ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

21
The abusive derivatives used prior to enactment of Section 1260 often involved an
investment bank and hedge fund. 66 The goal of the strategy was to permit an investor in a hedge
fund to convert their short-term gains from the hedge fund into long-term gains. The investment
bank designed the derivative so that it functioned like an ownership interest in the hedge fund,
with its value linked to the hedge fund’s investment performance. The bank marketed the
derivative to clients as an alternative to investing directly in the hedge fund. 67 To “hedge” its
derivative, the investment bank became the partner in the hedge fund. 68 The strategy sought to
allow the investment bank’s clients to take advantage of the hedge fund’s high pre-tax returns
from short-term trading activity (which would normally be treated as short-term capital gains)
using a derivative that would be held for over a year, contending that after the derivative was
cashed out, the short-term trading profits could be treated as long-term capital gains. 69 At the
time, the strategy was estimated to produce an 8% tax savings on the investment activity. 70
In 1999, to stop the abuses, Congress enacted Section 1260. Section 1260 treats the
profits from the “constructive ownership” of specified “financial assets” as ordinary income, not
long-term capital gains. 71 The conference report from the House of Representatives explained
that, without Section 1260: “[i]nvestors may enter into forward contracts, notional principal
contracts, and other similar arrangements with respect to property that provides the investor with
the same or similar economic benefits as owning the property directly but with potentially
different tax consequences.” 72 The conference report also explained that Section 1260 would
limit “the amount of long-term capital gain a taxpayer could recognize from certain derivative
contracts (‘constructive ownership transactions’) … to the amount of such gain the taxpayer
would have recognized if the taxpayer held the financial asset directly during the term of the
derivative contract.” 73
Section 1260 defined “constructive ownership” as applying to one of four types of
transactions in which the taxpayer:
“(A) holds a long position under a notional principal contract with respect to the financial
asset,
(B) enters into a forward or futures contract to acquire the financial asset,
(C) is the holder of a call option, and is the grantor of a put option, with respect to the
financial asset and such options have substantially equal strike prices and substantially
contemporaneous maturity dates, or
66 Id.
67 Id. at 19.
68 Id. at 20.
69 Id.
70 Id. at 19.
71 26 U.S.C. §1260 (a).
72 H.R. Rep. No. 106-478, at 159 (1999) (Conf. Rep.).
73 Id.