Regulations Under Section 1258 of the Internal Revenue Code of 1986; Netting Rule for Certain Conversion Transactions

DEPARTMENT OF THE TREASURY

26 CFR Parts 1 and 602

[TD 8649]

RIN 1545-AS87

Regulations Under Section 1258 of the Internal Revenue Code of

1986; Netting Rule for Certain Conversion Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to

conversion transactions. These 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 regulations reflect changes

to the law made by the Revenue Reconciliation Act of 1993 and affect

persons who enter into conversion transactions.

DATES: These regulations are effective December 21, 1995.

For applicability of these regulations, see EFFECTIVE DATES under

the SUPPLEMENTARY INFORMATION part of the preamble.

FOR FURTHER INFORMATION CONTACT: Alan B. Munro, (202) 622-3950 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1452. Responses to this collection of information

are required to obtain netting relief for conversion transactions.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated annual burden per recordkeeper varies from .05 to 10

hours, depending on individual circumstances, with an estimated average

of .10 hour.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and 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.

Books or records relating to this collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

On December 27, 1994, the IRS published in the Federal Register a

notice of proposed rulemaking and notice of public hearing at 59 FR

66498 (FI-43-94) under section 1258 of the Internal Revenue Code of

1986.

The IRS received a number of written comments on the proposed

regulations. No requests to speak at the public hearing were received,

however, and consequently the hearing was cancelled.

Explanation of Provisions

A. General

The proposed regulations allow taxpayers to net gains and losses on

the positions of certain conversion transactions for purposes of

section 1258(a). For a taxpayer to be eligible, the proposed

regulations require the taxpayer to 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 has to dispose of all the positions within a 14-

day period that is within a single taxable year. The proposed

regulations also define built- in loss and prohibit the netting of

built-in loss against gain.

The commenters uniformly supported the netting relief provided by

the proposed regulations. Accordingly, the final regulations are

substantially unchanged from the proposed regulations.

The proposed regulations provide that the regulations will be

effective for conversion transactions entered into on or after the date

of filing of final regulations with the Federal Register. Several

commenters requested that the regulations also apply to conversion

transactions entered into prior to the filing date. In response to

these comments, the final regulations provide for application of the

regulations to any conversion transaction that is outstanding on

December 21, 1995, provided that all the positions which are part of

the conversion transaction are identified under Sec. 1.1258-1(b)(2)

before the close of business on February 20, 1996. The final

regulations also provide a transition rule for the same-day

identification requirement that allows taxpayers to identify conversion

transactions entered into prior to February 20, 1996, at any time on or

before February 20, 1996.

Several commenters criticized the examples for failing to adjust

the applicable imputed income amount (AIIA) under section 1258(b) for

interest and dividends received. The scope of these regulations,

however, is limited to netting relief. The IRS is still studying

various situations to determine the extent to which it is appropriate

to reduce the AIIA by reason of amounts capitalized under section

263(g), ordinary income received, or otherwise. Accordingly, Example 3

has been deleted and Examples 1 and 2 have been clarified to eliminate

any implication on this issue.

One commenter requested that the identification requirement be

eliminated as impractical, unnecessary, and a trap for the unwary. This

same-day identification requirement is similar to identification

requirements under sections 475 and 1221. Identification of all the

positions of a conversion transaction will aid examiners attempting to

determine whether conversion transactions are present and will prevent

mismatching of those positions by both taxpayers and agents. The final

regulations retain the same-day identification requirement but provide

a transition rule.

[[Page 66084]]

Some commenters asked that netting relief be expanded to cover

unrealized losses in retained positions by allowing loss positions to

be marked to market when a gain position is disposed of or terminated.

Allowing retained positions to be marked to market raises valuation and

other potentially complex issues. For example, many of the issues

addressed by the regulations under section 475 would have to be

addressed here. The complexity of these issues outweighs the potential

benefit of allowing retained positions to be marked to market. Thus,

the final regulations do not include a mark-to-market provision.

To preserve the character of gain that arose before a position

became part of a conversion transaction, one commenter requested built-

in gain rules similar to the built-in loss rules in the proposed

regulations. The appropriateness of a built-in gain rule under section

1258 is beyond the scope of these regulations. Therefore, the final

regulations do not address this issue.

The IRS is aware that section 1258 presents a number of issues not

addressed by these final regulations. The IRS continues to study the

scope of section 1258, the types of transactions that should be

included under the regulatory authority of section 1258(c)(2)(D), and

what reductions, if any, in the AIIA are appropriate under section

1258(b). The IRS welcomes comments on these and other issues under

section 1258.

B. Effective Dates

The regulations are effective for conversion transactions that are

outstanding on or after December 21, 1995. In the case of a conversion

transaction entered into before February 20, 1996, the same-day

identification requirement is treated as satisfied if the

identification is made on or before February 20, 1996.

Special Analyses

It has been determined that this Treasury decision 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,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

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

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 taken into account for federal tax

purposes 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). For purposes of the preceding sentence, 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 means--

(1) Built-in loss as defined in section 1258(d)(3)(B); and

(2) If a taxpayer realizes gain or loss on any one position of a

conversion transaction (for example, under section 1256), as of the

date that gain or loss is realized, any unrecognized 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.

(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 with its counterparty, receiving

$10,200. No dividends were received on the stock during the time it

was part of the conversion transaction.

(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

[[Page 66085]]

($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.

(e) Effective date and transition rule--(1) In general. These

regulations are effective for conversion transactions that are

outstanding on or after December 21, 1995.

(2) Transition rule for identification requirements. In the case of

a conversion transaction entered into before February 20, 1996,

paragraph (b)(2) of this section is treated as satisfied if the

identification is made before the close of business on February 20,

1996.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Sec. 602.101 [Amended]

Par. 4. In Sec. 602.101, paragraph (c) is amended by adding the

entry ``1.1258-1 * * * .1545-1452'' in numerical order to the table.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: November 28, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-30900 Filed 12-20-95; 8:45 am]

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