1256: What were they
thinking?
DC Bar
14 December 2010
K. Scott Brown, IRS Chief Counsel (FIP)
Viva Hammer, KPMG LLP
Stephen Larson, IRS Associate Chief Counsel (FIP)
John Newton, Prudential Financial Inc.
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History of Section 1256
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1970s straddle shelters
Congressional hearings
Treasury input
1981 compromise
1982 and subsequent amendments
IRS guidance and cases
Status of 1256 as part of patchwork of taxation
of derivatives
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Taxation of Derivatives (preDodd-Frank)
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Over-the-counter derivatives
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Generally realization method of accounting
Mark-to-market mandated for dealers, elective for some
other taxpayers
Exchange-traded contracts
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Mandatory mark-to-market and 60/40 treatment (60%
LTCG/L, 40% STCG/L)
Regulated futures contracts and nonequity options listed on
qualified board or exchange, and foreign currency forwards
QBE: designated contract market and national securities
exchange
Page 2
Effect of Clearing and ExchangeTrading of OTC Derivatives
• Potential for section 1256 to apply to OTC
derivatives that migrate onto exchanges
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Timing (MTM) issues for some taxpayers
Character (capital) issues for others
Holding period benefit for others
• CBO scored derivatives part of Dodd-Frank as
losing $1.3 billion; estimate subject to
“considerable uncertainty”
Page 3
Dodd-Frank Amendment to
Section 1256
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Section 1601 of Dodd-Frank amends section 1256:
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The term ‘section 1256 contract’ shall not include—
‘‘(B) any interest rate swap, currency swap, basis swap,
interest rate cap, interest rate floor, commodity swap,
equity swap, equity index swap, credit default swap, or
similar agreement.’’
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The legislative history of this amendment states:
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[Title 16] also contains a provision to address the
recharacterization of income as a result of increased exchangetrading of derivatives contracts by clarifying that section 1256
of the Internal Revenue Code does not apply to certain
derivatives contracts transacted on exchanges.
Page 4
Summary of Dodd-Frank
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Dodd–Frank requires most “swaps” be cleared through a
central counterparty (a “clearinghouse”) and traded on a
regulated exchange
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The term “swap” broadly defined
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Includes list of 22 specific types of swaps
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Excludes futures contracts
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“Security-based swaps” subject to similar rules
Regulated exchange means (i) designated contract
market, (ii) national securities exchange, or (iii) swap
execution facility
End-user exception
Page 5
Scope of Dodd-Frank
Amendment?
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Only the 9 contracts listed (e.g., not the other 13
financial products included in the Dodd-Frank definition
of “swap”)
Notional principal contracts only?
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Compare NPC definition (Treas. Reg. §1.446-3(c)(1)(i)):
• Notional principal contracts governed by this section
include interest rate swaps, currency swaps, basis
swaps, interest rate caps, interest rate floors,
commodity swaps, equity swaps, equity index swaps,
and similar agreements
NPCs and other similar (non-NPC) agreements?
All products classified as Dodd-Frank "swaps“?
Other?
Page 6
Why Scope Matters
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Compare (i) interest rate swap, (ii) swap futures with
similar cash flows (OMX futures contract), and (ii) swap
futures with bullet cash payment (CME futures contract)
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Consider hedging issues, e.g., for dealer with book
including interest rate swaps, long and short positions in
Treasuries, Treasury futures and options, CME swap
futures, OMX swap futures, forward rate agreement and
swaptions
Page 7
Possibly Relevant Considerations
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Legislative history indicates intent to preserve status quo
History of section 1256
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Consistently construed by IRS to apply only to the
contracts Congress had in mind
Congress consistently amends section 1256 to add new
contracts where broadening of scope is desired
Mark D. Summitt, 134 T.C. No. 12 (May 20, 2010) (adopts
narrow reading of section 1256 based on “plain meaning”
interpretation)
Avoidance of whipsaw/arbitrage
Effect of daily MTM margin settlement for cleared
contracts
Need for clear rules
Page 8
Regulated Futures Contacts
The term “regulated futures contract” means a
contract—
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(A) with respect to which the amount required to be
deposited and the amount which may be withdrawn
depends on a system of marking to market, and
(B) which is traded on or subject to the rules of a
qualified board or exchange.
Page 9
Foreign Currency Contracts
Foreign currency contract. The term “foreign
currency contract” means a contract—
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(i) which requires delivery of, or the settlement of
which depends on the value of, a foreign currency
which is a currency in which positions are also traded
through regulated futures contracts,
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(ii) which is traded in the interbank market, and
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(iii) which is entered into at arm's length at a price
determined by reference to the price in the interbank
market.
Page 10
Listed Nonequity Options
Nonequity option.
The term “nonequity option” means any listed option which is
not an equity option.
Listed option.
The term “listed option” means any option (other than a right
to acquire stock from the issuer) which is traded on (or subject
to the rules of) a qualified board or exchange.
Equity option.
The term “equity option” means any option—
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(A) to buy or sell stock, or
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(B) the value of which is determined directly or indirectly by
reference to any stock or any narrow-based security index (as
defined in section 3(a)(55) of the Securities Exchange Act of 1934,
as in effect on the date of the enactment of this paragraph ).
Page 11
Qualified Board or Exchange
The term “qualified board or exchange” means—
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(A) a national securities exchange which is registered
with the Securities and Exchange Commission,
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(B) a domestic board of trade designated as a contract
market by the Commodity Futures Trading
Commission, or
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(C) any other exchange, board of trade, or other
market which the Secretary determines has rules
adequate to carry out the purposes of this section.
Page 12
Dodd-Frank Wall Street Reform and
Consumer Protection Act
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The term “swap” is defined broadly in Section 721(a)(21) of
the Dodd-Frank Act to include:
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An agreement that is commonly known (or in the future becomes
commonly known) as –
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an interest rate swap;
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a rate floor;
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a rate cap;
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a rate collar;
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a cross-currency rate swap;
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a basis swap;
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a currency swap;
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a foreign exchange swap
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a total return swap;
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an equity index swap;
Page 13
Dodd-Frank Wall Street Reform and
Consumer Protection Act (cont.)
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The term “swap” is defined broadly in Section 721(a)(21) of
the Dodd-Frank Act to include:
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an equity swap;
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a debt index swap;
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a debt swap;
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a credit spread;
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a credit default swap;
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a credit swap;
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a weather swap;
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an energy swap;
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a metal swap;
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an agricultural swap;
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an emissions swap; and
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a commodity swap
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