A derivative is a financial contract that gets its value from the price of another asset. There are different types of equity derivatives, like options and collars. An option gives the buyer the right to buy or sell a stock at a specific price within a certain time period. A collar is a combination of a put option (the right to sell a stock) and a call option (the right to buy a stock) to minimize costs. These derivatives can be used in everyday tax planning. A forward contract is when one person agrees to buy something and another person agrees to sell it at a set price and date in the future. Neither person usually pays anything until the contract is done.
An equity swap is a contract where two parties agree to make payments to each other based on the price and dividends of a company’s stock. People usually use equity swaps to make it seem like they own stock in a company without actually buying any, or to get rid of the risk of owning stock without selling it. But with equity swaps, the payments have to be made, while with other methods the payments may never have to be made. Taxpayer A wants to invest in a hedge fund but can’t, so they make a deal with a bank. A gets paid money every quarter based on how well the hedge fund is doing, and they also get a payment at the end if the fund has gone up in value. A has to pay the bank money every quarter and also at the end if the fund has gone down in value. The bank buys the shares to make sure everything is covered. When you buy an option, you can’t deduct the cost from your taxes. If you let the option expire, you can claim a loss equal to the price you paid for the option. If you sell the option before it ends, you’ll have to report any profit or loss. If you exercise the option, you will have to report any profit or loss.
If you sell an option, you won’t have to report any gain or loss on the money you receive upfront. If the person who bought the option lets it expire, you’ll have to report a short term capital gain equal to the money you received upfront. If the option is exercised, you’ll report any profit or loss.
The tax treatment of collars is not clear and may depend on specific circumstances. But generally, they could be treated as a single financial instrument or as separate options. When it comes to forwards, taxes aren’t usually an issue until the contract is closed. With equity swaps, the type of payment received determines the tax treatment. Periodic payments are taxed as regular income, while nonperiodic payments are also considered regular income. Termination payments are taxed as capital gains or losses.
People use equity derivatives to gain exposure to stocks without actually owning them, or to hedge their investments. For example, non-U.S. investors might use equity swaps to avoid paying a 30 percent U.S. withholding tax on dividends from American companies. A non-U.S. investor can use an equity swap with shares of U.S. stocks to avoid U.S. withholding tax. This means they still get the benefits of owning the stocks, like dividends and appreciation, without the tax consequences. Also, a tax-exempt organization can use derivative contracts to avoid paying unrelated business income tax on certain types of income. For example, they could use an equity swap to avoid this tax while still getting the benefits of owning the underlying investment. If you sell stock and then buy the same stock within 30 days, you can’t claim a tax loss. But if you use a different financial product like an equity swap, it might not be considered the same as buying the stock again, so you could still claim the loss for tax purposes. This is because a swap doesn’t give you the same rights as actually owning the stock. The synthetic ownership strategy can be used to avoid certain tax rules, like the passive foreign investment company (PFIC) rules and the U.S. federal estate tax rules. This strategy allows investors to invest in derivative products without being treated as directly owning the underlying assets, which can help them avoid negative tax consequences. However, it’s important to be aware of Section 1260, which recharacterizes certain gains from derivative contracts as ordinary income instead of long-term capital gains. But overall, this strategy can still be effective in minimizing tax impact. The hedging/monetization strategy involves getting cash from the current value of shares you already own, without having to pay taxes on the gain or worrying about the shares losing value. This can be done by borrowing money using the shares as collateral and entering into a type of trade that protects the value of the shares. This strategy is best for people who want to delay paying taxes on the gain or won’t have to pay taxes at all in the future. Equity derivatives can be used in tax planning to avoid certain tax rules, such as §1259 which treats certain transactions as if the underlying shares were sold. They can also be used in a repatriation strategy to bring cash back to the US without incurring tax under §956. Understanding the separation of economics from ownership of the underlying asset is key to using derivatives in tax planning. 1) There are two types of derivatives: over-the-counter (customized contracts between banks and end-users) and non-OTC (listed and traded on exchanges with standardized terms). This article focuses on OTC derivatives.
2) Equity derivatives involve shares of stock as the underlying asset.
3) Banks must follow “mark-to-market” rules and be indifferent to the tax consequences of owning shares directly.
4) Revenue Ruling 78-182.
5) Code Section 1234 (a)(2) and 1234 (a)(1).
6) Ibid.
7) Ibid.
8) Tax results are slightly different for cash-settled and physically-settled options.
9) Revenue Ruling 78-182.
10) Code Section 1234 (b).
11) This assumes cash settlement.
12) IRC Section 1259 treats entering into a forward contract to sell stock as a current sale of the stock.
13) Again, this assumes a cash settlement.
14) Treasury Regulation Section 1.446-3 (e)(1).
15) Treasury Regulation Section 1.446-3 (f)(1).
16) TAM 9730007 (July 25, 1997).
17) Treasury Regulation Section 1.446-3(h)(1).
18) Code Section 1234A.
19) Equity swaps make economic sense for stocks with high dividends due to transaction costs.
20) Code Sections 871 (a) and 881 (a) with reduced rates under some tax treaties.
21) Treasury Regulation Section 1.1441-4 (a)(3).
22) Treasury Regulation Section 1.863-7 (b).
23) Direct ownership has tax benefits such as the dividend received deduction.
24) Code Section 511 (a).
25) Treasury Regulation Section 1.512 (b)-1 (a)(1).
26) “Section” refers to sections of the Internal Revenue Code of 1986.
27) Wash sale rules may apply to the sale of an in-the-money put option.
28) Frank Lyon Co. v. U.S., 435 U.S. 561 and Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221.
29) Code Sections 1291-1298.
30) Code Sections 2101-2106.
31) Code Section 897.
32) Holder of call option on a passive foreign investment company (PFIC) may be treated as a PFIC shareholder.
33) The IRS is aware of planning opportunities related to FIRPTA.
34) When hedging shares, the taxpayer’s holding period is tolled for certain tax purposes.
35) Interest charges on borrowing may be subject to specific tax rules.
36) The transaction should not be subject to specific conversion rules.
37) Under certain circumstances, certain foreign currency gain or loss with respect to a section 1256 contract is treated as ordinary income or loss.
38) Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997.
39) New York State Bar Association report on the short-against-the-box proposal.
40) In general, a controlled foreign corporation is a foreign corporation that is more than 50 percent owned by 10 percent U.S. shareholders.
41) FSA 1999-794.
42) Rev. Rul. 82-150 (owner of deep in-the-money call option treated as shareholder).
Source: https://www.floridabar.org/the-florida-bar-journal/tax-planning-stategies-with-equity-derivatives/
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