SECTION 1. TREATMENT OF PREPAID DERIVATIVE CONTRACTS.

    (a) In General.--Part V of subchapter P of chapter 1 of the 
Internal Revenue Code of 1986 (relating to special rules for bonds and 
other debt instruments) is amended by adding at the end the following 
new subpart:

               ``Subpart E--Prepaid Derivative Contracts

``Sec. 1289. Treatment of prepaid derivative contracts.
``Sec. 1289A. Definitions.

``SEC. 1289. TREATMENT OF PREPAID DERIVATIVE CONTRACTS.

    ``(a) Current Inclusion in Income.--For purposes of this title, 
there shall be included in the gross income of the holder of a prepaid 
derivative contract an amount equal to the holder's interest accrual 
amount with respect to such contract for the taxable year. Any amount 
included in gross income under the preceding sentence shall be treated 
as interest.
    ``(b) Basis Adjustments.--If any interest accrual amount is 
included in the gross income of the holder of a prepaid derivative 
contract under subsection (a), such holder's basis in such contract 
shall be increased by the amount so included.
    ``(c) Loss Treated as Ordinary to Extent of Basis Increases.--In 
the case of any loss recognized on the disposition of any prepaid 
derivative contract, so much of such loss as does not exceed the 
aggregate increases in the basis of such contract under subsection (b) 
shall be treated as an ordinary loss.
    ``(d) Treatment of Distributions.--In the case of any distribution 
under a prepaid derivative contract--
            ``(1) except as provided in paragraph (3), such 
        distribution shall not be includible in gross income,
            ``(2) the adjusted basis of such contract shall be reduced 
        (but not below zero) by the amount of such distribution, and
            ``(3) the excess (if any) of such distribution over such 
        adjusted basis (determined before any reduction under paragraph 
        (2)) shall be treated as gain from the sale of such contract.
For purposes of this subsection, adjusted basis shall be determined 
after any adjustment to such basis under subsection (b) for the taxable 
year.
    ``(e) Interest Accrual Amount.--
            ``(1) In general.--For purposes of this section, the 
        interest accrual amount with respect to any prepaid derivative 
        contract for any taxable year is the product of--
                    ``(A) the holder's adjusted basis in such contract 
                as of the beginning of such taxable year, multiplied by
                    ``(B) the greater of--
                            ``(i) the monthly Federal short-term rate 
                        determined under section 1274(d) for the first 
                        month ending during such taxable year, or
                            ``(ii) in the case of a contract under 
                        which notional amounts are credited, the rate 
                        at which such amounts are credited.
            ``(2) Proration of interest accrual amount.--In the case of 
        a taxpayer who acquires or disposes of any prepaid derivative 
        contract during the taxable year, the interest accrual amount 
        determined under paragraph (1) with respect to such contract 
        for such year shall be an amount which bears the same ratio 
        to--
                    ``(A) the amount which would be so determined 
                without regard to this subparagraph, as
                    ``(B) the portion of such taxable year during which 
                such contract was held by such taxpayer bears to the 
                entire taxable year.
            ``(3) Adjusted basis determined at acquisition.--In the 
        case of the acquisition of any prepaid derivative contract 
        during the taxable year, paragraph (1) shall be applied by 
        substituting `the acquisition of such contract' for `the 
        beginning of such taxable year'.
    ``(f) Special Rules for Publicly Traded Prepaid Derivative 
Contracts.--
            ``(1) Limitation on inclusion.--The amount includible under 
        subsection (a) with respect to the holder of any publicly 
        traded prepaid derivative contract for any taxable year shall 
        not exceed the excess (if any) of--
                    ``(A) the sum of--
                            ``(i) the fair market value of such 
                        contract as of the close of such taxable year 
                        (or, in the case of the disposition of such 
                        contract during the taxable year, as of such 
                        disposition), plus
                            ``(ii) any distributions to the holder 
                        under such contract during such taxable year, 
                        over
                    ``(B) the holder's adjusted basis in such contract 
                as of the close of the preceding taxable year (or, in 
                the case of the acquisition of the contract during the 
                taxable year, as of such acquisition).
            ``(2) Excess carried forward.--If the interest accrual 
        amount with respect to any publicly traded prepaid derivative 
        contract for any taxable year exceeds the limitation determined 
        under paragraph (1) with respect to the holder of such contract 
        for such year, the interest accrual amount of such holder with 
        respect to such contract for the succeeding taxable year shall 
        be increased by such excess.
            ``(3) Interest accrual amount in succeeding years 
        unaffected by limitation.--Solely for purposes of subsection 
        (e)(1), the adjusted basis in a publicly traded prepaid 
        derivative contract shall be determined without regard to 
        paragraph (1).
    ``(g) Exception for Short Holding Periods and Instruments Marked to 
Market.--This section shall not apply to any prepaid derivative 
contract for any taxable year if such contract--
            ``(1) has been held for less than 1 year and is disposed of 
        in the taxable year in which acquired or on or before the due 
        date for the return of income tax for such taxable year 
        (without regard to any extension of time for filing such 
        return), or
            ``(2) is marked to market with respect to the taxpayer for 
        such taxable year under section 475 or 1256 or any other 
        provision of this title.
    ``(h) Regulations.--The Secretary shall issue such regulations as 
are necessary or appropriate to carry out the purposes of this section, 
including regulations to prevent the avoidance of the purposes of this 
section.

``SEC. 1290. DEFINITIONS.

    ``For purposes of this subpart--
            ``(1) Prepaid derivative contract.--
                    ``(A) In general.--The term `prepaid derivative 
                contract' means any prepaid contract with a term of 
                longer than 1 year from the date of issue which is a 
                derivative financial instrument with respect to--
                            ``(i) any security (as defined in section 
                        475(c)(2), determined without regard to 
                        subparagraph (F) and the last sentence thereof) 
                        or group of securities (as so defined),
                            ``(ii) any commodity (as defined in section 
                        475(e)(2), determined without regard to 
                        subparagraph (D) thereof) or group of 
                        commodities (as so defined), or
                            ``(iii) any financial index.
                    ``(B) Exceptions.--Such term shall not include any 
                instrument which is treated (for purposes of this 
                title) as--
                            ``(i) stock or debt,
                            ``(ii) an interest in a partnership,
                            ``(iii) part of a constructive ownership 
                        transaction to which section 1260 applies,
                            ``(iv) a hedging transaction (as defined in 
                        section 1256(e)(2)),
                            ``(v) a notional principal contract, or
                            ``(vi) an option.
                    ``(C) Certain options economically similar to 
                ownership.--To the extent provided by the Secretary in 
                regulations or other guidance, any option which by 
                reason of such option's term and strike price is 
                economically similar to a prepaid contract described in 
                subparagraph (A) shall not be treated as an option for 
                purposes of subparagraph (B)(vi).
            ``(2) Prepaid contract.--The term `prepaid contract' means 
        any contract under which there is no substantial likelihood 
        that the taxpayer will be required to pay any additional amount 
        under the contract. For purposes of the preceding sentence, a 
        taxpayer shall not be treated as having a substantial 
        likelihood of being required to pay any additional amount if 
        those additional amounts have been set aside (or are expected 
        to be set aside) with respect to such payment or are subject to 
        a defeasance arrangement or other arrangement similar to an 
        arrangement described in section 470(d)(1)(B).
            ``(3) Publicly traded prepaid derivative contract.--The 
        term `publicly traded prepaid derivative contract' means any 
        prepaid derivative contract--
                    ``(A) which is traded on or subject to the rules of 
                a qualified board or exchange, or
                    ``(B) with respect to which the issuer (or any 
                person acting on behalf of the issuer) regularly makes 
                available to the public (including customers or 
                subscribers) bid or offer quotes and stands ready to 
                effect buy or sell transactions at the quoted prices 
                for itself or on behalf of others.''.
    (b) Conforming Amendments.--
            (1) The table of subparts for part V of subchapter P of 
        chapter 1 of such Code is amended by adding at the end the 
        following new item:

             ``subpart e--prepaid derivative contracts.''.

            (2) The heading of part V of subchapter P of chapter 1 of 
        such Code, and the item relating to such part in the table of 
        parts for subchapter P of chapter 1 of such Code, are each 
        amended by striking ``debt''.
    (c) Effective Date.--The amendments made by this section shall 
apply to contracts acquired after the date of the enactment of this 
Act.
Amends the Internal Revenue Code to set forth rules for the treatment of income, loss, and distributions relating to a prepaid derivative contract. Defines "prepaid derivative contract" as any prepaid contract with a term longer than one year from the date of issue which is a derivative financial instrument with respect to any security, commodity, or financial index.
To amend the Internal Revenue Code of 1986 with respect to the treatment of prepaid derivative contracts.