[Federal Register Volume 60, Number 245 (Thursday, December 21, 1995)]
[Rules and Regulations]
[Pages 66083-66085]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30900]



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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[TD 8649]
RIN 1545-AS87


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to 
conversion transactions. These regulations provide that certain gains 
and losses from positions of the same conversion transaction may be 
netted for purposes of determining the amount of gain that is 
recharacterized as ordinary income. These regulations reflect changes 
to the law made by the Revenue Reconciliation Act of 1993 and affect 
persons who enter into conversion transactions.

DATES: These regulations are effective December 21, 1995.
    For applicability of these regulations, see EFFECTIVE DATES under 
the SUPPLEMENTARY INFORMATION part of the preamble.

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

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1452. Responses to this collection of information 
are required to obtain netting relief for conversion transactions.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The estimated annual burden per recordkeeper varies from .05 to 10 
hours, depending on individual circumstances, with an estimated average 
of .10 hour.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, 
DC 20224, and to the Office of Management and Budget, Attn: Desk 
Officer for the Department of the Treasury, Office of Information and 
Regulatory Affairs, Washington, DC 20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On December 27, 1994, the IRS published in the Federal Register a 
notice of proposed rulemaking and notice of public hearing at 59 FR 
66498 (FI-43-94) under section 1258 of the Internal Revenue Code of 
1986.
    The IRS received a number of written comments on the proposed 
regulations. No requests to speak at the public hearing were received, 
however, and consequently the hearing was cancelled.

Explanation of Provisions

A. General

    The proposed regulations allow taxpayers to net gains and losses on 
the positions of certain conversion transactions for purposes of 
section 1258(a). For a taxpayer to be eligible, the proposed 
regulations require the taxpayer to identify, before the close of the 
day on which the positions become part of the conversion transaction, 
all the positions that are part of the conversion transaction. In 
addition, the taxpayer has to dispose of all the positions within a 14-
day period that is within a single taxable year. The proposed 
regulations also define built- in loss and prohibit the netting of 
built-in loss against gain.
    The commenters uniformly supported the netting relief provided by 
the proposed regulations. Accordingly, the final regulations are 
substantially unchanged from the proposed regulations.
    The proposed regulations provide that the regulations will be 
effective for conversion transactions entered into on or after the date 
of filing of final regulations with the Federal Register. Several 
commenters requested that the regulations also apply to conversion 
transactions entered into prior to the filing date. In response to 
these comments, the final regulations provide for application of the 
regulations to any conversion transaction that is outstanding on 
December 21, 1995, provided that all the positions which are part of 
the conversion transaction are identified under Sec. 1.1258-1(b)(2) 
before the close of business on February 20, 1996. The final 
regulations also provide a transition rule for the same-day 
identification requirement that allows taxpayers to identify conversion 
transactions entered into prior to February 20, 1996, at any time on or 
before February 20, 1996.
    Several commenters criticized the examples for failing to adjust 
the applicable imputed income amount (AIIA) under section 1258(b) for 
interest and dividends received. The scope of these regulations, 
however, is limited to netting relief. The IRS is still studying 
various situations to determine the extent to which it is appropriate 
to reduce the AIIA by reason of amounts capitalized under section 
263(g), ordinary income received, or otherwise. Accordingly, Example 3 
has been deleted and Examples 1 and 2 have been clarified to eliminate 
any implication on this issue.
    One commenter requested that the identification requirement be 
eliminated as impractical, unnecessary, and a trap for the unwary. This 
same-day identification requirement is similar to identification 
requirements under sections 475 and 1221. Identification of all the 
positions of a conversion transaction will aid examiners attempting to 
determine whether conversion transactions are present and will prevent 
mismatching of those positions by both taxpayers and agents. The final 
regulations retain the same-day identification requirement but provide 
a transition rule. 

[[Page 66084]]

    Some commenters asked that netting relief be expanded to cover 
unrealized losses in retained positions by allowing loss positions to 
be marked to market when a gain position is disposed of or terminated. 
Allowing retained positions to be marked to market raises valuation and 
other potentially complex issues. For example, many of the issues 
addressed by the regulations under section 475 would have to be 
addressed here. The complexity of these issues outweighs the potential 
benefit of allowing retained positions to be marked to market. Thus, 
the final regulations do not include a mark-to-market provision.
    To preserve the character of gain that arose before a position 
became part of a conversion transaction, one commenter requested built-
in gain rules similar to the built-in loss rules in the proposed 
regulations. The appropriateness of a built-in gain rule under section 
1258 is beyond the scope of these regulations. Therefore, the final 
regulations do not address this issue.
    The IRS is aware that section 1258 presents a number of issues not 
addressed by these final regulations. The IRS continues to study the 
scope of section 1258, the types of transactions that should be 
included under the regulatory authority of section 1258(c)(2)(D), and 
what reductions, if any, in the AIIA are appropriate under section 
1258(b). The IRS welcomes comments on these and other issues under 
section 1258.

B. Effective Dates

    The regulations are effective for conversion transactions that are 
outstanding on or after December 21, 1995. In the case of a conversion 
transaction entered into before February 20, 1996, the same-day 
identification requirement is treated as satisfied if the 
identification is made on or before February 20, 1996.

Special Analyses

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

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

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

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

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


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

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

    Example 1. Identified netting transaction with simultaneous 
actual dispositions. (i) On December 1, 1995, A purchases 1,000 
shares of XYZ stock for $100,000 and enters into a forward contract 
to sell 1,000 shares of XYZ stock on November 30, 1997, for 
$110,000. The XYZ stock is actively traded as defined in 
Sec. 1.1092(d)-1(a) and is a capital asset in A's hands. A maintains 
books and records on which, on December 1, 1995, it identifies the 
two positions as all the positions of a single conversion 
transaction. A owns no other XYZ stock. On December 1, 1996, when 
the applicable imputed income amount for the transaction is $7,000, 
A sells the 1,000 shares of XYZ stock for $95,000. On the same day, 
A terminates its forward contract with its counterparty, receiving 
$10,200. No dividends were received on the stock during the time it 
was part of the conversion transaction.
    (ii) The XYZ stock and forward contract are positions of a 
conversion transaction. Under section 1258(c)(1), substantially all 
of A's expected return from the overall transaction is attributable 
to the time value of the net investment in the transaction. Under 
section 1258(c)(2)(B), the transaction is an applicable straddle as 
defined in section 1258(d)(1).
    (iii) A disposed of or terminated all the positions of the 
conversion transaction within 14 days and within the same taxable 
year as required by paragraph (b)(1) of this section. The 
transaction is an identified netting transaction because it meets 
the identification requirement of paragraph (b)(2) of this section. 
Solely for purposes of section 1258(a), the $5,000 loss realized 
($100,000 basis less $95,000 amount realized) on the disposition of 
the XYZ stock is netted against the $10,200 gain recognized on the 
disposition of the forward contract. Thus, the net gain from the 
conversion transaction for purposes of section 1258(a) is $5,200 

[[Page 66085]]
($10,200 gain less $5,000 loss). Only the $5,200 net gain is 
recharacterized as ordinary income under section 1258(a) even though 
the applicable imputed income amount is $7,000. For federal tax 
purposes other than section 1258(a), A has recognized a $10,200 gain 
on the disposition of the forward contract ($5,200 of which is 
treated as ordinary income) and realized a separate $5,000 loss on 
the sale of the XYZ stock.
    Example 2. Identified netting transaction with built-in loss. 
(i) The facts are the same as in Example 1, except that A had 
purchased the XYZ stock for $104,000 on May 15, 1995. The XYZ stock 
had a fair market value of $100,000 on December 1, 1995, the date it 
became part of a conversion transaction.
    (ii) The results are the same as in Example 1, except that A has 
built-in loss (in addition to the $5,000 loss that arose 
economically during the period of the conversion transaction), as 
defined in section 1258(d)(3)(B), of $4,000 on the XYZ stock. That 
$4,000 built-in loss is not netted against the $10,200 gain on the 
forward contract for purposes of section 1258(a). Thus, the net gain 
from the conversion transaction for purposes of section 1258(a) is 
$5,200, the same as in Example 1. The $4,000 built-in loss is 
recognized and has a character determined without regard to section 
1258.

    (e) Effective date and transition rule--(1) In general. These 
regulations are effective for conversion transactions that are 
outstanding on or after December 21, 1995.
    (2) Transition rule for identification requirements. In the case of 
a conversion transaction entered into before February 20, 1996, 
paragraph (b)(2) of this section is treated as satisfied if the 
identification is made before the close of business on February 20, 
1996.

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

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

    Authority: 26 U.S.C. 7805.


Sec. 602.101  [Amended]

    Par. 4. In Sec. 602.101, paragraph (c) is amended by adding the 
entry ``1.1258-1 * * * .1545-1452'' in numerical order to the table.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: November 28, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30900 Filed 12-20-95; 8:45 am]
BILLING CODE 4830-01-U