The definition of security under section 475 includes both direct interests in securities and derivative securities. Under section 475(c)(2), a security is defined as (1) a share of stock in a corporation; (2) a partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) a note, bond, debenture, or other evidence of indebtedness; (4) an interest rate, currency, or equity notional principal contract; (5) an evidence of an interest in, or a derivative financial instrument in, any security described in clauses (1) through (4), or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and (6) a position which (i) is not a security described in clauses (1) through (5), (ii) is a hedge with respect to such a security, and (iii) is clearly identified in the dealer's records as being described in this subparagraph before the close of the day on which it was acquired or entered into (or such other time as the Secretary may by regulations prescribe).

Section 1256 contracts are excluded from the application of section 475.^[5] While they are taxed on a mark-to-market basis, 60% of the gain or loss is taxable as long-term capital gain or loss and 40% is taxable as short-term capital gain or loss.^[6] There are five categories of section 1256 contracts including: (1) regulated futures contracts; (2) foreign currency contracts; (3) non-equity options; (4) dealer equity options; and (5) dealer securities futures contracts.^[7] The fact that dealer equity options and dealer securities futures contracts are excluded from ordinary income/loss treatment under the section 475 rules has been the object of some criticism.^[8]

By contrast, most other derivative financial products that are held by non-dealers and non-electing traders are taxed on a realization basis, with characterization of gain or loss dependent on whether the income recognition event is characterized as a sale or exchange. For example, option transactions are taxed on a wait and see basis, with gain or loss recognition deferred until the option is exercised or lapses.^[9] Notional principal contracts are taxed on a modified accrual basis.^[10] The recognition of losses by non-dealers is limited by both the straddle rules and the wash sale rules. The straddle rules, contained in section 1092, very generally, defer losses where there is unrecognized gain.^[11] The wash sale rules, contained in section 1091, defer realized losses whereby substantially identical positions have been entered into during a 61-day period (30 days before and 30 days after) surrounding the date of sale.^[12]

The Draft would add two new sections to the Code, sections 485 and 486. Under proposed section 485, gain or loss from "derivatives" generally must be reported on an annual basis under a mark-to-market rule.^[13] Each derivative held by a taxpayer is treated as if it were sold on the last business day of the year for its fair market value, and any resulting gain or loss is taken into account for such taxable year.^[14] All resulting mark-to-market gain or loss with respect to a derivative is treated as ordinary gain or loss and is treated, for purposes of determining the amount of nonbusiness deductions which are allowed in computing a net operating loss, as attributable to the trade or business of the taxpayer.^[15]

Proposed section 486 would define the term "derivative" as (1) any evidence of an interest in (or any derivative financial instrument with respect to) (A) any share of stock in a corporation, (B) any partnership or beneficial ownership interest in a partnership or trust, (C) any note, bond, debenture, or other evidence of indebtedness, (D) with limited exceptions, any real property,^[16] (E) any commodity which is actively traded, or (F) any currency; (2) any notional principal contract; and (3) any derivative financial instrument with respect to any interest or instrument of the foregoing.^[17] The term "derivative financial instrument" includes any option, forward contract, futures contract, short position, swap, or similar financial instrument.^[18]

The definition of "derivative" is intended to be broad.^[19] For example, the term includes any evidence of an interest in (or any derivative financial instrument with respect to) any partnership or beneficial ownership interest in a partnership or trust, regardless of whether such contract or interest (or underlying contract or interest) is privately held or publicly traded.^[20] The Technical Explanation provides that, despite some uncertainty regarding the tax characterization of credit default swaps for U.S. federal income tax purposes, it is intended that a credit default swap be treated as a derivative either because it represents an option with respect to a debt instrument or because it qualifies as a notional principal contract.^[21] Further, the definition of a "notional principal contract" under proposed section 486(c) is broader than the definition under current Treasury Regulations.^[22] For example, the definition of a "specified index" under proposed section 486 includes indices based on information (including the occurrence or nonoccurrence of any event) which is not within the control of any of the parties to the instrument and is not unique to any of the parties' circumstances, including indices other than those based on objective financial information (e.g., temperature, precipitation, snowfall, or frost).^[23] Further, the definition of "notional principal contract" under proposed section 486(c) provides that an amount shall not fail to be treated as a "payment" merely because such amount is fixed on one date and paid or otherwise taken into account on a different date.^[24] This provision is consistent with a similar provision included in proposed regulations released in September 2011, proposing to amend the notional principal contract definition in Treasury Regulations section 1.446-3.^[25]

Interestingly, debt instruments containing embedded derivative components would be bifurcated, with the derivative, but not the debt instrument, being subject to mark-to-market treatment under proposed section 485.^[26] Bifurcation generally is not allowed under the tax law, but is permitted under financial accounting rules. The Technical Explanation provides as an example of a debt instrument with an embedded derivative, debt that is convertible into the stock of the issuer. Such an instrument would be bifurcated into two instruments, non-convertible debt (not subject to the mark-to-market rule), and an option to acquire stock of the issuer (subject to the mark-to-market rule).^[27]

Rules for "mixed straddles" have been included in proposed section 485(c). Similar to the definition of mixed straddles under section 1256(d)(4), a mixed straddle is a straddle involving both non-mark-to-market and mark-to-market positions. For instance, it would include the underlying equity in a collar transaction. The mark-to-market and ordinary treatment rules of proposed section 485 would apply to all positions in a straddle that includes any derivative to which proposed section 485 applies, even if these positions are not otherwise marked-to-market.^[28] If a position has a built-in gain, the position would be deemed to have been sold at the time of entering into the mixed straddle.^[29] The character of such gain would not be determined by proposed section 485. While built-in gain would be recognized at the time of entering into the mixed straddle, any built-in loss would not be allowed either at the time of entering into the mixed straddle or during the period in which the position is subject to the mark-to-market regime.^[30] Instead, the built-in loss is taken into account when the position is disposed of in a taxable transaction. The holding period of a position included in a mixed straddle will not include any period during which it is part of such straddle.^[31]

The mark-to-market regime under proposed section 485 would not apply to any derivative that is part of a hedging transaction (as defined in proposed section 1221(c)), discussed below, or a section 988 hedging transaction.^[32]

A transaction treated as a hedging transaction for purposes of an audited financial statement is treated as a hedging transaction for tax purposes, as long as the transaction also meets the substantive definition of a tax hedging transaction, which is unchanged by the Draft.^[40] Thus, common transactions that qualify as hedges for financial accounting purposes, such as "hoover hedges," would not qualify by reason of meeting the financial accounting requirements.^[41] The rules under current Treasury regulations for improper identification of a hedging transaction would not be applicable to a hedge which is identified as a hedging transaction for financial statement purposes, but which does not qualify as a hedging transaction for tax purposes, unless the taxpayer improperly treats the transaction as a tax hedging transaction in its tax return for the taxable year which includes such transaction.^[42]

The Draft would make certain conforming amendments to the remaining portions of section 1221 and sections 170, 856, and 954. If adopted, this provision would apply to transactions entered into after December 31, 2013.

The Draft would add new section 1274B, under which the term "specified debt modification" would mean (1) the exchange by an issuer of a new debt instrument for an existing debt instrument issued by such issuer (including any deemed exchange resulting from a modification), and (2) the significant modification of an existing debt instrument, including a significant modification of an existing debt instrument which is accomplished by the issuer and holder indirectly through one or more transactions with unrelated parties.^[47] This provision is not intended to change the current definition of when a significant modification of a debt instrument constitutes an exchange pursuant to Treasury Regulations section 1.1001-3.^[48]

Under proposed section 1274B, the issue price of modified debt subject to a "specified debt modification," would be the lesser of (i) the adjusted issue price of the existing debt obligation (subject to adjustment for OID), and (ii) the issue price of the modified debt instrument which would be determined under section 1274 if the debt instrument were a debt instrument to which that section applied (i.e., the principal amount if there is adequate stated interest or, otherwise, the imputed principal amount).^[49] Since the determination of COD income will be based on the debt instrument's principal amount or on the adjusted issue price in the case of an OID debt instrument, COD income will not result from the deemed exchange. The Technical Explanation notes that because the new debt is subject to section 1274, COD income cannot be avoided by forgiving interest rather than principal on an outstanding debt.^[50]

The Technical Explanation provides the following example: If a publicly traded debt instrument with a redemption price and an adjusted issue price of $10,000 is exchanged for a new debt instrument with a redemption price of $10,000 (and adequate stated interest) with an extended maturity, the issue price of the new debt is $10,000 regardless of the fair market value of the old debt. Thus, the issuer will not have any COD income.^[51] The holder's treatment would depend on its tax basis in the debt instrument. The Draft would make certain conforming amendments to sections 108 and 1274. If adopted, this provision would apply to transactions after December 31, 2013.

The Draft would designate current section 1278 as section 1279 and add a new section 1278. Under new section 1278, a holder of a market discount bond would include in gross income currently the sum of the daily portions of the market discount for each day during the taxable year that the taxpayer holds the bond.^[60] The amount of the inclusion for any taxable year is computed on the basis of a constant interest rate.^[61] The amount included in gross income generally is treated as interest, with the same exceptions that apply under present law where an election to accrue market discount has been made.^[62] The daily portion of market discount is adjusted to exclude the daily portion of any OID on the bond so as to prevent a double inclusion of OID.^[63]

The amount of discount includible in gross income by reason of this provision will not exceed the amount that would be so includible if the basis of the bond immediately after its acquisition was the imputed principal amount determined by using a discount rate equal to the greater of (i) an amount equal to the bond's yield to maturity (determined as of the date of issuance) plus five percentage points or (ii) an amount equal to the applicable Federal rate for the bond (determined at the time of acquisition) plus ten percentage points.^[64] Thus, the interest includible in income cannot exceed the greater of the amounts determined above based on the acquisition price.^[65]

The adjusted basis of the bond is increased by amounts included in gross income of the holder of the bond under this provision.^[66] The market discount provisions of sections 1276 (treatment of gain), 1277 (deferral of interest deduction), and the to-be designated 1279(b) (election for inclusion) would not apply to any bond to which this proposed provision would apply. The provision would also repeal the special rules for short-term non-governmental obligations held by taxpayers subject to current inclusion, which require the accrual of original issue discount but not market discount.^[67]

The Draft adds the new term "covered bond" to the Code.^[68] A covered bond is any debt instrument that has OID or market discount that was acquired after 2013 through a broker or transferred from a broker with a statement prescribed by the Code with respect to the transfer.^[69] Brokers who hold a "covered bond" would be required to report includible OID and market discount with respect to such bonds to the IRS and the customer.^[70]

If adopted, this provision would apply to debt instruments acquired after December 31, 2013, however, it would not apply to corporate OID bonds which were issued before July 2, 1982.

The Draft would amend section 1012(d) to require that the cost of any "specified security" sold, exchanged, or otherwise disposed of on or after January 1, 2014, be determined in accordance with the average basis method.^[74] Basis is determined on an account-by-account basis, so that if a taxpayer owns specified securities in more than one account, basis computations are made separately for securities in each account.^[75] The provision also requires that brokers use the average basis method in satisfying their basis reporting requirements.^[76]

To facilitate the determination of the cost of a specified security in accordance with the average basis method, the provision treats any specified security that is acquired before January 1, 2014, as in a separate account from any security that that is acquired on or after that date.^[77] Accordingly, a taxpayer determines the basis of any specified security acquired in 2014 and later by disregarding the basis of specified securities acquired before 2014.^[78]

The Draft amends section 1091 to expand application of the wash sale rules to the acquisition of substantially identical stock or securities by a taxpayer or a related party. Additionally, the basis of the substantially identical stock or securities is not adjusted to include the disallowed loss in the case of any acquisition by a related party other than the taxpayer's spouse.

The Draft provides that, for purposes of the wash sale rules, a related party is: (1) the taxpayer's spouse; (2) any dependent of the taxpayer and any other taxpayer with respect to whom the taxpayer is a dependent; (3) any individual, corporation, partnership, trust, or estate that controls, or is controlled by the taxpayer or any individual described in (1) or (2); (4) any individual retirement arrangement, Archer MSA, or health savings account of the taxpayer or of any individual described in (1) or (2); (5) any account under a qualified tuition program or a Coverdell education savings account if the taxpayer or any individual described in (1) or (2) is the designated beneficiary of such account or has the right to make any decision with respect to the investment of any amount in such account; and (6) any account under a qualified retirement plan, qualified annuity plan, tax-sheltered annuity plan, or governmental eligible deferred compensation plan, if the taxpayer or any individual described in (1) or (2) with respect to the taxpayer has the right to make any decision with respect to the investment of any amount in such account.^[81] Most relationships are determined as of the time of the acquisition of substantially identical stock or securities, however, spousal and dependency relationships are determined for the taxable year that includes such acquisition.^[82]

If adopted, this provision would apply to sales and other dispositions after December 31, 2013.

Under a second Draft provision, the rules for accruing income on government savings bonds would change. Presently, income on a short-term governmental obligation generally is not taxed until maturity, or the obligation is otherwise disposed of.^[85] However, for certain taxpayers, such as those using the accrual method of accounting, the discount on a short-term governmental obligation is required to be included currently in income.^[86] Further, current tax law provides that United States obligations may be exchanged without recognition of gain or loss.^[87] The Draft would repeal current law requiring the accrual of interest on short-term government obligations.^[88] The Draft would also repeal current law allowing the tax-free exchange of certain government obligations.^[89] If adopted, this provision generally would be effective on the date of enactment, although the repeal of the tax-free exchange provision would apply to exchanges after December 31, 2013.