At the American Bar Association midyear meeting in January of this year, two panelists who spoke about the straddle rules contained in Internal Revenue Code (Code) section 1092 were asked what they expected would happen to the straddle rules over the subsequent 10 years. One panelist said that she thought they would be supplanted by a capital asset hedging regime, and the other said that he thought they would be supplanted by an expanded mark-to-market regime. A recent legislative proposal issued by Senator Ron Wyden (D, OR) if adopted, could satisfy both panelists’ predictions. This is because the Proposal would replace the current straddle rules, as well as certain other rules governing the taxation of derivatives, with a regime that would require that all derivatives, as well as all assets that constitute a so-called “investment hedging unit” (essentially, a capital asset and a hedge thereof) be marked to market.1
The straddle rules were part of a general overhaul of the taxation of financial instruments in 1981 and 1984 intended to limit the type of abuse that may arise in the context of a realization-based taxation system. In a classic commodity straddle transaction, the taxpayer would take offsetting positions in the same underlier, “harvest” the loss leg, and hold the gain leg long enough to qualify for long term capital gain. For example, in December 1978, the taxpayer might enter into a long position in a futures contract on silver that matured in June 1980, and a short position in a silver futures contract that matured in September 1980. If silver decreased in price prior to Dec. 31, 1978, the taxpayer would terminate her position in the long leg and immediately re-establish a long position in the same futures contract. Both the old contract and the new contract would be terminated on the same date in, say, January 1980. This would allow the taxpayer to recognize short term capital gain in 1978, insulate her from the risk of price fluctuations during 1979, and recognize long-term capital gain from the termination of the short contract in 1980.2
The current straddle rules combat this abuse by limiting loss recognition on a leg of a so-called “straddle” (defined as offsetting positions in personal property that are not part of a tax hedging transaction) to the extent of built-in gain on any other legs thereof, and by requiring the capitalization of certain carrying costs. Although these rules serve to limit abuse of this type, they are viewed as overinclusive, and they do not provide for a clear recognition of income in all cases. As a result, the straddle rules have never been popular.
The Proposal addresses many of the issues currently dealt with by the straddle rules in a more elegant manner that more clearly reflects income. It does this by marking all derivatives to market, and by marking certain nonderivative capital assets to market, to the extent that these assets are offset by derivatives that are themselves marked-to-market. This allows Panelist 1, the capital asset hedging proponent, to get her wish, while it also allows Panelist 2, the mark-to-market proponent, to get his.
- General Rules
- Mark-to-Market, Ordinary
Under the Wyden Proposal, all derivatives would be marked to market at the end of each tax year. Mark-to-market gain or loss would be ordinary, and sourced with reference to the residence of the taxpayer.3Gain or loss would also be recognized upon the termination or transfer of a derivative position.
Although the issue is not expressly discussed in the Proposal, mark-to-market losses from derivatives (and also from underlying investments, discussed below) appear to be “miscellaneous itemized deductions” for individuals, subject to a “floor” equal to 2 percent of adjusted gross income.
- Derivative Defined
For purposes of the Proposal, a “derivative” is defined as –
“[A]ny contract (including any option, forward contract, futures contract, short position, swap, or similar contract) the value of which, or any payment or other transfer with respect to which, is (directly or indirectly) determined by reference to one or more of the following:
- Any share of stock in a corporation.
- Any partnership or beneficial ownership interest in a partnership or trust.
- Any evidence of indebtedness.
- Any real property.
- Any commodity which is actively traded (within the meaning of section 1092(d)(1).
- Any currency.
- Any rate, price, amount, index, formula, or algorithm.
- Any other item as the secretary may provide.4
- Investment Hedging Units
The treatment becomes more complex when derivatives are used to hedge a capital asset. Generally, an investor is required to recognize mark-to-market gain or loss with respect to any “underlying investment” that is part of an “investment hedging unit.” For these purposes, an underlying investment is an asset of a type that may be referenced by a derivative (as defined above), if the value of the derivative is determined either directly or indirectly with reference thereto. An investment hedging unit held by a taxpayer consists of each derivative with respect to an underlying investment which by itself, or in combination with one or more other derivatives, has a delta with respect to the underlying investment equal to or greater than 0.7. For these purposes, “delta” means, with respect to any derivative and any underlying investment, the ratio of expected change in the fair market value of the derivative per unit of change in the fair market value of the underlying derivative. For the sake of administrative simplicity, a taxpayer may also elect to treat all derivatives with respect to an underlying investment, and all positions in the underlying investment, as a single investment hedging unit without regard to the delta thereof.
The Proposal also requires a taxpayer to recognize gain and loss when an investment hedging unit is entered into, exited, or adjusted. A derivative and an underlying investment that form part of an investment hedging unit are generally marked to market, and gain and loss are recognized when the investment unit is established, when a position in a derivative or an underlying investment is added to an investment hedging unit, or when a derivative or underlying investment that is part of an investment hedging unit is disposed of or terminated. However, built-in loss (defined as loss that is “built into” a position in a derivative or an underlying investment prior to the establishment of an investment hedging unit) is only recognized upon the disposition or termination of the applicable position. This prevents taxpayers from artificially accelerating the recognition of loss built into positions in underlying investments.
A taxpayer’s holding period in any underlying investment prior to entry into an investment hedging unit would be erased (to the extent that gain is not recognized with respect thereto upon establishment of the investment hedging unit), and tolled for the term of the investment hedging unit.
Example 1: A taxpayer purchases 100 shares of stock for $10 per share on January 1, 2015. On December 31, 2018, when the stock is worth $100 per share, the taxpayer enters into a short position in a single-stock futures contract on 100 shares of the stock. The taxpayer recognizes $90 of long-term capital gain on December 31, 2018. So long as both legs are held, the taxpayer is required to mark both positions to market, and to treat gain or loss with respect thereto as ordinary.
Example 2: The facts are the same as in Example 1, except the taxpayer purchases the shares on January 1, 2015 for $100 per share, and they are trading at $10 per share when the taxpayer enters into the futures contract. No gain or loss is recognized in 2018. So long as both legs are held, the taxpayer is required to mark both positions to market, and to treat gain or loss with respect thereto as ordinary. When the taxpayer disposes of the shares, $90 of short –term capital loss will be recognized with respect thereto.
- Identification Requirement
Taxpayers are required to test derivatives and underlying investments for delta, and to identify relevant positions as components of an investment hedging units on the date on which an investment hedging unit is established or adjusted. Taxpayers who do not make this identification are deemed to have elected to treat all positions in a derivative and its referenced underlying investment(s) as an investment hedging unit. Although the Proposal delegates the authority to determine the method for correct identification, it is anticipated that the method for identification of an investment hedging unit will be similar to method for the identification of a business hedging transactions under current Treas. Reg. 1.1221-2.
- Coordination with Existing Rules. Because the Proposal is intended to provide a new method for preventing abuse and distortions of income that result from a realization-based accounting method, adjustments to current rules intended to address the same issues are included in the proposal:
- Repeal of Current Rules. Because the Proposal would require that all derivatives be marked to market and gain or loss therefrom be treated as ordinary, current rules determining the timing and character of items from derivatives would be repealed. Sections to be repealed would include sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259 and 1260. These current rules all prescribe treatment for certain types of derivatives, for certain types of transactions involving derivatives, or for certain types of taxpayers who enter into derivative transactions. The over-arching rule contained in the Proposal would make these sections either redundant or contrary to the Proposal.
- Straddle Rules. The straddle rules would be amended to exclude business hedging transactions as defined in Code section 1221(b), and any investment hedging unit, as defined under the Proposal.5 Because current straddle rules prescribe timing and interest capitalization rules for “offsetting positions in personal property,” and because investment hedging units ought to be a subset of the group of offsetting positions in personal property, the general rule that positions in investment hedging units should be marked to market should make the straddle rules unnecessary in this context.
- Business Hedging Rules. Under the Proposal, a “derivative” does not include any contract that is part of a business hedging transaction as defined in Code section 1221(b). Effectively, this means that business hedging transactions that are not part of a bigger investment hedging unit should not themselves constitute an investment hedging unit.
- Section 475 Mark-to-Market Rules. Under the Proposal, Code section 475, requiring dealers in securities, and allowing traders in securities and dealers in commodities, to mark positions in securities or commodities, as applicable, to market, would be amended to exclude derivatives or any other position marked to market under the Proposal from the definition of security or commodity.
- Carve-Outs. The Proposal excludes certain types of transactions from the mark-to-market regime. Many of these exclusions were included in the Proposal to accommodate responses from commentators to the earlier Camp Proposal.
- Real Property. Under the Proposal, the term “derivative” does not include a contract with respect to interests in real property, if the contract requires physical delivery of the referenced real property. For these purposes, a contract that is nominally cash settled is treated as physically settled if it is not exercisable unconditionally for cash and exercisable for cash only in unusual and exceptional circumstances.
- Securities Loans and Repos. The Proposal delegates authority to the Service to issue regulations excluding securities lending and sale-repurchase transactions (repos) from the definition of derivative.
- Compensatory Options. Options described in Code section 83(e)(3) received in connection with the performance of services are not included in the definition of “derivative” under the Proposal.
- Insurance Contracts and Annuities. Insurance, annuity, and endowment contracts issued by an insurance company to which subchapter L applies (or issued by a foreign corporation to which subchapter L would apply, mutatis mutandis) are not derivatives for purposes of the Proposal.
- Derivatives on Affiliate Stock. For purposes of the Proposal, the term “derivative” does not include any derivative with respect to stock issued by any member of the same worldwide affiliated group (as defined in Code section 864(f) as the taxpayer).
- Commodities Used in the Normal Course of a Trade or Business. The term “derivative” does not include any contract with respect to a commodity if the contract requires physical delivery (absent unusual and exceptional circumstances), the commodity is used in quantities with respect to which the derivative relates in the normal course of the taxpayer’s trade or business (or, in the case of an individual, for personal consumption).
- Embedded Derivatives. If a contract has derivative and nonderivative components, each derivative component is treated as a derivative for purposes of the Proposal. If the derivative component cannot be separately valued, the entire contract is treated as a derivative for these purposes. This should mean that “plain vanilla” convertible debt instruments ought to be treated as derivatives (or as having derivative components) for relevant purposes. However, a debt instrument is not treated as having a derivative component merely because the debt instrument is denominated in nonfunctional currency, or payments with respect thereto are determined with reference to a nonfunctional currency.
- ADRs. American depository receipts and similar instruments are treated as shares of stock for purposes of the Proposal.
- Insurance Company Investments. In addition to the mark-to-market regime for derivatives and investment hedging units, the Proposal specifies that bonds and other debt instruments held by insurance companies are ordinary, rather than capital, assets. If adopted, this would remove some uncertainty surrounding tax hedging transactions entered into by insurance companies. Insurance companies generally hedge policy liabilities by purchasing securities (generally, debt instruments) and by hedging the “gap” between their security portfolio and their liabilities with derivatives. Because insurance companies’ securities portfolios are generally capital assets, and because, under current law, derivative positions may only be treated as tax hedging assets if they are entered into to hedge an ordinary asset or liability, the resulting ambiguity may expose insurance companies to the risk of character and timing mis-matches attendant upon tax hedging “fails.” Treatment of an insurance company’s securities portfolio as an ordinary asset would likely alleviate this problem.
- Areas for Comment. Ambiguous issues, and issues worthy of comment, include the following:
- Derivatives with Nonpublicly Traded Underliers. The Proposal would require that all derivatives, including derivatives with nonpublicly traded underliers, be marked to market. This would lead to the anomalous result that, if a taxpayer entered into a derivative on a nonpublicly traded underlier (say, a total return swap on an illiquid debt instrument), the derivative position would be marked to market, while an outright position that was not part of an investment hedging unit in the same debt instrument would be accounted for using a realization-based accounting method. This raises two issues: first – is it fair to require all investors in derivatives of this type to value them and mark them to market? In the case of a derivative on an illiquid asset not held by a broker, it may not be possible for a retail investor to value and/or mark the derivative. Second – is it fair to tax economically similar transactions differently? Counterparty credit issues aside, a taxpayer who owns a bond is in the same economic position as a taxpayer who enters into a total return swap on the same bond. Absent a rule that would require all assets to be marked to market, the taxpayer who gains exposure to the bond through a swap would be required to mark her position to market, while the taxpayer who holds the bond directly would be permitted to use a realization method of accounting. Is that a good policy result?
- 2 Percent Floor. As currently drafted, the Proposal would treat loss on derivatives and underlying investments as miscellaneous itemized deductions, subject to a “floor” equal to 2 percent of adjusted gross income in the case of individual taxpayers. This is a seemingly unjust result – if taxpayers are required to recognize gain and loss on these positions as ordinary income, they should be permitted to fully utilize any loss to offset other gain or income.
- Securities Lending and Repos. As currently drafted, the Proposal treats securities lending transactions and repos as derivatives, but delegates authority to the Service to issue regulations. Although regulations excluding securities loans and repos from the scope of the definition of “derivative” would be welcome, a legislative exclusion would be better, in order to ensure that similar positions are similarly taxed.6
- Beneficial Ownership Transactions. Under current common law rules, the holder of a position in a derivative may, in certain cases, be treated as the beneficial owner of the asset underlying the derivative. For example, a holder of a deep in-the-money call on a share of stock may be treated as the beneficial owner of the stock, and a long party to a total return swap on an illiquid asset may be treated as the beneficial owner of the asset referenced by the swap. Does that mean that the Proposal requires a holder of a position of this type to treat the position as a position in the derivative or in the referenced asset? The distinction would be meaningful if the referenced asset were not otherwise subject to mark-to-market accounting. Absent an explicit reference in the Proposal, it would be presumed that the drafters intend for common law tax ownership rules to control, but it would be best if the statutory language were to remove this ambiguity.
- Legislative Prognosis. Although the Proposal is only a proposal, it does seem to have legs. Because the Camp Proposal was introduced by a Republican in the House, and because the current Proposal has been introduced by a Democrat in the Senate, it would appear to have bipartisan, bicameral support. Whether it will progress further, either as an independent bill or as part of a larger tax reform proposal, remains to be seen.