Netting Rule for Certain Conversion Transactions

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.

-----------------------------------------------------------------------

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