PRESENT LAW AND ISSUES RELATED TO THE TAXATION OF FINANCIAL INSTRUMENTS AND PRODUCTS A REPORT TO THE JOINT COMMITTEE ON TAXATION Prepared by the Staff of the JOINT COMMITTEE ON TAXATION December 2, 2011 JCX-56-11 CONTENTS Page INTRODUCTION AND SUMMARY ........................................................................................... 1 I. CONSIDERATIONS IN HOLDING, ISSUING, AND STRUCTURING FINANCIAL INSTRUMENTS....................................................................................................................... 6 A. Economic Considerations ................................................................................................... 7 B. Financial Accounting Considerations ................................................................................. 9 C. Regulatory Considerations ................................................................................................ 12 II. U.S. INCOME TAX PRINCIPLES ........................................................................................ 14 A. Timing of Income Rules ................................................................................................... 16 B. Character of Income Rules................................................................................................ 19 C. Source of Income Rules .................................................................................................... 22 III. INCOME TAX AND ACCOUNTING RULES AND ECONOMIC ANALYSIS RELATED TO FIVE FUNDAMENTAL FINANCIAL INSTRUMENTS ........................... 24 A. Income Tax Rules ............................................................................................................. 24 1. Equity .......................................................................................................................... 24 2. Debt ............................................................................................................................. 30 3. Options ........................................................................................................................ 32 4. Forward contracts ........................................................................................................ 36 5. Notional principal contracts ........................................................................................ 39 B. Relationships among Financial Instruments ..................................................................... 44 C. Financial Accounting Treatment of Financial Instruments .............................................. 48 1. In general .................................................................................................................... 48 2. Consequences of holding and issuing debt and equity ............................................... 49 3. Consequences of entering into a derivative contract .................................................. 52 4. Special rules ................................................................................................................ 53 5. Issues in financial accounting for financial instruments ............................................. 56 6. Major differences between tax and financial accounting for financial instruments ... 58 IV. DISCUSSION OF SELECTED TAX ISSUES ...................................................................... 62 A. Issues Related to the Categorization of an Instrument ...................................................... 62 B. Issues Related to Timing ................................................................................................... 68 1. Deferral of income ...................................................................................................... 68 2. Acceleration of losses ................................................................................................. 70 C. Issues Related to Character ............................................................................................... 72 1. Conversion of short-term gain into long-term gain .................................................... 72 2. Conversion of capital to ordinary and vice versa ........................................................ 73 D. Issues Related to Source ................................................................................................... 75 1. Category of income conversion .................................................................................. 75 i 2. Gaps in source rules .................................................................................................... 77 E. When Issues of Timing, Character, and Source Intersect ................................................. 80 1. Timing and character rules for section 1256 contracts and tax straddles ................... 80 2. Constructive ownership transactions under section 1260 ........................................... 84 3. Exchange traded notes ................................................................................................ 86 APPENDIX: DATA ON TRADING IN FINANCIAL INSTRUMENTS .................................. 91 ii INTRODUCTION AND SUMMARY Introduction This document1 has been prepared by the staff of the Joint Committee on Taxation, in response to the request of the Chairman and Vice Chairman of the Joint Committee on Taxation for a report of Federal tax rules relating to the taxation of financial instruments.2 Starting in 2008, there have been a series of financial shocks, an ensuing worldwide recession, and persistent instability in global financial markets. The volume of financial instruments traded in the United States and abroad increased dramatically in the two decades preceding these developments. Policymakers have sought to understand the role of financial instruments in the economy. At the same time, policymakers have been interested in the tax treatment of financial instruments, in part out of concern about inconsistent treatment of instruments with similar economic characteristics. Financial instruments include basic investments such as stocks and bonds (or, more broadly, equity and debt), assets that combine features of both equity and debt, and contracts referred to as derivatives. Derivatives are instruments the value of which derives from the value of other property, liabilities, or other measures. Common derivatives are options, forward and futures contracts, and swaps. The tax term for a swap is a notional principal contract. Options, forwards and futures, and swaps have the following definitions: An option is a contract between two parties that gives the holder of the option the right but not the obligation to buy from (in the case of a call option) or sell to (in the case of a put option) the issuer of the option a specified amount of property (such as 100 shares of Microsoft stock) at a fixed price and specified time. In a forward contract one party to the contract obligates itself to purchase from the other party a fixed quantity of property (such as 1,000 shares of General Electric stock) at a fixed price on a fixed future date. A futures contract is a standardized forward contract that is traded on an exchange such as the Chicago Mercantile Exchange. Futures contracts historically have been for the purchase and sale of commodities. 1 This document may be cited as follows: Joint Committee on Taxation, Present Law and Issues Related to the Taxation of Financial Instruments and Products (JCX-56-11), December 2, 2011. This document can be found on our website at www.jct.gov. 2 The request was made at the 112th Congress Organizational Meeting of the Joint Committee on Taxation on March 15, 2011. 1 A swap or notional principal contract is an agreement between two parties to exchange over a specified period of time payments that are calculated by reference to an identified instrument (such as stock or a basket of stocks), index (such as the S&P 500 stock index), other amounts (such as fixed or variable interest rates), or the outcome of a specified event (such as a corporation’s default on its indebtedness). Equity, debt, and derivatives are traded in public markets on exchanges and by private means, also referred to as over-the-counter (“OTC”) trading. In absolute and historical terms, the volume of financial instruments traded in the United States is large. As Table 1 illustrates, at the end of 2010, U.S. persons held or issued $9.4 trillion of Treasury securities, $11.5 trillion of corporate and foreign bonds, $13.8 trillion of mortgages, $23.2 trillion of corporate equities, and $7.9 trillion of mutual fund shares. Table 1.−Selected Financial Instruments Issued or Held by U.S. Persons As of December 31, 2010 (Billions of U.S. Dollars) 2010 Money market fund shares 2,755 Credit market instruments 52,494 Open market paper 1,058 Treasury securities 9,362 Agency- and GSE-backed securities 7,598 Municipal securities 2,928 Corporate and foreign bonds 11,473 Bank loans not elsewhere classified 1,874 Other loans and advances 1,951 Mortgages 13,817 Consumer credit 2,435 Corporate equities 23,247 Mutual fund shares 7,935 Security credit 1,215 Source: Federal Reserve Board, Flow of Funds. 2 Figure 1 shows the rapid growth since 1998 in the notional amount outstanding of swaps (not including credit derivatives) held by banks required to report to the U.S. Office of the Comptroller of the Currency, from $14.3 trillion at the end of 1998 to $149.2 trillion at the end of 2010. Futures, forward, and option contract volumes have grown less quickly. The notional amount