[12967]
December 22, 2000
TO: TAX MEMBERS No. 38-00
ACCOUNTING/TREASURERS COMMITTEE No. 46-00
TRANSFER AGENT ADVISORY COMMITTEE No. 66-00
RE: TAX PROVISIONS ENACTED AS PART OF YEAR-END LEGISLATION
The Consolidated Appropriations Act for FY 2001, H.R. 4577 (“the FY 2001
Appropriations Act”), which was signed into law by President Clinton on December 21, 2000,
includes several provisions of interest to regulated investment companies (“RICs”) and their
shareholders. Except as described below, the provisions discussed in this memorandum are
contained in the Community Renewal Tax Relief Act of 2000, H.R. 5662 (“the Community
Renewal TRA”), which was enacted as part of the FY 2001 Appropriations Act.
A. Taxation of Securities Futures Contracts (New Internal Revenue Code Section 1234B)
The Commodity Futures Modernization Act of 2000, H.R. 5560 (“the Commodity
Futures Modernization Act”), which also was enacted as part of the FY 2001 Appropriations
Act, permits the creation of a new type of securities futures contract. A “security future”
generally is defined in new section 3(a)(55)(A) of the Securities Exchange Act of 1934 (“the 1934
Act”), as a contract of sale for future delivery of a single security or a narrow-based security
index.
A “narrow-based security index” generally is defined, in new section 3(a)(55)(B) of the
1934 Act, as an index: (1) that has nine or fewer component securities; (2) in which a component
security comprises more than 30 percent of the index’s weighting; (3) in which the five highest
weighted component securities in the aggregate comprise more than 60 percent of the index’s
weighting; or (4) in which the lowest weighted component securities comprising an aggregate
of 25 percent of the index’s weighting have less than specified aggregate dollar values of
average daily trading volume. Pursuant to new section 3(a)(55)(C) of the 1934 Act, however, an
index will not be a narrow-based security index if any one of six conditions is met. Under one
such condition, an index will not be narrow-based if a futures contract on the index is traded on,
or subject to the rules of, an exchange and the contract meets the requirements jointly
established by the Securities and Exchange Commission (“SEC”) and the Commodity Futures
Trading Commission (“CFTC”).
2Trading in these new securities futures generally cannot begin, pursuant to the
Commodity Futures Modernization Act, until after the exchanges have developed appropriate
rules and, in no event, earlier than December 21, 2001 (one year after the date the FY 2001
Appropriations Act was enacted).1
General Tax Treatment. The Community Renewal TRA establishes new Internal
Revenue Code section 1234B to provide the tax rules for these new securities futures contracts.
Under this Act, securities futures contracts generally are not treated as section 1256 contracts
that must be marked to market;2 hence, gain or loss on the sale of a securities futures contract
(other than by a dealer)3 will be treated as having the same character as any gain or loss that
would arise from the sale of the property to which the contract relates (rather than receiving
“60/40” treatment (60 percent long-term, and 40 percent short-term, gain or loss), as is the case
with section 1256 contracts).4
Short Sales. The Act also treats a securities futures contract to sell property as equivalent
to a short sale of the underlying property. Thus, capital gain or loss arising from the sale or
exchange of a securities futures contract to sell property (i.e., the short side of a securities
futures contract) generally will be short-term capital gain or loss.5 Likewise, in applying the
short sale rules, a securities futures contract to acquire property will be treated similarly to the
property itself. Thus, if a taxpayer holds a securities futures contract to acquire property and
sells short property which is substantially identical to the property under the contract, the
taxpayer will be treated as holding the property itself, thus triggering the holding period rules
of section 1233(b).6
Wash Sales. The Act also clarifies that, under the wash sale rules, a contract or option to
acquire or sell stock or securities shall include options and contracts that are (or may be) settled
in cash or property other than the stock or security to which the contract relates.
Straddles. Similarly, the Act provides that a stock offset by a securities futures contract
will constitute a straddle.
Holding Period. The holding period of stock acquired as delivery in satisfaction of a
securities futures contract will include the period that the taxpayer held the contract.
1 Certain trading between principals may occur, if conditions set forth in the Act are met, beginning eight months
after date of enactment.
2 A securities futures contract will not be treated as a commodities futures contract for purposes of the Code.
3 A securities futures contract held by a dealer will be a section 1256 contract. The Treasury Department is to
determine before July 1, 2001 who is to be treated as a dealer. These new rules are intended to provide comparable
tax treatment to (a) dealers in securities futures contracts and (b) dealers in equity options.
4 Any securities futures contract that is not treated as a section 1256 contract will be treated as a “security” for
purposes of section 475. Consequently, traders in these instruments could elect to apply the mark-to-market rules of
section 475.
5 Certain losses from a straddle will be treated as long-term pursuant to section 1092(b).
6 Under these rules, the holding period of the substantially identical property shall be considered to begin on the date
the short sale is closed or the property is sold, gifted or otherwise disposed, whichever date occurs first.
3B. Narrowed Definition of Equity Options under Section 1256(g)
The Community Renewal TRA, in conjunction with the Commodity Futures
Modernization Act, also effectively modifies the tax treatment of certain equity index options
that previously were not treated as broad-based -- and, therefore, were not taxed as section 1256
contracts -- under prior law,7 but that are broad-based in light of the new definition of a narrow-
based security index. The effect of this change is to treat options on these equity indexes as
section 1256 contracts -- beginning on December 21, 2000.
The Community Renewal TRA accomplishes this change by modifying section 1256(g)
to treat as an equity option -- not subject to section 1256 -- only an option (1) to buy or sell stock,
or (2) the value of which is determined, directly or indirectly, by reference to (a) any stock, (b)
any narrow-based security index, as defined by new section 3(a)(55)(A) of the 1934 Act, or (c)
any group of stocks if the group meets the requirements for a narrow-based security index.
Listed options that do not meet this revised definition of equity options will be treated by all
taxpayers as nonequity options to which section 1256 applies.
C. Qualified 5-Year Gains
The Community Renewal TRA includes a technical correction to the qualified 5-year
gain rules enacted in 1997.8 Under the 1997 Act, a taxpayer holding an asset (defined to include
any single lot of a security)9 acquired prior to 2001 may elect to mark the asset to market as of
the beginning of 2001 and include any mark-to-market gain in income for the taxable year that
includes January 1, 2001. This election permits the taxpayer to treat the asset as acquired after
2000 so that it will qualify for the 18 percent tax rate if it is held for more than an additional 5
years.
The technical correction provides, however, that this mark-to-market election “shall not
apply to any asset which is disposed of . . . before the close of the 1-year period beginning on
the date that the asset would have been treated as sold under such election.” Thus, a RIC that
elected to mark a security lot to market as of January 2001 and sold the marked-to-market asset
later in 2001 would effectively invalidate its mark-to-market election and could not include the
gain otherwise arising from that election in income -- even if the sale occurred in the fund’s next
fiscal year and/or after the date on which the tax return for the fiscal year that includes January
1, 2001 had been filed.
7 Under prior law, an index was treated as broad-based if the CFTC was authorized to permit futures trading with
respect to the index.
8 See, e.g., Institute Memorandum to Tax Members No. 27-97, Accounting/Treasurers Members No. 31-97 and the
Transfer Agent Advisory Committee No. 36-97, dated August 1, 1997. Under these rules, the capital gains tax rate
applicable to taxpayers in the 15-percent tax bracket will be reduced from 10 percent to 8 percent for assets held for
more than 5 years and sold after December 31, 2000. For taxpayers in higher tax brackets, the capital gains tax rate
will be reduced from 20 percent to 18 percent for assets acquired after December 31, 2000 (or marked to market at the
beginning of 2001) and held for more than 5 years.
9 See, e.g., Institute Memorandum to Tax Members No. 37-00, Transfer Agent Advisory Committee No. 65-00 and
Accounting/Treasurers Committee No. 44-00, dated December 15, 2000.
4In addition, the Act’s Conference Agreement clarifies that “the deemed sale and
repurchase by reason of the election is not taken into account in applying the wash sale rules of
section 1091.”
Keith Lawson
Senior Counsel
Attachments
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Attachment no. 1 (in .pdf format)