March 18, 2011 Ms. Jessica Howard Tax Policy Analyst Office of Tax Policy Analysis New York State Department of Taxation and Finance W.A. Harriman Campus Albany, New York 12227 Re: New York State Corporate Tax Reform: Responding to Your Request for a Summary of IRC Section 1256 Dear Ms. Howard: Near the end of last year, you requested that The Clearing House Association L.L.C. ( The Clearing House ) 1 follow up on our offer to provide you with some background information about Internal Revenue Code ( IRC ) Section 1256. We made that offer in connection with the New York State corporate tax reform project and our request that the proposed qualified financial instrument definition include, not only assets marked to market under IRC Section 475, but also assets marked tomarket under IRC Section 1256. We attach a summary of IRC Section 1256 which we hope will assist you. We note that the Governor s 2011 12 Executive Budget includes an extension of the Gramm Leach Bliley transitional rules for two years. The Memorandum in Support explains that: Making permanent the bank tax provisions and providing a two year extender for the Gramm Leach Bliley Act transitional provisions provides filing and accounting continuity for business taxpayers, while allowing for the potential introduction of more comprehensive corporate tax reform in the future. Following on this, and the progress made on the tax reform effort last year, we thought it might be helpful to you if we listed the few items that we believe had been left open at the end of last year and/or about which we would like to have further discussions: 1 Established in 1853, The Clearing House is the nation s oldest banking association and payments company. It is owned by the world s largest commercial banks, which collectively employ 1.4 million people in the United States and hold more than half of all U.S. deposits. The Clearing House Association L.L.C. is a nonpartisan advocacy organization representing through regulatory comment letters, amicus briefs and white papers the interests of its owner banks on a variety of systemically important banking issues. Its affiliate, The Clearing House Payments Company L.L.C., provides payment, clearing, and settlement services to its member banks and other financial institutions, clearing almost $2 trillion daily and representing nearly half of the automated-clearing-house, funds-transfer, and check-image payments made in the U.S. See The Clearing House s web page at www.theclearinghouse.org.
Ms. Jessica Howard 2 March 18, 2011 defining qualified financial instruments (for purposes of the 8% sourcing rule) to include not only IRC Section 475 assets, but also IRC Section 1256 assets); adding to the draft bill s provisions addressing the disallowance of interest expense attributable to stock in foreign subsidiaries that, in the case of foreign subsidiaries held by a bank through a so called Edge Act corporation, the bank s shares in the Edge Act corporation be treated as if they were the shares in all the foreign subsidiaries held by the Edge Act corporation (discussed in our letter dated May 6, 2010); and whether contracts on physical commodities and physical commodities themselves would be excluded from the QFI regime (as the Department had last proposed) or included. We look forward to our continuing dialogue with the Department. * * * If you have any questions or if the members of The Clearing House can assist you in any way, please contact me at 212.613.9883 (email: david.wagner@theclearinghouse.org). Sincerely yours, David Wagner Senior Vice President, Financial and Tax Affairs cc: Thomas H. Mattox Commissioner New York State Department of Taxation and Finance Robert Plattner Deputy Commissioner for Tax Policy New York State Department of Taxation and Finance Thomas Powers, JPMorgan Chase Bank, National Association Chair, State Tax Working Group The Clearing House Association L.L.C. Diana L. Wollman, Esq. Sullivan & Cromwell LLP
March 18, 2011 The Clearing House Association Internal Revenue Code Sections 475 and 1256 You requested some additional information about Section 1256 of the Internal Revenue of 1986, as amended (the Code ), and its interrelationship with Code Section 475. 1 Code Section 475 imposes a mark to market tax regime on certain securities held by a dealer in such securities. Under Code Section 475, a dealer s Section 475 securities held at year end are marked to market (i.e., treated as sold for their fair market value) at the end of each tax year, and any gains or losses from such marking to market are treated as ordinary income or ordinary loss (as opposed to capital gain or capital loss). Persons who are traders in securities (or dealers or traders in commodities ) may elect to have Code Section 475 apply to their securities (or, as applicable, commodities) under Code Sections 475(e) and (f). The types of securities to which Code Section 475 applies are listed in Code Section 475(c)(2) and the list is fairly comprehensive. 2 Code Section 1256 also applies a mark to market regime, but Code Section 1256 applies to a more limited universe of financial instruments. Since the instruments described in Code Section 1256 are generally also described in Code Section 475(c)(2)(E), Code Section 475 includes a tie breaker or carve out rule that provides that any instrument described in both Code Section 475(c)(2)(E) and Code Section 1256 is subject to Code Section 1256 only. (See Code Section 475(c)(2)(last sentence).) 3 Under the Code Section 1256 regime, all of the taxpayer s Section 1256 contracts are markedto market at the end of each year (in the same way in which Code Section 475 securities are marked tomarket). The only notable difference between the two mark to market regimes is that under Code Section 1256 any gains or losses from such marking to market or from an actual disposition are treated 1 2 3 References herein to Section or Sections shall be to the Code, except as otherwise noted. The Code Section 475 list of securities includes (i) shares of stock in a corporation, (ii) ownership interests in a widely held or publicly traded partnership or trust, (iii) debt instruments, (iv) interest rate, currency, or equity notional principal contracts, (v) an interest in, or a derivative financial instrument in, any security described above in (i) (iv) or any currency, including any option, forward contract, short position, or any similar financial instrument in any such security or currency, and (vi) a position which is not described above but which is identified as a hedge of a security that is described above and is held by the taxpayer. Certain securities that would otherwise qualify as securities under this definition are excluded (and thus not subject to Section 475 mark to market) based upon how the taxpayer holds them, including any securities held for investment and any debt instruments not held for sale. (See Code Sections 475(b)(1)(A) and (B)). Thus, section 210 a(5)(a) of the last released proposed reform bill from June 2010, which would define qualified financial instrument as any security that is marked to market under section 475 of the internal revenue code, would not include securities that are marked to market under Code Section 1256 (rather than Code Section 475).
- 2 - as 40% short term capital gain (or loss) and 60% long term capital gain (or loss), 4 whereas under Code Section 475 the gains and losses are treated as ordinary. Under Code Section 1256, the 40/60 treatment applies regardless of how long the Section 1256 contract has actually been held by the taxpayer. 5 Currently, Code Section 1256 applies to five types of Section 1256 contracts, as follows: Regulated Futures Contracts and Dealer Securities Future Contracts A futures contract is generally a contract pursuant to which one party agrees to sell and another party agrees to purchase a specified underlying asset on a future designated date and at a specified price. Futures contracts are generally traded on exchanges and have standardized terms, so that a futures contract is often settled by acquiring an opposite position in a futures contract having identical terms as the original contract and then netting the two contracts; settlement in cash or in kind is also possible. A Section 1256 regulated futures contract means a contract (i) which is traded on or subject to the rules of a qualified board or exchange, 6 and (ii) in respect of which the amount required to be deposited on account of the contract, and the amount that may be withdrawn, depends on a system of marking to market. 4 5 6 Certain contracts that would otherwise qualify as Section 1256 contracts are excluded (and thus not subject to Section 1256 mark to market) based upon how the taxpayer holds them, including a contract that has been identified as a hedge of another asset. See Code Section 1256(e). Additionally, a Code Section 1256 contract that would otherwise (but for Section 1256) be an ordinary income asset to the taxpayer is required to be marked to market at the end of each year under Code Section 1256, but the gain or loss is treated as ordinary (rather the 40/60 capital characterization as described above). See Code Section 1256(f)(2). Further, H.R. 4173, the Dodd Frank Wall Street Reform and Consumer Protection Act ( Dodd Frank ), enacted on July 21, 2010, amended Code Section 1256 to add a new set of exclusions from the definition of Code Section 1256 contracts. Under this amendment, interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, credit default swaps and similar agreements are not treated as Code Section 1256 contracts. This amendment was intended to ensure that after Dodd Frank, all swaps would be excluded from Code Section 1256. See H.R. Rep. No. 111 517, at 879 (2010) (Conf. Rep.) ( The title contains a provision to address the recharacterization of income as a result of increased exchange trading of derivatives contracts by clarifying that section 1256 of the Internal Revenue Code does not apply to certain derivatives contracts transacted on exchanges. ). The 40/60 capital treatment provided for by Code Section 1256 is something that the Obama Administration has proposed to do away with. See Department of the Treasury, General Explanations of the Administration s Fiscal Year 2012 Revenue Proposals, page 36, available at http://www.treasury.gov/resource center/taxpolicy/documents/final%20greenbook%20feb%202012.pdf. The term qualified board or exchange is used throughout Code Section 1256 and is defined as (1) a national securities exchange which is registered with the Securities and Exchange Commission, (2) a domestic board of trade designated as a contract market by the Commodities Futures Trading Commission, or (3) any other exchange that the U.S. Treasury Department has determined has rules adequate to carry out the purposes of Code Section 1256.
- 3 - A Section 1256 dealer securities futures contract means any securities future contract and any option on such a contract, which is (i) entered into by a dealer in the normal course of its activity of dealing in such contracts or options, and (ii) is traded on a qualified board or exchange. Dealer Equity Options and Nonequity Options An option is a contractual right to buy or sell a specified underlying asset (and may be settled in kind or in cash). For Code Section 1256 purposes, equity option means an option to buy or sell stock (or an option the value of which is determined by reference to any stock or certain narrow based security indices). A Section 1256 dealer equity option is an equity option that is (i) entered into by an options dealer in the normal course of its activity of dealing in options, and (ii) listed in a qualified board or exchange on which such options dealer is registered. A Section 1256 nonequity option is any option that is (i) traded on or subject to the rules of a qualified board or exchange, and (ii) not an equity option. Foreign Currency Contract A Section 1256 foreign currency contract is a contract which (i) requires the delivery of (or settlement based on the value of) a foreign currency which is a currency in which positions are also traded through regulated futures contracts, (ii) is traded in the interbank market, 7 and (iii) is entered into at arm s length at a price determined by reference to the price in the interbank market. * * * We believe that the main feature of Code Section 475 is the annual marking to market requirement. As the foregoing explains, Code Section 1256 and Code Section 475 are essentially identical mark to market regimes for securities. Therefore, excluding Code Section 1256 contracts from the qualified financial instrument regime applicable to Code Section 475 securities would create an unnecessary difference and unnecessary complexity. Moreover, we believe that the reform proposal adopted Code Section 475 as the reference for defining qualified financial instruments because the intention was to capture all the securities and derivatives contracts that a financial institution might hold as part of its business. As the foregoing explains, the broad scope of Code Section 475 is subject to a carve out for Code Section 1256 contracts. The reason for that carve out is not related to the 7 Interbank market is not defined in Code Section 1256, but the IRS has indicated that it means the overthe counter market by which banks and investment banks purchase and sell foreign currency and financial products. See Field Service Advisory 200025020 (June 23, 2000).
- 4 - reform project s goal of defining qualified financial instruments to include all the financial instruments held by a financial institution as part of its business. Thus, excluding Code Section 1256 contracts from the qualified financial instrument regime would both be contrary to what we believe was the goal of the regime and add unnecessary complexity.