[Federal Register Volume 66, Number 12 (Thursday, January 18, 2001)]
[Proposed Rules]
[Pages 4746-4751]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1240]
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DEPARTMENT OF TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-105801-00]
RIN 1545-AX92
Capitalization of Interest and Carrying Charges Properly
Allocable to Straddles
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 that clarify the
application of the straddle rules to a variety of financial
instruments. The proposed regulations clarify what constitutes interest
and carrying charges and when interest and carrying charges are
properly allocable to personal property that is part of a straddle. The
proposed regulations also clarify that a taxpayer's obligation under a
debt instrument can be a position in personal property that is part of
a straddle. The proposed regulations provide guidance to taxpayers that
enter into straddle transactions. This document provides notice of a
public hearing on these proposed regulations.
DATES: Written and electronic comments and requests to appear and
outlines of topics to be discussed at the public hearing scheduled for
May 22, 2001, at 10 a.m., must be submitted by May 1, 2001.
ADDRESSES: Send submissions to: CC:M&SP:RU (REG-105801-00), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand delivered between the hours of 8 a.m.
and 5 p.m. to: CC:M&SP:RU (REG-105801-00), Courier's Desk, Internal
Revenue Service, 1111 Constitution Avenue NW., Washington, DC.
Alternatively, taxpayers may submit comments electronically via the
Internet by submitting comments directly to the IRS Internet site at
http://www.irs.gov/tax__regs/regslist.html. The public hearing will be
held in the Auditorium, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Kenneth Christman (202) 622-3950; concerning submission and delivery of
comments and the public hearing, Treena Garrett, (202) 622-7180 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Sections 501 and 502 of the Economic Recovery Tax Act of 1981 (Pub.
L. 97-34, 95 Stat. 172) added sections 1092 and 263(g), respectively,
to the Internal Revenue Code to address certain deferral and conversion
strategies involving economically offsetting positions in actively
traded personal property. These economically offsetting positions are
called straddles. Section 1092(c)(1).
In general, under section 1092, a taxpayer that realizes a loss on
a position in actively traded personal property must defer the
recognition of the loss to the extent the taxpayer has unrecognized
gain on an economically offsetting position in the property. This
deferral rule matches the recognition of loss with the recognition of
the economically offsetting income. Section 263(g) addresses interest
and carrying charges properly allocable to personal property that is
part of a straddle. Under this section, these otherwise deductible
expenses are not currently deductible. Instead, they must be
capitalized into the basis of the property. By requiring
capitalization, section 263(g) prevents: (1) A taxpayer from gaining a
timing advantage by accruing deductions associated with carrying the
straddle transaction before recognizing income from a position in
personal property that is part of the straddle; and (2) the deductions
from having a character different from that of the income.
These proposed regulations provide certain rules with respect to
the application of section 263(g) and section 1092.
Explanation of Provisions
The proposed regulations consist of Sec. 1.263(g)-1, which provides
a general introduction, and Secs. 1.263(g)-2, 1.263(g)-3, 1.263(g)-4,
and 1.263(g)-5, described below. The proposed regulations also include
a new paragraph 1.1092(d)-1(d).
The proposed regulations generally address four issues: (1) The
definition of personal property as such term is used in section 263(g)
(in Sec. 1.263(g)-2); (2) the type of payments that are subject to the
capitalization rules of section 263(g) (in Sec. 1.263(g)-3); (3) the
operation of the capitalization rules of section 263(g) (in
Sec. 1.263(g)-4); and (4) the circumstances under which an issuer's
obligation under a debt instrument can be a position in actively traded
personal property and, therefore, part of a straddle (in
Sec. 1.1092(d)-1(d)). These issues are discussed in more detail below.
Definition of the Term Personal Property for Purposes of Section 263(g)
Section 263(g)(1) requires capitalization of interest and carrying
charges properly allocable to personal property that is part of a
straddle (as defined in section 1092(c)). Section 1092(d)(1) defines
personal property for purposes of section 1092, as personal property of
a type that is actively traded. Commentators have suggested that
because sections 263(g) and 1092 were enacted at the same time, the
term personal property as used in section 263(g) should be given the
same definition under section 1092(d)(1). This would limit the
definition of personal property in section 263(g) to personal property
of a type that is actively traded.
Despite this suggestion, the proposed regulations provide that
personal property has its common law meaning in section 263(g) for two
reasons. First, the definition in section 1092(d)(1) by its terms
applies only for purposes of section 1092. Second, the broader, common
law interpretation of personal property more closely accords with the
purposes of section 263(g). Application of the limited definition in
section
[[Page 4747]]
1092(d)(1) for purposes of section 263(g) could result in dissimilar
tax treatment of economically similar transactions. For example,
adoption of the narrower definition would cause section 263(g) to apply
to a transaction in which a taxpayer borrows to purchase actively
traded personal property that is a part of a straddle but not to a
similar transaction in which the taxpayer borrows to purchase a
derivative instrument that is not itself actively traded but is a
position in actively traded property.
Consequently, proposed Sec. 1.263(g)-2 defines personal property as
a property right, whether or not actively traded, other than a right in
real property. This definition includes both financial positions that
provide substantial rights but do not impose substantial obligations on
the holder (e.g., common stock or a purchased option) and executory
contracts that impose both rights and obligations on the holder (e.g.,
notional principal contracts (NPC's) and forward transactions).
However, the definition excludes straddles comprised only of financial
positions that impose only obligations on the holder (e.g., the
obligor's position in a debt instrument or a writer's position in an
option).
Payments That Are Subject to the Capitalization Rules of Section 263(g)
Section 263(g)(1) provides for the capitalization of interest and
carrying charges. For this purpose, interest and carrying charges are
collectively defined in section 263(g)(2) as ``interest incurred or
continued to purchase or carry the personal property'' and ``all other
amounts (including charges to insure, store, or transport) paid or
incurred to carry the personal property,'' less certain types of income
from the personal property.
The phrase ``incurred or continued to purchase or carry'' also
appears in section 265(a)(2), which disallows interest expense on
indebtedness incurred or continued to purchase or carry tax-exempt
debt. Rev. Proc. 72-18 (1972-1 C.B. 740) sets out rules for determining
when this standard is met for purposes of section 265(a)(2). Under that
revenue procedure, indebtedness issued by a taxpayer that is not a
dealer in tax-exempt obligations meets this standard if: (1) The
proceeds of the indebtedness are directly traceable to the purchase of
the tax-exempt obligations, (2) the tax-exempt obligations are used as
collateral for the borrowing, or (3) the totality of the facts and
circumstances supports a reasonable inference that the purpose of the
borrowing was to purchase or carry tax-exempt obligations. In general,
the facts-and-circumstances test is met if there is a ``sufficiently
direct relationship'' between the borrowing and the investment in the
tax-exempt obligations. Similarly, the proposed regulations provide
that a sufficiently direct relationship between indebtedness or other
financing and personal property that is part of a straddle exists if
payments on the indebtedness or other financing are determined by
reference to the value or change in value of the personal property. See
Sec. 1.263(g)-3(c).
Section 263(g) also applies to ``all other amounts (including
charges to insure, store or transport the personal property)'' paid or
incurred to carry personal property that is part of a straddle. As
noted by one commentator, ``taxpayers should not be permitted to deduct
items incurred in connection with protecting or preserving the value of
assets'' that are part of a straddle. Therefore, the term, to carry in
the context of section 263(g) includes the reduction of the risk of
holding an asset. Because straddles necessarily involve positions that
offset each other, the positions ``carry'' each other.
Accordingly, under Sec. 1.263(g)-3(b) of the proposed regulations,
interest and carrying charges subject to capitalization under section
263(g) include: (1) Otherwise deductible payments or accruals
(including interest and original issue discount) on indebtedness or
other financing issued or continued to purchase or carry personal
property that is part of a straddle; (2) otherwise deductible fees or
expenses paid or incurred in connection with the taxpayer's acquiring
or holding personal property that is part of a straddle, including, but
not limited to, fees or expenses incurred to purchase, insure, store,
maintain, or transport the personal property; and (3) other otherwise
deductible payments or accruals on financial instruments that are part
of a straddle or that carry part of a straddle.
Section 263(g) requires capitalization of interest and carrying
charges that exceed certain specified income inclusions (allowable
offsets) listed in section 263(g)(2)(B). Section 1.263(g)-3(e) sets
forth the allowable offsets, including amounts that are receipts or
accruals on financial instruments that are part of a straddle or carry
part of a straddle. The Treasury Department and the IRS solicit
comments regarding whether other amounts should be treated as allowable
offsets for purposes of section 263(g).
Operation of the Capitalization Rules of Section 263(g)
Generally, section 263(g) coordinates the character and timing of
items of income and loss attributable to a taxpayer's position in a
straddle by allocating interest and carrying charges to the capital
account of a position in personal property that is part of the
straddle. Proposed regulation Sec. 1.263(g)-4 provides a set of
allocation rules governing the ``capitalization'' of interest and
carrying charges.
In many cases, certain allocation rules readily suggest themselves.
Congress was aware of ``cash and carry'' transactions in adopting
section 263(g). See H.R. Rep. No. 201, 97th Cong. 1st Sess. 203-04
(1981). In a typical transaction, a taxpayer borrows to purchase
personal property and sells the property forward. The debt instrument
generates ordinary deductions (interest expense) that precede
predictable (and approximately equal) capital gains on the sale of the
personal property. Coordination of the amount and timing of income and
loss in a cash and carry transaction is achieved under the proposed
regulation by allocating the interest expense to the capital account of
the personal property. This rule applies to all transactions in which a
taxpayer has borrowed to purchase personal property that is part of a
straddle.
If the proceeds of a borrowing are not used to purchase personal
property, a second allocation rule allocates interest expense to
personal property when the personal property collateralizes the
borrowing. See Rev. Proc. 72-18, Sec. 3.03 (disallowing interest
deduction for debt secured by tax-exempt obligations); Rev. Rul. 78-348
(1978-2 C.B. 95) (applying yield restrictions to investments pledged by
person benefitting from tax-exempt bond financing).
A third allocation rule of the proposed regulations allocates
interest on indebtedness to personal property when payments on the
indebtedness are determined by reference to the value, or change in
value, of the personal property that is part of a straddle.
Fees and charges related to the maintenance of the personal
property, such as charges to insure, store, or transport the personal
property, are allocated to the capital account of that personal
property. See S. Rep. No. 144, 97th Cong. 1st Sess. 154 (1981).
In other cases, the appropriate method for allocating capitalized
interest and carrying charges is less obvious. This may be true of
payments or accruals on a financial instrument, such as a NPC,
described in proposed Sec. 1.263(g)-3(d).
[[Page 4748]]
For example, the proposed rules would apply to a taxpayer that holds
stock and enters into an equity swap that is a short position with
respect to the stock. In such a case, both the stock and the equity
swap may be personal property that is part of a straddle, and payments
on the equity swap could be capitalized with respect to the capital
account of either the stock or the equity swap. However, it may not be
clear how a capitalization rule would apply in conjunction with the
rules under Sec. 1.446-3 with respect to payments on NPCs. Accordingly,
the proposed rules provide that, in cases to which a specific
allocation rule is not applicable, interest and carrying charges will
be allocated to personal property that is part of a straddle in the
manner that is most appropriate under all the facts and circumstances.
Proposed regulations Sec. 1.263(g)-4(c) Example 7 (relating to a
straddle consisting of stock and an equity swap) illustrate one
application of this facts and circumstances rule. The Treasury
Department and the IRS invite comments and suggestions regarding both
the proposed specific allocation rules and the general facts and
circumstances allocation rule.
The regulations under section 263(g) are proposed to be effective
for expenses paid, incurred, or accrued after the date the regulations
are adopted as final for straddles established on or after January 17,
2001. See Sec. 1.263(g)-5.
Obligation Under a Debt Instrument as a Position in Personal Property
If a taxpayer is the obligor under a debt instrument that provides
for one or more payments linked to the value of actively traded
personal property, the value of the taxpayer's obligation under the
debt instrument changes as the value of the referenced property
changes. For this reason, the taxpayer's position as obligor under the
debt instrument functions as a position in the referenced property.
Some commentators have suggested that a debt instrument (other than
one denominated in an actively traded foreign currency) cannot be a
position of the obligor in personal property that is part of a
straddle. Section 1092(d)(7) provides that an obligor's interest in a
nonfunctional-currency-denominated debt instrument is treated under
section 1092(d)(2) as a position in the nonfunctional currency. From
this, the commentators infer that an obligor's interest in a debt
instrument may never be treated as an interest in personal property
other than a nonfunctional currency.
However, neither the legislative history nor the express language
of section 1092(d)(7) indicates that Congress intended to exclude
interests in personal property from the definition of position in
section 1092(d)(2). A rule that a debt instrument can be a position in
currency does not establish that a debt instrument is a position only
in currency. This interpretation of section 1092(d)(7) has already been
rejected by the IRS and Treasury in Sec. 1.1275-4(b)(9)(vi), which
provides that increased interest expense on a contingent payment debt
instrument issued by a taxpayer may be a straddle loss subject to
section 1092 deferral.
To clarify the definition of position under section 1092(d)(2),
Sec. 1.1092(d)-1(d) of the proposed regulations explicitly provides
that an obligation under a debt instrument may be a position in
personal property that is part of a straddle. This provision is
proposed to be effective for straddles established on or after January
17, 2001. However, no inference is intended with respect to straddles
established prior to Janaury 17, 2001. Thus, in appropriate cases, the
IRS may take the position under section 1092(d)(2) that, even in the
absence of a regulation, an obligation under a debt instrument was part
of a straddle prior to the effective date of Sec. 1.1092(d)-1(d) if the
debt instrument functioned economically as an interest in actively
traded personal property.
In 1995, the IRS published proposed regulation Sec. 1.1092(d)-(2).
See 60 F.R. 21482; FI-21-95, 1995-1 C.B. 935. The proposed regulations
clarify the circumstances in which common stock may be personal
property for the purposes of section 1092. Because proposed regulation
Secs. 1.1092(d)-2 and 1.1092(d)-1(d) address similar issues, the IRS
proposes to finalize both regulations simultaneously. The Treasury
Department and the IRS, therefore, invite additional comment on
proposed Sec. 1.1092(d)-(2).
In addition, in 1985, the Treasury Department and the IRS adopted
Temporary Regulation Sec. 1.1092(d)-5T(d), which defines the term loss
for purposes of Secs. 1.1092(b)-1T through 1.1092(b)-4T as a loss
otherwise allowable under section 165(a). The Treasury Department and
the IRS request comments on whether that definition should be expanded
to include expenses such as interest and carrying charges or payments
on notional principal contracts. If so, how should such a change be
coordinated with the proposed regulations in this document?
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
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) does not apply to these regulations, and because
the regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. 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 or electronic comments (a
signed original and eight (8) copies, if written) that are submitted
timely (in the manner described in the ADDRESSES portion of this
preamble) to the IRS. The IRS and Treasury request comments on the
clarity of the proposed regulations and how they may be made easier to
understand. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for May 22, 2001, at 10 a.m. in
the Auditorium, Internal Revenue Building, 1111 Constitution Avenue
NW., Washington DC. Due to building security procedures, visitors must
enter at the 10th Street entrance located between Constitution and
Pennsylvania Avenues, NW. In addition, all visitors must present photo
identifications to enter the building. Because of access restrictions,
visitors will not be admitted beyond the immediate entrance area more
than 15 minutes before the hearing starts. For information about having
your name placed on the building access list to attend the hearing, see
the FOR FURTHER INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit and an outline
of the topics to be discussed and the time to be devoted to each topic
(signed original and eight (8) copies) by May 1, 2001. 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.
[[Page 4749]]
Drafting Information
The principal author of these regulations is Kenneth Christman,
Office of Associate 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 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.263(g)-1 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-2 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-3 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-4 also issued under 26 U.S.C. 1092(b)(1).
Section 1.263(g)-5 also issued under 26 U.S.C. 1092(b)(1). * * *
Section 1.1092(d)-1 also issued under 26 U.S.C. 1092(b)(1).
Par. 2. Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, 1.263(g)-4,
and 1.263(g)-5 are added to read as follows:
Sec. 1.263(g)-1 Treatment of interest and carrying charges in the case
of straddles; in general.
(a) Under section 263(g), no deduction is allowed for interest and
carrying charges allocable to personal property that is part of a
straddle (as defined in section 1092(c)). The purpose of section 263(g)
is to coordinate the character and the timing of items of income and
loss attributable to a taxpayer's positions that are part of a
straddle. In order to prevent payments or accruals related to a
straddle transaction from giving rise to recognition of deductions or
losses before related income is recognized and to prevent the items of
loss and income from having different character, no deduction is
allowed for interest and carrying charges properly allocable to
personal property that is part of a straddle. Rather, such amounts are
chargeable to the capital account of the personal property to which the
interest and carrying charges are properly allocable.
(b) Section 263(g) does not apply if none of the taxpayer's
positions that are part of the straddle are personal property. Section
263(g) also does not apply to hedging transactions as defined in
section 1256(e) (see section 263(g)(3)) or to securities to which the
mark-to-market accounting method provided by section 475 applies (see
section 475(d)(1)).
(c) Section 1.263(g)-2 provides a definition of personal property
for purposes of section 263(g) and Secs. 1.263(g)-1 through 1.263(g)-5.
Section 1.263(g)-3 provides a definition of interest and carrying
charges for purposes of section 263(g), section 1092, Secs. 1.263(g)-1
through 1.263(g)-5, and Sec. 1.1092(b)-4T. Section 1.263(g)-4 provides
a set of allocation rules governing the capitalization of amounts to
which section 263(g) applies.
Sec. 1.263(g)-2 Personal property to which interest and carrying
charges may properly be allocable.
(a) Definition of personal property. For purposes of section 263(g)
and of Secs. 1.263(g)-1 through 1.263(g)-5, personal property means
property, whether or not actively traded, that is not real property.
For purposes of the preceding sentence, a position in personal property
may itself be property. In general, however, a position in personal
property is not property of a taxpayer unless the position confers or
may confer substantial rights on the taxpayer.
(1) Application to certain financial instruments. Personal property
includes a stockholder's ownership of common stock, a holder's
ownership of a debt instrument, and either party's position in a
forward contract or in a conventional swap agreement. Personal property
does not include a position that imposes obligations but does not
confer substantial rights on the taxpayer. Therefore, the obligor's
position in a debt instrument generally is not personal property, even
though the obligor may have typical rights of a debtor, such as the
right to prepay the debt. However, the obligor on a debt instrument has
a position in any personal property underlying the debt instrument. See
Sec. 1.1092(d)-1(d).
(2) Options. For the purposes of applying this section, a put
option or call option imposes obligations but does not confer
substantial rights on the grantor, whether or not the option is cash-
settled.
(b) Example. The following example illustrates the rules stated
in paragraph (a) of this section:
Example. (i) Facts. A purchases 100 ounces of gold at a cost of
$x. A transfers the 100 ounces of gold to a trust that issues
multiple classes of trust certificates and is treated as a
partnership for tax purposes. In return, A receives two trust
certificates that are not personal property of a type that is
actively traded within the meaning of section 1092(d)(1). One
certificate entitles A to a payment on termination of the trust at
the end of four years equal to the value of the 100 ounces of gold
up to a maximum value of
$(x + y). The other certificate entitles A to a payment equal to the
amount by which the value of 100 ounces of gold exceeds $(x + y) on
termination of the trust. A sells the second certificate and keeps
the first certificate.
(ii) Analysis. The trust certificate retained by A is property
that is not real property. In addition, ownership of the trust
certificate confers certain substantial rights on A. Therefore,
although the trust certificate is not personal property of a type
that is actively traded, A's interest in the trust certificate is
personal property for purposes of section 263(g).
Sec. 1.263(g)-3 Interest and carrying charges properly allocable to
personal property that is part of a straddle.
(a) In general. For purposes of section 263(g), section 1092,
Secs. 1.263(g)-1 through 1.263(g)-5, and Sec. 1.1092(b)-4T, interest
and carrying charges properly allocable to personal property that is
part of a straddle means the excess of interest and carrying charges
(as defined in paragraph (b) of this section) over the allowable income
offsets (as defined in paragraph (e) of this section).
(b) Interest and carrying charges. Interest and carrying charges
are otherwise deductible amounts paid or accrued with respect to
indebtedness or other financing incurred or continued to purchase or
carry personal property that is part of a straddle and otherwise
deductible amounts paid or incurred to carry personal property that is
part of a straddle. As provided in section 263(g)(2), interest includes
any amount paid or incurred in connection with personal property used
in a short sale. Interest and carrying charges include--
(1) Otherwise deductible payments or accruals (including interest
and original issue discount) on indebtedness or other financing issued
or continued to purchase or carry personal property that is part of a
straddle;
(2) Otherwise deductible fees or expenses paid or incurred in
connection with acquiring or holding personal property that is part of
a straddle including, but not limited to, fees or expenses incurred to
purchase, insure, store, maintain or transport the personal property;
and
(3) Other otherwise deductible payments or accruals on financial
instruments that are part of a straddle or that carry part of a
straddle.
(c) Indebtedness or other financing incurred or continued to
purchase or carry personal property that is part of a
[[Page 4750]]
straddle. For purposes of paragraph (b)(1) of this section,
indebtedness or other financing that is incurred or continued to
purchase or carry personal property that is part of a straddle
includes--
(1) Indebtedness or other financing the proceeds of which are used
directly or indirectly to purchase or carry personal property that is
part of the straddle;
(2) Indebtedness or other financing that is secured directly or
indirectly by personal property that is part of the straddle; and
(3) Indebtedness or other financing the payments on which are
determined by reference to payments with respect to the personal
property or the value of, or change in value of, the personal property.
(d) Financial instruments that are part of a straddle or that carry
part of a straddle. For purposes of paragraph (b)(3), financial
instruments that are part of a straddle or that carry part of a
straddle include--
(1) A financial instrument that is part of the straddle;
(2) A financial instrument that is issued in connection with the
creation or acquisition of a position in personal property if that
position is part of the straddle;
(3) A financial instrument that is sold or marketed as part of an
arrangement that involves a taxpayer's position in personal property
that is part of the straddle and that is purported to result in either
economic realization of all or part of the appreciation in an asset
without simultaneous recognition of taxable income or a current tax
deduction (for interest, carrying charges, payments on a notional
principal contract, or otherwise) reflecting a payment or expense that
is economically offset by an increase in value that is not concurrently
recognized for tax purposes or has a different tax character (for
example, an interest payment that is economically offset by an increase
in value that may result in a capital gain in a later tax period); and
(4) Any other financial instrument if the totality of the facts and
circumstances support a reasonable inference that the issuance,
purchase, or continuation of the financial instrument by the taxpayer
was intended to purchase or carry personal property that is part of the
straddle.
(e) Allowable income offsets. The allowable income offsets are:
(1) The amount of interest (including original issue discount)
includible in gross income for the taxable year with respect to such
personal property;
(2) Any amount treated as ordinary income under section
1271(a)(3)(A), 1278, or 1281(a) with respect to such personal property
for the taxable year;
(3) The excess of any dividends includible in gross income with
respect to such property for the taxable year over the amount of any
deductions allowable with respect to such dividends under section 243,
244, or 245;
(4) Any amount that is a payment with respect to a security loan
(within the meaning of section 512(a)(5)) includible in income with
respect to the personal property for the taxable year; and
(5) Any amount that is a receipt or accrual includible in income
for the taxable year with respect to a financial instrument described
in Sec. 1.263(g)-3(d) to the extent the financial instrument is entered
into to purchase or carry the personal property.
Sec. 1.263(g)-4 Rules for allocating amounts to personal property that
is part of a straddle.
(a) Allocation rules. (1) Interest and carrying charges paid or
accrued on indebtedness or other financing issued or continued to
purchase or carry personal property that is part of a straddle are
allocated, in the order listed--
(i) To personal property that is part of the straddle purchased,
directly or indirectly, with the proceeds of the indebtedness or other
financing;
(ii) To personal property that is part of the straddle and directly
or indirectly secures the indebtedness or other financing; or
(iii) If all or a portion of such interest and carrying charges are
determined by reference to the value or change in value of personal
property, to such personal property.
(2) Fees and expenses described in Sec. 1.263(g)-3(b)(2) are
allocated to the personal property, the acquisition or holding of which
resulted in the fees and expenses being paid or incurred.
(3) In all other cases, interest and carrying charges are allocated
to personal property that is part of a straddle in the manner that
under all the facts and circumstances is most appropriate.
(b) Coordination with other provisions. In the case of a short
sale, section 263(g) applies after section 263(h). See sections
263(g)(4)(A) and (h)(6). In case of an obligation to which section 1277
(dealing with deferral of interest deduction allocable to accrued
market discount) or 1282 (dealing with deferral of interest deduction
allocable to certain accruals on short-term indebtedness) applies,
section 263(g) applies after section 1277 and section 1282. See section
263(g)(4)(B). Capitalization under section 263(g) applies before loss
deferral under section 1092.
(c) Examples. The following examples illustrate the rules stated in
Secs. 1.263(g)-2, 1.263(g)-3, and 1.263(g)-4.
Example 1. Cash and Carry Silver.
(i) Facts. On January 1, 2002, A borrows $x at 6% interest and
uses the proceeds to purchase y ounces of silver from B. At
approximately the same time, A enters into a forward contract with C
to deliver y ounces of silver to C in one year.
(ii) Analysis. The y ounces of silver and the forward contract
to deliver y ounces of silver in one year are offsetting positions
with respect to the same personal property and therefore constitute
a straddle. See sections 1092(c)(1), (c)(3)(A)(i). The proceeds of
the debt instrument were used to purchase personal property that is
part of the straddle. Consequently, A's interest payments are
interest and carrying charges properly allocable to personal
property that is part of a straddle. See Sec. 1.263(g)-3(b)(1) &
(c)(1). Under Sec. 1.263(g)-4(a)(1)(i), the interest payments must
be charged to the capital account for the y ounces of silver
purchased by A with the proceeds of the borrowing.
Example 2. Additional indebtedness issued to carry personal
property.
(i) Facts. The facts are the same as for Example 1 except that
during the year 2002, the market price of silver increases and A is
required to post variation margin as security for its obligation to
deliver y ounces of silver to C. A incurs additional indebtedness to
obtain funds necessary to meet A's variation margin requirement.
(ii) Analysis. The additional indebtedness is incurred to
continue to carry A's holding of z ounces of silver. Consequently,
A's interest payments on the additional indebtedness are interest
and carrying charges properly allocable to personal property that is
part of a straddle and must be charged to the capital account for
the y ounces of silver.
Example 3. Contingent payment debt instrument.
(i) Facts. On January 1, 2002, D enters into a contract to
deliver x barrels of fuel oil to E on July 1, 2004, at an aggregate
price equal to $y. Soon afterward, D issues a contingent payment
debt instrument to F with a principal amount of $z and a 2-year term
that pays interest quarterly at a rate determined at the beginning
of each quarter equal to the greater of zero and the London
Interbank Offered Rate (LIBOR) adjusted by an index that varies
inversely with changes in the price of fuel oil (so that the
interest rate increases as the price of fuel oil decreases and vice
versa). The change in the aggregate amount of interest paid on the
$z of debt due to the functioning of the index approximates the
concurrent aggregate change in value of x barrels of fuel oil and,
thus, the value of D's interest in the forward contract.
(ii) Analysis. The debt instrument and the forward contract are
offsetting positions with respect to the same personal property and
[[Page 4751]]
constitute a straddle. See section 1092(c)(1), (c)(3)(A)(i). When
issued, the debt instrument is a position in personal property that
is part of a straddle. See Sec. 1.1092(d)-1(d). Consequently, D's
interest payments are interest and carrying charges properly
allocable to personal property that is part of a straddle and must
be allocated to the capital account for the forward contract for the
delivery of x barrels of fuel oil to E. See Secs. 1.263(g)-3(b)(1),
(b)(3), (c)(3), and (d)(1) and -4(a)(1)(iii).
Example 4. Financial instrument issued to carry personal
property that is part of a straddle. (i) Facts. The facts are the
same as for Example 3 except that D also enters into a two-year
interest rate swap under which D receives LIBOR times a notional
principal amount equal to $z and pays 7% times $z.
(ii) Analysis. Because of the relationship between the two-year
debt instrument issued by D and the interest rate swap, the interest
rate swap is a financial instrument that carries personal property
that is part of a straddle. See Sec. 1.263(g)-3(d)(4). Net payments
made by D under the interest rate swap are chargeable to the capital
account for the forward contract for the delivery of x barrels of
fuel oil to E. Similarly, net payments received by D under the
interest rate swap are allowable offsets. See Sec. 1.263(g)-3(e)(5).
Example 5. Contingent payment debt instrument with embedded
short position.
(i) Facts. On January 1, 1998, G purchases 100,000 shares of the
common stock of XYZ corporation (which is publicly traded). On
January 1, 2002, the 100,000 shares of XYZ corporation common stock
were worth $x per share. On that date, G issued a contingent payment
debt instrument for $100,000x. The terms of the debt instrument
provided that the holder would receive an annual payment of $2,000x
on December 31 of each year up to and including the maturity date of
December 31, 2007. On the maturity date, the holders would also
receive a payment of $100,000x plus an additional amount, if the
price of an XYZ share exceeded $1.2x on such date, equal to 100,000
times three-quarters of the amount of such excess per share. Thus,
G's aggregate payments on the debt instrument varied directly with
the increase in value in the XYZ shares.
(ii) Analysis. The debt instrument is a position in XYZ stock.
See Sec. 1.1092(d)-1(d). The XYZ stock is personal property within
the meaning of section 1092(d)(3)(B) because the debt instrument is
a position with respect to substantially similar or related property
(other than stock) within the meaning of section
1092(d)(3)(B)(i)(II). See Sec. 1.1092(d)-2(c). The debt instrument
and the XYZ shares are offsetting positions with respect to the same
personal property and constitute a straddle. See sections
1092(c)(1), (c)(3)(A)(i). Consequently, G's interest payments are
interest and carrying charges properly allocable to personal
property that is part of a straddle, see Secs. 1.263(g)-3(b)(1),
(b)(3), (c)(3), and (d)(1), and must be allocated to the capital
account for the XYZ common stock, see Sec. 1.263(g)-4(a)(1)(iii) and
(a)(3).
Example 6. Straddle including partnership interest.
(i) Facts. H borrows money from I to purchase 100 ounces of gold
at a cost of $u. H transfers the 100 ounces of gold and $v to a
newly created trust that issues multiple classes of trust
certificates and is treated as a partnership for tax purposes. In
return, H receives two trust certificates. One certificate entitles
the holder to a payment on termination of the trust at the end of
four years equal to the value of the 100 ounces of gold up to a
maximum value of $(u + w). The other certificate entitles the holder
to a payment equal to the amount by which the value of 100 ounces of
gold exceeds $(u + w) on termination of the trust. H sells the
second certificate and keeps the first certificate. H also enters
into a forward contract to sell 100 ounces of gold for $1.12u per
ounce on a date two years after creation of the trust. The trust
uses part of the $v and similar cash contributions from other
investors to pay costs of storing the gold held by the trust and
allocates H's share of the expenses to H.
(ii) Analysis. The trust certificate retained by H and the
forward contract entered into by H are personal property for the
purposes of section 263(g). See Sec. 1.263(g)-2(a). They are also
offsetting positions and constitute a straddle. Section 1092(c)(1).
The borrowing from I is an indebtedness incurred to purchase
personal property that is part of a straddle. See Secs. 1.263(g)-
3(b)(1) and (c)(1). Similarly, the gold storage expenses are
expenses incurred due to the taxpayer's holding personal property
that is part of a straddle. See Sec. 1.263(g)-3(b)(2). Therefore
both the interest on the borrowing and the gold storage expenses
must be allocated to the capital account for the partnership
interest represented by the retained trust certificate. See
Sec. 1.263(g)-4(a)(1)(i) and (a)(2).
Example 7. Equity Swap.
(i) Facts. On January 1, 1998, J purchases 100,000 shares of the
common stock of XYZ corporation (which is publicly traded). On
December 31, 2001, the 100,000 shares of XYZ corporation common
stock were worth $x per share. On that date, J entered into a NPC
with K. The terms of the NPC provided that K would receive an annual
payment on December 31 of each year equal to 100,000 times any
appreciation in the value of a share of XYZ corporation stock above
its price at the end of trading on December 31 of the preceding year
and 100,000 times the dividends paid during the year on each share
of XYZ corporation stock. In return, on December 31 of each year, J
would receive an amount equal to LIBOR times the value of 100,000
XYZ shares at the end of trading on December 31 of the preceding
year plus 100,000 times the amount of any decrease in the value of a
share of XYZ corporation stock below its price at the end of trading
on December 31 of the preceding year. Payments between J and K would
be netted and continue up to and including the maturity date of the
NPC on December 31, 2008. Thus, J's aggregate payments on the NPC
varied directly with the increase in value in the XYZ shares.
(ii) Analysis. The NPC is a position in XYZ stock. See
Sec. 1.1092(d)-2(c). The XYZ stock is personal property within the
meaning of section 1092(d)(3)(B) because the NPC is a position with
respect to substantially similar or related property (other than
stock) within the meaning of section 1092(b)(3)(B)(i)(II). See
Sec. 1.1092(d)-2(a)(1)(ii). The NPC and the XYZ shares are
offsetting positions with respect to the same personal property and
constitute a straddle. See sections 1092(c)(1), (c)(3)(A)(i).
Consequently, J's payments are interest and carrying charges
properly allocable to personal property that is part of a straddle.
See Secs. 1.263(g)-3(b)(3) and (d)(1). Therefore, they should be
allocated to the personal property that is part of the straddle in
the manner that is most appropriate under all the facts and
circumstances. In this case, because these payments are incurred to
carry the XYZ shares, they should be allocated to the capital
account for the XYZ common stock. See Sec. 1.263(g)-4(a)(3).
Sec. 1.263(g)-5 Effective dates.
Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, and 1.263(g)-4 apply
to interest and carrying charges properly allocable to personal
property that are paid, incurred, or accrued after the date these
regulations are adopted as final regulations by publication in the
Federal Register for a straddle established on or after January 17,
2001.
Par. 3. Section 1.1092(d)-1 is amended by revising paragraph (d)
and adding paragraph (e), to read as follows:
Sec. 1.1092(d)-1 Definitions and special rules.
* * * * *
(d) Debt instrument linked to the value of personal property. If a
taxpayer is the obligor under a debt instrument one or more payments on
which are linked to the value of personal property or a position with
respect to personal property, then the taxpayer's obligation under the
debt instrument is a position with respect to personal property and may
be part of a straddle.
(e) Effective dates. Paragraph (b)(1)(vii) of this section applies
to positions entered into on or after October 14, 1993. Paragraph (c)
of this section applies to positions entered into on or after July 8,
1991. Paragraph (d) of this section is effective for straddles
established on or after January 17, 2001.
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-1240 Filed 1-17-01; 8:45 am]
BILLING CODE 4830-01-P