United States: New Tax Rules For Securities Futures Contracts

Co-written by David Miller

President Clinton signed into law on December 21, 2000, The Consolidated Appropriations Act, 2001 (the "Act"),¹ which includes a new section 1234B and a series of corresponding changes to many of the financial products provisions of the Internal Revenue Code (the "Code").² The subject matter of section 1234B is "securities futures contracts," a new type of financial instrument created by the Commodity Futures Modernization Act of 2000 (the "CFMA"), a sweeping series of changes to the existing laws regulating the securities and commodities markets that also was signed into law as part of the Act. Under the Act’s tax accounting rules for newly authorized "securities futures contracts," investors (i.e. nondealers) are taxed on gains or losses only when realized, and such gains or losses are generally treated as short-term capital gains or losses. "Dealer securities futures contracts" will be marked to market, and gains an losses on such contracts will generally be treated as 60 percent long-term and 40 percent short term capital gains or losses.³ The Act also amends existing short sale, wash sale, and straddle rules to incorporate securities futures contracts.

This memorandum summarizes the new rules governing the tax treatment of securities futures contracts.

Under the Act, a "securities futures contract" generally is defined as "a contract of sale for future delivery of a single security or a narrow-based securities index, including any interest therein or based on the value thereof."⁴ This definition most clearly describes futures contracts on shares of stock of one or a relatively small number of issuers. However, there are several complex exceptions relating to other securities on which a security futures contract can be based, and what constitutes a security futures contract.⁵

Four alternate definitions are provided of a "narrow-based security index." A "narrow-based security index" is defined as (i) an index that has 9 or fewer component securities, (ii) an index for which a component security comprises more than 30 percent of the index’s weighting, (iii) an index for which the 5 highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting, or, generally, (iv) an index for which the lowest weighted component securities comprising, in the aggregate 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million).⁶ However, six alternate exclusions also are provided that can prevent an otherwise qualifying index from meeting the definition of narrow-based security index.⁷

Gains and losses attributable to the sale or exchange of a securities futures contract generally are considered gains and losses from the sale or exchange of property which 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).⁸ Thus, where the security (or securities) to which a securities futures contract relates is or would be a capital asset in the hands of the taxpayer, gain or loss resulting from the sale or exchange of the securities futures contract will be capital gain or loss. An additional rule provides that any capital gain or loss resulting from the sale or exchange of a securities futures contract will be treated as short-term capital gain or loss,⁹ except as otherwise provided under the straddle rules or in regulations under section 1234B.¹⁰ On the other hand, if a securities futures contract is inventory¹¹ or part of an identified hedge¹² in the hands of a taxpayer,¹³ or would otherwise give rise to ordinary income,¹⁴ gain or loss, then gain or loss on a securities futures contract generally will give rise to ordinary income or loss.

Securities futures that are "dealer securities futures contracts" are treated as section 1256 contracts,¹⁵ and therefore are give rise to 60 percent long-term capital and 40 percent short-term capital treatment. A dealer securities futures contract is defined as a securities futures contract, or any option on such a contract, which is entered into (or, in the case of an option, is purchased or granted) by a dealer in securities futures contracts in the normal course of his activity of dealing in such contracts or options, and is traded on a qualified board or exchange.¹⁶ The Treasury Department is directed to determine who shall be treated as a dealer in securities futures contracts, or options on such contracts, by July 1, 2001.¹⁷ A special rule provides that gains or losses from dealer securities futures contracts allocable to limited partners or limited entrepreneurs are treated as 100 percent short-term capital gain or loss.¹⁸

Finally, gain or loss attributable to the cancellation, lapse, expiration, or other termination of a securities futures contract, which is a capital asset in the hands of the taxpayer, is treated as short-term capital gain or loss.¹⁹

None of the new Code provisions address options on securities futures contracts that are not treated as dealer security futures contracts under section 1256. However, new flush language to section 1256(b) provides, "The term ‘section 1256 contract’ shall not include any securities futures contract or option on such a contract unless such contract or option is a dealer securities futures contract." As a consequence, no room is left for arguments that a particular securities futures contract, or option thereon, qualified as a section 1256 contract (the gains or losses resulting from which are eligible for treatment as 60 percent long-term capital/40 percent short-term capital gain or loss) other than a dealer securities futures contract. In the absence of a more specific rule for options on securities futures contracts held by a nondealer, the Code’s general rule regarding gains and losses from the sale or exchange or the failure to exercise an option to buy or sell property would apply. Under those rules, the gain or loss would be of the same character as the property to which the option relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).²⁰ Thus, gain or loss on an option on a securities futures contract held by a nondealer would possess the character of any gain or loss on the underlying securities futures contract. The combination of the Code’s existing rule for gains and losses on the sale or exchange of an option with the new rule for securities futures contracts, in effect, creates a double look-through rule for determining the character of any gain or loss on a option on a securities futures contract held by a nondealer. Since the rule for options on securities futures contracts requires that one look to the character of the underlying securities futures contract and the rule for securities futures contracts requires that one look to the character of the asset to which the securities futures contract relates, the rule for options effectively also requires that one look to the character of the asset to which the securities futures contract relates to determine the character of any gain or loss on the sale or exchange of the option.

If a security to which a securities futures contract relates (other than a dealer securities futures contract) is acquired by a taxpayer in satisfaction of such a contract, the holding period of the acquired security includes the taxpayer’s holding period of the securities futures contract, provided that the securities futures contract constituted a capital asset in the taxpayer’s hands.²¹

The existing Code provisions relating to short sales, wash sales, and straddles are amended to take into account securities futures contracts. Under the new tax rules governing short sales, securities futures contracts to acquire substantially identical property are treated as substantially identical property.²² Consequently, the holding of a securities futures contract to acquire property and the short sale of property which is substantially identical to the property under the contract will result in the application of the holding period limitations in section 1233(b) of the Code to the securities futures contract. For example, if the securities futures contract has not been held for longer than one year when a taxpayer makes a short sale of property substantially identical to the underlying property to which the securities futures contract relates, then the taxpayer’s holding period on the securities futures contract would not begin until the short sale was closed. As a result, the taxpayer would lose the benefit of the addition of the holding period of the securities futures contract to the holding period of any securities acquired in satisfaction of it.²³

The Conference Report accompanying the enactment of the rules regarding securities futures contracts also explains that the entering into of a securities futures contract to sell property is the equivalent to the short sale of the underlying property, and the short-term capital treatment of any gains and losses resulting therefrom ensures a result consistent with the short-term capital treatment of gains and losses resulting from short sales under existing Code provisions.²⁴

The existing wash sale rules of the Code are amended to provide that they will not fail to apply to a contract (such as a securities futures contract) or option to acquire or sell stock or securities solely by reason of the fact that the contract or option settles in (or could be settled in) cash or property other than stock or securities.²⁵ As a result, the sale of a security at a loss accompanied with the purchase of a securities futures contract to purchase a substantially identical security within the period beginning 30 days before the date of the sale and ending 30 days after that date will result in the disallowance of the loss notwithstanding the fact that the securities futures contract may be settled in cash.²⁶ The same result would pertain if a securities futures contract was sold at a loss and substantially identical stock or securities was purchased within the requisite period.

The Code’s straddle rules are amended to provide that the term "personal property" includes stock that is part of a straddle at least 1 of the offsetting positions of which is a securities futures contract with respect to such stock or substantially identical stock or securities. In a situation in which a taxpayer holds actively traded stock and enters into a securities futures contract to sell substantially identical stock, this means that the provisions of section 1092 and the regulations thereunder will apply to any loss recognized on either the stock or the securities futures contract. Any such loss, therefore, will be disallowed to the extent of the unrecognized gain at the close of the taxable year on the offsetting position (or any successor position to either the loss position or the position that was offsetting to the loss position).²⁷ Where the stock had been held for the long-term capital gains holding period prior to the entering into of the securities futures contract, the Treasury regulations under section 1092(b) applying the principles of section 1233(d) will require that any loss on the securities futures contract will be treated as long-term capital loss.²⁸

1Pub. L. No. 106-554 (2000).

2All references to section numbers are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

3Section 1256(a).

4Section 1234B(c) (incorporating by reference new section 3(a)(55)(A) of the Securities Exchange Act of 1934, Pub. L. No. 106-554, section 201(5) of the CFMA).

5Id.

6See Section 3(a)(55)(B) of the Securities Exchange Act of 1934 (section 201(5) of the CFMA).

7See Section 3(a)(55)(C) of the Securities Exchange Act of 1934 (section 201(5) of the CFMA).

8Section 1234B(a)(1).

9Section 1234B(b).

10Id^.

11See section 1221(a)(1).

12See section 1221(a)(7).

13Section 1234B(a)(2)(A).

14Section 1234B(a)(2)(B).

15Section 1256(b)(5).

16Section 1256(g)(9)(A).

17Pub. L. No. 106-554, Section 401(g)(4) of the Community Renewal Tax Relief Act of 2000 (H.R. 5662 as introduced on December 14, 2000). See H.R. Conf. Rep. No. 106-1033, at 976 (2000).

18Section 1256(f)(4).

19Section 1234A(3).

20Sections 1234(a).

21Section 1223(16).

22Section 1233(e)(2)(D).

23If the short sale continued to remain open after the taxpayer had taken delivery of the securities to which the securities futures contract related, the holding period rules of section 1233(b) also would prevent the running of the holding period on the acquired securities until the short sale was closed.

24H.R. Conf. Rep. No. 106-1033, at 1034.

25Section 1091(f).

26Section 1091(a).

27See Treasury Regulation § 1.1092(b)-1T(a)(2). The regulations under section 1092(b) also incorporate a modified wash sale rule under which loss on stock or securities would be disallowed to the extent that the taxpayer acquired substantially identical stock or securities within a period beginning 30 days before the disposition of the loss position and ending 30 days after the disposition of the loss position. See Treasury Regulation § 1.1092(b)-1T(a)(1).

28See Treasury Regulation § 1.1092(b)-2T.