IRS Regs Neutralize Diversification Techniques
By Thomas J. Boczar and Robert Gordon
Twenty-First Securities Corporation
Originally published in Trust and Investments, American Bankers Association: Washington, D.C., September/October 2001.

Investors subject to straddle rules stand to lose if proposed regulations are enacted.

Proposed Regs Could Make Swaps Less Attractive (February 2004).

Editor’s Note: This is the second of two articles assessing the relative merits of stock concentration risk management techniques that are implemented through financial derivatives, including options, swaps and forwards.  “New Moves for Concentrated Stock Positions” in the July/August issue of Trust and Investments focused on investors who are not subject to the “straddle rules” because their stock was acquired before 1984.  This article focuses on investors who are subject to the straddle rules, having acquired stock after 1983.

Under the current state of the tax law, in most instances a collar will prove to be the superior hedging strategy.  Specifically, the “income-producing collar” (one that generates a net credit to the investor) has emerged as the superior strategy because its economics and cash flows somewhat resemble a synthetic short sale, yet it can be structured in a manner that should not violate the constructive sale rules.

A collar strategy can be implemented through various financial derivatives (options, swaps and forwards).  The challenge for the wealth manager is to implement the collar strategy by using the derivative “tool” that minimizes the after-tax cost to each particular investor.

The Straddle Rules

Internal Revenue Code Section 1092 addresses “straddles”.  If stock was acquired after 1983, the straddle rules apply.  A straddle exists when holding one position substantially reduces the risk of holding another.  Because a collar substantially reduces the risk of owning the underlying stock, the stock and collar together should in most instances be treated as a straddle for federal tax purposes.

Investors can encounter two negative ramifications from the stock and collar being deemed a straddle.  First, any loss realized from closing one leg of a straddle must be deferred to the extent that there is any unrealized gain on the open leg.  Thus, as a collar expires, is terminated, or is rolled forward, any losses must be deferred.  Gains are currently taxed.

Second, interest expense incurred to “carry a straddle” must be capitalized (as opposed to being currently deductible).  There has been (and continues to be) spirited debate about the methodology to be applied in determining the amount, if any, of the interest expense that must be capitalized under Code Section 263(g).

The objective for the investor who owns stock that was acquired after 1983 is to mitigate the negative impact of the straddle rules as much as possible.

The Jobs and Growth Tax Reconciliation Act of 2003 lowered the short-term capital gain tax rate to 35%.

Evolution of the Single-Contract Collar. Investors can address the first problem of getting "whipsawed" using an over-the-counter (OTC) derivative contract that encompasses both the put and the call. For example, suppose that XYZ is selling at $100 per share. The investor constructs a three-year zero-cost collar on the stock (with either listed or OTC options), buying puts struck at $90 for $14, and selling calls struck at $160 for $14. If the collar expires with the stock price between $90 and $160, the investor faces a tax of $5.47 (39.1% of $14 short-term capital gain) on each expired call. However, the investor cannot currently deduct the "wasted" $14 cost of the puts (deferred long-term capital loss). The investor created economic protection and some potential for profit, but the after-tax cost is more than $5 per share (with no actual profits realized).

Suppose that instead of buying separate puts and calls, the investor hedges XYZ by employing a one-contract collar. With this approach, the investor could create the same economic structure - effectively buying puts at $90 and selling calls at $160. But when a zero-cost collar is documented using a single contract, the price of the collar for tax purposes should be zero even if the straddle rules apply. Thus, if the collar expires with the stock price anywhere between $90 and $160, the expiration should not create any taxable income or loss. The investor has created the same level of economic protection and potential for profit without incurring any additional tax burden.

Unfortunately, it is not currently possible to implement a single-contract collar with listed options because the documentation that is currently used by the options exchanges treats the put and call as separate contracts. Some practitioners are encouraging the exchanges to develop this type of collar. It is possible, however, to implement a single-contract collar with OTC options.

With respect to a swap with an embedded collar or a variable forward, the amount received for the embedded call and the amount paid for the embedded put will also net against each other.

An equity swap with an embedded collar is tax-disadvantaged because any payments received by the investor up-front or during its term will be taxed currently as ordinary income, whereas a single-contract options-based collar or a variable forward would allow such a payment to be part of an open transaction with the taxation deferred.

No matter where the stock price is on the expiration date, OTC options documented as a single contract and variable forwards should receive essentially the same tax treatment when settling the collar. Listed options are tax-disadvantaged because of the current inability to net the option premiums.

Tax Analysis - Deductibility of Interest Expense

In addition to hedging, most investors with appreciated stock wish to generate liquidity in order to reinvest and diversify their investments. Often investors choose to monetize, or borrow against, their appreciated stock. Borrowing creates interest expense. If the borrowing cost occurs in conjunction with a straddle, there is the possibility that the interest expense might need to be capitalized.

On January 17, 2001, the Internal Revenue Service proposed regulations making clear that if shares that are hedged by a collar are pledged as collateral for a borrowing, the interest must be capitalized.¹ However, the regulations do give an investor the right to specify which shares form a straddle and which are being leveraged. A careful identification of collateral will preclude the IRS from allocating (and therefore capitalizing) any of the borrowed proceeds against the shares that have been collared.

Because of this "specific identification" rule, if an investor has liquid securities (other than the collared shares) to post as collateral, it is still possible to deduct some or all of the interest expense. For example, suppose an investor with $100 of XYZ wants to hedge the stock with either an options-based collar or a variable forward that is not prepaid² and then monetize the maximum amount possible under the margin rules (Regulation T) in order to diversify. The investor could borrow $50 against the hedged XYZ position. Assuming that the investor diversifies into publicly traded securities, the investor then could finance the purchase of $100 of reinvestment securities through an additional $50 margin loan against the reinvestment portfolio. Under the regulations, the interest expense incurred by borrowing against the hedged XYZ position must be capitalized, while the interest expense incurred by borrowing against the reinvestment portfolio would be deductible.

Changing the facts slightly, suppose an investor with $200 of XYZ wants to hedge $100 of XYZ with either an options-based collar or a swap with an embedded collar and then monetize $100 in order to diversify. The investor could borrow $50 against the unhedged XYZ position. Assuming that the investor diversifies into publicly traded securities, the investor could then finance the purchase of $100 of reinvestment securities through an additional $50 margin loan against the reinvestment portfolio.

Under the regulations, currently both the interest expense incurred by borrowing against the unhedged XYZ position and the interest expense incurred by borrowing against the reinvestment portfolio would be deductible because there was no borrowing against the collared position.

Therefore, under the regulations investors can readily monetize both options-based collars and swaps with embedded collars through margin loans and in most instances still achieve a current deduction for some or all of the interest expense incurred with respect to the monetization. In certain instances, however, it might be necessary to use a prepaid variable forward to achieve the monetization level that is desired because of margin rule (Regulation T) limitations.

For example, assume that an investor with $100 of XYZ wants to hedge the stock with a collar and then monetize the maximum amount possible in order to diversify into a portfolio of investments that are not publicly traded (e.g., alternative investments, such as hedge funds, private equity, and venture capital).

If an investor hedges the XYZ with either an options-based collar or a variable forward that is not prepaid combined with a margin loan, a maximum of $50 could be borrowed against the hedged XYZ under Reg. T. It will not be possible to borrow against the reinvestment portfolio in this instance because it consists of investments that cannot be given collateral value by a brokerage firm because they are not publicly traded securities. In this instance only $50 could be monetized, and under the proposed regulations all of the interest expense would need to be capitalized because the borrowing was incurred against a collared position.

If the investor instead used a prepaid variable forward, the investor most likely would be able to monetize between 80% and 90% of the value of the position because the Reg. T limitations do not apply to prepaid variable forwards. Although the nature of a prepaid variable forward effectively defers and converts interest expense into a deferred capital loss, in this instance there is no tax disadvantage because if margin loans were used to monetize the position, the interest expense would have to be capitalized because the borrowing is against the collared stock.

Investors under the proposed regulations have the right to specify the collateral pledged to secure margin indebtedness. If the interest expense is incurred by borrowing against securities that are unhedged, the investor currently can deduct such expense; otherwise, it must be capitalized.

Therefore, the monetization structure that should deliver optimal after-tax results should be either an option-based collar or variable forward that is not prepaid combined with a margin loan. A prepaid variable forward is tax-disadvantaged because its structure ensures that all net borrowing costs are deferred and capitalized.

Optimal Tool For Post-1983 Stock
Under The Regulations

Assuming that the proposed regulations (with respect to straddles rules and the capitalization of interest) become effective, it appears that in most instances a single-contract collar combined with a margin loan should deliver the minimum after-tax cost.  Listed options are clearly disadvantaged because of the inability to net the option premiums, which can easily be accomplished with OTC derivatives.

Prepaid variable forwards are clearly tax disadvantaged because of their structure, which gives an investor no choice but to defer and capitalize the net cost of carry. However, prepaid variable forwards do have several nontax advantages. First, the cost of the borrow is fixed throughout its term, in contrast to a floating rate borrow typical of a margin loan. Second, because Reg. T is not applicable, a margin call would not be possible in the future (a margin call is possible only if margin loans are used). Third, because Reg. T is not applicable, the investor is not limited to borrowing a maximum of 50% of the value of the hedged position if the purpose of such borrowing is to reinvest in other securities, as it would be if a margin loan were used. Fourth, because there are no "moving parts" (that is, no interest payments because the interest has been prepaid, no interest rate resets because it is fixed rate debt, no mark to markets, etc.) until the expiration date, there are no monthly statements and other periodic communications from the brokerage firm (as there are with options and swaps) to confuse and frustrate a private client.

Finally, it should be noted that recently released Field Service Advisory 200111011 casts new doubts on the variable forward structure because a taxpayer was deemed to have sold his shares by executing a particular type of prepaid variable forward. Although in the end this advisory may have minor importance, investors should be aware of its existence.

Other Recent Developments -
Exchange Funds

On May 9, 2001, Rep. Richard E. Neal, D-Mass., introduced a bill that, if enacted in its current form, would eliminate the use of exchange funds as they are currently structured as a viable strategy to diversify highly appreciated securities. Until the Neal bill becomes law, exchange funds can prove useful in two situations.

If a derivative-based solution is not available due to the characteristics

of a particular stock³ (e.g., the stock is difficult to borrow or is subject to liquidity constraints) an exchange fund might be thought of as the diversification tool of last resort. Also, if an investor's objective is to diversify out of all or a portion of a highly appreciated stock position and into a passively managed portfolio that tracks a certain index (e.g., the Standard and Poor's 500) certain exchange funds should prove particularly useful. Certain exchange funds have historically exhibited a very high degree of correlation with the index they were designed to track and their "all in" cost compares favorably to what it would otherwise cost to monetize through a derivative-based solution and re-deploy the proceeds into an index fund.

Because of the constructive sale rules, derivative-based solutions generally have a maximum length of five years at which time they must be rolled over in order to maintain the benefit of the tax deferral. Exchange funds are often structured with an unlimited life.

Given that exchange funds have once again come under attack, this time via the Neal proposal, investors considering an investment in an exchange fund might wish to act sooner rather than later to take advantage of the current opportunities.

Negative Impact

The regulations recently proposed by the IRS are mostly negative with respect to investors interested in hedging and monetizing appreciated securities. The regulations have to some degree "leveled the playing field" because of the various derivative tools that are available to hedge and monetize stock acquired after 1983. Listed options no longer enjoy the huge potential advantage they once did, and the fact that interest expense incurred by a borrowing that is collateralized by a hedged stock position must be capitalized has narrowed the possible advantage that a single-contract collar combined with a margin loan has over a prepaid variable forward. In addition, the Neal proposal, if enacted in its current form, would eliminate exchange funds as they are currently structured as a viable strategy to diversify highly appreciated securities.

1. Proposed Regulation Section 1.263(g)-3(c)(2).

2. A variable forward can be either prepaid or not. If it is prepaid, the investor has economically collared the position and receives an up-front payment from the dealer that is not currently taxed. If it is not prepaid, the investor has economically collared the position but does not receive an up-front payment from the dealer. In the latter situation, the investor could effectively monetize the stock hedged through the variable forward through margin loans.

3. If an investor hedges a long stock position through a collar, the dealer will be synthetically long in the underling stock. To hedge this exposure, the dealer will typically establish a short position in that stock. In order to establish a short position, the dealer must be able to borrow shares from someone who currently owns them in order to be able to deliver shares to the buyer on settlement date of the short sale. Also, the stock must be sufficiently liquid to enable the dealer to increase or decrease its short position without significantly impacting the stock price.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".