Mark to Market for Dealers in Securities

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-42-94]

RIN 1545-AS85

Mark to Market for Dealers in Securities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

mark-to-market method of accounting for securities that is required to

be used by a dealer in securities. The proposed regulations address the

relationship between mark-to-market accounting and the accrual of

stated interest and discount and the amortization of premium and

between mark-to-market accounting and the tax treatment of bad debts.

They also provide rules relating to certain dispositions and

acquisitions of securities required to be marked to market, the

exemption from mark-to-market treatment of securities in certain

securitization transactions, and the identification requirements for

obtaining exemption from mark-to-market treatment. Finally, these

proposed regulations provide guidance relating to the exclusion of

REMIC residual interests from the definition of security and to the

relationship between the mark-to-market provisions and the integrated

transaction rules in the proposed regulations on debt instruments with

contingent payments. This document also provides notice of a public

hearing on these proposed regulations.

DATES: Written comments must be received by April 4, 1995. Outlines of

oral comments to be presented at a public hearing scheduled for May 3,

1995, at 10 a.m. must be received by April 4, 1995.

ons and the integrated

transaction rules in the proposed regulations on debt instruments with

contingent payments. This document also provides notice of a public

hearing on these proposed regulations.

DATES: Written comments must be received by April 4, 1995. Outlines of

oral comments to be presented at a public hearing scheduled for May 3,

1995, at 10 a.m. must be received by April 4, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-42-94), 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-42-94),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW,

Washington, DC.

The public hearing will be held in the Internal Revenue Auditorium,

7400 Corridor, Internal Revenue Building, 1111 Constitution Ave., NW,

Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. 1.475(c)-2(a)(4),

Carol A. Schwartz, (202) 622-3920; concerning other sections of the

regulations, Robert B. Williams, (202) 622-3960, or JoLynn Ricks, (202)

622-3920; concerning submissions and the hearing, Michael Slaughter,

(202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has 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 collection 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 collection of information is in Sec. 1.475(b)-4. The

information required to be recorded under Sec

n 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 collection of information is in Sec. 1.475(b)-4. The

information required to be recorded under Sec. 1.475(b)-4 is required

by the IRS to determine whether exemption from mark-to-market treatment

is properly claimed. This information will be used to make that

determination upon audit of taxpayers' books and records. The likely

recordkeepers are businesses or other for-profit institutions.

Estimated total annual recordkeeping burden: 2,500 hours.

The estimated annual burden per recordkeeper varies from 15 minutes

to 3 hours, depending on individual circumstances, with an estimated

average of 1 hour.

Estimated number of recordkeepers: 2,500.

Background

Section 475 of the Internal Revenue Code requires mark-to-market

accounting for dealers in securities, broadly defined. Section 475 was

added by section 13223 of the Revenue Reconciliation Act of 1993 (Pub.

L. 103-66, 107 Stat. 481), and is effective for all taxable years

ending on or after December 31, 1993.

On December 29, 1993, temporary regulations (T.D. 8505, 58 FR

68747) and cross-reference proposed regulations (FI-72-93, 58 FR 68798)

were published to furnish guidance on several issues, including the

scope of exemptions from the mark-to-market requirements, certain

transitional issues relating to the scope of exemptions, and the

meaning of the statutory terms ``dealer in securities'' and ``held for

investment.'' This notice contains proposed regulations that

supplement, and in a few cases revise, the proposed regulations that

were published last December.

Explanation of Provisions

Stated Interest, Discount, and Premium

-to-market requirements, certain

transitional issues relating to the scope of exemptions, and the

meaning of the statutory terms ``dealer in securities'' and ``held for

investment.'' This notice contains proposed regulations that

supplement, and in a few cases revise, the proposed regulations that

were published last December.

Explanation of Provisions

Stated Interest, Discount, and Premium

The proposed regulations contained in this notice provide rules for

taking into account interest (including original issue discount (OID)

and market discount), premium, and certain gains and

losses on securities that are debt instruments. In general, immediately

before a debt instrument is marked to market, Code provisions related

to calculating interest must be applied, and basis must be

correspondingly adjusted. The mark-to-market computations do not affect

either the amount treated as interest earned from a debt instrument or

the taxable years in which that interest is taken into account.

For example, immediately before a debt instrument is marked to

market, accruals of unpaid qualified stated interest (QSI) must be

taken into account, and basis must be correspondingly increased. This

is true regardless of the taxpayer's regular method of accounting.

Marking a debt instrument to market under section 475(a) precludes the

deferral that a cash-basis taxpayer might have experienced in the

absence of the statutory provision, and the current accrual under the

proposed regulations is needed in order to preserve the interest

character of the QSI.

For debt instruments acquired with original issue discount or

market discount, the proposed regulations require that, immediately

before the mark-to-market gain or loss is computed under section

475(a), any OID or market discount accrued through the date of

computation must be taken into account, and basis must be

correspondingly increased

le bond

premium, the proposed regulations provide that, if a dealer has made an

election to amortize premium under section 171, any amortization for

the taxable year (or for the portion of the taxable year during which

the instrument is held by the dealer) must be taken into account (and

basis must be appropriately reduced) before the mark-to-market gain or

loss is computed under section 475. Because section 171 applies only to

instruments not held primarily for sale to customers in the ordinary

course of the taxpayer's trade or business, this proposed regulatory

provision is applicable only to premium instruments described in

section 475(b)(1) for which the taxpayer has not made the

identification described in section 475(b)(2).

In the case of tax-exempt bonds, the proposed regulations require

basis to be reduced as required by section 1016(a)(5) or (6) before

mark-to-market gain or loss is computed.

If a dealer acquires a bond with premium and a section 171 election

first applies to the bond in a taxable year after the year of

acquisition, the proposed regulations require the dealer to amortize

premium based on the original basis, without regard to any mark-to-

market adjustments that may have been taken into account before the

section 171 election became effective, but with regard to the

adjustments required under section 171(b)(1). Thus, for example, if a

dealer acquires in year 1 an instrument that is subject to section

475(a) and that has $10 of amortizable premium and if the dealer makes

an election to amortize premium that is first effective in year 4 (when

unamortized premium attributable to years 1 through 3 is $4), the

dealer takes into account the appropriate portion of the remaining $6

of amortizable bond premium (as required under section 171(b)(3)) each

taxable year before computing the mark-to-market adjustment on the

instrument

zable premium and if the dealer makes

an election to amortize premium that is first effective in year 4 (when

unamortized premium attributable to years 1 through 3 is $4), the

dealer takes into account the appropriate portion of the remaining $6

of amortizable bond premium (as required under section 171(b)(3)) each

taxable year before computing the mark-to-market adjustment on the

instrument. Any mark-to-market basis adjustments in taxable years 1

through 3 are ignored in determining the amount of amortizable bond

premium to which the election applies.

Under section 475(a)(2), a dealer in securities recognizes mark-to-

market gain or loss on a security, other than inventory, as if the

security were sold on the last business day of the taxable year.

Although there may be circumstances under which marking a security to

market produces results similar to the actual sale of the security, the

statutory reference to the deemed sale prescribes the amount of gain or

loss to be taken into account and does not trigger all of the

consequences of a sale and reacquisition under the Code. For example,

when a dealer in securities marks a bond (or other security) to market

and takes recognized gain or loss into account, the dealer has not

actually sold and reacquired the bond. Thus, under the proposed

regulations, marking a debt instrument does not create, increase, or

reduce market discount, acquisition premium, or bond premium.

The proposed regulations also contain a special rule to provide the

proper character for mark-to-market gains or losses on a market

discount instrument that was originally identified as held for

investment by the dealer. This rule is necessary to ensure that all

market discount is ultimately characterized as interest income and not

as gain from the sale of a security.

Worthless Debts

emium.

The proposed regulations also contain a special rule to provide the

proper character for mark-to-market gains or losses on a market

discount instrument that was originally identified as held for

investment by the dealer. This rule is necessary to ensure that all

market discount is ultimately characterized as interest income and not

as gain from the sale of a security.

Worthless Debts

The proposed regulations provide rules for marking a partially or

wholly worthless debt to market. These rules coordinate the mark-to-

market rules with the bad debt rules under the Code. The amount of gain

or loss recognized under section 475(a)(2) when a debt instrument is

marked to market generally is the difference between the adjusted basis

and the fair market value of the debt. Under the proposed regulations,

if a debt becomes partially or wholly worthless during a taxable year,

the amount of any gain or loss required to be taken into account under

section 475(a) is determined using a basis that reflects the

worthlessness. The basis of the mark-to-market debt is treated as

having been reduced by the amount of any book or regulatory charge-off

(including the establishment of a specific allowance for a loan loss)

for which a deduction could have been taken, without regard to whether

any portion of the charge-off is, in fact, deducted or charged to a tax

reserve for bad debts. The difference between this adjusted basis and

the fair market value of the debt is the amount of gain or loss to be

taken into account under section 475(a)(2). Thus, if the debt is wholly

worthless, its basis would be reduced to zero and no gain or loss would

be taken into account under section 475(a)(2).

This proposed treatment preserves the longstanding distinctions

between losses due to the worthlessness of debts and other losses on

debt instruments held by a taxpayer. See Sec

unt of gain or loss to be

taken into account under section 475(a)(2). Thus, if the debt is wholly

worthless, its basis would be reduced to zero and no gain or loss would

be taken into account under section 475(a)(2).

This proposed treatment preserves the longstanding distinctions

between losses due to the worthlessness of debts and other losses on

debt instruments held by a taxpayer. See Sec. 1.166-1(a), which

requires bad debts to be taken into account either as a specific

deduction in respect of debts or as a deduction for a reasonable

addition to a reserve for bad debts. See also Secs. 1.585-3 and 1.593-

7(c), which require a reserve-method taxpayer to charge bad debts to

the reserve for bad debts. In addition, computing the mark-to-market

adjustment as if the debt's basis had been adjusted to reflect

worthlessness preserves a taxpayer's ability to postpone

claiming a deduction for partial worthlessness until the debt becomes

wholly worthless. To the extent that a debt has been previously charged

off, mark-to-market gain is treated as a recovery.

The rules that are provided for bad debts in the proposed

regulations do not apply to debts accounted for by a dealer as

inventory under section 475(a)(1). Although it is possible for a debt

that is in inventory to become partially worthless prior to sale, the

likelihood or frequency of such an occurrence is difficult to ascertain

given the speed with which inventory is sold. Comments are requested,

however, concerning whether similar rules are necessary for partially

worthless debt that is accounted for as inventory of the dealer.

Dispositions

Although it is possible for a debt

that is in inventory to become partially worthless prior to sale, the

likelihood or frequency of such an occurrence is difficult to ascertain

given the speed with which inventory is sold. Comments are requested,

however, concerning whether similar rules are necessary for partially

worthless debt that is accounted for as inventory of the dealer.

Dispositions

Section 475(a) states that regulations may provide for securities

held by a dealer to be marked to market at times other than the end of

the dealer's taxable year. In general, the proposed regulations provide

that, if a dealer in securities ceases to be the owner of a security

for tax purposes, and if the security would have been marked to market

under section 475(a) if the dealer's taxable year had ended immediately

before the dealer ceases to own it, then (whether or not the security

is inventory in the hands of the dealer) the dealer must recognize gain

or loss as if the security had been sold for its fair market value

immediately before the dealer ceases to own it. Any gain or loss so

recognized is taken into account at that time.

In the absence of a mark upon disposition, a gain on a security

held by a dealer could be deferred by transferring the security before

the end of the taxable year to a related non-dealer in an intercompany

transaction or in a non-recognition, carry-over-basis transaction. This

potential for abuse is avoided if marking to market is required in

every case in which a dealer ceases to be the owner of a security for

tax purposes. The proposed requirement is analogous to the requirement

that applies to dispositions of securities that are required to be

marked to market under section 1256.

Transfers to which the proposed rule applies include the following:

saction. This

potential for abuse is avoided if marking to market is required in

every case in which a dealer ceases to be the owner of a security for

tax purposes. The proposed requirement is analogous to the requirement

that applies to dispositions of securities that are required to be

marked to market under section 1256.

Transfers to which the proposed rule applies include the following:

(a) Transfers to a controlled corporation under section 351; (b)

Transfers to a trust (other than a grantor trust); (c) Transfers by

gift to a charitable or non-charitable donee; (d) Transfers to other

members of the same controlled group; (e) Transfers to a partnership

under section 721; and (f) Transfers of mortgages to a REMIC under

section 860F(b).

In the case of a transfer by a dealer to a partnership, the basis

of a security transferred is generally its fair market value, because

the security is marked to market immediately before the transfer. Thus,

no special allocation issues arise. If there is any difference between

a transferred security's basis after the mark and its fair market value

(because, for example, the security transferred had been properly

identified as held for investment but ceased to be so held at some time

prior to the date of transfer), any special allocation of built-in gain

or loss with respect to that security in the hands of the partnership

will be made under section 704 and the regulations thereunder.

The mark to market immediately before disposition is separate and

distinct from the disposition transaction. Thus, for example, the gain

or loss from the mark is not gain or loss from a deferred intercompany

transaction under Sec. 1.1502-13.

Securities Acquired With Substituted Basis

that security in the hands of the partnership

will be made under section 704 and the regulations thereunder.

The mark to market immediately before disposition is separate and

distinct from the disposition transaction. Thus, for example, the gain

or loss from the mark is not gain or loss from a deferred intercompany

transaction under Sec. 1.1502-13.

Securities Acquired With Substituted Basis

The proposed regulations provide rules for situations where a

dealer in securities receives a security with a basis in its hands that

is determined, in whole or in part, either by reference to the basis of

the security in the hands of the transferor or by reference to other

property held at any time by the dealer. In these cases, section 475(a)

applies only to post-acquisition gain and loss with respect to the

security. That is, section 475(a) applies only to changes in value of

the security occurring after its acquisition. See section 475(b)(3).

The character of the mark-to-market gain or loss is determined as

provided under section 475(d)(3). The character of pre-acquisition gain

or loss (that is, the built-in gain or loss at the date the dealer

acquires the security) and the time for taking that gain or loss into

account are determined without regard to section 475. The fact that a

security has a substituted basis in the dealer's hands does not affect

the security's date of acquisition for purposes of determining the

timeliness of an identification under section 475(b).

The proposed regulations provide rules for the identification of

securities contributed and received in securitization transactions

account are determined without regard to section 475. The fact that a

security has a substituted basis in the dealer's hands does not affect

the security's date of acquisition for purposes of determining the

timeliness of an identification under section 475(b).

The proposed regulations provide rules for the identification of

securities contributed and received in securitization transactions.

Under the proposed regulations, a taxpayer that expects to contribute

securities to a trust or other entity in exchange for interests therein

may identify the contributed securities as held for investment (within

the meaning of section 475(b)(1)(A)) or not held for sale (within the

meaning of section 475(b)(1)(B)) only if it expects each of the

interests received (whether or not a security within the meaning of

section 475(c)(2)) to be either held for investment or not held for

sale to customers in the ordinary course of the taxpayer's business.

Thus, for example, if a mortgage banker securitizes its loans and does

not intend to hold for investment (or for other than sale to customers)

all of the interests received in the securitization transaction, the

mortgage banker will be required to account for its inventory of

mortgages at fair market value under section 475(a)(1), regardless of

whether the mortgages are to be sold to a trust or contributed to a

REMIC.

Under the proposed regulations, if a dealer engages in a

securitization transaction that results in dispositions of only partial

interests in the contributed securities, the dealer is not permitted to

identify the contributed securities as exempt under section

475(b)(1)(A) or (B). As a result, all of the contributed securities

must be accounted for under section 475(a). Moreover, under the mark-

on-disposition rule of these proposed regulations, the dealer is

required to mark the securities to market immediately before the

securitization transaction

curities, the dealer is not permitted to

identify the contributed securities as exempt under section

475(b)(1)(A) or (B). As a result, all of the contributed securities

must be accounted for under section 475(a). Moreover, under the mark-

on-disposition rule of these proposed regulations, the dealer is

required to mark the securities to market immediately before the

securitization transaction. The Service invites comments on whether

there are other administrable approaches that reflect the fact that

only a partial disposition of the securities has occurred.

In other securitization transactions, a taxpayer transfers

securities to a trust (or other entity) in a transaction that is not a

disposition of the securities for tax purposes. The trust issues

certificates (or other forms of interest) that represent secured debt

of the taxpayer rather than debt of the trust or ownership of the

underlying securities. In these cases, if the taxpayer retains the full

ownership of the contributed securities for tax purposes and if the

contributed securities otherwise qualify to be identified as held for

investment or not held for sale, then the taxpayer may identify the

securities as held for investment or not held for sale notwithstanding

the transfer.

Further, if a transfer of securities is a disposition, a taxpayer

may identify the interests received in a securitization transaction as

exempt from mark-to-market if the interests are described in section

475(b)(1) and are not treated for tax purposes as continuing ownership

of the securities transferred. This identification is permitted even if

the securitized assets were marked to market under section 475. For

example, a taxpayer may identify some of the REMIC regular

interests received on the transfer of mortgage securities to a REMIC,

even if the mortgages were subject to section 475(a)

n

475(b)(1) and are not treated for tax purposes as continuing ownership

of the securities transferred. This identification is permitted even if

the securitized assets were marked to market under section 475. For

example, a taxpayer may identify some of the REMIC regular

interests received on the transfer of mortgage securities to a REMIC,

even if the mortgages were subject to section 475(a). Conversely, a

taxpayer that has marked mortgages to market but subsequently

contributes those mortgages to a grantor trust and receives beneficial

interests therein may not identify the beneficial interests as exempt

from mark-to-market treatment, because the beneficial interests

represent continued ownership of the contributed securities, whose

eligibility for exemption was determined when they were acquired.

The proposed regulations clarify that an identification of a

security as exempt must specify the subparagraph of section 475(b)(1)

under which the exemption is claimed and that the time by which a

dealer must identify a security as exempt is not affected by whether

the dealer has a substituted basis in the security. The proposed

regulations also provide rules for determining whether an

identification of a security as exempt is timely where a dealer engages

in certain integrated transactions described in Sec. 1.1275-6 as

proposed on December 16, 1994 (FI-59-91, 59 FR 64884, 64905).

Definition of Dealer in Securities

as exempt is not affected by whether

the dealer has a substituted basis in the security. The proposed

regulations also provide rules for determining whether an

identification of a security as exempt is timely where a dealer engages

in certain integrated transactions described in Sec. 1.1275-6 as

proposed on December 16, 1994 (FI-59-91, 59 FR 64884, 64905).

Definition of Dealer in Securities

Section 475(c)(1) defines a dealer in securities as a taxpayer who

regularly purchases securities from, or sells securities to, customers

in the ordinary course of a trade or business or who regularly offers

to enter into, assume, offset, assign or otherwise terminate positions

in securities with customers in the ordinary course of a trade or

business.

The proposed regulations provide that whether a taxpayer is

transacting business with customers is determined based on all of the

facts and circumstances.

Under section 475(c)(1)(B) and the proposed regulations, the term

dealer in securities includes a taxpayer that, in the ordinary course

of its trade or business, regularly holds itself out as being willing

and able to enter into either side of a transaction enumerated in

section 475(c)(1)(B). For instance, if a taxpayer regularly holds

itself out as being willing to enter a swap in which it is either the

fixed or the floating payor, the taxpayer is a swaps dealer.

The proposed regulations clarify that a life insurance company does

not become a dealer in securities solely by selling annuity, endowment,

or life insurance policies to its customers. Under the temporary

regulations published on December 29, 1993 (T.D. 8505), a contract that

is treated for federal income tax purposes as an annuity, endowment, or

life insurance contract is deemed to have been identified as held for

investment, and is therefore not marked to market by the policy holder.

This was necessary because variable life and annuity products fall

within the literal language of section 475(c)(2)(E)

ns published on December 29, 1993 (T.D. 8505), a contract that

is treated for federal income tax purposes as an annuity, endowment, or

life insurance contract is deemed to have been identified as held for

investment, and is therefore not marked to market by the policy holder.

This was necessary because variable life and annuity products fall

within the literal language of section 475(c)(2)(E). Because many life

insurance companies sell these insurance contracts to their customers,

some commentators asked whether these life insurance companies were

dealers in securities. There is no indication that Congress intended

for a life insurance company that was not otherwise a dealer in

securities to be characterized as a dealer merely because it sells life

insurance policies to its customers. These proposed regulations provide

the appropriate clarification.

Definition of Security

The temporary regulations that were published on December 29, 1993

(T.D. 8505), exclude certain items from the definition of security.

Among the excluded items are liabilities of the taxpayer and negative

value residual interests (NVRIs) in a REMIC and other arrangements that

are determined to have substantially the same economic effect as NVRIs

(for example, a widely held partnership that holds noneconomic REMIC

residual interests). Those rules are needed to carry out the purposes

of section 475 and other Code provisions, including section 860E.

These proposed regulations clarify that a liability of the taxpayer

means a debt issued by the taxpayer. Also, for the reasons given below,

these proposed regulations exclude all REMIC residual interests from

the definition of security.

A typical REMIC holds a pool of long-term, real estate mortgages

originated at a ``blended'' interest rate. These mortgages are used to

support the issuance of regular interests, which are treated as debt,

with varied maturities and interest rates

the taxpayer. Also, for the reasons given below,

these proposed regulations exclude all REMIC residual interests from

the definition of security.

A typical REMIC holds a pool of long-term, real estate mortgages

originated at a ``blended'' interest rate. These mortgages are used to

support the issuance of regular interests, which are treated as debt,

with varied maturities and interest rates. The REMIC takes cash flows

on the mortgages and redirects them to holders of the regular

interests. As a result, there is generally a mismatch in the

recognition of interest income from the mortgages and the interest

expense attributable to the regular interests. This mismatch of

interest income and interest deductions results in taxable income or

loss that does not represent economic gain or loss. Some commentators

refer to this as ``phantom'' income or loss.

Phantom income or loss is allocated to the holders of the residual

interests in a REMIC even though that income or loss does not represent

any economic benefit or detriment to those holders. Further, sections

860C and 860E require a residual interest holder to pay taxes on a

portion of phantom income (called ``excess inclusion'') and to increase

the basis of the residual interest by the amount of phantom income.

Because this basis increase does not represent economic value, a

subsequent mark to market is likely to result in a loss. Permitting

taxpayers to take this loss into account currently under the mark-to-

market provisions effectively undermines the Congressional mandate

embodied in section 860E to require current taxation of phantom income.

Although the adverse effect of section 475 on section 860E is most

apparent when the residual interests being considered are NVRIs,

residual interests with positive value present the same issue

ers to take this loss into account currently under the mark-to-

market provisions effectively undermines the Congressional mandate

embodied in section 860E to require current taxation of phantom income.

Although the adverse effect of section 475 on section 860E is most

apparent when the residual interests being considered are NVRIs,

residual interests with positive value present the same issue. Many

residual interests with positive value, in spite of being entitled to

REMIC distributions, have substantially the same economic effect as

NVRIs and thus are already excluded by the temporary regulations from

the definition of ``security.'' The IRS is concerned, however, that

residual interests may be structured in a way that avoids embodying

substantially the same economic effects as an NVRI but that still

undermines the purposes of section 860E. The proposed regulations,

therefore, contain a rule that would remove from the category of

securities subject to section 475 all residual interests that are

acquired after January 4, 1995. Also removed are arrangements that are

acquired after that date and are determined to have substantially the

same economic effect as a REMIC residual interest (for instance, an

interest in a widely held partnership holding residual interests). The

temporary regulations continue to apply to all residual interests

described therein for all taxable years ending on or after December 31,

1993.

In addition, the Commissioner has determined that, if a residual

interest, or an interest or arrangement that has substantially the same

economic effect, is not a security within the meaning of section 475,

it should not be treated as inventory under other provisions.

Additional guidance on this matter will be issued.

Comments are requested concerning whether there are any residual

interests that do not undermine section 860E upon being marked to

market

interest, or an interest or arrangement that has substantially the same

economic effect, is not a security within the meaning of section 475,

it should not be treated as inventory under other provisions.

Additional guidance on this matter will be issued.

Comments are requested concerning whether there are any residual

interests that do not undermine section 860E upon being marked to

market. If comments are received that describe any such interests,

subsequent guidance may provide that they are included in the mark-to-

market regime. In this regard, it is important that any mechanism for

identifying these interests not impose an undue burden on either

taxpayers or the IRS.

Additional Comments Requested

The provisions of section 475 generally apply in determining the

taxable income of a dealer that may also be subject to various

international provisions of the Code. The Service is considering the

possibility of using the definitions contained in section 475 and the

regulations thereunder for purposes of various international

provisions, except where a modification of the provisions is necessary

to carry out the purposes of those international provisions. Comments

on this issue also are welcome.

Finally, the Service is considering whether there are additional

situations in which securities should not be accounted for under

section 475(a). (The temporary and proposed regulations that were

published on December 29, 1993, listed some such situations.) For

example, a dealer in securities may acquire at original issue and in

exchange for property certain non-interest-bearing debt instruments

that are not subject to the interest imputation provisions of section

1274 or 483. Because these instruments will seldom appreciate in value,

it may be inappropriate to subject them to the mark-to-market regime.

Dates of Applicability

such situations.) For

example, a dealer in securities may acquire at original issue and in

exchange for property certain non-interest-bearing debt instruments

that are not subject to the interest imputation provisions of section

1274 or 483. Because these instruments will seldom appreciate in value,

it may be inappropriate to subject them to the mark-to-market regime.

Dates of Applicability

The proposed regulations will apply to identifications made,

securities acquired, or events occurring, on or after January 4, 1995,

or to taxable years beginning on or after January 1, 1995, as

appropriate.

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 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 Wednesday, May 3, 1995 at

10 a.m. The public hearing will be held in the Internal Revenue

Auditorium, 7400 corridor, Internal Revenue Building, 1111 Constitution

Avenue NW, Washington, DC 20224. 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

y, May 3, 1995 at

10 a.m. The public hearing will be held in the Internal Revenue

Auditorium, 7400 corridor, Internal Revenue Building, 1111 Constitution

Avenue NW, Washington, DC 20224. 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 April 4, 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 authors of these regulations are Robert B. Williams

and JoLynn Ricks, Office of Assistant Chief Counsel (Financial

Institutions & 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 is amended by adding

entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

ated 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 is amended by adding

entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.475(a)-1 also issued under 26 U.S.C. 475(e).

Section 1.475(a)-2 also issued under 26 U.S.C. 475(a) and 26

U.S.C. 475(e).

Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).

* * * * *

Section 1.475(b)-3 also issued under 26 U.S.C. 475(e).

Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2) and 26

U.S.C. 475(e).

Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).

* * * * *

Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26

U.S.C. 860G(e).

* * * * *

Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).

* * * * *

Par. 2. Section 1.475-0 is added to read as follows:

Sec. 1.475-0 Table of contents.

This section lists headings contained in Secs. 1.475-0, 1.475(a)-1,

1.475(a)-2, 1.475(a)-3, 1.475(b)-1, 1.475(b)-2, 1.475(b)-3, 1.475(b)-4,

1.475(c)-1, 1.475(c)-2, 1.475(d)-1, and 1.475(e)-1.

Sec. 1.475-0 Table of contents.

Sec. 1.475(a)-1 Mark to market of debt instruments.

(a) Overview.

(b) No effect on amount of market discount, acquisition premium, or

bond premium.

(c) Accrual of interest, discount, and premium.

(1) Qualified stated interest.

(2) General rule regarding accrual of discount.

(3) Bond premium.

(d) Mandatory current inclusion of market discount.

(1) General rule.

(2) Interaction with section 1278(b).

(e) Recognition of market discount that accrued before section

475(a) applies to a market discount bond.

(1) General rule.

(2) Examples.

(f) Worthless debts

(1) Computation of mark-to-market gain or loss.

(2) Treatment of mark-to-market gain or loss.

(g) Additional rules applicable to reserve-method taxpayers.

usion of market discount.

(1) General rule.

(2) Interaction with section 1278(b).

(e) Recognition of market discount that accrued before section

475(a) applies to a market discount bond.

(1) General rule.

(2) Examples.

(f) Worthless debts

(1) Computation of mark-to-market gain or loss.

(2) Treatment of mark-to-market gain or loss.

(g) Additional rules applicable to reserve-method taxpayers.

(h) Example.

Sec. 1.475(a)-2 Mark to market upon disposition of security by a

dealer.

(a) General rule.

(b) Example.

Sec. 1.475(a)-3 Acquisition by a dealer of a security with a

substituted basis.

(a) Scope.

(b) Rules.

Sec. 1.475(b)-1 Scope of exemptions from mark-to-market

requirement.

(a) Securities held for investment or not held for sale.

(b) Securities deemed identified as held for investment.

(1) In general.

(2) Control defined.

(c) Securities deemed not held for investment.

(1) General rule for dealers in notional principal contracts and

derivatives.

(2) Exception for securities not acquired in dealer capacity.

Sec. 1.475(b)-2 Exemptions--Transitional issues.

(a) Transitional identification.

(1) Certain securities previously identified under section 1236.

(2) Consistency requirement for other securities.

(b) Corrections on or before January 31, 1994.

(1) Purpose.

(2) To conform to Sec. 1.475(b)-1(a)

(i) Added identifications.

(ii) Limitations.

(3) To conform to Sec. 1.475(b)-1(c).

(c) Effect of corrections.

Sec. 1.475(b)-3 Exemption of securities in certain securitization

transactions.

(a) Exemption of contributed assets.

(b) Exemption of resulting interests.

(1) General rule.

(2) Examples.

Sec. 1.475(b)-4 Exemptions--Identification requirements.

(a) Identification of the basis for exemption.

(b) Time for identifying a security with a substituted basis.

.475(b)-1(c).

(c) Effect of corrections.

Sec. 1.475(b)-3 Exemption of securities in certain securitization

transactions.

(a) Exemption of contributed assets.

(b) Exemption of resulting interests.

(1) General rule.

(2) Examples.

Sec. 1.475(b)-4 Exemptions--Identification requirements.

(a) Identification of the basis for exemption.

(b) Time for identifying a security with a substituted basis.

(c) Securities involved in integrated transactions under

Sec. 1.1275-6.

(1) Definitions.

(2) Synthetic debt held by a taxpayer as a result of legging in.

(3) Securities held after legging out.

Sec. 1.475(c)-1 Definitions--Dealer in securities.

(a) Sellers of nonfinancial goods and services.

(b) Taxpayers that purchase securities but do not sell more than a

negligible portion of the securities.

(1) Exemption from dealer status.

(2) Negligible portion.

(3) Special rules.

(c) Dealer-customer relationship.

(1) [Reserved].

(2) Transactions described in section 475(c)(1)(B).

(d) Issuance of life insurance products.

Sec. 1.475(c)-2 Definitions--Security.

(a) In general.

(b) Negative value REMIC residuals.

(c) Special rules.

(d) Synthetic debt held by a taxpayer as a result of an integrated

transaction under Sec. 1.1275-6.

Sec. 1.475(d)-1 Character of gain or loss.

Sec. 1.475(e)-1 Effective dates.

(a) Taxable years ending on or after December 31, 1993.

(b) Taxable years beginning on or after January 1, 1995.

(c) Securities acquired on or after January 4, 1995.

(d) Events occurring on or after January 4, 1995

.Par. 3. Section 1.475(a)-1 is added to read as follows:

Sec. 1.475(a)-1 Mark to market of debt instruments.

1.475(d)-1 Character of gain or loss.

Sec. 1.475(e)-1 Effective dates.

(a) Taxable years ending on or after December 31, 1993.

(b) Taxable years beginning on or after January 1, 1995.

(c) Securities acquired on or after January 4, 1995.

(d) Events occurring on or after January 4, 1995

.Par. 3. Section 1.475(a)-1 is added to read as follows:

Sec. 1.475(a)-1 Mark to market of debt instruments.

(a) Overview. This section provides rules for taking into account

interest accruals and gain and loss on a debt instrument to which

section 475(a) applies. Paragraph (b) of this section clarifies that

the mark-to-market computation affects neither the amount treated as

interest earned from a debt instrument nor the taxable year in which

that interest is taken into account. Paragraph (c) of this section

prescribes general rules. Paragraph (d) of this section prescribes

additional rules for instruments acquired with market discount.

Paragraph (e) of this section provides rules for taking into account

market discount that accrued on a bond before the bond became subject

to the mark-to-market requirements. Paragraph (f) of this section

prescribes rules for computing the mark-to-market gain or loss on

partially or wholly worthless debts, and paragraph (g) provides rules

for dealers accounting for bad debts using a reserve method of

accounting.

(b) No effect on amount of market discount, acquisition premium, or

bond premium. Marking a debt instrument to market does not create,

increase, or reduce market discount, acquisition premium, or bond

premium, nor does it affect the adjusted issue price of, or accruals of

original issue discount (OID) on, a bond issued with OID.

accounting for bad debts using a reserve method of

accounting.

(b) No effect on amount of market discount, acquisition premium, or

bond premium. Marking a debt instrument to market does not create,

increase, or reduce market discount, acquisition premium, or bond

premium, nor does it affect the adjusted issue price of, or accruals of

original issue discount (OID) on, a bond issued with OID.

(c) Accrual of interest, discount, and premium. In general, the

amount of gain or loss from marking a debt instrument to market is

computed after adjustments to basis for accruals of stated interest,

discount, and premium.

(1) Qualified stated interest. Immediately before a debt instrument

is marked to market under section 475(a), the holder of the instrument

must take any unpaid accrued qualified stated interest into account and

must correspondingly increase the basis of the instrument. The holder

must later decrease the basis of the instrument when accrued qualified

stated interest is actually received. (See Sec. 1.1273-1(c) for the

definition of qualified stated interest and Sec. 1.446-2(b) for the

rule governing its accrual.)

(2) General rule regarding accrual of discount. If a bond that was

acquired with OID or market discount is marked to market under section

475(a), then, immediately before the bond is marked to market, the

discount accrued through that date (determined under section 1272,

1275(d), or 1276, as applicable) is included in gross income, to the

extent not previously included, and the bond's basis is correspondingly

increased for amounts so included. (Because accrued OID is determined

under all of the rules of section 1272 and the regulations thereunder,

it is computed taking into account the reduction for acquisition

premium that is required by section 1272(a)(7).) See paragraph (d) of

this section, which requires the current inclusion in income of market

discount on bonds marked to market

respondingly

increased for amounts so included. (Because accrued OID is determined

under all of the rules of section 1272 and the regulations thereunder,

it is computed taking into account the reduction for acquisition

premium that is required by section 1272(a)(7).) See paragraph (d) of

this section, which requires the current inclusion in income of market

discount on bonds marked to market. See paragraph (e) of this section

for exceptions, and additional rules, for market discount bonds that

become subject to section 475(a) after acquisition.

(3) Bond premium. If a debt instrument that is subject to the basis

adjustment required by section 1016(a) (5) or (6) is marked to market

under section 475(a), then, immediately before the debt instrument is

marked to market, the required basis adjustment must be made.

Accordingly, the mark-to-market adjustment is computed after the basis

of the debt instrument has been adjusted under section 1016(a) (5) or

(6) for disallowed amortizable bond premium (in the case of tax-exempt

bonds) or deductible bond premium (in the case of taxable bonds). If an

election under section 171(c) is made after the first taxable year in

which section 475(a) applies to the bond, the amount of bond premium is

determined under section 171(b)(1) without regard to any basis

adjustments that may have been required as a result of the bond being

marked to market in prior taxable years. See paragraph (b) of this

section for the rule that marking a debt instrument to market does not

affect bond premium.

fter the first taxable year in

which section 475(a) applies to the bond, the amount of bond premium is

determined under section 171(b)(1) without regard to any basis

adjustments that may have been required as a result of the bond being

marked to market in prior taxable years. See paragraph (b) of this

section for the rule that marking a debt instrument to market does not

affect bond premium.

(d) Mandatory current inclusion of market discount--(1) General

rule. If section 475(a) applies to a bond during any portion of a

taxable year, gross income for that taxable year includes the market

discount attributable to the portion of the year to which section

475(a) applies (as determined under section 1276(b)). Section 1276 does

not apply to the bond except with respect to market discount, if any,

that accrued before the bond became subject to section 475(a).

Similarly, section 1277 does not apply to the bond except with respect

to any net direct interest expense (as defined in section 1277(c)) that

accrued before the bond became subject to section 475(a). See paragraph

(e) of this section for additional rules governing this situation. For

purposes of the Code other than the purposes described in the last

sentence of section 1278(b)(1), any amount included in gross income

under this paragraph (d)(1) is treated as interest. The bond's basis is

correspondingly increased for any amount so included in gross income.

(2) Interaction with section 1278(b). Paragraph (d)(1) of this

section applies to a dealer, even if the dealer has not elected under

section 1278(b) to include market discount currently. If the dealer has

not made that election, however, this paragraph (d) does not require

current inclusion of market discount on any bond to which section

475(a) does not apply.

nt so included in gross income.

(2) Interaction with section 1278(b). Paragraph (d)(1) of this

section applies to a dealer, even if the dealer has not elected under

section 1278(b) to include market discount currently. If the dealer has

not made that election, however, this paragraph (d) does not require

current inclusion of market discount on any bond to which section

475(a) does not apply.

(e) Recognition of market discount that accrued before section

475(a) applies to a market discount bond--(1) General rule. In the case

of a debt instrument that is acquired with market discount, that is not

subject to an election under section 1278(b), and that first becomes

subject to section 475(a) in the taxpayer's hands on a date after its

acquisition, this paragraph (e) governs the recognition of market

discount that is attributable (as determined under section 1276(b)) to

any period before section 475(a) applies to the debt instrument. To the

extent that the market discount described in the preceding sentence is

greater than the excess, if any, of the fair market value of the debt

instrument at the time it became subject to section 475(a) over its

adjusted basis at that time, section 1276(a)(1) applies to any gain

recognized under section 475(a). To the extent of any remaining market

discount that had accrued before section 475(a) became applicable,

section 1276(a) applies no later than it would have applied if section

475(a) did not apply to the bond. For example, section 1276(a) applies

to the previously accrued market discount as partial principal payments

are made. Except as provided in the preceding sentences, gain

recognized under section 475(a) is not recharacterized as interest by

section 1276(a).

(2) Examples. The rules of paragraphs (d) and (e) of this section

are illustrated by the following examples:

Example 1.

y to the bond. For example, section 1276(a) applies

to the previously accrued market discount as partial principal payments

are made. Except as provided in the preceding sentences, gain

recognized under section 475(a) is not recharacterized as interest by

section 1276(a).

(2) Examples. The rules of paragraphs (d) and (e) of this section

are illustrated by the following examples:

Example 1.

(i) Facts. Bond X was issued on January 1, 1996, for $1,000.

Bond X matures on December 31, 2005, provides for a principal

payment of $1,000 on the maturity date, and provides for interest

payments at a rate of 8%, compounded annually, on December 31 of

each year. D is a dealer in securities within the meaning of section

475(c)(1). On January 1, 1997, D purchased bond X for $955. D had

not elected under section 1278(b) to include market discount in

gross income currently. Under section 475(b), section 475(a) did not

apply to bond X until January 1, 1999, at which time bond X had a

fair market value of $961. On December 31, 1999, bond X had a fair

market value of $980.

(ii) Holdings. In the absence of an election under section

1276(b)(2), market discount on bond X accrues under section

1276(b)(1) at the rate of $5 per year. On January 1, 1999, when bond

X became subject to section 475(a), $10 of market discount had

accrued, but the excess of the bond's fair market value on January

1, 1999, over its adjusted basis on that date (the built-in gain)

was only $6 ($961--$955). During 1999, D is required to include as

interest income the $5 of market discount that accrues during that

year, and D increases by that amount its basis in the bond and the

amount to be used in computing mark-to-market gain or loss. On

December 31, 1999, B must mark bond X to market and recognize a gain

of $14 ($980--[$961 + $5]). Under section 1276(a)(1) and (4) and

paragraph (e)(1) of this section, $4 of that $14 gain is treated as

interest income

$5 of market discount that accrues during that

year, and D increases by that amount its basis in the bond and the

amount to be used in computing mark-to-market gain or loss. On

December 31, 1999, B must mark bond X to market and recognize a gain

of $14 ($980--[$961 + $5]). Under section 1276(a)(1) and (4) and

paragraph (e)(1) of this section, $4 of that $14 gain is treated as

interest income. The $4 is the amount by which the market discount

of $10 that had accrued on January 1, 1999, exceeded the $6 built-in

gain on that date.

Example 2.

(i) Facts. The facts are the same as in Example 1, except that,

in addition, D sells bond X for its fair market value of $1,000 on

June 30, 2000.

(ii) Holdings. Immediately before the sale, D is required to

include as interest income the $2.50 of market discount that accrued

during the portion of the year through June 30, and D increases by

that amount its basis in the bond and the amount to be used in

computing mark-to-market gain or loss. Also, under Sec. 1.475(a)-2,

immediately before the sale, D recognizes $17.50 of mark-to-market

gain (the increase in value since the preceding mark to market, less

the basis increase of $2.50 from the market discount accrual. See

Sec. 1.475(a)-2). On the sale, D also recognizes the $6 of built-in

gain, all of which is recharacterized as ordinary interest income

under section 1276(a)(4).

Example 3.

(i) Facts. The facts are the same as in Example 1, except that,

during 2001, the issuer of bond X made a partial principal payment

in the amount of $20.

(ii) Holdings. Under paragraph (e)(1) of this section and

section 1276(a)(4), $6 of the partial principal payment is included

in D's 2001 income as interest income. The $6 is the portion of the

$10 of market discount that had accrued at the time bond X became

subject to section 475(a) and that had not previously caused gain or

a partial principal payment to be treated as interest income.

20.

(ii) Holdings. Under paragraph (e)(1) of this section and

section 1276(a)(4), $6 of the partial principal payment is included

in D's 2001 income as interest income. The $6 is the portion of the

$10 of market discount that had accrued at the time bond X became

subject to section 475(a) and that had not previously caused gain or

a partial principal payment to be treated as interest income.

(f) Worthless debts--(1) Computation of mark-to-market gain or

loss. This paragraph (f) applies to any dealer that, under section

475(a)(2), marks to market either a debt that was charged off during

the year because it became partially worthless or a debt that became

wholly worthless during the taxable year (without regard to whether the

debt was charged off). Any gain or loss attributable to marking a debt

to market is determined by deeming the debt's adjusted basis to be the

debt's adjusted basis under Sec. 1.1011-1, less the amount charged off

during the taxable year or during any prior taxable year, to the extent

that amount has not previously reduced tax basis. A debt that becomes

wholly worthless is deemed to have an adjusted basis of zero. The

deemed adjusted basis, however, is used solely for this paragraph (f).

Thus, any portion of a loss attributable to a bad debt continues to be

accounted for under the bad debt provisions of the Code, and the basis

of the debt continues to be adjusted as otherwise required under the

Code.

y reduced tax basis. A debt that becomes

wholly worthless is deemed to have an adjusted basis of zero. The

deemed adjusted basis, however, is used solely for this paragraph (f).

Thus, any portion of a loss attributable to a bad debt continues to be

accounted for under the bad debt provisions of the Code, and the basis

of the debt continues to be adjusted as otherwise required under the

Code.

(2) Treatment of mark-to-market gain or loss. To the extent that a

debt has been previously charged off, mark-to-market gain is treated as

a recovery. Thus, for example, a dealer using the section 585 reserve

method of accounting for bad debts must credit to the reserve any

portion of mark-to-market gain that is treated as a recovery of a bad

debt previously charged to the reserve account, and the dealer must

include any excess in gross income as required by Sec. 1.585-3(a).

Similarly, if a dealer is a large bank that changed to the specific

charge-off method of accounting for bad debts using the elective cut-

off procedures described in Sec. 1.585-7, the dealer must charge to the

reserve for pre-disqualification loans all losses recognized as a

result of marking to market a debt that is a pre-disqualification loan

within the meaning of Sec. 1.585-7(b)(2). Marking a pre-

disqualification loan to market, however, is not a disposition of that

loan under Sec. 1.585-7(d).

(g) Additional rules applicable to reserve-method taxpayers. If a

dealer accounts for bad debts using the reserve method of accounting

under section 585 or 593, the following additional rules apply in

computing a reasonable addition to a reserve--

(1) To determine the amount of total loans outstanding, the

outstanding balance on a debt that is marked to market is increased or

decreased by the amount of any mark-to-market gain or loss recognized,

except that the outstanding balance of the debt may never exceed the

actual balance currently due; and

3, the following additional rules apply in

computing a reasonable addition to a reserve--

(1) To determine the amount of total loans outstanding, the

outstanding balance on a debt that is marked to market is increased or

decreased by the amount of any mark-to-market gain or loss recognized,

except that the outstanding balance of the debt may never exceed the

actual balance currently due; and

(2) If the reasonable addition to the reserve is computed based on

a percentage of taxable income, any gain or loss attributable to

marking a debt to market must be taken into account in computing

taxable income.

(h) Example. This example illustrates paragraphs (f) and (g) of

this section.

Example.

(i) B, a calendar year taxpayer, is a dealer that marks some of

its debts to market under section 475(a)(2). Additionally, B is a

bank that accounts for bad debts using the section 585 reserve

method of accounting. B has not made an election to use the

conformity method of accounting described in Sec. 1.166-2(d)(3).

(ii) On December 31, 1995, B has total loans outstanding of

$1,000,000 and a bad debt reserve balance of $1000. Among the loans

that B marks to market is loan X. On January 1, 1995, loan X had a

book and tax basis of $100. During the taxable year, loan taxable

became partially worthless, and B charged off the loan by $5. Thus,

loan X had a book basis of $95 and a tax basis of $100. The fair

market value of loan X was $94 on December 31, 1995.

(iii) B computes the amount of gain or loss to be taken into

account under section 475(a)(2) with respect to loan X

using the rules of paragraph (f) of this section. Under paragraph

axable year, loan taxable

became partially worthless, and B charged off the loan by $5. Thus,

loan X had a book basis of $95 and a tax basis of $100. The fair

market value of loan X was $94 on December 31, 1995.

(iii) B computes the amount of gain or loss to be taken into

account under section 475(a)(2) with respect to loan X

using the rules of paragraph (f) of this section. Under paragraph

(f)(1) of this section, B treats the adjusted tax basis of loan X as

having been reduced by the $5 charge-off. Thus, B determines that it

is required to take into account a $1 mark-to-market loss based on

the difference between B's adjusted basis in loan X of $95, as

determined under paragraph (f)(1) of this section, and loan X's fair

market value of $94.

(iv) Further, B decides to claim a bad debt deduction with

respect to loan X in 1995, rather than waiting until loan X becomes

totally worthless. Thus, B charges the $5 of partial worthlessness

to its reserve for bad debts. In computing a reasonable addition to

the reserve under section 585(b), B reduces the amount of its total

loans outstanding by $6 ($5 charged to the reserve for bad debts,

plus $1 mark-to-market loss).

(v) On December 31, 1997, loan X has a fair market value of $93

and an adjusted basis (and outstanding principal balance) of $90. No

additional worthlessness occurred with respect to loan X in 1996 or

1997. B determines that it is required to recognize a $3 mark-to-

market gain with respect to loan X. Because B previously charged $5

to the bad debt reserve with respect to loan X, the entire $3 is a

recovery item and must be credited to the bad debt reserve. See

paragraph (f)(2) of this section. In computing a reasonable addition

to the reserve for 1997, B does not increase the balance of its

total loans outstanding by the $3 mark-to-market gain, because that

adjustment would increase the balance to an amount in excess of the

actual outstanding principal balance of $90. See paragraph (g)(1) of

this section.

t be credited to the bad debt reserve. See

paragraph (f)(2) of this section. In computing a reasonable addition

to the reserve for 1997, B does not increase the balance of its

total loans outstanding by the $3 mark-to-market gain, because that

adjustment would increase the balance to an amount in excess of the

actual outstanding principal balance of $90. See paragraph (g)(1) of

this section.

Par. 4. Section 1.475(a)-2 is added to read as follows:

Sec. 1.475(a)-2 Mark to market upon disposition of security by a

dealer.

(a) General rule. If a dealer in securities ceases to be the owner

of a security for federal income tax purposes and if the security would

have been marked to market under section 475(a) if the dealer's taxable

year had ended immediately before the dealer ceases to own it, then

(whether or not the security is inventory in the hands of the dealer)

the dealer must recognize gain or loss on the security as if it were

sold for its fair market value immediately before the dealer ceases to

own it, and gain or loss is taken into account at that time. The amount

of any gain or loss subsequently realized must be properly adjusted, in

the form of a basis adjustment or otherwise, for gain or loss taken

into account under this paragraph (a). See Sec. 1.475(b)-4(b) for the

rule governing when a security with substituted basis must be

identified if it is to be exempted from the application of section

475(a).

(b) Example. The rule of paragraph (a) of this section is

illustrated by the following example.

Example.

djusted, in

the form of a basis adjustment or otherwise, for gain or loss taken

into account under this paragraph (a). See Sec. 1.475(b)-4(b) for the

rule governing when a security with substituted basis must be

identified if it is to be exempted from the application of section

475(a).

(b) Example. The rule of paragraph (a) of this section is

illustrated by the following example.

Example.

(i) Facts. D is a dealer in securities within the meaning of

section 475(c)(1) and is a member of a consolidated group that uses

the calendar year as its taxable year. On February 1, 1995, D

acquired for $100 a debt instrument issued by an unrelated party. On

June 1, 1995, D sold the debt instrument to another member of the

group, M1, for $110, which was the fair market value of the security

on that date. D would have been required to mark the debt instrument

to market under section 475(a) if its taxable year had ended

immediately before it sold the debt instrument to M1.

(ii) Holding. Under paragraph (a) of this section, D marks the

debt instrument to market immediately before the sale to M1 and

takes into account $10 of gain. The gain is not deferred

intercompany gain. As a result, D's basis in the debt instrument

increases to $110 immediately before the sale. Accordingly, there is

no gain or loss on the sale, and M1's basis in the debt instrument

is $110.

Par. 5. Section 1.475(a)-3 is added to read as follows:

Sec. 1.475(a)-3 Acquisition by a dealer of a security with a

substituted basis.

account $10 of gain. The gain is not deferred

intercompany gain. As a result, D's basis in the debt instrument

increases to $110 immediately before the sale. Accordingly, there is

no gain or loss on the sale, and M1's basis in the debt instrument

is $110.

Par. 5. Section 1.475(a)-3 is added to read as follows:

Sec. 1.475(a)-3 Acquisition by a dealer of a security with a

substituted basis.

(a) Scope. This section applies if--

(1) A dealer in securities acquires a security that is subject to

section 475(a) and the dealer's basis in the security is determined, in

whole or in part, by reference to the basis of that security in the

hands of the person from whom the security was acquired; or

(2) A dealer in securities acquires a security that is subject to

section 475(a) and the dealer's basis in the security is determined, in

whole or in part, by reference to other property held at any time by

the dealer.

(b) Rules. If this section applies to a security--

(1) Section 475(a) applies only to changes in value of the security

occurring after the acquisition; and

(2) Any built-in gain or loss with respect to the security (based

on the difference between the fair market value of the security on the

date the dealer acquired it and its basis to the dealer on that date)

is taken into account at the time, and has the character, provided by

the sections of the Code that would apply to the built-in gain or loss

if section 475(a) did not apply to the security.

Par. 6. Section 1.475(b)-3 is added to read as follows:

Sec. 1.475(b)-3 Exemption of securities in certain securitization

transactions.

ate the dealer acquired it and its basis to the dealer on that date)

is taken into account at the time, and has the character, provided by

the sections of the Code that would apply to the built-in gain or loss

if section 475(a) did not apply to the security.

Par. 6. Section 1.475(b)-3 is added to read as follows:

Sec. 1.475(b)-3 Exemption of securities in certain securitization

transactions.

(a) Exemption of contributed assets. If a taxpayer expects to

contribute securities (for example, mortgages) to a trust or other

entity, including a REMIC, in exchange for interests therein (including

ownership interests or debt issued by the trust or other entity), the

contributed securities qualify as held for investment (within the

meaning of section 475(b)(1)(A)) or not held for sale (within the

meaning of section 475(b)(1)(B)) only if the taxpayer expects each of

the interests received (whether or not a security within the meaning of

section 475(c)(2)) to be either held for investment or not held for

sale to customers in the ordinary course of the taxpayer's trade or

business.

(b) Exemption of resulting interests--(1) General rule. If a

taxpayer contributes securities to a trust or other entity in exchange

for interests therein (including ownership interests or debt issued by

the trust or other entity) and if, for federal income tax purposes, the

ownership of the interests received is not treated as ownership of the

securities contributed, the interests received may be identified as

being described in section 475(b)(1), even if some or all of the

contributed securities were not so described and could not have been so

identified. For purposes of determining the timeliness of an

identification of an interest received, the interest is treated as

acquired on the day of its receipt.

eated as ownership of the

securities contributed, the interests received may be identified as

being described in section 475(b)(1), even if some or all of the

contributed securities were not so described and could not have been so

identified. For purposes of determining the timeliness of an

identification of an interest received, the interest is treated as

acquired on the day of its receipt.

(2) Examples. The following examples illustrate the principles of

paragraph (b)(1) of this section.

Example 1. Identification of REMIC regular interests. If a

taxpayer holds mortgages that are marked to market under section 475

and the taxpayer contributes the mortgages to a REMIC in exchange

for REMIC regular interests that are described in section 475(b)(1),

the taxpayer may identify the regular interests as exempt from mark-

to-market treatment. This is permissible because REMIC regular

interests are debt securities issued by the REMIC and do not

represent continued ownership of the contributed mortgages.

Example 2. Identification of interests in a grantor trust. If a

taxpayer contributes securities to a grantor trust and receives

beneficial interests therein and if the taxpayer marked the

contributed securities to market under section 475, the taxpayer

cannot identify the beneficial interests in the grantor trust as

exempt from mark-to-market treatment. Because ownership of a

beneficial interest in a grantor trust represents continued

ownership of an undivided interest in the contributed assets, no new

security has been acquired.

Par. 7. Section 1.475(b)1-4 is added to read as follows:

Sec. 1.475(b)-4 Exemptions--Identification requirements.

(a) Identification of the basis for exemption. An identification of

a security as exempt does not satisfy section 475(b)(2) if it fails to

identify the subparagraph of section 475(b)(1) in which the security is

described.

contributed assets, no new

security has been acquired.

Par. 7. Section 1.475(b)1-4 is added to read as follows:

Sec. 1.475(b)-4 Exemptions--Identification requirements.

(a) Identification of the basis for exemption. An identification of

a security as exempt does not satisfy section 475(b)(2) if it fails to

identify the subparagraph of section 475(b)(1) in which the security is

described.

(b) Time for identifying a security with a substituted basis. For

purposes of determining the timeliness of an identification under

section 475(b)(2), the date that a dealer acquires a security is not

affected by whether the dealer's basis in the security is determined,

in whole or in part, either by reference to the basis of the security

in the hands of the person from whom the security was acquired or by

reference to other property held at any time by the dealer. See

Sec. 1.475(a)-3 for rules governing how the dealer accounts for such a

security if this identification is not made.

(c) Securities involved in integrated transactions under

Sec. 1.1275-6--(1) Definitions. The following terms are used in this

paragraph (c) with the meanings that are given to them by Sec. 1.1275-

6: integrated transaction, legging into, legging out, qualifying debt

instrument, Sec. 1.1275-6 hedge, and synthetic debt instrument.

(2) Synthetic debt held by a taxpayer as a result of legging in. If

a taxpayer becomes the holder of a synthetic debt instrument as the

result of legging into an integrated transaction, then, for purposes of

the timeliness of an identification under section 475(b)(2), the

synthetic debt instrument is treated as having the same acquisition

date as the qualifying debt instrument. A pre-leg-in identification of

the qualifying debt instrument under section 475(b)(2) applies to the

synthetic debt instrument as well.

rument as the

result of legging into an integrated transaction, then, for purposes of

the timeliness of an identification under section 475(b)(2), the

synthetic debt instrument is treated as having the same acquisition

date as the qualifying debt instrument. A pre-leg-in identification of

the qualifying debt instrument under section 475(b)(2) applies to the

synthetic debt instrument as well.

(3) Securities held after legging out. If a taxpayer legs out of an

integrated transaction, then, for purposes of the timeliness of an

identification under section 475(b)(2), the qualifying debt instrument,

or the Sec. 1.1275-6 hedge, that remains in the taxpayer's hands is

generally treated as having been acquired, originated, or entered into,

as the case may be, immediately after the leg-out. If any loss or

deduction determined under Sec. 1.1275-6(d)(2)(ii)(B) is disallowed by

Sec. 1.1275-6(d)(2)(ii)(D) (which disallows deductions when a taxpayer

legs out of an integrated transaction within 30 days of legging in),

then, for purposes of this section and section 475(b)(2), the

qualifying debt instrument that remains in the taxpayer's hands is

treated as having been acquired on the same date that the synthetic

debt instrument was treated as having been acquired.

Par. 8. Section 1.475(c)-1, as proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is revised.

2. Paragraphs (c) and (d) are added.

3. The revision and additions read as follows:

Sec. 1.475(c)-1 Definitions--Dealer in securities.

* * * * *

ing been acquired on the same date that the synthetic

debt instrument was treated as having been acquired.

Par. 8. Section 1.475(c)-1, as proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is revised.

2. Paragraphs (c) and (d) are added.

3. The revision and additions read as follows:

Sec. 1.475(c)-1 Definitions--Dealer in securities.

* * * * *

(c) Dealer-customer relationship. Whether a taxpayer is transacting

business with customers is determined on the basis of all of the facts

and circumstances.

(1) [Reserved].

(2) Transactions described in section 475(c)(1)(B). For purposes of

section 475(c)(1)(B), the term dealer in securities includes, but is

not limited to, a taxpayer that, in the ordinary course of the

taxpayer's trade or business, regularly holds itself out as being

willing and able to enter into either side of a transaction enumerated

in section 475(c)(1)(B). An example of a taxpayer willing to enter into

either side of a transaction is a taxpayer willing to enter into an

interest rate swap and either pay a fixed interest rate and receive a

floating rate or pay a floating rate and receive a fixed rate.

(d) Issuance of life insurance products. A life insurance company

that is not otherwise a dealer in securities under section 475(c)(1)

does not become a dealer solely because it regularly issues life

insurance products to its customers in the ordinary course of a trade

or business. For purposes of the preceding sentence, the term life

insurance product means a contract that is treated for federal income

tax purposes as an annuity, endowment, or life insurance contract. See

sections 817 and 7702.

Par. 9. Section 1.475(c)-2, as proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is revised.

2. Paragraph (a)(2) is revised.

3. Paragraph (a)(3) is amended by adding ``; or'' in lieu of the

period at the end of that paragraph.

4. Paragraph (a)(4) and paragraph (d) are added.

5

endowment, or life insurance contract. See

sections 817 and 7702.

Par. 9. Section 1.475(c)-2, as proposed on December 29, 1993 (58 FR

68798), is amended as follows:

1. The heading of the section is revised.

2. Paragraph (a)(2) is revised.

3. Paragraph (a)(3) is amended by adding ``; or'' in lieu of the

period at the end of that paragraph.

4. Paragraph (a)(4) and paragraph (d) are added.

5. The revisions and additions read as follows:

Sec. 1.475(c)-2 Definitions--Security.

(a) * * *

(2) A debt issued by the taxpayer (including a synthetic debt

instrument, within the meaning of Sec. 1275-6(b), that the taxpayer is

treated as having issued as a result of an integrated transaction under

Sec. 1.1275-(6);

(3) * * * ; or

(4) A REMIC residual interest, or an interest or arrangement that

is determined by the Commissioner to have substantially the same

economic effect, if the residual interest or the interest or

arrangement is acquired on or after January 4, 1995.

* * * * *

(d) Synthetic debt held by a taxpayer as a result of an integrated

transaction under Sec. 1.1275-6. If, as the result of an integrated

transaction under Sec. 1.1275-6, a taxpayer is treated as the holder of

a synthetic debt instrument (within the meaning of Sec. 1.1275-6(b)),

the synthetic debt instrument is a security held by the taxpayer within

the meaning of section 475(c)(2)(C). See Sec. 1.475(b)-4(c) for rules

governing identification of such a synthetic debt instrument for

purposes of section 475(b).

Par. 10. Section 1.475(e)-1, as proposed on December 29, 1993 (58

FR 68798), is revised to read as follows:

Sec. 1.475(e)-1. Effective dates.

c. 1.1275-6(b)),

the synthetic debt instrument is a security held by the taxpayer within

the meaning of section 475(c)(2)(C). See Sec. 1.475(b)-4(c) for rules

governing identification of such a synthetic debt instrument for

purposes of section 475(b).

Par. 10. Section 1.475(e)-1, as proposed on December 29, 1993 (58

FR 68798), is revised to read as follows:

Sec. 1.475(e)-1. Effective dates.

(a) Taxable years ending on or after December 31, 1993. The

following sections apply to taxable years ending on or after December

31, 1993: Secs. 1.475(b)-1 (concerning the scope of exemptions from

mark-to-market requirement), 1.475(b)-2 (concerning transitional issues

relating to exemptions), 1.475(c)-1(a) (concerning sellers of

nonfinancial goods and services) and (b) (concerning taxpayers that

purchase securities but do not sell more than a negligible portion of

the securities), 1.475(c)-2 (concerning the definition of security),

and 1.475(d)-1 (concerning the character of gain or loss). Note,

however, that, by its terms, Sec. 1.475(c)-2(a)(4) applies only to

interests or arrangements that are acquired on or after January 4,

1995, and the integrated transactions to which Sec. 1.475(c)-2(d)

applies will exist only after the effective date of Sec. 1.1275-6.

(b) Taxable years beginning on or after January 1, 1995. The

following sections apply to taxable years beginning on or after January

1, 1995: Secs. 1.475(a)-1 (concerning mark to market accounting for

debt instruments) and 1.475(c)-1(c) (concerning the dealer-customer

relationship) and (d) (concerning the issuance of life insurance

products).

t only after the effective date of Sec. 1.1275-6.

(b) Taxable years beginning on or after January 1, 1995. The

following sections apply to taxable years beginning on or after January

1, 1995: Secs. 1.475(a)-1 (concerning mark to market accounting for

debt instruments) and 1.475(c)-1(c) (concerning the dealer-customer

relationship) and (d) (concerning the issuance of life insurance

products).

(c) Securities acquired on or after January 4, 1995. The following

sections apply to securities acquired, originated, or entered into on

or after January 4, 1995: Secs. 1.475(a)-3 (concerning acquisition by a

dealer of a security with a substituted basis), 1.475(b)-3(a)

(concerning securities the taxpayer expects to contribute to a trust or

other entity in a securitization transaction), and 1.475(b)-3(b)

(concerning securities received in a securitization transaction).

(d) Events occurring on or after January 4, 1995.

(1) Section 1.475(a)-2 (concerning marking a security to market

upon disposition) applies to dispositions occurring on or after January

4, 1995.

(2) Section 1.475(b)-4 (concerning the identification requirements

for obtaining an exemption from mark-to-market treatment) applies to

identifications made on or after January 4, 1995.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-13 Filed 01-03-95; 8:45 am]

BILLING CODE 4830-01-U