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The Revenue Reconciliation Act of 1993 attacks the conversion of ordinary income to capital gain; additional changes are aimed at limiting benefits from capital gains.

The Revenue Reconciliation Act of 1993 (RRA) raised the top marginal tax rate on ordinary investment income for noncorporate taxpayers to 39.6%, while retaining the pre-RRA maximum tax rate of 28% on long-term capital gains. While the primary purpose of this increase in rates was to raise revenue, Congress was apparently concerned that the increased differential between the rates on ordinary income and capital gains might cause taxpayers to enter into certain transactions that would generate capital gains and take advantage of the lower rate. In response to this concern, the RRA adds new Sec. 1258 to prevent transactions, known as conversion transactions, that are designed to convert ordinary income into capital gain. The Act has also made changes to several existing provisions that will reduce the actual amount of capital gains recognized in certain transactions, make it more difficult to recognize capital gains or eliminate a related tax benefit from 'recognizing capital gains. These changes affect market discount bonds, stripped preferred stock, investment interest expense and the definition of substantially appreciated inventory of partnerships. Although these provisions were listed under the RRA's individual provisions, with the exception of the changes to the investment interest expense rules, they could also apply to corporate taxpayers. This article will analyze these changes and the significant complications that result.

Conversion Transactions--New Sec. 1258

* Overview

Sec. 12581 is a complex provision that adds new concepts that will require substantial guidance through regulations or other administrative pronouncements. Sec. 1258 generally requires a taxpayer to recharacterize a portion of recognized capital gain from a "conversion transaction" as ordinary income. The amount of the recharacterization is equal to an imputed rate of return on the taxpayer's net investment in the transaction. This recharacterization would apply to gain that, absent this provision, would otherwise be a long-term or short-term gain even though there is no rate differential between short-term capital gains and ordinary income. The recharacterization rules would also apply to corporations, even though there is no difference in the corporate tax rate on capital gains and ordinary income. It appears that the major hammer aimed at corporations is to prevent the circumvention of the restrictive capital loss rules. Although Sec. 1258 would recharacterize capital gain as ordinary income in specified situations, it does not create tax symmetry because it does not recharacterize capital loss as ordinary loss in "reverse" conversion transactions.(2) Sec. 1258 applies to conversion transactions entered into after Apr. 30, 1993.

* Conversion transaction

The Explanation of the Senate Finance Committee(3) describes a conversion transaction as one in which the taxpayer is in the economic position of a lender, i.e., "he has an expectation of a return from the transaction which in substance is in the nature of interest and he undertakes no significant risks other than those typical of a lender." Sec. 1258(c) defines a conversion transaction as any transaction in which "substantially all" of the taxpayer's expected return is attributable to the time value of the taxpayer's net investment in such transaction (lender-type transactions) and falls into one of the following four specified categories:

1. Transactions that consist of the acquisition of property by the taxpayer and a substantially contemporaneous agreement to sell the same or substantially identical property in the future.

2. An applicable straddle.

3. A transaction that was marketed or sold to the taxpayer on the basis that it would have the economic characteristics of a loan but the interest-like return would be taxed as capital gain.

4. Any other transaction described in regulations to be promulgated by the Treasury.

The statute creates immediate uncertainty by failing to define the term "substantially all." Absent a clear definition of substantially all, certain taxpayers may hesitate to enter into legitimate transactions while others, no doubt, will pursue arguably more questionable transactions. This type of uncertainty and resulting conflicting behavior undermines the effectiveness of the statute and tends to result in needless audit disputes and/or litigation. However, operational questions will still remain even if a clear definition of substantially all is provided by future administrative guidance.

Example 1: X purchases $200 of gold on jan. 1, 1994, and simultaneously agrees to sell on jan. 1, 1995 $100 of the gold for $106. Is this entire transaction a conversion transaction? Should it be divided into two transactions, i.e., $100 investment and $100 conversion transaction?

The statute and legislative history do not provide guidance for this simple scenario. Future guidance should not only define "substantially all" but also explain the treatment of transactions that are not entirely conversion transactions. Transactions that consist of the acquisition of property and the substantially contemporaneous entry into a contract to sell such property or substantially identical property: Further definitional guidance in this category is necessary. For example, what is substantially identical property?(4) When is a transaction considered to be "substantially" contemporaneous?(5)

"Applicable straddles:" For this purpose, Sec. 1258(d)(1) defines an applicable straddle as any straddle within the meaning of Sec. 1092(c), except that the term "personal property" includes stock. Sec. 1092(c)(1) defines a straddle as offsetting positions with respect to personal property. For Sec.

1258 purposes, personal property means any personal property of a type that is actively traded, including stock. Positions are offsetting if there is a substantial diminution of the taxpayer's risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property (whether or not of the same kind). It would seem that a typical "cash and carry" transaction, in which a taxpayer acquires a physical commodity and enters into a short position to sell the commodity at a future date would be subject to Sec. 1258 as an applicable straddle.

A conversion, as that term is used in the equity markets, would appear likely to fit within the provisions of Sec. 1258. In this type of conversion, a taxpayer would enter into a long purchase of a stock, and buy a put and sell a call with the same terms.

Example 2: Taxpayer T buys 100 shares of ABC common at $55 per share, buys an ABC january 50 put at $1 and sells an ABC january 50 call at $6.50. The total cost of the position is $4,950 ($5,500 for the stock + $100 for the put - $650 received on the call). (Note: This example ignores commission costs, carrying costs and dividends paid by ABC.) Since the total cost of $4,950 is less than the strike price (100 shares at $50), there is a locked-in profit of one-half point on the transaction.(6)

Sec. 1258 does not specifically include qualified covered calls in the definition of an applicable straddle. Under Sec. 1092(c)(4), a taxpayer holds a qualified covered call option if the following five factors are met at the time the call option is written: (1) the option is traded on a national securities exchange; (2) the option will not expire for more than 30 days; (3) the option is not deep-in-the-money; (4) the option is not granted by an options dealer; and (5) any gain or loss with respect to the option is not ordinary income or loss. Since a qualified covered call does not place the taxpayer in the economic position of a lender the exclusion from Sec. 1258 seems appropriate. However, for unexplained reasons, the House Ways and Means Committee Explanation used what appears to be a qualified covered call as an illustration of a taxpayer's net investment in a conversion transaction.(7)

Transactions that are marketed or sold as producing capital gains: The scope of this category is somewhat narrowed by the Senate Report, which provides that this category includes a transaction that is marketed and sold on the basis that it would have the economic characteristics of a loan but the accompanying interest-like return would be taxed as capital gain. Problems abound in using the way a product is marketed to determine its tax consequences. For example, if company A employs such "bad marketing" of its product but company B has the same product without the "bad marketing," should A's product be taxed differently from B's? If a product is offered to certain taxpayers using "bad marketing" and to others without the "bad marketing," does the latter group receive more favorable tax treatment? Without further guidance, this language adds further uncertainty to a Provision that seems to raise more questions than it answers.

Certain mutual bond funds are available that use as a strategy paying as little in dividends as possible. These funds use "equalization accounting," which counts shareholders" redemptions in determining whether a regulated investment company (RIC) has satisfied the 90% distribution requirement.(8) If enough shareholders cash out by the end of the year, a fund using this method has virtually no income to pay out to its shareholders who would be subject to the new higher tax rates. The earnings accumulated within the fund should increase the net asset value of the fund, thereby allowing investors to receive capital gains when redeeming their interests. Is the investor in this type of fund subject to Sec. 1258, i.e., is the investor in the fund taking on more risk than that of a lender? In assessing the risk of a particular fund relative to that of a lender, will this require a review of the fund's asset mix? Certain of these funds have arguably marketed the fact that they generate capital gains, but if the investor has more risk than that of a lender, should it matter how the transaction was marketed? These questions illustrate the type of uncertainty surrounding this category of transactions and the need for further guidance.

Any lender-type transaction specified in regulations: This category, the broadest of all, has the same retroactive potential as many other items in the RRA. Fairness might dictate that such transactions should be subject to Sec. 1258 on a prospective basis only; however, there is no indication in the statute or legislative history that this will be the case.

* Amount of gain recharacterized

Sec. 1258(a) provides that gain from the sale or exchange of a capital asset, which is recognized on the disposition (or other termination)(9) of any position held as part of a conversion transaction, is treated as ordinary income to the extent of the applicable imputed income amount ("ordinary income amount").

The ordinary income amount is an amount calculated by multiplying the taxpayer's net investment in the conversion transaction by a given rate accruing for the period ending on the date of such disposition or other termination (or, if earlier, the date on which the transaction ceases to meet the definitional requirements of a conversion transaction). This rate equals 120% of the applicable Federal rate (AFR) (as defined in Sec. 1274(d), compounded semiannually for a bond of the same maturity or, in the case of a conversion transaction of indefinite maturity, 120% of the Federal short-term rate in effect under Sec. 6621(b) (compounded daily)).(10) Thus, Sec. 1258 changes the character of a gain within its scope but not the total amount of that gain. (However, see the discussion later on built-in loss property.) This mechanical aspect of Sec. 1258 may recharacterize certain gain attributable solely to appreciation as ordinary income in cases in which the "locked-in" gain is less than the imputed amount and appreciated property is disposed of in the transaction.

Example 3: X owns gold with an adjusted basis of $350 and a fair market value (FMV) of $450 (i.e., the gold has $100 of built-in gain). X enters into a conversion transaction in which he sells the gold forward for $475. X's net investment under Sec. 1258(d)(4) is $450, i.e., FMV. Assume the ordinary income amount calculated on disposition is $40. In this case, $15 ($40 - ($475 - $450)) of the built-in capital gain appears to be subject to recharacterization under Sec. 1258, even though only $25 is the equivalent of an interest-like return. This problem will arise only when built-in gain property becomes part of a conversion transaction. It would seem that in this situation the statute should limit the recharacterized amount to the locked-in interest-like return of $25.

Sec. 1258(b)(2) allows the taxpayer to reduce the amount treated as ordinary income to the extent the taxpayer has previously recognized ordinary income under Sec. 1258 for a prior disposition or termination of a position that was held as a part of the conversion transaction. In addition, future regulations will provide for a similar reduction for amounts capitalized under Sec. 263(g), ordinary income received, or otherwise.

* Net investment

The term "taxpayer's net investment" in the transaction includes the FMV of any position that becomes part of the conversion transaction (determined as of the time the position becomes part of the transaction), but is otherwise not defined in the statute.(11) In general, a taxpayer's net investment in a conversion transaction will be the aggregate amount invested in the conversion transaction less any amount received by the taxpayer as consideration for entering into any position held as part of the conversion transaction (such as an option premium). It may be useful to analogize the concept of a taxpayer's net investment in a conversion transaction to "funds loaned" by the taxpayer. In determining a taxpayer's net investment in the transaction, the Senate Report provides that the source of the taxpayer's funds will generally not be taken into account.

Example 4: X purchased stock for $ 100 on Jan. 1, 1994, and simultaneously agreed to sell it to Y on Jan. 1, 1996 for $115. Assume the applicable rate is 5%, compounded annually. On Jan. 1, 1996, X delivers the stock to Y in exchange for $115 in accordance with their agreement. Assume that, under pre-RRA law, X would have recognized $15 of capital gain. Sec. 1258 recharacterizes $12.36 of the $15 gain as ordinary income (120% of 5% compounded annually for two years on a net investment of $100). X's net investment is $ 100 even if he had borrowed $90 of the purchase price.(12)

The Senate Report also provides that "[a]mounts that a taxpayer may be committed to provide in the future generally will not be treated as an investment until such time as such amounts are committed to the transaction and unavailable to the taxpayer to invest in other ways."(13)

Example 5: On lan. 1, 1994, X enters into a long futures contract committing him to purchase a certain quantity of gold on Mar. 1, 1994 for $100, and simultaneously enters into a short futures contract to sell the same quantity of gold on Apr. 1, 1994 for $106. X is required to make a "margin deposit" as security for his obligation under these contracts but is not required to make an investment at the time the contracts are executed. X terminates both contracts on Feb. 1, 1994 at a net profit of $2. No part of the $2 is subject to recharacterization under Sec. 1258, since X has no investment in the transaction on which the $2 could be considered to be an interest equivalent return.(14)

* Built-in loss property

Sec. 1258(d)(3) provides that the basis of built-in loss property (property with an adjusted basis greater than its FMV on the date it becomes part of a conversion transaction) will be reduced to FMV at that time. The built-in loss will be realized on the disposition or other termination of the position. This appears to result in splitting a taxpayer's disposition in a conversion transaction into two parts: (1) a gain subject to Sec. 1258 recharacterization and (2) a greater amount of loss.

Example 6: X owns gold with an adjusted basis of $450 and an FMV of $350 at the time he enters into a conversion transaction in which X sells the gold forward for $380. On the sale of the gold, X would be treated as recognizing $30 of capital gain subject to recharacterization and $100 of capital loss. This result applies even if the FMV of gold had risen to $380 so that, absent Sec. 1258, X would have only a true economic loss of $70.

* Character of recharacterized capital gain

The Senate Report indicates that the recharacterized income will be treated as ordinary income, but not as interest. The report provides in a footnote that such recharacterized income will continue to be treated as gain from the sale of property for purposes of the nrelated business income tax for tax-exempt organizations and the gross income requirements for regulated investment companies (RICs).(15) Will the recharacterized ordinary income be treated as net investment income for purposes of being able to deduct investment interest expense under Sec. 163(d)?

No specific treatment is outlined for withholding tax purposes. If the recharacterized income is not from gain on the sale or exchange of property or interest income, it may be fixed or determinable annual or periodic income subject to the withholding rules of Sec. 1441 or 1442. This does not appear to be the proper answer but given the potential personal liability of withholding agents involved, clarification would certainly be warranted.

* Exceptions

Sec. 1258 does not apply to transactions of (1) an options dealer (as defined in Sec. 1256(g)(8)), in the normal course of the dealer's trade or business of dealing in options, or (2) a commodities trader in the normal course of the trader's trade or business of trading Sec. 1256 contracts. A special rule eliminates the exception when gain is allocated to limited partners or limited entrepreneurs (LPs) (as defined in Sec. 464(e)(2)) if (1) substantially all of the LP's expected return from the entity is attributable to the time value of the LP's net investment in such entity; (2) the transaction (or the interest in the entity) was marketed or sold as producing capital gains; or (3) the transaction (or the interest in the entity) is a transaction (or interest) specified in regulations prescribed by the Treasury.

Market Discount Bonds

A market discount bond is a bond with a stated redemption price at maturity that exceeds the basis of the bond immediately after its acquisition by the taxpayer. Market discount must be recognized as ordinary income either as it accrues if the taxpayer so elects or on disposition of, the bond to the extent the market discount has accrued. Under pre-RRA law, this ordinary income rule did not apply to market discount bonds issued before July 19, 1984, or to tax-exempt obligations. In addition, the rules required deferral of interest expense deductions in certain circumstances. The RRA repeals, effective for bonds purchased after Apr. 30, 1993, the transitional rule for market discount bonds issued before July 19, 1984. The RRA also subjects tax-exempt bonds purchased after Apr. 30, 1993 to the market discount rules.(16) Thus, such market discount will be includible as ordinary taxable interest income (not tax-exempt income) either currently, if so elected, or on disposition of the bond. The special rule in Sec. 1277 requiring the deferral of interest expense attributable to market discount bonds will not apply to tax-exempt bonds. Rather, the Sec. 265 disallowance rules will continue to apply.

Stripped Preferred Stock

The RRA requires a purchaser of stripped preferred stock after Apr. 30, 1993 to recognize the stock's stated redemption price in excess of the purchase price as ordinary income (not as dividend or interest income) based on rules similar to the original issue discount (OID) rules. New Sec. 305(e)(5) defines stripped preferred stock as stock (1) in which the ownership of the stock has been separated from the right to receive any dividend that has not become payable; (2) that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent; and (3) that has a fixed redemption premium.(17)

To become subject to new Sec. 305(e), the stripped preferred stock must be purchased. A purchase is defined as any acquisition of stock in which the basis of such stock is not determined in whole or in part by reference to the adjusted basis of the stock in the hands of the person from whom it was acquired.(18) The general rule also applies to any person whose basis in such stock is determined by reference to the basis in the hands of such a purchaser.(19)

The ordinary income accrued under the OID-like rules is not a dividend and therefore a corporate holder would apparently not be eligible for the 70% dividends received deduction (DRD). The House Report expressly states that no implication is intended as to the availability of the DRD to the holder of the dividends stripped from the preferred stock.(20)

The stripper will be treated as purchasing the stripped stock for an amount equal to the stripper's adjusted basis in the stock. The House Report states that no inference is intended as to the allocation of basis by the stripper or the proper characterization of the purported sale of the stripped dividend rights.(21) As noted, the RRA does not address the many related issues necessary to effectively apply this provision. It would seem that rules similar to those in Sec. 1286 for stripped bonds should be used as a starting point.(22)

Investment Interest Limitation

For a taxpayer other than a corporation, Sec. 163(d) limits the deduction for investment interest expense to the taxpayer's net investment income. Effective retroactive to tax years beginning after 1992, the RRA amends Sec. 163(d) to provide that net capital gain will not be considered investment income for purposes of computing the investment interest limitation, except to the extent the taxpayer elects to forgo the 28% maximum rate on the capital gain.(23) This prevents a taxpayer from deducting investment interest expense and receiving a benefit at the new 39.6 % rate, while paying tax at the 28% rate on long-term capital gain. Taxpayers with both net capital gain and investment interest expense (in excess of other investment income) will be required to determine the appropriate break-even amount for forgoing the benefit of the long-term capital gain rate. The election appears to be made simply by reporting the net capital gain on the appropriate schedule in the taxpayer's tax return.

Partnership Inventory Items

As a general rule, Sec. 741 provides that gain or loss on the sale of a partnership interest is considered gain or loss from the sale of a capital asset. However, amounts received by a partner in exchange for his interest in a partnership are treated as ordinary income to the extent they are attributable to substantially appreciated inventory of the partnership.(24) In addition, certain non-pro rata distributions of substantially appreciated inventory can result in a taxable sale or exchange of property, rather than a nontaxable distribution.

Under pre-RRA law, partnership inventory items were considered to have substantially appreciated in value if their FMV exceeded (1) 120% of the adjusted basis to the partnership of such property and (2) 10% of the FMV of all partnership property other than money. The RRA deletes the second part of the test and adds an anti-avoidance provision that excludes any inventory property if a principal purpose for acquiring such property was to avoid the provisions of Sec. 751(d).(25) The 10% rule was eliminated because Congress believed it presented an opportunity to manipulate the partnership's gross assets and therefore avoid the appreciated inventory rule.(26) The anti-avoidance rule appears to be aimed at attempts by partnerships to avoid the 120% limit by acquiring a sufficient amount of additional, nonappreciated inventory.(27) Amended Sec. 751(d) applies to sales, exchanges and distributions after Apr. 30, 1993.

Conclusion

It is unfortunate that the desire to raise revenue and the related urgency gets in the way of tax simplification. The addition of Sec. 1258 adds yet another layer of significant complexity to the Code. This new provision seems to raise more questions than it answers. Anytime this type of uncertainty surrounds a provision of the tax law it almost guarantees inconsistent treatment on the part of taxpayers, which invariably leads to unnecessary audit disputes and/or litigation. It is hoped that the much needed guidance to the questions surrounding this provision will be forthcoming in the very near future.

It is also hoped that regulations will address recharacterization in the case of reverse conversion transactions. Any argument relating to recharacterization in accordance with economic substance loses credibility when reverse conversion transactions are not similarly treated. Overall, the provisions discussed in this article appear to have arisen from a concern that taxpayers will attempt to take advantage of transactions in an effort to beat the income tax rate increases. (1) Added by RRA Section 13206(a). (2) Interestingly, the Service has a coordinated issues paper outstanding on reverse conversions that concludes that any loss generated by the transaction would be capital loss. (3) Explanation of the Senate Finance Committee Revenue Provisions as submitted to the Budget Committee and released on June 23, 1993 (hereinafter, the "Senate Report"), at 234. (4) Maybe the short sale provisions of Sec. 1233, which also use the term "substantially identical property," but in similar fashion do not define it, could be used as guidance. Perhaps the wash sale rules of Sec. 1091, which apply to substantially identical stock and securities, can also be referenced. (5) Beyond a certain period after the acquisition of property, entering into a contract to sell such property or substantially identical property should not cause the transaction to be a conversion transaction. Again, without guidance, certain taxpayers will be more aggressive than others. (6) McMillan, "Options as a Strategic Investment," New York Institute of Finance (2d Edition, 1986), at 377. (7) WMCP: 103-11, 103d Cong., 1st Sess. (1993), at 201 (hereinafter, the "House Report"). (8) Rev. Rul. 55-416, 1955-1 CB 416. (9) The term "disposition or other termination" is not defined. It would appear to be used in a broad sense to cover not only sales and exchanges but expirations, worthlessness and abandonments. (10) Sec. 1258(b) and (d)(2). (11) Sec. 1258(d)(4). (12) Adapted from an example in the Senate Report, at 235. (13) Senate Report, at 235-236. (14) Adapted from an example in the Senate Report, at 236. (15) Senate Report, at 233. (16) RRA Section 13206(b). (17) RRA Section 13206(c). (18) Sec. 305(e)(6). (19) Sec. 305(e)(1), last sentence. (20) House Report, at 203. (21) Id. (22) Sec. 1286(b)(3) in general provides for the allocation of basis by the stripper of a debt instrument between the items retained and the items disposed of on the basis of their relative FMVs. (23) RRA Section 13206(d). Sec. 1222(11) defines "net capital gain" as the excess of net long-term capital gain for the tax year over net short-term capital loss for that year. Thus, the new rule does not affect the treatment of net short-term capital gain for net investment income purposes. (24) Sec. 751(a). (25) RRA Section 13206(e). (26) Senate Report, at 240. (27) For example, a partnership could borrow money and invest the proceeds in marketable securities (or even Treasury bills) sufficient to avoid the 10% test.
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Author:Choate, Gary M.
Publication:The Tax Adviser
Date:Nov 1, 1993
Words:4563
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