Article by Barbara Flom
Barbara M. Flom’s critique of new Code Sec. 1260 examines the adverse, overly broad federal income tax changes brought to bear upon a number of popular market investment strategies. Pending the issuance of Treasury regulations, she advises taxpayers to take special care in their recordkeeping and analysis of applicable transactions.
New Code Sec. 1260 was ushered into the Internal Revenue Code (the "Code") with remarkably little fanfare on December 17, 1999.1 In essence, it treats certain forms of derivative investments as "constructive ownership transactions" (COTs), and applies a complex and somewhat punitive income tax regime to investments in COTs. Although the provision, as enacted, has been toned down considerably from the version first proposed by former Rep. Barbara Kennelly of Connecticut back in February 1998,2 it still represents a significant adverse change to the federal income tax consequences of several popular market investment strategies. Moreover, coming along in a year where the corporate tax shelter drum began to beat with vigor, Code Sec. 1260 reminds us that new anti-abuse rules can be brought to bear upon the types of transactions entered into by our non-corporate clients as well.
The impetus for the adoption of Code Sec. 1260 was the proliferation of transactions that use derivatives to permit investors to make indirect, tax-advantaged investments in economically desirable, but tax-disadvantaged, property. For example, wealthy individuals might use derivatives to acquire economic interests in private investment partnerships (commonly called "hedge funds"). These investments are touted as producing market-beating returns but, because of their trading strategies, often generate substantial amounts of ordinary income and short-term capital gains taxed at the highest marginal rates. In contrast, a derivative investment referencing such a fund (the "referent"), if taxed according to its form under the Code prior to the enactment of Code Sec. 1260, might have been expected to generate mostly long-term capital gains (or losses).
In the pre-Code Sec. 1260 marketplace, at least three forms of derivative transactions were in common use for gaining exposure to the economic return of an asset without directly owning it: (a) total return equity swaps; (b) combinations of put and call options at or near the money, with close or identical expiration dates; and (c) prepaid or collateralized forward contracts to acquire the referent. Each type of transaction typically had a term of three to five years, giving the investor all of the upside benefit and downside risk associated with a direct investment in the referent for the specified period of time. In general, other than transaction fees and costs, little if any cash changed hands while the derivative was in place: the investor may have been required to post funds as collateral to secure its obligations under the derivative, and the counterparty might be obligated currently to pay to the investor an amount equal to any actual distributions made by the referent.3
Although the alternative derivative transactions had different formal elements, and raised some different tax as well as other legal issues, all of them were offered to investors on the understanding that tax deferral and long-term capital gain treatment were arguably available. The swap form of transaction was drafted to obtain favorable treatment under the notional principal contract regulations;4 the paired options were arguably governed by Code Secs. 1234 and 1234A; and forward contracts were perhaps the last great category of "open transactions" under the Code. Although any of these transactions might be settled in kind—i.e., in actual stock or other interests in the referent—one might reasonably expect that the ongoing tax detriment of the direct investment form would militate in favor of the parties settling the transaction in cash at (or perhaps slightly before) maturity.
Some practitioners have suggested that these derivative transactions are abusive for two reasons. First, the indirect investments generally are effected through the medium of a counterparty, an investment bank, which hedges its exposure under the derivative by investing directly in the referent. Thus, the overall economic picture suggests that the investment bank acts as the investor’s agent—yet a true agency relationship should be treated as direct ownership by the investor (the agent’s principal), a result clearly inconsistent with the claimed tax treatment of the indirect investment. Second, although the investor stands to save taxes by investing indirectly, the counterparty suffers no correlative tax detriment. The investment bank, as a dealer in securities subject to Code Sec. 475, generally marks its securities holdings to market annually, treating net gains as ordinary income pursuant to Code Sec. 475(d)(3). Since, as an economic matter, any mark-to-market loss on the derivative would precisely offset the mark-to-market gain on its position in the referent, the investment bank has no net tax exposure in its role. This absence of tax symmetry between the contracting parties suggested to some people that these transactions achieved an inappropriate tax result and should be curtailed.
Scope Narrowed Before Enactment
The supporters of Code Sec. 1260 have, from the beginning, taken the view that the conversion of ordinary income or of short-term capital gains from investments into long-term capital gains and the deferral of taxation on the converted amounts are evils to be averted. Consistent with that view, Code Sec. 1260’s remedy for these evils is to recharacterize some or all of the gain arising from an indirect investment as ordinary income, to spread that income over the period of the taxpayer’s indirect investment, and to impose an interest charge on the income improperly deferred. Despite this consistency of view and approach, Code Sec. 1260, in its original form, posed difficult issues of definition and administration, resulting in the provision being refined and scaled back somewhat before enactment.5
As originally and expansively drafted, Code Sec. 1260 would have applied to any "position" with respect to any type of referent property which constituted a "financial position." Borrowing from Code Sec. 1259 (an earlier Kennelly proposal), Code Sec. 1260 proposed to define "position" as any interest, including a futures or forward contract, short sale, or option, and "financial position" as any position with respect to stock, debt instruments, partnership interests, and interests in investment trusts.6 Had the bill been enacted in this form, a standard option to acquire stock or debt would have been a COT.7 Only derivative interests in non-financial types of property—such as an option to purchase Blackacre or a forward contract to buy a bushel of wheat—would have escaped Code Sec. 1260’s ambit.
However, one thorny problem raised by this broad formulation was how to characterize certain derivative transactions, including some common types of market-traded investments. For example, an equity swap referencing the S&P 500 stock index could have as a referent either (a) the individual stocks in the S&P 500 or (b) an exchange-traded S&P 500 futures contract, either of which would constitute a "financial position" for this purpose. A direct investment in the former referent would produce some dividends but (one hopes) much capital gain at maturity, while the latter referent is a Section 1256 contract presently marked to market each year and taxed as 60-percent long-term and 40-percent short-term capital gain. The basic question is how far one drills down through layers of form before stopping. So, if the referent is a "fund of funds" hedge fund, do you (can you) look through that referent to its individual portfolio holdings? What if some of those holdings are themselves indirect "interests" in other "financial positions"?
As these examples indicate, the choice of referent could easily have a substantial impact upon the amount of gain recharacterized and taxed under Code Sec. 1260. Moreover, given the absence of limits on the tiering of investments through partnerships and other vehicles, Code Sec. 1260 might quickly become unadministrable due to a lack of accurate tax information about lower-tier entities. Both taxpayers and the IRS could find themselves stymied in attempting to report transactions properly and to audit them effectively, if the governing principle of Code Sec. 1260 was defined to be "don’t stop drilling until you reach stock in a C corporation."
Unfortunately, no theories exist for selecting the appropriate referent for a COT from among competing, economically equivalent transactions, or for deciding how many investment tiers to scrutinize. Absent such theories, any decision as to tax law consequences of particular forms of COTs would have been ad hoc, perhaps motivated by a desire to raise the most revenue or to create a rule which avoids the problems of application and enforcement noted above. In view of the conceptual and administrative difficulties presented if Code Sec. 1260 were enacted in its original, expansive form, the Treasury Department (which took up the cudgel after Rep. Kennelly retired from Congress) prudently scaled back the provision—at least for the moment—so that, as enacted, and absent regulations, Code Sec. 1260 covers only certain types of indirect investments in "financial assets."
Scope Of Code Sec. 1260, As Enacted
Definition Of A COT
Under new Code Sec. 1260, not every form of indirect investment will automatically be taxed as a COT. Instead, a COT is defined as a transaction where the taxpayer does any of the following: (a) holds a long position under a notional principal contract (NPC), such as a swap, with respect to a financial asset; (b) enters into a forward or futures contract to acquire a financial asset; (c) holds a call option, and grants a put option, with respect to a financial asset and the options have substantially equal strike prices and substantially contemporaneous maturity dates (matched options); or (d) to the extent provided in regulations, engages in other transaction(s) or acquires other position(s) which have substantially the same effect as one of the enumerated transactions.8 Further restricting the scope of Code Sec. 1260 as enacted, an NPC will only constitute a COT if the taxpayer receives payment or credit for all or substantially all of the investment yield and appreciation in the referent, while suffering all or substantially all of the decline in the referent’s value during the term of the NPC.9
Absent regulations, then, only transactions involving "total return" equity swaps (or close analogues), matched options, or long forward and futures contracts should bring the COT rules into play. However, as discussed in the succeeding paragraphs, the financial assets concept in Code Sec. 1260, as enacted, is still sufficiently expansive to sweep in many categories of investments which taxpayers might wish to make indirectly. Thus, tax advisors may well encounter frequent occasions to analyze a client’s derivative investment transactions in light of Code Sec. 1260.
Definition Of Financial Asset
Code Sec. 1260(c)(1) defines a financial asset primarily as "any equity interest in any pass-thru entity," including mutual funds (RICs), real estate investment trusts (REITs), real estate mortgage investment conduits (REMICs), S corporations, partnerships and limited liability companies (LLCs), trusts, common trust funds, passive foreign investment companies (PFICs), foreign personal holding companies and foreign investment companies.10 Since most domestic hedge funds are formed as limited partnerships (or, less frequently, as LLCs), the common forms of indirect hedge fund investment are now clearly characterized as COTs. Foreign hedge funds are typically either PFICs or entities treated as partnerships, so indirect investments in these funds will also constitute COTs.
However, as the list indicates, the financial asset definition sweeps in much more than hedge funds. Although the statute lumps these varied referents under the rubric of "pass-thru entity," a categorization which emphasizes the fact that these entities are not themselves subject to federal income taxation, the more salient feature shared by these vehicles for purposes of Code Sec. 1260 is the propensity to throw off various forms of ordinary income rather than capital gains. REITs pay dividends; REMIC regular interests are taxed on the accrual method for amounts constituting interest and original issue discount; RICs, like hedge funds, produce a mix of income types; S corporations, partnerships and LLCs may be engaged in operating businesses and recognize trade or business taxable income. In each case, an indirect, derivative investment by an investor could presumably serve the same purposes of deferring recognition of this income while transmuting gains received at maturity to long-term capital gains. Now, under Code Sec. 1260, if the derivative is a total-return equity swap, forward or futures contract, or pair of matched options linked to one of these types of referents, the transaction will be subject to taxation as a COT.
In addition, as discussed below, the Treasury Department is statutorily empowered to expand the definition of financial asset by regulations to include any debt instrument and any stock in a corporation which is not a pass-thru entity.11 If the Treasury Department exercises its regulatory authority to expand the categories of COTs and of financial assets, then stimulating intellectual exercises regarding choices among referents or the appropriate depth for look-through rules, of a kind which the original version of Code Sec. 1260 might have sparked, will not necessarily be avoided, but merely deferred.
Taxation Of COTs
A taxpayer’s entry into a COT will not trigger any immediate tax effects. Rather, Code Sec. 1260 provides that if a taxpayer would otherwise recognize gain from a COT under normal Code rules (e.g., on a sale, exchange or other taxable disposition), certain complex rules and alternative tax consequences will apply.
First, the taxpayer must determine how much of the gain recognized in the transaction is attributable to the "net underlying long-term capital gain" (NULCG) in the referent. For this purpose, NULCG means the aggregate net capital gain that the taxpayer would have recognized if it had invested directly in the referent on the date that the COT was acquired and disposed of the referent on the date that the COT was closed out, taking into account only gains and losses that would have resulted from its deemed ownership of the referent.12 The taxpayer bears the burden of proving the amount of NULCG that the referent would have generated by clear and convincing evidence; otherwise, the NULCG is deemed to be zero.13 Any NULCG recognized by a taxpayer is unaffected by Code Sec. 1260; thus, it is taxed as long-term capital gain under the normal Code rules, at the appropriate marginal tax rates.14
Second, any remaining gain recognized on the sale or other disposition of a COT is treated as ordinary income, taxable at the appropriate marginal rates.15 In addition, an interest charge, at the rates prescribed for interest on tax underpayments under Code Sec. 6601, is imposed on this amount of ordinary income as if the taxpayer had in fact recognized the income over the term of the COT and simply neglected to pay the appropriate taxes when due.16 Although this interest is calculated in the same manner as interest on tax deficiencies under Code Sec. 6601, the statute specifically states that interest amounts so paid by a taxpayer are allowed in computing the taxpayer’s deduction for interest paid or accrued during the tax year.17
Code Sec. 1260’s approach to allocating the ordinary income component from a COT across time was originally modeled on the interest charge regime applied to PFICs in Code Sec. 1291, which treats income as accruing ratably over the period of PFIC ownership. However, in its enacted form, Code Sec. 1260(b)(2) allocates the ordinary income amount by assuming that it accrued at a constant rate, equal to the applicable federal rate in effect on the day that the COT was acquired.
Of course, the fairest approach to allocating income from a COT for the purposes of assessing an interest charge on any inappropriate tax deferral would be to determine when the ordinary income amounts actually arose during the period that the taxpayer owned the COT, and to then tax them accordingly. Any concern that a taxpayer might be unable to provide accurate documentation of the timing of these income amounts could be dealt with by providing a mechanical rule as a fallback method of allocating this income. But perhaps such respectful treatment of taxpayers is too much to expect of a provision intended as an anti-abuse rule! At least taxpayers can be thankful that, as between the PFIC and Code Sec. 1260 methods for allocating the COT’s ordinary income, the Code Sec. 1260 constant growth rate approach should result in a smaller interest charge, and thus be more favorable in that it accrues the income as if the COT were an original issue discount obligation, earning larger amounts of interest in later years, rather than as a debt instrument earning simple interest without any compounding (which is what the PFIC rules basically provide).
Code Sec. 1260 is effective for COTs entered into on or after July 12, 1999. If a pre-existing COT is extended or modified on or after July 12, 1999, it will be treated as a new COT for purposes of Code Sec. 1260. The legislative history states that no inference is intended as to the proper tax treatment of COTs prior to the effective date of Code Sec. 1260. However, even though the tax treatment of a pre-effective date COT can be challenged, taxpayers should feel reasonably comfortable continuing to report any gain recognized under a "grandfathered" COT as capital gain in accordance with its form, the taxpayers’ prior practice or their tax advisors’ recommendations. Furthermore, although Code Sec. 1260 has some limited retroactive application, as enacted, it is more favorable to taxpayers than Rep. Kennelly’s original proposal, which would have applied to all gains recognized on or after the date of enactment, regardless of the date that the COT was originally entered into.
COT Rules Apply To All Taxpayers, But Only To Gains
Although Code Sec. 1260 was primarily designed to strip unwarranted tax benefits away from wealthy individuals (and possibly trusts and estates) making derivative investments in hedge funds, the provision itself is not so limited. Code Sec. 1260 by its terms applies to all taxpayers, even those (such as corporations) for which there is no marginal tax rate differential between ordinary income or short-term capital gains and long-term capital gains. Therefore, if a domestic C corporation enters into a COT, it will pay the same "deficiency-like" interest as an individual would pay on the tax deferral with respect to any ordinary income generated by the COT. To minimize the amount of such interest, a corporation—no less than an individual—will need to maintain accurate records of the financial performance of the referent sufficient to satisfy the clear and convincing evidence standard for proving the amount of NULCG on the COT.18
Perhaps the least defensible aspect of Code Sec. 1260’s breadth is the fact that all forward and futures contracts referencing financial assets are COTs. Although swaps and other NPCs are taxed under Code Sec. 1260 only if they transfer substantially all of the financial risk and reward in the referent, and options must have substantially equal exercise prices and terms, forward and futures contracts are statutorily presumed to create constructive ownership in referent financial assets. The broad scope of this definition will mean that many normal business contracts which are entered into with no thought of tax deferral or gain transmutation will be reportable under Code Sec. 1260.
The Treasury Department is granted regulatory authority, under Code Sec. 1260(g)(2), to exclude from Code Sec. 1260 those forward contracts "which do not convey substantially all of the economic return" of a financial asset. Nevertheless, absent such regulations, all of these contracts will be taxed as COTs—unless they are marked to market as discussed in the next section. For forward contracts with a term of one year or less, the chief effect of Code Sec. 1260’s application will be the characterization of any gain as ordinary income rather than as short-term capital gain. For longer-term contracts, taxpayers will be forced to demonstrate their NULCG amounts or to pay Code Sec. 1260 interest charges. In either situation, a taxpayer’s best defense is keeping good records.
Code Sec. 1260 does not apply to any COT which, when sold, generates a loss. Nor has any regulatory authority been granted to the Treasury Department to permit taxpayers to elect to treat such a transaction as a COT. Presumably, therefore, a taxpayer in such a situation will be bound by the form chosen for the derivative investment, and the loss recognized will be a long-term capital loss if the COT has been held by the taxpayer for more than one year. In view of the enactment of Code Sec. 1260, then, it may be worthwhile for certain taxpayers to consider specifying in a COT that the derivative counterparty is actually serving as the taxpayer’s agent, holding a direct investment in the referent on the taxpayer’s behalf. In other words, if one can no longer argue that the COT form offers any tax benefits, perhaps it is wise to think about avoiding COT characterization of investments in order to ameliorate potential tax detriments.
Punitive Aspects Of Code Sec. 1260
As this discussion shows, Code Sec. 1260 is clearly designed to operate as an anti-abuse rule, rather than being some neutral tax provision of general application to a class of transactions. Instead of simply treating each and every COT as constituting direct ownership of its referent, and taxing it in accordance with that recharacterization, Code Sec. 1260 actively punishes taxpayers for choosing an indirect rather than a direct form of investment. A taxpayer cannot obtain any long-term capital gains treatment of gains recognized on a COT unless the taxpayer demonstrates the existence of NULCG by meeting a higher-than-normal evidentiary standard. Moreover, if a taxpayer is unfortunate enough to engage in a COT which declines in value over its holding period, the loss recognized will constitute a capital loss even if, had the taxpayer owned the referent directly, some or all of the loss would be a net operating loss or a bad debt garnering ordinary loss treatment under the Code. A taxpayer who enters into multiple COTs may face the worst of all possible worlds, in that gains and losses on equivalent transactions will not be permitted to offset each other. Code Sec. 1260 is just the latest instance of "heads I win, tails you lose" tax provisions which do not stop at countering perceived abuses, but go on to create implicit or explicit tax penalties for engaging in the disfavored conduct.19
One other potential unfairness of Code Sec. 1260 deserves brief mention. As discussed earlier, the COT rules were designed to achieve appropriate tax results in situations where the investor’s tax advantages (capital gain treatment and deferral) were not balanced by the counterparty’s tax detriment (e.g., because the counterparty was taxed under Code Sec. 475). However, Code Sec. 1260 does not require the presence of a tax-indifferent party for its application—meaning that two taxpayers may be taxed for "owning" the same property, possibly resulting in the overpayment of income taxes on the referent’s economic gains. Perhaps regulatory discretion could be exercised to exclude such an inequitable result.
Escaping Code Sec. 1260 By Marking To Market
A transaction that otherwise would be taxed as a COT will be excluded from Code Sec. 1260 if all positions constituting part of the transaction are marked to market under any provision of the Code or regulations.20 Thus, securities dealers and traders and commodities dealers and traders which are (or have elected to be) subject to Code Sec. 475 will not be subject to Code Sec. 1260, and certain transactions involving only Section 1256 contracts are not covered by Code Sec. 1260. Taxpayers reporting under these rules will each year recognize gain or loss on COTs disposed of during the year, as well as any COTs remaining open at year-end (treating these latter as being closed out at their fair market values on the last business day of the year). The entire amount of gain or loss recognized under Code Sec. 475 would be ordinary in character, while amounts taxed under Code Sec. 1256 are treated as consisting of 60-percent long-term and 40-percent short-term capital gains or losses.
In addition, the Treasury Department has the authority to prescribe regulations permitting other taxpayers to elect to mark their COTs to market. This is likely to be a one-time election, applicable to all COTs, and irrevocable without the IRS’s consent.21 Absent regulations, taxpayers cannot avail themselves of this election; moreover, it is likely that regulations, when proposed, will require all amounts recognized under a COT to be treated as ordinary income or loss—a sensible result for persons engaged in the securities business, but unduly harsh for other taxpayers. The chief advantage of the election is that it frees a taxpayer from cumbersome recordkeeping to demonstrate the NULCG on its COTs; however, the cost of this freedom may be too high.
Other Uses For COTs: What’s Left?
As mentioned earlier, Code Sec. 1260 applies to all taxpayers, even though its primary purpose is to prevent the conversion of ordinary income and short-term capital gain into long-term capital gain, an issue primarily of interest to individual taxpayers, estates and trusts for whom there is a substantial marginal tax rate differential. Moreover, the derivative investments subject to recharacterization under Code Sec. 1260 include many which are useful to other categories of taxpayers. For example, qualified employee benefit plans and other tax-exempt organizations have employed derivatives to insulate themselves from recognizing "unrelated business taxable income" (UBTI) when making investments in operating businesses and leveraged assets or real property.22 Similarly, foreign persons used derivatives to make investments in a manner which would not constitute a "United States real property interest" or produce "effectively connected income" (ECI) or "fixed or determinable annual or periodical gains, profits, and income" (FDAP).23 These investments must now be analyzed under Code Sec. 1260 in order to ascertain whether the treatment of such transactions as COTs will present any disadvantages to these special types of taxpayers.
COTs and TEOs
Tax-exempt organizations (TEOs) are concerned about two types of UBTI: income generated from either (1) operating businesses or (2) "debt-financed property."24 A TEO’s income from securities investing and trading activities is not taxable under Code Secs. 512(b)(1) and (b)(5). Therefore, hedge funds—both domestic partnerships and foreign PFICs—and other passive investment vehicles generally implicate UBTI issues only when: (1) they make leveraged investments; (2) they invest in operating businesses conducted in partnership or LLC form; or (3) the TEO leverages its own investment in the vehicle. Similarly, a TEO is not taxable on most types of rental income under Code Sec. 512(b)(3), so only investments in leveraged real estate partnerships typically raise UBTI concerns.25
Suppose a TEO buys a COT referencing a leveraged partnership or PFIC because direct ownership of an interest in the vehicle would expose the TEO to taxation on UBTI. When the TEO sells or otherwise disposes of the COT at a gain, nothing about Code Sec. 1260’s recharacterization of the gain as ordinary income should change the baseline rule that only limited classes of ordinary income are taxable to a TEO. Although the Treasury Department might attempt to stretch its regulatory authority under Code Sec. 1260(g) to characterize gains recognized in such circumstances as UBTI to a TEO, it is difficult to understand why the Treasury Department would take this approach in preference to treating the COT as an agency relationship and taxing the TEO as if it directly owned the UBTI-producing investment.26
COTs and Foreign Persons
COTs entered into by foreign persons presumably should be analyzed in much the same way as the COT described in the preceding paragraph. For example, if a foreign person purchases a COT referencing a domestic hedge fund, which throws off mostly ordinary income and short-term capital gains, and the gain on the sale of the COT is treated as ordinary income under Code Sec. 1260, that gain may also be susceptible to characterization as FDAP under Code Secs. 871(a)(1) and 881(a)(1). Similarly, if the COT references a domestic partnership engaged in an operating business, such gain might also be characterized as ECI, taxable in itself and potentially affecting the tax treatment of other U.S.-source income recognized by the foreign person. Lastly, although it requires a more strenuous conceptual stretch, if the COT references a partnership holding United States real property interests (USRPIs) (as defined in Code Sec. 897(c)) or a REIT, perhaps gain recognized on the COT by a foreign person could be taxed under Code Sec. 897(a).27
There are two ways in which these draconian tax consequences might arise. First, of course, the Treasury Department could attempt to impose these results through regulations promulgated under Code Sec. 1260. Although one would expect regulations of such import to be vociferously challenged as outside of the scope of Congress’s intent in enacting Code Sec. 1260, one should not forget that this is an anti-abuse rule, with abuse being in the eye of the beholder. Such regulations, if proposed, would certainly have to be prospective in application, but that may be cold comfort to foreign investors and the financial intermediaries that assist them in effectuating indirect investments of these types.
Second, these untoward tax results might be achievable through case law development. The author suspects that this issue may play out differently in court with respect to FDAP and ECI than under the UBTI provisions of the Code because the operating principles and policies of the two Code regimes cut in opposite directions—foreign persons are generally taxable on their United States activities, with specific exceptions for capital gains and portfolio debt instruments, while exempt organizations are generally not taxed on their financial dealings unless they stray into overly businesslike activities. These principles and policies might lead a court to use Code Secs. 1260 and 871 or 881 in tandem, to tax the transaction in consonance with Subchapter N. Moreover, Code Sec. 1260’s spreading of ordinary income from a COT across its period of ownership may superimpose a certain (albeit artificial) "determinable" and "periodical" quality to the income received, which could facilitate its characterization as FDAP. Finally, FDAP and ECI are concepts which have relied on the collective mental efforts of generations of judges for their development—these determinations, being common law exercises, may offer more freedom to a factfinder to analogize Code Sec. 1260’s concept of ordinary income to items traditionally regarded as FDAP or ECI.
In light of these risks, foreign persons who invest in COTs referencing U.S.-based assets should be advised to keep meticulous records. The foregoing analysis suggests that if any portion of the COT gain can be shown to arise from capital gains recognized by the referent (either long- or short-term), it may be possible to convince a court either that such amounts escape taxation under Code Sec. 1260 altogether or, as to any short-term capital gains, that equitable application of FDAP (or ECI) concepts precludes taxing a foreign person on amounts which, if realized directly, would not have been taxed.28
COTs—The Next Generation
It will come as no surprise to any reader of this article that much effort has been expended over the past two years—since the Kennelly proposal for Code Sec. 1260 was first introduced—in designing structures which would escape taxation as COTs. Now that we have an enacted statute with specific terms, and the prior generation of transactions is no longer useful in many cases, the efforts to create the next generation of financial products in this area have redoubled. Although the author is unaware of any new-style transactions that have been effectuated, it is possible to predict at least some of the directions in which innovations will naturally proceed.
From the definition of a COT, we know that not all NPCs and not all pairs of options will be subject to taxation under Code Sec. 1260, but only those types of derivatives which transfer substantially all of the upside opportunity and downside risk in the referent for the period of time that the COT is in effect. Therefore, to avoid Code Sec. 1260, we would attempt to design derivatives which would reduce the holder’s exposure to the referent’s economic performance in some dimension. Time is not a helpful variable unless we create an instrument which is not coterminous on both sides of the transaction. For example, if a swap gives one party downside exposure to a hedge fund for three years beginning January 1, 2000, but an upside opportunity in the same fund beginning January 1, 2001, is there enough discontinuity to take the transaction out of Code Sec. 1260? Almost certainly not, because the transaction could simply be analyzed as a two-year COT (January 1, 2001 to December 31, 2002), with the tails at the ends analyzed and taxed separately.29 The tails represent very different kinds of economic exposure, as well, suggesting that even if this transaction worked for tax purposes it might encounter resistance in the marketplace.
Similarly, we could design a swap where the investor’s exposure on either the risk or reward side, or both, was subject to a cap or floor. This swap might be viewed as not transferring "all or substantially all" of either the investment yield and appreciation, or the decline in value of the referent, over the swap term. This kind of modulation is probably the most straightforward way to attempt to avoid Code Sec. 1260, and approximates the analysis currently used in deciding that certain option collar transactions are not constructive sales under Code Sec. 1259 (while we continue to wait for regulations on this subject). Interestingly, given the similarity of language and approach between Code Secs. 1259 and 1260, one might surmise that "all or substantially all" should mean the same thing in both statutes, and that laying off a sufficient level of risk to trigger a constructive sale in the Code Sec. 1259 context would be a sufficient risk undertaken to be deemed constructive ownership under Code Sec. 1260.
Now, instead of a cap or floor, imagine interposing a feature like a premium or a multiplier in our swap. So, for example, if the referent increases by 100 percent over the term of the swap, the counterparty will pay the investor 110 percent, or 200 percent, of that gain; on the flip side, the investor would similarly overcompensate the counterparty for a decline in the referent’s value. Does this swap escape Code Sec. 1260? Arguably not, because, as we saw when using time as a variable, it may be possible to bifurcate the transaction to carve away the effects of the premium or multiplier, analyzing what is left as a COT.
Perhaps the most fruitful possibilities for designing a non-COT are presented by instruments which could be structured to reflect the economic performance of multiple referents, only some of which are "financial assets" under Code Sec. 1260. Unless the Treasury Department exercises its regulatory authority to treat certain debt instruments as financial assets, a swap referencing both a hedge fund and a debt instrument may escape taxation as a COT. Similarly, a swap referencing both C corporation stock and a REIT could avoid Code Sec. 1260, absent regulations. Could such regulations be issued retroactively, "to prevent abuse"?30 Code Sec. 7805, as amended in 1996, broadens and clarifies the circumstances in which the Treasury Department may issue retroactive regulations. However, the author is unaware that the Treasury Department has yet exercised this expanded authority, and would be surprised to see retroactive regulations here, where Congress did not clearly indicate, in the legislative history, any awareness of or concern about "hybrid COTs."
Of course, in addition to designing a transaction which avoids punitive treatment under Code Sec. 1260, it will be important for the financial engineers to create a product which can be priced accurately and which investors are willing to buy. COTs, unlike certain corporate tax shelters, are genuine investments made with the goal of economic gain. A next-generation COT, which sacrificed this characteristic in pursuit of advantageous tax treatment, would probably find few buyers.
Whence The Other Shoe?
Although Code Sec. 1260 offers plenty of intellectual fodder in its current form, it is also intriguing for what it may presage for the future. It may already be possible to use Code Sec. 1260 to recharacterize COT income as UBTI, FDAP or ECI. Looking ahead, how far can the constructive ownership idea logically extend, and how much of this extension might be achieved through regulations alone?
Code Sec. 1260(c)(1)(B) states that, to the extent provided in regulations, the Treasury Department has the authority to define as a financial asset any debt instrument and any stock in a corporation which is not a pass-thru entity. Code Sec. 1260(d)(1)(D) provides correlative regulatory authority for the Treasury Department to treat as COTs transactions "that have substantially the same effect" as the enumerated NPCs, matched options and forwards/futures contracts. Might the combination of these two provisions, in daring hands, expand the application of Code Sec. 1260 to many indirect forms of investment transactions?
For example, would it be possible to apply Code Sec. 1260 to debt instruments linked to the performance of (and sometimes settled in) stock?31 Perhaps, but this would appear to serve little purpose. The COT rules do not govern the taxation of the issuer (although Code Sec. 1259’s constructive sale rules could be used to tax this party). Moreover, if the referent is stock, the chief result of applying Code Sec. 1260 would be to tax implicit dividends—but unless these amounts exceed the "interest" paid, in form, on the debt instruments, the exercise will produce no net tax revenues.
Also, one might use the latitude offered by combining "all or substantially all" (risk and reward) with "substantially the same effect" (transactions) in order to treat as COTs instruments which participate significantly, but less than fully, in a referent’s economic results. Such a response might even be appropriate to counter the next generation of COTs discussed in the preceding section, although one might hope that the Treasury Department would exclude certain common types of transactions (e.g., options to acquire partnership interests, issued "at the money"). Any regulations taking this approach might well overreach Congressional intent in enacting Code Sec. 1260; nevertheless, it may be difficult to convince a court to overturn such regulations given the broad grant of regulatory authority and Code Sec. 1260’s purpose to corral abuse.
Although it would be absurd to suppose that Code Sec. 1260, standing alone, radically transforms the taxation of numerous financial instruments, even in its current form it represents a step beyond anything which has existed in the Code before. After the Treasury Department has had an opportunity to research the marketplace and to consider the taxation opportunities presented by the constructive ownership concept, it may find applications for Code Sec. 1260 beyond the types of transactions which spawned it.
Code Sec. 1260 is something of a Frankenstein’s monster, borrowing its definition of COT largely from Code Sec. 1259’s constructive sale concept, and its interest-charge approach mostly from Code Sec. 1291, the original PFIC regime. However, unlike its legislative forebears, Code Sec. 1260 can apply to a taxpayer whose investment activities are wholly domestic and represented by a single instrument. Therefore, some tax cases will likely arise in situations where a taxpayer simply failed to realize that his or her investment activities were encompassed by this new provision. Nevertheless, one can be grateful that Code Sec. 1260, as enacted, does not (so far) require every taxpayer to analyze every "long" position in a portfolio in order to determine whether a position is a COT because it can be recharacterized as an indirect interest in some other referent property.
The most intellectually intriguing aspect of Code Sec. 1260 is how different constructive ownership is from constructive sale, in spite of numerous similarities in statutory language. Constructive ownership is substantially less clear and potentially much broader, and may create greater unfairness in its application to various transactions than Code Sec. 1259’s constructive sale rules. Regulations, when issued, may ameliorate or exacerbate one or more of these characteristics of constructive ownership. In the meantime, care should be taken both in recordkeeping for COTs and in analyzing new transactions which may be swept within the ambit of Code Sec. 1260 by regulations.
1 The Tax Relief Extension Act of 1999 (P.L. 106-170).
2 H.R. 3170, 105th Cong., 2nd Sess. (Feb. 5, 1998).
3 Hedge funds are structured not to be "regulated investment companies" (RICs) taxable under Code Secs. 851-855. Thus, hedge funds, unlike RICs, are not subject to the Code Sec. 852(a) requirement to pay annual dividends of at least 90 percent of their investment company taxable income and tax-exempt income. Taking advantage of this freedom from distribution requirements, many hedge funds maintain illiquid portfolios and reinvest earnings for extended periods of time.
4 Reg. §1.446-3. For high net worth individuals, equity swaps were likely the least favorable form of transaction because any net periodic payments made by the taxpayer would be deductible only to the extent that they exceeded two percent of the taxpayer’s adjusted gross income. Code Sec. 67.
5 Code Sec. 1260 originally owed too much to the structure and language of Code Sec. 1259, perhaps because the drafters viewed "constructive ownership" as the mirror image of "constructive sale." Thus, in its initial draft, Code Sec. 1260 spoke of the taxpayer or a related party entering into certain types of transactions with respect to "the same or substantially identical property." The conceptual flaw in this approach is that, although it takes two transactions or instruments to create a constructive sale, it takes only one to have a COT. These vestigial elements were thus appropriately removed from Code Sec. 1260 as enacted.
6 Proposed Code Sec. 1260(c)(1).
7 An unintentionally humorous, albeit harmless, effect of recycling Code Sec. 1259’s broad definition of "interest" was that the purchase of stock itself also could have constituted a COT.
8 Code Sec. 1260(d)(1).
9 Code Sec. 1260(d)(3).
10 Code Sec. 1260(c)(2).
11 Code Sec. 1260(c)(1)(B).
12 Code Sec. 1260(e).
14 Code Sec. 1260(a)(2).
15 Code Sec. 1260(b)(1).
16 Code Sec. 1260(b)(2).
17 Code Sec. 1260(b)(1).
18 In passing, the author notes that the corporate tax directors’ surprise at their transactions being subject to Code Sec. 1260 is likely no greater than individuals’ amazement will be upon finding out that the proposed codification of the "economic substance" doctrine, touted as a way to combat corporate tax shelters, may have some bearing on their own stratagems for income tax avoidance. General Explanations of the Administration’s Fiscal Year 2001 Revenue Proposals (paragraphs 617—626).
19 See, e.g., Code Secs. 1258 and 1259.
20 Code Sec. 1260(d)(2).
21 Elections of this type are commonly irrevocable. See, e.g., Code Sec. 1278(b) (election to include market discount in income currently).
22 Code Sec. 512(a)(1).
23 Code Secs. 897(c), 871(a)(1)(A) and 864(c).
24 Code Secs. 511-514.
25 Although TEOs can avoid UBTI treatment of income even from leveraged real estate partnerships which use the "fractions rule" of Code Sec. 514(c)(9), many partnerships do not adopt the rule because it precludes them from making certain types of special allocations which are of value to their taxable partners.
26 The agency analysis may be particularly compelling where the underlying asset is nonfungible or unique, so that economic exposure to the asset is not replicable by the investor otherwise than by accepting the disadvantageous tax results of direct ownership.
27 Using Code Sec. 1260 to tax gains from USRPIs may be unnecessary if the Code Sec. 897 definition of USRPI were construed to include COTs as "interests" in real property.
28 Of course, the IRS may still argue that the COT represents an agency relationship between the foreign investor and a financial intermediary, and the IRS may attempt to tax the investor in accordance with this characterization.
29 Whether and when the IRS may have the power to bifurcate an integrated transaction in order to tax it differently than in its form is a question well beyond the scope of this article. In practice, whether a reviewing agent actually attempts to bifurcate a transaction is substantially dependent upon the agent’s ability to sort the transaction into logical, separable pieces.
30 Code Sec. 7805(b)(3).
31 These instruments have been offered as DECS, ACES, and other acronyms too numerous to mention.
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