Global Tax Alert | 20 September 2013

US IRS issues regulations applying straddle rules to certain debt instruments

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On 5 September 2013, the Service published temporary and proposed regulations clarifying that a taxpayer's obligation under a debt instrument can constitute a “position in personal property” that is a leg of a straddle (TD 9635, REG-111753-12). These regulations implement, in temporary form, proposed regulations from 2001 (REG-105801-00) and address one aspect of prior non-precedential guidance in the form of a Chief Counsel Advice Memorandum (CCA 201310027) and several Technical Advice Memoranda (TAM 200509022, TAM 200530027 and TAM 200541040).


Section 1092(c)(1) generally defines a straddle for tax purposes as “offsetting positions with respect to personal property.” Section 1092(c)(2)(A) then provides that positions are offsetting if there is substantial diminution of the taxpayer's risk of loss from holding one position by reason of holding the other position. Section 1092(d)(1) defines “personal property” as any personal property of a type that is actively traded. Section 1092(d)(2) then defines a “position” as an interest (including a futures or forward contract or option) in personal property.

Section 263(g)(1) generally requires the capitalization of interest and carrying charges properly allocable to personal property that is part of a straddle under Section 1092(c). Under Section 263(g)(2)(A) the phrase “interest or carrying charges” includes the interest on indebtedness incurred or continued to purchase or carry the personal property, plus all other amounts paid or incurred to carry the personal property, less certain amounts set forth in Section 263(g)(2)(B).

The issue of whether a taxpayer's own debt can constitute a “position” arose shortly after the straddle rules were enacted in 1981 because fixed-rate debt changes in value inversely in response to changes in interest rates. If a taxpayer's debt were viewed as a position in personal property, and if the taxpayer also owned bonds or other debt instruments of a comparable term, then the debt issued and debt owned could be a straddle, with the result that recognition of losses on the sale of debt owned by the taxpayer could be deferred. Practitioners and taxpayers generally became comfortable that this was not the case, i.e., debt issued by a taxpayer did not constitute a position that could offset debt owned by the taxpayer.

Also in the 1980s, Congress became aware that some taxpayers issued debt denominated in a nonfunctional currency and used the proceeds to invest in bonds denominated in the same currency, thereby creating a neutral position with respect to the currency. If such arrangement were not treated as a straddle, the taxpayer could wait for the exchange rate to change and then terminate either the borrowing or investment at a loss and recognize that loss immediately. To prevent this, Congress enacted Section 1092(d)(7), providing that a taxpayer's debt issued in a nonfunctional currency is a position in that currency.

Around 2000, some taxpayers issued so-called PHONES debentures, which are long-term debt instruments that are exchangeable by a holder for a set number of shares of portfolio stock owned by the issuer (or an equivalent amount of cash). Some of those taxpayers and their advisors became comfortable that the PHONES were not a “position” in the underlying stock because of (1) the generally accepted view that a taxpayer's debt cannot be a position, and (2) the implication from Congress's enactment of Section 1092(d)(7) that a special statutory rule was required to create an exception from this general rule. This practice may have ceased after regulations were proposed in 2001, particularly given that they were proposed to be effective as of the date they were proposed.

The Temporary and Proposed Regulations

Under the temporary and proposed regulations, if a debt instrument is linked to the value of personal property, by, for example, being exchangeable for stock held by the issuer, then it can constitute a position in that personal property and comprise a leg of a straddle.

The proposed regulations were proposed to apply to straddles established on or after 17 January 2001. The temporary regulations apply to straddles established on or after this date, but they are effective on 5 September 2013, and expire on 2 September 2016. It is not clear what the Service thought was accomplished by making the temporary regulations retroactively applicable, but not retroactively effective.

The proposed regulations also contained a rule under Section 263(g) providing that, if a debt instrument embodies a position in personal property that is part of a straddle, that debt is per se “indebtedness incurred or continued to purchase or carry personal property which is part of a straddle” and thus the interest on the debt is required to be capitalized, rather than being currently deductible. The Service did not put this proposed regulation into temporary or final form.


It is unclear why the Service issued the temporary regulations at this time. Some commentators have speculated that it was done to bolster cases currently in appeals or that may ultimately end in litigation, although this seems somewhat implausible, as most if not all PHONES cases have been settled by now. Further, the on-going impact of the change is likely minimal in light of the expansion of Section 163(l) as part of the American Jobs Creation Act of 2004. As revised, Section 163(l) now disallows interest on debt obligations that are payable in (or by reference to) portfolio stock if the option to exchange is the holders' and there is substantial certainty of the exercise of that option. Nevertheless, the regulations may apply to other situations in which a taxpayer issued debt that is linked to the value of personal property other than stock, such as commodity-linked notes.

If the Service is indeed still contesting a PHONES case for instruments issued on or after 17 January 2001, and if that case makes it to court, it will be interesting to see if the court ascribes retroactive applicability of the temporary regulations, as the Service apparently hopes, or if the court refuses to give any effect to a regulation that was not in temporary or final form at the time of the transaction.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services — Capital Markets, Washington, DC
  • David Golden
    +1 202 327 6526
  • David Garlock
    +1 202 327 8733
  • Petya Kirilova
    +1 202 327 6075
  • Tyler Arbogast
    +1 202 327 6867

EYG no. CM3812