SIA Recommends Changes In Conversion Transaction Regulations.

Saul Rosen has submitted the comments of the Securities Industry Association (SIA), New York, on the proposed regulations relating to the netting of certain gains and losses from positions in a conversion transaction. According to Rosen, SIA supports the regs' general policy to permit the netting of gains and losses. It believes, however, that the proposed regulations are too restrictive to provide adequate protection for most taxpayers, and it offers several recommendations to alleviate the perceived problem.

First, SIA says, the regs should provide a rule -- analogous to that of section 1258(d)(3)(A) -- under which (i) any position with a built-in gain that becomes part of a conversion transaction would be taken into account under section 1258 at its fair market value as of the time that the position became part of the conversion transaction, and (ii) any built-in gain on such a position would be recognized, and its character determined, without regard to section 1258.

SIA further recommends that an exclusion for built-in gains (like that for built-in losses) should incorporated in the regs' netting rule. An additional rule, it says, should be provided under which taxpayers that acquired all positions of a conversion transaction within a 14-day period and within the same tax year, but disposed of the positions at different times, could (i) mark to market any retained positions on the date that any other position is disposed of or otherwise terminated and (ii) net gains and losses (whether realized or deemed realized) on all positions in computing the amount of gain subject to ordinary income treatment.

Also, SIA believes that the regs should reduce the "applicable imputed income amount" for a conversion transaction by any amount that is capitalized by the taxpayer under section 263(g) and by prior inclusions of ordinary income (such as interest or dividends) with respect to the property held in the conversion transaction.

Finally, SIA recommends that the proposed regulations be made effective retroactively to the effective date of section 1258; that is, for conversion transactions entered into after April 30, 1993.

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May 9, 1995

Internal Revenue Service,

Re: Proposed Treasury Regulations under Internal

Dear Sir or Madam:

On behalf of the Securities Industry Association ("SIA"), /1/ this letter responds to the request by the Internal Revenue Service (the "Service") for comments on the proposed Treasury regulations issued on December 26, 1994 under section 1258 of the Internal Revenue Code of 1986, as amended (the "Code"), relating to the netting of certain gains and losses from positions in a conversion transaction (the "Proposed Regulations"). /2/

SUMMARY

SIA supports the general policy of the Proposed Regulations to permit the netting of gains and losses from positions of a conversion transaction. We believe that the Proposed Regulations are too restrictive, however, to provide adequate protection for most taxpayers. Therefore, we have the following recommendations:

1. The Proposed Regulations should provide a rule, analogous to that of Code section 1258(d)(3)(A), under which (i) any position with a built-in gain that becomes part of a conversion transaction would be taken into account under Code section 1258 at its fair market value as of the time that the position became part of the conversion transaction, and (ii) any built-in gain on such a position would be recognized, and its character determined, without regard to Code section 1258.

2. An exclusion for built-in gains (like that for built-in losses) should be incorporated in the netting rule of the Proposed Regulations. An additional rule should be provided under which taxpayers that acquired all positions of a conversion transaction within a 14-day period and within the same taxable year, but disposed of the positions at different times, would be permitted to (i) mark to market any retained positions on the date that any other position is disposed of or otherwise terminated and (ii) net gains and losses (whether realized or deemed realized) on all positions in computing the amount of gain subject to ordinary income treatment.

3. The Proposed Regulations should reduce the "applicable imputed income amount" for a conversion transaction by any amount that is capitalized by the taxpayer pursuant to Code section 263(g) and by prior inclusions of ordinary income (such as interest or dividends) with respect to the property held in the conversion transaction.

4. The Proposed Regulations should be made effective retroactively to the effective date of Code section 1258.

DISCUSSION

We believe that, ideally, the net amount of gain attributable to a conversion transaction would be determined for purposes of Code section 1258 by determining the fair market value of each position as of the date that the position became part of the conversion transaction and again upon termination of the transaction. Under this approach, only the net amount of gain arising on all positions during the term of the conversion transaction would be subject to ordinary income treatment. Any built-in gain or loss existing in a position at the time it became part of a conversion transaction, and any gain or loss arising in a position after termination of the conversion transaction, would be excluded from the scope of Code section 1258 and accounted for separately.

We recognize, however, that a "separate accounting" approach would be difficult to implement and administer, and we understand that Code section 1258 and the Proposed Regulations seek to approximate the results of a separate accounting approach through a series of more limited rules. Thus, under Code section 1258(d)(3), positions with built-in losses are taken into account at their fair market value at the time the positions become part of a conversion transaction, and such built-in losses are excluded in computing the amount of gain subject to ordinary income treatment. Further, under the Proposed Regulations, taxpayers would be permitted to net gains and losses (other than built-in losses) from positions of the same conversion transaction, if (i) the taxpayer has properly identified the conversion transaction as an "identified netting transaction" and (ii) the taxpayer disposes of or terminates all of the positions of the "identified netting transaction" within a 14-day period that is within a single taxable year. /3/

SIA supports the general policy of the Proposed Regulations to permit the netting of gains and losses on positions of a conversion transaction. If the Proposed Regulations are adopted in their current form, however, we believe that many taxpayers will still be required to treat as ordinary income an amount of gain that substantially exceeds the net gain attributable to the conversion transaction, i.e., the amount that would be determined under the separate accounting approach described above. To achieve results closer to separate accounting, certain additional provisions (discussed below) should be added to the Proposed Regulations.

1. EXCLUSION OF BUILT-IN GAINS.

Under Code section 1258(d)(3)(A), any position with a built-in loss that becomes part of a conversion transaction is taken into account under Code section 1258 at its fair market value as of the time that the position becomes part of the conversion transaction, and the amount of the built-in loss on such a position is recognized, and its character is determined, without regard to Code section 1258. For this purpose, the term "built-in loss" is defined in Code section 1258(d)(3)(B) to mean any loss that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became part of the conversion transaction.

Neither the statute nor the Proposed Regulations provide a similar exclusion for built-in gain in a position of a conversion transaction, i.e., any gain that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became part of the conversion transaction. Built-in gain that arose before the taxpayer entered into a conversion transaction is therefore subject to recharacterization as ordinary income, to the extent that gain arising during the transaction is less than the "applicable imputed income amount", i.e., the amount of interest that would have accrued on the taxpayer's net investment in the conversion transaction over the term of the transaction at a rate equal to 120 percent of the applicable Federal rate. Code section 1258(b).

Built-in gains are not, however, within the intended scope of Code section 1258, as described in its legislative history. The Committee reports on the Revenue Reconciliation Bill of 1993 describe a conversion transaction as a transaction in which "the taxpayer is in the economic position of a lender -- he has an expectation of a return from the transaction which in substance is in the nature of interest and he undertakes no significant risks other than those typical of a lender." See Report of the Committee on Ways and Means, House of Representatives, 103d Cong., 1st Sess., on Title XIV of H.R. 2141, WMCP 103-11, at p. 199; Report of the Senate Finance Committee, 103d Cong., 1st Sess. on S.1134, S.Rpt. 103-36, at p.234. Built-in gains are not in the nature of interest, because these gains arose during periods when the taxpayer held no offsetting position to reduce its risk. Rather, built-in gains are attributable solely to the increase in the value of the position prior to the creation of the conversion transaction. /4/

We note also that, in most cases, taxpayers with built-in gain on a position of a conversion transaction will be required to treat some portion of the built-in gain as ordinary income (in addition to the gain attributable to the transaction). This will occur because the interest rate used to calculate the "applicable imputed income amount" (120 percent of the applicable Federal rate) is higher than the rate of return available to most investors on a fully-hedged position such as a conversion transaction. Thus, the "applicable imputed income amount" will generally exceed the amount of gain that can be derived from a conversion transaction.

SIA recommends, therefore, that the Service provide, by regulation, a rule comparable to that of Code section 1258(d)(3)(A) for built-in gains. Specifically, the Proposed Regulations should provide that any position with a built-in gain that becomes part of a conversion transaction is taken into account under Code section 1258 at its fair market value as of the time that the position becomes part of the conversion transaction, and that the amount of any built- in gain on such a position is recognized, and its character is determined, without regard to Code section 1258. For this purpose, the term "built-in gain" would be defined as any gain that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became part of the conversion transaction.

We recognize that Code section 1258 does not provide explicit regulatory authority to exclude built-in gains from the scope of that section. Nonetheless, we believe that regulations providing for such an exclusion could be issued under the regulatory authority granted by Code section 1258(b) to provide for appropriate reductions to the applicable imputed income amount. This regulatory authority was granted to ensure that taxpayers are not required to treat as ordinary income any gain in excess of the amount attributable to the time value element of a conversion transaction. As discussed above, built-in gains are not attributable to any time value element of a conversion transaction, and thus are appropriately excluded from ordinary income treatment.

2. NETTING OF GAINS AND LOSSES.

As noted above, the Proposed Regulations permit taxpayers to net gains and losses from positions in an "identified netting transaction" only where all positions in the transaction are disposed of within a 14-day period falling in a single taxable year. The Proposed Regulations also provide for the exclusion of built-in losses in computing the net amount of gain from the identified netting transaction. For this purpose, Prop. Treas. Reg. section 1.1258-1(c) defines the term "built-in loss" to include any loss that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became part of the conversion transaction. /5/

a. PARALLEL EXCLUSION FOR BUILT-IN GAINS. The netting rule of Prop. Treas. Reg. section 1.1258-1(b) should be modified to provide an exclusion for built-in gains, similar to the exclusion for built- in losses. For this purpose, the term "built-in gain" should be defined to include any gain that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became part of the conversion transaction.

As discussed in 1. above, we recommend that the Proposed Regulations provide a general exclusion for built-in gains. Clearly, if our recommendation is adopted, the netting rule should reflect this general exclusion. Even if our recommendation is not adopted, however, built-in gains should still be excluded in determining the net amount of gain from a conversion transaction under the netting rule. Without this exclusion, the net amount of gain determined under the netting rule cannot be considered to approximate the true amount of gain attributable to the conversion transaction (unless no positions have built-in gain), and the netting rule will not achieve its purpose. Further, we believe that providing for the exclusion of built-in gains within the limited scope of the netting rule is clearly within the regulatory authority granted by Code section 1258(b).

b. POSITIONS ACQUIRED WITHIN 14-DAY PERIOD BUT DISPOSED OF AT DIFFERENT TIMES. The Proposed Regulations should also be expanded to provide an additional netting rule under which a taxpayer would not be required to dispose of all positions in a conversion transaction within any specified time period in order to net gains and losses. Under this rule, netting of gains and losses would be permitted where the taxpayer (i) acquired all positions of the conversion transaction within the same 14-day period and within the same taxable year and (ii) identified each position as part of an "identified netting transaction," under rules similar to those of Prop. Treas. Reg. section 1.1258-1(b)(2), before the close of the day on which the position becomes part of the conversion transaction.

If the taxpayer satisfied these requirements, the taxpayer would be treated as "legging out" of an identified netting transaction on the first date that any position is disposed of or otherwise terminated. Each position that the taxpayer has retained would be treated as sold for its fair market value on the leg-out date. The net amount of gain that would be subject to ordinary income treatment under Code section 1258(a) would be computed as of the leg-out date, taking into account gains and losses (whether realized or deemed realized) from all positions in the transaction.

This additional netting rule, in combination with the netting rule of Prop. Treas. Reg. section 1.1258-1(b), would achieve results similar to the separate accounting approach described above. We note also that the requirement that all positions of the "identified netting transaction" be acquired by the taxpayer within the same 14- day period, and within the same taxable year, should address any potential concern that an additional netting rule of this type might be used to accelerate or defer built-in gains or losses with respect to any position of a conversion transaction. Because all of the positions of the identified netting transaction would be acquired within a short period of time, there should be no meaningful built-in gain or loss in any position at the time the conversion transaction is created.

3. REDUCTION OF APPLICABLE IMPUTED INCOME AMOUNT BY AMOUNTS

Code section 1258(b) authorizes the Secretary of the Treasury to provide, by regulation, for the reduction of the "applicable imputed income amount" (i.e., the maximum amount of gain from a conversion transaction that may be treated as ordinary income under Code section 1258(a)) by amounts capitalized under Code section 263(g) and by prior inclusions of ordinary income (such as interest or dividends) with respect to property held in a conversion transaction. The Proposed Regulations do not, however, provide for these reductions.

We note that the legislative history of Code section 1258 contemplates that the "applicable imputed income amount" will be reduced by these items. /6/ We recognize that amounts capitalized under Code section 263(g) generally reduce gain from the sale of property by increasing the property's basis, and that ordinary income from property, in theory, reduces anticipated gain by reducing the forward price of the property. Nevertheless, reducing the "applicable imputed income amount" by capitalized expenses and ordinary income inclusions would help to ensure that gain in excess of the time value element in a conversion transaction is not treated as ordinary income. As discussed in 1. above, the "applicable imputed income amount" will generally exceed the amount of gain that can be derived from a conversion transaction, because 120 percent of the applicable Federal rate is higher than the rate of return available to most investors on a fully-hedged position, such as a conversion transaction. We recommend, therefore, that the final regulations provide for reduction of the "applicable imputed income amount" by amounts capitalized under Code section 263(g) and by prior inclusions of ordinary income with respect to property held in a conversion transaction.

4. EFFECTIVE DATE.

The Proposed Regulations are proposed to be effective for conversion transactions entered into on or after the date of the filing of final regulations with the Federal Register. The Proposed Regulations are necessary, however, to ensure that taxpayers are not required to recharacterize capital gain from a conversion transaction in an amount that exceeds the time value element. If final regulations are effective only prospectively, taxpayers who are subject to Code section 1258 during the interim period between the effective date of section 1258 and publication of the final regulations may be required to include ordinary income in excess of the amount contemplated by Congress.

SIA urges, therefore, that final regulations be made effective for conversion transactions entered into after April 30, 1993, i.e., the effective date of section 1258. In view of the fact that the Proposed Regulations were issued pursuant to an explicit grant of regulatory authority in Code section 1258(b), and that the Proposed Regulations are necessary to prevent undue penalties under Code section 1258, there should be no question as to the authority of the Service to adopt a retroactive effective date.

Any questions on the foregoing may be directed to the undersigned or to David Hariton (212-558-4248) or Emily McMahon (212- 558-3144) of Sullivan & Cromwell.

Very truly yours,

Saul Rosen

cc: Internal Revenue Service

Department of the Treasury

Leslie B. Samuels, Assistant Secretary (Tax Policy)

FOOTNOTES

/1/ SIA is the trade organization of the securities industry, representing more than 600 stock brokerage and investment banking firms in the United States and Canada. As a group, these firms account for more than 90 percent of the securities business in North America.

/2/ FI-43-94, published in the Federal Register on December 27, 1994.

/3/ Each of the positions in the conversion transaction must be identified as part of the same "identified netting transaction" before the close of the day on which the position becomes part of the transaction.

/4/ Thus, for example, built-in gains would be excluded in determining the net gain from a conversion transaction under the separate accounting approach described above.

/5/ Prop. Treas. Reg. section 1.1258-1(c) also includes within the definition of "built-in loss" any unrealized loss in a position (the "loss position") that exists on any date when the taxpayer realizes gain or loss on any other position of the conversion transaction, if the loss position is not also disposed of or otherwise terminated within 14 days and within the same taxable year.

/6/ See Report of the Committee on Ways and Means, U.S. House of Representatives, 103d Cong., 1st Sess., on Title XIV of H.R. 2141, WMCP 103-11, at p. 200; Report of the Senate Finance Committee, U.S. Senate, 103d Cong., 1st Sess. on S.1134, S.Rpt. 103-36, at p. 235.

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