[Federal Register Volume 59, Number 247 (Tuesday, December 27, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31433]
[[Page Unknown]]
[Federal Register: December 27, 1994]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[FI-43-94]
RIN 1545-AS87
Netting Rule for Certain Conversion Transactions
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: The proposed regulations relate to the amount of gain from a
conversion transaction position that is subject to recharacterization
as ordinary income. The proposed regulations provide that certain gains
and losses from positions of the same conversion transaction may be
netted for purposes of determining the amount of gain that is
recharacterized as ordinary income. These proposed regulations reflect
changes to the law made by the Revenue Reconciliation Act of 1993 and
affect persons who enter into conversion transactions.
DATES: Written comments must be received by March 28, 1995. Requests to
speak (with outlines of oral comments) at a public hearing scheduled
for April 25, 1995, must be received by April 4, 1995.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-43-94), room 5228,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-43-94),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. The public hearing has been scheduled to be held in the
Auditorium, Internal Revenue Building, 1111 Constitution Avenue NW.,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Alan B.
Munro, (202) 622-3950; concerning submissions and the hearing, Carol
Savage, (202) 622-8452 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act (44 U.S.C.
3504(h)). Comments on the collections of information should be sent to
the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC
20224.
The collections of information are in Sec. 1.1258-1(b)(2). This
information is required by the IRS to aid in administering the law and
to prevent manipulation of the netting rules through the use of
hindsight. This information will be used to determine whether the
taxpayer has elected to net losses against gains before applying
section 1258(a) and to verify that the taxpayer is properly reporting
its conversion transactions that are subject to netting. The likely
recordkeepers are business or other for-profit institutions and
nonprofit institutions.
Estimated total annual recordkeeping burden: 5,000 hours.
The estimated annual burden per recordkeeper varies from .05 to 10.00
hours, depending on individual circumstances, with an estimated average
of .10 hour.
Estimated number of recordkeepers: 50,000.
Background
This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) under section 1258(a) of the Internal
Revenue Code of 1986. Section 1258 was added to the Code by section
13206(a) of the Revenue Reconciliation Act of 1993.
Section 1258 treats certain capital gains from conversion
transactions as ordinary income. A transaction is a conversion
transaction if substantially all of the taxpayer's expected return is
attributable to the time value of the taxpayer's net investment in the
transaction and the transaction falls within one of four categories.
The four categories of covered transactions are (1) acquiring property
and substantially contemporaneously entering into a contract to sell
that (or substantially identical) property, (2) applicable straddles,
(3) transactions marketed or sold as producing capital gains, and (4)
transactions specified in regulations.
Gain generated by any position of a conversion transaction is
treated as ordinary income to the extent of the applicable imputed
income amount (AIIA). The AIIA is equal to the taxpayer's net
investment in the transaction multiplied by the applicable rate, with
certain adjustments. The applicable rate is generally 120 percent of
the applicable Federal rate, determined as if the conversion
transaction were a debt instrument.
Explanation of Provisions
A. Overview
The purpose of section 1258 is to treat the time value income from
conversion transactions as ordinary income. Section 1258(a) may create
a character mismatch, however, because it focuses only on the gain
recognized on the transaction. If a taxpayer separately disposes of the
positions of a conversion transaction, the taxpayer's inability to net
losses on the positions against gains could result in the
recharacterization of gain in excess of the time value element.
For example, assume that a taxpayer buys a capital asset for $100
and simultaneously sells that asset forward for $105 in one year.
Assume that the AIIA is $8. If the asset were delivered to close out
the forward contract, the taxpayer would have a $5 capital gain. Even
though the AIIA is $8, no more than the $5 gain would be
recharacterized.
Assume, instead, that the taxpayer sells the asset and closes out
the forward contract in separate transactions when the value of the
asset has dropped to $97. Gain subject to recharacterization under
section 1258(a), determined separately for each position, is $8 on the
forward contract. If the $3 loss on the asset were not netted against
that $8 gain prior to applying section 1258(a), the full $8 gain would
be recharacterized as ordinary income. This recharacterization would
force the taxpayer to recognize $8 of ordinary income and $3 of non-
offsetting capital loss.
The proposed regulations provide relief from this potential
character mismatch in certain circumstances.
B. Specific Provisions
The proposed regulations allow taxpayers to net gains and losses on
the positions of certain conversion transactions for purposes of
section 1258(a). To be eligible, the taxpayer must identify, before the
close of the day on which the positions become part of the conversion
transaction, all the positions that are part of the conversion
transaction. In addition, the taxpayer must dispose of all the
positions within a 14-day period that is within a single taxable year.
The proposed regulations also provide special rules for losses on
positions of conversion transactions. These rules prevent the netting
of built-in loss against gain. In addition, the rules treat certain
losses that arise during the term of a conversion transaction as built-
in losses.
These regulations are proposed to be effective for conversion
transactions entered into on or after the date of the filing of the
final regulations with the Federal Register.
C. Solicitation of Comments on Other Issues
The scope of the relief provided by the proposed regulations would
be broadened if a taxpayer could elect to treat retained positions of a
conversion transaction as if they were sold for their fair market
values whenever another position of that transaction was disposed of,
terminated, or treated as sold under any other provision of the Code or
regulations. The proposed regulations do not include such a mark-to-
market provision. Marking positions to market raises a number of issues
under other provisions of the Code (for example, sections 1271 through
1278).
The Service solicits comments on the necessity for and terms of a
mark-to-market provision under section 1258.
The Service is aware that section 1258 presents a number of issues
not addressed by the proposed regulations. The Service invites comments
concerning which, if any, of these issues should be addressed in future
regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for Tuesday, April 25, 1995, at
10:00 a.m. in the IRS Auditorium. Because of access restrictions,
visitors will not be admitted beyond the Internal Revenue Building
lobby more than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by March 28, 1995, and submit an outline of the
topics to be discussed and the time to be devoted to each topic (signed
original and eight (8) copies) by April 4, 1995.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Alan B. Munro, Office
of Assistant Chief Counsel (Financial Institutions and Products).
However, other personnel from the IRS and Treasury Department
participated in their development.
List of Subjects in 26 CFR Part 1
Income Taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.1258-1 is added to read as follows:
Sec. 1.1258-1 Netting rule for certain conversion transactions.
(a) Purpose. The purpose of this section is to provide taxpayers
with a method to net certain gains and losses from positions of the
same conversion transaction before determining the amount of gain
treated as ordinary income under section 1258(a).
(b) Netting of gain and loss for identified transactions--(1) In
general. If a taxpayer disposes of or terminates all the positions of
an identified netting transaction (as defined in paragraph (b)(2) of
this section) within a 14-day period in a single taxable year, all
gains and losses on those positions realized within that period (other
than built-in losses as defined in paragraph (c) of this section) are
netted solely for purposes of determining the amount of gain treated as
ordinary income under section 1258(a). A taxpayer is treated as
disposing of any position that is treated as sold under any provision
of the Code or regulations thereunder (for example, under section
1256(a)(1)).
(2) Identified netting transaction. For purposes of this section,
an identified netting transaction is a conversion transaction (as
defined in section 1258(c)) that the taxpayer identifies as an
identified netting transaction on its books and records. Identification
of each position of the conversion transaction must be made before the
close of the day on which the position becomes part of the conversion
transaction. No particular form of identification is necessary, but all
the positions of a single conversion transaction must be identified as
part of the same transaction and must be distinguished from all other
positions.
(c) Definition of built-in loss. For purposes of this section,
built-in loss can arise in two situations. First, built-in loss as
defined in section 1258(d)(3)(B) is built-in loss. Second, if a
taxpayer realizes gain or loss on any one position of a conversion
transaction (for example, under section 1256) and, as of the date that
gain or loss is realized, there is unrealized loss in any other
position of the conversion transaction that is not disposed of,
terminated, or treated as sold under any provision of the Code or
regulations thereunder within 14 days of and within the same taxable
year as the realization event, that unrealized loss is built-in loss.
See paragraph (d) Example 3 of this section.
(d) Examples. These examples illustrate this section:
Example 1. Identified netting transaction with simultaneous
actual dispositions. (i) On December 1, 1995, A purchases 1,000
shares of XYZ stock for $100,000 and enters into a forward contract
to sell 1,000 shares of XYZ stock on November 30, 1997, for
$110,000. The XYZ stock is actively traded as defined in
Sec. 1.1092(d)-1(a) and is a capital asset in A's hands. A maintains
books and records on which, on December 1, 1995, it identifies the
two positions as all the positions of a single conversion
transaction. A owns no other XYZ stock. On December 1, 1996, when
the applicable imputed income amount for the transaction is $7,000,
A sells the 1,000 shares of XYZ stock for $95,000. On the same day,
A terminates its forward contract by entering into an offsetting
position, receiving $10,200.
(ii) The XYZ stock and forward contract are positions of a
conversion transaction. Under section 1258(c)(1), substantially all
of A's expected return from the overall transaction is attributable
to the time value of the net investment in the transaction. Under
section 1258(c)(2)(B), the transaction is an applicable straddle as
defined in section 1258(d)(1).
(iii) A disposed of or terminated all the positions of the
conversion transaction within 14 days and within the same taxable
year as required by paragraph (b)(1) of this section. The
transaction is an identified netting transaction because it meets
the identification requirement of paragraph (b)(2) of this section.
Solely for purposes of section 1258(a), the $5,000 loss realized
($100,000 basis less $95,000 amount realized) on the disposition of
the XYZ stock is netted against the $10,200 gain recognized on the
disposition of the forward contract. Thus, the net gain from the
conversion transaction for purposes of section 1258(a) is $5,200
($10,200 gain less $5,000 loss). Only the $5,200 net gain is
recharacterized as ordinary income under section 1258(a) even though
the applicable imputed income amount is $7,000. For federal tax
purposes other than section 1258(a), A has recognized a $10,200 gain
on the disposition of the forward contract ($5,200 of which is
treated as ordinary income) and realized a separate $5,000 loss on
the sale of the XYZ stock.
Example 2. Identified netting transaction with built-in loss.
(i) The facts are the same as in Example 1, except that A had
purchased the XYZ stock for $104,000 on May 15, 1995. The XYZ stock
had a fair market value of $100,000 on December 1, 1995, the date it
became part of a conversion transaction.
(ii) The results are the same as in Example 1, except that A has
built-in loss (in addition to the $5,000 loss that arose
economically during the period of the conversion transaction), as
defined in section 1258(d)(3)(B), of $4,000 on the XYZ stock. That
$4,000 built-in loss is not netted against the $10,200 gain on the
forward contract for purposes of section 1258(a). Thus, the net gain
from the conversion transaction for purposes of section 1258(a) is
$5,200, the same as in Example 1. The $4,000 built-in loss is
recognized and has a character determined without regard to section
1258.
Example 3. Identified netting transaction with position marked
to market. (i) B, a calendar year taxpayer, holds a portfolio of
Treasury securities that are capital assets in B's hands. On
December 1, 1995, B enters into a short futures contract on Treasury
securities that is a regulated futures contract (RFC) as defined in
section 1256(g)(1). Although the RFC and some portion of B's
portfolio of Treasury securities (the conversion Treasuries)
constitute a straddle as defined in section 1092(c), B does not make
an election under section 1256(d) to have section 1256 not apply to
the RFC, nor does B make any identification or election under
Sec. 1.1092(b)-3T or Sec. 1.1092(b)-4T (relating to certain
identified mixed straddles or mixed straddle accounts,
respectively). B maintains books and records on which, on December
1, 1995, it identifies the conversion Treasuries and the RFC as all
the positions of a single conversion transaction.
(ii) As of December 29, 1995, the last business day of the
taxable year, B has an unrealized loss on the conversion Treasuries
of $8,000, wholly attributable to the period beginning December 1,
1995, and ending December 29, 1995, and an unrealized gain on the
RFC of $8,800. Under section 1256, B marks the RFC to market as of
December 29, 1995. B continues to hold the conversion Treasuries.
(iii) The conversion Treasuries and RFC are positions of a
conversion transaction. Under section 1258(c)(1), substantially all
of B's expected return from the overall transaction is attributable
to the time value of the net investment in the transaction. Under
section 1258(c)(2)(B), the transaction is an applicable straddle as
defined in section 1258(d)(1).
(iv) The transaction is an identified netting transaction
because it meets the identification requirement of paragraph (b)(2)
of this section. Paragraph (b)(1) of this section does not apply to
the transaction, however, because B did not dispose of or terminate
all the positions of the conversion transaction within the same 14-
day period in the same taxable year. There has been no disposition
or termination of the conversion Treasuries by December 31, 1995,
the end of B's taxable year in which it is treated as having sold
the RFC.
(v) The $8,000 excess of B's basis in the conversion Treasuries
over their fair market value on December 29, 1995, is built-in loss
under paragraph (c) of this section. Under paragraph (b)(1) of this
section, that $8,000 built-in loss is not available to offset later
gain on the positions.
(e) Effective date. This section is effective for conversion
transactions entered into on or after the date of the filing of the
final regulations with the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 94-31433 Filed 12-23-94; 8:45 am]
BILLING CODE 4830-01-U
