IRS on Financial Instruments

New Tax Law Creates Two New Financial Instruments

By George G. Jones, J.D., LL.M., Managing Editor, CCH Washington, D.C. Office, Contributing Author, CCH Focus.

he Community Renewal Tax Relief Act of 2000 (P.L. 106-554) introduced two new financial instruments that will provide investors with special tax benefits and advantages. They are ownership interests in community development entities that pass along the new markets tax credit to investors and securities futures contracts that result in capital gains and losses. Here are some of the basic rules and advantages for each of these new investment vehicles.

New Markets Tax Credit

A new tax credit — the new markets credit — has been created to spur investment in low-income or economically disadvantaged areas. The new markets tax credit (part of the general business credit) is 5 percent of a “qualified equity investment” in a qualified community development entity (CDE) as of the original issue date. A 5-percent rate applies for the first three “allowance dates” and increases to 6 percent for each of the four remaining allowance dates. The allowance dates are the initial offering date and the first six anniversary dates of the initial offering date. Thus, the total credit is 39 percent and is claimed over seven annual allowance dates.

Qualified equity investment. A qualified equity investment is the cost of any stock in a corporation or any capital interest in a partnership that is a qualified CDE if: (1) the investment is acquired on the original issue date solely in exchange for cash, (2) substantially all of the cash is used to make qualified low-income community investments (an 85-percent safe harbor applies), and (3) the investment is designated by the qualified CDE for new markets credit purposes.

With respect to (1), above, the investments will maintain their characterization for subsequent purchasers, allowing the credit to continue to be claimed.

Community development entity. A qualified community development entity is any domestic corporation or partnership:

whose primary mission is serving or providing investment capital for low-income communities or persons,
that maintains accountability to residents of low-income communities through representation on any governing or advisory boards of the entity, and
is certified by the Secretary of the Treasury as an eligible CDE.

Limitations. National limitations are imposed on the amount of investments to be used to claim the new markets tax credit. The amount gradually increases from $1 billion in 2001 to $3.5 billion in 2006 and 2007. The Treasury Secretary is authorized to allocate the amounts to qualified CDEs, giving priority to CDEs that have a record of successfully providing capital or technical assistance to disadvantaged businesses or communities. Priority will also be given to CDEs that intend to satisfy the requirements of investing substantially all of the cash from the equity offering in low-income community investments in one or more businesses that are unrelated to the majority equity interest.

Securities Futures Contracts

The 2000 Act generally treats gain or loss on a “securities futures contract” as a gain or loss from the sale or exchange of property that has the same character as the property, to which the contract relates, has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by the taxpayer). As a result, if the underlying security is a capital asset, the gain or loss on the sale or exchange of a securities futures contract will be treated as the sale or exchange of a capital asset.

Securities futures contracts are not new but will be given new life from the certainty in the tax treatment that will be afforded investors. A “security futures contract” is defined by reference to the Securities and Exchange Act of 1934, which was amended by the Commodity Futures Modernization Act of 2000 to include single-stock futures. In general, the 1934 Act provides that a securities futures contract means a contract of sale for future delivery of a single security or a narrow-based security index.

Note that the Chicago Board Options Exchange and the American Stock Exchange have both indicated that they will consider listing single stock contracts. The timetable for listing these products, however, remains tentative.

Capital gain or loss. Any capital gain or loss on the sale of a securities futures contract to sell property is treated as short-term gain or loss. In effect, a securities futures contract to sell property is treated as equivalent to a short sale of the underlying property. This rule does not apply to a loss that is treated as a long-term capital loss from a straddle based on regulations under Code Sec. 1092(b) or Code Sec. 1234B.

For purposes of the short sale rules of Code Sec. 1233, a securities futures contract to acquire property will be treated in a manner similar to the property itself. Thus, the short sale rules under Code Sec. 1233(b) will be applicable to the holding of a securities futures contract to acquire property and the short sale of property that is substantially identical to the property under the contract.

Terminations. Gain or loss arising upon the cancellation, lapse, expiration or other termination of a securities futures contract, which is a capital asset in the hands of a taxpayer, is treated as gain or loss from the sale of a capital asset.

Straddle rules. Straddle rules are intended to prevent the deferral of income and conversion of ordinary income and short-term capital gain into long-term capital gain on straddle transactions. The straddle rules will apply where a taxpayer holds a long-term position in actively traded stock that is a capital asset and enters into a securities futures contract to sell substantially identical stock at a time when the stock has not appreciated in value (so that the constructive sale rules of Code Sec. 1059 do not apply). As a result, any loss on closing the securities futures contract will be a long-term capital loss under the principles of the short sale rules of Code Sec. 1233(d).

Proposals Cover Straddles, Hedging and Covered Calls

n an effort to catch up with some new financial instruments being marketed, the IRS has proposed three sets of regulations. These new proposals would expand existing straddle rules to debt instruments and swap payments, provide ordinary gain and loss treatment for certain hedging transactions and clarify the relationship of equity call options to the qualified cover call rules.

Straddle Permutations

The first set of proposals would give detail to the general principle that offsetting positions in a straddle should require the deferral of gain and loss until both legs match. Among its provisions, the regulations would require capitalization of interest incurred or continued to purchase or carry the personal property. Interest and carrying charges subject to capitalization would include: (1) interest and original issue discount on indebtedness issued or continued to purchase or carry personal property that is part of a straddle; (2) otherwise deductible fees or expenses paid or incurred in connection with the acquisition or holding of personal property; and (3) payments or accruals on financial instruments that would otherwise be deductible and are part of a straddle or carry part of a straddle.

Hedging Transactions

In conformity with the Ticket to Work and Work Incentives Improvement Act of 1999, the second set of proposed regulations would provide ordinary gain or loss treatment for hedging transactions that are clearly identified as such before the close of the day on which they were acquired, originated or entered into. Property that is part of a hedging transaction would not qualify as a capital asset.

Qualified Cover Calls

The third set of proposed regulations would clarify that strike prices available for equity options with flexible terms do not affect the benchmarks used to determine whether equity options with standardized terms are eligible for qualified coverage call treatment. The regulations also address when QCC treatment applies to equity options with flexible terms, over-the-counter options and standardized options with terms longer than one year.