WSC BRIEFING The Tax Reporting Challenges of 1256 Options

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1 WALL STREET CONCEPTS [Title] WSC BRIEFING The Tax Reporting Challenges of 1256 Options Closing transactions for options on specified securities acquired on or after January 1, 2014 are reportable on a 1099-B as are annual mark to market adjustments for section 1256 options Distinguishing which options are covered under section 1234 from those covered under section 1256 will be challenging Section 1256 option reporting requires tax reporting similar to regulated futures contracts Identifying a section 1256 non equity option is complicated and due to a lack of definitive guidance involves a series of classification decisions Looking beyond marketing classifications of Exchange Traded Funds (ETF) and Exchange Traded Notes (ETN) to their more precise tax classifications is required to differentiate between section 1234 and section 1256 treatment of options on these securities December 23, 2013

2 Issue The implementation of cost basis reporting for options includes the tracking of basis and marking to market section 1256 contract options for specified securities. 1 It is the broker s responsibility to determine if an option is subject to section 1256 or section 1234 reporting. 2 This briefing discusses how to determine the applicability of section 1234 and section 1256 to option contracts and how specifically to identify non equity options as defined under Internal Revenue Code section It further sets out the 1099-B reporting obligations for section 1256 options. This briefing also examines the 1099-B reporting status of options on exchange traded funds (ETFs) and exchange traded notes (ETNs). Summary Under the basis reporting regulations brokers must track and report basis on covered options pursuant to section 1234 or section 1256 as of January 1, 2014 Brokers must also adjust basis and proceeds for assignments and exercises resulting in physical settlement of the underlying shares as of January 1, 2014 Reporting on a section 1256 option is to be done in the same manner as reporting on a regulated futures contract 3 In determining section 1256 or section 1234 treatment for options, brokers must know the difference between a broad-based stock index and a narrow-based stock index 4 o o o A listed option on a broad-based stock index is generally considered a non equity option described in section 1256(b)(1)(C) and therefore a section 1256 option The definition of a non equity option involves three sets of regulations: the Internal Revenue Code (the Code) the Securities Exchange Act of 1934 (the 34 Act) the Commodities Exchange Act (the CEA) A listed option on a narrow-based stock index is generally considered an equity option CFR (m)(2) 2 There is no requirement to track basis or report proceeds for options on non specified securities although brokers may chose to report as a value added service. The absence of the reporting requirement is not a prohibition against inclusion CFR (m)(3) 4 Section 3(a)(55)(B) and (C) of the Securities Exchange Act of 1934 SunGard Wall Street Concepts CONFIDENTIAL May 20,

3 o o The cost basis regulations grant relief under sections 6721 and 6722 if a broker determines in good faith that an index is, or is not, a narrow-based stock index described in section 1256(g)(6) and reports in a manner consistent with that determination 6 This relief is limited to an incorrect determination of an equity index and does not provide a safe harbor from the mischaracterization of options between section 1234 and section1256 for any other reason The terms ETF and ETN are marketing concepts with no relevance to the actual tax characterization of the listed security The tax reporting obligation for an option on an ETF depends upon its legal status which, in general, may be a regulated investment company (RIC) or a grantor trust Since tax rules strive to ensure common treatment in substantially similar circumstances, 7 there is an argument to be made that an option on an ETF designed to mirror a broad based equity index or bond index, which is currently treated as a section 1234 option on stock, should be treated as a section 1256 option similar to those options which derive their value directly from the underlying indexes. The choice to purchase an option on an ETF that tracks an index or purchase an option on the index itself should be a tax planning consideration for investors Options on ETNs are reportable by brokers depending upon the tax classification of the specific ETN While brokers are only required to report option information on specified securities taxpayers must include all of their option transactions annually on Forms 6781 (section 1256 options) and 8949 (section 1234 options) 5 Not to be confused with a listed option on non-stock securities, narrow or broad based, which can never be an equity option CFR (m)(6) 7 Southgate Master Fund, LLC v. U.S., No (5th Cir. September 30, 2011) SunGard Wall Street Concepts CONFIDENTIAL May 20,

4 Impact Under the basis reporting regulations brokers must identify what is and isn t a section 1256 option and mark to market covered section 1256 option contracts that are open at year end. The 1099 reporting encompasses both realized gain or loss and the gain or loss from the unrealized mark to market at year end. If a listed option is based upon an equity index, a broker must evaluate, 8 at the time of disposition or year end, the underlying component securities of that index to make certain the index is broad based to qualify as a non equity option subject to section 1256 treatment. Along with preparing systems to handle this new recordkeeping requirement brokers will be challenged to educate their customer base on the differences between section 1256 and section 1234 options and their reporting status. Brokers must also examine whether listed options on structured products such as ETFs, ETNs, royalty trusts and master limited partnerships should be considered non equity options subject to section 1256 reporting. Discussion Covered options that are reportable as of January 1, 2014 include options on stock and interests in stock, options on futures, and options on most debt instruments. There are two distinct treatments of options under the tax code and these require different reporting methods. There are: section 1234 reportable options (equity options and non listed options); and section 1256 reportable options (listed non equity options). Section 1234 options are reportable upon their sale, expiration or other disposition and their duration is determined based upon holding period and whether the option was written or purchased. Gain or loss is generally the net of proceeds and cost. On the other hand, section 1256 options (non-equity), are subject to year end mark to market adjustments, with gain or loss recognition on the sale, expiration or mark at a 60 percent long-term rate and 40 percent short-term rate. The year-end mark to market adjusts the basis in the option so the gain or loss on any subsequent event is based on the change from the adjusted basis. The determination of whether an option is subject to section 1234 reporting or section 1256 reporting is complicated and involves a series of classification decisions. The classification begins with the definition of a section 1256 contract under the Internal Revenue Code. Section 1256(b) specifies five types of contracts that are to receive 8 While not specifically providing how a broker should treat a change to an index, section 1256(g)((6)(B) states The Secretary may prescribe regulations regarding the status of options the values of which are determined directly or indirectly by reference to any index which becomes (or ceases to be) a narrow-based security index (as so defined). SunGard Wall Street Concepts CONFIDENTIAL May 20,

5 section 1256 treatment. 9 As only one is a non-equity option, the others are outside the scope of this document. Section 1256(g)(3) defines the term non-equity option to mean any listed option which is not an equity option. Thus the definition of a 1256 option begins with the option being listed. This listing must be on a qualified board or exchange 10 as determined by the IRS / Treasury Department. If an option is not listed, it will always be subject to section1234 treatment. Having determined that an option is listed the next step is to define what constitutes a non equity option. Unfortunately, there is no definition of a non equity option in section 1256 or elsewhere. Rather, in making the determination, one must look to what is an equity option and exclude such options from the universe of listed options to arrive at the group of options that are non equity. The regulations define an equity option under Section 1256(g)(6)(A) as any option to buy or sell stock, or the value of which is determined directly or indirectly by reference to any stock (or group of stocks) or stock index. A listed option that does not meet the above equity option criteria would be a section 1256 option (e.g., listed options on bonds, futures, master limited partnership units, royalty trusts, etc.). It should be noted that when defining the term equity option the IRS uses the word stock rather than equity interest or equivalent term to connote ownership beyond a corporate structure. Under the 34 Act and the CEA, which are both relied upon heavily in section 1256, the term security is defined to include a wide variety of investments and forms of equity ownership, only one of which is stock. 11 With this in mind, and the fact that (a)(14) of the cost basis regulations defines the specified security term stock as corporate ownership, 12 this discussion makes the assumption that an equity option is an option that derives its value from corporate stocks and no other type of equity ownership interest. 9 The term section 1256 contract means - 1) any regulated futures contract, 2) any foreign currency contract, 3) any non equity option, 4) any dealer equity option, and 5) any dealer securities futures contract. 10 Section 1256(g)(7) 11 See Sec. 1a(41) of the CEA / Sec. 3(a)(10) and (11) of the 34 Act 12 Any share of stock (or any interest treated as stock, including, for example, an American Depositary Receipt) in an entity organized as, or treated for Federal tax purposes as, a corporation, either foreign or domestic (provided that, solely for purposes of this paragraph (a)(14)(i), a security classified as stock by the issuer is treated as stock, and if the issuer has not classified the security, the security is not treated as stock unless the broker knows that the security is reasonably classified as stock under general Federal tax principles) ; SunGard Wall Street Concepts CONFIDENTIAL May 20,

6 When identifying an equity option there are two exceptions to the definition for options whose value are determined by reference to a group of stocks or stock index. The exceptions are meant to distinguish between options on a broad range of the market and options that are narrow in scope and focus on a security or particular segment of the market. Revenue rulings and in reference to section 1256(g)(6)(B) of the Code state that the term "equity option" does not include any option with respect to any group of stocks or stock index if there is in effect a designation by the CFTC of a contract market for a contract based on such group of stocks or index, or the Secretary determines that such option meets the requirements of law for such a designation. This means that if the option related to the underlying group of stocks or index (e.g. the S&P 500 Index Option) is trading on a contract market like the Chicago Board Options Exchange (commodities/futures) or is eligible to trade on such a market, then the option is a non equity option and subject to section Such a designation would imply that the option covers a broad segment of the securities market and not a narrow segment. If the option is not trading on a contract market, but rather on an exchange (NYSE, NASDAQ) then the application of the second of the two exceptions (that the option meets the requirements to trade on a contract market) must be satisfied. The ability to make this determination requires that the broker understand the eligibility requirements for options to trade on a contract market. Under Section 2(a)(1)(B)(ii) of the CEA, the CFTC can designate a market for a futures contract based on a stock index if, among other regulatory conditions, the futures contract meets the following minimum requirements: 1) The contract must provide for cash settlement; 2) The contract must not be readily susceptible to manipulation or to being used to manipulate any underlying security; and 3) The index must be predominantly composed of the securities of unaffiliated issuers and must reflect the market for all publicly traded securities or a substantial segment of the market. 13 Revenue Rulings: Revenue Rulings include rulings to taxpayers, technical advice to district offices, studies undertaken by the IRS, court decisions, suggestions from practitioner groups, and so on. They are written determinations which address issues of substantive tax law within the Internal Revenue Code, related statutes, tax treaties and regulations. They are official interpretations of the law as applied to a specific set of facts and generally are binding on revenue agents and other IRS officials. Revenue Rulings are selected for publication in the Internal Revenue Bulletin because of their potential interest to the general public. SunGard Wall Street Concepts CONFIDENTIAL May 20,

7 As a part of the approval process, the CFTC is required to get the Securities and Exchange Commission (SEC) to opine on these three requirements. 14 If the SEC determines that the futures contract fails to satisfy any of these requirements it cannot be traded on a contract market and will be subject to section 1234 treatment. In performing an analysis similar to the SEC s, a broker can look to the prospectus to determine if the option provides for cash settlement. If it does not, it cannot be a section 1256 contract. With regard to the second requirement, any option that has been approved for trading on an exchange by the SEC is deemed not to be susceptible to manipulation. So the fact that the option is listed satisfies the second requirement. If the first two requirements are satisfied, the broker must determine whether the option satisfies the third requirement reflecting a substantial segment of the market. This introduces the broad based versus narrow based index test. In Revenue Ruling the IRS noted that The SEC uses the same analysis in determining both (1) whether a stock index underlying an option or warrant is "broadbased," and (2) whether a stock index underlying a futures contract is predominantly composed of the securities of unaffiliated issuers and reflects the market for all publicly traded securities or a substantial segment thereof. Thus, an SEC determination that a stock index is "broad-based" is equivalent to a determination that the index meets the third requirement of 2(a)(1) (B)(ii) of the CEA. In determining whether an index is broad based or not the SEC will look to the definition of a narrow-based security index found in section 3(a)(55)(B) of the 34 Act. In general, an index is narrow based 15 if it is 1) made up of 9 or fewer stocks, 2) in which a component security comprises more than 30 percent of the index s weighting; and 3) in which the five highest weighted component securities in the aggregate comprise more than 60 percent of the index s weighting. This index test is codified in both the SEC and CTFC rules. Upon determining that an index is not a narrow based index, (i.e., has more than 9 stocks, one stock is worth more than 30% of the index value, etc.) the option on it will be treated as a non equity option subject to section Once a broker has identified those options subject to section 1234 reporting and those subject to section 1256 reporting, it is then a matter of identifying which options are covered (options on specified securities) and which are not. While the broker is required to report to the IRS on covered options, the broker may also want to report to the 14 RR See Additional Information below for further requirements of the narrow-based index test under section 3(a)(55)(B) and (C). SunGard Wall Street Concepts CONFIDENTIAL May 20,

8 customer (not necessarily the IRS) information on non covered options to facilitate a customer s year end tax return filings. Exchange Traded Funds and Exchange Traded Notes An additional complication that brokers may have to consider relates to options on ETFs and ETNs. Some in the industry have questioned whether the tax treatment for options on these instruments should be determined by the substance of the transactions and not the form of the instruments upon which the options are related. Since the vast majority of options that are traded on exchanges are short-term instruments they are typically subject to short-term tax rates. However, if they can be considered section 1256 options the taxpayer would be able to convert 60% of any gains to long-term status even though the life of the instrument generally does not exceed 12 months. The tax treatment of an ETF may depend upon the asset class it covers (i.e., equities, fixed income, commodities, currencies, MLPs, etc.) and its particular structure (open-end funds, unit investment trusts, grantor trusts, limited partnerships). Listed options on ETFs structured as grantor trusts or master limited partnerships are non equity options subject to section 1256 based upon both their ETF structures and the investments they follow which are generally focused on currencies, commodities or energy partnerships. Regardless of whether the option is related to the ETF or the underlying securities, it is a non equity option. Funds and unit investment trusts that are registered under the Investment Company Act of 1940, are regulated investment companies (RICs) and considered stock in a corporation thus making options on them reportable under section These investments typically follow equity or debt indexes or other groupings of such securities. Since listed options on ETFs are subject to physical settlement and not cash settlement, such options on equity indexes would be excluded from section 1256 consideration, even if the index is broad based because the option on the index must be cash settled as a prerequisite to considering whether the index is broad based. However, it would be to a taxpayer s advantage to treat these options as section 1256 if there were a reasonable tax argument to be advanced for such treatment. From a substance point of view, the investor could advance the position that there is little difference when investing in an option on a group of equities and an option on an ETF that derives its value from those same equities, unless the option is actually exercised and the investor take takes physical delivery of the securities or delivers them. Given the great similarity in these investments and their returns, the IRS may accept options on equity indexes, whether direct or through an ETF, as the same in substance. In Southgate Master Fund, LLC v. U.S. the Fifth Circuit Court of Appeals noted that the doctrine of substance over form provides that the tax consequences of a transaction are determined based on the underlying substance of the transaction rather than its legal form. The substance-overform doctrine allows a transaction to be re-characterized so that its taxable form corresponds to its economic substance. There is a position that could be put forth that inserting an ETF between the option and a broad based index could easily be re- SunGard Wall Street Concepts CONFIDENTIAL May 20,

9 characterized as an option on the index in substance and as such subject to the section 1256 treatment especially in situations where the option is closed out via a sale or expiration. However, since in most cases it is possible to trade an option on the index instead of on an ETF that tracks the index the ability exists to insulate oneself from the doubt or uncertainty. From the perspective of 1099 reporting the more conservative approach of reporting options on ETFs that track broad based indexes and are structured as RICs under section 1234 will likely be the industry preference. In the case of listed options on RICs that cover debt indexes a taxpayer s argument could be more compelling as there is no cash settlement requirement and the insertion of the ETF between the option and the index does not alter the substance of the transaction, which is an option that derives its value from an index. While this may be a sound argument from a taxpayer s perspective to garner the favorable 60% long-term treatment, from a broker s reporting perspective it is better to be conservative and report options on ETFs that are RICs under section 1234 unless the IRS issues guidance to the contrary. Along with informing their customers about this issue for discussion with their own tax advisors, brokers may want to suggest that customers consider using listed options on indexes if they plan on holding options for less than one year or if they are writing options. This would enable them to take advantage of section 1256 treatment. But if a customer s investment horizon is greater than one year, then using listed options on ETFs, or unlisted options, would be attractive because gains on those options held more than one year would be long-term in their entirety. For example, depending upon tax strategy, an investor who seeks exposure to the S&P 500, can select to purchase options on the Vanguard ETF VOO chain (section 1234 treatment) or purchase options directly on the S&P 500 from the SPX option chain (section 1256 treatment) to achieve comparable returns while minimizing tax liability. With regard to options on ETNs, there is uncertainty about what type of security the ETN actually is and if the underlying index or asset (Reference Asset) has any impact upon that determination. ETNs are generally structured to provide investors exposure to commodities, emerging markets, foreign currencies, master limited partnerships, and security indexes. ETNs are issued for a term of at least one year but not greater than thirty years. Although linked to a Reference Asset, there is no ownership of a Reference Asset by an ETN sponsor and as such no underlying security to serve as collateral. ETN s trade as individual exchange-listed securities. Options on ETNs are physically settled and have American-style exercise features. There is a misconception that ETNs are bank issued debt instruments in the form of unsecured notes that do not require payment of interest or principal prior to maturity. Contrary to this belief, the IRS currently recognizes most ETNs as prepaid forward contracts that provide for payment of an amount linked to the performance of the Reference Asset less the fee charged by the issuer at the end of the contract s term. In general, issuers of ETNs are also advising their customers in the prospectus that an ETN is a prepaid forward contract, which upon its disposition will spring forth capital gain or SunGard Wall Street Concepts CONFIDENTIAL May 20,

10 loss. As such the recognition of income is deferred until the disposition of the contract and no payments are made by the issuer with respect to the ETN until maturity or redemption of the contract. The determination of where a listed option on an ETN fits within the section 1234 and section 1256 option regimes seems to be settled with regard to one type of ETN. In Revenue Ruling the IRS determined that a foreign currency prepaid forward contract should be taxed as a debt instrument. Thus an option on a foreign currency ETN would likely be considered an option on a debt instrument subject to broker reporting, unless, of course, one looks through the ETN to the Reference Asset which is currency and not a specified security. In either event from the taxpayer s perspective, this would meet the section 1256 test of an exchange listed, non equity option subject to mark to market and the 60/40 duration split. The question of how to treat the many other ETNs for tax purposes was raised by the IRS in Notice That Notice sought comments from the securities industry about issues that arose related to ETNs and whether the parties to them should be required to accrue income and expenses during the term of the transaction. The IRS questions provide a view into what they may be thinking about ETNs. Among the questions asked were whether a mark to market accrual approach should be used for income recognition and what the appropriate character of the income should be, ordinary or capital gains, and if ordinary is it interest? They also asked whether all the transactions should be treated as indebtedness under section 7872 which addresses the treatment of loans with below-market interest rates. Of particular interest to the topic of section 1256 options were the following two questions: Whether the tax treatment of the transactions should vary depending on the nature of the underlying asset (for example, stocks vs. commodities); and Whether the tax treatment of the transactions should vary depending on whether the transactions are (i) executed on a futures exchange (and are not otherwise subject to section 1256 of the Internal Revenue Code), or (ii) memorialized in an instrument that is traded on a securities exchange; The Securities Industry and Financial Markets Association (SIFMA) provided a comment letter wherein they set forth the issues and arrived at the conclusion that the best approach would be to continue to treat ETNs as prepaid forward contracts applying the 16 A Notice provides guidance before revenue rulings and regulations are available. Gail Richmond, Federal Tax Research: Guide to Materials and Techniques, p. 94 (5th ed. 1997)(Foundation Press). [Notices and Announcements] may... contain substantive guidance regarding the tax laws or contain guidance to taxpayers of a procedural nature. Generally, Notices and Announcements are used when expeditious guidance is needed. Since Notices and Announcements that contain substantive or procedural guidance are intended to be relied on by taxpayers, they are the equivalent of revenue rulings and revenue procedures.... Rev. Rul , C.B [N]otices and announcements... will constitute authority for purposes of the substantial understatement portion of the accuracy-related penalty.... Notice 90-20, C.B SunGard Wall Street Concepts CONFIDENTIAL May 20,

11 realization principle which means that no tax is paid on uncertain future returns until investors actually receive such returns or become unconditionally entitled to receive them in the future. SIFMA believes that none of the proposed alternatives would be better than current law and that taxing phantom income could distort investment decisions. The 96 page SIFMA comment letter apparently gave the IRS quite a bit to consider since it is now more than five years later and no guidance has been forthcoming. Given the many possible interpretations that can be made about the taxability and structure of ETNs, it is perhaps most prudent for taxpayers to rely on the prospectus and file their returns accordingly B Reporting Highlights The basis reporting regulations specify that when reporting for section 1256 options a broker should treat the option as if it were a regulated futures contract. On Form 1099-B, (see Additional Information below for Form 1099-B) the amount of information provided for such contracts, other than recipient and payer information, in general, is limited to Boxes 9 through 12 which is profit and loss. Since section 1256 options are always subject to the 60/40 duration split, duration is not indicated on the form. All of the transactions in an account are aggregated in three separate amounts and then netted, as follows: Box 9 Profit or (loss) realized on closed contract Box 10 Unrealized profit or (loss) on open contracts at the beginning of the year Box 11 Unrealized profit or (loss) on open contracts at the end of the year Box 12 Aggregate profit or (loss) on all contracts open or closed This reporting has required futures brokers to have cost basis systems in place long before the basis reporting regulations for covered securities were implemented. The only other information required is a description of the section 1256 contracts in Box 8 and, if withholding occurred, the amount withheld indicated in Box 4. Brokers are permitted, but not required, to report the amounts for non equity options and regulated futures contracts as a net amount on one 1099-B for each reportable item (Boxes 9 12). This may not be practicable as the information for basis reporting on covered securities may be derived from a different system than one already in use for futures. With regard to exposure from an incorrect determination of index status (broad or narrow) the IRS has stated that Penalties will not be asserted under sections 6721 and 6722 if a broker in good faith determines that an index is, or is not, a narrow-based index described in section 1256(g)(6) and reports in a manner consistent with this determination. 17 This relief is limited to the determination of broad based versus narrow based equity indexes. It does not provide a safe harbor for inaccuracies in tax reporting arising from any issues associated with differences between section 1234 and section 1256 options. It should be noted that although commenters on the proposed basis CFR (m)(6) SunGard Wall Street Concepts CONFIDENTIAL May 20,

12 reporting regulations raised concerns over tracking short sales and performing backup withholding, the IRS did not address these and gave no indication that such transactions are beyond the scope of basis reporting for section 1256 options. Therefore, brokers should carefully examine these rules to determine what impact they may have upon tracking and 1099-B reporting on section 1256 options. It should also be noted that section 1256 contracts are not subject to the wash sale rules for year end marks to market. 18 Consistent with the approach taken for broker basis reporting for stock, the final option regulations explicitly provide that a broker will not take section 1092 (with regard to straddles) into account when determining basis of an option that is a covered security. However, taxpayers can utilize section 1256 options in hedging strategies and elect not to mark to market their positions at year end, even though the regulations always require brokers to mark to market and issue a 1099-B for section 1256 options on specified securities. In such situations, the taxpayer will require original cost information when filing Form Therefore, acquisition cost should always be retained for taxpayer information purposes when closing a section 1256 option. Original acquisition dates should also be maintained for taxpayer information as they may be required on Part III of Form Conclusion The advent of tax reporting on section 1256 options brings with it many new issues for brokers to address. Principal among them is the need to understand how to determine what constitutes such an option. While the tendency has been to focus upon the difference between broad based and narrow based equity indexes, there are several other steps that must be taken prior to that particular task. In review, those decision steps can be summarized as follows: 1. Determine if the option is listed If not listed it is a section 1234 option 2. If the option is listed determine if the option is on a single stock or a group of stocks if the option is not on stocks it is a section 1256 option 3. If the option is on a single stock it is a section 1234 option 4. If the option on a group of stocks or stock index then determine if it meets the non equity option definition a. Is it a physically settled option? if yes it is a section 1234 option b. If it is cash settled, is the option index narrow based or not i. If the option index is narrow based it is a section 1234 option ii. If it is not a narrow based index option it is a section 1256 option. 18 Sec. 1256(f)(5) SunGard Wall Street Concepts CONFIDENTIAL May 20,

13 When reporting on section 1256 options, brokers must also keep in mind that, analogous to the 1099-B reporting for wash sales, the 1099-B reporting information may not be a correct reflection of information that the taxpayer will use when filing a tax return, as brokers are only reporting on a portion of section 1256 options and treating all of those as if subject to mark to market. Brokers should consider providing added value to their customers by reporting to them as much information as possible about section 1256 options. This could include reporting on all option activity, not just covered options, and providing information concerning original cost and acquisition dates. Further, as part of the customer education process on section 1234 and section 1256 options a discussion about the tax planning strategies that can be employed when using options on indexes would also be a value add. The manner in which brokers handle this new reporting obligation can distinguish their services from the competition. And as always, while WSC Briefings are meant to raise interest in and awareness of tax issues firms should consult their own tax advisors before taking any actions based upon the views expressed herein. Additional Information Form 1099-B SunGard Wall Street Concepts CONFIDENTIAL May 20,

14 Narrow Based Security Index Section 3(a)(55)(B) of the Securities Exchange Act (A) The term narrow-based security index means an index (i) (ii) (iii) that has 9 or fewer component securities; in which a component security comprises more than 30 percent of the index s weighting; in which the five highest weighted component securities in the aggregate comprise more than 60 percent of the index s weighting; or (iv) in which the lowest weighted component securities comprising, in the aggregate, 25 percent of the index s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with 15 or more component securities, $30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25 percent of the index s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security. Broad Based Security Index Section 3(a)(55)(C) of the Securities Exchange Act (I) (II) (III) it has at least 9 component securities; no component security comprises more than 30 percent of the index s weighting; and each component security is (aa) registered pursuant to section 12 of the Securities Exchange Act of 1934 [15 U.S.C. 78l]; (bb) one of 750 securities with the largest market capitalization; and (cc) one of 675 securities with the largest dollar value of average daily trading volume; (ii) a board of trade was designated as a contract market by the Commodity Futures Trading Commission with respect to a contract of sale for future delivery on the index, before December 21, 2000; (iii) (I) a contract of sale for future delivery on the index traded on a designated contract market or registered derivatives transaction execution facility for at least 30 days as a contract of sale for future delivery on an index that was not a narrow-based security index; and (II) it has been a narrow-based security index for no more than 45 business days over 3 consecutive calendar months; SunGard Wall Street Concepts CONFIDENTIAL May 20,

15 (iv) (v) a contract of sale for future delivery on the index is traded on or subject to the rules of a foreign board of trade and meets such requirements as are jointly established by rule or regulation by the Commission and the Securities and Exchange Commission; no more than 18 months have passed since December 21, 2000, and (I) (II) (III) it is traded on or subject to the rules of a foreign board of trade; the offer and sale in the United States of a contract of sale for future delivery on the index was authorized before December 21, 2000; and the conditions of such authorization continue to be met; or (vi) a contract of sale for future delivery on the index is traded on or subject to the rules of a board of trade and meets such requirements as are jointly established by rule, regulation, or order by the Commission and the Securities and Exchange Commission. (C) (D) (E) Within 1 year after December 21, 2000, the Commission and the Securities and Exchange Commission jointly shall adopt rules or regulations that set forth the requirements under subparagraph (B)(iv). An index that is a narrow-based security index solely because it was a narrow-based security index for more than 45 business days over 3 consecutive calendar months pursuant to clause (iii) of subparagraph (B) shall not be a narrow-based security index for the 3 following calendar months. For purposes of subparagraphs (A) and (B) (i) (ii) the dollar value of average daily trading volume and the market capitalization shall be calculated as of the preceding 6 full calendar months; and the Commission and the Securities and Exchange Commission shall, by rule or regulation, jointly specify the method to be used to determine market capitalization and dollar value of average daily trading volume. SunGard Wall Street Concepts CONFIDENTIAL May 20,

16 References and Citations 26 CFR CFR 6045 IRC Sec IRC Sec Form 1099-B Instructions RR RR RR Notice The Securities Exchange Act of 1934 SEC Release Southgate Master Fund, LLC v. U.S. The Commodities Exchange Act Key Words and Definitions Section 1256 Option An option that is considered a non equity option. In general it is any listed option that is not an option to buy or sell stock or does not derive its value by reference to any stock or narrow based index or grouping of stocks. Narrow Based Index A narrow based index is defined in Section 3(a)(55)(B) of the Securities Exchange Act of In general a narrow based index or grouping of stocks is 1) made up of 9 or fewer stocks, 2) of which no one stock is more than 30% of the value, and 3) no more than 60% of the index or groups value can be attributed to 5 or fewer stocks. Broad Based Index A broad based index is defined in Section 3(a)(55)(C) of the Securities Exchange Act of 1934 and in general is any index on stocks or grouping of stocks made up of 9 or more stocks that doesn t meet the narrow based criteria. o o o Specified Securities In general the definition includes shares of stock, bonds (except those subject to 1272(a)(6) and short-term obligations), options on specified securities and securities futures contracts. See footnote 7 above. Exchange Traded Fund Investment funds traded on an exchange, generally organized as registered open end investment companies or unit investment trusts. Its value is derived from an underlying index or group of securities. Exchange Traded Note Generally a prepaid forward contract issued by a bank and publicly traded on an exchange. The issuer of the ETN will pay an investor an amount of money upon the redemption or maturity of the ETN based upon a reference asset such as a commodity or stock index. The IRS has yet to determine the taxability of many ETNs. SunGard Wall Street Concepts CONFIDENTIAL May 20,

17 THIS IS A CONFIDENTIAL DOCUMENT In consideration of making this document available to you and your firm, you agree to keep confidential the contents of this document and shall not, without the prior written approval of SunGard, disclose to any person outside of your firm, the whole or any part of the information contained in or associated with this document. No part of this publication may be reproduced or utilized, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of SunGard. DISCLAIMER The information contained in this document is provided for informational purposes only and does not purport to be legal, tax or professional advice. This document is provided on the understanding that its content is based on information available as of the date of publication and is solely intended to promote discussion and inquiry by you and your firm on its subject matter. The individual circumstances of a firm should always dictate the actions, if any, a firm takes with regard to the subject matter contained herein and SunGard will not be held responsible for the results of any actions you or your firm may take in reliance upon or as a result of reading the information in this document. Applicability of this information to specific situations at your firm and determinations as to the appropriate approach your firm should take must always be made in consultation with your legal and/or tax advisors SunGard. Trademark Information: SunGard and the SunGard logo are trademarks or registered trademarks of SunGard Data Systems Inc. or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders. SunGard Wall Street Concepts CONFIDENTIAL May 20,