THE TAXATION OF EXOTIC INVESTMENT PRODUCTS. Paul S. Lee, J.D., LL.M. National Managing Director Bernstein Global Wealth Management.

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1 THE TAXATION OF EXOTIC INVESTMENT PRODUCTS Paul S. Lee, J.D., LL.M. National Managing Director Bernstein Global Wealth Management August 2013 TABLE OF CONTENTS I. EXOTIC INVESTMENTS 1 A. Generally 1 B. Focus of Outline 2 II. FINANCIAL DERIVATIVES 2 A. Generally 2 B. Options 3 C. Forward and Futures Contracts 5 D. Swaps or Notional Principal Contracts 6 E. Financial Equivalency 8 F. Short Sales 9 III. TAXATION OF THE FINANCIAL DERIVATIVES 10 A. Taxation of Options 10 B. Taxation of Forward and Futures Contracts 12 C. Taxation of Notional Principal Contracts 14 D. Taxation of Short Sales 18 E. Section 1256 Contracts 19 F. Source Rules for Dividend Equivalents 21 G. Conversion Transactions (Section 1258) 26 H. Constructive Ownership Transactions (Section 1260) 26 IV. STRUCTURED NOTES (PRINCIPAL-PROTECTED INVESTMENTS) 29 A. Generally 29 B. What Is Actually Behind a Structured Note? 29 C. Taxation of Structured Notes 30 V. ETFS INCLUDING LEVERAGED, INVERSE, PHYSICAL, AND CURRENCY ETFS 40 A. Generally 40 B. Leveraged ETFs and Inverse ETFs 41 C. Commodity and Currency ETFs 42 D. Taxation of ETFs that Are RICs 43 E. Taxation of ETFs that Are Grantor Trusts 50 VI. EXCHANGE-TRADED NOTES 53 A. Generally 53 B. Taxation of ETNs 53 VII. FOREIGN CURRENCY INVESTMENTS 54 A. Generally 54 i

2 B. Investing in Foreign Currency 55 C. Principles of Taxing Foreign Currency Transactions 56 D. Section 988 Gains or Losses 57 VIII. INFLATION-SENSITIVE INVESTMENTS 63 A. Generally 63 B. Taxation of Inflation-Sensitive Debt Instruments and Swaps 64 IX. HEDGE FUNDS 68 A. Generally 68 C. Selected Tax Issues General Taxation Overview and Status of Hedge Fund Classification of the Partnership for Tax Purposes Tax Issues for the Investor/Limited Partner 72 a. Contributions of Assets In-Kind to the Hedge Fund 72 b. Allocations of Profit and Loss 73 c. Section d. Withdrawing/Redeeming Investors and Distributions 74 e. Section f. Deductibility of Interest and Short Sale Expenses 78 g. Deductibility of Hedge Fund Investment Expenses 80 h. Passive Activity Rules 81 i. The At Risk Limitations 82 j. Straddle Rules and Securities Held by Investors/Limited Partners 83 X. SELECT ESTATE PLANNING ISSUES 86 A. Introduction 86 B. Contingent Liabilities under Section C. Futures and Forward Contracts 88 D. Options 90 E. Short Sales 91 F. Swaps or Notional Principal Contracts 92 G. ETFs and ETNs 92 H. Structured Notes 92 I. Hedge Fund Investments 93 XI. CONCLUSION 96 ii

3 I. EXOTIC INVESTMENTS A. Generally THE TAXATION OF EXOTIC INVESTMENT PRODUCTS By Paul S. Lee, J.D., LL.M. National Managing Director Bernstein Global Wealth Management New York, NY (212) Investing for individuals has gone beyond simply buying U.S. stocks, bonds, and mutual funds. Over the last 20 years, a proliferation of additional asset classes have been made available to individual investors that provide broader investment opportunities by geography (emerging market stocks, for example) and type of asset (commodities, for example). In conjunction with this development, investment managers have developed investment strategies that purport to provide amplified returns (leveraged strategies) or even inverse returns (short strategies) vis-à-vis the broad market or returns that have both equity-like and fixed income-like characteristics. These more exotic investments are often lightly regulated, sometimes publicly-traded but more often privately negotiated, and can be offered directly, in a packaged product (like a fund or a note), or through a private partnership like a hedge fund. 2. Financial derivatives stand behind most of these exotic investment products. There has been a rapid proliferation of the use of financial derivatives. To a large extent, many of these derivatives can be combined to provide exactly the same economic returns, but the taxation (timing, character and source) of the returns under the Internal Revenue Code of 1986, as amended (the Code ) can be quite different. In certain circumstances, it is unclear how these investments should be taxed and reflected from an accounting and financial reporting standpoint. 3. On December 2, 2011, the Joint Committee on Taxation published a report, Present Law and Issues Related to the Taxation of Financial Instruments and Products, 1 (the 2011 Joint Committee Report ) that highlights a number of these issues. 4. The 2011 Joint Committee Report points out: a. Tax considerations affect decisions related to holding, issuing, and structuring financial instruments. The taxation of financial instruments generally depends on a categorization based on the type of instrument rather than on the economic characteristics of the instrument Because the instruments with similar or identical economic characteristics may be categorized differently from one another, a taxpayer with a particular goal may choose one instrument rather than another because of the tax considerations. 2 1 Present Law And Issues Related To The Taxation Of Financial Instruments And Products, JCX (December 2, 2011), (last accessed on January 3, 2012) (the 2011 Joint Committee Report ) Joint Committee Report, p. 4. 1

4 b. The timing, character, and source rules apply differently to (and are sometimes uncertain for) equity, debt, options, forward contracts, and notional principal contracts. These five basic instruments can be combined in various ways to replicate the economic returns of any underlying asset. Individuals and firms also regularly create new instruments intended to produce particular economic outcomes. This ability to combine basic instruments and to create new instruments represents financial innovation that might lower the cost of capital for business expansion or might mitigate the risk of new projects. The flexibility of financial instruments also creates great difficulty in the taxation of financial instruments As a word of caution, how these exotic investments are treated for tax purposes is often unsettled, and how they will be treated in the future is even more unclear. Proposed regulations have been issued that, if finalized, could dramatically alter the tax treatment of many of these investments. B. Focus of Outline 1. This outline focuses on the tax treatment of some of the more popular exotic investments that have been and are being sold to individuals. I do not discuss private equity and venture capital investments, as the taxation of these investments are relatively straight-forward. 2. My assumption throughout this outline is that the individuals making these investments are doing so as investors (rather than dealers or businesses seeking to hedge certain exposures), and the investors are taxable U.S. taxpayers. As such, I do not discuss is any detail the U.S. taxation of these investments for foreign taxpayers, the sourcing rules, and the tax implications of these types of investments to tax-exempt entities like charitable organizations, charitable remainder trusts, and retirement accounts. II. FINANCIAL DERIVATIVES A. Generally 1. A financial derivative is an instrument, the investment return from and the value of which is dependent upon an underlying asset or index, or the occurrence of an event with an ascertainable outcome. 2. Two parties (perhaps with the facilitation of an exchange) enter into a contract that specifies the timing and amount of any payments (in cash or in kind) to be made between them where the amount is determined with reference to the value of the underlying asset. 3. There has been explosive growth in the use of financial derivatives, in particular, in swaps or what the Code refers to as notional principal contracts. According to the Office of the Comptroller of the Currency, at the end of the first quarter of 2013, the notional amount of outstanding financial derivatives totaled $231.6 trillion, $138.4 trillion of which were swaps (not including credit default swaps). The growth of the financial derivatives since 1998 is shown in the following table: 4 3 Id. at 5. 4 Source: Office of the Comptroller of the Currency. 2

5 Notional Amount Outstanding of U.S. OTC & Exchange-Traded Derivatives (Billions of U.S. Dollars) Financial Instrument Q 2013 Swaps (ex. CDS) 14,345 21,949 64, , ,361 Futures and Forwards 10,918 9,877 12,049 35,709 45,599 Options 7,592 8,292 18,869 32,075 33,760 Credit Default Swaps ,822 14,150 13,901 TOTALS 32,999 40, , , ,621 B. Options 1. An option is a contract that gives the holder of the option the right (but not the obligation) to buy from, or sell to, another party a specified amount of property at a fixed price at a specified time. (1) The holder of the option is also often referred to as the buyer of the option. The party with the obligation to sell or buy, as the case may be, is referred to as the writer, seller, or issuer of the option. (2) If the option is the right to buy, it is referred to as a call, and if the option is the right to sell, it is referred to as a put. (3) For the right to call or put the property, the holder/buyer of the option pays the seller/issuer a premium that is typically paid at the inception of the contract. (4) If the option must be can only be exercised on a particular date, it is referred to as a European-style option, but if the option allows for exercise at any point during a specified period of time, it is referred to as an American-style option. 2. The options can be on publicly-traded stocks, stock market indices, commodities, bonds, interest rates, exchange-traded funds, and currencies. Options can also be on other financial derivatives like options on futures contracts or swaps (swaptions). 3. Options can be traded on an established exchange (exchange-traded or listed options) or over-the-counter options (OTC or dealer options). Exchange-traded options have standardized contracts and are traded on a national exchange like the Chicago Board of Options Exchange whose trades are cleared and insured by the Options Clearing Corporation. An option contract quoted on the exchange will have the following primary terms: a. Underlying property or security. b. Expiration date. c. Exercise or strike price. d. Type of option (put or call). e. Premium (which is essentially determined by buyers and sellers of the option in the market. General option theory provides that the premium of an equity option is equal to the intrinsic 3

6 value of the option the difference between the value of the security and the strike price and the time value of the option. 4. Specifically to call options (assuming options on publicly-traded stocks, by way of example), the holder of a call option has the right to buy a certain number of shares (generally in 100 share increments) of the underlying stock, at a fixed price. If the holder of a call option exercises the option, the writer of the call option is obligated to deliver the stock. a. The holder of a call option pays a premium and has the right to purchase 100 shares of the underlying stock at the stated stock price. The buyer of a call option hopes the stock price will appreciate. If the stock appreciates above the strike price, the buyer of a call option will exercise the right to purchase the underlying stock at the strike price. Because the value of the underlying stock price theoretically can appreciate infinitely, the maximum gain that the buyer or holder of a call can make is unlimited. If the stock depreciates or does not appreciate above the strike price, the call option will go unexercised. Thus, the maximum loss for a call buyer is the premium paid. b. The writer of a call option receives the option premium and is obligated to sell the underlying stock at the stated price. The writer of a call option hopes the stock price will depreciate or not go above the strike price. An uncovered call is when the writer of a call does not own the underlying stock (writing a naked call). If the stock depreciates or does not go above the strike price, the option will go unexercised and the writer of the will not have to sell the underlying stock. Thus, the maximum gain that the writer of a call option can make is the premium already received. If the stock appreciates above the strike price, the option will be exercised. The writer of a naked call option must purchase the underlying stock and sell that stock, at the stated price, to the holder of the call option. Because the value of the underlying stock price can theoretically appreciate infinitely, the maximum loss is unlimited. On the other hand, if the writer of a call option owns the underlying stock, it is a covered call and the maximum loss is quite different. As with a naked call, if the stock depreciates or does not go above the strike price, the option will go unexercised and the writer of the will not have to sell the underlying stock. Thus, the maximum gain that the writer of a call option can make is the premium already received. If the stock appreciates above the strike price, the option will be exercised. The writer of a covered call option already owns the underlying stock and will sell that stock, at the stated price, to the holder of the call option. Thus, the loss to the covered call writer is the lost appreciation foregone as a result of having to sell the stock at the strike price. 5. Specifically to put options (assuming options on publicly-traded stocks, by way of example), the holder of a put option has the right to sell a certain number of shares (generally in 100 share increments) of the underlying stock, at a fixed price. If the holder of a put option exercises the option, the writer of the put option is obligated to buy the stock. a. The holder of a put option pays a premium and has the right to sell 100 shares of the underlying stock at the stated stock price. The buyer of a put option hopes the stock price will depreciate. If the stock depreciates below the strike price, the buyer of a put option will exercise the right to sell the underlying stock at the strike price. Because the value of the underlying stock price can only depreciate to zero, the maximum gain that the buyer or holder of a put can make is the strike price at which it can be sold (minus the premium paid). If the stock appreciates above the strike price, the put option will go unexercised. Thus, the maximum loss for a put buyer is the premium paid. b. The writer of a put option receives the option premium and is obligated to buy the underlying stock at the stated price. The writer of a put option hopes the stock price will appreciate. If the stock appreciates above the strike price, the put option will go unexercised and the writer of the put option will not have the obligation to purchase the underlying security. Thus, the maximum gain that the 4

7 writer of a put option can make is the premium paid. If the stock depreciates below the strike price, the put option will be exercised and the writer of the put option will have the obligation to purchase the underlying stock at the stated price. Because the value of the underlying stock price can only depreciate to zero, the maximum loss that the writer of a put can have is the strike price at which he is obligated to purchase (minus the premium paid). C. Forward and Futures Contracts 1. A forward contract is a contract where one party agrees to purchase from another party a fixed quantity of property at a fixed price on a fixed future date. a. The party who has the obligation to purchase (the long position) is called the forward buyer, and the party who has obligation to sell (the short position) is called the forward seller. forward price. b. The fixed price at which the property is to be purchased or sold is called the c. The fixed future date is sometimes referred to as the delivery date. d. Traditionally, no consideration (payment and delivery) is exchanged until the future date. This is referred to as a postpaid forward contract although posting of collateral may be required. A prepaid forward contract requires the forward buyer to pay the forward seller the forward price, discounted to present value, at the time the contract is executed. e. Like options, forward contracts can be physically settled (settlement by delivery of the underlying asset) or net cash settled (settlement by payment in cash equal to the difference between the forward price and the then current price at the time of the delivery date). 2. A futures contract is a forward contract that has standardized terms and is traded on an organized futures exchange, like the Chicago Mercantile Exchange. a. The exchange acts as the counterparty to every transaction. Every trade on the futures exchange effectively involves two contracts, one between the future buyer and the exchange, and the other with the future seller and the exchange. The imposition of the clearing house eliminates the credit risk associated with the forward market. b. The buyer and the seller post variation margin, an initial deposit (approximately 50% for stock futures and 1%-15% for commodity futures) to secure performance which is then adjusted daily to reflect the extent to which the position of the futures contract buyer or seller is in or out of the money (unrealized profit or loss at that time). Futures contracts are marked-to-market each day, and the holder of an appreciated contract is allowed to withdraw the appreciation of the margin account (as the holder of a depreciated contract is required to deposit additional margin). This allows parties to more highly leverage their economic positions because only margin is required to trade. c. Typically, investors in the futures market will cash settle, rather than physically settle, or close out the position prior to delivery date by entering into the other side of the contract and offsetting the contracts with the clearinghouse with appropriate cash settlements. 5

8 d. Futures contracts are available on physical commodities (like agricultural products and precious metals), financial assets (like currencies and fixed-income obligations), broadbased stock indices (like the S&P 500 or the MSCI World), narrow-based stock indices, and single stocks. 3. Like the party to options discussed above, whether one is a buyer or seller in the forward contract reflects differing outlooks on the underlying property. The forward buyer expects the underlying property to appreciate above the forward price, and the forward seller expects the underlying property to depreciate below the forward price. 4. The prices of forward and futures contracts when compared to current prices of the underlying property provide information about investors expectations of prices in the future. Under standard forward theory, the forward price under a forward or futures contract for a nonperishable, storable commodity (for example, gold 5 ) or a traded financial instrument (for example, stock) is determined by a. The subject item s current (spot) price, plus b. The cost to carry the item for the term of the contract (a time value of money return on the cash that would be invested in acquiring the item at execution of the contract and holding it until the final delivery date, together with any warehousing or similar expenses), minus c. The expected cash yield on the item (for example, expected dividends on stock), over the term of the contract. d. Because the cost of carry and the cash yield typically are netted against each other, the economic cost of a forward or futures contract is different from an option, for example. Most forward contracts don t require an upfront payment because the initial economic interests of the party are equal. An option, on the other hand requires the payment of a premium. It has been observed that the holder or buyer of an option is in the same position as a party to a forward contract but without the obligation to buy or sell. The obligation has been eliminated, and the cost of that is the option premium We will see that understanding how to determine the forward price is critical to anticipating how certain investment products will be taxed (see the discussion on structured notes below). 6. For example, if 1 share of XYZ stock costs $100 today and the one-year interest rate is 6%, and XYZ is expected to pay a $4 dividend over the next year, the one-year forward price of 1 share of XYZ would be $102. If XYZ paid no dividends, then the one-year forward price would be $106. a. In both of these instances, the selling party in the short position only has market risk associated with the price of XYZ. It assumes the selling party has financed the purchase of XYZ at 6% interest, and by holding the XYZ position it has hedged its exposure under the forward contract. b. Alternatively, this can be viewed as the selling party loaning funds to the party in the purchasing or long position to purchase the XYZ position. D. Swaps or Notional Principal Contracts 5 A gold forward contract can only be acquired legally through a regulated futures contract. 6 The option is typically valued under a number of different option pricing models based on the work of Fisher Black and Myron Scholes. 6

9 1. A notional principal contract (NPC) is defined in the Treasury Regulations as a financial instrument that provides for the payment of amounts by one party to another party at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. 7 a. NPCs are more commonly referred to as swaps. b. A specified index is defined as a fixed rate, price or amount that must be based on objective financial information not in control of either party. c. A notional principal amount is defined as a specified amount of money or property that, when multiplied by a specified index, measures a party s rights or obligations under the contract but is not borrowed or loaned between the parties. In other words, a hypothetical or notional investment by each of the parties. d. The notional investment can be based on virtually any index or asset including equities, interest rates, a bond issuer s credit-worthiness, bonds, currencies, etc. The variety of possible swaps (and the terms of the swap) is limited only by the imagination of parties to the contract. e. Swaps have also been combined with other financial instruments. For example, forward swaps are swaps in which values or variables in the contract are fixed at some date in the future, and swaptions are options on swaps that give the holder the right to enter into a specified swap at a later date, or to terminate or extend an existing swap at a later date. f. In a swap, each party is primarily subject to the credit worthiness of the counterparty because there is no collateral, funds, or actual investment at the center of the 2. The most popular types of swaps are interest rate and foreign currency swaps, primarily because they are used as mechanisms to hedge against exposure to interest and currency rate fluctuations. 3. Like forward contracts, swaps are privately negotiated between the parties without the intermediation of an exchange. That being said, swap dealers have developed standardized contract terms on common swaps (like interest rate swaps), and the dealers act in a similar fashion as an exchange (guaranteeing the obligations of and the succeeding rights of each party to a transfer, terminate or liquidate a swap position). 4. In a typical interest rate swap, one party agrees to make payments based on a fixed interest rate (for example, 5%) applied to a notional mount (for example, $1 million) at regular intervals (for example, quarterly for 2 years). The counterparty agrees to make interest payments based on a floating or variable rate of interest (for example, 3% above the London Interbank Offered Rate [LIBOR]) applied to the same notional amount. The $1 million notional amount does not exist and obviously does not exchange between the parties. Typically the amounts are netted against each other, so only a single payment is made by one party to the other. 5. In a typical total return equity swap, one party (Party S, for short) agrees to make annual payments over the next 5 years in an amount equal to the sum of the total appreciation in value of 7 Treas. Reg (c)(1)(i). 7

10 100 shares of XYZ stock during the year, and dividends paid on 100 shares of XYZ stock during the year. The counterparty (Party L, for Long) agrees to make 5 annual payments (at the same time) in an amount equal to the total depreciation in value of 100 shares of XYZ stock during the year, and a fixed rate of interest multiplied by the value of 100 shares of XYZ stock at the beginning of each year. The amounts are netted against each other. a. From an economic standpoint, Party L is in the same situation it would be if Party L had borrowed funds from Party S and used those proceeds to buy 100 shares of XYZ shares from Party S, with an agreement to sell the shares back to Party S at the end of the 5 year period (100%- leveraged investment in 100 shares of XYZ shares). However, Party L does not have any actual stock ownership rights like the right to vote the shares on corporation matters. In addition, current securities laws limit leveraged margin to 50% of the value of the underlying security. 8 b. It is also economically similar to an agreement to enter into a sequential series of 5 cash-settled forward contracts, in which Party S is the selling party and Party L is the purchasing party. c. The foregoing is a traditionally structured equity swap, but an equity swap can involve cross-payments linked to different equities, so that the parties are each taking simultaneous long and short positions in different equities, instead of one party making payments based on interest rates (compound equity swap). An equity swap can also include a cap on the amount of profit that one party earn, a floor on the amount of loss one party can lose, or a collar of return and loss. 6. A credit default swap is an arrangement where the buyer is obligated to the seller a periodic stream of payments over the term of the contract in return for a contingent payment (typically, the par value of the notional debt) upon the occurrence of a credit event with respect to a notional debt obligation. A credit event means bankruptcy, failure to pay, obligation acceleration or modified restructuring of the debt. The contingent payment can be cash settled or satisfied by physical delivery (with the seller holding the defaulted obligation). E. Financial Equivalency 1. Because these financial derivatives can be negotiated and paired in many different ways, the same economic result can be obtained in a number of different ways. This is sometime referred to as financial equivalency. 2. A postpaid forward contract is economically equivalent to selling a European-style put option and purchasing a European-style call option where the strike prices are equal in both cases to the forward price. This is sometimes referred to as the put-call parity. For example, assume the one year forward price of XYZ stock is $106 (see example above). A party selling a put with a $106 strike price and then buying a call at the same strike price (exercisable one year from now) is in the same position as the buyer of a one year forward contract on XYZ stock. a. In the case of the forward contract, if the stock is $110, the seller of the forward contract has the obligation to sell XYZ stock to the buyer at $106. If it s cash-settled, as it usually is, the seller pays the buyer $4. If the stock is $100, then the buyer of the forward contract has the obligation to buy at $106, and in lieu of that, cash settles the contract by paying the seller $6. 8 See 12 C.F.R. 220 (Regulation T, securities margin rules for securities brokers and dealers), 12 C.F.R. 221 (Regulation U, rules for banks that are not brokers or dealers), and 12 C.F.R. (Regulation X, rules for loans not covered by Regulations T or U). 8

11 b. In the case of the options, if XYZ stock $110, the put option expires worthless, but the party with the all option has the right to buy the stock at $106, thereby netting $4. If the stock is $100, the call option expires worthless, and the option seller has the obligation to buy the stock at $106, but in lieu of that, cash settles the contract by paying the buyer of the put option $6. 3. A prepaid forward contract is financially equivalent to the sale of a put and the purchase of a call at the forward price plus the acquisition of a zero-coupon bond (maturing on the delivery date) with a principal amount equal to the forward price The 2011 Joint Committee Report points out that the put-call parity relationship can be algebraically expressed as follows: 10 S + P(K) = Z(K) + C(K) S is the value of a share of stock, which pays no dividends, on the expiration date of Europeanstyle put and call options (P and C); P(K) is the value of an option to sell (put) S at strike price K on the expiration date; Z(K) is a zero-coupon bond worth K on the expiration date of the options (P and C); and C(K) is the value of an option to buy (call) S at a strike K on the expiration date. 5. This equation can be rearranged to show that the value of the stock (S) can be replicated by purchasing a zero-coupon bond that pays K (the strike price of the options), purchasing a call option, and writing a put option. S = Z(K) + C(K) P(K) 6. As we will see in the next section, despite the fact that the financial derivatives can be combined to create financial equivalency, the taxation of the combination depends on what derivatives are used, rather than the end result. F. Short Sales 1. While not technically a financial derivative, a short sale is a technique that allows an investor to make a profit if the underlying security (typically a publicly-traded stock) drops in value. 2. In a short sale, the owner of the stock (the lender) transfers the stock to the borrower who agrees to (a) return identical stock (same number of shares, issuer, class but obviously not the same exact shares), and (b) make substitute payments equal to the dividends that otherwise would be payable to the original owners of the stock but for the short sale transaction. The borrower then sells the stock for cash (the short sale). When the borrower repays the lender, it closes out the short sale. If the stock has dropped in price, the borrower is able to purchase the stock in the open market at a lower price than the cash proceeds, thus making a profit. If, consequently, the stock price rises, the borrower will have a loss, which theoretically is unlimited since stock prices can rise infinitely. 9 See 2011 Joint Committee Report, p Id. at 45. 9

12 III. TAXATION OF THE FINANCIAL DERIVATIVES A. Taxation of Options 1. From a tax standpoint, there are a number of tax realization events that are possible with respect to options: a. The options can be exercised and physically settled or cash settled. Physical settlement involves the actual exchange of shares pursuant to the terms of the option. Cash settlement involves the writer or issuer of the option making a cash payment equal to the difference in price between the value of the underlying stock and the strike price (keep in mind, if the option goes unexercised the writer or issuer of the option already has the premium and no exchange or payment is required). b. The options can lapse (go unexercised). c. The options contracts can be sold or exchanged (or enter into a closing or offsetting position) prior to the expiration date. 2. The general rules regarding these tax realization events are on an open transaction basis, and they are as follows: 11 a. When a buyer or holder of an option pays a premium, the buyer is not entitled to a deduction nor is the seller of the option required to take the premium into account for tax purposes. (a) If the option lapses, the holder of the option recognizes a loss equal to the premium previously paid, and the seller recognizes gain equal to the same. (b) If a call option is exercised and physically settled, the option premium is added to the amount realized by the seller of the option (strike price plus the premium), and the tax basis in the stock purchased by the call option holder is equal to the same amount (strike price plus the premium). (c) If a put option is exercised and physically settled, the option premium is subtracted from the amount realized by the holder of the option (strike price minus the premium), and the tax basis in the stock received by the put option seller is equal to the same (strike price paid by the seller of the put option minus premium previously paid). (d) If an option is exercised and cash settled, gain or loss is determined at that time and such amount of gain or loss is simply the difference between the amounts paid (the premium for the holder of the option and the cash settlement amount, if any, for the seller of the option) and the amounts received (the premium for the seller of the option and the cash settlement amount, if any, for the holder of the option). (e) If the holder of an option sells, exchanges, closes or otherwise offsets its option position, the premium originally paid is incorporated into calculating any gain or loss upon the sale (the difference between the amount received or the closing price of the offsetting position) and the original price paid for the option. 11 See Rev. Rul , C.B. 302, Rev. Rul , C.B. 265, Rev. Rul , C.B. 363, and Rev. Rul , C.B

13 (2) For the holder of an option, any gain or loss attributable to the sale or exchange of an option, and loss attributable to the lapse of an option shall have the same character as the property to which the option relates in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him). 12 The gain or loss will be long-term or short-term depending on how long the holder has held the option. 13 However, except for specialized long-term options, most actively-traded options have a term of 9 months. The character with respect to cash settlement upon exercise of an option is essentially the same as discussed above. 14 (3) For the seller of an option, 15 Section 1234(b) of the Code provides that any gain or loss attributable to any closing transaction 16 (which includes any termination of the seller s obligations other than the exercise or lapse of the option) and any gain attributable to the lapse of an option will be treated as short-term gain or loss regardless of holding period. 17 If seller has gain or loss as a result of something other than a closing transaction, then Section 1234A of the Code is applicable and that specifically provides for capital asset treatment and the regular holding rules. 18 Thus, the Section 1234(b) short-term gain or loss rule is applicable for only lapsed option and cash-settled option. (4) The foregoing general tax rules are altered if the options are considered Section 1256 Contracts (as discussed in more detail in this outline), a constructive sale under Section 1259 of the Code 19 (as discussed also in the short sale section of this outline), the straddle rules (also discussed in more detail later in this outline) and Conversion Transactions (discussed in more detail later in this outline) (a) and Reg (a). Equity options do not get capital character treatment with respect to: options that are inventory in the hands of the taxpayer (under 1221(a)(1)); (2) gain attributable to the sale or exchange of an option that would not otherwise be treated as a sale of a capital asset (for example, the option is used to hedge another exposure); or (3) loss resulting from the lapse of certain married puts described in 1233(c) where the taxpayer owns the property to which the option relates. 1234(a)(3) and Reg (c). Holders of equity options that are compensatory do not get capital character treatment. See Reg (e) (a)(2) provides that options that lapse will be deemed to have been sold or exchanged on the date of expiration (a) does not apply to cash settlement payments. Rather 1234A provides that [g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of--a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer, shall be treated as gain or loss from the sale of a capital asset. 15 It should be noted that this rule specifically applies to all sellers of options on stock, securities, commodities, or commodity futures (but not other property). With respect to options on property other than stock and securities, commodities, or commodity futures, the Regulations provide that "any gain to the grantor of an option arising from the failure of the holder to exercise it, and any gain or loss realized by the grantor of an option as a result of a closing transaction, such as repurchasing the option from the holder, is considered ordinary income or loss." Reg (b) (b)(2)(A) (b) A. 19 Appreciated financial positions include appreciated options on stock. 1259(b). A constructive sale under Section 1259 of the Code will occur if the taxpayer enters into: (1) a short sale of the same or substantially identical property; (2) an offsetting notional principal contract with respect to the same or substantially identical property; (3) a futures or forward contract to deliver the same or substantially identical property; or (4) one or more other transactions (or acquires one or more positions) that have substantially the same effect. 11

14 3. Gain or loss with respect to equity options is sourced according to the residence of the recipient of such gain or loss. 20 For offshore hedge funds which are generally non-u.s. corporations (as discussed later in this outline), any gain or loss on equity options will generally be considered foreign source income and generally not subject to U.S. withholding tax The option holder capitalizes the cost of the option premium, and the option writer does not immediately include the premium into income. 22 For example, the buyer of a cash-settled option determines gain or loss at the time the option is exercised by subtracting the option premium from the amount received from the seller of the option (if any). On the other hand, if the option is physically settled, recognition of gain or loss is deferred until the acquired asset under the option has subsequently sold. The option buyer s premium is added to the basis of the acquired asset, along with the strike price that was paid to acquire the asset. For the seller of a call option, the premium is taken into income at the time the option is exercised or expires. 5. Gain or loss attributable to the sale or exchange of an option, or loss attributable to failure to exercise an option by the purchaser, is considered to have the same character as the property to which the options relates in the hands of the option purchaser (or would have if acquired by the purchaser). 23 For individual investors, in the case of a purchaser of an option on publicly-traded securities like stock, this means the character of the gain is gain or loss. 24 In the case of an option writer, gain or loss from delivery is typically capital. For the writer of an option, gain or loss from the termination of the option (other than through delivery of the underlying property), and any gain or loss on a lapse of the option is treated as short-term, rather than long-term, regardless of the term of the contract. 25 B. Taxation of Forward and Futures Contracts 1. As an executory contract, the execution of a forwards or futures contract is not considered a taxable event. The taxable event occurs when the contract is settled. 26 As such, gain or loss on a forwards or futures contract can be realized in a number of different ways: a. Sale or exchange of the contract; b. Physical settlement on the contract at maturity; c. Offsetting by entering into another forward or futures contract (on the same property, at the same strike price and maturity); or (a) and 865(j)(2) (Treasury has authority to issue Regulations regarding the sourcing rules of options but none have been issued at this point). 21 Generally, provided the hedge fund is not effectively connected with a U.S. trade or business, there is no withholding on capital gains or option premiums. See Reg (b)(2)(i). 22 Rev. Rul , C.B This would be different if the purchaser is a dealer in securities, if the option is being used as a hedging contract, or a corporation is a purchases an option in its own stock (b)(1). 26 See e.g., Rev. Rul , C.B. 305, Rev. Rul , C.B. 144, Rev. Rul , C.B. 155, and Rev. Rul , C.B

15 d. Cash settlement on the contract at maturity. 2. Generally, the tax treatment of the gain or loss is the same regardless of the manner in which it was generated. If the underlying security would be a capital asset in the taxpayer's hands, then gain or loss from the sale or exchange of the securities futures contract would be capital gain or loss. 27 Proposed Regulations have been issued that provide that any payment on a forward contract will be a termination payment for purposes of Section 1234A, resulting in capital gain or loss If the forward or futures contract is physically settled, the seller recognizes gain or loss at the time it delivers the underlying property in an amount determined by the difference between its adjusted basis in the property and the amount received pursuant to the terms of the forwards contract. 29 The buyer takes a basis in the underlying property based upon the price paid and ultimately realizes gain or loss upon the subsequent disposition of the property. Buyers cannot include the period during which they held the forward or futures contract in the holding period of the asset acquired because they don t actually own the property until it is purchased. On the other hand, specific to securities futures contracts, for the seller, the Code provides that the holding period of stock acquired in satisfaction of a securities futures contract will include the holding period of the futures contract itself If the forward or futures contract is cash-settled (the party who is at a loss pays the other party), then the recipient recognizes gain, and the paying party recognizes a loss If the forward or futures contract is sold, exchanged, or offset, the gain or loss is recognized at that time in an amount equal to the full payment received or made by the disposing party. 32 An offset of a futures contract is not considered the purchase or sale of the underlying property; rather, it is treated as the sale of the contract itself. 33 Section 1234B(a) mandates that gain or loss from the sale or exchange of a securities futures contract has the same character as the property to which the futures contract relates would have in the hands of the taxpayer. 34 The Code further provides that any such capital gain or loss will be short-term capital gain or loss The foregoing timing rules apply even if the forward contract is prepaid upon execution. What often is referred to as a prepaid variable forward contract is essentially a prepaid forward contract and a loan from the purchasing party to the selling party. That loan is repaid by the selling party at the expiration of the term with either the selling party delivering the property in-kind (typically shares of publicly-traded stock) or with cash. Notwithstanding the similarity to a loan transaction, interest is not accrued or recognized by the selling party. In a 2008 notice, the IRS requested A provides that [g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation... with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer... shall be treated as gain or loss from the sale of a capital asset. See also Prop. Reg A- 1(c)(1). 28 Prop. Reg A-1(c)(1) (14). 31 See 1234A A(1) and 1234B(1). 33 Rev. Rul , C.B. 305 (dealing with a commodities futures contract) B(a) B(b). 13

16 comments on the proper treatment of prepaid forward contracts. The notice provides that Treasury is considering whether the parties should be required to accrue income and expense during the term of the contract The source of the gain under a forward or futures contract is determined by the residence of the recipient of the income. 37 U.S. parties in securities futures contract generally recognize U.S. source gain or loss on the sale, and non-u.s. parties generally recognize foreign source gain or loss on the sale and are not subject to U.S. withholding tax on the sale proceeds. 38 Notwithstanding the foregoing, Congress has directed the Treasury to prescribe necessary or appropriate regulations applying the source rules for personal property sales to income derived from trading in futures contracts, forward contracts, option contracts, and other instruments, but Treasury has not yet issued such regulations Under certain circumstances, the gain or loss from securities futures contract will be considered ordinary, if the contract is considered a conversion transaction, as defined in more detail in this outline. C. Taxation of Notional Principal Contracts 1. The Treasury Regulations under Section 446 ( Section 446 Regulations ) define notional principal contracts as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts The Treasury Regulations specifically mention, but don t otherwise define, interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements as examples of NPCs. 41 Recently issued proposed regulations on September 16, 2011, would also add to the definition credit default swaps and weatherrelated swaps to the definition of NPCs A specified index 43 is defined as: a. A fixed rate, price, or amount; b. A fixed rate, price, or amount applicable in one or more specified periods followed by one or more different fixed rates, prices, or amounts applicable in other periods; 36 IRS Notice , I.R.B (a). The source of cash-settled contracts is not clear under current law. Generally, in a cash-settled contract, the source of the gain is based on the residence of the relevant taxpayer. For example, a cash payment made by a U.S. taxpayer to a foreign taxpayer would generally result in a U.S. source loss to the U.S. taxpayer and foreign source income to the foreign taxpayer. 38 See Treas. Reg (b)(2)(i) (j). 40 Treas. Reg (c)(1)(i). 41 Id. 42 Prop. Reg (c)(1)(iii), REG , 76 Fed. Reg (9/16/11). These proposed rules also reflect changes under Section Treas. Reg (c)(2). 14

17 c. An index that is based on objective financial information; or d. An interest rate index that is regularly used in normal lending transactions between a party to the contract and unrelated persons 4. The Treasury Regulations specifically exclude from the definition of a NPC, any of the financial instruments: a. Section 1256 contract (discussed later in this outline) b. Futures contract c. Forward contract d. Option, and e. Any instrument or contract that constitutes indebtedness under general principles of Federal income tax law If a swap arrangement defers all payments to the end of the contract, then the transaction will likely not be considered an NPC for tax purposes. These are sometimes referred to as bullet swaps. These types of arrangements will likely be treated as forward contracts for tax purposes. 45 An NPC requires payments to be made at specified intervals. 6. The Treasury Regulations further provide that to the extent the Section 446 Regulations are inconsistent with the currency rules of Section 988 (as discussed later in this outline), the rules of Section 988 will govern The Treasury Regulations direct that the parties to a NPC must classify each payment under the contract as one of the following: a. Periodic payment; 47 b. Non-periodic payment; 48 and c. Termination payment Treas. Reg (c)(1)(ii). 45 See Prop. Reg A-1(c)(1)(iv). 46 Treas. Reg (c)(1)(iv). Also, the mark-to-market rules for securities dealers under Section 475 also take precedence over the NPC rules of Section 446. Treas. Reg (c)(1)(iii), 47 Treas. Reg (e)(1). 48 Treas. Reg (f)(1). 49 Treas. Reg (h)(1). 15

18 8. Periodic Payments a. Periodic payments are payable at intervals of one year or less during the entire term of the contract and must be based on a specified index, appropriately adjusted for the length of the interval. 50 b. The parties to the transaction must recognize ratable daily portions of each periodic payment for the taxable year to which the payment relates Non-periodic Payments a. A non-periodic payment is defined as any payment that is not considered a periodic payment or termination payment. 52 A nonperiodic payment would exist if one party to the swap was already in the money at the time the swap is executed. For example, one party agrees to pay interest at a rate that is greater (or less) than the market at that time. The benefited party would be required make an up-front prepayment at the outset, and this prepayment would be considered a nonperiodic payment. b. Generally, a fixed non-periodic payment must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract. 53 Generally, the Treasury Regulations provide an allocation methodology based upon forward rates of a series of cashsettled forward contracts that reflect the specific index and the notional principal amount. 54 c. Proposed Regulations have been issued that would allow taxpayers to opt out of these allocation/amortization rules, and instead elect to use a mark-to-market regime. 55 This election would be limited to NPCs that are actively traded, marked-to-market by the taxpayer for financial reporting purposes, subject to an agreement by a counterparty dealer to provide the taxpayer with the value of the contract each year, or marked-to-market by a regulated investment company. 56 d. In the case of significant non-periodic payments, 57 the swap is treated as two separate transactions consisting of an on-market level payment swap and a loan. Interest on the loan is recognized as interest for all purposes 58 of the Code. 50 Treas. Reg (e)(1). 51 Treas. Reg (e)(2). 52 Treas. Reg (f)(1). 53 Treas. Reg (f)(2)(i). 54 Treas. Reg (f)(2)(ii). An upfront non-periodic payment can also be allocated over the term by assuming that it represents the present value of a series of equal payments made throughout the term of the swap. Treas. Reg (f)(2)(iii)(A). 55 Prop. Reg (i). 56 Prop. Reg (i)(2). 57 The Treasury Regulations do not define a significant non-periodic payment, but the examples point out that at 10% prepayment is not considered significant, but a prepayment greater than 40% of the present value is significant. See Treas. Reg (g)(6), Ex. 2 and Treas. Reg (g)(4). 16

19 e. The treatment of non-periodic payments that are contingent upon some event or occurrence is not clear, although Proposed Regulations have been issued to address the issue. 59 Contingent, non-periodic payments occur quite often in the swap context. For example, if in the total return equity swap described above, the terms of the swap provided that the payment based upon the appreciation or depreciation of XYZ stock is to be paid at the end of the 5 year period, the last payment is considered a non-periodic payment (not a termination payment). 60 The Proposed Regulations adopt a methodology that would require taxpayers to project the reasonably expected amount of contingent payments and to allocate portions annually over the term of the contract. 61 Generally, the projected amounts of the contingent payments would be determined by using a future value of the index underlying the NPC (stock or commodity), which can be ascertained from actively traded futures or forward contracts, or can be extrapolated by compounding the current value of the index at the applicable federal rate (AFR). 62 Once the projected amounts have been calculated, the Proposed Regulations then require the taxpayers to annually redetermine the projected amount of contingent, non-periodic payments to take into accounts changes in value of the underlying index upon which the contingency is based. 63 If the newly determined projected amounts differ from the prior year s projected amount, the difference will cause adjustments to income (and deduction) for that year and all prior years of the contract Termination Payments a. A termination payment is a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under a notional principal contract. 65 b. A termination payment is deemed to include a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third party (an assignment), and any gain or loss realized on the exchange of one notional principal contract for another Character of Gain or Loss on NPCs a. The Treasury Regulations do not really address the character of payments under a NPC. However, significant non-periodic payments are sometimes referred to as interest REG , 69 Fed. Reg (2/26/04). See also IRS Notice , I.R.B. 77, Rev. Rul , I.R.B. 971, and Rev. Rul , I.R.B. 992, modified by IRS Notice , I.R.B See Rev. Rul , I.R.B. 971, and Tech. Adv. Mem Prop. Reg (g)(6)(ii). 62 Prop. Reg (c)(5) and (g)(6)(iii). If these methods don t provide a reasonable estimate, a taxpayer is permitted to use another method, so long as it is based on objective financial information. Prop. Reg (g)(6)(iii)(C). 63 Prop. Reg (g)(6)(iv). 64 Prop. Reg (g)(6)(v) and (vi). 65 Treas. Reg (h)(1). 66 Id. 67 See Treas. Reg (g)(4). 17

20 b. Termination payments appear to be capital (rather than ordinary), provided the NPC itself is a capital asset in the hands of the taxpayer or provided the property underlying the NPC is a capital asset in the hands of the taxpayer. The Treasury Regulations provide, The rights and obligations of a party to a notional principal contract are rights and obligations with respect to personal property and constitute an interest in personal property. 68 In addition, Section 1234A provides [g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer shall be treated as gain or loss from the sale of a capital asset. 69 c. Payments other than termination payments are probably ordinary in nature. 70 d. The Proposed Regulations provide that amounts accruing on the contract pursuant to its terms (both periodic and non-periodic) will be ordinary in nature. 71 Termination payments on NPCs that are capital assets in the taxpayer s hands will be treated as capital gain or loss To the extent a payment is not otherwise treated as a dividend equivalent payment under Section 871(m), as discussed later in this outline, income from a NPC is generally sourced by reference to the residence of the recipient. 73 D. Taxation of Short Sales 1. In a short sale, from the lender s standpoint, entering into the short sale transaction is a realization event but the lender does not recognize gain or loss at that time. 74 The payments made to the lender in lieu of the dividends are not considered dividends (thus, not qualifying for qualified dividend 75 status), rather they are treated as ordinary income. 76 The does not seem to be any direct authority on the characterization of the borrow fee, if any, paid to the lender. However, the fee will be considered taxable income to the lender. 77 While an argument can be made to characterize the borrow fee as interest for tax purposes, the more appropriate characterization is treat the fee as ordinary income (a fee for the use of property) Treas. Reg (d)-1(c)(2). See, also, Prop. Treas. Reg A-1. The proposed regulations would treat any payment on a bullet swap or forward contract, including payments made pursuant to the terms of the contract, as termination payments for purposes of Section 1234A. Both of these types of contracts provide for all payments to be made at or close to the maturity of the contract. Prop. Reg A-1(c) A. 70 See Tech. Adv. Memo (commodity swap) and Ltr. Rul (interest rate swap). 71 See Prop. Reg , (q) and A-1(b). 72 Prop. Reg A-1(b). 73 Treas. Reg (b)(1) provides the source of notional principal contract income shall be determined by reference to the residence of the taxpayer. Thus, periodic or non-periodic payments received by a foreign person are not subject to U.S. withholding tax (assuming that the foreigner is not otherwise engaged in a U.S. trade or business) (h)(11). 76 See Prop. Reg (d) and Rev. Rul , C.B See e.g., Ltr. Ruls , and See Treas. Reg (d) (payments in lieu of dividends are fees for the use of property). 18