[Federal Register Volume 66, Number 12 (Thursday, January 18, 2001)]
[Proposed Rules]
[Pages 4746-4751]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 01-1240]


-----------------------------------------------------------------------

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105801-00]
RIN 1545-AX92


Capitalization of Interest and Carrying Charges Properly 
Allocable to Straddles

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations that clarify the 
application of the straddle rules to a variety of financial 
instruments. The proposed regulations clarify what constitutes interest 
and carrying charges and when interest and carrying charges are 
properly allocable to personal property that is part of a straddle. The 
proposed regulations also clarify that a taxpayer's obligation under a 
debt instrument can be a position in personal property that is part of 
a straddle. The proposed regulations provide guidance to taxpayers that 
enter into straddle transactions. This document provides notice of a 
public hearing on these proposed regulations.

DATES: Written and electronic comments and requests to appear and 
outlines of topics to be discussed at the public hearing scheduled for 
May 22, 2001, at 10 a.m., must be submitted by May 1, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-105801-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to: CC:M&SP:RU (REG-105801-00), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC.
    Alternatively, taxpayers may submit comments electronically via the 
Internet by submitting comments directly to the IRS Internet site at 
http://www.irs.gov/tax__regs/regslist.html. The public hearing will be 
held in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Kenneth Christman (202) 622-3950; concerning submission and delivery of 
comments and the public hearing, Treena Garrett, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Sections 501 and 502 of the Economic Recovery Tax Act of 1981 (Pub. 
L. 97-34, 95 Stat. 172) added sections 1092 and 263(g), respectively, 
to the Internal Revenue Code to address certain deferral and conversion 
strategies involving economically offsetting positions in actively 
traded personal property. These economically offsetting positions are 
called straddles. Section 1092(c)(1).
    In general, under section 1092, a taxpayer that realizes a loss on 
a position in actively traded personal property must defer the 
recognition of the loss to the extent the taxpayer has unrecognized 
gain on an economically offsetting position in the property. This 
deferral rule matches the recognition of loss with the recognition of 
the economically offsetting income. Section 263(g) addresses interest 
and carrying charges properly allocable to personal property that is 
part of a straddle. Under this section, these otherwise deductible 
expenses are not currently deductible. Instead, they must be 
capitalized into the basis of the property. By requiring 
capitalization, section 263(g) prevents: (1) A taxpayer from gaining a 
timing advantage by accruing deductions associated with carrying the 
straddle transaction before recognizing income from a position in 
personal property that is part of the straddle; and (2) the deductions 
from having a character different from that of the income.
    These proposed regulations provide certain rules with respect to 
the application of section 263(g) and section 1092.

Explanation of Provisions

    The proposed regulations consist of Sec. 1.263(g)-1, which provides 
a general introduction, and Secs. 1.263(g)-2, 1.263(g)-3, 1.263(g)-4, 
and 1.263(g)-5, described below. The proposed regulations also include 
a new paragraph 1.1092(d)-1(d).
    The proposed regulations generally address four issues: (1) The 
definition of personal property as such term is used in section 263(g) 
(in Sec. 1.263(g)-2); (2) the type of payments that are subject to the 
capitalization rules of section 263(g) (in Sec. 1.263(g)-3); (3) the 
operation of the capitalization rules of section 263(g) (in 
Sec. 1.263(g)-4); and (4) the circumstances under which an issuer's 
obligation under a debt instrument can be a position in actively traded 
personal property and, therefore, part of a straddle (in 
Sec. 1.1092(d)-1(d)). These issues are discussed in more detail below.

Definition of the Term Personal Property for Purposes of Section 263(g)

    Section 263(g)(1) requires capitalization of interest and carrying 
charges properly allocable to personal property that is part of a 
straddle (as defined in section 1092(c)). Section 1092(d)(1) defines 
personal property for purposes of section 1092, as personal property of 
a type that is actively traded. Commentators have suggested that 
because sections 263(g) and 1092 were enacted at the same time, the 
term personal property as used in section 263(g) should be given the 
same definition under section 1092(d)(1). This would limit the 
definition of personal property in section 263(g) to personal property 
of a type that is actively traded.
    Despite this suggestion, the proposed regulations provide that 
personal property has its common law meaning in section 263(g) for two 
reasons. First, the definition in section 1092(d)(1) by its terms 
applies only for purposes of section 1092. Second, the broader, common 
law interpretation of personal property more closely accords with the 
purposes of section 263(g). Application of the limited definition in 
section

[[Page 4747]]

1092(d)(1) for purposes of section 263(g) could result in dissimilar 
tax treatment of economically similar transactions. For example, 
adoption of the narrower definition would cause section 263(g) to apply 
to a transaction in which a taxpayer borrows to purchase actively 
traded personal property that is a part of a straddle but not to a 
similar transaction in which the taxpayer borrows to purchase a 
derivative instrument that is not itself actively traded but is a 
position in actively traded property.
    Consequently, proposed Sec. 1.263(g)-2 defines personal property as 
a property right, whether or not actively traded, other than a right in 
real property. This definition includes both financial positions that 
provide substantial rights but do not impose substantial obligations on 
the holder (e.g., common stock or a purchased option) and executory 
contracts that impose both rights and obligations on the holder (e.g., 
notional principal contracts (NPC's) and forward transactions). 
However, the definition excludes straddles comprised only of financial 
positions that impose only obligations on the holder (e.g., the 
obligor's position in a debt instrument or a writer's position in an 
option).

Payments That Are Subject to the Capitalization Rules of Section 263(g)

    Section 263(g)(1) provides for the capitalization of interest and 
carrying charges. For this purpose, interest and carrying charges are 
collectively defined in section 263(g)(2) as ``interest incurred or 
continued to purchase or carry the personal property'' and ``all other 
amounts (including charges to insure, store, or transport) paid or 
incurred to carry the personal property,'' less certain types of income 
from the personal property.
    The phrase ``incurred or continued to purchase or carry'' also 
appears in section 265(a)(2), which disallows interest expense on 
indebtedness incurred or continued to purchase or carry tax-exempt 
debt. Rev. Proc. 72-18 (1972-1 C.B. 740) sets out rules for determining 
when this standard is met for purposes of section 265(a)(2). Under that 
revenue procedure, indebtedness issued by a taxpayer that is not a 
dealer in tax-exempt obligations meets this standard if: (1) The 
proceeds of the indebtedness are directly traceable to the purchase of 
the tax-exempt obligations, (2) the tax-exempt obligations are used as 
collateral for the borrowing, or (3) the totality of the facts and 
circumstances supports a reasonable inference that the purpose of the 
borrowing was to purchase or carry tax-exempt obligations. In general, 
the facts-and-circumstances test is met if there is a ``sufficiently 
direct relationship'' between the borrowing and the investment in the 
tax-exempt obligations. Similarly, the proposed regulations provide 
that a sufficiently direct relationship between indebtedness or other 
financing and personal property that is part of a straddle exists if 
payments on the indebtedness or other financing are determined by 
reference to the value or change in value of the personal property. See 
Sec. 1.263(g)-3(c).
    Section 263(g) also applies to ``all other amounts (including 
charges to insure, store or transport the personal property)'' paid or 
incurred to carry personal property that is part of a straddle. As 
noted by one commentator, ``taxpayers should not be permitted to deduct 
items incurred in connection with protecting or preserving the value of 
assets'' that are part of a straddle. Therefore, the term, to carry in 
the context of section 263(g) includes the reduction of the risk of 
holding an asset. Because straddles necessarily involve positions that 
offset each other, the positions ``carry'' each other.
    Accordingly, under Sec. 1.263(g)-3(b) of the proposed regulations, 
interest and carrying charges subject to capitalization under section 
263(g) include: (1) Otherwise deductible payments or accruals 
(including interest and original issue discount) on indebtedness or 
other financing issued or continued to purchase or carry personal 
property that is part of a straddle; (2) otherwise deductible fees or 
expenses paid or incurred in connection with the taxpayer's acquiring 
or holding personal property that is part of a straddle, including, but 
not limited to, fees or expenses incurred to purchase, insure, store, 
maintain, or transport the personal property; and (3) other otherwise 
deductible payments or accruals on financial instruments that are part 
of a straddle or that carry part of a straddle.
    Section 263(g) requires capitalization of interest and carrying 
charges that exceed certain specified income inclusions (allowable 
offsets) listed in section 263(g)(2)(B). Section 1.263(g)-3(e) sets 
forth the allowable offsets, including amounts that are receipts or 
accruals on financial instruments that are part of a straddle or carry 
part of a straddle. The Treasury Department and the IRS solicit 
comments regarding whether other amounts should be treated as allowable 
offsets for purposes of section 263(g).

Operation of the Capitalization Rules of Section 263(g)

    Generally, section 263(g) coordinates the character and timing of 
items of income and loss attributable to a taxpayer's position in a 
straddle by allocating interest and carrying charges to the capital 
account of a position in personal property that is part of the 
straddle. Proposed regulation Sec. 1.263(g)-4 provides a set of 
allocation rules governing the ``capitalization'' of interest and 
carrying charges.
    In many cases, certain allocation rules readily suggest themselves.
    Congress was aware of ``cash and carry'' transactions in adopting 
section 263(g). See H.R. Rep. No. 201, 97th Cong. 1st Sess. 203-04 
(1981). In a typical transaction, a taxpayer borrows to purchase 
personal property and sells the property forward. The debt instrument 
generates ordinary deductions (interest expense) that precede 
predictable (and approximately equal) capital gains on the sale of the 
personal property. Coordination of the amount and timing of income and 
loss in a cash and carry transaction is achieved under the proposed 
regulation by allocating the interest expense to the capital account of 
the personal property. This rule applies to all transactions in which a 
taxpayer has borrowed to purchase personal property that is part of a 
straddle.
    If the proceeds of a borrowing are not used to purchase personal 
property, a second allocation rule allocates interest expense to 
personal property when the personal property collateralizes the 
borrowing. See Rev. Proc. 72-18, Sec. 3.03 (disallowing interest 
deduction for debt secured by tax-exempt obligations); Rev. Rul. 78-348 
(1978-2 C.B. 95) (applying yield restrictions to investments pledged by 
person benefitting from tax-exempt bond financing).
    A third allocation rule of the proposed regulations allocates 
interest on indebtedness to personal property when payments on the 
indebtedness are determined by reference to the value, or change in 
value, of the personal property that is part of a straddle.
    Fees and charges related to the maintenance of the personal 
property, such as charges to insure, store, or transport the personal 
property, are allocated to the capital account of that personal 
property. See S. Rep. No. 144, 97th Cong. 1st Sess. 154 (1981).
    In other cases, the appropriate method for allocating capitalized 
interest and carrying charges is less obvious. This may be true of 
payments or accruals on a financial instrument, such as a NPC, 
described in proposed Sec. 1.263(g)-3(d).

[[Page 4748]]

For example, the proposed rules would apply to a taxpayer that holds 
stock and enters into an equity swap that is a short position with 
respect to the stock. In such a case, both the stock and the equity 
swap may be personal property that is part of a straddle, and payments 
on the equity swap could be capitalized with respect to the capital 
account of either the stock or the equity swap. However, it may not be 
clear how a capitalization rule would apply in conjunction with the 
rules under Sec. 1.446-3 with respect to payments on NPCs. Accordingly, 
the proposed rules provide that, in cases to which a specific 
allocation rule is not applicable, interest and carrying charges will 
be allocated to personal property that is part of a straddle in the 
manner that is most appropriate under all the facts and circumstances. 
Proposed regulations Sec. 1.263(g)-4(c) Example 7 (relating to a 
straddle consisting of stock and an equity swap) illustrate one 
application of this facts and circumstances rule. The Treasury 
Department and the IRS invite comments and suggestions regarding both 
the proposed specific allocation rules and the general facts and 
circumstances allocation rule.
    The regulations under section 263(g) are proposed to be effective 
for expenses paid, incurred, or accrued after the date the regulations 
are adopted as final for straddles established on or after January 17, 
2001. See Sec. 1.263(g)-5.

Obligation Under a Debt Instrument as a Position in Personal Property

    If a taxpayer is the obligor under a debt instrument that provides 
for one or more payments linked to the value of actively traded 
personal property, the value of the taxpayer's obligation under the 
debt instrument changes as the value of the referenced property 
changes. For this reason, the taxpayer's position as obligor under the 
debt instrument functions as a position in the referenced property.
    Some commentators have suggested that a debt instrument (other than 
one denominated in an actively traded foreign currency) cannot be a 
position of the obligor in personal property that is part of a 
straddle. Section 1092(d)(7) provides that an obligor's interest in a 
nonfunctional-currency-denominated debt instrument is treated under 
section 1092(d)(2) as a position in the nonfunctional currency. From 
this, the commentators infer that an obligor's interest in a debt 
instrument may never be treated as an interest in personal property 
other than a nonfunctional currency.
    However, neither the legislative history nor the express language 
of section 1092(d)(7) indicates that Congress intended to exclude 
interests in personal property from the definition of position in 
section 1092(d)(2). A rule that a debt instrument can be a position in 
currency does not establish that a debt instrument is a position only 
in currency. This interpretation of section 1092(d)(7) has already been 
rejected by the IRS and Treasury in Sec. 1.1275-4(b)(9)(vi), which 
provides that increased interest expense on a contingent payment debt 
instrument issued by a taxpayer may be a straddle loss subject to 
section 1092 deferral.
    To clarify the definition of position under section 1092(d)(2), 
Sec. 1.1092(d)-1(d) of the proposed regulations explicitly provides 
that an obligation under a debt instrument may be a position in 
personal property that is part of a straddle. This provision is 
proposed to be effective for straddles established on or after January 
17, 2001. However, no inference is intended with respect to straddles 
established prior to Janaury 17, 2001. Thus, in appropriate cases, the 
IRS may take the position under section 1092(d)(2) that, even in the 
absence of a regulation, an obligation under a debt instrument was part 
of a straddle prior to the effective date of Sec. 1.1092(d)-1(d) if the 
debt instrument functioned economically as an interest in actively 
traded personal property.
    In 1995, the IRS published proposed regulation Sec. 1.1092(d)-(2). 
See 60 F.R. 21482; FI-21-95, 1995-1 C.B. 935. The proposed regulations 
clarify the circumstances in which common stock may be personal 
property for the purposes of section 1092. Because proposed regulation 
Secs. 1.1092(d)-2 and 1.1092(d)-1(d) address similar issues, the IRS 
proposes to finalize both regulations simultaneously. The Treasury 
Department and the IRS, therefore, invite additional comment on 
proposed Sec. 1.1092(d)-(2).
    In addition, in 1985, the Treasury Department and the IRS adopted 
Temporary Regulation Sec. 1.1092(d)-5T(d), which defines the term loss 
for purposes of Secs. 1.1092(b)-1T through 1.1092(b)-4T as a loss 
otherwise allowable under section 165(a). The Treasury Department and 
the IRS request comments on whether that definition should be expanded 
to include expenses such as interest and carrying charges or payments 
on notional principal contracts. If so, how should such a change be 
coordinated with the proposed regulations in this document?

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written or electronic comments (a 
signed original and eight (8) copies, if written) that are submitted 
timely (in the manner described in the ADDRESSES portion of this 
preamble) to the IRS. The IRS and Treasury request comments on the 
clarity of the proposed regulations and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for May 22, 2001, at 10 a.m. in 
the Auditorium, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington DC. Due to building security procedures, visitors must 
enter at the 10th Street entrance located between Constitution and 
Pennsylvania Avenues, NW. In addition, all visitors must present photo 
identifications to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 15 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
the FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit and an outline 
of the topics to be discussed and the time to be devoted to each topic 
(signed original and eight (8) copies) by May 1, 2001. A period of 10 
minutes will be allotted to each person for making comments. An agenda 
showing the scheduling of the speakers will be prepared after the 
deadline for receiving outlines has passed. Copies of the agenda will 
be available free of charge at the hearing.

[[Page 4749]]

Drafting Information

    The principal author of these regulations is Kenneth Christman, 
Office of Associate Chief Counsel (Financial Institutions and 
Products). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.263(g)-1 also issued under 26 U.S.C. 1092(b)(1).
    Section 1.263(g)-2 also issued under 26 U.S.C. 1092(b)(1).
    Section 1.263(g)-3 also issued under 26 U.S.C. 1092(b)(1).
    Section 1.263(g)-4 also issued under 26 U.S.C. 1092(b)(1).
    Section 1.263(g)-5 also issued under 26 U.S.C. 1092(b)(1). * * *
    Section 1.1092(d)-1 also issued under 26 U.S.C. 1092(b)(1).
    Par. 2. Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, 1.263(g)-4, 
and 1.263(g)-5 are added to read as follows:

Sec. 1.263(g)-1  Treatment of interest and carrying charges in the case 
of straddles; in general.

    (a) Under section 263(g), no deduction is allowed for interest and 
carrying charges allocable to personal property that is part of a 
straddle (as defined in section 1092(c)). The purpose of section 263(g) 
is to coordinate the character and the timing of items of income and 
loss attributable to a taxpayer's positions that are part of a 
straddle. In order to prevent payments or accruals related to a 
straddle transaction from giving rise to recognition of deductions or 
losses before related income is recognized and to prevent the items of 
loss and income from having different character, no deduction is 
allowed for interest and carrying charges properly allocable to 
personal property that is part of a straddle. Rather, such amounts are 
chargeable to the capital account of the personal property to which the 
interest and carrying charges are properly allocable.
    (b) Section 263(g) does not apply if none of the taxpayer's 
positions that are part of the straddle are personal property. Section 
263(g) also does not apply to hedging transactions as defined in 
section 1256(e) (see section 263(g)(3)) or to securities to which the 
mark-to-market accounting method provided by section 475 applies (see 
section 475(d)(1)).
    (c) Section 1.263(g)-2 provides a definition of personal property 
for purposes of section 263(g) and Secs. 1.263(g)-1 through 1.263(g)-5. 
Section 1.263(g)-3 provides a definition of interest and carrying 
charges for purposes of section 263(g), section 1092, Secs. 1.263(g)-1 
through 1.263(g)-5, and Sec. 1.1092(b)-4T. Section 1.263(g)-4 provides 
a set of allocation rules governing the capitalization of amounts to 
which section 263(g) applies.


Sec. 1.263(g)-2  Personal property to which interest and carrying 
charges may properly be allocable.

    (a) Definition of personal property. For purposes of section 263(g) 
and of Secs. 1.263(g)-1 through 1.263(g)-5, personal property means 
property, whether or not actively traded, that is not real property. 
For purposes of the preceding sentence, a position in personal property 
may itself be property. In general, however, a position in personal 
property is not property of a taxpayer unless the position confers or 
may confer substantial rights on the taxpayer.
    (1) Application to certain financial instruments. Personal property 
includes a stockholder's ownership of common stock, a holder's 
ownership of a debt instrument, and either party's position in a 
forward contract or in a conventional swap agreement. Personal property 
does not include a position that imposes obligations but does not 
confer substantial rights on the taxpayer. Therefore, the obligor's 
position in a debt instrument generally is not personal property, even 
though the obligor may have typical rights of a debtor, such as the 
right to prepay the debt. However, the obligor on a debt instrument has 
a position in any personal property underlying the debt instrument. See 
Sec. 1.1092(d)-1(d).
    (2) Options. For the purposes of applying this section, a put 
option or call option imposes obligations but does not confer 
substantial rights on the grantor, whether or not the option is cash-
settled.

    (b) Example. The following example illustrates the rules stated 
in paragraph (a) of this section:
    Example. (i) Facts. A purchases 100 ounces of gold at a cost of 
$x. A transfers the 100 ounces of gold to a trust that issues 
multiple classes of trust certificates and is treated as a 
partnership for tax purposes. In return, A receives two trust 
certificates that are not personal property of a type that is 
actively traded within the meaning of section 1092(d)(1). One 
certificate entitles A to a payment on termination of the trust at 
the end of four years equal to the value of the 100 ounces of gold 
up to a maximum value of 
$(x + y). The other certificate entitles A to a payment equal to the 
amount by which the value of 100 ounces of gold exceeds $(x + y) on 
termination of the trust. A sells the second certificate and keeps 
the first certificate.
    (ii) Analysis. The trust certificate retained by A is property 
that is not real property. In addition, ownership of the trust 
certificate confers certain substantial rights on A. Therefore, 
although the trust certificate is not personal property of a type 
that is actively traded, A's interest in the trust certificate is 
personal property for purposes of section 263(g).


Sec. 1.263(g)-3  Interest and carrying charges properly allocable to 
personal property that is part of a straddle.

    (a) In general. For purposes of section 263(g), section 1092, 
Secs. 1.263(g)-1 through 1.263(g)-5, and Sec. 1.1092(b)-4T, interest 
and carrying charges properly allocable to personal property that is 
part of a straddle means the excess of interest and carrying charges 
(as defined in paragraph (b) of this section) over the allowable income 
offsets (as defined in paragraph (e) of this section).
    (b) Interest and carrying charges. Interest and carrying charges 
are otherwise deductible amounts paid or accrued with respect to 
indebtedness or other financing incurred or continued to purchase or 
carry personal property that is part of a straddle and otherwise 
deductible amounts paid or incurred to carry personal property that is 
part of a straddle. As provided in section 263(g)(2), interest includes 
any amount paid or incurred in connection with personal property used 
in a short sale. Interest and carrying charges include--
    (1) Otherwise deductible payments or accruals (including interest 
and original issue discount) on indebtedness or other financing issued 
or continued to purchase or carry personal property that is part of a 
straddle;
    (2) Otherwise deductible fees or expenses paid or incurred in 
connection with acquiring or holding personal property that is part of 
a straddle including, but not limited to, fees or expenses incurred to 
purchase, insure, store, maintain or transport the personal property; 
and
    (3) Other otherwise deductible payments or accruals on financial 
instruments that are part of a straddle or that carry part of a 
straddle.
    (c) Indebtedness or other financing incurred or continued to 
purchase or carry personal property that is part of a

[[Page 4750]]

straddle. For purposes of paragraph (b)(1) of this section, 
indebtedness or other financing that is incurred or continued to 
purchase or carry personal property that is part of a straddle 
includes--
    (1) Indebtedness or other financing the proceeds of which are used 
directly or indirectly to purchase or carry personal property that is 
part of the straddle;
    (2) Indebtedness or other financing that is secured directly or 
indirectly by personal property that is part of the straddle; and
    (3) Indebtedness or other financing the payments on which are 
determined by reference to payments with respect to the personal 
property or the value of, or change in value of, the personal property.
    (d) Financial instruments that are part of a straddle or that carry 
part of a straddle. For purposes of paragraph (b)(3), financial 
instruments that are part of a straddle or that carry part of a 
straddle include--
    (1) A financial instrument that is part of the straddle;
    (2) A financial instrument that is issued in connection with the 
creation or acquisition of a position in personal property if that 
position is part of the straddle;
    (3) A financial instrument that is sold or marketed as part of an 
arrangement that involves a taxpayer's position in personal property 
that is part of the straddle and that is purported to result in either 
economic realization of all or part of the appreciation in an asset 
without simultaneous recognition of taxable income or a current tax 
deduction (for interest, carrying charges, payments on a notional 
principal contract, or otherwise) reflecting a payment or expense that 
is economically offset by an increase in value that is not concurrently 
recognized for tax purposes or has a different tax character (for 
example, an interest payment that is economically offset by an increase 
in value that may result in a capital gain in a later tax period); and
    (4) Any other financial instrument if the totality of the facts and 
circumstances support a reasonable inference that the issuance, 
purchase, or continuation of the financial instrument by the taxpayer 
was intended to purchase or carry personal property that is part of the 
straddle.
    (e) Allowable income offsets. The allowable income offsets are:
    (1) The amount of interest (including original issue discount) 
includible in gross income for the taxable year with respect to such 
personal property;
    (2) Any amount treated as ordinary income under section 
1271(a)(3)(A), 1278, or 1281(a) with respect to such personal property 
for the taxable year;
    (3) The excess of any dividends includible in gross income with 
respect to such property for the taxable year over the amount of any 
deductions allowable with respect to such dividends under section 243, 
244, or 245;
    (4) Any amount that is a payment with respect to a security loan 
(within the meaning of section 512(a)(5)) includible in income with 
respect to the personal property for the taxable year; and
    (5) Any amount that is a receipt or accrual includible in income 
for the taxable year with respect to a financial instrument described 
in Sec. 1.263(g)-3(d) to the extent the financial instrument is entered 
into to purchase or carry the personal property.


Sec. 1.263(g)-4  Rules for allocating amounts to personal property that 
is part of a straddle.

    (a) Allocation rules. (1) Interest and carrying charges paid or 
accrued on indebtedness or other financing issued or continued to 
purchase or carry personal property that is part of a straddle are 
allocated, in the order listed--
    (i) To personal property that is part of the straddle purchased, 
directly or indirectly, with the proceeds of the indebtedness or other 
financing;
    (ii) To personal property that is part of the straddle and directly 
or indirectly secures the indebtedness or other financing; or
    (iii) If all or a portion of such interest and carrying charges are 
determined by reference to the value or change in value of personal 
property, to such personal property.
    (2) Fees and expenses described in Sec. 1.263(g)-3(b)(2) are 
allocated to the personal property, the acquisition or holding of which 
resulted in the fees and expenses being paid or incurred.
    (3) In all other cases, interest and carrying charges are allocated 
to personal property that is part of a straddle in the manner that 
under all the facts and circumstances is most appropriate.
    (b) Coordination with other provisions. In the case of a short 
sale, section 263(g) applies after section 263(h). See sections 
263(g)(4)(A) and (h)(6). In case of an obligation to which section 1277 
(dealing with deferral of interest deduction allocable to accrued 
market discount) or 1282 (dealing with deferral of interest deduction 
allocable to certain accruals on short-term indebtedness) applies, 
section 263(g) applies after section 1277 and section 1282. See section 
263(g)(4)(B). Capitalization under section 263(g) applies before loss 
deferral under section 1092.
    (c) Examples. The following examples illustrate the rules stated in 
Secs. 1.263(g)-2, 1.263(g)-3, and 1.263(g)-4.
    Example 1. Cash and Carry Silver.
    (i) Facts. On January 1, 2002, A borrows $x at 6% interest and 
uses the proceeds to purchase y ounces of silver from B. At 
approximately the same time, A enters into a forward contract with C 
to deliver y ounces of silver to C in one year.
    (ii) Analysis. The y ounces of silver and the forward contract 
to deliver y ounces of silver in one year are offsetting positions 
with respect to the same personal property and therefore constitute 
a straddle. See sections 1092(c)(1), (c)(3)(A)(i). The proceeds of 
the debt instrument were used to purchase personal property that is 
part of the straddle. Consequently, A's interest payments are 
interest and carrying charges properly allocable to personal 
property that is part of a straddle. See Sec. 1.263(g)-3(b)(1) & 
(c)(1). Under Sec. 1.263(g)-4(a)(1)(i), the interest payments must 
be charged to the capital account for the y ounces of silver 
purchased by A with the proceeds of the borrowing.
    Example 2. Additional indebtedness issued to carry personal 
property.
    (i) Facts. The facts are the same as for Example 1 except that 
during the year 2002, the market price of silver increases and A is 
required to post variation margin as security for its obligation to 
deliver y ounces of silver to C. A incurs additional indebtedness to 
obtain funds necessary to meet A's variation margin requirement.
    (ii) Analysis. The additional indebtedness is incurred to 
continue to carry A's holding of z ounces of silver. Consequently, 
A's interest payments on the additional indebtedness are interest 
and carrying charges properly allocable to personal property that is 
part of a straddle and must be charged to the capital account for 
the y ounces of silver.
    Example 3. Contingent payment debt instrument.
    (i) Facts. On January 1, 2002, D enters into a contract to 
deliver x barrels of fuel oil to E on July 1, 2004, at an aggregate 
price equal to $y. Soon afterward, D issues a contingent payment 
debt instrument to F with a principal amount of $z and a 2-year term 
that pays interest quarterly at a rate determined at the beginning 
of each quarter equal to the greater of zero and the London 
Interbank Offered Rate (LIBOR) adjusted by an index that varies 
inversely with changes in the price of fuel oil (so that the 
interest rate increases as the price of fuel oil decreases and vice 
versa). The change in the aggregate amount of interest paid on the 
$z of debt due to the functioning of the index approximates the 
concurrent aggregate change in value of x barrels of fuel oil and, 
thus, the value of D's interest in the forward contract.
    (ii) Analysis. The debt instrument and the forward contract are 
offsetting positions with respect to the same personal property and

[[Page 4751]]

constitute a straddle. See section 1092(c)(1), (c)(3)(A)(i). When 
issued, the debt instrument is a position in personal property that 
is part of a straddle. See Sec. 1.1092(d)-1(d). Consequently, D's 
interest payments are interest and carrying charges properly 
allocable to personal property that is part of a straddle and must 
be allocated to the capital account for the forward contract for the 
delivery of x barrels of fuel oil to E. See Secs. 1.263(g)-3(b)(1), 
(b)(3), (c)(3), and (d)(1) and -4(a)(1)(iii).
    Example 4. Financial instrument issued to carry personal 
property that is part of a straddle. (i) Facts. The facts are the 
same as for Example 3 except that D also enters into a two-year 
interest rate swap under which D receives LIBOR times a notional 
principal amount equal to $z and pays 7% times $z.
    (ii) Analysis. Because of the relationship between the two-year 
debt instrument issued by D and the interest rate swap, the interest 
rate swap is a financial instrument that carries personal property 
that is part of a straddle. See Sec. 1.263(g)-3(d)(4). Net payments 
made by D under the interest rate swap are chargeable to the capital 
account for the forward contract for the delivery of x barrels of 
fuel oil to E. Similarly, net payments received by D under the 
interest rate swap are allowable offsets. See Sec. 1.263(g)-3(e)(5).
    Example 5.  Contingent payment debt instrument with embedded 
short position.
    (i) Facts. On January 1, 1998, G purchases 100,000 shares of the 
common stock of XYZ corporation (which is publicly traded). On 
January 1, 2002, the 100,000 shares of XYZ corporation common stock 
were worth $x per share. On that date, G issued a contingent payment 
debt instrument for $100,000x. The terms of the debt instrument 
provided that the holder would receive an annual payment of $2,000x 
on December 31 of each year up to and including the maturity date of 
December 31, 2007. On the maturity date, the holders would also 
receive a payment of $100,000x plus an additional amount, if the 
price of an XYZ share exceeded $1.2x on such date, equal to 100,000 
times three-quarters of the amount of such excess per share. Thus, 
G's aggregate payments on the debt instrument varied directly with 
the increase in value in the XYZ shares.
    (ii) Analysis. The debt instrument is a position in XYZ stock. 
See Sec. 1.1092(d)-1(d). The XYZ stock is personal property within 
the meaning of section 1092(d)(3)(B) because the debt instrument is 
a position with respect to substantially similar or related property 
(other than stock) within the meaning of section 
1092(d)(3)(B)(i)(II). See Sec. 1.1092(d)-2(c). The debt instrument 
and the XYZ shares are offsetting positions with respect to the same 
personal property and constitute a straddle. See sections 
1092(c)(1), (c)(3)(A)(i). Consequently, G's interest payments are 
interest and carrying charges properly allocable to personal 
property that is part of a straddle, see Secs. 1.263(g)-3(b)(1), 
(b)(3), (c)(3), and (d)(1), and must be allocated to the capital 
account for the XYZ common stock, see Sec. 1.263(g)-4(a)(1)(iii) and 
(a)(3).
    Example 6. Straddle including partnership interest.
    (i) Facts. H borrows money from I to purchase 100 ounces of gold 
at a cost of $u. H transfers the 100 ounces of gold and $v to a 
newly created trust that issues multiple classes of trust 
certificates and is treated as a partnership for tax purposes. In 
return, H receives two trust certificates. One certificate entitles 
the holder to a payment on termination of the trust at the end of 
four years equal to the value of the 100 ounces of gold up to a 
maximum value of $(u + w). The other certificate entitles the holder 
to a payment equal to the amount by which the value of 100 ounces of 
gold exceeds $(u + w) on termination of the trust. H sells the 
second certificate and keeps the first certificate. H also enters 
into a forward contract to sell 100 ounces of gold for $1.12u per 
ounce on a date two years after creation of the trust. The trust 
uses part of the $v and similar cash contributions from other 
investors to pay costs of storing the gold held by the trust and 
allocates H's share of the expenses to H.
    (ii) Analysis. The trust certificate retained by H and the 
forward contract entered into by H are personal property for the 
purposes of section 263(g). See Sec. 1.263(g)-2(a). They are also 
offsetting positions and constitute a straddle. Section 1092(c)(1). 
The borrowing from I is an indebtedness incurred to purchase 
personal property that is part of a straddle. See Secs. 1.263(g)-
3(b)(1) and (c)(1). Similarly, the gold storage expenses are 
expenses incurred due to the taxpayer's holding personal property 
that is part of a straddle. See Sec. 1.263(g)-3(b)(2). Therefore 
both the interest on the borrowing and the gold storage expenses 
must be allocated to the capital account for the partnership 
interest represented by the retained trust certificate. See 
Sec. 1.263(g)-4(a)(1)(i) and (a)(2).
    Example 7. Equity Swap.
    (i) Facts. On January 1, 1998, J purchases 100,000 shares of the 
common stock of XYZ corporation (which is publicly traded). On 
December 31, 2001, the 100,000 shares of XYZ corporation common 
stock were worth $x per share. On that date, J entered into a NPC 
with K. The terms of the NPC provided that K would receive an annual 
payment on December 31 of each year equal to 100,000 times any 
appreciation in the value of a share of XYZ corporation stock above 
its price at the end of trading on December 31 of the preceding year 
and 100,000 times the dividends paid during the year on each share 
of XYZ corporation stock. In return, on December 31 of each year, J 
would receive an amount equal to LIBOR times the value of 100,000 
XYZ shares at the end of trading on December 31 of the preceding 
year plus 100,000 times the amount of any decrease in the value of a 
share of XYZ corporation stock below its price at the end of trading 
on December 31 of the preceding year. Payments between J and K would 
be netted and continue up to and including the maturity date of the 
NPC on December 31, 2008. Thus, J's aggregate payments on the NPC 
varied directly with the increase in value in the XYZ shares.
    (ii) Analysis. The NPC is a position in XYZ stock. See 
Sec. 1.1092(d)-2(c). The XYZ stock is personal property within the 
meaning of section 1092(d)(3)(B) because the NPC is a position with 
respect to substantially similar or related property (other than 
stock) within the meaning of section 1092(b)(3)(B)(i)(II). See 
Sec. 1.1092(d)-2(a)(1)(ii). The NPC and the XYZ shares are 
offsetting positions with respect to the same personal property and 
constitute a straddle. See sections 1092(c)(1), (c)(3)(A)(i). 
Consequently, J's payments are interest and carrying charges 
properly allocable to personal property that is part of a straddle. 
See Secs. 1.263(g)-3(b)(3) and (d)(1). Therefore, they should be 
allocated to the personal property that is part of the straddle in 
the manner that is most appropriate under all the facts and 
circumstances. In this case, because these payments are incurred to 
carry the XYZ shares, they should be allocated to the capital 
account for the XYZ common stock. See Sec. 1.263(g)-4(a)(3).


Sec. 1.263(g)-5  Effective dates.

    Sections 1.263(g)-1, 1.263(g)-2, 1.263(g)-3, and 1.263(g)-4 apply 
to interest and carrying charges properly allocable to personal 
property that are paid, incurred, or accrued after the date these 
regulations are adopted as final regulations by publication in the 
Federal Register for a straddle established on or after January 17, 
2001.
    Par. 3. Section 1.1092(d)-1 is amended by revising paragraph (d) 
and adding paragraph (e), to read as follows:


Sec. 1.1092(d)-1  Definitions and special rules.

* * * * *
    (d) Debt instrument linked to the value of personal property. If a 
taxpayer is the obligor under a debt instrument one or more payments on 
which are linked to the value of personal property or a position with 
respect to personal property, then the taxpayer's obligation under the 
debt instrument is a position with respect to personal property and may 
be part of a straddle.
    (e) Effective dates. Paragraph (b)(1)(vii) of this section applies 
to positions entered into on or after October 14, 1993. Paragraph (c) 
of this section applies to positions entered into on or after July 8, 
1991. Paragraph (d) of this section is effective for straddles 
established on or after January 17, 2001.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-1240 Filed 1-17-01; 8:45 am]
BILLING CODE 4830-01-P