PRESENT LAW AND ISSUES RELATED TO THE TAXATION OF FINANCIAL INSTRUMENTS AND PRODUCTS A REPORT TO THE JOINT COMMITTEE ON TAXATION Prepared by the Staff of the JOINT COMMITTEE ON TAXATION December 2, 2011 JCX-56-11 i CONTENTS Page INTRODUCTION AND SUMMARY . 1 I. CONSIDERATIONS IN HOLDING, ISSUING, AND STRUCTURING FINANCIAL INSTRUMENTS. 6 A. Economic Considerations . 7 B. Financial Accounting Considerations . 9 C. Regulatory Considerations . 12 II. U.S. INCOME TAX PRINCIPLES . 14 A. Timing of Income Rules . 16 B. Character of Income Rules. 19 C. Source of Income Rules . 22 III. INCOME TAX AND ACCOUNTING RULES AND ECONOMIC ANALYSIS RELATED TO FIVE FUNDAMENTAL FINANCIAL INSTRUMENTS . 24 A. Income Tax Rules . 24 1. Equity . 24 2. Debt . 30 3. Options . 32 4. Forward contracts . 36 5. Notional principal contracts . 39 B. Relationships among Financial Instruments . 44 C. Financial Accounting Treatment of Financial Instruments . 48 1. In general . 48 2. Consequences of holding and issuing debt and equity . 49 3. Consequences of entering into a derivative contract . 52 4. Special rules . 53 5. Issues in financial accounting for financial instruments . 56 6. Major differences between tax and financial accounting for financial instruments . 58 IV. DISCUSSION OF SELECTED TAX ISSUES . 62 A. Issues Related to the Categorization of an Instrument . 62 B. Issues Related to Timing . 68 1. Deferral of income . 68 2. Acceleration of losses . 70 C. Issues Related to Character . 72 1. Conversion of short-term gain into long-term gain . 72 2. Conversion of capital to ordinary and vice versa . 73 D. Issues Related to Source . 75 1. Category of income conversion . 75 ii 2. Gaps in source rules . 77 E. When Issues of Timing, Character, and Source Intersect . 80 1. Timing and character rules for section 1256 contracts and tax straddles . 80 2. Constructive ownership transactions under section 1260 . 84 3. Exchange traded note