4746 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

§ 1.1256(e)–1 Identification of hedging

transactions.

(a) Identification and recordkeeping

requirements. Under section 1256(e)(2),

a taxpayer that enters into a hedging

transaction must identify the transaction

as a hedging transaction before the close

of the day on which the taxpayer enters

into the transaction.

(b) Requirements for identification.

The identification of a hedging

transaction for purposes of section

1256(e)(2) must satisfy the requirements

of § 1.1221–2(e)(1). Solely for purposes

of section 1256(f)(1), however, an

identification that does not satisfy all of

the requirements of § 1.1221–2(e)(1) is

nevertheless treated as an identification

under section 1256(e)(2).

(c) Consistency with § 1.1221–2. Any

identification for purposes of § 1.1221–

2(e)(1) is also an identification for

purposes of this section. If a taxpayer

satisfies the requirements of § 1.1221–

2(f)(1)(ii), the transaction is treated as if

it were not identified as a hedging

transaction for purposes of section

1256(e)(2).

(d) Effective date. This section applies

to transactions entered into on or after

January 18, 2001.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 01–491 Filed 1–17–01; 8:45 am]

BILLING CODE 4830–01–P

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–105801–00]

RIN 1545–AX92

Capitalization of Interest and Carrying

Charges Properly Allocable to

Straddles

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations that clarify the

application of the straddle rules to a

variety of financial instruments. The

proposed regulations clarify what

constitutes interest and carrying charges

and when interest and carrying charges

are properly allocable to personal

property that is part of a straddle. The

proposed regulations also clarify that a

taxpayer’s obligation under a debt

instrument can be a position in personal

property that is part of a straddle. The

proposed regulations provide guidance

to taxpayers that enter into straddle

transactions. This document provides

notice of a public hearing on these

proposed regulations.

DATES: Written and electronic comments

and requests to appear and outlines of

topics to be discussed at the public

hearing scheduled for May 22, 2001, at

10 a.m., must be submitted by May 1,

2001.

ADDRESSES: Send submissions to:

CC:M&SP:RU (REG–105801–00), room

5226, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. Submissions may be hand

delivered between the hours of 8 a.m.

and 5 p.m. to: CC:M&SP:RU (REG–

105801–00), Courier’s Desk, Internal

Revenue Service, 1111 Constitution

Avenue NW., Washington, DC.

Alternatively, taxpayers may submit

comments electronically via the Internet

by submitting comments directly to the

IRS Internet site at http://www.irs.gov/

taxlregs/regslist.html. The public

hearing will be held in the Auditorium,

Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations,

Kenneth Christman (202) 622–3950;

concerning submission and delivery of

comments and the public hearing,

Treena Garrett, (202) 622–7180 (not tollfree numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 501 and 502 of the Economic

Recovery Tax Act of 1981 (Pub. L. 97–

34, 95 Stat. 172) added sections 1092

and 263(g), respectively, to the Internal

Revenue Code to address certain

deferral and conversion strategies

involving economically offsetting

positions in actively traded personal

property. These economically offsetting

positions are called straddles. Section

1092(c)(1).

In general, under section 1092, a

taxpayer that realizes a loss on a

position in actively traded personal

property must defer the recognition of

the loss to the extent the taxpayer has

unrecognized gain on an economically

offsetting position in the property. This

deferral rule matches the recognition of

loss with the recognition of the

economically offsetting income. Section

263(g) addresses interest and carrying

charges properly allocable to personal

property that is part of a straddle. Under

this section, these otherwise deductible

expenses are not currently deductible.

Instead, they must be capitalized into

the basis of the property. By requiring

capitalization, section 263(g) prevents:

(1) A taxpayer from gaining a timing

advantage by accruing deductions

associated with carrying the straddle

transaction before recognizing income

from a position in personal property

that is part of the straddle; and (2) the

deductions from having a character

different from that of the income.

These proposed regulations provide

certain rules with respect to the

application of section 263(g) and section

1092.

Explanation of Provisions

The proposed regulations consist of

§ 1.263(g)–1, which provides a general

introduction, and §§ 1.263(g)–2,

1.263(g)–3, 1.263(g)–4, and 1.263(g)–5,

described below. The proposed

regulations also include a new

paragraph 1.1092(d)–1(d).

The proposed regulations generally

address four issues: (1) The definition of

personal property as such term is used

in section 263(g) (in § 1.263(g)–2); (2)

the type of payments that are subject to

the capitalization rules of section 263(g)

(in § 1.263(g)–3); (3) the operation of the

capitalization rules of section 263(g) (in

§ 1.263(g)–4); and (4) the circumstances

under which an issuer’s obligation

under a debt instrument can be a

position in actively traded personal

property and, therefore, part of a

straddle (in § 1.1092(d)–1(d)). These

issues are discussed in more detail

below.

Definition of the Term Personal Property

for Purposes of Section 263(g)

Section 263(g)(1) requires

capitalization of interest and carrying

charges properly allocable to personal

property that is part of a straddle (as

defined in section 1092(c)). Section

1092(d)(1) defines personal property for

purposes of section 1092, as personal

property of a type that is actively traded.

Commentators have suggested that

because sections 263(g) and 1092 were

enacted at the same time, the term

personal property as used in section

263(g) should be given the same

definition under section 1092(d)(1).

This would limit the definition of

personal property in section 263(g) to

personal property of a type that is

actively traded.

Despite this suggestion, the proposed

regulations provide that personal

property has its common law meaning

in section 263(g) for two reasons. First,

the definition in section 1092(d)(1) by

its terms applies only for purposes of

section 1092. Second, the broader,

common law interpretation of personal

property more closely accords with the

purposes of section 263(g). Application

of the limited definition in section

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4747

1092(d)(1) for purposes of section 263(g)

could result in dissimilar tax treatment

of economically similar transactions.

For example, adoption of the narrower

definition would cause section 263(g) to

apply to a transaction in which a

taxpayer borrows to purchase actively

traded personal property that is a part

of a straddle but not to a similar

transaction in which the taxpayer

borrows to purchase a derivative

instrument that is not itself actively

traded but is a position in actively

traded property.

Consequently, proposed § 1.263(g)–2

defines personal property as a property

right, whether or not actively traded,

other than a right in real property. This

definition includes both financial

positions that provide substantial rights

but do not impose substantial

obligations on the holder (e.g., common

stock or a purchased option) and

executory contracts that impose both

rights and obligations on the holder

(e.g., notional principal contracts

(NPC’s) and forward transactions).

However, the definition excludes

straddles comprised only of financial

positions that impose only obligations

on the holder (e.g., the obligor’s position

in a debt instrument or a writer’s

position in an option).

Payments That Are Subject to the

Capitalization Rules of Section 263(g)

Section 263(g)(1) provides for the

capitalization of interest and carrying

charges. For this purpose, interest and

carrying charges are collectively defined

in section 263(g)(2) as ‘‘interest incurred

or continued to purchase or carry the

personal property’’ and ‘‘all other

amounts (including charges to insure,

store, or transport) paid or incurred to

carry the personal property,’’ less

certain types of income from the

personal property.

The phrase ‘‘incurred or continued to

purchase or carry’’ also appears in

section 265(a)(2), which disallows

interest expense on indebtedness

incurred or continued to purchase or

carry tax-exempt debt. Rev. Proc. 72–18

(1972–1 C.B. 740) sets out rules for

determining when this standard is met

for purposes of section 265(a)(2). Under

that revenue procedure, indebtedness

issued by a taxpayer that is not a dealer

in tax-exempt obligations meets this

standard if: (1) The proceeds of the

indebtedness are directly traceable to

the purchase of the tax-exempt

obligations, (2) the tax-exempt

obligations are used as collateral for the

borrowing, or (3) the totality of the facts

and circumstances supports a

reasonable inference that the purpose of

the borrowing was to purchase or carry

tax-exempt obligations. In general, the

facts-and-circumstances test is met if

there is a ‘‘sufficiently direct

relationship’’ between the borrowing

and the investment in the tax-exempt

obligations. Similarly, the proposed

regulations provide that a sufficiently

direct relationship between

indebtedness or other financing and

personal property that is part of a

straddle exists if payments on the

indebtedness or other financing are

determined by reference to the value or

change in value of the personal

property. See § 1.263(g)–3(c).

Section 263(g) also applies to ‘‘all

other amounts (including charges to

insure, store or transport the personal

property)’’ paid or incurred to carry

personal property that is part of a

straddle. As noted by one commentator,

‘‘taxpayers should not be permitted to

deduct items incurred in connection

with protecting or preserving the value

of assets’’ that are part of a straddle.

Therefore, the term, to carry in the

context of section 263(g) includes the

reduction of the risk of holding an asset.

Because straddles necessarily involve

positions that offset each other, the

positions ‘‘carry’’ each other.

Accordingly, under § 1.263(g)–3(b) of

the proposed regulations, interest and

carrying charges subject to

capitalization under section 263(g)

include: (1) Otherwise deductible

payments or accruals (including interest

and original issue discount) on

indebtedness or other financing issued

or continued to purchase or carry

personal property that is part of a

straddle; (2) otherwise deductible fees

or expenses paid or incurred in

connection with the taxpayer’s

acquiring or holding personal property

that is part of a straddle, including, but

not limited to, fees or expenses incurred

to purchase, insure, store, maintain, or

transport the personal property; and (3)

other otherwise deductible payments or

accruals on financial instruments that

are part of a straddle or that carry part

of a straddle.

Section 263(g) requires capitalization

of interest and carrying charges that

exceed certain specified income

inclusions (allowable offsets) listed in

section 263(g)(2)(B). Section 1.263(g)–

3(e) sets forth the allowable offsets,

including amounts that are receipts or

accruals on financial instruments that

are part of a straddle or carry part of a

straddle. The Treasury Department and

the IRS solicit comments regarding

whether other amounts should be

treated as allowable offsets for purposes

of section 263(g).

Operation of the Capitalization Rules of

Section 263(g)

Generally, section 263(g) coordinates

the character and timing of items of

income and loss attributable to a

taxpayer’s position in a straddle by

allocating interest and carrying charges

to the capital account of a position in

personal property that is part of the

straddle. Proposed regulation

§ 1.263(g)–4 provides a set of allocation

rules governing the ‘‘capitalization’’ of

interest and carrying charges.

In many cases, certain allocation rules

readily suggest themselves.

Congress was aware of ‘‘cash and

carry’’ transactions in adopting section

263(g). See H.R. Rep. No. 201, 97th

Cong. 1st Sess. 203–04 (1981). In a

typical transaction, a taxpayer borrows

to purchase personal property and sells

the property forward. The debt

instrument generates ordinary

deductions (interest expense) that

precede predictable (and approximately

equal) capital gains on the sale of the

personal property. Coordination of the

amount and timing of income and loss

in a cash and carry transaction is

achieved under the proposed regulation

by allocating the interest expense to the

capital account of the personal property.

This rule applies to all transactions in

which a taxpayer has borrowed to

purchase personal property that is part

of a straddle.

If the proceeds of a borrowing are not

used to purchase personal property, a

second allocation rule allocates interest

expense to personal property when the

personal property collateralizes the

borrowing. See Rev. Proc. 72–18, § 3.03

(disallowing interest deduction for debt

secured by tax-exempt obligations); Rev.

Rul. 78–348 (1978–2 C.B. 95) (applying

yield restrictions to investments

pledged by person benefitting from taxexempt bond financing).

A third allocation rule of the

proposed regulations allocates interest

on indebtedness to personal property

when payments on the indebtedness are

determined by reference to the value, or

change in value, of the personal

property that is part of a straddle.

Fees and charges related to the

maintenance of the personal property,

such as charges to insure, store, or

transport the personal property, are

allocated to the capital account of that

personal property. See S. Rep. No. 144,

97th Cong. 1st Sess. 154 (1981).

In other cases, the appropriate method

for allocating capitalized interest and

carrying charges is less obvious. This

may be true of payments or accruals on

a financial instrument, such as a NPC,

described in proposed § 1.263(g)–3(d).

4748 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

For example, the proposed rules would

apply to a taxpayer that holds stock and

enters into an equity swap that is a short

position with respect to the stock. In

such a case, both the stock and the

equity swap may be personal property

that is part of a straddle, and payments

on the equity swap could be capitalized

with respect to the capital account of

either the stock or the equity swap.

However, it may not be clear how a

capitalization rule would apply in

conjunction with the rules under

§ 1.446–3 with respect to payments on

NPCs. Accordingly, the proposed rules

provide that, in cases to which a

specific allocation rule is not applicable,

interest and carrying charges will be

allocated to personal property that is

part of a straddle in the manner that is

most appropriate under all the facts and

circumstances. Proposed regulations

§ 1.263(g)–4(c) Example 7 (relating to a

straddle consisting of stock and an

equity swap) illustrate one application

of this facts and circumstances rule. The

Treasury Department and the IRS invite

comments and suggestions regarding

both the proposed specific allocation

rules and the general facts and

circumstances allocation rule.

The regulations under section 263(g)

are proposed to be effective for expenses

paid, incurred, or accrued after the date

the regulations are adopted as final for

straddles established on or after January

17, 2001. See § 1.263(g)–5.

Obligation Under a Debt Instrument as

a Position in Personal Property

If a taxpayer is the obligor under a

debt instrument that provides for one or

more payments linked to the value of

actively traded personal property, the

value of the taxpayer’s obligation under

the debt instrument changes as the

value of the referenced property

changes. For this reason, the taxpayer’s

position as obligor under the debt

instrument functions as a position in the

referenced property.

Some commentators have suggested

that a debt instrument (other than one

denominated in an actively traded

foreign currency) cannot be a position of

the obligor in personal property that is

part of a straddle. Section 1092(d)(7)

provides that an obligor’s interest in a

nonfunctional-currency-denominated

debt instrument is treated under section

1092(d)(2) as a position in the

nonfunctional currency. From this, the

commentators infer that an obligor’s

interest in a debt instrument may never

be treated as an interest in personal

property other than a nonfunctional

currency.

However, neither the legislative

history nor the express language of

section 1092(d)(7) indicates that

Congress intended to exclude interests

in personal property from the definition

of position in section 1092(d)(2). A rule

that a debt instrument can be a position

in currency does not establish that a

debt instrument is a position only in

currency. This interpretation of section

1092(d)(7) has already been rejected by

the IRS and Treasury in § 1.1275–

4(b)(9)(vi), which provides that

increased interest expense on a

contingent payment debt instrument

issued by a taxpayer may be a straddle

loss subject to section 1092 deferral.

To clarify the definition of position

under section 1092(d)(2), § 1.1092(d)–

1(d) of the proposed regulations

explicitly provides that an obligation

under a debt instrument may be a

position in personal property that is part

of a straddle. This provision is proposed

to be effective for straddles established

on or after January 17, 2001. However,

no inference is intended with respect to

straddles established prior to Janaury

17, 2001. Thus, in appropriate cases, the

IRS may take the position under section

1092(d)(2) that, even in the absence of

a regulation, an obligation under a debt

instrument was part of a straddle prior

to the effective date of § 1.1092(d)–1(d)

if the debt instrument functioned

economically as an interest in actively

traded personal property.

In 1995, the IRS published proposed

regulation § 1.1092(d)–(2). See 60 F.R.

21482; FI–21–95, 1995–1 C.B. 935. The

proposed regulations clarify the

circumstances in which common stock

may be personal property for the

purposes of section 1092. Because

proposed regulation §§ 1.1092(d)–2 and

1.1092(d)–1(d) address similar issues,

the IRS proposes to finalize both

regulations simultaneously. The

Treasury Department and the IRS,

therefore, invite additional comment on

proposed § 1.1092(d)–(2).

In addition, in 1985, the Treasury

Department and the IRS adopted

Temporary Regulation § 1.1092(d)–

5T(d), which defines the term loss for

purposes of §§ 1.1092(b)–1T through

1.1092(b)–4T as a loss otherwise

allowable under section 165(a). The

Treasury Department and the IRS

request comments on whether that

definition should be expanded to

include expenses such as interest and

carrying charges or payments on

notional principal contracts. If so, how

should such a change be coordinated

with the proposed regulations in this

document?

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a

significant regulatory action as defined

in Executive Order 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) does not apply

to these regulations, and because the

regulation does not impose a collection

of information on small entities, the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to

section 7805(f) of the Internal Revenue

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 or electronic comments (a

signed original and eight (8) copies, if

written) that are submitted timely (in

the manner described in the ADDRESSES

portion of this preamble) to the IRS. The

IRS and Treasury request comments on

the clarity of the proposed regulations

and how they may be made easier to

understand. All comments will be

available for public inspection and

copying.

A public hearing has been scheduled

for May 22, 2001, at 10 a.m. in the

Auditorium, Internal Revenue Building,

1111 Constitution Avenue NW.,

Washington DC. Due to building

security procedures, visitors must enter

at the 10th Street entrance located

between Constitution and Pennsylvania

Avenues, NW. In addition, all visitors

must present photo identifications to

enter the building. Because of access

restrictions, visitors will not be

admitted beyond the immediate

entrance area more than 15 minutes

before the hearing starts. For

information about having your name

placed on the building access list to

attend the hearing, see the FOR FURTHER

INFORMATION CONTACT section of this

preamble.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing. Persons who wish

to present oral comments at the hearing

must submit and an outline of the topics

to be discussed and the time to be

devoted to each topic (signed original

and eight (8) copies) by May 1, 2001. 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.

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4749

Drafting Information

The principal author of these

regulations is Kenneth Christman,

Office of Associate Chief Counsel

(Financial Institutions and 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 1.263(g)–1 also issued under

26 U.S.C. 1092(b)(1).

Section 1.263(g)–2 also issued under

26 U.S.C. 1092(b)(1).

Section 1.263(g)–3 also issued under

26 U.S.C. 1092(b)(1).

Section 1.263(g)–4 also issued under

26 U.S.C. 1092(b)(1).

Section 1.263(g)–5 also issued under

26 U.S.C. 1092(b)(1). * * *

Section 1.1092(d)–1 also issued under

26 U.S.C. 1092(b)(1).

Par. 2. Sections 1.263(g)–1, 1.263(g)–

2, 1.263(g)–3, 1.263(g)–4, and 1.263(g)–

5 are added to read as follows:

§ 1.263(g)–1 Treatment of interest and

carrying charges in the case of straddles;

in general.

(a) Under section 263(g), no deduction

is allowed for interest and carrying

charges allocable to personal property

that is part of a straddle (as defined in

section 1092(c)). The purpose of section

263(g) is to coordinate the character and

the timing of items of income and loss

attributable to a taxpayer’s positions

that are part of a straddle. In order to

prevent payments or accruals related to

a straddle transaction from giving rise to

recognition of deductions or losses

before related income is recognized and

to prevent the items of loss and income

from having different character, no

deduction is allowed for interest and

carrying charges properly allocable to

personal property that is part of a

straddle. Rather, such amounts are

chargeable to the capital account of the

personal property to which the interest

and carrying charges are properly

allocable.

(b) Section 263(g) does not apply if

none of the taxpayer’s positions that are

part of the straddle are personal

property. Section 263(g) also does not

apply to hedging transactions as defined

in section 1256(e) (see section 263(g)(3))

or to securities to which the mark-tomarket accounting method provided by

section 475 applies (see section

475(d)(1)).

(c) Section 1.263(g)–2 provides a

definition of personal property for

purposes of section 263(g) and

§§ 1.263(g)–1 through 1.263(g)–5.

Section 1.263(g)–3 provides a definition

of interest and carrying charges for

purposes of section 263(g), section 1092,

§§ 1.263(g)–1 through 1.263(g)–5, and

§ 1.1092(b)–4T. Section 1.263(g)–4

provides a set of allocation rules

governing the capitalization of amounts

to which section 263(g) applies.

§ 1.263(g)–2 Personal property to which

interest and carrying charges may properly

be allocable.

(a) Definition of personal property.

For purposes of section 263(g) and of

§§ 1.263(g)–1 through 1.263(g)–5,

personal property means property,

whether or not actively traded, that is

not real property. For purposes of the

preceding sentence, a position in

personal property may itself be

property. In general, however, a position

in personal property is not property of

a taxpayer unless the position confers or

may confer substantial rights on the

taxpayer.

(1) Application to certain financial

instruments. Personal property includes

a stockholder’s ownership of common

stock, a holder’s ownership of a debt

instrument, and either party’s position

in a forward contract or in a

conventional swap agreement. Personal

property does not include a position

that imposes obligations but does not

confer substantial rights on the

taxpayer. Therefore, the obligor’s

position in a debt instrument generally

is not personal property, even though

the obligor may have typical rights of a

debtor, such as the right to prepay the

debt. However, the obligor on a debt

instrument has a position in any

personal property underlying the debt

instrument. See § 1.1092(d)–1(d).

(2) Options. For the purposes of

applying this section, a put option or

call option imposes obligations but does

not confer substantial rights on the

grantor, whether or not the option is

cash-settled.

(b) Example. The following example

illustrates the rules stated in paragraph (a) of

this section:

Example. (i) Facts. A purchases 100 ounces

of gold at a cost of $x. A transfers the 100

ounces of gold to a trust that issues multiple

classes of trust certificates and is treated as

a partnership for tax purposes. In return, A

receives two trust certificates that are not

personal property of a type that is actively

traded within the meaning of section

1092(d)(1). One certificate entitles A to a

payment on termination of the trust at the

end of four years equal to the value of the 100

ounces of gold up to a maximum value of

$(x + y). The other certificate entitles A to a

payment equal to the amount by which the

value of 100 ounces of gold exceeds $(x + y)

on termination of the trust. A sells the second

certificate and keeps the first certificate.

(ii) Analysis. The trust certificate retained

by A is property that is not real property. In

addition, ownership of the trust certificate

confers certain substantial rights on A.

Therefore, although the trust certificate is not

personal property of a type that is actively

traded, A’s interest in the trust certificate is

personal property for purposes of section

263(g).

§ 1.263(g)–3 Interest and carrying charges

properly allocable to personal property that

is part of a straddle.

(a) In general. For purposes of section

263(g), section 1092, §§ 1.263(g)–1

through 1.263(g)–5, and § 1.1092(b)–4T,

interest and carrying charges properly

allocable to personal property that is

part of a straddle means the excess of

interest and carrying charges (as defined

in paragraph (b) of this section) over the

allowable income offsets (as defined in

paragraph (e) of this section).

(b) Interest and carrying charges.

Interest and carrying charges are

otherwise deductible amounts paid or

accrued with respect to indebtedness or

other financing incurred or continued to

purchase or carry personal property that

is part of a straddle and otherwise

deductible amounts paid or incurred to

carry personal property that is part of a

straddle. As provided in section

263(g)(2), interest includes any amount

paid or incurred in connection with

personal property used in a short sale.

Interest and carrying charges include—

(1) Otherwise deductible payments or

accruals (including interest and original

issue discount) on indebtedness or other

financing issued or continued to

purchase or carry personal property that

is part of a straddle;

(2) Otherwise deductible fees or

expenses paid or incurred in connection

with acquiring or holding personal

property that is part of a straddle

including, but not limited to, fees or

expenses incurred to purchase, insure,

store, maintain or transport the personal

property; and

(3) Other otherwise deductible

payments or accruals on financial

instruments that are part of a straddle or

that carry part of a straddle.

(c) Indebtedness or other financing

incurred or continued to purchase or

carry personal property that is part of a

4750 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

straddle. For purposes of paragraph

(b)(1) of this section, indebtedness or

other financing that is incurred or

continued to purchase or carry personal

property that is part of a straddle

includes—

(1) Indebtedness or other financing

the proceeds of which are used directly

or indirectly to purchase or carry

personal property that is part of the

straddle;

(2) Indebtedness or other financing

that is secured directly or indirectly by

personal property that is part of the

straddle; and

(3) Indebtedness or other financing

the payments on which are determined

by reference to payments with respect to

the personal property or the value of, or

change in value of, the personal

property.

(d) Financial instruments that are part

of a straddle or that carry part of a

straddle. For purposes of paragraph

(b)(3), financial instruments that are part

of a straddle or that carry part of a

straddle include—

(1) A financial instrument that is part

of the straddle;

(2) A financial instrument that is

issued in connection with the creation

or acquisition of a position in personal

property if that position is part of the

straddle;

(3) A financial instrument that is sold

or marketed as part of an arrangement

that involves a taxpayer’s position in

personal property that is part of the

straddle and that is purported to result

in either economic realization of all or

part of the appreciation in an asset

without simultaneous recognition of

taxable income or a current tax

deduction (for interest, carrying charges,

payments on a notional principal

contract, or otherwise) reflecting a

payment or expense that is

economically offset by an increase in

value that is not concurrently

recognized for tax purposes or has a

different tax character (for example, an

interest payment that is economically

offset by an increase in value that may

result in a capital gain in a later tax

period); and

(4) Any other financial instrument if

the totality of the facts and

circumstances support a reasonable

inference that the issuance, purchase, or

continuation of the financial instrument

by the taxpayer was intended to

purchase or carry personal property that

is part of the straddle.

(e) Allowable income offsets. The

allowable income offsets are:

(1) The amount of interest (including

original issue discount) includible in

gross income for the taxable year with

respect to such personal property;

(2) Any amount treated as ordinary

income under section 1271(a)(3)(A),

1278, or 1281(a) with respect to such

personal property for the taxable year;

(3) The excess of any dividends

includible in gross income with respect

to such property for the taxable year

over the amount of any deductions

allowable with respect to such

dividends under section 243, 244, or

245;

(4) Any amount that is a payment

with respect to a security loan (within

the meaning of section 512(a)(5))

includible in income with respect to the

personal property for the taxable year;

and

(5) Any amount that is a receipt or

accrual includible in income for the

taxable year with respect to a financial

instrument described in § 1.263(g)–3(d)

to the extent the financial instrument is

entered into to purchase or carry the

personal property.

§ 1.263(g)–4 Rules for allocating amounts

to personal property that is part of a

straddle.

(a) Allocation rules. (1) Interest and

carrying charges paid or accrued on

indebtedness or other financing issued

or continued to purchase or carry

personal property that is part of a

straddle are allocated, in the order

listed—

(i) To personal property that is part of

the straddle purchased, directly or

indirectly, with the proceeds of the

indebtedness or other financing;

(ii) To personal property that is part

of the straddle and directly or indirectly

secures the indebtedness or other

financing; or

(iii) If all or a portion of such interest

and carrying charges are determined by

reference to the value or change in value

of personal property, to such personal

property.

(2) Fees and expenses described in

§ 1.263(g)–3(b)(2) are allocated to the

personal property, the acquisition or

holding of which resulted in the fees

and expenses being paid or incurred.

(3) In all other cases, interest and

carrying charges are allocated to

personal property that is part of a

straddle in the manner that under all the

facts and circumstances is most

appropriate.

(b) Coordination with other

provisions. In the case of a short sale,

section 263(g) applies after section

263(h). See sections 263(g)(4)(A) and

(h)(6). In case of an obligation to which

section 1277 (dealing with deferral of

interest deduction allocable to accrued

market discount) or 1282 (dealing with

deferral of interest deduction allocable

to certain accruals on short-term

indebtedness) applies, section 263(g)

applies after section 1277 and section

1282. See section 263(g)(4)(B).

Capitalization under section 263(g)

applies before loss deferral under

section 1092.

(c) Examples. The following examples

illustrate the rules stated in §§ 1.263(g)–

2, 1.263(g)–3, and 1.263(g)–4.

Example 1. Cash and Carry Silver.

(i) Facts. On January 1, 2002, A borrows $x

at 6% interest and uses the proceeds to

purchase y ounces of silver from B. At

approximately the same time, A enters into

a forward contract with C to deliver y ounces

of silver to C in one year.

(ii) Analysis. The y ounces of silver and the

forward contract to deliver y ounces of silver

in one year are offsetting positions with

respect to the same personal property and

therefore constitute a straddle. See sections

1092(c)(1), (c)(3)(A)(i). The proceeds of the

debt instrument were used to purchase

personal property that is part of the straddle.

Consequently, A’s interest payments are

interest and carrying charges properly

allocable to personal property that is part of

a straddle. See § 1.263(g)–3(b)(1) & (c)(1).

Under § 1.263(g)–4(a)(1)(i), the interest

payments must be charged to the capital

account for the y ounces of silver purchased

by A with the proceeds of the borrowing.

Example 2. Additional indebtedness issued

to carry personal property.

(i) Facts. The facts are the same as for

Example 1 except that during the year 2002,

the market price of silver increases and A is

required to post variation margin as security

for its obligation to deliver y ounces of silver

to C. A incurs additional indebtedness to

obtain funds necessary to meet A’s variation

margin requirement.

(ii) Analysis. The additional indebtedness

is incurred to continue to carry A’s holding

of z ounces of silver. Consequently, A’s

interest payments on the additional

indebtedness are interest and carrying

charges properly allocable to personal

property that is part of a straddle and must

be charged to the capital account for the y

ounces of silver.

Example 3. Contingent payment debt

instrument.

(i) Facts. On January 1, 2002, D enters into

a contract to deliver x barrels of fuel oil to

E on July 1, 2004, at an aggregate price equal

to $y. Soon afterward, D issues a contingent

payment debt instrument to F with a

principal amount of $z and a 2-year term that

pays interest quarterly at a rate determined

at the beginning of each quarter equal to the

greater of zero and the London Interbank

Offered Rate (LIBOR) adjusted by an index

that varies inversely with changes in the

price of fuel oil (so that the interest rate

increases as the price of fuel oil decreases

and vice versa). The change in the aggregate

amount of interest paid on the $z of debt due

to the functioning of the index approximates

the concurrent aggregate change in value of

x barrels of fuel oil and, thus, the value of

D’s interest in the forward contract.

(ii) Analysis. The debt instrument and the

forward contract are offsetting positions with

respect to the same personal property and

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4751

constitute a straddle. See section 1092(c)(1),

(c)(3)(A)(i). When issued, the debt instrument

is a position in personal property that is part

of a straddle. See § 1.1092(d)–1(d).

Consequently, D’s interest payments are

interest and carrying charges properly

allocable to personal property that is part of

a straddle and must be allocated to the

capital account for the forward contract for

the delivery of x barrels of fuel oil to E. See

§§ 1.263(g)–3(b)(1), (b)(3), (c)(3), and (d)(1)

and -4(a)(1)(iii).

Example 4. Financial instrument issued to

carry personal property that is part of a

straddle. (i) Facts. The facts are the same as

for Example 3 except that D also enters into

a two-year interest rate swap under which D

receives LIBOR times a notional principal

amount equal to $z and pays 7% times $z.

(ii) Analysis. Because of the relationship

between the two-year debt instrument issued

by D and the interest rate swap, the interest

rate swap is a financial instrument that

carries personal property that is part of a

straddle. See § 1.263(g)–3(d)(4). Net

payments made by D under the interest rate

swap are chargeable to the capital account for

the forward contract for the delivery of x

barrels of fuel oil to E. Similarly, net

payments received by D under the interest

rate swap are allowable offsets. See

§ 1.263(g)–3(e)(5).

Example 5. Contingent payment debt

instrument with embedded short position.

(i) Facts. On January 1, 1998, G purchases

100,000 shares of the common stock of XYZ

corporation (which is publicly traded). On

January 1, 2002, the 100,000 shares of XYZ

corporation common stock were worth $x per

share. On that date, G issued a contingent

payment debt instrument for $100,000x. The

terms of the debt instrument provided that

the holder would receive an annual payment

of $2,000x on December 31 of each year up

to and including the maturity date of

December 31, 2007. On the maturity date, the

holders would also receive a payment of

$100,000x plus an additional amount, if the

price of an XYZ share exceeded $1.2x on

such date, equal to 100,000 times threequarters of the amount of such excess per

share. Thus, G’s aggregate payments on the

debt instrument varied directly with the

increase in value in the XYZ shares.

(ii) Analysis. The debt instrument is a

position in XYZ stock. See § 1.1092(d)–1(d).

The XYZ stock is personal property within

the meaning of section 1092(d)(3)(B) because

the debt instrument is a position with respect

to substantially similar or related property

(other than stock) within the meaning of

section 1092(d)(3)(B)(i)(II). See § 1.1092(d)–

2(c). The debt instrument and the XYZ shares

are offsetting positions with respect to the

same personal property and constitute a

straddle. See sections 1092(c)(1), (c)(3)(A)(i).

Consequently, G’s interest payments are

interest and carrying charges properly

allocable to personal property that is part of

a straddle, see §§ 1.263(g)–3(b)(1), (b)(3),

(c)(3), and (d)(1), and must be allocated to the

capital account for the XYZ common stock,

see § 1.263(g)–4(a)(1)(iii) and (a)(3).

Example 6. Straddle including partnership

interest.

(i) Facts. H borrows money from I to

purchase 100 ounces of gold at a cost of $u.

H transfers the 100 ounces of gold and $v to

a newly created trust that issues multiple

classes of trust certificates and is treated as

a partnership for tax purposes. In return, H

receives two trust certificates. One certificate

entitles the holder to a payment on

termination of the trust at the end of four

years equal to the value of the 100 ounces of

gold up to a maximum value of $(u + w). The

other certificate entitles the holder to a

payment equal to the amount by which the

value of 100 ounces of gold exceeds $(u + w)

on termination of the trust. H sells the second

certificate and keeps the first certificate. H

also enters into a forward contract to sell 100

ounces of gold for $1.12u per ounce on a date

two years after creation of the trust. The trust

uses part of the $v and similar cash

contributions from other investors to pay

costs of storing the gold held by the trust and

allocates H’s share of the expenses to H.

(ii) Analysis. The trust certificate retained

by H and the forward contract entered into

by H are personal property for the purposes

of section 263(g). See § 1.263(g)–2(a). They

are also offsetting positions and constitute a

straddle. Section 1092(c)(1). The borrowing

from I is an indebtedness incurred to

purchase personal property that is part of a

straddle. See §§ 1.263(g)–3(b)(1) and (c)(1).

Similarly, the gold storage expenses are

expenses incurred due to the taxpayer’s

holding personal property that is part of a

straddle. See § 1.263(g)–3(b)(2). Therefore

both the interest on the borrowing and the

gold storage expenses must be allocated to

the capital account for the partnership

interest represented by the retained trust

certificate. See § 1.263(g)–4(a)(1)(i) and (a)(2).

Example 7. Equity Swap.

(i) Facts. On January 1, 1998, J purchases

100,000 shares of the common stock of XYZ

corporation (which is publicly traded). On

December 31, 2001, the 100,000 shares of

XYZ corporation common stock were worth

$x per share. On that date, J entered into a

NPC with K. The terms of the NPC provided

that K would receive an annual payment on

December 31 of each year equal to 100,000

times any appreciation in the value of a share

of XYZ corporation stock above its price at

the end of trading on December 31 of the

preceding year and 100,000 times the

dividends paid during the year on each share

of XYZ corporation stock. In return, on

December 31 of each year, J would receive an

amount equal to LIBOR times the value of

100,000 XYZ shares at the end of trading on

December 31 of the preceding year plus

100,000 times the amount of any decrease in

the value of a share of XYZ corporation stock

below its price at the end of trading on

December 31 of the preceding year. Payments

between J and K would be netted and

continue up to and including the maturity

date of the NPC on December 31, 2008. Thus,

J’s aggregate payments on the NPC varied

directly with the increase in value in the

XYZ shares.

(ii) Analysis. The NPC is a position in XYZ

stock. See § 1.1092(d)–2(c). The XYZ stock is

personal property within the meaning of

section 1092(d)(3)(B) because the NPC is a

position with respect to substantially similar

or related property (other than stock) within

the meaning of section 1092(b)(3)(B)(i)(II).

See § 1.1092(d)–2(a)(1)(ii). The NPC and the

XYZ shares are offsetting positions with

respect to the same personal property and

constitute a straddle. See sections 1092(c)(1),

(c)(3)(A)(i). Consequently, J’s payments are

interest and carrying charges properly

allocable to personal property that is part of

a straddle. See §§ 1.263(g)–3(b)(3) and (d)(1).

Therefore, they should be allocated to the

personal property that is part of the straddle

in the manner that is most appropriate under

all the facts and circumstances. In this case,

because these payments are incurred to carry

the XYZ shares, they should be allocated to

the capital account for the XYZ common

stock. See § 1.263(g)–4(a)(3).

§ 1.263(g)–5 Effective dates.

Sections 1.263(g)–1, 1.263(g)–2,

1.263(g)–3, and 1.263(g)–4 apply to

interest and carrying charges properly

allocable to personal property that are

paid, incurred, or accrued after the date

these regulations are adopted as final

regulations by publication in the

Federal Register for a straddle

established on or after January 17, 2001.

Par. 3. Section 1.1092(d)–1 is

amended by revising paragraph (d) and

adding paragraph (e), to read as follows:

§ 1.1092(d)–1 Definitions and special rules.

* * * * *

(d) Debt instrument linked to the

value of personal property. If a taxpayer

is the obligor under a debt instrument

one or more payments on which are

linked to the value of personal property

or a position with respect to personal

property, then the taxpayer’s obligation

under the debt instrument is a position

with respect to personal property and

may be part of a straddle.

(e) Effective dates. Paragraph

(b)(1)(vii) of this section applies to

positions entered into on or after

October 14, 1993. Paragraph (c) of this

section applies to positions entered into

on or after July 8, 1991. Paragraph (d)

of this section is effective for straddles

established on or after January 17, 2001.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 01–1240 Filed 1–17–01; 8:45 am]

BILLING CODE 4830–01–P

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–115560–99]

RIN 1545–AX66

Equity Options With Flexible Terms;

Qualified Covered Call Treatment

AGENCY: Internal Revenue Service (IRS),

Treasury.