[Federal Register Volume 59, Number 247 (Tuesday, December 27, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31433]


[[Page Unknown]]

[Federal Register: December 27, 1994]


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DEPARTMENT OF THE TREASURY
Internal Revenue Service

26 CFR Part 1

[FI-43-94]
RIN 1545-AS87

 

Netting Rule for Certain Conversion Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: The proposed regulations relate to the amount of gain from a 
conversion transaction position that is subject to recharacterization 
as ordinary income. The proposed regulations provide that certain gains 
and losses from positions of the same conversion transaction may be 
netted for purposes of determining the amount of gain that is 
recharacterized as ordinary income. These proposed regulations reflect 
changes to the law made by the Revenue Reconciliation Act of 1993 and 
affect persons who enter into conversion transactions.

DATES: Written comments must be received by March 28, 1995. Requests to 
speak (with outlines of oral comments) at a public hearing scheduled 
for April 25, 1995, must be received by April 4, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-43-94), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-43-94), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. The public hearing has been scheduled to be held in the 
Auditorium, Internal Revenue Building, 1111 Constitution Avenue NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Alan B. 
Munro, (202) 622-3950; concerning submissions and the hearing, Carol 
Savage, (202) 622-8452 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act (44 U.S.C. 
3504(h)). Comments on the collections of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 
20224.
    The collections of information are in Sec. 1.1258-1(b)(2). This 
information is required by the IRS to aid in administering the law and 
to prevent manipulation of the netting rules through the use of 
hindsight. This information will be used to determine whether the 
taxpayer has elected to net losses against gains before applying 
section 1258(a) and to verify that the taxpayer is properly reporting 
its conversion transactions that are subject to netting. The likely 
recordkeepers are business or other for-profit institutions and 
nonprofit institutions.

Estimated total annual recordkeeping burden: 5,000 hours.
The estimated annual burden per recordkeeper varies from .05 to 10.00 
hours, depending on individual circumstances, with an estimated average 
of .10 hour.
Estimated number of recordkeepers: 50,000.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 1258(a) of the Internal 
Revenue Code of 1986. Section 1258 was added to the Code by section 
13206(a) of the Revenue Reconciliation Act of 1993.
    Section 1258 treats certain capital gains from conversion 
transactions as ordinary income. A transaction is a conversion 
transaction if substantially all of the taxpayer's expected return is 
attributable to the time value of the taxpayer's net investment in the 
transaction and the transaction falls within one of four categories. 
The four categories of covered transactions are (1) acquiring property 
and substantially contemporaneously entering into a contract to sell 
that (or substantially identical) property, (2) applicable straddles, 
(3) transactions marketed or sold as producing capital gains, and (4) 
transactions specified in regulations.
    Gain generated by any position of a conversion transaction is 
treated as ordinary income to the extent of the applicable imputed 
income amount (AIIA). The AIIA is equal to the taxpayer's net 
investment in the transaction multiplied by the applicable rate, with 
certain adjustments. The applicable rate is generally 120 percent of 
the applicable Federal rate, determined as if the conversion 
transaction were a debt instrument.

Explanation of Provisions

A. Overview

    The purpose of section 1258 is to treat the time value income from 
conversion transactions as ordinary income. Section 1258(a) may create 
a character mismatch, however, because it focuses only on the gain 
recognized on the transaction. If a taxpayer separately disposes of the 
positions of a conversion transaction, the taxpayer's inability to net 
losses on the positions against gains could result in the 
recharacterization of gain in excess of the time value element.
    For example, assume that a taxpayer buys a capital asset for $100 
and simultaneously sells that asset forward for $105 in one year. 
Assume that the AIIA is $8. If the asset were delivered to close out 
the forward contract, the taxpayer would have a $5 capital gain. Even 
though the AIIA is $8, no more than the $5 gain would be 
recharacterized.
    Assume, instead, that the taxpayer sells the asset and closes out 
the forward contract in separate transactions when the value of the 
asset has dropped to $97. Gain subject to recharacterization under 
section 1258(a), determined separately for each position, is $8 on the 
forward contract. If the $3 loss on the asset were not netted against 
that $8 gain prior to applying section 1258(a), the full $8 gain would 
be recharacterized as ordinary income. This recharacterization would 
force the taxpayer to recognize $8 of ordinary income and $3 of non-
offsetting capital loss.
    The proposed regulations provide relief from this potential 
character mismatch in certain circumstances.

B. Specific Provisions

    The proposed regulations allow taxpayers to net gains and losses on 
the positions of certain conversion transactions for purposes of 
section 1258(a). To be eligible, the taxpayer must identify, before the 
close of the day on which the positions become part of the conversion 
transaction, all the positions that are part of the conversion 
transaction. In addition, the taxpayer must dispose of all the 
positions within a 14-day period that is within a single taxable year.
    The proposed regulations also provide special rules for losses on 
positions of conversion transactions. These rules prevent the netting 
of built-in loss against gain. In addition, the rules treat certain 
losses that arise during the term of a conversion transaction as built-
in losses.
    These regulations are proposed to be effective for conversion 
transactions entered into on or after the date of the filing of the 
final regulations with the Federal Register.

C. Solicitation of Comments on Other Issues

    The scope of the relief provided by the proposed regulations would 
be broadened if a taxpayer could elect to treat retained positions of a 
conversion transaction as if they were sold for their fair market 
values whenever another position of that transaction was disposed of, 
terminated, or treated as sold under any other provision of the Code or 
regulations. The proposed regulations do not include such a mark-to-
market provision. Marking positions to market raises a number of issues 
under other provisions of the Code (for example, sections 1271 through 
1278).
    The Service solicits comments on the necessity for and terms of a 
mark-to-market provision under section 1258.
    The Service is aware that section 1258 presents a number of issues 
not addressed by the proposed regulations. The Service invites comments 
concerning which, if any, of these issues should be addressed in future 
regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Tuesday, April 25, 1995, at 
10:00 a.m. in the IRS Auditorium. Because of access restrictions, 
visitors will not be admitted beyond the Internal Revenue Building 
lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by March 28, 1995, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by April 4, 1995.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Alan B. Munro, Office 
of Assistant Chief Counsel (Financial Institutions and Products). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

    Par. 2. Section 1.1258-1 is added to read as follows:


Sec. 1.1258-1  Netting rule for certain conversion transactions.

    (a) Purpose. The purpose of this section is to provide taxpayers 
with a method to net certain gains and losses from positions of the 
same conversion transaction before determining the amount of gain 
treated as ordinary income under section 1258(a).
    (b) Netting of gain and loss for identified transactions--(1) In 
general. If a taxpayer disposes of or terminates all the positions of 
an identified netting transaction (as defined in paragraph (b)(2) of 
this section) within a 14-day period in a single taxable year, all 
gains and losses on those positions realized within that period (other 
than built-in losses as defined in paragraph (c) of this section) are 
netted solely for purposes of determining the amount of gain treated as 
ordinary income under section 1258(a). A taxpayer is treated as 
disposing of any position that is treated as sold under any provision 
of the Code or regulations thereunder (for example, under section 
1256(a)(1)).
    (2) Identified netting transaction. For purposes of this section, 
an identified netting transaction is a conversion transaction (as 
defined in section 1258(c)) that the taxpayer identifies as an 
identified netting transaction on its books and records. Identification 
of each position of the conversion transaction must be made before the 
close of the day on which the position becomes part of the conversion 
transaction. No particular form of identification is necessary, but all 
the positions of a single conversion transaction must be identified as 
part of the same transaction and must be distinguished from all other 
positions.
    (c) Definition of built-in loss. For purposes of this section, 
built-in loss can arise in two situations. First, built-in loss as 
defined in section 1258(d)(3)(B) is built-in loss. Second, if a 
taxpayer realizes gain or loss on any one position of a conversion 
transaction (for example, under section 1256) and, as of the date that 
gain or loss is realized, there is unrealized loss in any other 
position of the conversion transaction that is not disposed of, 
terminated, or treated as sold under any provision of the Code or 
regulations thereunder within 14 days of and within the same taxable 
year as the realization event, that unrealized loss is built-in loss. 
See paragraph (d) Example 3 of this section.
    (d) Examples. These examples illustrate this section:

    Example 1. Identified netting transaction with simultaneous 
actual dispositions. (i) On December 1, 1995, A purchases 1,000 
shares of XYZ stock for $100,000 and enters into a forward contract 
to sell 1,000 shares of XYZ stock on November 30, 1997, for 
$110,000. The XYZ stock is actively traded as defined in 
Sec. 1.1092(d)-1(a) and is a capital asset in A's hands. A maintains 
books and records on which, on December 1, 1995, it identifies the 
two positions as all the positions of a single conversion 
transaction. A owns no other XYZ stock. On December 1, 1996, when 
the applicable imputed income amount for the transaction is $7,000, 
A sells the 1,000 shares of XYZ stock for $95,000. On the same day, 
A terminates its forward contract by entering into an offsetting 
position, receiving $10,200.
    (ii) The XYZ stock and forward contract are positions of a 
conversion transaction. Under section 1258(c)(1), substantially all 
of A's expected return from the overall transaction is attributable 
to the time value of the net investment in the transaction. Under 
section 1258(c)(2)(B), the transaction is an applicable straddle as 
defined in section 1258(d)(1).
    (iii) A disposed of or terminated all the positions of the 
conversion transaction within 14 days and within the same taxable 
year as required by paragraph (b)(1) of this section. The 
transaction is an identified netting transaction because it meets 
the identification requirement of paragraph (b)(2) of this section. 
Solely for purposes of section 1258(a), the $5,000 loss realized 
($100,000 basis less $95,000 amount realized) on the disposition of 
the XYZ stock is netted against the $10,200 gain recognized on the 
disposition of the forward contract. Thus, the net gain from the 
conversion transaction for purposes of section 1258(a) is $5,200 
($10,200 gain less $5,000 loss). Only the $5,200 net gain is 
recharacterized as ordinary income under section 1258(a) even though 
the applicable imputed income amount is $7,000. For federal tax 
purposes other than section 1258(a), A has recognized a $10,200 gain 
on the disposition of the forward contract ($5,200 of which is 
treated as ordinary income) and realized a separate $5,000 loss on 
the sale of the XYZ stock.
    Example 2. Identified netting transaction with built-in loss. 
(i) The facts are the same as in Example 1, except that A had 
purchased the XYZ stock for $104,000 on May 15, 1995. The XYZ stock 
had a fair market value of $100,000 on December 1, 1995, the date it 
became part of a conversion transaction.
    (ii) The results are the same as in Example 1, except that A has 
built-in loss (in addition to the $5,000 loss that arose 
economically during the period of the conversion transaction), as 
defined in section 1258(d)(3)(B), of $4,000 on the XYZ stock. That 
$4,000 built-in loss is not netted against the $10,200 gain on the 
forward contract for purposes of section 1258(a). Thus, the net gain 
from the conversion transaction for purposes of section 1258(a) is 
$5,200, the same as in Example 1. The $4,000 built-in loss is 
recognized and has a character determined without regard to section 
1258.
    Example 3. Identified netting transaction with position marked 
to market. (i) B, a calendar year taxpayer, holds a portfolio of 
Treasury securities that are capital assets in B's hands. On 
December 1, 1995, B enters into a short futures contract on Treasury 
securities that is a regulated futures contract (RFC) as defined in 
section 1256(g)(1). Although the RFC and some portion of B's 
portfolio of Treasury securities (the conversion Treasuries) 
constitute a straddle as defined in section 1092(c), B does not make 
an election under section 1256(d) to have section 1256 not apply to 
the RFC, nor does B make any identification or election under 
Sec. 1.1092(b)-3T or Sec. 1.1092(b)-4T (relating to certain 
identified mixed straddles or mixed straddle accounts, 
respectively). B maintains books and records on which, on December 
1, 1995, it identifies the conversion Treasuries and the RFC as all 
the positions of a single conversion transaction.
    (ii) As of December 29, 1995, the last business day of the 
taxable year, B has an unrealized loss on the conversion Treasuries 
of $8,000, wholly attributable to the period beginning December 1, 
1995, and ending December 29, 1995, and an unrealized gain on the 
RFC of $8,800. Under section 1256, B marks the RFC to market as of 
December 29, 1995. B continues to hold the conversion Treasuries.
    (iii) The conversion Treasuries and RFC are positions of a 
conversion transaction. Under section 1258(c)(1), substantially all 
of B's expected return from the overall transaction is attributable 
to the time value of the net investment in the transaction. Under 
section 1258(c)(2)(B), the transaction is an applicable straddle as 
defined in section 1258(d)(1).
    (iv) The transaction is an identified netting transaction 
because it meets the identification requirement of paragraph (b)(2) 
of this section. Paragraph (b)(1) of this section does not apply to 
the transaction, however, because B did not dispose of or terminate 
all the positions of the conversion transaction within the same 14-
day period in the same taxable year. There has been no disposition 
or termination of the conversion Treasuries by December 31, 1995, 
the end of B's taxable year in which it is treated as having sold 
the RFC.
    (v) The $8,000 excess of B's basis in the conversion Treasuries 
over their fair market value on December 29, 1995, is built-in loss 
under paragraph (c) of this section. Under paragraph (b)(1) of this 
section, that $8,000 built-in loss is not available to offset later 
gain on the positions.

    (e) Effective date. This section is effective for conversion 
transactions entered into on or after the date of the filing of the 
final regulations with the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 94-31433 Filed 12-23-94; 8:45 am]
BILLING CODE 4830-01-U