Financial Derivatives: Disparate Tax Treatment and Information Gaps Create Uncertainty and Potential Abuse
Published: 2011-09-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Recently, concerns have arisen about the use of certain financial derivatives to avoid or evade tax obligations. As requested, this report (1) identifies and evaluates how financial derivatives can be used to avoid or evade tax liability or achieve differing tax results in economically similar situations, (2) evaluates Internal Revenue Service (IRS) actions to address the tax effects of investments in financial derivatives through guidance, and (3) evaluates IRS actions to identify financial derivative products and trends through information from other agencies. GAO reviewed research and IRS documents and interviewed IRS and, Department of the Treasury (Treasury) officials and other experts. GAO analyzed the completion of financial derivative projects on the agencies' Priority Guidance Plans (PGP) from 1996 to 2010.
section_title: What GAO Found
paragraphs: Taxpayers have used financial derivatives to lower their tax liability in ways that the courts have found improper or that Congress has disallowed. Taxpayers do this by using the ease with which derivatives can be redesigned to take advantage of the current patchwork of relevant tax rules. As new products are developed, IRS and taxpayers attempt to fit them into existing "cubbyholes" of relevant tax rules. This sometimes leads to inconsistent tax treatment for economically similar positions, which violates a basic tax policy criterion. While the tax rules for each cubbyhole represent Congress's and Treasury's explicit policy decisions, some of these decisions were made long before today's complex financial derivative products were created. Some experts have suggested alternate methods to the current approach for taxing financial derivatives. IRS and Treasury, because of their unique position to define policy and administer the tax code, are best positioned to study and recommend a new approach. When application of tax law is complex or uncertain, as is often the case for financial derivatives, guidance to taxpayers is an important tool for IRS to address tax effects and potential abuse. However, between 1996 and 2010, Treasury and IRS did not complete 14 out of 53 guidance projects related to financial derivatives that they designated as a priority on their annual PGP. While completing guidance is important in providing certainty to taxpayers and IRS and reducing the potential for abuse, challenges like the risk of adverse economic impacts of guidance changes and the transactional complexity of financial derivatives may delay the completion of guidance. Since challenges may prevent IRS from finalizing guidance within a 12-month PGP period, taxpayers need to be aware of ongoing guidance projects' status, some of which may span a number of years. IRS sometimes identifies new financial derivative products or new uses of them long after they have been introduced and gained considerable use. This slows its ability to address potential abuses. IRS's 2009-2013 Strategic Plan lists strengthening partnerships across government agencies to gather and share information as key to identifying and addressing new products and emerging tax schemes more quickly. Through their oversight roles for financial derivative markets, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) may have information on financial derivatives that is relevant to IRS. Similarly, bank regulators may gain relevant knowledge of derivatives' use. IRS officials said such routine communications in the early 1990s did provide relevant information. Although IRS communicates with SEC and CFTC on derivatives, it does not do so systematically or regularly. Strengthening partnerships would increase opportunities for IRS to gain information on new financial derivative products and uses. Studies of interagency coordination suggest that agencies should look for opportunities to enhance collaboration in order to achieve results that would not be available if they were to work separately, and a number of best practices exist to help agencies meet this goal.
section_title: What GAO Recommends
paragraphs: GAO recommends that (1) Treasury determine whether alternatives to the current approach to taxing financial derivatives would promote consistent treatment of economically similar positions and be beneficial, that (2) Treasury and IRS provide more public information on the status of PGP projects, including those related to financial derivatives, and that (3) IRS strengthen information-sharing partnerships with relevant agencies. IRS agreed with the third recommendation and disagreed with the second; Treasury disagreed with the first two recommendations. GAO continues to believe its recommendations would be beneficial.

section_title: Letter
paragraphs: Over the past few years some attention has been focused on certain  financial derivatives that have been used to avoid or evade tax  obligations. Financial derivatives are financial instruments whose value is  based on one or more underlying reference items. Recent legislation has  directly addressed one of the most prominent tax avoidance transactions  enabled by financial derivatives, and another was addressed through  litigation. While a majority of the world’s largest companies use financial  derivatives to manage and hedge risks, some taxpayers have used  financial derivatives to reduce their tax liabilities in ways that have been  aggressive and later disallowed, and such use is likely to continue.
In response to your request, this report (1) identifies and evaluates how  financial derivatives can be used to avoid or evade tax liability or achieve  differing tax results in economically similar situations, (2) evaluates  Internal Revenue Service (IRS) actions to address the tax effects of  investments in financial derivatives through its taxpayer guidance, and   (3) evaluates IRS actions to identify new financial derivatives products  and trends through information sharing with its partners in other federal  financial regulatory agencies.
To identify and evaluate how financial derivatives can be used to avoid or  evade tax liability, we reviewed academic studies and IRS documents.  We also interviewed officials and staff at IRS and the Department of the  Treasury (Treasury), and tax experts from the private sector. For this part  of the report, we focused on two case studies of financial derivative  transactions—variable prepaid forward contracts and cross-border total  return equity swaps—as illustrations of the use of financial derivatives to  achieve improper or disallowed tax results. We analyzed the taxation of  financial derivatives against consistency, a criterion meaning that  transactions with equivalent economic outcomes are taxed the same. We  identified this criterion through testimonial evidence from tax experts and  Treasury officials, and a review of research on the taxation of financial  derivatives. It was one of the most frequently cited criteria by these  sources, and also the most applicable to our objectives. The criterion of  consistency is related to simplicity, administrability, and economic  efficiency, several of the criteria for a good tax system that are discussed  in our 2005 report on tax reform. A lack of consistency can make the tax  system more difficult for taxpayers to comply with, more difficult for IRS to  administer, and reduce economic efficiency by influencing the  investments taxpayers make by taxing different investments under  different tax rules. While consistency may not be the only criteria to  consider, we believe it is an important guideline to evaluate whether  financial derivatives can be used by taxpayers for abusive purposes.
To evaluate IRS actions to address the tax effects of investments in  financial derivatives through its guidance, we reviewed IRS documents  and interviewed IRS and Treasury staff and officials about the guidance  process, with a specific focus on IRS’s and Treasury’s processes for  developing their Priority Guidance Plan (PGP), which identifies and  prioritizes the tax issues that IRS believes are most important to  taxpayers and tax administration and should be addressed through  guidance. We analyzed financial derivative-related guidance projects  included in the PGP from the years 1996 to 2010, determined how long it  took for Treasury and IRS to release guidance on those projects, and  compared the time required with the criteria established by IRS and  Treasury for the PGP. In addition, we completed case studies of four  financial derivative issues that were included in the PGP and were  highlighted as significant in interviews with Treasury, IRS, and private  sector experts. The four case studies cover credit default swaps,  contingent swap payments, variable prepaid forward contracts, and cross- border total return equity swaps.
To evaluate IRS actions to identify new financial derivatives products and  trends through information sharing with its partners in other financial  regulatory agencies, we examined IRS’s information sharing with other  federal financial market regulators. To examine information sharing with  other agencies, we interviewed relevant officials and staff at IRS and at  two financial market regulatory agencies, the Securities and Exchange  Commission (SEC) and the Commodity Futures Trading Commission  (CFTC). As our criterion, we used IRS’s 2009-2013 Strategic Plan, which  lists strengthening partnerships across government agencies to gather  and share additional information as key to enforcing tax law in a timely  manner to ensure taxpayers meet their obligations to pay taxes. In prior  work, we have also reported on the importance and value of cross- agency information sharing and coordination, and have established  criteria on federal agency coordination and information sharing. We also  identified the legislative authorities that govern IRS’s disclosure of  taxpayer information.
For the purposes of this review, we determined that data on financial  derivatives from the Office of the Comptroller of the Currency (OCC) and  the subset of IRS PGP data used in our analysis were reliable. See  appendix 1 for additional details on our scope and methodology. We  conducted this performance audit from May 2010 through September  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Financial derivatives are globally used financial products that unbundle  exposure to an underlying asset and transfer risks—the exposure to  financial loss caused by adverse changes in the values of assets or  liabilities—from entities less able or willing to manage them to those more  willing or able to do so. The values of financial derivatives are based on  an underlying reference item or items, such as equities, debt, exchange  rates, and interest rates. Since 2001, interest rate contracts have made  up the vast majority of all financial derivative contracts, on average         80 percent of all derivatives in terms of notional amount outstanding, and  are used to hedge against changes in the cost of capital.
Parties involved in financial derivative transactions do not need to own or  invest in the underlying reference items, and often do not. The most  common purpose of financial derivatives is to manage the holder’s risk,  and this is often accomplished by constructing financial derivative  contracts that produce more favorable rather than unfavorable tax results.  Financial derivatives are sold and traded either on regulated exchanges  or in private, over-the-counter markets that allow highly customized  transactions specific to the needs of the parties. Financial derivatives are  bilateral agreements that shift risk from one party to another but can be  used to structure more complicated arrangements involving multiple  transactions and parties. Simple financial derivatives act as building  blocks for more complex products, and can be broken down into three  general categories of products, described in figure 1. Credit derivatives,  depending on their structure, fall into one of these three categories, but  are often measured as a separate category by government agencies.
Dealers participate in the financial derivatives market by quoting prices to,  buying derivatives from, and selling derivatives to end users and other  dealers. They also develop customized derivative products for their  clients. Commercial banks, which most often act as dealers, are typically  one of the two parties involved in financial derivative transactions. In 2010  the holdings of five large commercial banks represented over 95 percent  of the banking industry’s notional amounts outstanding.
End users, including commercial banks, securities firms, hedge funds,  insurance companies, governments, mutual funds, pension funds,  individuals, commercial entities, and other dealers, often use derivatives  to protect against adverse change in the values of assets or liabilities,  called hedging. Hedgers try to protect themselves from risk by entering  into derivatives transactions whose values are expected to change in the  opposite direction from the values of their assets or liabilities. According  to a 2009 survey conducted by the International Swaps and Derivatives  Association, over 94 percent of the largest companies’ worldwide use  financial derivatives to manage and hedge risks. End users can also use  derivatives for speculation by taking on risk in an attempt to profit from  changes in the values of derivatives or their reference items. Derivatives  are attractive to speculators because they can be more cost-effective  than transactions in the underlying reference item, due to reduced  transaction costs and the leverage that derivatives provide. Financial  derivatives transactions are generally leveraged since parties to these  transactions most often initiate the transaction with little money down  relative to the expected outcome of the transaction. In any financial  transaction, the degree of permissible leverage is determined by the  collateral required to secure the transaction. While a high degree of  leverage has the potential for large gains, it also carries risks of large  losses. As we and others have reported, the risk exposures resulting from  derivatives were one of many factors that contributed to the systemic risk  that led to the recent financial crisis.
The market for financial derivatives has grown considerably in size over  the past two decades. Two common ways to measure the size of financial  derivative markets overall are total notional amount and fair market value.  Total notional amount represents the value of the reference items  underlying financial derivative transactions, and is the amount upon which  payments are computed between parties of derivatives contracts.  Notional amount does not represent money exchanged, nor does it  represent the risk exposure. The second measure, fair market value, can  be either the gross positive fair value or the gross negative fair value. The  gross positive fair value represents the sum of the fair values of the  financial derivative contracts where the commercial bank is owed money  by the other party in the contract and represents the maximum losses the  bank could incur if all other parties in the contracts default. According to  the OCC, between the first quarter of 1999 and the fourth quarter of 2010,  the total notional amount outstanding used to calculate payments for  derivatives contracts held by insured U.S. commercial banks and trust  companies grew over six times, from $32.7 trillion to $231.2 trillion. For  those same institutions, gross positive market value grew nearly seven- and-a-half times, from $0.46 trillion to $3.87 trillion (see fig. 2). The  difference in these numbers is due to the fact that the notional amount is  used to calculate payments from the contracts, which are typically a small  percentage of the notional amount. The net present value of these  payments determine, in part, gross positive market value. Because  commercial banks are one of the parties involved in over 95 percent of  financial derivative contracts, these measures are good indicators of the  entire U.S. market. The volatility seen in figure 2 during the latter part of  2007 and 2008 is attributed in part to turmoil in financial markets and  banking consolidation. In part because different types of financial  derivatives are reported differently to IRS by taxpayers and third parties,  and in most cases are not clearly identified as financial derivatives, IRS  told us that data are not available to estimate overall gains and losses of  income earned from financial derivatives.  announcements, and technical advice memorandums. Regulations,  which provide taxpayers with directions on complying with new legislation  or existing sections of the tax code, hold more legal weight than IRS’s  other forms of guidance. Generally, regulations are first published in draft  form in a Notice of Proposed Rulemaking, and final regulations are issued  after public input is fully considered through written comments and  potentially a public hearing. Where new or amended regulations may not  be published in the immediate future, notices are often used to provide  substantive interpretations of the tax code and other provisions of the law.  In addition, IRS issues revenue rulings to provide official interpretations of  the tax code, related statutes, tax treaties, and regulations. These  interpretations are specific to how the law is applied to a particular set of  facts. Revenue procedures provide return filing or other instructions  concerning an IRS position. Private letter rulings are written statements  issued to a single taxpayer that interpret and apply tax laws to that  taxpayer’s specific set of facts. They are not officially published and may  not be relied on as precedent by other taxpayers or IRS.  Announcements, which generally have only immediate or short-term  relevance, summarize laws and regulations without making any  substantive interpretation; state what regulations will say in the future; or  notify taxpayers of the existence of an approaching deadline. Finally,  technical advice memorandums are developed in response to technical or  procedural questions that develop during an examination or a processing  in Appeals.
section_title: Financial Derivatives Do Not Fit Neatly into the Tax System, Allowing Taxpayers to Use Them in Potentially Abusive or Improper Ways
paragraphs: Unique characteristics of financial derivatives make them particularly  difficult for the tax code and IRS to address. The tax code’s current  approach to the taxation of financial derivatives is characterized by many  experts as the “cubbyhole” approach. Under this approach, the tax code  establishes broad categories for financial instruments, such as debt,  equity, forwards, and options, each with its own rules governing how and  when gains and losses are taxed. As new instruments are developed, IRS  and taxpayers attempt to fit them into existing tax categories by  comparing the new instrument to the most closely analogous instruments  for which tax rules exist. However, a new financial instrument could be  similar to multiple tax categories, and therefore IRS and taxpayers must  choose between alternatives. This could result in inconsistent tax  consequences for a transaction that produces the same economic results.
Derivative contracts, particularly those traded over-the-counter, are highly  flexible, allowing taxpayers to structure transactions to take advantage of  the different tax rules for each tax category. Derivatives can also be  coupled with each other and with other types of financial instruments, like  more traditional debt or equity instruments, to create hybrid securities.  Because hybrid securities often do not clearly fall within a single tax  category, it can be challenging for IRS and taxpayers to determine which  tax rules are appropriate, and whether the hybrid should be treated as a  single instrument or broken up into multiple instruments. While the tax  rules for each tax category represent Congress’s and Treasury’s explicit  policy decisions, some of these decisions were made long before today’s  complex financial derivative products were created. The cumulative effect  of these decisions combined with the fact that many financial derivatives  do not fit neatly in any one tax category can result in mistakes or  opportunities for abuse by taxpayers.
subsections: section_title: A Patchwork of Rules from Different Parts of the Tax Code Govern the Taxation of Financial Derivatives
paragraphs: Tax rules governing financial derivatives can be broken down into rules  governing the timing, character, and source of gains and losses, as  described in table 1. These rules vary depending on a number of factors,  including the type of financial derivative product, the underlying reference  item, the transaction’s cash flows, the type of taxpayer, the taxpayer’s  purpose for using the transaction, and applicable anti-abuse rules. Over  time, as financial derivative products have been developed that do not fit  neatly into existing tax categories, numerous tax rules have been created  to address new financial products, sometimes without anticipating the  relationship between those transactions and others. Therefore, tax rules  for financial derivatives can vary widely from one transaction to another.
While the source of gains and losses resulting from financial derivatives is  generally that of the residence of the recipient, the tax rules for timing and  character are more complicated. As stated above, some of these tax rules  depend on the type of financial derivative product. For example,  nonequity options not held to hedge a transaction are taxed under section  1256 of the Internal Revenue Code (IRC), which requires that the timing  of gains and losses are marked-to-market at the end of the tax year, and  that the character of gains and losses is treated as 60 percent long-term  capital and 40 percent short-term capital. Equity options held by dealers  are also taxed under section 1256. However, for equity options not held  by dealers, the timing rules are that gains and losses are not realized until  the contract matures. Depending on the option’s term, the character is  either 100 percent short-term capital gain or loss or 100 percent long-term  capital gain or loss.
Some tax rules for character also depend on the underlying reference  item, regardless of the transaction type. An example of this is a foreign  currency contract (known as a section 988 transaction), which may be  ordinary or capital depending on a variety of factors outlined in IRC  section 988. The gains or losses on a section 988 transaction are  ordinary to the extent they are due to changes in exchange rates.  However, the taxpayer may elect capital treatment in certain instances if  the contract is a capital asset in the hands of the taxpayer and not part of  an offsetting position, also known as a straddle.
Other timing and character rules are based on the purpose of the  transaction, such as transactions used for hedging, which are generally  treated as ordinary and timed according to the hedged item. Regardless  of the type of transaction or reference item, if the transaction qualifies as  a hedge, these rules apply.
There are also timing and character rules that are based on the type of  taxpayer. For example, the rules under IRC section 475 apply to dealers  in securities and, if they elect, commodities dealers and traders in  securities or commodities, who must generally mark-to-market securities  or commodities under IRS section 475 and recognize gains and losses  annually. The character of these gains and losses is ordinary. Since a  securities dealer is typically one of the two parties involved in a financial  derivative transaction, this often results in different tax treatment for both  sides of the transaction. The dealer would generally mark-to-market  annually the gains and losses from a financial derivative contract and  treat the income or losses as ordinary, while the other party to the  transaction would be taxed depending on the factors described in this  section.
Finally, the rules for the timing and character of financial derivatives can  also vary for different types of payments within a single financial  derivative transaction. For example, periodic payments in a NPC are  treated differently than nonperiodic payments. Periodic payments are  taxed as ordinary income and recognized annually on an accrual basis  like interest payments. Nonperiodic payments must be amortized and  recognized as ordinary income over the life of the contract. However,  early termination payments in a NPC are recognized for timing purposes  when they occur, and they give rise to capital gain or loss if the underlying  item is capital. In contrast, nonperiodic, contingent payments do not have  defined treatment; the tax rules only require taxpayers to account for the  payments in a manner consistent with other tax positions. Proposed  regulations issued in 2004 stated that taxpayers could use a  noncontingent swap method to determine the timing and character of  these payments or elect mark-to-market treatment.
There are a number of anti-abuse rules that can supersede the tax rules  described above, which further complicate the tax treatment of a  transaction. Many sections of the tax code exist for the sole purpose of  applying additional rules for certain transactions, including IRC sections  1091 (wash sales), 1092 (straddles), 1233 (short sales), 1258 (conversion  transactions), 1259 (constructive sales), and 1260 (constructive  ownership transactions). For example, under IRC section 1092, for two or  more transactions that are offsetting positions, known as a straddle, a  realized loss on one position is currently deductible only to the extent that  the loss exceeds unrecognized gains in any remaining offsetting  positions. A second example involves constructive sales, or transactions  that are treated as sales for tax purposes even though ownership in the  property may not have legally transferred. Constructive sales include  when a taxpayer enters into a short sale of the same or substantially  identical property, an offsetting notional principal contract with respect to  the same or substantially identical property, or a futures or forward  contract to deliver the same or substantially identical property. Under IRC  section 1259, taxpayers are considered as having sold a position at fair  market value on the date of the constructive sale.
The tax rules for character, timing, and source described above can be  challenging for both taxpayers and IRS to apply. Where these rules  overlap or contradict one another, they can create gray areas that allow  the same economic outcome to be taxed differently. Even anti-abuse  rules, some of which IRS and tax experts believe are largely effective,  can contribute to the uncertainty because determining when to apply  them can be difficult.
section_title: Financial Derivative Transactions with Economically Similar Positions Can Have Inconsistent Tax Treatments
paragraphs: One basic principle of taxation commonly used to evaluate the tax  treatment of financial derivatives is consistency, meaning that  transactions with equivalent economic outcomes are taxed the same. The  tax rules for financial derivatives with equivalent economic outcomes are  not always consistent, in part because of their piecemeal development  over time as well as the difficulty of developing tax rules for products that  are constantly changing. For some types of financial derivatives, similar  transactions can fall under different tax rules, particularly if the  transactions do not fit well into the tax categories of the existing tax code.
While the pretax economic outcome of a taxpayer using a financial  derivative and actually holding the financial asset underlying the  derivative may be the same, due to the inconsistent tax treatment of  derivatives, the after-tax outcome can be starkly different. The flexibility in  financial derivative contracts allows them to be used to mimic different  economic positions. By combining the basic building blocks of financial  derivatives highlighted in table 1, together with traditional instruments like  debt and equity, taxpayers can virtually create any synthetic position that  allows the same economic returns as the reference item without actually  owning the reference item. Financial derivatives therefore allow users, in  many circumstances, to structure transactions to alter the timing,  character, and source of gains and losses to produce more tax-favorable  results. For example, through financial derivatives taxpayers can defer  gains or accelerate losses, change ordinary income into capital gains or  vice versa for losses, or alter the source of the gains to avoid paying  withholding taxes. While permitting taxpayers to elect a more favorable  tax treatment is not uncommon, when they have done so using financial  derivatives, the result has at times been disallowed by Congress. In other  cases, IRS and Treasury have successfully challenged during audit or in  litigation taxpayers’ treatment of financial derivatives.
In certain instances, financial derivative transactions can be used to  produce equivalent economic outcomes that have different tax results  because one financial derivative can fall under numerous tax rules. One  prominent example of this is the credit default swap (CDS), which first  appeared on the market in the early 1990s. As is shown in figure 3, in a  CDS, the buyer pays a periodic fee to the seller in return for  compensation if a specified credit event occurs to a reference item. The  reference item may be bonds or loans from a corporate entity, sovereign  debt, an asset, or an index of these. The credit event may be default,  bankruptcy, debt restructuring, or any number of events related to the  significant loss in value of the underlying reference item.
Although CDSs became prominent in the market in the 1990s, their tax  treatment has remained uncertain. In the absence of guidance, taxpayers  do not take a uniform treatment of CDSs, instead selecting the tax  position that is most favorable. Taxpayers commonly elect NPC treatment  for CDS transactions. As discussed previously, different payments from a  NPC have different character treatments, and CDS users can take  advantage of these differences to lower their tax liability when one party  in the transaction is neutral to the tax results. For example, in a situation  when a taxpayer holds a CDS that has appreciated in value and the other  party is a dealer, rather than hold the contract until maturity and pay  ordinary rates on the income, the taxpayer can terminate the contract  early. By doing so the taxpayer receives a termination payment of the  same economic value but pays lower long-term capital gains rates.  Experts that we interviewed stated that the inconsistent treatment of  CDSs increases compliance risk for taxpayers. In the final guidance,  Treasury and IRS may determine that the tax treatment of CDSs does not  align with how a taxpayer elected to treat a CDS now, and there is a risk  that a different treatment could be imposed on transactions entered into  prior to the new guidance.
Financial derivatives also allow taxpayers to take advantage of the  inconsistencies between asset classes, such as differences in deductions  between payments on debt and equity. Taxpayers have done this with  one type of financial derivative, by coupling a forward contract with the  issuance of debt, which is one type of a mandatory convertible security.  Mandatory convertibles are a broad class of securities linked to equity  that automatically convert to common stock on a specific date, and allow  the issuer to raise capital that is treated as debt in financial statements.  However, interest payments on the issuance can be deducted, which  would not be possible with dividend payments on a more traditional equity  security. In the transaction, a corporation issues units of the security that  consist of two components: a forward contract to purchase the  corporation’s equity, and debt in the form of the corporation’s note. The  purchaser of the unit pledges the note back to the corporation as  collateral to pay the settlement price of the forward contract. If the note  and the forward are treated as a single hybrid instrument for tax  purposes, the single instrument resembles an equity position, and  payments on such a position would not be deductible. Currently the note  and the forward can be separated for tax purposes under certain  circumstances, in which case the corporation can deduct all payments on  the note as interest payments on debt, despite the presence of the  forward contract.
Financial derivatives also have allowed taxpayers to mimic the ownership  of assets such as equities, while achieving a lower tax liability than direct  ownership of those assets. One example of this was the disparate  treatment of dividend payments on U.S. equity and dividend-equivalent  payments from a total return equity swap (equity TRS), held by foreign  entities. Foreign entities must pay 30 percent withholding taxes on any  dividends received from U.S. sources because the dividend is considered  U.S.-source income. However, until recently payments from a swap  based on that U.S. asset would not be subject to withholding taxes, as  swaps are sourced to the residency of the recipient of swap payments,  the foreign entity in the case of the equity TRSs that attempt to avoid  withholding taxes. In order to avoid withholding taxes on dividends, a  foreign entity would enter an equity TRS, replacing the dividends with  dividend-equivalent payments that arise from the swap. In this  transaction, a U.S. financial institution pays the foreign entity a cash-flow  equivalent to the dividends of a given stock plus any appreciation in the  stock price, while the foreign entity pays a floating interest rate used to  enter into the agreement plus any stock depreciation. The contract results  in the foreign entity mimicking stock ownership without paying withholding  tax by taking advantage of differences in source rules for dividend  payments and dividend-equivalent payments. The use of equity TRS by  foreign entities to avoid withholding had become standard practice since  the 1990s, until the Hiring Incentives to Restore Employment (HIRE) Act  statutorily required withholding on dividend-equivalent payments           (see fig. 4). For tax years before the enactment of the HIRE Act, IRS is  challenging equity TRS transactions through the examination process,  arguing that they were used to improperly avoid withholding taxes. In  addition, IRS issued an Industry Director Directive on January 14, 2010,  to assist IRS agents to identify and develop cases with questionable  equity TRS transactions.
Another example where taxpayers have used the inconsistent tax  treatment between financial derivatives and direct ownership of the  underlying asset was the case of a variable prepaid forward contract  (VPFC) held in combination with a share-lending agreement. Taxpayers  attempted to use this transaction to defer income by mimicking a sale of  equity without recognizing the gains for tax purposes. When taxpayers  sell an appreciated security, they must pay short-term or long-term capital  gains taxes upon sale. However, over the past decade, taxpayers have  used VPFCs to monetize gains in a security’s value without paying taxes  at the time of the sale. In situations where VPFCs have been used for this  purpose, taxpayers agree to sell a variable number of shares to the other  party in the transaction, usually an investment bank, at an agreed-upon  date, typically 3 to 5 years in the future. VPFCs are customized to the  investor and an option to cash-settle is usually included in the contract.  The number of shares delivered (or the cash value thereof) is based on a  formula involving the stock price on the contract’s expiration date. The  dealer typically pays the taxpayer between 75 percent and 85 percent of  the market value of the shares up front that is not required to be repaid.  By manipulating differences in timing rules, the VPFC thus closely mimics  the sale of stock, but the income is not recognized for tax purposes until  the contract matures. Because of the variability in the number of  deliverable shares, the transaction avoids anti-abuse rules that do not  permit deferred recognition of prepaid sales (see fig. 5).
While holding a VPFC, taxpayers still retain control of the underlying  asset. To earn a greater return on the VPFC as discussed above,  taxpayers sometimes couple the VPFC with a share-lending agreement.  This type of agreement stipulates that taxpayers lend shares to the  investment bank to sell, invest, or use in other ways the shares in its  course of business. In this manner, the taxpayers have transferred  substantially all of the attributes of owning the shares, but have argued  that the shares have not been sold for tax purposes (see fig. 6).
The current tax treatment is not the only possible method of taxing  financial derivatives, and experts have suggested a number of  alternatives that they believe would adopt a more consistent view of  financial derivatives and potentially reduce abuse. For example, one  common idea is to require mark-to-market treatment on all financial  derivatives for all taxpayers, meaning that all gains and losses from  financial derivatives would be recognized at the end of each tax year, and  to treat all such income as ordinary income. While this approach would  result in higher tax burdens for some, proponents cite benefits, which  include reduced compliance costs and potential for abuse. This report  does not evaluate this approach or any other alternative approaches,  which would require significant changes to the tax code. We have  previously developed criteria for establishing a good tax system, which  include equity; economic efficiency; and simplicity, transparency, and  administrability. Consistency, the criterion used in this report, is related  to simplicity, administrability, and economic efficiency. While the  examples above describe issues that arise from inconsistent tax rules,  any alternative approach would involve tradeoffs among these criteria. In  considering the effects of alternative tax rules on economic efficiency, IRS  and several experts told us that one potential effect of any alternative with  less favorable tax outcomes could be that certain financial sector activity  might leave the United States. Because of their unique position to define  policy and administer the tax code, Treasury and IRS are in the best  position to recommend an alternative approach to the taxation of financial  derivatives.
section_title: Challenges Slow the Development of Guidance on Financial Derivatives Increasing Uncertainty and Potential for Abuse
paragraphs: In their role of implementing tax laws enacted by Congress, Treasury and  IRS play the crucial role of translating tax laws into detailed regulations,  rules, and procedures. When application of the law is complex or  uncertain, as is often the case for financial derivatives, guidance is an  important tool for addressing tax compliance and emerging abusive tax  schemes. Particularly when financial derivative products are new, how  financial derivative products should be taxed under the current tax regime  can be unclear. However, Treasury and IRS face a number of challenges  in developing guidance for financial derivatives that may delay completion  of guidance. Although taxpayers are accustomed to exercising judgment  when taking a tax position for their transactions, the lack of clarity for  many derivatives can lead to heightened compliance risk and abuse.
Taxpayers we interviewed said that Treasury and IRS have not issued  guidance on a number of financial derivative tax issues that have a  significant impact on their decision making. For example, before the  passage of the HIRE Act in 2010, the last guidance IRS issued on  transactions that avoid withholding taxes on dividends similar to cross- border equity TRSs were final regulations in 1997. During the past two  decades, the use of equity TRSs to avoid withholding taxes grew as many  taxpayers interpreted the lack of tax guidance as IRS’s approval of the tax  treatment of the transaction.
Similarly, IRS has not issued final regulations on contingent swaps since  the proposed regulations in 2004, and finalized guidance on the  appropriate tax treatment of CDSs has not been issued since a notice  requesting comment on their tax treatment in 2004 (see fig. 7 for a  timeline). This leaves taxpayers with little clarity on how to treat gains or  losses from a swap payment dependent on a contingency. Contingent  swaps are swaps that contain contingent nonperiodic payments  determined by the occurrence of a specified event, such as the price  movement of an underlying asset. CDSs are a special type of a  contingent swap, where the triggering event is a credit event, such as the  default of debt issued by a third party. According to IRS, the only  requirement for taxpayers is that they clearly reflect income in their  method of accounting for these transactions. IRS first issued a notice  soliciting comments on the tax treatment of contingent swap payments in  2001, which eventually led to a first round of proposed regulations in  2004. These proposed regulations offer two accounting methods:           (1) mark-to-market treatment, or (2) annually projecting the expected  value of the contingent payment and paying the appropriate tax as if it  were a nonperiodic, noncontingent payment, known as the noncontingent  swap method. After issuing the proposed regulations in 2004, IRS has  gone through several internal iterations of draft regulations without issuing  final regulations on contingent swaps.
IRS first learned of CDSs in a request for a private letter ruling from a  taxpayer in 2000. However, IRS did not issue any guidance on CDSs until  2004, when it requested information from taxpayers on four alternative  treatments. In the absence of finalized guidance, the 2004 notice allows  taxpayers to place CDSs in one of four distinct tax categories for financial  instruments. Experts and practitioners told us that the tax treatment for  CDSs is unclear, the alternatives do not necessarily arrive at the same  tax liability, and taxpayers do not uniformly use one of the alternatives.  The lack of guidance has resulted in taxpayers choosing different tax  treatments, and according to some taxpayers we interviewed, deferring  income recognition even when they are reasonably certain of gains.  Taxpayers and experts that we interviewed also stated that the  inconsistent treatment of CDSs increases the tax compliance risk they  face because Treasury and IRS may determine that the final tax  treatment of CDSs will not align with how some taxpayers are treating  CDSs now and that determination may be applied to transactions entered  into in prior years.
The absence of guidance on contingent swaps and CDSs affects IRS’s  ability to assess tax liability and address potential abuse. When exam  teams in IRS identify a potentially abusive financial derivative used by a  taxpayer, they have a number of resources to understand the tax effects  and determine the appropriate tax liability. IRS has specialists in financial  instruments that regularly assist revenue agents, as well as IRS attorneys  who provide specialized legal advice. When an IRS exam division  determines that a potential abuse has a large enough scale to warrant the  necessary resources to address broadly, there are multiple avenues to  raise the issue beyond the particular exam. One of these avenues is the  issuance of guidelines by an IRS exam division to field examiners, such  as an Industry Directive, as was the case with cross-border equity  TRSs. Another mechanism is a request for nonprecedential guidance  from IRS’s Chief Counsel in the form of a legal memorandum to IRS staff.  Issues can also be developed into a series of cases for litigation. For  issues that are broad enough, Chief Counsel can eventually issue  published guidance, which differs from the previous options in that it  typically has a broader legal application. The other alternatives are not  generally legally binding on IRS or taxpayers, except with regard to the  taxpayer involved. As another example, for VPFCs with share-lending  agreements, IRS has issued guidance from exam divisions and Chief  Counsel, and has also developed a number of cases for litigation.
IRS and Treasury issue guidance in the form of regulations, revenue  rulings, revenue procedures, notices, and announcements as well as  other types of guidance. IRS Chief Counsel and Treasury’s Office of Tax  Policy have established a prioritization schedule for developing and  issuing guidance, known as the Priority Guidance Plan (PGP). The PGP  is issued each year and identifies the guidance projects that are the  current IRS and Treasury guidance priorities to be completed over a      12-month period that runs from July 1st to June 30th of that PGP year.  The PGP is available to the public on IRS’s website, and is updated  periodically to include additional guidance project priorities and identifies  which guidance projects have been completed up to that point. However,  periodic updates to the PGP do not identify guidance projects that have  been removed from the plan without having any guidance issued. Not all  guidance projects being worked on are on the PGP, and a number of  pieces of guidance affecting derivatives were not PGP projects. For  example, Notice 2002-35, which addressed tax shelters using NPCs, was  not on the PGP before it was published. The PGP serves as both a public  statement of the guidance taxpayers can expect to receive over a          12-month period and an internal prioritization of resources within IRS and  Treasury. Given the pace at which derivative markets evolve, timely  guidance that addresses tax issues is important to reduce uncertainty and  opportunities for abusive tax strategies. However, Treasury and IRS face  a number of challenges that are discussed below that may delay the  completion of guidance.
subsections: section_title: Between 1996 and 2010 IRS and Treasury Did Not Complete One-Fourth of the Priority Guidance Projects That Involved Financial Derivatives
paragraphs: We analyzed 53 projects that involve financial derivatives that IRS and  Treasury have placed on the PGP since 1996, and found that one-fourth  of the projects were not completed (see table 2). Almost all of the  guidance projects that were completed were published within 2 years of  first appearing on the PGP.
Of the 53 projects on the PGP, IRS and Treasury completed just over half  (29) within their first year on the plan, and removed 5 that were not  completed. Of the 19 projects that remained on the plan for 2 years or  longer, just under half of those (9) were completed and 3 were not  completed and removed. Only 1 of the 7 projects that were on the PGP  for 3 or more years was completed as of the end of the 2010 PGP year  (June 30, 2010). Some of the PGP projects that were removed or not  completed from 1996-2010 dealt with tax issues related to the case  studies described above on contingent swaps and equity TRSs. Figure 8  presents the completion rates for projects related to financial derivatives  on the plan for 1 or more years.
We found, that on the basis of our analysis, projects not issued within       3 years were more likely to be regulations, and related to more complex  issues. Four projects that were on the plan for 4 years or longer without  being completed were regulations addressing particularly controversial  and complicated issues, including (1) capitalization of interest and  charges in straddles under IRC section 263(g), (2) constructive sales  rules under IRC section 1259, (3) contingent payments in notional  principal contracts, and (4) elective mark-to-market accounting for certain  qualifying taxpayers under IRC section 475. While it is important for IRS  and Treasury to finalize guidance on these projects to provide clarity to  IRS and taxpayers, there are a number of challenges involved, including  the patchwork structure of the relevant tax rules and other issues  discussed below. These challenges can make it difficult to issue guidance  on the tax treatment of financial derivatives within the 12-month time  frame established in the PGP.
section_title: Challenges Specific to Financial Derivatives Slow the Guidance Process
paragraphs: While some reasons for the delay in the issuance of guidance on financial  derivatives are common to all guidance projects, financial derivatives  have characteristics that present challenges to IRS and Treasury.
Overcoming these challenges requires time and resources, which can  cause significant delays in issuing guidance that addresses the concerns  facing taxpayers and IRS.
The growing sophistication of financial derivatives and the complex tax  rules governing them have made it difficult for Treasury and IRS to  resolve issues not addressed in legislation or existing guidance. On the  one hand, financial derivative products can involve multiple transactions  and entities, or terms can be altered to reach different tax results. These  factors impede IRS’s ability to identify a product’s economic outcome,  business purpose, and the applicable tax rules. The complexity of VPFCs  is one example where IRS concluded and the courts agreed that some  claimed tax results of the transactions were improper, depending on the  entities involved and what other contracts the VPFCs were coupled with.  On the other hand, multiple tax rules can apply to the same financial  derivative product depending on certain factors such as the type of  taxpayer, the underlying asset, and the context in which the product is  being used. Treasury and IRS often spend years working through these  complexities, and at times have been unable to reach a consensus.
The tax treatment of gains and losses that are contingent on a particular  event is an example of an issue that Treasury, IRS, and private sector  experts have identified as particularly difficult to resolve. Treasury and  IRS legal counsel have devoted considerable resources—as of April 2011  IRS alone had logged nearly 7,800 staff hours over a 9-year period—to  determine the appropriate treatment of contingent swap payments, but  have been unable to reach a consensus. Despite being on the PGP every  year since 2004, when proposed regulations were issued, Treasury and  IRS have been unable to establish the appropriate treatment of  contingent nonperiodic payments in final regulations in large part due to  the complexity of the timing and character issues, as well as other issues  discussed earlier. CDSs have also been the subject of considerable  analysis by Treasury, IRS, and experts on the appropriate tax treatment.  Since issuing a notice in 2004, IRS has not issued any guidance on how  CDSs should be treated for tax purposes. During this time, the structure  of CDS products has diversified from products that were referenced to a  single entity to products based on a pool of obligations, such as an index  and others that are rolled into more complex products. IRS and Treasury  have not established the appropriate treatment of a basic CDS product, a  necessary first step in determining the tax treatment of more complex  CDS products.
The timeliness of Treasury and IRS guidance is also affected by concerns  that issuing new guidance could provide new opportunities for tax abuse.  This is especially true for financial derivatives, as they can easily be  altered to achieve a desired tax effect. IRS told us that whether it issues  further guidance depends on a careful consideration of the possible  unintended effects that guidance might have, and that Treasury and IRS  must carefully evaluate potential guidance changes to help ensure that  while addressing problems in one area they do not raise issues in  another. One example of guidance that Treasury and IRS issued that had  unintended consequences was IRS Notice 97-66, which dealt with  withholding taxes on dividend-substitute payments. Certain payments  made by a domestic entity to a foreign entity may be subject to a             30 percent withholding tax, depending on source rules for that type of  payment. Dividend payments made from owning equity and dividend  substitute payments made from a securities loan are subject to  withholding tax. Prior to the passage of legislation in 2010, some  taxpayers and representatives took the position that dividend-equivalent  payments made from an equity TRS were not subject to withholding tax.  IRS had begun challenging the equity TRS transaction based on judicial  doctrines before the 2010 legislation was enacted.
When Treasury finalized the regulations for dividend-substitute payments  in 1997, tax practitioners were concerned that the regulations could result  in the cascading of withholding taxes in cases where the same shares of  equity were lent between two foreign parties. As seen in figure 9, in this  transaction, the actual dividend and the dividend-substitute payment  would be subject to withholding tax, resulting in withholding tax exceeding  the 30 percent withholding rate.
In response, IRS issued Notice 97-66, intended to avoid cascading  withholding on instances described in the example above. However,  some financial institutions took the position that a literal reading of the  IRS notice meant that a dividend-substitute payment made between two  foreign parties located in jurisdictions subject to the same withholding rate  was not subject to any withholding tax. As seen in figure 10, in this  transaction, the dividend-equivalent payment would not be subject to  withholding tax because of 1991 Treasury regulations and the dividend- substitute payment would not be subject to withholding tax based on the  taxpayer’s interpretation of IRS Notice 97-66. As stated above, Congress  eventually disallowed the avoidance of dividend withholding through this  transaction with the passage of the HIRE Act.
This example and others have made Treasury and IRS aware of the  importance of weighing the need for guidance with the potential that new  guidance may also provide new opportunities for taxpayers to  aggressively reduce their tax liability by altering the structure of a  transaction. The ability of financial market participants to react quickly to  guidance means that Treasury and IRS have to consider the unintended  effects that may occur when issuing guidance. As indicated in the  example above regarding Notice 97-66, the time it takes Treasury and  IRS to identify and mitigate any tax avoidance strategies that arise from  issuing guidance can take a number of years. While timeliness is an  important factor for issuing guidance, taking steps to ensure the  effectiveness and the desired results of the guidance are also important  factors for IRS and Treasury to consider.
The considerable growth in financial derivatives markets has increased  the potential economic effects of guidance issued by Treasury and IRS.  IRS officials have said that in preparing guidance they do not consider the  number of taxpayers taking a certain tax position on a financial derivative  product, but rather they base their decisions on tax rules established in  the IRC, Treasury regulations, and judicial doctrine. However, in light of  the size of a product’s market, officials told us that it is important to  consider the economic effects of their guidance decisions. Economic  consequences of concern identified by officials and experts include losing  financial business overseas to countries with more business-friendly tax  regimes.
An example of one of the economic risks facing IRS and Treasury  surfaced during the process of issuing guidance on how withholding taxes  should apply to cross-border derivative payments. When Treasury and  IRS considered requiring withholding on cross-border equity TRSs in  1998, Congress, IRS, and Treasury faced numerous concerns from  taxpayers that this would limit foreign investment in the U.S.  Withholding has also been a concern for cross-border CDSs. In terms of  notional amount outstanding, the U.S. share of the global CDS market  has, on average, been about one-third of the total market since the end of  2004. IRS staff and private sector experts have said that subjecting CDSs  to withholding tax presents a risk that investors will move their business  overseas. IRS officials said that this has been a major impediment in the  resolution of whether withholding tax should apply to CDSs, particularly in  light of the rapid growth of the credit derivatives market.
As Treasury and IRS work through the many complexities of issuing  guidance for financial derivatives, they also must deal with institutional  factors such as staff turnover, legal authority, and the different roles of  Treasury and IRS that can delay the issuance of guidance. Staff turnover  at IRS and Treasury can bring current market knowledge from the private  sector; however, this turnover can also sometimes affect the timeliness of  guidance. New staff typically have to familiarize themselves with the  issues raised in ongoing guidance projects, may have a different  perspective on the issues raised in the projects, or may believe the  project should have a different priority.
Determining whether Treasury and IRS have the necessary authority to  take certain positions can also delay the development of guidance  projects. Treasury and IRS have at times been reluctant to explore and  ultimately issue guidance to resolve tax issues when there is concern  about whether IRS has the legal authority to require a certain tax  treatment for financial products. For example, although many experts  consider mark-to-market treatment the most appropriate resolution for  contingent swap payments, IRS had concerns about whether it could  require taxpayers to follow mark-to-market treatment for contingent swap  payments.
IRS’s enforcement responsibilities can also affect the time it takes to  complete guidance projects. Treasury and IRS may want to issue  guidance on a certain issue, but if IRS is currently conducting litigation or  auditing on that issue it may be difficult to consider alternative guidance  positions when IRS has already taken a position in an audit or in court.  For example, one of the reasons that Treasury and IRS did not attempt to  address gaps in existing guidance on VPFCs with new guidance was  because IRS was litigating the issue and did not want to publish guidance  that might affect IRS’s case.
section_title: Delayed Guidance Increases Compliance Risk and Costs, among Other Negative Consequences
paragraphs: Delays in the issuance of guidance on financial derivatives have  substantial negative consequences for both taxpayers and IRS, which are  summarized in table 3. However, IRS and Treasury may also benefit by  not issuing timely guidance. The ambiguity that results from a lack of  clear guidance could make taxpayers less willing to take risky tax  positions because of the concern that IRS may determine the position is  abusive in the future.
For taxpayers, one of the main tax-related consequences is the increased  compliance risk associated with uncertainty. (For an example see the  sidebar on Exchange-Traded Notes.) For example, if no clear guidance  exists on how to treat a transaction for tax purposes, taxpayers must  come up with their own position, which may be different than IRS’s  approach and present increased compliance risk. Tax positions may also  differ among taxpayers, which causes a consistency problem for both  taxpayers and IRS. In developing tax positions where no clear guidance  exists, taxpayers often look to other sources of information provided by  IRS and Treasury that lack the legal status of finalized guidance. Tax  experts said that they prefer written guidance to informal statements  made by agency officials at conferences, which do not necessarily  represent IRS’s official position on a transaction. In addition, taxpayers  rely on nonprecedential advice that IRS issues to either individual  taxpayers or to IRS exam teams. If IRS disagrees with a taxpayer’s  position, the taxpayer is at risk of either penalties or litigation costs if the  taxpayer decides to challenge the agency. If guidance is later issued that  affects positions taken by taxpayers retroactively, this could put  taxpayers’ current positions at risk of being noncompliant, although  officials said it may be unlikely that Treasury and IRS would do this, as  long as the taxpayer’s method was reasonable and consistently applied.
Another consequence that the absence of guidance results in is imperfect  market competition. According to market participants, because most  derivatives are not tax driven, contracts may be executed even if the tax  results are unclear. Taxpayers may look for other parties in a transaction  who are willing to take on the additional tax risk, resulting in what one  expert called a “race to the bottom” as parties vie for business by taking  on riskier tax positions. In addition, all of these issues can reduce  taxpayers’ confidence in the fairness of the tax system.
See IRS Revenue Ruling 2008-1 and IRS Notice 2008-2.
For IRS, one negative consequence of delays in guidance on financial  derivatives is increases in time and resources spent on examinations and  litigation. Without clarity on a tax issue, audit teams must often spend  more resources examining the tax results of derivative transactions,  which may include requesting advice from IRS Chief Counsel, often a  time-consuming process. IRS staff told us that having clear, timely  guidance can significantly reduce the amount of time and uncertainty  revenue agents and IRS counsel encounter resolving tax issues during an  exam. If taxpayers and revenue agents have divergent views on tax  positions, a technical advice memorandum or other legal memorandum  may be requested, which can increase the amount of time in exam. If IRS  is unable to issue guidance on a transaction, they may pursue a litigation  strategy, which itself can take years and require a great deal of resources  from both IRS and the taxpayer.
Another negative consequence for IRS is that in the absence of guidance  taxpayers may attempt to take positions that may be abusive. (For an  example see the sidebar on Variable Prepaid Forward Contracts.) For  both cross-border equity TRSs and VPFCs, delays in guidance from IRS  led to the transactions becoming more widespread throughout the market.  The burden may be increased on exam teams to address a greater  number of completed transactions. Delays in issuing guidance can also  put IRS’s reputation at risk. Tax experts and practitioners that we spoke  with expressed frustration at the delay in the issuance of guidance on  financial derivatives and in the lack of information on the status of  guidance projects, which negatively affected their perspectives of IRS.
section_title: Taxpayers are Unaware of the Status of Guidance Projects for Financial Derivatives
paragraphs: IRS and Treasury guidance priorities may change due to a number of  factors, including changes in legislation, policy, market circumstances,  and management agendas. Taxpayers need to know about these  changes when they affect their tax planning and business decisions. As  discussed earlier, one-fourth of derivative guidance projects were not  completed between 1996 and 2010, and tax experts and practitioners that  we spoke with were not aware of the status and prioritization of many of  these guidance projects. Tax experts and practitioners stated that  information about the status of projects was not publicly available, and  they often only knew about a project’s status through informal statements  made by IRS and Treasury officials at conferences and other meetings.  IRS will purposely keep some guidance projects off the public list when  the issue is legally sensitive and could negatively affect IRS’s efforts in an  audit or litigation if the guidance projects were publicly announced.
The current system for communicating the PGP does not allow IRS to  effectively communicate the status of guidance projects to taxpayers. For  most years since 1996, IRS has issued periodic updates on its website to  the PGPs after initial plans were released, listing projects that were added  or completed during the year. All PGPs, whether initial or updated, are  potentially subject to change. However, because projects can be added to  the PGP at any time without an accompanying change in the publicly  available plans, changes in guidance prioritization are not always clearly  communicated to taxpayers. In addition, PGPs do not include target  completion dates, something IRS uses internally, which would give  taxpayers a clearer timeframe for expecting guidance. Therefore,  taxpayers lack clarity as to when they can expect guidance on issues that  IRS and Treasury have publicly stated are priorities. While there may be  challenges and risks in communicating more detailed information and  updated status, particularly when there may be unanticipated setbacks in  the development of guidance, other federal agencies routinely do so.
Providing status information for PGP projects would require IRS to  maintain reliable internal monitoring data on guidance projects. IRS Chief  Counsel uses a data management system, Counsel Automated Systems  Environment – Management Information System (CASE-MIS), to track  progress of guidance projects and monitor interim milestones in project  lifecycles. CASE-MIS has been available since 1996, and was modified in  2008. The effectiveness of this system has been critiqued multiple times  over the past 10 years by the Treasury Inspector General for Tax  Administration, and in response IRS has made improvements to the  monitoring of projects in the database. In our own review of data used  by IRS to monitor guidance projects, we found a number of data reliability  issues that may impede the agency’s ability to effectively monitor  guidance projects in order to report status to taxpayers. Most notable, the  current status and target date of projects are not consistently recorded  correctly for all projects. In addition, discerning when a project moved  onto the PGP, its date of publication, and when or why it was removed  without publication is difficult. This information is essential for IRS and  Treasury to effectively manage the guidance process and to  communicate project status to taxpayers. Although status information can  be collected manually, the electronic management system is intended to  improve efficiency and reporting capability by avoiding time-consuming  manual data collection and processing. Since 2008, IRS has been taking  steps to improve the effectiveness and reliability of CASE-MIS, including  the issuance of staff memorandums and closer attention to reliable data  entry, with the purpose of increasing efficiency, productivity, and decision  making.
section_title: Opportunities Exist for IRS to Leverage Information from SEC and CFTC on Financial Derivatives
subsections: section_title: IRS Does Not Systematically or Regularly Communicate with SEC or CFTC on Financial Derivatives
paragraphs: Currently, IRS does not systematically or regularly communicate with  SEC or CFTC on financial derivatives. IRS’s 2009-2013 Strategic Plan  lists strengthening partnerships across government agencies to gather  and share additional information as key to enforcing the law in a timely  manner to ensure taxpayers meet their obligations to pay taxes. SEC’s  and CFTC’s oversight role for financial derivative markets make them key  agencies for IRS to partner with on financial derivatives. Both regulatory  agencies told us that opportunities may exist to share additional  information on financial derivatives with IRS. However, IRS’s ability to  share taxpayer information with other federal agencies is limited under  IRC section 6103, which governs the confidentiality of taxpayer data. IRS  officials say that the lack of reciprocal information sharing is an  impediment to effective collaboration with SEC and CFTC.
IRS has occasionally received information from SEC on financial  derivatives that were suspected of being used for abusive tax purposes.  Such information, however, is received only on an ad hoc basis, either  through requests initiated by IRS or referrals from SEC. SEC officials told  us that when potential tax abuses have been identified and shared with  IRS, the SEC examiner involved in the case typically had some tax  expertise or had worked with IRS in the past. For example, in 2008, SEC  examiners discovered a strategy employed by hedge funds to structure  short-term capital gains into long-term capital gains through the use of  options. This information was referred to IRS because SEC staff believed  that IRS may conclude that the structuring of transactions in this manner  may result in an incorrect treatment of capital gains. IRS said that this  information was essential to the eventual development and issuance of  related guidance. However, agency officials told us that SEC and CFTC  examiners often do not have tax expertise. As a result, potential tax  abuses may not be identified and shared with IRS.
section_title: Information from SEC and CFTC Could Help IRS Identify New Products, Emerging Trends, and Relevant Issues
paragraphs: The proliferation of financial derivatives present a challenge for IRS in  identifying potential abuses and ensuring timely guidance addresses the  full range of financial derivative products. In recent years, new uses of  financial derivative products have been introduced, and abusive uses  have spread faster as technology developments have made it easier to  create new products.
In the past, IRS met regularly with a group of federal agency officials,  including those from SEC and CFTC, academics, and other market  experts, to discuss financial products, including financial derivatives, and  market trends. The group was established by an academic institution and  met for about 10 years beginning in 1990, and participants joined the  group by invitation. IRS and others who were part of the group told us that  academic sponsorship encouraged both federal agency and private  sector experts to join the group and candidly share information on new  financial derivative products and uses. According to Treasury officials,  regularly participating in these meetings with officials from SEC and  CFTC and the private sector helped them to (1) identify new financial  derivatives, (2) improve their understanding of these new products,         (3) become aware of regulatory schemes that may have tax implications,  and (4) make contacts with other knowledgeable agency officials and  experts in financial derivative products. IRS told us that understanding all  sides of a financial derivative transaction, both tax and regulatory, helps  to clarify the purpose of the transaction and reveal potential tax abuse.  Since the group disbanded after the academic sponsorship dissolved,  there has been no regular, coordinated communication process for  sharing information on financial derivatives between IRS and SEC and  CFTC. According to IRS officials, such a process could help IRS ensure  they are fully using all available information to identify and address  compliance issues and abuses related to financial derivatives.
In addressing problems in financial markets that emerge quickly, we have  found that collaboration between federal agencies is especially important  for federal agencies to maximize performance and identify and resolve  problems faster. IRS officials told us that they typically uncover new  financial derivative abuses during an audit, meaning by the time IRS  identifies the financial derivative product, and issues guidance, the market  for a financial derivative product can be relatively large and developed.  SEC may identify new products and emerging trends in financial  derivatives trading before IRS because new products on exchanges must  be approved by SEC before they can be traded, and others may be  disclosed in financial statements. According to IRS officials, improved  collaboration could help IRS more quickly identify and analyze emerging  financial trends and new products in the financial derivatives market  before taxpayers even file their tax returns.
According to IRS officials, having a more regular way to obtain  information about certain sales reported to SEC in disclosures of insider  trading could have sped IRS’s identification of the use of VPFCs with  share-lending agreements. When taxpayers deferred income recognition  by not considering a VPFC and share-lending agreement as constituting  a sale on their tax return, some taxpayers reported the transaction as a  sale for SEC purposes. IRS officials obtained this information, but had  they been regularly and systematically communicating with other agency  officials on financial derivatives, problems with these transactions may  have been identified earlier. IRS officials believe that because certain  information on financial derivatives may be reported for both regulatory  and tax purposes, reviewing certain types of transactions collaboratively  with SEC and CFTC could help IRS better identify abuse. For example,  IRS told us that certain information on financial derivatives from SEC  Form 4s, which relate to insider trading, and 10Ks have been useful for  identifying new financial derivative products and potential tax issues.
Federal banking regulators, such as OCC, also have information on  financial derivatives. Although the federal banking regulators do not  oversee derivatives markets, their oversight of banking institutions  includes evaluations of risks to bank safety and soundness from  derivatives activities. For example, as we reported in 2009, their oversight  captures most CDS activity because banks act as dealers in the majority  of transactions and because they generally oversee CDS dealer banks as  part of their ongoing examination programs. Furthermore, as OCC- regulated banks may only engage in activities deemed permissible for a  national bank, the agency periodically receives requests from banks to  approve new financial activities, including derivatives transactions.  Information collected during these reviews may provide IRS with  information on financial derivatives.
As we were completing our audit work, IRS officials told us that they had  recently begun developing plans to have regular meetings with SEC to  discuss new products and emerging issues related to financial  derivatives. In previous work, we have established best practices on  interagency coordination to help maximize results and sustain  collaboration. These best practices suggest that agencies should look  for opportunities to enhance collaboration in order to achieve results that  would not be available if they were to work separately. Federal agencies  can enhance and sustain collaborative partnerships and produce more  value for taxpayers by applying the following eight best practices:  1.  Define and articulate a common outcome.  2.  Establish mutually reinforcing or joint strategies.  3.  Identify and address needs by leveraging resources.  4.  Agree on roles and responsibilities.  5.  Establish compatible policies, procedures, and other means to  operate across agency boundaries.  6.  Develop mechanisms to monitor, evaluate, and report on results.  7.  Reinforce agency accountability for collaborative efforts through  agency plans and reports.  8.  Reinforce individual accountability for collaborative efforts through  performance management systems.
These best practices would support a collaborative working relationship  between the IRS and SEC and CFTC. While we generally believe that the  application of as many of these practices as possible increases the  likelihood of effective collaboration, we also recognize that there is a wide  range of situations and circumstances in which agencies work together.  Following even a few of these practices may be sufficient for effective  collaboration.
section_title: Conclusions
paragraphs: Although financial derivatives enable companies and others to manage  risks, some taxpayers have used financial derivatives to take advantage  of the current tax system, sometimes in ways that courts have later  deemed improper or Congress has disallowed. The tax code establishes  broad categories for financial instruments, such as debt, equity, forwards,  and options, each with its own tax rules governing how and when gains  and losses are taxed. However, as new financial derivative products and  uses are developed, they could be similar to multiple tax categories, and  therefore IRS and taxpayers must choose different tax treatments. In  certain instances, this has allowed economically equivalent outcomes to  be taxed inconsistently. Without changes to the approach to how financial  derivatives are taxed, the potential for abuse continues. Experts have  suggested alternative approaches that they believe would provide more  comprehensive and consistent treatment. However, each alternative  would present tradeoffs to IRS and taxpayers, including tradeoffs to  simplicity, administrability, and economic efficiency. This report does not  address or evaluate alternatives for taxing financial derivatives. Because  of their unique role in defining policy and administering the tax code,  Treasury and IRS are best positioned to study and recommend an  alternative approach to the taxation of financial derivatives.
Outside of any comprehensive changes to the current approach to the  taxation of financial derivatives, one way that Treasury and IRS address  potential abuses and provide clarity to tax issues is through its taxpayer  guidance. The lack of finalized guidance has negative consequences for  both IRS and taxpayers, including uncertainty that inhibits IRS staff during  audits and litigation and leaves taxpayers uncertain about whether they  have appropriately determined their tax liabilities. However, challenges  that IRS and Treasury face in developing guidance for financial  derivatives, including the risk of adverse economic effects of guidance  changes and the complexity of financial derivative products, have resulted  in some PGP projects taking longer than the 12-month period established  in the plan. As such, uncertainty is heightened because taxpayers may  not be aware when projects are going to take longer than the 12-month  period and IRS does not provide public updates to the PGP as changes  occur to project status, priorities, and target dates.
The growth in the complexity and use of financial derivatives presents  another challenge for IRS. IRS sometimes identifies new financial  derivative products or new uses of existing products long after they have  been introduced into the market. Consequently, IRS is not always able to  quickly identify and prevent potential abuse. One way to identify new  products or new uses of products in a timelier manner could be through  increased information sharing with SEC and CFTC given their oversight  role of financial derivative markets and products. Our prior work suggests  that there may also be opportunities for bank regulators to share any  knowledge of derivatives that they gain. This would be consistent with  IRS’s goal of strengthening partnerships across government to ensure  taxpayers meet their obligations to pay taxes.
section_title: Recommendations for Executive Action
paragraphs: To better ensure that economically similar outcomes are taxed similarly  and minimize opportunities for abuse, the Secretary of the Treasury  should undertake a study that compares the current approach to  alternative approaches for the taxation of financial derivatives. To  determine if changes would be beneficial, such a study should weigh the  tradeoffs to IRS and taxpayers that each alternative presents, including  simplicity, administrability, and economic efficiency.
To provide more useful and timely information to taxpayers on the status  of financial derivative guidance projects, the Secretary of the Treasury  and the Commissioner of Internal Revenue should consider additional,  more frequently updated reporting to the public on ongoing projects listed  in the PGP, including project status, changes in priorities, and target  completion dates both within and beyond the 12-month PGP period.
To more quickly identify new financial derivative products and emerging  tax issues, IRS should work to improve information-sharing partnerships  with SEC and CFTC to better ensure that IRS is fully using all available  information to identify and address compliance issues and abuses related  to the latest financial derivative product innovations. IRS should also  consider exploring whether such partnerships with bank regulatory  agencies would be beneficial.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Secretary of the Treasury and the  Commissioner of Internal Revenue for review and comment. Treasury  disagreed with our first recommendation to undertake a study that  compares the current approach to alternative approaches for the taxation  of financial derivatives. Treasury cited a body of literature written by  academics, practitioners, and others that considers the subject. Treasury  also mentioned that Congress has resources available, such as the Joint  Committee on Taxation, which could advise them about alternative  approaches to the taxation of financial derivatives. Treasury said that its  resources would be better spent drafting and issuing guidance on these  subjects. Treasury also noted that it is available to assist the Ways and  Means Committee and the Finance Committee in any undertaking  concerning alternative approaches to the taxation of financial derivatives.
In our report, we describe how the current approach to the taxation of  financial derivatives results in inconsistent tax consequences for  transactions that produce similar economic outcomes. We cite the  existing body of literature and alternatives to the current approach of  taxing financial derivatives proposed by some tax experts and  practitioners that they believe would adopt a more consistent and  comprehensive view of financial derivatives and potentially reduce abuse.  However, no consensus has emerged on these issues from existing  literature or from the resources available to Congress. As the tax policy  setting body for the executive branch, the Treasury Department, in  consultation with IRS, is uniquely suited to weigh the alternative  approaches and, along with Congress, make judgments as to which is  best for the economy, tax administration, and the proper application of  sound tax principles. While Treasury states it would rather focus on  guidance development to address tax compliance and emerging abusive  tax schemes, the current piecemeal development of guidance as well as  the difficulty of developing tax rules for new products has presented  challenges and opportunities for abuse. We believe that as the locus of  tax policy expertise in the executive branch, Treasury has a responsibility  to make proposals to overcome the deficiencies to the current approach  to taxing financial derivatives. Towards that end, we recommended  Treasury should undertake a study that compares the current approach to  alternative approaches to the taxation of financial derivatives. Regardless  of whether Treasury decides it needs a study to make such proposals,  achieving a more comprehensive approach is the desired end.
IRS and Treasury disagreed with our second recommendation to provide  more timely and useful information to taxpayers on the status of financial  derivative guidance projects. IRS said that while it firmly supports  transparency in the regulatory process, officials do not believe that the  additional reporting recommended would be worth the additional  resources such reporting would require. They believe that the annual  updates provide an appropriate measure of the status of projects.  Treasury also said that it would be difficult to provide precise predictions  of when guidance would be issued and that attempting to pinpoint the  timing of when guidance might be released would not necessarily be that  helpful.
We agree that it is important for IRS and Treasury to balance the  usefulness of additional reporting on the status of priority guidance  projects with any additional administrative burden. However, Treasury  and IRS also need to ensure that taxpayers have sufficient information to  make intelligent decisions. In this report, we describe that one-fourth of  financial derivative guidance projects on Treasury and IRS’s PGP were  not completed between 1996 and 2010. A number of the guidance  projects that were not completed were on the PGP for 3 or more years,  and tax experts and practitioners that we spoke with said they were not  aware of the status and prioritization of many of these guidance projects.  In recommending more frequent updates to the public on priority  guidance projects, we recognize the difficulty in estimating how long the  development of a particular piece of guidance may take. Our  recommendation did not envision pinpointing the timing of when guidance  may be released, but rather being timelier in officially revising estimates  when the agencies know that announced time frames are no longer  realistic. When it becomes likely that a project on the PGP will not be  completed in the plan year because of delays or a change in priorities, the  public should be alerted. Tax experts and practitioners we interviewed  said that information about the status of projects was not publicly  available, and that they often only knew about a project’s status through  informal statements made by IRS and Treasury officials at conferences  and other meetings. Such information on the status of guidance projects  should be provided to all interested taxpayers as part of formal periodic  updates to the PGP. Some of this information is already available in IRS’s  internal guidance tracking database and providing it would, therefore,  likely add little additional administrative burden for the agencies.
IRS agreed with our third recommendation to improve information-sharing  partnerships with the SEC and CFTC. IRS said that they recognize the  benefits of systematically gathering and sharing information that would  identify new financial products and the potential for abusive tax avoidance  transactions.
IRS’s and Treasury’s letters commenting on our report are presented in  appendix III and IV. IRS also provided technical comments, which we  incorporated as appropriate.
As we agreed with your office, unless you publicly announce the contents  of this report earlier, we plan no further distribution of it until 30 days from  the date of this report. At that time, we will send copies of this report to  the Chairmen and Ranking Members of other Senate and House  committees and subcommittees that have appropriation, authorization,  and oversight responsibilities for IRS. We are also sending copies to the  Commissioner of Internal Revenue, the Secretary of the Treasury, the  Chairman of the IRS Oversight Board, and the Director of the Office of  Management and Budget. Copies are also available at no charge on the  GAO website at http://www.gao.gov.
If you or your staffs have any questions or wish to discuss the material in  this report further, please contact me at (202) 512-9110 or  brostekm@gao.gov. Contact points for our offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  GAO staff members who made major contributions to this report are listed  in appendix V.
section_title: Appendix I: Additional Methodology Details
subsections: section_title: Criteria to Evaluate How Well the Tax System Addresses Financial Derivatives
paragraphs: To evaluate the tax rules for financial derivatives, our criterion was  consistency, meaning that economically similar transactions are taxed  similarly. We identified this criterion through interviews with tax experts  and a review of research articles on the taxation of financial derivatives.  This was the most commonly mentioned criterion by these sources, and  also the most applicable to our objectives. We evaluated the tax effects of  financial derivatives based on testimonial evidence, academic studies,  and our analysis of four financial derivative case studies. These case  studies included cross-border total return equity swaps, variable prepaid  forward contracts, credit default swaps, and contingent swaps. Through  interviews with Department of the Treasury (Treasury) and Internal  Revenue Service (IRS) staff, former Treasury staff, and other tax experts,  we identified how the transactions were structured, when IRS first  recognized these transactions, and all guidance issued by Treasury and  IRS on these issues. We also identified the challenges of issuing timely  guidance and the consequences for IRS and taxpayers due to delayed or  absent guidance. Based on these case studies, we applied the criterion of  consistency to highlight how the structure of these transactions was not in  line with the criterion.
section_title: Criteria and Methodology to Evaluate the Issuance of Published Guidance Related to Financial Derivatives
paragraphs: To evaluate IRS’s and Treasury’s ability to publish timely guidance on  emerging financial derivative tax issues, we analyzed guidance projects  from Treasury and IRS’s Priority Guidance Plan (PGP). We also  performed an in-depth study of four case studies of specific financial  derivative transactions that have had delayed guidance. According to  Treasury and IRS, the PGP is used each year to identify and prioritize the  tax issues that should be addressed through regulations, revenue rulings,  revenue procedures, notices, and other published administrative  guidance. The PGP focuses resources on guidance items that are most  important to taxpayers and tax administration. To measure the timeliness  of guidance on financial derivative tax issues, we used the criterion  established by Treasury and IRS that guidance projects on the PGP are  intended to be published within the 12-month period of the PGP year.
We reviewed the projects included on the PGP from 1996 to 2010, the  years for which IRS had electronic records available. We submitted a  data request to IRS Chief Counsel from their Counsel Automated  Systems Environment-Management Information System (CASE-MIS),  which the agency uses to track the development of guidance projects. We  searched the database for projects, focusing primarily on the units within  Chief Counsel that work closest with financial derivatives. We selected  projects whose description mentioned either a type of derivative in  particular (future, forward, swap/notional principal contract, or option), a  section of the Internal Revenue Code that directly affects financial  derivatives, or a use or abuse of financial instruments that typically  involves derivatives (such as hedging or straddles). In reviewing the data  from CASE-MIS, we encountered some data issues, such as the same  guidance project showing up more than once on the same PGP year or  guidance projects with start dates after their publication date, among  other issues, which led us to conclude that the CASE-MIS data were  unreliable for an analysis of all guidance projects, which did not allow a  comparison of derivative projects to nonderivative projects. However, we  did determine that the use of CASE-MIS data was sufficiently reliable to  analyze the subset of projects dealing with financial derivatives alone.  This is because the small number of derivative projects allowed us to  address and resolve individually each of the data issues we encountered,  something not feasible for the much larger dataset of all PGP guidance  projects. After identifying the financial derivative guidance projects based  on the criteria above we submitted the list to IRS Chief Counsel for their  verification. They identified additional projects we had not found in our  prior searches, some of which did not meet our criteria for selecting  projects or our scope and were not included. In total, we identified 53  guidance projects in the PGP related to financial derivatives.
To analyze the timeliness of the identified projects, we calculated  completion rates for projects that were completed within the 1-year  criterion, and rates for projects that were completed at any point. These  calculations only included projects that were on the plan before the  current PGP year. To take account of the fact that guidance projects can  be censored (i.e., have not yet been completed within the time frame of  the study or were dropped from the PGP before they had a chance to be  completed), we estimated completion rates over time using hazard rates.  Hazard rates calculate the rate at which projects are complete in a period,  given that they were open at the start of that period, and therefore allow  us to adequately account for censored projects. In the report, we refer to  hazard rates as completion rates. The small sample size does not allow  us to draw conclusions on the process for issuing guidance in IRS and  Treasury more generally beyond financial derivatives or the time period  under study.
To further examine the IRS and Treasury guidance process and evaluate  the challenges that IRS and Treasury face when issuing guidance on  financial derivatives, we selected four financial derivative case studies  that have been on the PGP and have been highlighted in interviews with  Treasury, IRS, and tax practitioners as financial derivative transactions  that presented tax abuse or tax compliance concerns. The case studies  that met this criterion included contingent payment swaps, credit default  swaps, variable prepaid forward contracts, and cross-border total return  equity swaps. For each of the four case studies, we interviewed IRS and  Treasury officials and other tax experts, and analyzed research on the  taxation of derivatives, to discuss the identification and progression of  these transactions as guidance projects, the challenges IRS and Treasury  face issuing guidance on these transactions, and the consequences IRS  and taxpayers face from a lack of guidance.
section_title: Appendix II: Financial Derivative Priority Guidance Projects
subsections: section_title: Description of guidance projects 1
paragraphs: Information reporting requirements for securities futures  contracts  Tax shelter using options to shift tax basis  Tax shelter using foreign currency straddle  Tax shelter using foreign currency straddle  Tax shelter using foreign currency options  Tax shelter using S corporations and warrants  Tax shelter using options to toggle grantor trust status  Exchange traded notes (prepaid forward contracts)
This project was completed in 2007, when it was no longer on the Priority Guidance Plan (PGP). To  be designated as completed for our analysis, a project must be completed while on the PGP.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: Comments from the Department of the Treasury
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, the following staff made  significant contributions to this report, Jay McTigue, Assistant Director;  Kevin Averyt; Timothy Bober; Tara Carter; William Cordrey; Robin  Ghertner; Colin Gray; George Guttman; Alex Katz; Natalie Maddox;  Matthew McDonald; Edward Nannenhorn; Jose Oyola; Andrew Stephens;  Jason Vassilicos; and James White.
section_title: Glossary
paragraphs: The process of dividing a financial instrument into its component parts.
subsections: section_title: Constructive Ownership Transaction
paragraphs: Under Internal Revenue Code (IRC) section 1260, gains from  constructive ownership transactions are taxed as ordinary income and not  capital gains to the extent that such gains exceed the net underlying long- term capital gains and impose accompanying interest charges. Section  1260 applies to derivatives that stimulate the return of certain assets,  such as a hedge fund or another pass-though entity by offering the holder  substantially all of the risk of loss and opportunity for gain from the  underlying asset.
section_title: Constructive Sale
paragraphs: A transaction where a taxpayer attempts to obtain economic gains from  the sale of an appreciated position without legally transferring ownership  and triggering taxable income. IRC section 1259 contains rules that affect  the treatment of gains from constructive sales.
section_title: Contingent Swap
paragraphs: A swap contract in which a payment is contingent or otherwise conditional  on some event occurring during the period of the contract.
section_title: Conversion transaction
paragraphs: A transaction that generally consists or two or more positions taken with  regard to the same or similar investments, where substantially all of the  taxpayer’s return is attributable to the time-value of the taxpayer’s net  investment in the transaction. IRC section 1258 contains rules for the  treatment of conversion transactions.
Credit Default Swap (CDS)  Bilateral contract that is sold over-the-counter and transfers credit risk  from one party to another. The seller, who is offering credit protection,  agrees, in return for a periodic fee, to compensate the buyer, who is  buying credit protection, if a specified credit event, such as default,  occurs.
See gross positive fair value.
section_title: Forward
paragraphs: A privately negotiated contract between two parties in which the forward  buyer agrees to purchase from the forward seller a fixed quantity of the  underlying reference item at a fixed price on a fixed date.
section_title: Future
paragraphs: A forward contract that is standardized and traded on an organized  futures exchange.
section_title: Gross Positive Fair Value
paragraphs: The sum total of the fair values of contracts owed to commercial banks.  Represents the maximum losses banks could incur if all other parties in  the transactions default and the banks hold no collateral from the other  party in the transaction and there is no netting of the contracts.
section_title: Hedging
paragraphs: The process whereby an entity will attempt to balance or manage its risk  of doing business or investing.
For tax purposes, under mark-to-market rules, any contract held at the  end of the tax year will generally be treated as sold at its fair market value  on the last day of the tax year, and the taxpayer must recognize any gain  or loss that results.
section_title: Mandatory Convertible
paragraphs: Security linked to equity that automatically converts to common stock on  a prespecified date.
section_title: Notional Principal Contract (NPC)
paragraphs: According to section 1.446-3 (c)(1)(i) of title 26, Code of Federal  Regulations, a financial instrument that provides for the payment of  amounts by one party to another at specified intervals calculated by  reference to a specified index upon a notional principal amount, in  exchange for specified consideration or a promise to pay similar amounts.
section_title: Notional Amount
paragraphs: Total notional amount represents the amount of the reference items  underlying financial derivative transactions, and is the amount upon which  payments are computed between parties of financial derivatives  contracts. Notional amount generally does not represent money  exchanged, nor does it represent the risk exposure.
section_title: Option
paragraphs: Contracts that gives the holder of the options the right, but not the  obligation, to buy (call option) or sell (put option) a specified amount of  the underlying reference item at a predetermined price (strike price) at or  before the end of the contract.
section_title: Over-the-Counter Derivatives
paragraphs: Privately negotiated financial derivative contracts whose market value is  determined by the value of the underlying asset, reference rate, or index.
section_title: Short Sale
paragraphs: This type of transaction occurs when a taxpayer borrows property (often a  stock) and then sells the borrowed property to a third party. If the short  seller can buy that property later at a lower price to satisfy his or her  obligation under the borrowing, a profit results; if the price rises, however,  a loss results. IRC Section 1233 contains rules that can affect the  treatment of gains and losses realized on short sales.
section_title: Straddle
paragraphs: The value of offsetting positions moves in opposite directions so a loss on  one position is cancelled out by the gain on an offsetting position. IRC  Section 1092 contains rules that can affect the treatment of straddles.
section_title: Total Return Equity Swap
paragraphs: A contract that provides one party in the transaction with the total  economic performance from a specified reference equity or group of  equities and the other party in the transaction receives a specified fixed or  floating cash flow that is not related to the reference equity. A cross- border total return equity swap is a contract that occurs between a  domestic and foreign party.
section_title: Variable Prepaid Forward Contract (VPFC)
paragraphs: Agreement between two parties to deliver a variable number of shares at  maturity (typically 3 to 5 years) in exchange for an up-front cash payment,  which generally represents 75 to 85 percent of the current fair market  value of the stock. The VPFC usually has a cash settlement option in lieu  of shares at maturity.
section_title: Wash Sale
paragraphs: A wash sale is when a taxpayer acquires a stock or security within 30  days of selling a substantially similar stock or security; under IRC section  1091, the taxpayer is not generally permitted to claim a loss on such a  sale.