IX. Dealers In Securities
“Dealers in securities: are generally taxed in a different manner than other taxpayers. Securities held by dealers are subject to mark-to-market treatment. A “dealer” is broadly defined as a taxpayer which (1) regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business or (2) regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. In this context, security includes stock, evidence of indebtedness, swap, or any other derivative financial instruments. As a credit derivative is within the definition of a security under the mark-to-market rules, a dealer holding a credit derivative at the close of the taxable year must recognize gain or loss on the derivatives as if it were sold for its fair market value, unless the derivatives are held for investment or is a hedge of a security held for investment.
The character rules determine whether income or loss is treated as ordinary or capital. Generally, capital gains earned by non-corporate taxpayers on capital assets held for more than 12 months are subject to a maximum tax rate of 20 percent. Ordinary income earned by non-corporate taxpayers is subject to the maximum tax rate of 39.6 per cent. Corporate taxpayers are subject to a marginal tax rate of 35 percent. Furthermore, non-corporate taxpayers may deduct up to USD 3,000 annually of excess capital losses from ordinary income, while corporations cannot use capital losses to offset ordinary income.
A. Dealers in Securities
A dealer treats gain or loss as ordinary gain or loss under the mark-market rules. Unless one of the exceptions described below applies, a dealer also treats as ordinary the gain or loss recognized on the deposition of security before the close of the taxable year when the security, if held at year-end would have been treated as ordinary income or loss. Ordinary income treatment does not apply during the period security is:
- a hedge of investment security or an ordinary course of the business debt instrument (i.e securities not mark-to-market);
- a hedge of a position, right to income, or liability which is not a security in hands of the taxpayer and thus no marked-to-market;
- security held by the taxpayer other than in connection with its activities as a dealer; or
- a security that is improperly identified as qualifying for the exceptions under the mark-to-market rules.
If a total return swap gets ordinary income treatment (i.e the exception listed above does not apply), the character of payments of the swap in the hands of the dealer does not pose a mismatch issue. For example, again on a reference obligation will offset a loss incurred under the total return swap, as gains and losses on brother securities will be ordinary. However, if ordinary income treatment is not available to a dealer’s total return swap, the dealer will be in the same boat as other taxpayers, with a potential character mismatch.
B. Character of payments under total return swaps
The character of total return swap payments is uncertain with respect to non-dealers and dealers for whom ordinary income treatment is not available. Payments under total return swaps will generally be treated as ordinary income unless a “sale or exchange” has taken place. Section 1234A of the Internal Revenue Code provides that gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to any property that is or on acquisition would be a capital asset in the taxpayer’s hands is treated as gain or loss from the sale of a capital asset. A total return swap is “property”; however, it is not clear whether all payments under a total return swap are subject to capital treatment.