Demystifying Section 1260 - Using Options Under the Constructive Ownership Rules

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Background

Section 1260 of the U.S. Internal Revenue Code (the "Code") was enacted in 1999 in response to a specific targeted tax planning strategy that involved writing derivatives on hedge funds. Many hedge funds generally adopt investment strategies that involve frequent trading, restuling in short-term capital gains and losses for U.S. federal income tax purposes. The funds generally are treated as partnerships for tax purposes, i.e. entities that pass through trading gains and losses to their investors on a crurent basis. Thus, direct investors in the funds are taxed on a current basis on their distributive share of gains at the higher short-term capital gains rate.

To plan around this result, financial engineers structured derivate products, such as forwards, option strategies and swaps, which provided investors with substantially all of the economic exposure to hedge funds without actually owning the fund interests. Prior to the enactment of Section 1260, investors took the position that income on these derivatives, if properly structured, was recognized only upon a sale or termination of the derivative-i.e., on a deferred basis-and that such gains were long-term capital gains if the derivative was held for more than one year. Section 1260 was enacted to rectify this perceived abuse....

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