The IRS has concluded in an internal legal memorandum (ILM 201310027) that certain debt instruments issued by a taxpayer constituted an offsetting position in a straddle under Section 1092 and the regulations (the straddle rules).
The memorandum addressed a taxpayer who issued notes (the notes) that were exchangeable (the exchange feature) upon demand by a holder for certain shares of a corporation (X). X stock was publicly traded, and the taxpayer also held a specified amount of X stock. Immediately before the issuance of the notes, the trading price of X stock was less than the exercise price for the exchange feature (i.e., the exchange feature was "out of the money").
Prior to the notes' maturity, the exchange feature became "in-the-money" (i.e., the exercise price of the exchange feature was less than the trading price of X stock), and the taxpayer redeemed the notes in exchange for an amount of cash that exceeded the adjusted issue price of the notes (the repurchase premium).
The straddle rules defer recognition of loss attributed to offsetting positions. Specifically, under Section 1092(a)(1)(B), if there is a loss with respect to any position of an identified straddle, the basis of each offsetting position is increased by the ratable amount to the unrecognized gain in the offsetting position.
In addition, Section 263(g) requires the capitalization of certain interest and carrying charges that can be properly allocated to a straddle.
The IRS concluded that the taxpayer's deduction for the repurchase premium was deferred under the straddle rules because the notes constituted an offsetting position to taxpayer's X stock. In addition, the interest related to the notes was required to be capitalized under Section 263(g).
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