[Federal Register Volume 60, Number 2 (Wednesday, January 4, 1995)]
[Proposed Rules]
[Pages 397-406]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-13]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-42-94]
RIN 1545-AS85


Mark to Market for Dealers in Securities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
mark-to-market method of accounting for securities that is required to 
be used by a dealer in securities. The proposed regulations address the 
relationship between mark-to-market accounting and the accrual of 
stated interest and discount and the amortization of premium and 
between mark-to-market accounting and the tax treatment of bad debts. 
They also provide rules relating to certain dispositions and 
acquisitions of securities required to be marked to market, the 
exemption from mark-to-market treatment of securities in certain 
securitization transactions, and the identification requirements for 
obtaining exemption from mark-to-market treatment. Finally, these 
proposed regulations provide guidance relating to the exclusion of 
REMIC residual interests from the definition of security and to the 
relationship between the mark-to-market provisions and the integrated 
transaction rules in the proposed regulations on debt instruments with 
contingent payments. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written comments must be received by April 4, 1995. Outlines of 
oral comments to be presented at a public hearing scheduled for May 3, 
1995, at 10 a.m. must be received by April 4, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-42-94), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-42-94), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, 
Washington, DC.
    The public hearing will be held in the Internal Revenue Auditorium, 
7400 Corridor, Internal Revenue Building, 1111 Constitution Ave., NW, 
Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. 1.475(c)-2(a)(4), 
Carol A. Schwartz, (202) 622-3920; concerning other sections of the 
regulations, Robert B. Williams, (202) 622-3960, or JoLynn Ricks, (202) 
622-3920; concerning submissions and the hearing, Michael Slaughter, 
(202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act (44 U.S.C. 
3504(h)). Comments on the collection of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 
20224.
    The collection of information is in Sec. 1.475(b)-4. The 
information required to be recorded under Sec. 1.475(b)-4 is required 
by the IRS to determine whether exemption from mark-to-market treatment 
is properly claimed. This information will be used to make that 
determination upon audit of taxpayers' books and records. The likely 
recordkeepers are businesses or other for-profit institutions.
    Estimated total annual recordkeeping burden: 2,500 hours.
    The estimated annual burden per recordkeeper varies from 15 minutes 
to 3 hours, depending on individual circumstances, with an estimated 
average of 1 hour.
    Estimated number of recordkeepers: 2,500.

Background

    Section 475 of the Internal Revenue Code requires mark-to-market 
accounting for dealers in securities, broadly defined. Section 475 was 
added by section 13223 of the Revenue Reconciliation Act of 1993 (Pub. 
L. 103-66, 107 Stat. 481), and is effective for all taxable years 
ending on or after December 31, 1993.
    On December 29, 1993, temporary regulations (T.D. 8505, 58 FR 
68747) and cross-reference proposed regulations (FI-72-93, 58 FR 68798) 
were published to furnish guidance on several issues, including the 
scope of exemptions from the mark-to-market requirements, certain 
transitional issues relating to the scope of exemptions, and the 
meaning of the statutory terms ``dealer in securities'' and ``held for 
investment.'' This notice contains proposed regulations that 
supplement, and in a few cases revise, the proposed regulations that 
were published last December.

Explanation of Provisions

Stated Interest, Discount, and Premium

    The proposed regulations contained in this notice provide rules for 
taking into account interest (including original issue discount (OID) 
and market discount), premium, and certain gains [[Page 398]] and 
losses on securities that are debt instruments. In general, immediately 
before a debt instrument is marked to market, Code provisions related 
to calculating interest must be applied, and basis must be 
correspondingly adjusted. The mark-to-market computations do not affect 
either the amount treated as interest earned from a debt instrument or 
the taxable years in which that interest is taken into account.
    For example, immediately before a debt instrument is marked to 
market, accruals of unpaid qualified stated interest (QSI) must be 
taken into account, and basis must be correspondingly increased. This 
is true regardless of the taxpayer's regular method of accounting. 
Marking a debt instrument to market under section 475(a) precludes the 
deferral that a cash-basis taxpayer might have experienced in the 
absence of the statutory provision, and the current accrual under the 
proposed regulations is needed in order to preserve the interest 
character of the QSI.
    For debt instruments acquired with original issue discount or 
market discount, the proposed regulations require that, immediately 
before the mark-to-market gain or loss is computed under section 
475(a), any OID or market discount accrued through the date of 
computation must be taken into account, and basis must be 
correspondingly increased. The amount of discount attributable to a 
particular period of time is computed under sections 1272 through 1275 
(in the case of OID) and sections 1276 through 1278 (in the case of 
market discount). Thus, for example, the computation of OID 
attributable to a particular period takes into account any reduction 
for acquisition premium under section 1272(a)(7).
    As indicated in the preceding paragraph, the proposed regulations 
provide that, in the case of a market discount bond to which section 
475(a) applies, the holder must take market discount into account as it 
accrues, regardless of whether the holder elected under section 1278(b) 
to do so for all of its bonds. This rule is necessary to prevent market 
discount from producing gain on the mark instead of interest income. 
This provision, however, does not impose a section 1278(b) election on 
the taxpayer, because it does not apply to bonds that are not marked to 
market under section 475.
    For taxable debt instruments acquired with amortizable bond 
premium, the proposed regulations provide that, if a dealer has made an 
election to amortize premium under section 171, any amortization for 
the taxable year (or for the portion of the taxable year during which 
the instrument is held by the dealer) must be taken into account (and 
basis must be appropriately reduced) before the mark-to-market gain or 
loss is computed under section 475. Because section 171 applies only to 
instruments not held primarily for sale to customers in the ordinary 
course of the taxpayer's trade or business, this proposed regulatory 
provision is applicable only to premium instruments described in 
section 475(b)(1) for which the taxpayer has not made the 
identification described in section 475(b)(2).
    In the case of tax-exempt bonds, the proposed regulations require 
basis to be reduced as required by section 1016(a)(5) or (6) before 
mark-to-market gain or loss is computed.
    If a dealer acquires a bond with premium and a section 171 election 
first applies to the bond in a taxable year after the year of 
acquisition, the proposed regulations require the dealer to amortize 
premium based on the original basis, without regard to any mark-to-
market adjustments that may have been taken into account before the 
section 171 election became effective, but with regard to the 
adjustments required under section 171(b)(1). Thus, for example, if a 
dealer acquires in year 1 an instrument that is subject to section 
475(a) and that has $10 of amortizable premium and if the dealer makes 
an election to amortize premium that is first effective in year 4 (when 
unamortized premium attributable to years 1 through 3 is $4), the 
dealer takes into account the appropriate portion of the remaining $6 
of amortizable bond premium (as required under section 171(b)(3)) each 
taxable year before computing the mark-to-market adjustment on the 
instrument. Any mark-to-market basis adjustments in taxable years 1 
through 3 are ignored in determining the amount of amortizable bond 
premium to which the election applies.
    Under section 475(a)(2), a dealer in securities recognizes mark-to-
market gain or loss on a security, other than inventory, as if the 
security were sold on the last business day of the taxable year. 
Although there may be circumstances under which marking a security to 
market produces results similar to the actual sale of the security, the 
statutory reference to the deemed sale prescribes the amount of gain or 
loss to be taken into account and does not trigger all of the 
consequences of a sale and reacquisition under the Code. For example, 
when a dealer in securities marks a bond (or other security) to market 
and takes recognized gain or loss into account, the dealer has not 
actually sold and reacquired the bond. Thus, under the proposed 
regulations, marking a debt instrument does not create, increase, or 
reduce market discount, acquisition premium, or bond premium.
    The proposed regulations also contain a special rule to provide the 
proper character for mark-to-market gains or losses on a market 
discount instrument that was originally identified as held for 
investment by the dealer. This rule is necessary to ensure that all 
market discount is ultimately characterized as interest income and not 
as gain from the sale of a security.

Worthless Debts

    The proposed regulations provide rules for marking a partially or 
wholly worthless debt to market. These rules coordinate the mark-to-
market rules with the bad debt rules under the Code. The amount of gain 
or loss recognized under section 475(a)(2) when a debt instrument is 
marked to market generally is the difference between the adjusted basis 
and the fair market value of the debt. Under the proposed regulations, 
if a debt becomes partially or wholly worthless during a taxable year, 
the amount of any gain or loss required to be taken into account under 
section 475(a) is determined using a basis that reflects the 
worthlessness. The basis of the mark-to-market debt is treated as 
having been reduced by the amount of any book or regulatory charge-off 
(including the establishment of a specific allowance for a loan loss) 
for which a deduction could have been taken, without regard to whether 
any portion of the charge-off is, in fact, deducted or charged to a tax 
reserve for bad debts. The difference between this adjusted basis and 
the fair market value of the debt is the amount of gain or loss to be 
taken into account under section 475(a)(2). Thus, if the debt is wholly 
worthless, its basis would be reduced to zero and no gain or loss would 
be taken into account under section 475(a)(2).
    This proposed treatment preserves the longstanding distinctions 
between losses due to the worthlessness of debts and other losses on 
debt instruments held by a taxpayer. See Sec. 1.166-1(a), which 
requires bad debts to be taken into account either as a specific 
deduction in respect of debts or as a deduction for a reasonable 
addition to a reserve for bad debts. See also Secs. 1.585-3 and 1.593-
7(c), which require a reserve-method taxpayer to charge bad debts to 
the reserve for bad debts. In addition, computing the mark-to-market 
adjustment as if the debt's basis had been adjusted to reflect 
worthlessness [[Page 399]] preserves a taxpayer's ability to postpone 
claiming a deduction for partial worthlessness until the debt becomes 
wholly worthless. To the extent that a debt has been previously charged 
off, mark-to-market gain is treated as a recovery.
    The rules that are provided for bad debts in the proposed 
regulations do not apply to debts accounted for by a dealer as 
inventory under section 475(a)(1). Although it is possible for a debt 
that is in inventory to become partially worthless prior to sale, the 
likelihood or frequency of such an occurrence is difficult to ascertain 
given the speed with which inventory is sold. Comments are requested, 
however, concerning whether similar rules are necessary for partially 
worthless debt that is accounted for as inventory of the dealer.

Dispositions

    Section 475(a) states that regulations may provide for securities 
held by a dealer to be marked to market at times other than the end of 
the dealer's taxable year. In general, the proposed regulations provide 
that, if a dealer in securities ceases to be the owner of a security 
for tax purposes, and if the security would have been marked to market 
under section 475(a) if the dealer's taxable year had ended immediately 
before the dealer ceases to own it, then (whether or not the security 
is inventory in the hands of the dealer) the dealer must recognize gain 
or loss as if the security had been sold for its fair market value 
immediately before the dealer ceases to own it. Any gain or loss so 
recognized is taken into account at that time.
    In the absence of a mark upon disposition, a gain on a security 
held by a dealer could be deferred by transferring the security before 
the end of the taxable year to a related non-dealer in an intercompany 
transaction or in a non-recognition, carry-over-basis transaction. This 
potential for abuse is avoided if marking to market is required in 
every case in which a dealer ceases to be the owner of a security for 
tax purposes. The proposed requirement is analogous to the requirement 
that applies to dispositions of securities that are required to be 
marked to market under section 1256.
    Transfers to which the proposed rule applies include the following: 
(a) Transfers to a controlled corporation under section 351; (b) 
Transfers to a trust (other than a grantor trust); (c) Transfers by 
gift to a charitable or non-charitable donee; (d) Transfers to other 
members of the same controlled group; (e) Transfers to a partnership 
under section 721; and (f) Transfers of mortgages to a REMIC under 
section 860F(b).
    In the case of a transfer by a dealer to a partnership, the basis 
of a security transferred is generally its fair market value, because 
the security is marked to market immediately before the transfer. Thus, 
no special allocation issues arise. If there is any difference between 
a transferred security's basis after the mark and its fair market value 
(because, for example, the security transferred had been properly 
identified as held for investment but ceased to be so held at some time 
prior to the date of transfer), any special allocation of built-in gain 
or loss with respect to that security in the hands of the partnership 
will be made under section 704 and the regulations thereunder.
    The mark to market immediately before disposition is separate and 
distinct from the disposition transaction. Thus, for example, the gain 
or loss from the mark is not gain or loss from a deferred intercompany 
transaction under Sec. 1.1502-13.

Securities Acquired With Substituted Basis

    The proposed regulations provide rules for situations where a 
dealer in securities receives a security with a basis in its hands that 
is determined, in whole or in part, either by reference to the basis of 
the security in the hands of the transferor or by reference to other 
property held at any time by the dealer. In these cases, section 475(a) 
applies only to post-acquisition gain and loss with respect to the 
security. That is, section 475(a) applies only to changes in value of 
the security occurring after its acquisition. See section 475(b)(3). 
The character of the mark-to-market gain or loss is determined as 
provided under section 475(d)(3). The character of pre-acquisition gain 
or loss (that is, the built-in gain or loss at the date the dealer 
acquires the security) and the time for taking that gain or loss into 
account are determined without regard to section 475. The fact that a 
security has a substituted basis in the dealer's hands does not affect 
the security's date of acquisition for purposes of determining the 
timeliness of an identification under section 475(b).
    The proposed regulations provide rules for the identification of 
securities contributed and received in securitization transactions. 
Under the proposed regulations, a taxpayer that expects to contribute 
securities to a trust or other entity in exchange for interests therein 
may identify the contributed securities as held for investment (within 
the meaning of section 475(b)(1)(A)) or not held for sale (within the 
meaning of section 475(b)(1)(B)) only if it expects each of the 
interests received (whether or not a security within the meaning of 
section 475(c)(2)) to be either held for investment or not held for 
sale to customers in the ordinary course of the taxpayer's business. 
Thus, for example, if a mortgage banker securitizes its loans and does 
not intend to hold for investment (or for other than sale to customers) 
all of the interests received in the securitization transaction, the 
mortgage banker will be required to account for its inventory of 
mortgages at fair market value under section 475(a)(1), regardless of 
whether the mortgages are to be sold to a trust or contributed to a 
REMIC.
    Under the proposed regulations, if a dealer engages in a 
securitization transaction that results in dispositions of only partial 
interests in the contributed securities, the dealer is not permitted to 
identify the contributed securities as exempt under section 
475(b)(1)(A) or (B). As a result, all of the contributed securities 
must be accounted for under section 475(a). Moreover, under the mark-
on-disposition rule of these proposed regulations, the dealer is 
required to mark the securities to market immediately before the 
securitization transaction. The Service invites comments on whether 
there are other administrable approaches that reflect the fact that 
only a partial disposition of the securities has occurred.
    In other securitization transactions, a taxpayer transfers 
securities to a trust (or other entity) in a transaction that is not a 
disposition of the securities for tax purposes. The trust issues 
certificates (or other forms of interest) that represent secured debt 
of the taxpayer rather than debt of the trust or ownership of the 
underlying securities. In these cases, if the taxpayer retains the full 
ownership of the contributed securities for tax purposes and if the 
contributed securities otherwise qualify to be identified as held for 
investment or not held for sale, then the taxpayer may identify the 
securities as held for investment or not held for sale notwithstanding 
the transfer.
    Further, if a transfer of securities is a disposition, a taxpayer 
may identify the interests received in a securitization transaction as 
exempt from mark-to-market if the interests are described in section 
475(b)(1) and are not treated for tax purposes as continuing ownership 
of the securities transferred. This identification is permitted even if 
the securitized assets were marked to market under section 475. For 
example, a taxpayer may identify some of the [[Page 400]] REMIC regular 
interests received on the transfer of mortgage securities to a REMIC, 
even if the mortgages were subject to section 475(a). Conversely, a 
taxpayer that has marked mortgages to market but subsequently 
contributes those mortgages to a grantor trust and receives beneficial 
interests therein may not identify the beneficial interests as exempt 
from mark-to-market treatment, because the beneficial interests 
represent continued ownership of the contributed securities, whose 
eligibility for exemption was determined when they were acquired.
    The proposed regulations clarify that an identification of a 
security as exempt must specify the subparagraph of section 475(b)(1) 
under which the exemption is claimed and that the time by which a 
dealer must identify a security as exempt is not affected by whether 
the dealer has a substituted basis in the security. The proposed 
regulations also provide rules for determining whether an 
identification of a security as exempt is timely where a dealer engages 
in certain integrated transactions described in Sec. 1.1275-6 as 
proposed on December 16, 1994 (FI-59-91, 59 FR 64884, 64905).

Definition of Dealer in Securities

    Section 475(c)(1) defines a dealer in securities as a taxpayer who 
regularly purchases securities from, or sells securities to, customers 
in the ordinary course of a trade or business or who regularly offers 
to enter into, assume, offset, assign or otherwise terminate positions 
in securities with customers in the ordinary course of a trade or 
business.
    The proposed regulations provide that whether a taxpayer is 
transacting business with customers is determined based on all of the 
facts and circumstances.
    Under section 475(c)(1)(B) and the proposed regulations, the term 
dealer in securities includes a taxpayer that, in the ordinary course 
of its trade or business, regularly holds itself out as being willing 
and able to enter into either side of a transaction enumerated in 
section 475(c)(1)(B). For instance, if a taxpayer regularly holds 
itself out as being willing to enter a swap in which it is either the 
fixed or the floating payor, the taxpayer is a swaps dealer.
    The proposed regulations clarify that a life insurance company does 
not become a dealer in securities solely by selling annuity, endowment, 
or life insurance policies to its customers. Under the temporary 
regulations published on December 29, 1993 (T.D. 8505), a contract that 
is treated for federal income tax purposes as an annuity, endowment, or 
life insurance contract is deemed to have been identified as held for 
investment, and is therefore not marked to market by the policy holder. 
This was necessary because variable life and annuity products fall 
within the literal language of section 475(c)(2)(E). Because many life 
insurance companies sell these insurance contracts to their customers, 
some commentators asked whether these life insurance companies were 
dealers in securities. There is no indication that Congress intended 
for a life insurance company that was not otherwise a dealer in 
securities to be characterized as a dealer merely because it sells life 
insurance policies to its customers. These proposed regulations provide 
the appropriate clarification.

Definition of Security

    The temporary regulations that were published on December 29, 1993 
(T.D. 8505), exclude certain items from the definition of security. 
Among the excluded items are liabilities of the taxpayer and negative 
value residual interests (NVRIs) in a REMIC and other arrangements that 
are determined to have substantially the same economic effect as NVRIs 
(for example, a widely held partnership that holds noneconomic REMIC 
residual interests). Those rules are needed to carry out the purposes 
of section 475 and other Code provisions, including section 860E.
    These proposed regulations clarify that a liability of the taxpayer 
means a debt issued by the taxpayer. Also, for the reasons given below, 
these proposed regulations exclude all REMIC residual interests from 
the definition of security.
    A typical REMIC holds a pool of long-term, real estate mortgages 
originated at a ``blended'' interest rate. These mortgages are used to 
support the issuance of regular interests, which are treated as debt, 
with varied maturities and interest rates. The REMIC takes cash flows 
on the mortgages and redirects them to holders of the regular 
interests. As a result, there is generally a mismatch in the 
recognition of interest income from the mortgages and the interest 
expense attributable to the regular interests. This mismatch of 
interest income and interest deductions results in taxable income or 
loss that does not represent economic gain or loss. Some commentators 
refer to this as ``phantom'' income or loss.
    Phantom income or loss is allocated to the holders of the residual 
interests in a REMIC even though that income or loss does not represent 
any economic benefit or detriment to those holders. Further, sections 
860C and 860E require a residual interest holder to pay taxes on a 
portion of phantom income (called ``excess inclusion'') and to increase 
the basis of the residual interest by the amount of phantom income. 
Because this basis increase does not represent economic value, a 
subsequent mark to market is likely to result in a loss. Permitting 
taxpayers to take this loss into account currently under the mark-to-
market provisions effectively undermines the Congressional mandate 
embodied in section 860E to require current taxation of phantom income.
    Although the adverse effect of section 475 on section 860E is most 
apparent when the residual interests being considered are NVRIs, 
residual interests with positive value present the same issue. Many 
residual interests with positive value, in spite of being entitled to 
REMIC distributions, have substantially the same economic effect as 
NVRIs and thus are already excluded by the temporary regulations from 
the definition of ``security.'' The IRS is concerned, however, that 
residual interests may be structured in a way that avoids embodying 
substantially the same economic effects as an NVRI but that still 
undermines the purposes of section 860E. The proposed regulations, 
therefore, contain a rule that would remove from the category of 
securities subject to section 475 all residual interests that are 
acquired after January 4, 1995. Also removed are arrangements that are 
acquired after that date and are determined to have substantially the 
same economic effect as a REMIC residual interest (for instance, an 
interest in a widely held partnership holding residual interests). The 
temporary regulations continue to apply to all residual interests 
described therein for all taxable years ending on or after December 31, 
1993.
    In addition, the Commissioner has determined that, if a residual 
interest, or an interest or arrangement that has substantially the same 
economic effect, is not a security within the meaning of section 475, 
it should not be treated as inventory under other provisions. 
Additional guidance on this matter will be issued.
    Comments are requested concerning whether there are any residual 
interests that do not undermine section 860E upon being marked to 
market. If comments are received that describe any such interests, 
subsequent guidance may provide that they are included in the mark-to-
market regime. In this regard, it is important that any mechanism for 
identifying these interests not impose an undue burden on either 
taxpayers or the IRS. [[Page 401]] 

Additional Comments Requested

    The provisions of section 475 generally apply in determining the 
taxable income of a dealer that may also be subject to various 
international provisions of the Code. The Service is considering the 
possibility of using the definitions contained in section 475 and the 
regulations thereunder for purposes of various international 
provisions, except where a modification of the provisions is necessary 
to carry out the purposes of those international provisions. Comments 
on this issue also are welcome.
    Finally, the Service is considering whether there are additional 
situations in which securities should not be accounted for under 
section 475(a). (The temporary and proposed regulations that were 
published on December 29, 1993, listed some such situations.) For 
example, a dealer in securities may acquire at original issue and in 
exchange for property certain non-interest-bearing debt instruments 
that are not subject to the interest imputation provisions of section 
1274 or 483. Because these instruments will seldom appreciate in value, 
it may be inappropriate to subject them to the mark-to-market regime.

Dates of Applicability

    The proposed regulations will apply to identifications made, 
securities acquired, or events occurring, on or after January 4, 1995, 
or to taxable years beginning on or after January 1, 1995, as 
appropriate.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Code, this notice of proposed rulemaking will be submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Wednesday, May 3, 1995 at 
10 a.m. The public hearing will be held in the Internal Revenue 
Auditorium, 7400 corridor, Internal Revenue Building, 1111 Constitution 
Avenue NW, Washington, DC 20224. Because of access restrictions, 
visitors will not be admitted beyond the Internal Revenue Building 
lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by April 4, 1995 and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by April 4, 1995.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Robert B. Williams 
and JoLynn Ricks, Office of Assistant Chief Counsel (Financial 
Institutions & Products). However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.475(a)-1 also issued under 26 U.S.C. 475(e).
    Section 1.475(a)-2 also issued under 26 U.S.C. 475(a) and 26 
U.S.C. 475(e).
    Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).
* * * * *
    Section 1.475(b)-3 also issued under 26 U.S.C. 475(e).
    Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2) and 26 
U.S.C. 475(e).
    Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).
* * * * *
    Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 
U.S.C. 860G(e).
* * * * *
    Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).
* * * * *
    Par. 2. Section 1.475-0 is added to read as follows:


Sec. 1.475-0  Table of contents.

    This section lists headings contained in Secs. 1.475-0, 1.475(a)-1, 
1.475(a)-2, 1.475(a)-3, 1.475(b)-1, 1.475(b)-2, 1.475(b)-3, 1.475(b)-4, 
1.475(c)-1, 1.475(c)-2, 1.475(d)-1, and 1.475(e)-1.


Sec. 1.475-0  Table of contents.

Sec. 1.475(a)-1  Mark to market of debt instruments.

(a) Overview.
(b) No effect on amount of market discount, acquisition premium, or 
bond premium.
(c) Accrual of interest, discount, and premium.
    (1) Qualified stated interest.
    (2) General rule regarding accrual of discount.
    (3) Bond premium.
(d) Mandatory current inclusion of market discount.
    (1) General rule.
    (2) Interaction with section 1278(b).
(e) Recognition of market discount that accrued before section 
475(a) applies to a market discount bond.
    (1) General rule.
    (2) Examples.
(f) Worthless debts
    (1) Computation of mark-to-market gain or loss.
    (2) Treatment of mark-to-market gain or loss.
(g) Additional rules applicable to reserve-method taxpayers.
(h) Example.

Sec. 1.475(a)-2  Mark to market upon disposition of security by a 
dealer.

(a) General rule.
(b) Example.

Sec. 1.475(a)-3  Acquisition by a dealer of a security with a 
substituted basis.

(a) Scope.
(b) Rules.

Sec. 1.475(b)-1  Scope of exemptions from mark-to-market 
requirement.

(a) Securities held for investment or not held for sale.
(b) Securities deemed identified as held for investment.
    (1) In general.
    (2) Control defined.
(c) Securities deemed not held for investment.
    (1) General rule for dealers in notional principal contracts and 
derivatives.
    (2) Exception for securities not acquired in dealer capacity.

Sec. 1.475(b)-2  Exemptions--Transitional issues.

(a) Transitional identification. [[Page 402]] 
    (1) Certain securities previously identified under section 1236.
    (2) Consistency requirement for other securities.
(b) Corrections on or before January 31, 1994.
    (1) Purpose.
    (2) To conform to Sec. 1.475(b)-1(a)
    (i) Added identifications.
    (ii) Limitations.
    (3) To conform to Sec. 1.475(b)-1(c).
(c) Effect of corrections.

Sec. 1.475(b)-3  Exemption of securities in certain securitization 
transactions.

(a) Exemption of contributed assets.
(b) Exemption of resulting interests.
    (1) General rule.
    (2) Examples.

Sec. 1.475(b)-4  Exemptions--Identification requirements.

(a) Identification of the basis for exemption.
(b) Time for identifying a security with a substituted basis.
(c) Securities involved in integrated transactions under 
Sec. 1.1275-6.
    (1) Definitions.
    (2) Synthetic debt held by a taxpayer as a result of legging in.
    (3) Securities held after legging out.

Sec. 1.475(c)-1  Definitions--Dealer in securities.

(a) Sellers of nonfinancial goods and services.
(b) Taxpayers that purchase securities but do not sell more than a 
negligible portion of the securities.
    (1) Exemption from dealer status.
    (2) Negligible portion.
    (3) Special rules.
(c) Dealer-customer relationship.
    (1) [Reserved].
    (2) Transactions described in section 475(c)(1)(B).
(d) Issuance of life insurance products.

Sec. 1.475(c)-2  Definitions--Security.

(a) In general.
(b) Negative value REMIC residuals.
(c) Special rules.
(d) Synthetic debt held by a taxpayer as a result of an integrated 
transaction under Sec. 1.1275-6.

Sec. 1.475(d)-1  Character of gain or loss.

Sec. 1.475(e)-1  Effective dates.

(a) Taxable years ending on or after December 31, 1993.
(b) Taxable years beginning on or after January 1, 1995.
(c) Securities acquired on or after January 4, 1995.
(d) Events occurring on or after January 4, 1995

    .Par. 3. Section 1.475(a)-1 is added to read as follows:


Sec. 1.475(a)-1  Mark to market of debt instruments.

    (a) Overview. This section provides rules for taking into account 
interest accruals and gain and loss on a debt instrument to which 
section 475(a) applies. Paragraph (b) of this section clarifies that 
the mark-to-market computation affects neither the amount treated as 
interest earned from a debt instrument nor the taxable year in which 
that interest is taken into account. Paragraph (c) of this section 
prescribes general rules. Paragraph (d) of this section prescribes 
additional rules for instruments acquired with market discount. 
Paragraph (e) of this section provides rules for taking into account 
market discount that accrued on a bond before the bond became subject 
to the mark-to-market requirements. Paragraph (f) of this section 
prescribes rules for computing the mark-to-market gain or loss on 
partially or wholly worthless debts, and paragraph (g) provides rules 
for dealers accounting for bad debts using a reserve method of 
accounting.
    (b) No effect on amount of market discount, acquisition premium, or 
bond premium. Marking a debt instrument to market does not create, 
increase, or reduce market discount, acquisition premium, or bond 
premium, nor does it affect the adjusted issue price of, or accruals of 
original issue discount (OID) on, a bond issued with OID.
    (c) Accrual of interest, discount, and premium. In general, the 
amount of gain or loss from marking a debt instrument to market is 
computed after adjustments to basis for accruals of stated interest, 
discount, and premium.
    (1) Qualified stated interest. Immediately before a debt instrument 
is marked to market under section 475(a), the holder of the instrument 
must take any unpaid accrued qualified stated interest into account and 
must correspondingly increase the basis of the instrument. The holder 
must later decrease the basis of the instrument when accrued qualified 
stated interest is actually received. (See Sec. 1.1273-1(c) for the 
definition of qualified stated interest and Sec. 1.446-2(b) for the 
rule governing its accrual.)
    (2) General rule regarding accrual of discount. If a bond that was 
acquired with OID or market discount is marked to market under section 
475(a), then, immediately before the bond is marked to market, the 
discount accrued through that date (determined under section 1272, 
1275(d), or 1276, as applicable) is included in gross income, to the 
extent not previously included, and the bond's basis is correspondingly 
increased for amounts so included. (Because accrued OID is determined 
under all of the rules of section 1272 and the regulations thereunder, 
it is computed taking into account the reduction for acquisition 
premium that is required by section 1272(a)(7).) See paragraph (d) of 
this section, which requires the current inclusion in income of market 
discount on bonds marked to market. See paragraph (e) of this section 
for exceptions, and additional rules, for market discount bonds that 
become subject to section 475(a) after acquisition.
    (3) Bond premium. If a debt instrument that is subject to the basis 
adjustment required by section 1016(a) (5) or (6) is marked to market 
under section 475(a), then, immediately before the debt instrument is 
marked to market, the required basis adjustment must be made. 
Accordingly, the mark-to-market adjustment is computed after the basis 
of the debt instrument has been adjusted under section 1016(a) (5) or 
(6) for disallowed amortizable bond premium (in the case of tax-exempt 
bonds) or deductible bond premium (in the case of taxable bonds). If an 
election under section 171(c) is made after the first taxable year in 
which section 475(a) applies to the bond, the amount of bond premium is 
determined under section 171(b)(1) without regard to any basis 
adjustments that may have been required as a result of the bond being 
marked to market in prior taxable years. See paragraph (b) of this 
section for the rule that marking a debt instrument to market does not 
affect bond premium.
    (d) Mandatory current inclusion of market discount--(1) General 
rule. If section 475(a) applies to a bond during any portion of a 
taxable year, gross income for that taxable year includes the market 
discount attributable to the portion of the year to which section 
475(a) applies (as determined under section 1276(b)). Section 1276 does 
not apply to the bond except with respect to market discount, if any, 
that accrued before the bond became subject to section 475(a). 
Similarly, section 1277 does not apply to the bond except with respect 
to any net direct interest expense (as defined in section 1277(c)) that 
accrued before the bond became subject to section 475(a). See paragraph 
(e) of this section for additional rules governing this situation. For 
purposes of the Code other than the purposes described in the last 
sentence of section 1278(b)(1), any amount included in gross income 
under this paragraph (d)(1) is treated as interest. The bond's basis is 
correspondingly increased for any amount so included in gross income.
    (2) Interaction with section 1278(b). Paragraph (d)(1) of this 
section applies to a dealer, even if the dealer has not elected under 
section 1278(b) to include market discount currently. If the dealer has 
not made that election, however, this paragraph (d) does not require 
current inclusion of market discount on any bond to which section 
475(a) does not apply.
[[Page 403]]

    (e) Recognition of market discount that accrued before section 
475(a) applies to a market discount bond--(1) General rule. In the case 
of a debt instrument that is acquired with market discount, that is not 
subject to an election under section 1278(b), and that first becomes 
subject to section 475(a) in the taxpayer's hands on a date after its 
acquisition, this paragraph (e) governs the recognition of market 
discount that is attributable (as determined under section 1276(b)) to 
any period before section 475(a) applies to the debt instrument. To the 
extent that the market discount described in the preceding sentence is 
greater than the excess, if any, of the fair market value of the debt 
instrument at the time it became subject to section 475(a) over its 
adjusted basis at that time, section 1276(a)(1) applies to any gain 
recognized under section 475(a). To the extent of any remaining market 
discount that had accrued before section 475(a) became applicable, 
section 1276(a) applies no later than it would have applied if section 
475(a) did not apply to the bond. For example, section 1276(a) applies 
to the previously accrued market discount as partial principal payments 
are made. Except as provided in the preceding sentences, gain 
recognized under section 475(a) is not recharacterized as interest by 
section 1276(a).
    (2) Examples. The rules of paragraphs (d) and (e) of this section 
are illustrated by the following examples:

    Example 1.
    (i) Facts. Bond X was issued on January 1, 1996, for $1,000. 
Bond X matures on December 31, 2005, provides for a principal 
payment of $1,000 on the maturity date, and provides for interest 
payments at a rate of 8%, compounded annually, on December 31 of 
each year. D is a dealer in securities within the meaning of section 
475(c)(1). On January 1, 1997, D purchased bond X for $955. D had 
not elected under section 1278(b) to include market discount in 
gross income currently. Under section 475(b), section 475(a) did not 
apply to bond X until January 1, 1999, at which time bond X had a 
fair market value of $961. On December 31, 1999, bond X had a fair 
market value of $980.
    (ii) Holdings. In the absence of an election under section 
1276(b)(2), market discount on bond X accrues under section 
1276(b)(1) at the rate of $5 per year. On January 1, 1999, when bond 
X became subject to section 475(a), $10 of market discount had 
accrued, but the excess of the bond's fair market value on January 
1, 1999, over its adjusted basis on that date (the built-in gain) 
was only $6 ($961--$955). During 1999, D is required to include as 
interest income the $5 of market discount that accrues during that 
year, and D increases by that amount its basis in the bond and the 
amount to be used in computing mark-to-market gain or loss. On 
December 31, 1999, B must mark bond X to market and recognize a gain 
of $14 ($980--[$961 + $5]). Under section 1276(a)(1) and (4) and 
paragraph (e)(1) of this section, $4 of that $14 gain is treated as 
interest income. The $4 is the amount by which the market discount 
of $10 that had accrued on January 1, 1999, exceeded the $6 built-in 
gain on that date.
    Example 2.
    (i) Facts. The facts are the same as in Example 1, except that, 
in addition, D sells bond X for its fair market value of $1,000 on 
June 30, 2000.
    (ii) Holdings. Immediately before the sale, D is required to 
include as interest income the $2.50 of market discount that accrued 
during the portion of the year through June 30, and D increases by 
that amount its basis in the bond and the amount to be used in 
computing mark-to-market gain or loss. Also, under Sec. 1.475(a)-2, 
immediately before the sale, D recognizes $17.50 of mark-to-market 
gain (the increase in value since the preceding mark to market, less 
the basis increase of $2.50 from the market discount accrual. See 
Sec. 1.475(a)-2). On the sale, D also recognizes the $6 of built-in 
gain, all of which is recharacterized as ordinary interest income 
under section 1276(a)(4).
    Example 3.
    (i) Facts. The facts are the same as in Example 1, except that, 
during 2001, the issuer of bond X made a partial principal payment 
in the amount of $20.
    (ii) Holdings. Under paragraph (e)(1) of this section and 
section 1276(a)(4), $6 of the partial principal payment is included 
in D's 2001 income as interest income. The $6 is the portion of the 
$10 of market discount that had accrued at the time bond X became 
subject to section 475(a) and that had not previously caused gain or 
a partial principal payment to be treated as interest income.

    (f) Worthless debts--(1) Computation of mark-to-market gain or 
loss. This paragraph (f) applies to any dealer that, under section 
475(a)(2), marks to market either a debt that was charged off during 
the year because it became partially worthless or a debt that became 
wholly worthless during the taxable year (without regard to whether the 
debt was charged off). Any gain or loss attributable to marking a debt 
to market is determined by deeming the debt's adjusted basis to be the 
debt's adjusted basis under Sec. 1.1011-1, less the amount charged off 
during the taxable year or during any prior taxable year, to the extent 
that amount has not previously reduced tax basis. A debt that becomes 
wholly worthless is deemed to have an adjusted basis of zero. The 
deemed adjusted basis, however, is used solely for this paragraph (f). 
Thus, any portion of a loss attributable to a bad debt continues to be 
accounted for under the bad debt provisions of the Code, and the basis 
of the debt continues to be adjusted as otherwise required under the 
Code.
    (2) Treatment of mark-to-market gain or loss. To the extent that a 
debt has been previously charged off, mark-to-market gain is treated as 
a recovery. Thus, for example, a dealer using the section 585 reserve 
method of accounting for bad debts must credit to the reserve any 
portion of mark-to-market gain that is treated as a recovery of a bad 
debt previously charged to the reserve account, and the dealer must 
include any excess in gross income as required by Sec. 1.585-3(a). 
Similarly, if a dealer is a large bank that changed to the specific 
charge-off method of accounting for bad debts using the elective cut-
off procedures described in Sec. 1.585-7, the dealer must charge to the 
reserve for pre-disqualification loans all losses recognized as a 
result of marking to market a debt that is a pre-disqualification loan 
within the meaning of Sec. 1.585-7(b)(2). Marking a pre-
disqualification loan to market, however, is not a disposition of that 
loan under Sec. 1.585-7(d).
    (g) Additional rules applicable to reserve-method taxpayers. If a 
dealer accounts for bad debts using the reserve method of accounting 
under section 585 or 593, the following additional rules apply in 
computing a reasonable addition to a reserve--
    (1) To determine the amount of total loans outstanding, the 
outstanding balance on a debt that is marked to market is increased or 
decreased by the amount of any mark-to-market gain or loss recognized, 
except that the outstanding balance of the debt may never exceed the 
actual balance currently due; and
    (2) If the reasonable addition to the reserve is computed based on 
a percentage of taxable income, any gain or loss attributable to 
marking a debt to market must be taken into account in computing 
taxable income.
    (h) Example. This example illustrates paragraphs (f) and (g) of 
this section.

    Example.
    (i) B, a calendar year taxpayer, is a dealer that marks some of 
its debts to market under section 475(a)(2). Additionally, B is a 
bank that accounts for bad debts using the section 585 reserve 
method of accounting. B has not made an election to use the 
conformity method of accounting described in Sec. 1.166-2(d)(3).
    (ii) On December 31, 1995, B has total loans outstanding of 
$1,000,000 and a bad debt reserve balance of $1000. Among the loans 
that B marks to market is loan X. On January 1, 1995, loan X had a 
book and tax basis of $100. During the taxable year, loan taxable 
became partially worthless, and B charged off the loan by $5. Thus, 
loan X had a book basis of $95 and a tax basis of $100. The fair 
market value of loan X was $94 on December 31, 1995.
    (iii) B computes the amount of gain or loss to be taken into 
account under section [[Page 404]] 475(a)(2) with respect to loan X 
using the rules of paragraph (f) of this section. Under paragraph 
(f)(1) of this section, B treats the adjusted tax basis of loan X as 
having been reduced by the $5 charge-off. Thus, B determines that it 
is required to take into account a $1 mark-to-market loss based on 
the difference between B's adjusted basis in loan X of $95, as 
determined under paragraph (f)(1) of this section, and loan X's fair 
market value of $94.
    (iv) Further, B decides to claim a bad debt deduction with 
respect to loan X in 1995, rather than waiting until loan X becomes 
totally worthless. Thus, B charges the $5 of partial worthlessness 
to its reserve for bad debts. In computing a reasonable addition to 
the reserve under section 585(b), B reduces the amount of its total 
loans outstanding by $6 ($5 charged to the reserve for bad debts, 
plus $1 mark-to-market loss).
    (v) On December 31, 1997, loan X has a fair market value of $93 
and an adjusted basis (and outstanding principal balance) of $90. No 
additional worthlessness occurred with respect to loan X in 1996 or 
1997. B determines that it is required to recognize a $3 mark-to-
market gain with respect to loan X. Because B previously charged $5 
to the bad debt reserve with respect to loan X, the entire $3 is a 
recovery item and must be credited to the bad debt reserve. See 
paragraph (f)(2) of this section. In computing a reasonable addition 
to the reserve for 1997, B does not increase the balance of its 
total loans outstanding by the $3 mark-to-market gain, because that 
adjustment would increase the balance to an amount in excess of the 
actual outstanding principal balance of $90. See paragraph (g)(1) of 
this section.

    Par. 4. Section 1.475(a)-2 is added to read as follows:


Sec. 1.475(a)-2  Mark to market upon disposition of security by a 
dealer.

    (a) General rule. If a dealer in securities ceases to be the owner 
of a security for federal income tax purposes and if the security would 
have been marked to market under section 475(a) if the dealer's taxable 
year had ended immediately before the dealer ceases to own it, then 
(whether or not the security is inventory in the hands of the dealer) 
the dealer must recognize gain or loss on the security as if it were 
sold for its fair market value immediately before the dealer ceases to 
own it, and gain or loss is taken into account at that time. The amount 
of any gain or loss subsequently realized must be properly adjusted, in 
the form of a basis adjustment or otherwise, for gain or loss taken 
into account under this paragraph (a). See Sec. 1.475(b)-4(b) for the 
rule governing when a security with substituted basis must be 
identified if it is to be exempted from the application of section 
475(a).
    (b) Example. The rule of paragraph (a) of this section is 
illustrated by the following example.

    Example.
    (i) Facts. D is a dealer in securities within the meaning of 
section 475(c)(1) and is a member of a consolidated group that uses 
the calendar year as its taxable year. On February 1, 1995, D 
acquired for $100 a debt instrument issued by an unrelated party. On 
June 1, 1995, D sold the debt instrument to another member of the 
group, M1, for $110, which was the fair market value of the security 
on that date. D would have been required to mark the debt instrument 
to market under section 475(a) if its taxable year had ended 
immediately before it sold the debt instrument to M1.
    (ii) Holding. Under paragraph (a) of this section, D marks the 
debt instrument to market immediately before the sale to M1 and 
takes into account $10 of gain. The gain is not deferred 
intercompany gain. As a result, D's basis in the debt instrument 
increases to $110 immediately before the sale. Accordingly, there is 
no gain or loss on the sale, and M1's basis in the debt instrument 
is $110.

    Par. 5. Section 1.475(a)-3 is added to read as follows:


Sec. 1.475(a)-3  Acquisition by a dealer of a security with a 
substituted basis.

    (a) Scope. This section applies if--
    (1) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to the basis of that security in the 
hands of the person from whom the security was acquired; or
    (2) A dealer in securities acquires a security that is subject to 
section 475(a) and the dealer's basis in the security is determined, in 
whole or in part, by reference to other property held at any time by 
the dealer.
    (b) Rules. If this section applies to a security--
    (1) Section 475(a) applies only to changes in value of the security 
occurring after the acquisition; and
    (2) Any built-in gain or loss with respect to the security (based 
on the difference between the fair market value of the security on the 
date the dealer acquired it and its basis to the dealer on that date) 
is taken into account at the time, and has the character, provided by 
the sections of the Code that would apply to the built-in gain or loss 
if section 475(a) did not apply to the security.
    Par. 6. Section 1.475(b)-3 is added to read as follows:


Sec. 1.475(b)-3  Exemption of securities in certain securitization 
transactions.

    (a) Exemption of contributed assets. If a taxpayer expects to 
contribute securities (for example, mortgages) to a trust or other 
entity, including a REMIC, in exchange for interests therein (including 
ownership interests or debt issued by the trust or other entity), the 
contributed securities qualify as held for investment (within the 
meaning of section 475(b)(1)(A)) or not held for sale (within the 
meaning of section 475(b)(1)(B)) only if the taxpayer expects each of 
the interests received (whether or not a security within the meaning of 
section 475(c)(2)) to be either held for investment or not held for 
sale to customers in the ordinary course of the taxpayer's trade or 
business.
    (b) Exemption of resulting interests--(1) General rule. If a 
taxpayer contributes securities to a trust or other entity in exchange 
for interests therein (including ownership interests or debt issued by 
the trust or other entity) and if, for federal income tax purposes, the 
ownership of the interests received is not treated as ownership of the 
securities contributed, the interests received may be identified as 
being described in section 475(b)(1), even if some or all of the 
contributed securities were not so described and could not have been so 
identified. For purposes of determining the timeliness of an 
identification of an interest received, the interest is treated as 
acquired on the day of its receipt.
    (2) Examples. The following examples illustrate the principles of 
paragraph (b)(1) of this section.

    Example 1. Identification of REMIC regular interests. If a 
taxpayer holds mortgages that are marked to market under section 475 
and the taxpayer contributes the mortgages to a REMIC in exchange 
for REMIC regular interests that are described in section 475(b)(1), 
the taxpayer may identify the regular interests as exempt from mark-
to-market treatment. This is permissible because REMIC regular 
interests are debt securities issued by the REMIC and do not 
represent continued ownership of the contributed mortgages.
    Example 2. Identification of interests in a grantor trust. If a 
taxpayer contributes securities to a grantor trust and receives 
beneficial interests therein and if the taxpayer marked the 
contributed securities to market under section 475, the taxpayer 
cannot identify the beneficial interests in the grantor trust as 
exempt from mark-to-market treatment. Because ownership of a 
beneficial interest in a grantor trust represents continued 
ownership of an undivided interest in the contributed assets, no new 
security has been acquired.

    Par. 7. Section 1.475(b)1-4 is added to read as follows:


Sec. 1.475(b)-4  Exemptions--Identification requirements.

    (a) Identification of the basis for exemption. An identification of 
a security as exempt does not satisfy section 475(b)(2) if it fails to 
identify the subparagraph of section 475(b)(1) in which the security is 
described. [[Page 405]] 
    (b) Time for identifying a security with a substituted basis. For 
purposes of determining the timeliness of an identification under 
section 475(b)(2), the date that a dealer acquires a security is not 
affected by whether the dealer's basis in the security is determined, 
in whole or in part, either by reference to the basis of the security 
in the hands of the person from whom the security was acquired or by 
reference to other property held at any time by the dealer. See 
Sec. 1.475(a)-3 for rules governing how the dealer accounts for such a 
security if this identification is not made.
    (c) Securities involved in integrated transactions under 
Sec. 1.1275-6--(1) Definitions. The following terms are used in this 
paragraph (c) with the meanings that are given to them by Sec. 1.1275-
6: integrated transaction, legging into, legging out, qualifying debt 
instrument, Sec. 1.1275-6 hedge, and synthetic debt instrument.
    (2) Synthetic debt held by a taxpayer as a result of legging in. If 
a taxpayer becomes the holder of a synthetic debt instrument as the 
result of legging into an integrated transaction, then, for purposes of 
the timeliness of an identification under section 475(b)(2), the 
synthetic debt instrument is treated as having the same acquisition 
date as the qualifying debt instrument. A pre-leg-in identification of 
the qualifying debt instrument under section 475(b)(2) applies to the 
synthetic debt instrument as well.
    (3) Securities held after legging out. If a taxpayer legs out of an 
integrated transaction, then, for purposes of the timeliness of an 
identification under section 475(b)(2), the qualifying debt instrument, 
or the Sec. 1.1275-6 hedge, that remains in the taxpayer's hands is 
generally treated as having been acquired, originated, or entered into, 
as the case may be, immediately after the leg-out. If any loss or 
deduction determined under Sec. 1.1275-6(d)(2)(ii)(B) is disallowed by 
Sec. 1.1275-6(d)(2)(ii)(D) (which disallows deductions when a taxpayer 
legs out of an integrated transaction within 30 days of legging in), 
then, for purposes of this section and section 475(b)(2), the 
qualifying debt instrument that remains in the taxpayer's hands is 
treated as having been acquired on the same date that the synthetic 
debt instrument was treated as having been acquired.
    Par. 8. Section 1.475(c)-1, as proposed on December 29, 1993 (58 FR 
68798), is amended as follows:
    1. The heading of the section is revised.
    2. Paragraphs (c) and (d) are added.
    3. The revision and additions read as follows:


Sec. 1.475(c)-1  Definitions--Dealer in securities.

* * * * *
    (c) Dealer-customer relationship. Whether a taxpayer is transacting 
business with customers is determined on the basis of all of the facts 
and circumstances.
    (1) [Reserved].
    (2) Transactions described in section 475(c)(1)(B). For purposes of 
section 475(c)(1)(B), the term dealer in securities includes, but is 
not limited to, a taxpayer that, in the ordinary course of the 
taxpayer's trade or business, regularly holds itself out as being 
willing and able to enter into either side of a transaction enumerated 
in section 475(c)(1)(B). An example of a taxpayer willing to enter into 
either side of a transaction is a taxpayer willing to enter into an 
interest rate swap and either pay a fixed interest rate and receive a 
floating rate or pay a floating rate and receive a fixed rate.
    (d) Issuance of life insurance products. A life insurance company 
that is not otherwise a dealer in securities under section 475(c)(1) 
does not become a dealer solely because it regularly issues life 
insurance products to its customers in the ordinary course of a trade 
or business. For purposes of the preceding sentence, the term life 
insurance product means a contract that is treated for federal income 
tax purposes as an annuity, endowment, or life insurance contract. See 
sections 817 and 7702.
    Par. 9. Section 1.475(c)-2, as proposed on December 29, 1993 (58 FR 
68798), is amended as follows:
    1. The heading of the section is revised.
    2. Paragraph (a)(2) is revised.
    3. Paragraph (a)(3) is amended by adding ``; or'' in lieu of the 
period at the end of that paragraph.
    4. Paragraph (a)(4) and paragraph (d) are added.
    5. The revisions and additions read as follows:


Sec. 1.475(c)-2  Definitions--Security.

    (a) * * *
    (2) A debt issued by the taxpayer (including a synthetic debt 
instrument, within the meaning of Sec. 1275-6(b), that the taxpayer is 
treated as having issued as a result of an integrated transaction under 
Sec. 1.1275-(6);
    (3) * * * ; or
    (4) A REMIC residual interest, or an interest or arrangement that 
is determined by the Commissioner to have substantially the same 
economic effect, if the residual interest or the interest or 
arrangement is acquired on or after January 4, 1995.
* * * * *
    (d) Synthetic debt held by a taxpayer as a result of an integrated 
transaction under Sec. 1.1275-6. If, as the result of an integrated 
transaction under Sec. 1.1275-6, a taxpayer is treated as the holder of 
a synthetic debt instrument (within the meaning of Sec. 1.1275-6(b)), 
the synthetic debt instrument is a security held by the taxpayer within 
the meaning of section 475(c)(2)(C). See Sec. 1.475(b)-4(c) for rules 
governing identification of such a synthetic debt instrument for 
purposes of section 475(b).
    Par. 10. Section 1.475(e)-1, as proposed on December 29, 1993 (58 
FR 68798), is revised to read as follows:


Sec. 1.475(e)-1.  Effective dates.

    (a) Taxable years ending on or after December 31, 1993. The 
following sections apply to taxable years ending on or after December 
31, 1993: Secs. 1.475(b)-1 (concerning the scope of exemptions from 
mark-to-market requirement), 1.475(b)-2 (concerning transitional issues 
relating to exemptions), 1.475(c)-1(a) (concerning sellers of 
nonfinancial goods and services) and (b) (concerning taxpayers that 
purchase securities but do not sell more than a negligible portion of 
the securities), 1.475(c)-2 (concerning the definition of security), 
and 1.475(d)-1 (concerning the character of gain or loss). Note, 
however, that, by its terms, Sec. 1.475(c)-2(a)(4) applies only to 
interests or arrangements that are acquired on or after January 4, 
1995, and the integrated transactions to which Sec. 1.475(c)-2(d) 
applies will exist only after the effective date of Sec. 1.1275-6.
    (b) Taxable years beginning on or after January 1, 1995. The 
following sections apply to taxable years beginning on or after January 
1, 1995: Secs. 1.475(a)-1 (concerning mark to market accounting for 
debt instruments) and 1.475(c)-1(c) (concerning the dealer-customer 
relationship) and (d) (concerning the issuance of life insurance 
products).
    (c) Securities acquired on or after January 4, 1995. The following 
sections apply to securities acquired, originated, or entered into on 
or after January 4, 1995: Secs. 1.475(a)-3 (concerning acquisition by a 
dealer of a security with a substituted basis), 1.475(b)-3(a) 
(concerning securities the taxpayer expects to contribute to a trust or 
other entity in a securitization transaction), and 1.475(b)-3(b) 
(concerning securities received in a securitization transaction).
    (d) Events occurring on or after January 4, 1995. [[Page 406]] 
    (1) Section 1.475(a)-2 (concerning marking a security to market 
upon disposition) applies to dispositions occurring on or after January 
4, 1995.
    (2) Section 1.475(b)-4 (concerning the identification requirements 
for obtaining an exemption from mark-to-market treatment) applies to 
identifications made on or after January 4, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-13 Filed 01-03-95; 8:45 am]
BILLING CODE 4830-01-U