The use of stock indexes is prevalent in today's investment environment. Investors may practically invest in a fund that holds the components of an index or a derivative that references the index. For tax purposes, it is not always clear whether an investment in an index should be viewed as separate investments in each underlying component or a single investment in aggregate. In recently released Chief Counsel Advice (CCA) 201827011, the IRS concluded that a derivative that referenced a stock index was "substantially similar or related property" (SSRP) to the stock of an exchange-traded fund (ETF) that held the components of the index.
In the CCA, a corporation, X, was a member of a consolidated group. X was a customer-facing equity-swap dealer and a dealer in securities under Sec. 475. X entered into both long positions and short positions with respect to a stock index, using a combination of stock and derivatives.
Specifically, X acquired short positions with respect to the index using notional principal contracts that it entered into with a third-party counterparty (the swaps). The terms of the swaps required X to pay to the counterparty the sum of the appreciation in the value of the index and any dividends with respect to the stocks in the index. Conversely, the counterparty was required to pay to X the sum of any depreciation in the value of the index and a financing fee.
X also acquired shares in an ETF that was a regulated investment company (RIC) under Subchapter M of the Code. The ETF held a portfolio of the stocks in the index, with the weight of each stock closely corresponding to the weight of that stock in the index. In fact, the ETF and the index produced nearly identical economic returns. Shareholders of the ETF received quarterly dividends corresponding to the amount of cash dividends declared with respect to the stocks held by the ETF during the applicable period less fees, expenses associated with operating the ETF, and taxes.
X converted into an LLC, and a different member of the consolidated group, Z, acquired the ETF shares afterward. X continued to enter into swaps with third-party customers but would enter into corresponding "back-to-back" swaps with Z. Similar to the swaps, the terms of the back-to-back swaps required Z to pay to X the sum of the appreciation in the value of the index and any dividends with respect to stocks in the index, and X was required to pay to Z the sum of any depreciation in the value of the index and a financing fee.
X and Z (the taxpayers) were both economically neutral with respect to dividends received on the ETF shares because they were obligated to pay the same amounts under the swaps. Notwithstanding these offsetting cash flows, the taxpayers claimed a dividends-received deduction (DRD) under Sec. 243 with respect to the dividends that they received on the ETF shares.
While the taxpayers could have offset the swaps by acquiring the various components of the index, it was most profitable for them to purchase the ETF shares, even without taking into account the DRD. However, the economics of holding the swaps and the ETF shares were materially enhanced by the tax benefit from claiming a DRD.
Sec. 243(a) generally provides a DRD to corporations for certain dividends received from a domestic corporation that is subject to income tax. Prior to the passage of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, the amount of the DRD was at least 70% of those dividends. After the TCJA, for tax years beginning after Dec. 31, 2017, the amount of the DRD is at least 50% of those dividends. The DRD for a consolidated group is governed by Regs. Sec. 1.1502-26.
The holding period requirement
Sec. 246 provides rules that limit the deduction allowed under Sec. 243. Under Sec. 246(c)(1)(A), there is no DRD for a dividend on a share of stock that is held by the taxpayer for 45 days or less during the 91-day period beginning 45 days before the ex-dividend date.
For purposes of this holding period requirement, the holding period of stock is reduced for any period that a taxpayer has diminished its risk of loss by holding one or more positions with respect to SSRP (Sec. 246(c)(4)(C) and Regs. Sec. 1.246-5(a)). A position with respect to property is an interest in property (including a futures or forward contract or an option), or any contractual right to a payment, whether or not it is severable from stock or other property (Regs. Sec. 1.246-5(b)(3)). A taxpayer has diminished its risk of loss on its stock by holding positions with respect to SSRP if changes in the fair market values (FMVs) of the stock and such positions are reasonably expected to vary inversely (Regs. Sec. 1.246-5(b)(2)).
For purposes of the holding period requirement, "reasonable expectations" are the expectations of a reasonable person based on all of the facts and circumstances and include all explicit and implicit representations made with respect to the marketing or sale of the position (Regs. Sec. 1.246-5(b)(4)).
A taxpayer is also treated as diminishing its risk of loss by holding SSRP if the taxpayer holds an interest in a passthrough entity with a view to avoid the application of Regs. Sec. 1.246-5 or Regs. Sec. 1.1092(d)-2 (Regs. Sec. 1.246-5(c)(6)). The term "passthrough entity" is undefined in the regulations.
Rights and obligations under notional principal contracts (e.g., swaps) are considered separately, even though payments related to such rights and obligations are generally netted for other purposes. Thus, if a taxpayer is treated as receiving payments under a swap when the FMV of the underlying security declines, the taxpayer has diminished its risk of loss by holding a position in SSRP regardless of the netting of payments under the contract (Regs. Sec. 1.246-5(c)(7)).
Substantially similar or related property
The term "substantially similar or related property" is applied according to the facts and circumstances in each case. In general, property is SSRP with respect to stock when two conditions are met:
- The FMVs of the stock and the property primarily reflect the performance of either: (1) a single firm or enterprise; (2) the same industry or industries; or (3) the same economic factor or factors (e.g., interest rates, commodity prices, or foreign-currency exchange rates); and
- Changes in the FMV of the stock are reasonably expected to approximate, directly or indirectly, changes in the FMV of the property, or in a fraction or multiple of the FMV (Regs. Sec. 1.246-5(b)(1)).
The legislative history of Sec. 246 stated that the scope of SSRP includes the acquisition of a short position on a stock index while holding the stock of an investment company whose principal holdings mimic the performance of the stock index (Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84) (Dec. 31, 1984) at 143).
Special rules under Regs. Sec. 1.246-5(c)(1) apply when a position reflects the value of more than one stock. A position reflecting the value of a portfolio of stocks is SSRP to the stocks held by the taxpayer only if the position and the taxpayer's holdings substantially overlap. For this purpose, a portfolio of stocks is any group of stocks of 20 or more unrelated issuers. A position may be SSRP to a taxpayer's entire stock holdings or a portion of a taxpayer's stock holdings (Regs. Sec. 1.246-5(c)(1)).
Whether a position and a taxpayer's stock holdings substantially overlap is determined by a three-step process (the portfolio rules) (Regs. Sec. 1.246-5(c)(1)(iii)). In the first step, the taxpayer must construct a subportfolio that consists of stock in an amount equal to the lesser of: (1) the FMV of each stock represented in the position; and (2) the FMV of the stock in the taxpayer's stock holdings. Such a subportfolio may contain fewer than 20 stocks. The second step provides that the position and the subportfolio substantially overlap if the FMV of the subportfolio is equal to or greater than 70% of the FMV of the stocks in the position. If the position does not substantially overlap with the subportfolio, the third step provides that the taxpayer must reduce the size of the position and repeat the first and second step. The largest percentage of the position that results in a substantial overlap is SSRP to the subportfolio with respect to that percentage of the position.
Analysis of CCA 201827011
The primary issue in CCA 201827011 was whether the taxpayers were entitled to a DRD for the dividends received from the ETF shares. X and Z had acquired the swaps and the ETF shares contemporaneously; therefore, the holding period requirement would not be met if the swaps constituted SSRP that diminished the taxpayers' risk of loss in the ETF shares. The IRS noted that Sec. 246(c)(1)(B) (which disallows a DRD to the extent the taxpayer is under an obligation to make related payments with respect to SSRP positions) could also apply but that both the holding period requirement and the application of Sec. 246(c)(1)(B) were based on whether the swaps were SSRP with respect to the ETF shares.
The taxpayers argued that they were entitled to a DRD because the swaps represented the value of all of the stocks in the index, and whether the swaps were SSRP was determined solely by the portfolio rules in Regs. Sec. 1.246-5(c)(1). Because X and Z did not actually hold the stocks in the index and instead held the ETF shares, the taxpayers contended, there was no substantial overlap between the swaps and the ETF shares under the portfolio rules.
In its analysis, the IRS noted that the swaps were positions that reflected the performance of all of the stocks in the index but also the performance of the ETF. Thus, the FMVs of the positions (i.e., the swaps) and the dividend-paying stock (i.e., the ETF shares) reflected the performance of a single firm or enterprise (i.e., the ETF). Furthermore, changes in the FMV of the ETF shares were reasonably expected to closely match the changes in the FMV of the index. The IRS stated that the existence of the portfolio rules did not preclude the swaps from being a position in SSRP with respect to the stock of a single corporation such as the ETF. Therefore, the IRS concluded, the swaps were SSRP with respect to the ETF shares under Regs. Sec. 1.246-5(b)(1).
Because X and Z had diminished their risk of loss in the ETF shares by holding positions with respect to SSRP, their holding period in the ETF shares was reduced by excluding the period that their risk of loss was diminished. This meant that the holding periods for the taxpayers' ETF shares did not meet the holding period requirement and they were not entitled to a DRD for the dividends from the ETF shares.
The IRS went further to state that the ETF was a passthrough entity for purposes of Regs. Sec. 1.246-5(c)(6) because it was a RIC and the taxpayers held the ETF shares with a view to avoid the application of Regs. Sec. 1.246-5. The IRS stated that the application of Regs. Secs. 1.246-5(b)(1) and (c)(6) was consistent with the legislative history.
The IRS's conclusion in CCA 201827011 may not be surprising, but the analysis may have broaderimplications.
First, the analysis may apply in other contexts because other rules reference the holding period requirement and SSRP. For example, the holding period requirement applies to Sec. 245 and, in a one-year requirement, to Sec. 245A (Sec. 246(c)(5)). Sec. 1(h)(11)(B)(iii) also provides a modified version of the holding period requirement that must be met for a dividend to constitute qualified dividend income. In addition, Regs. Sec. 1.1092(d)-2(a) references the definition of SSRP for determining whether stock is personal property for purposes of the Sec. 1092 straddle rules.
Second, it is noteworthy that a RIC constitutes a passthrough entity for purposes of Sec. 246. As stated in the CCA, there is no definition of passthrough entity for purposes of Sec. 246. By analogy, however, Sec. 1260 defines the same term to include a RIC (Sec. 1260(c)(2)(A)). In the CCA, the IRS stated that it was significant that dividends eligible for the DRD pass through to the RIC shareholders when the RIC distributes dividends attributed to that income and gain.
Finally, the portfolio rules did not preclude the application of Regs. Sec. 1.246-5(b)(1). As noted above, Regs. Sec. 1.246-5 has rules specific to whether a position that reflects more than one stock should constitute SSRP. There are special rules if the position reflects a portfolio (i.e., stocks of 20 or more issuers) and other rules if the position does not reflect a portfolio (i.e., stocks of fewer than 20 issuers). The IRS stated that the portfolio rules apply when a taxpayer holds a portfolio. However, the existence of the portfolio rules does not preclude a position referencing a portfolio to be SSRP with respect to stock of a single corporation. SSRP is determined under the facts and circumstances of each case in all instances.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.