Revenue
Ruling
2000-12
 
Revenue Ruling 2000-12
, 2000-1 CB 744,
February 28, 2000
.
ISSUE
Under the circumstances
described below, if a taxpayer acquires two debt
instruments that are structured so that it is
expected that the value of one will increase
significantly at the same time that the value of the
other one decreases significantly, can the taxpayer
recognize a current loss on the sale of the debt
instrument that decreases in value while not
recognizing the gain on the other debt instrument?
FACTS
Situation 1
X
is a corporation that files returns on a
calendar-year basis. On
September 1, 1993
, X purchases two privately-placed debt
instruments, Note 1 and Note 2, from unrelated
issuers for $1,000,000 each.
Note 1
has a 10-year term and a stated principal amount of
$1,000,000. It provides for quarterly interest
payments, beginning on
December 1, 1993
. The interest rate for the first quarter is 5.9
percent, compounded quarterly. Note 1 provides for
contingent payments based on an event that will
occur (or not occur) with a probability of 50
percent on
December 1, 1993
(the reset event). The reset event does not depend
on actively traded personal property. If the reset
event occurs, the interest rate doubles to 11.8
percent, compounded quarterly. If the reset event
does not occur, the interest rate is reset at zero.
Note 2
has the same terms as Note 1 except that the
consequences of the contingency are reversed. Thus,
if the reset event occurs, the interest rate is
reset at zero. If the reset event does not occur,
the interest rate doubles to 11.8 percent,
compounded quarterly.
At the
time the notes are purchased, based upon the
structure of the notes, it can be expected that, as
a result of the reset, one note will increase
significantly in value and the other note will
decrease in value by the same amount. The expected
tax loss on the note that decreases in value
significantly exceeds any reasonably expected
economic loss on the two notes.
On
December 1, 1993
, the reset event does not occur. Thus, on that
date, the interest rate on Note 1 is reset at zero,
and the interest rate on Note 2 doubles to 11.8
percent, compounded quarterly. As a result of the
reset, the fair market value of Note 2 increases
significantly because of the doubling of its
interest rate, and the fair market value of Note 1
decreases by the same amount. On
December 2, 1993
, X sells Note 1 for its fair market value
and claims a loss.
Situation
2
Y
is a corporation that files returns on a
calendaryear basis. On
September 1, 1998
, Y purchases two privately-placed debt
instruments, Note 3 and Note 4, from unrelated
issuers for $1,000,000 each.
Note 3
has a 10-year term and a stated principal amount of
$1,000,000. It provides for quarterly interest
payments, beginning on
December 1, 1998
. The interest rate for the first quarter is 5.7
percent, compounded quarterly. Note 3 provides for
contingent payments based on an event that will
occur (or not occur) with a probability of 50
percent on
December 1, 1998
(the reset event). The reset event does not depend
on actively traded personal property. If the reset
event occurs, the interest rate doubles to 11.4
percent, compounded quarterly. If the reset event
does not occur, the interest rate is reset at zero.
Note 4
has the same terms as Note 3 except that the
consequences of the contingency are reversed. Thus,
if the reset event occurs, the interest rate is
reset at zero. If the reset event does not occur,
the interest rate doubles to 11.4 percent,
compounded quarterly.
At the
time the notes are purchased, based upon the
structure of the notes, it can be expected that, as
a result of the reset, one note will increase
significantly in value and the other note will
decrease in value by the same amount. The expected
tax loss on the note that decreases in value
significantly exceeds any reasonably expected
economic loss on the two notes.
On
December 1, 1998
, the reset event does not occur. Thus, on that
date, the interest rate on Note 3 is reset at zero,
and the interest rate on Note 4 doubles to 11.4
percent, compounded quarterly. As a result of the
reset, the fair market value of Note 4 increases
significantly because of the doubling of its
interest rate, and the fair market value of Note 3
decreases by the same amount. On
December 2, 1998
, Y sells Note 3 for its fair market value
and claims a loss.
Situation
3
Z
is a corporation that files returns on a
calendaryear basis. On
September 1, 1998
, Z purchases two privately-placed debt
instruments, Note 5 and Note 6, from unrelated
issuers.
Note 5
is purchased for $1,000,000. Note 5 has a 10-year
term and a stated principal amount of $1,000,000. It
provides for quarterly interest payments, beginning
on
December 1, 1998
. The interest rate for the first quarter is 5.7
percent, compounded quarterly. Note 5 provides for
contingent payments based on an event that will
occur (or not occur) with a probability of 50
percent on
December 1, 1998
(the reset event). The reset event does not depend
on actively traded personal property. If the reset
event occurs, the interest rate doubles to 11.4
percent, compounded quarterly. If the reset event
does not occur, the interest rate is reset at zero.
Note 6
is purchased for $615,000. Note 6 has a 20-year term
and a stated principal amount of $615,000. It
provides for quarterly interest payments beginning
on
December 1, 1998
. The interest rate on Note 6 for the first quarter
is set at 3-month LIBOR. If the reset event occurs,
the interest rate is reset at zero. If the reset
event does not occur, the interest rate doubles to
200 percent of 3-month LIBOR, adjusted quarterly.
At the
time the notes are purchased, based upon the
structure of the notes, it can be expected that, as
a result of the reset, the value of one note will
increase significantly and the value of the other
note will decrease significantly. The expected tax
loss on the note that decreases in value
significantly exceeds any reasonably expected
economic loss on the two notes.
On
December 1, 1998
, the reset event does not occur. Thus, on that
date, the interest rate on Note 5 is reset at zero,
and the interest rate on Note 6 doubles to 200
percent of 3-month LIBOR, adjusted quarterly. As a
result, the fair market value of Note 6 increases
significantly because of the doubling of its
interest rate, and the fair market value of Note 5
decreases significantly. On
December 2, 1998
, Z sells Note 5 for its fair market value
and claims a loss.
LAW
AND
ANALYSIS
Situation 1
Section
165(a) of the Internal Revenue Code provides that
there shall be allowed as a deduction any loss
sustained during the taxable year and not
compensated for by insurance or otherwise. Section
1.165-1(b) of the Income Tax Regulations provides,
in addition, that for a loss to be allowable as a
deduction under §165(a) , it must be evidenced by
closed and completed transactions, fixed by
identifiable events, and actually sustained during
the taxable year. Section 1.165-1(b) also provides
that only a bona fide loss is allowable and that
substance and not mere form shall govern in
determining a deductible loss.
The
courts have held that a loss is allowable as a
deduction for federal income tax purposes only if it
is bona fide and reflects actual economic
consequences. An artificial loss lacking economic
substance is not allowable. See ACM Partnership
v. Commissioner, 157 F.3d 231, 252 (3d Cir.
1998) ("Tax losses such as these ... which do
not correspond to any actual economic losses, do not
constitute the type of 'bona fide' losses that are
deductible under the Internal Revenue Code and
regulations."), cert. denied, 526 U.S.
1017 (1999); Scully v. United States, 840
F.2d 478, 486 (7th Cir. 1988) (to be deductible, a
loss must be a "genuine economic loss"); Shoenberg
v. Commissioner, 77 F.2d 446, 448 (8th Cir.
1935) (to be deductible, a loss must be "actual
and real"), cert. denied, 296 U.S. 586
(1935).
The
courts similarly have disallowed losses from
option-straddle transactions that were found to be
devoid of economic substance. The option-straddle
transactions were prearranged to generate a loss for
tax purposes while deferring an offsetting gain.
Even though the relevant trades may have taken
place, the loss deduction claimed was not allowed
because no true loss had occurred. Lerman v.
Commissioner, 939 F.2d 44, 52 (3d Cir. 1991), cert.
denied, 502 U.S. 984 (1991), and Keane v.
Commissioner, 865 F.2d 1088, 1092 (9th Cir.
1989), aff'g Glass v. Commissioner, 87 T.C.
1087 (1986).
The
sale of Note 1 in Situation 1 does not
produce an allowable loss under §165 . When X
sells Note 1 before its maturity date but retains
Note 2, X does not realize an actual economic
loss because the purported loss on the sale of Note
1 is substantially offset by the unrealized gain in
Note 2. Such an artificial loss is not allowable for
federal income tax purposes.
Situation
2
Sections
1271 through 1275 , and the regulations thereunder,
provide rules for the taxation of holders of debt
instruments, including debt instruments that provide
for one or more contingent payments. These rules
generally require holders of debt instruments to
accrue original issue discount (OID) using the
constant-yield method. Note 3 and Note 4 are subject
to the OID rules because the notes provide for
contingent payments.
Section
1.1275-6 generally provides for the integration of a
"qualifying debt instrument" with a "§1.1275-6
hedge" if the combined cash flows of the
components are substantially equivalent to the cash
flows on a fixed rate debt instrument or a variable
rate debt instrument that pays interest at a
qualified floating rate. When §1.1275-6 applies,
the combined cash flows of the qualifying debt
instrument and the §1.1275-6 hedge generally are
treated as a synthetic debt instrument for all
federal income tax purposes. The purpose of §1.1275-6
is to permit a more appropriate determination of the
character and timing of income, deductions, gains,
or losses than would be achieved by separate
treatment of the components. Section 1.1275-6
generally applies to qualifying debt instruments
issued on or after
August 13, 1996
.
Under
§1.1275-6(b)(1) , a contingent payment debt
instrument (CPDI) that is issued for cash is a
qualifying debt instrument. Under §1.1275-6(b)(2)(i)
, a §1.1275-6 hedge is any financial instrument
(including a debt instrument) if the combined cash
flows of the financial instrument and the qualifying
debt instrument permit the calculation of a yield to
maturity (under the principles of §1272 ) or the
right to the combined cash flows would qualify under
§1.1275-5 as a variable rate debt instrument that
pays interest at a qualified floating rate or rates
(except for the requirement that the interest
payments be stated as interest) (fixed-or-floating
requirement).
Section
1.1275-6(b)(2)(ii)(B) provides that a debt
instrument can be a §1.1275-6 hedge only if it is
issued substantially contemporaneously with, and has
the same maturity (including rights to accelerate or
delay payments) as, the qualifying debt instrument.
Section
1.1275-6(c)(2) grants the Commissioner authority to
integrate a qualifying debt instrument that is a
CPDI with a §1.1275-6 hedge if the combined cash
flows are substantially the same as either of the
cash flows necessary to satisfy the
fixed-or-floating requirement of §1.12756(b)(2)(i)
. This rule allows the Commissioner to prevent the
potential timing and character mismatches that arise
if the CPDI and its hedge are treated separately.
Section
1.1275-6(d)(2) provides rules for legging out of an
integrated transaction. Section 1.1275-6(d)(2)(i)(B)
sets out the rules for determining when a legging
out occurs if the Commissioner has integrated a
qualifying debt instrument and a financial
instrument under §1.1275-6(c)(2) . Under those
rules, the taxpayer legs out of the integrated
transaction if, prior to the maturity of the
synthetic debt instrument, the requirements for
Commissioner integration under §1.1275-6(c)(2) are
no longer met. Section 1.1275-6(d)(2)(ii) provides
that if the taxpayer legs out of an integrated
transaction, then the taxpayer is treated as selling
or otherwise terminating the synthetic debt
instrument, immediately before legging out, for its
fair market value and realizing and recognizing at
that time any resulting income, deduction, gain, or
loss.
In Situation
2, unlike Situation 1, the notes are
issued after the effective date of the integration
rules of §1.1275-6 and qualify for integration by
the Commissioner under §1.1275-6(c)(2) . In this
case, the Commissioner integrates the notes under §1.1275-6(c)(2)
as of the issue date. Upon the sale of Note 3, the
requirements for Commissioner integration under §1.1275-6(c)(2)
are no longer met. Therefore, Y is treated as
legging out of the integrated transaction under §1.1275-6(d)(2)(ii)
.
Under
the legging out rules of §1.1275-6(d)(2)(ii) ,
immediately before Note 3 is sold, Y is
treated as disposing of the synthetic debt
instrument for its fair market value, and Y
must realize and recognize at that time any gain or
loss on the deemed disposition. As a result, Y
cannot recognize the claimed loss on the sale of
Note 3 while not recognizing the gain on Note 4.
Situation
3
Under
§1.1275-2(g) , if a principal purpose in
structuring a debt instrument or engaging in a
transaction is to achieve a result that is
unreasonable in light of the purposes of §§163(e)
, 1271 through 1275, or any related section of the
Code, the Commissioner can apply or depart from the
regulations under the applicable sections as
necessary or appropriate to achieve a reasonable
result. Section 1.1275-2(g) applies to debt
instruments issued on or after
August 13, 1996
.
Section
1.1275-2(g)(2) provides that whether a result is
unreasonable is determined based on all the facts
and circumstances. A significant fact is whether the
treatment of the debt instrument is expected to have
a substantial effect on the issuer's or a holder's
U.S.
tax liability. A result is unreasonable only if
there is an expected substantial effect on the
present value of a taxpayer's tax liability.
A
principal purpose of §§1271 through 1275 and
related sections of the Code is to tax holders of
debt instruments according to economic income as
determined by the constant-yield method. These
provisions ensure that the holder of a debt
instrument cannot artificially avoid, defer, or
offset timely recognition of the economic income
from the debt instrument.
In Situation
3, the notes are issued after the effective
dates of the integration rules of §1.1275-6 and the
anti-abuse rule of §1.1275-2(g) . But for the
anti-abuse rule, there are two reasons why the
integration rules would not apply. First, it cannot
be determined at the time of issuance whether the
combined cash flows will be substantially the same
as either of the cash flows necessary to satisfy the
fixed-or-floating requirement of §1.1275-6(b)(2)(i)
. Second, the notes have different maturities and,
thus, they do not meet the same-maturity limitation
of §1.1275-6(b)(2)(ii)(B) .
If the
structure of the transaction were respected for
federal income tax purposes, Z would be able
to recognize the claimed loss upon the sale of Note
5 even though it could be expected, when Z
purchased the two notes, that, as a result of the
reset, one note would increase significantly in
value and the other note would decrease
significantly in value. The expected tax loss on the
note that decreases in value significantly exceeds
any reasonably expected economic loss on the two
notes. Essentially, Z purchased a series of
cash flows that, absent the application of the
anti-abuse rule of §1.1275-2(g) (or §165
principles), would produce an artificial loss
immediately after the reset.
This
result is unreasonable in light of the purposes of
the OID rules. The OID rules were intended, in part,
to ensure that the holder of a debt instrument
cannot artificially avoid, defer, or offset timely
recognition of the economic income from the debt
instrument. In this case, the transaction is
structured to defeat this purpose by creating an
artificial loss immediately after the reset. Section
1.1275-2(g) authorizes the Commissioner to apply or
depart from the OID regulations as necessary or
appropriate to prevent this unreasonable result.
In this
case, the Commissioner departs from the literal
requirements of the integration rules by integrating
the two notes before Note 5 is sold. Upon the sale
of Note 5, Z is treated as legging out of an
integrated transaction under §1.1275-6(d)(2)(ii) .
Under the legging out rules of §1.1275-6(d)(2)(ii)
, immediately before Note 5 is sold, Z is
treated as disposing of the synthetic debt
instrument for its fair market value, and Z
must realize and recognize at that time any gain or
loss on the deemed disposition. As a result, Z
cannot recognize the claimed loss on the sale of
Note 5 while not recognizing the gain on Note 6.
HOLDING
In each
situation the taxpayer cannot recognize the claimed
loss on the sale of the debt instrument that
decreases in value while not recognizing the gain on
the other debt instrument.
In Situation
1, the loss on the sale of Note 1 is not allowed
under §165 .
In Situation
2, the integration rule of §1.1275-6(c)(2)
applies. The Commissioner integrates the notes as of
the issue date. Upon the sale of Note 3, Y is
treated as legging out of the integrated
transaction. Accordingly, Y is treated as
disposing of the synthetic debt instrument at its
fair market value immediately before the sale.
In Situation
3, the anti-abuse rule of §1.1275-2(g) applies.
The Commissioner integrates the notes before Note 5
is sold. Upon the sale of Note 5, Z is
treated as legging out of the integrated
transaction. Accordingly, Z is treated as
disposing of the synthetic debt instrument at its
fair market value immediately before the sale.
DRAFTING
INFORMATION
The
principal authors of this revenue ruling are Charles
W. Culmer and Christina A. Morrison of the Office of
Assistant Chief Counsel (Financial Institutions and
Products). For further information regarding this
revenue ruling contact Mr. Culmer at
(202)
622-3950
or Ms. Morrison at
(202)
622-3960
(not a toll-free call). |
