7622 / What is a “constructive ownership transaction”?

Generally, a taxpayer is treated as having entered into a constructive ownership transaction with respect to any financial asset if the taxpayer:

(1)   holds a long position under a notional principal contract (defined below) with respect to the financial asset;

(2)   enters into a forward contract (defined below) or futures contract (see Q 7588) to acquire the financial asset;

(3)   is the holder of a call option and the grantor (i.e., writer) of a put option (see Q 7561) on a financial asset, and the options have substantially equal strike prices and substantially contemporaneous maturity dates; or

(4)   to the extent provided in future regulations, enters into one or more other transactions (or acquires one or more positions) that have substantially the same effect as those described above.³

The types of transactions intended to be targeted by the regulations are those that replicate the economic benefits of direct ownership of a financial asset without a significant change in the risk-reward profile with respect to the underlying transaction.⁴ The Secretary may also issue regulations that permit taxpayers to mark constructive ownership transactions to the market instead of applying these rules, and to exclude certain forward contracts that do not convey substantially all of the economic return with respect to a financial asset.⁵

Mark to market exception. A constructive ownership transaction will not be subject to these rules if all of the positions are marked to the market (see Q 7592).⁶

For the tax treatment of gain from a constructive ownership transaction, see Q 7623.

One example of a conversion transaction involving a derivative contract is set forth in the Senate Report for TREA ’99. The transaction involves an arrangement between a taxpayer and a securities dealer whereby the dealer agrees to pay the taxpayer any appreciation with respect to a notional investment in a hedge fund. In return, the taxpayer agrees to pay the securities dealer any depreciation in the value of the notional investment. The arrangement lasts for more than one year. The taxpayer is in substantially the same economic position as if he or she owned the interest in the hedge fund directly, yet the taxpayer may treat any appreciation resulting from the contractual arrangement as long-term capital gain. Moreover, any tax attributable to such gain is deferred until the arrangement is terminated.⁷

Definitions

Financial asset means any equity interest in any pass-through entity and, to the extent provided in regulations, any debt instrument and any stock in a corporation that is not a pass-through entity.⁸

Pass-through entity is defined to include: (1) a regulated investment company (RIC, i.e., mutual fund) (see Q 7922 and Q 7936); (2) a real estate investment trust (REIT) (see Q 7975); (3) an S corporation (see Q 805); (4) a partnership (see Q 7711 to Q 7714); (5) a trust (see Q 7685 to Q 7686); (6) a common trust fund; (7) a passive foreign investment company; (8) a foreign personal holding company; (9) a foreign investment company; and (10) a REMIC (see Q 7693 and Q 7694).⁹

A taxpayer will be treated as holding a long position under a notional principal contract with respect to any financial asset if the taxpayer has the right to be paid (or receive credit for) all or substantially all of the investment yield (including appreciation) on that financial asset for a specified period, and is obligated to reimburse (or provide credit for) all or substantially all of any decline in the value of that financial asset.¹⁰

The term forward contract means any contract to acquire in the future (or provide or receive credit for the future value of) any financial asset.¹¹

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Planning Point: Do not confuse a “constructive sale of an appreciated financial position” (see Q 7617 to Q 7621) with a “constructive ownership transaction.” The former applies to certain hedging positions held by a taxpayer and results in deemed sale treatment and immediate recognition of gain. The latter applies to a taxpayer’s purchase of a derivative contract whose investment return is tied to the performance of a pass-through entity, instead of purchasing a direct interest in the pass-through entity, and results in the conversion of long-term capital gain into ordinary income. In other words, the former represents a deemed sale, and the latter represents deemed (i.e., constructive) ownership.

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