hedging Regulations
 a. In General
 b. Risk “Reduction” Standard
 (1) Reducing Risk
 (2) Macro and Micro Hedges
 C. Definition of “Hedging Transaction” Under §1221 and Reg. §1.1221-2
 1. In General
 2. Risk Management Standard
 a. Introduction
 b. General Rule: Risk Reduction Transactions
 (1) Micro and Macro Hedges
 (2) Written Options
 (3) Fixed-to-Floating Price Hedges
 c. Interest Rate Conversions
 d. Transactions that Counteract Hedging Transactions
 e. Transactions Not Entered Into Primarily to Manage Risk
 f. Hedges of Risks Other than Interest Rate or Price Changes, or Currency Fluctuations
 g. Recycling
 h. Extent of Risk Management
 i. Number of Transactions
 3. Hedged Items Must Be Ordinary
 a. Ordinary Property Hedges
 b. Ordinary Obligations and Borrowings
 c. Gap Hedges
 D. Identification Requirements
 1. In General
 2. Timing of Identification
 3. Content of Identification
 4. Required Manner of Making Identification and Record Retention
 E. Effect of Hedge Characterization
 1. Character Issues
 2. Timing Issues
 a. In General
 b. Clear Reflection of Income Standard
 c. Books and Records Requirement
 d. Choice of Method and Consistency
 e. Special Rules for Hedges of Certain Assets and Liabilities
 (1) Hedges of Aggregate Risk
 (2) Hedges of Items Marked to Market
 (3) Hedges of Inventory
 (4) Hedges of Debt Instruments
 (5) Notional Principal Contracts
 (6) Disposition of a Hedged Asset or Liability
 (7) Recycled Hedges
 (8) Unfulfilled Anticipatory Hedges
 F. Consolidated Group Hedging
 1. Background
 2. Final Consolidated Hedging Regulations
 a. Single-Entity Approach
 (1) General Rule
 (2) Identification Requirements
 b. Exception: Separate-Entity Election
 3. Related-Party Hedging with Non-Consolidated Affiliates
 G. Other Aspects of Hedging Transactions
 1. Integration Treatment for Qualified Debt Instruments Under §1275
 2. International Hedging Issues
 a. Foreign Personal Holding Company Income
 b. Foreign Tax Credit Implications
 c. Hedging Foreign Currency Risks Under §988(d)
 VII. The Straddle Provisions of §1092 and §263(g)
 Introductory Material
 A. Historical Background
 B. Overview of Straddle Rules
 1. Loss Deferral
 2. Holding Period
 3. Modified Wash Sale Rules
 4. Interest and Carrying Cost Capitalization
 5. Section 1256
 C. Scope of Straddle Rules
 1. Definitional Issues
 a. Personal Property
 b. Actively Traded
 c. Position
 d. Offsetting Positions
 e. Partially Offsetting Positions and Unbalanced Straddles
 f. Related Party Positions
 2. Special Rules Applicable to Stock Positions
 a. When Stock Is Treated as “Personal Property”
 b. Straddle Corporations
 c. Stock Plus Position in Stock or Substantially Similar or Related Property
 (1) Definition of “Substantially Similar or Related Property”
 (2) Examples of Application of “Substantially Similar or Related Property” Rules
 (3) Portfolio Rules
 d. QCCOs
 D. Consequences of Straddle Rules
 1. Modified Wash Sale Rules
 2. Loss Deferral
 3. Identified Straddle Regime of §1092(a)(2)
 4. Section 263(g) — Expense Capitalization
 a. Historical Background
 b. Proposed §263(g) Regulations
 (1) Personal Property
 (2) Interest and Carrying Costs
 (3) Allocation Rules
 5. Modified Short Sale Rules
 6. The Killer Rule
 7. Mixed Straddle Rules
 a. Definition of Mixed Straddle
 b. Identified Mixed Straddle Accounting
 c. Identification
 d. Mixed Straddle Accounts
 (1) Designated Class of Activities
 (2) Accounting Conventions
 (3) Pre-Straddle Gain/Loss Mark-to-Market Rule
 (4) Special Interest and Carrying Cost Capitalization Rules
 (5) Mixed Straddle Account Identification Rules
 (6) Application of Mixed Straddle Accounting Principles to Foreign Currency Positions
 VIII. Overview of Limitations on Taxpayer's Ability to Exploit Financial Equivalences to Achieve Desired Tax Treatment
 Introductory Material
 A. Limitation on Taxpayer's Ability to Control Time of Recognition of Income, Gains and Losses
 1. Capital Loss Limitation of §1211
 2. Wash Sale Provisions of §1091
 3. Straddle Provisions of §1092
 4. Capitalization Requirements Under §263(g)
 5. Constructive Sales Concepts
 a. Section 1259 Constructive Sales
 b. Reg. §1.988-2(d)(2)(ii) Realization by Offset
 c. Common Law Constructive Sales Authorities
 6. Constructive Ownership — §1260
 B. Limitations on a Taxpayer's Ability to Control Character of Gain or Loss Through Choice of Instrument
 1. Section 1258
 2. Ability of Commissioner to Designate Hedges
 a. Reg. §1.1221-2(f)
 b. Reg. §1-988-5(a)
 c. Reg. §1.1275-6
 3. Anti-Abuse Regulations Limiting Application of Specific Regulatory Regimes
 a. Notional Principal Contract Anti-Abuse Regulations
 b. Original Issue Discount Anti-Abuse Rule
 C. Other Limitations on Taxpayer's Ability to Manipulate Tax Treatment Through Choice of Instrument
 1. Expense Allocation — Reg. §1.861-9T(b)(2) & §1.861-9T(b)(6)
 2. Subpart F Treatment of Interest Equivalent to Interest
 3. Embedded Loan Rules of Reg. §1.446-3T(g)(4)
 4. Common Law Doctrines

Working Papers

Table of Worksheets
Worksheet 1 Excerpt from IRS Publication 550 Investment Income and Expense
Worksheet 2 List of Master Repo and Securities Loan Documents and Supplementary Materials*
Worksheet 3 Technical Explanation of the Ways And Means Committee Discussion Draft Provisions to Reform the Taxation of Financial Instruments (January 24, 2013)
Worksheet 4 Ways And Means Committee Discussion Draft Provisions to Reform the Taxation of Financial Instruments (January 24, 2013)