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United States Government Accountability Office: 
GAO: 

Report to Congressional Requesters: 

September 2011: 

Financial Derivatives: 

Disparate Tax Treatment and Information Gaps Create Uncertainty and 
Potential Abuse: 

GAO-11-750: 

GAO Highlights: 

Highlights of GAO-11-750, a report to congressional requesters. 

Why GAO Did This Study: 

Recently, concerns have arisen about the use of certain financial 
derivatives to avoid or evade tax obligations. As requested, this 
report (1) identifies and evaluates how financial derivatives can be 
used to avoid or evade tax liability or achieve differing tax results 
in economically similar situations, (2) evaluates Internal Revenue 
Service (IRS) actions to address the tax effects of investments in 
financial derivatives through guidance, and (3) evaluates IRS actions 
to identify financial derivative products and trends through 
information from other agencies. GAO reviewed research and IRS 
documents and interviewed IRS and, Department of the Treasury 
(Treasury) officials and other experts. GAO analyzed the completion of 
financial derivative projects on the agencies’ Priority Guidance
Plans (PGP) from 1996 to 2010. 

What GAO Found: 

Taxpayers have used financial derivatives to lower their tax liability 
in ways that the courts have found improper or that Congress has 
disallowed. Taxpayers do this by using the ease with which derivatives 
can be redesigned to take advantage of the current patchwork of 
relevant tax rules. As new products are developed, IRS and taxpayers 
attempt to fit them into existing “cubbyholes” of relevant tax rules. 
This sometimes leads to inconsistent tax treatment for economically 
similar positions, which violates a basic tax policy criterion. While 
the tax rules for each cubbyhole represent Congress’s and Treasury’s 
explicit policy decisions, some of these decisions were made long 
before today’s complex financial derivative products were created. 
Some experts have suggested alternate methods to the current approach 
for taxing financial derivatives. IRS and Treasury, because of their 
unique position to define policy and administer the tax code, are best 
positioned to study and recommend a new approach. 

When application of tax law is complex or uncertain, as is often the 
case for financial derivatives, guidance to taxpayers is an important 
tool for IRS to address tax effects and potential abuse. However, 
between 1996 and 2010, Treasury and IRS did not complete 14 out of 53 
guidance projects related to financial derivatives that they 
designated as a priority on their annual PGP. While completing 
guidance is important in providing certainty to taxpayers and IRS and 
reducing the potential for abuse, challenges like the risk of adverse 
economic impacts of guidance changes and the transactional complexity 
of financial derivatives may delay the completion of guidance. Since 
challenges may prevent IRS from finalizing guidance within a 12-month 
PGP period, taxpayers need to be aware of ongoing guidance projects’ 
status, some of which may span a number of years. 

IRS sometimes identifies new financial derivative products or new uses 
of them long after they have been introduced and gained considerable 
use. This slows its ability to address potential abuses. IRS’s 2009-
2013 Strategic Plan lists strengthening partnerships across government 
agencies to gather and share information as key to identifying and 
addressing new products and emerging tax schemes more quickly. Through 
their oversight roles for financial derivative markets, the Securities 
and Exchange Commission (SEC) and the Commodity Futures Trading 
Commission (CFTC) may have information on financial derivatives that 
is relevant to IRS. Similarly, bank regulators may gain relevant 
knowledge of derivatives’ use. IRS officials said such routine 
communications in the early 1990s did provide relevant information. 
Although IRS communicates with SEC and CFTC on derivatives, it does 
not do so systematically or regularly. Strengthening partnerships 
would increase opportunities for IRS to gain information on new 
financial derivative products and uses. Studies of interagency 
coordination suggest that agencies should look for opportunities to 
enhance collaboration in order to achieve results that would not be 
available if they were to work separately, and a number of best 
practices exist to help agencies meet this goal. 

What GAO Recommends: 

GAO recommends that (1) Treasury determine whether alternatives to the 
current approach to taxing financial derivatives would promote 
consistent treatment of economically similar positions and be 
beneficial, that (2) Treasury and IRS provide more public information 
on the status of PGP projects, including those related to financial 
derivatives, and that (3) IRS strengthen information-sharing 
partnerships with relevant agencies. IRS agreed with the third 
recommendation and disagreed with the second; Treasury disagreed with 
the first two recommendations. GAO continues to believe its 
recommendations would be beneficial. 

View [hyperlink, http://www.gao.gov/products/GAO-11-750]. For more 
information, contact Michael Brostek at (202) 512-9110 or 
brostekm@gao.gov. 

[End of section] 

Contents: 

Letter: 

Background: 

Financial Derivatives Do Not Fit Neatly into The Tax System, Allowing 
Taxpayers to Use Them in Potentially Abusive or Improper Ways: 

Challenges Slow the Development of Guidance on Financial Derivatives 
Increasing Uncertainty and Potential for Abuse: 

Opportunities Exist for IRS to Leverage Information from SEC and CFTC 
on Financial Derivatives: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Additional Methodology Details: 

Appendix II: Financial Derivative Priority Guidance Projects: 

Appendix III: Comments from the Internal Revenue Service: 

Appendix IV: Comments from the Department of the Treasury: 

Appendix V: GAO Contact and Staff Acknowledgments: 

Glossary: 

Tables: 

Table 1: Timing, Character, and Source Applied to Financial 
Derivatives: 

Table 2: Completion Rate of Financial Derivative Guidance Projects, 
1996-2010: 

Table 3: Negative Consequences of Delayed Guidance on Financial 
Derivatives: 

Figures: 

Figure 1: Basic Financial Derivative Contracts and Their Market Share 
by Product Type as of the Fourth Quarter of 2010: 

Figure 2: Growth in U.S. Derivative Markets: Quarterly Notional Amount 
Outstanding and Gross Positive Fair Value (1999-2010): 

Figure 3: Credit Default Swap: 

Figure 4: Cross-Border Total Return Equity Swap: 

Figure 5: Variable Prepaid Forward Contract: 

Figure 6: Variable Prepaid Forward Contract and Share-Lending 
Agreement: 

Figure 7: IRS Actions on Contingent Swaps and CDS: 

Figure 8: Completion Rates of Financial Derivative Guidance Projects, 
1996-2010: 

Figure 9: Cascading Withholding Taxes through Equity Securities Loan: 

Figure 10: Combining a Total Return Equity Swap and an Equity 
Securities Loan: 

[End of section] 

United States Government Accountability Office: 
Washington, DC 20548: 

September 20, 2011: 

The Honorable Max Baucus: 
Chairman: 
The Honorable Orrin G. Hatch: 
Ranking Member: 
Committee on Finance: 
United States Senate: 

The Honorable Charles E. Grassley: 
Ranking Member: 
Committee on the Judiciary: 
United States Senate: 

Over the past few years some attention has been focused on certain 
financial derivatives that have been used to avoid or evade tax 
obligations. Financial derivatives are financial instruments whose 
value is based on one or more underlying reference items.[Footnote 1] 
Recent legislation has directly addressed one of the most prominent 
tax avoidance transactions enabled by financial derivatives, and 
another was addressed through litigation.[Footnote 2] While a majority 
of the world's largest companies use financial derivatives to manage 
and hedge risks, some taxpayers have used financial derivatives to 
reduce their tax liabilities in ways that have been aggressive and 
later disallowed, and such use is likely to continue. 

In response to your request, this report (1) identifies and evaluates 
how financial derivatives can be used to avoid or evade tax liability 
or achieve differing tax results in economically similar situations, 
(2) evaluates Internal Revenue Service (IRS) actions to address the 
tax effects of investments in financial derivatives through its 
taxpayer guidance, and (3) evaluates IRS actions to identify new 
financial derivatives products and trends through information sharing 
with its partners in other federal financial regulatory agencies. 

To identify and evaluate how financial derivatives can be used to 
avoid or evade tax liability, we reviewed academic studies and IRS 
documents. We also interviewed officials and staff at IRS and the 
Department of the Treasury (Treasury), and tax experts from the 
private sector. For this part of the report, we focused on two case 
studies of financial derivative transactions--variable prepaid forward 
contracts and cross-border total return equity swaps--as illustrations 
of the use of financial derivatives to achieve improper or disallowed 
tax results. We analyzed the taxation of financial derivatives against 
consistency, a criterion meaning that transactions with equivalent 
economic outcomes are taxed the same. We identified this criterion 
through testimonial evidence from tax experts and Treasury officials, 
and a review of research on the taxation of financial derivatives. It 
was one of the most frequently cited criteria by these sources, and 
also the most applicable to our objectives. The criterion of 
consistency is related to simplicity, administrability, and economic 
efficiency, several of the criteria for a good tax system that are 
discussed in our 2005 report on tax reform. [Footnote 3] A lack of 
consistency can make the tax system more difficult for taxpayers to 
comply with, more difficult for IRS to administer, and reduce economic 
efficiency by influencing the investments taxpayers make by taxing 
different investments under different tax rules. While consistency may 
not be the only criteria to consider, we believe it is an important 
guideline to evaluate whether financial derivatives can be used by 
taxpayers for abusive purposes. 

To evaluate IRS actions to address the tax effects of investments in 
financial derivatives through its guidance, we reviewed IRS documents 
and interviewed IRS and Treasury staff and officials about the 
guidance process, with a specific focus on IRS's and Treasury's 
processes for developing their Priority Guidance Plan (PGP), which 
identifies and prioritizes the tax issues that IRS believes are most 
important to taxpayers and tax administration and should be addressed 
through guidance. We analyzed financial derivative-related guidance 
projects included in the PGP from the years 1996 to 2010, determined 
how long it took for Treasury and IRS to release guidance on those 
projects, and compared the time required with the criteria established 
by IRS and Treasury for the PGP. In addition, we completed case 
studies of four financial derivative issues that were included in the 
PGP and were highlighted as significant in interviews with Treasury, 
IRS, and private sector experts. The four case studies cover credit 
default swaps, contingent swap payments, variable prepaid forward 
contracts, and cross-border total return equity swaps. 

To evaluate IRS actions to identify new financial derivatives products 
and trends through information sharing with its partners in other 
financial regulatory agencies, we examined IRS's information sharing 
with other federal financial market regulators. To examine information 
sharing with other agencies, we interviewed relevant officials and 
staff at IRS and at two financial market regulatory agencies, the 
Securities and Exchange Commission (SEC) and the Commodity Futures 
Trading Commission (CFTC). As our criterion, we used IRS's 2009-2013 
Strategic Plan, which lists strengthening partnerships across 
government agencies to gather and share additional information as key 
to enforcing tax law in a timely manner to ensure taxpayers meet their 
obligations to pay taxes. In prior work, we have also reported on the 
importance and value of cross-agency information sharing and 
coordination, and have established criteria on federal agency 
coordination and information sharing.[Footnote 4] We also identified 
the legislative authorities that govern IRS's disclosure of taxpayer 
information. 

For the purposes of this review, we determined that data on financial 
derivatives from the Office of the Comptroller of the Currency (OCC) 
and the subset of IRS PGP data used in our analysis were reliable. See 
appendix 1 for additional details on our scope and methodology. We 
conducted this performance audit from May 2010 through September 2011 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

Background: 

Financial derivatives are globally used financial products that 
unbundle exposure to an underlying asset and transfer risks--the 
exposure to financial loss caused by adverse changes in the values of 
assets or liabilities--from entities less able or willing to manage 
them to those more willing or able to do so. The values of financial 
derivatives are based on an underlying reference item or items, such 
as equities, debt, exchange rates, and interest rates. Since 2001, 
interest rate contracts have made up the vast majority of all 
financial derivative contracts, on average 80 percent of all 
derivatives in terms of notional amount outstanding, and are used to 
hedge against changes in the cost of capital[Footnote 5]. 

Parties involved in financial derivative transactions do not need to 
own or invest in the underlying reference items, and often do not. The 
most common purpose of financial derivatives is to manage the holder's 
risk, and this is often accomplished by constructing financial 
derivative contracts that produce more favorable rather than 
unfavorable tax results. Financial derivatives are sold and traded 
either on regulated exchanges or in private, over-the-counter markets 
that allow highly customized transactions specific to the needs of the 
parties. Financial derivatives are bilateral agreements that shift 
risk from one party to another but can be used to structure more 
complicated arrangements involving multiple transactions and parties. 
Simple financial derivatives act as building blocks for more complex 
products, and can be broken down into three general categories of 
products, described in figure 1. Credit derivatives, depending on 
their structure, fall into one of these three categories, but are 
often measured as a separate category by government agencies. 

Figure 1: Basic Financial Derivative Contracts and Their Market Share 
by Product Type as of the Fourth Quarter of 2010: 

[Refer to PDF for image: pie-chart and associated data] 

Swaps: 64.6%; 
Forwards and futures: 15.4%; 
Options: 13.9%; 
Credit derivatives: 6.1%. 

Product: Forwards and Futures; 
Description: Contract between two parties in which the forward buyer 
agrees to purchase from the forward seller a fixed quantity of the 
underlying reference item at a fixed price on a fixed date. A futures 
contract is a forward contract that is standardized and traded on a 
organized futures exchange, while a forward contract is privately 
negotiated among the buyer and seller. 

Product: Options; 
Description: Contract that gives the holder of the option the right, 
but not the obligation, to buy (call option) or sell (put option) a 
specified amount of the underlying reference item at a predetermined 
price (strike price) at or before the end of the contract. 

Product: Notional Principal Contracts (NPC), or Swaps; 
Description: According to section 1.446-3(c)(1)(i) of title 26, Code 
of Federal Regulations, a notional principal contract (NPC) is defined 
as a financial instrument that provides for the payment of amounts by 
one party to another at specified intervals calculated by reference to 
a specified index on a notional amount in exchange for specified 
consideration or a promise to pay similar amounts. An NPC is a swap 
under which the parties agree to exchange payments calculated by 
reference to a notional amount, however not all swaps are considered 
NPCs. 

Product: Credit derivatives; 
Description: Contract that is designed to explicitly shift credit risk 
from one party to another. Payments are contingent on the occurrence 
of a credit event and the value of the contract is derived from the 
credit performance of one of more corporations, sovereign entities, or 
debt obligations. Credit derivatives can be structured as forwards, 
options, or swaps. 

Source: GAO analysis of Office of the Comptroller of the Currency 
(OCC) data. 

Note: Office of the Comptroller of the Currency (OCC) reports credit 
derivatives separate from the other three categories above. 

[End of figure] 

Dealers participate in the financial derivatives market by quoting 
prices to, buying derivatives from, and selling derivatives to end 
users and other dealers. They also develop customized derivative 
products for their clients. Commercial banks, which most often act as 
dealers, are typically one of the two parties involved in financial 
derivative transactions. In 2010 the holdings of five large commercial 
banks represented over 95 percent of the banking industry's notional 
amounts outstanding. 

End users, including commercial banks, securities firms, hedge funds, 
insurance companies, governments, mutual funds, pension funds, 
individuals, commercial entities, and other dealers, often use 
derivatives to protect against adverse change in the values of assets 
or liabilities, called hedging. Hedgers try to protect themselves from 
risk by entering into derivatives transactions whose values are 
expected to change in the opposite direction from the values of their 
assets or liabilities. According to a 2009 survey conducted by the 
International Swaps and Derivatives Association, over 94 percent of 
the largest companies' worldwide use financial derivatives to manage 
and hedge risks. End users can also use derivatives for speculation by 
taking on risk in an attempt to profit from changes in the values of 
derivatives or their reference items. Derivatives are attractive to 
speculators because they can be more cost-effective than transactions 
in the underlying reference item, due to reduced transaction costs and 
the leverage that derivatives provide. Financial derivatives 
transactions are generally leveraged since parties to these 
transactions most often initiate the transaction with little money 
down relative to the expected outcome of the transaction. In any 
financial transaction, the degree of permissible leverage is 
determined by the collateral required to secure the transaction. While 
a high degree of leverage has the potential for large gains, it also 
carries risks of large losses. As we and others have reported, the 
risk exposures resulting from derivatives were one of many factors 
that contributed to the systemic risk that led to the recent financial 
crisis.[Footnote 6] 

The market for financial derivatives has grown considerably in size 
over the past two decades. Two common ways to measure the size of 
financial derivative markets overall are total notional amount and 
fair market value. Total notional amount represents the value of the 
reference items underlying financial derivative transactions, and is 
the amount upon which payments are computed between parties of 
derivatives contracts. Notional amount does not represent money 
exchanged, nor does it represent the risk exposure. The second 
measure, fair market value, can be either the gross positive fair 
value or the gross negative fair value. The gross positive fair value 
represents the sum of the fair values of the financial derivative 
contracts where the commercial bank is owed money by the other party 
in the contract and represents the maximum losses the bank could incur 
if all other parties in the contracts default.[Footnote 7] According 
to the OCC, between the first quarter of 1999 and the fourth quarter 
of 2010, the total notional amount outstanding used to calculate 
payments for derivatives contracts held by insured U.S. commercial 
banks and trust companies grew over six times, from $32.7 trillion to 
$231.2 trillion. For those same institutions, gross positive market 
value grew nearly seven-and-a-half times, from $0.46 trillion to $3.87 
trillion (see figure 2). The difference in these numbers is due to the 
fact that the notional amount is used to calculate payments from the 
contracts, which are typically a small percentage of the notional 
amount. The net present value of these payments determine, in part, 
gross positive market value. Because commercial banks are one of the 
parties involved in over 95 percent of financial derivative contracts, 
these measures are good indicators of the entire U.S. market. The 
volatility seen in figure 2 during the latter part of 2007 and 2008 is 
attributed in part to turmoil in financial markets and banking 
consolidation. In part because different types of financial 
derivatives are reported differently to IRS by taxpayers and third 
parties, and in most cases are not clearly identified as financial 
derivatives, IRS told us that data are not available to estimate 
overall gains and losses of income earned from financial derivatives. 

Figure 2: Growth in U.S. Derivative Markets: Quarterly Notional Amount 
Outstanding and Gross Positive Fair Value (1999-2010): 

[Refer to PDF for image: 2 line graphs] 

Notional amount outstanding (billions of dollars): 

Quarter: 1999-Q1: $32,662; 
Quarter: 1999-Q2: $33,003; 
Quarter: 1999-Q3: $35,658; 
Quarter: 1999-Q4: $34,816; 
Quarter: 2000-Q1: $37,631; 
Quarter: 2000-Q2: $39,325; 
Quarter: 2000-Q3: $38,314; 
Quarter: 2000-Q4: $40,543; 
Quarter: 2001-Q1: $43,921; 
Quarter: 2001-Q2: $47,820; 
Quarter: 2001-Q3: $51,283; 
Quarter: 2001-Q4: $45,385; 
Quarter: 2002-Q1: $46,331; 
Quarter: 2002-Q2: $50,083; 
Quarter: 2002-Q3: $53,173; 
Quarter: 2002-Q4: $56,074; 
Quarter: 2003-Q1: $61,423; 
Quarter: 2003-Q2: $65,837; 
Quarter: 2003-Q3: $67,113; 
Quarter: 2003-Q4: $71,081; 
Quarter: 2004-Q1: $76,524; 
Quarter: 2004-Q2: $81,012; 
Quarter: 2004-Q3: $84,176; 
Quarter: 2004-Q4: $87,880; 
Quarter: 2005-Q1: $91,115; 
Quarter: 2005-Q2: $96,199; 
Quarter: 2005-Q3: $98,783; 
Quarter: 2005-Q4: $101,478; 
Quarter: 2006-Q1: $110,183; 
Quarter: 2006-Q2: $119,243; 
Quarter: 2006-Q3: $126,196; 
Quarter: 2006-Q4: $131,499; 
Quarter: 2007-Q1: $144,790; 
Quarter: 2007-Q2: $152,502; 
Quarter: 2007-Q3: $172,175; 
Quarter: 2007-Q4: $164,196; 
Quarter: 2008-Q1: $180,344; 
Quarter: 2008-Q2: $182,135; 
Quarter: 2008-Q3: $175,842; 
Quarter: 2008-Q4: $200,382; 
Quarter: 2009-Q1: $201,964; 
Quarter: 2009-Q2: $203,460; 
Quarter: 2009-Q3: $204,264; 
Quarter: 2009-Q4: $212,808; 
Quarter: 2010-Q1: $216,452; 
Quarter: 2010-Q2: $223,376; 
Quarter: 2010-Q3: $234,655; 
Quarter: 2010-Q4: $231,181; 

Gross positive fair value (billions of dollars): 

Quarter: 1999-Q1: $456; 
Quarter: 1999-Q2: $411; 
Quarter: 1999-Q3: $419; 
Quarter: 1999-Q4: $428; 
Quarter: 2000-Q1: $437; 
Quarter: 2000-Q2: $420; 
Quarter: 2000-Q3: $413; 
Quarter: 2000-Q4: $517; 
Quarter: 2001-Q1: $602; 
Quarter: 2001-Q2: $575; 
Quarter: 2001-Q3: $771; 
Quarter: 2001-Q4: $643; 
Quarter: 2002-Q1: $543; 
Quarter: 2002-Q2: $766; 
Quarter: 2002-Q3: $1,082; 
Quarter: 2002-Q4: $1,171; 
Quarter: 2003-Q1: $1,218; 
Quarter: 2003-Q2: $1,404; 
Quarter: 2003-Q3: $1,266; 
Quarter: 2003-Q4: $1,173; 
Quarter: 2004-Q1: $1,308; 
Quarter: 2004-Q2: $1,001; 
Quarter: 2004-Q3: $1,148; 
Quarter: 2004-Q4: $1,328; 
Quarter: 2005-Q1: $1,213; 
Quarter: 2005-Q2: $1,495; 
Quarter: 2005-Q3: $1,351; 
Quarter: 2005-Q4: $1,224; 
Quarter: 2006-Q1: $1,207; 
Quarter: 2006-Q2: $1,320; 
Quarter: 2006-Q3: $1,149; 
Quarter: 2006-Q4: $1,132; 
Quarter: 2007-Q1: $1,122; 
Quarter: 2007-Q2: $1,345; 
Quarter: 2007-Q3: $1,375; 
Quarter: 2007-Q4: $1,604; 
Quarter: 2008-Q1: $2,681; 
Quarter: 2008-Q2: $2,257; 
Quarter: 2008-Q3: $2,102; 
Quarter: 2008-Q4: $5,978; 
Quarter: 2009-Q1: $5,229; 
Quarter: 2009-Q2: $3,975; 
Quarter: 2009-Q3: $4,213; 
Quarter: 2009-Q4: $3,617; 
Quarter: 2010-Q1: $3,613; 
Quarter: 2010-Q2: $4,509; 
Quarter: 2010-Q3: $5,216; 
Quarter: 2010-Q4: $3,873. 

Source: OCC data. 

[End of figure] 

The range and complexity of financial derivative products have grown 
along with the market. Whereas the first financial derivatives were 
simple forwards and options contracts on commodities, today financial 
derivatives can be based on more complex reference items, such as 
bundles of mortgage-backed securities. These transactions may also 
combine different simple derivatives with traditional assets like debt 
or equity, and involve various contractual contingencies, such as 
credit default or the occurrence of catastrophic events. For example, 
credit derivatives, which are derivative contracts designed to shift 
credit risk between parties in the contract, have developed from 
simple contracts based on a single credit event to more complicated 
structured products that combine different contracts into a single 
security. 

In its role in administering the tax code, IRS must implement the laws 
enacted by Congress, through detailed regulations and guidance. The 
IRS Office of Chief Counsel produces several forms of guidance to 
accomplish this. The seven most common forms include regulations, 
revenue rulings, revenue procedures, private letter rulings, notices, 
announcements, and technical advice memorandums.[Footnote 8] 
Regulations, which provide taxpayers with directions on complying with 
new legislation or existing sections of the tax code, hold more legal 
weight than IRS's other forms of guidance. Generally, regulations are 
first published in draft form in a Notice of Proposed Rulemaking, and 
final regulations are issued after public input is fully considered 
through written comments and potentially a public hearing. Where new 
or amended regulations may not be published in the immediate future, 
notices are often used to provide substantive interpretations of the 
tax code and other provisions of the law. In addition, IRS issues 
revenue rulings to provide official interpretations of the tax code, 
related statutes, tax treaties, and regulations. These interpretations 
are specific to how the law is applied to a particular set of facts. 
Revenue procedures provide return filing or other instructions 
concerning an IRS position. Private letter rulings are written 
statements issued to a single taxpayer that interpret and apply tax 
laws to that taxpayer’s specific set of facts. They are not officially 
published and may not be relied on as precedent by other taxpayers or 
IRS.[Footnote 9] Announcements, which generally have only immediate or 
short-term relevance, summarize laws and regulations without making 
any substantive interpretation; state what regulations will say in the 
future; or notify taxpayers of the existence of an approaching 
deadline. Finally, technical advice memorandums are developed in 
response to technical or procedural questions that develop during an 
examination or a processing in Appeals. 

Financial Derivatives Do Not Fit Neatly into the Tax System, Allowing 
Taxpayers to Use Them in Potentially Abusive or Improper Ways: 

Unique characteristics of financial derivatives make them particularly 
difficult for the tax code and IRS to address. The tax code's current 
approach to the taxation of financial derivatives is characterized by 
many experts as the "cubbyhole" approach. Under this approach, the tax 
code establishes broad categories for financial instruments, such as 
debt, equity, forwards, and options, each with its own rules governing 
how and when gains and losses are taxed. As new instruments are 
developed, IRS and taxpayers attempt to fit them into existing tax 
categories by comparing the new instrument to the most closely 
analogous instruments for which tax rules exist. However, a new 
financial instrument could be similar to multiple tax categories, and 
therefore IRS and taxpayers must choose between alternatives. This 
could result in inconsistent tax consequences for a transaction that 
produces the same economic results. 

Derivative contracts, particularly those traded over-the-counter, are 
highly flexible, allowing taxpayers to structure transactions to take 
advantage of the different tax rules for each tax category. 
Derivatives can also be coupled with each other and with other types 
of financial instruments, like more traditional debt or equity 
instruments, to create hybrid securities. Because hybrid securities 
often do not clearly fall within a single tax category, it can be 
challenging for IRS and taxpayers to determine which tax rules are 
appropriate, and whether the hybrid should be treated as a single 
instrument or broken up into multiple instruments. While the tax rules 
for each tax category represent Congress's and Treasury's explicit 
policy decisions, some of these decisions were made long before 
today's complex financial derivative products were created. The 
cumulative effect of these decisions combined with the fact that many 
financial derivatives do not fit neatly in any one tax category can 
result in mistakes or opportunities for abuse by taxpayers. 

A Patchwork of Rules from Different Parts of the Tax Code Govern the 
Taxation of Financial Derivatives: 

Tax rules governing financial derivatives can be broken down into 
rules governing the timing, character, and source of gains and losses, 
as described in table 1. These rules vary depending on a number of 
factors, including the type of financial derivative product, the 
underlying reference item, the transaction's cash flows, the type of 
taxpayer, the taxpayer's purpose for using the transaction, and 
applicable anti-abuse rules. Over time, as financial derivative 
products have been developed that do not fit neatly into existing tax 
categories, numerous tax rules have been created to address new 
financial products, sometimes without anticipating the relationship 
between those transactions and others. Therefore, tax rules for 
financial derivatives can vary widely from one transaction to another. 

Table 1: Timing, Character, and Source Applied to Financial 
Derivatives: 

Timing: 
When is the gain or loss taxed? Examples include deferral of income 
recognition until settlement date or expiration of the contract, 
marking-to-market at the end of the taxpayer's year, or amortizing 
over the life of the contract. When gains and losses are recognized 
can affect the tax rate, as well as the present value of the gains and 
losses actually taxed. 

Character: 
What is the type of gain or loss? Income or losses can be either 
ordinary income or loss or short-or long-term capital gains or losses, 
which affects the tax rate and the ability to defer gains and deduct 
losses. 

Source: 
Where is the source of the gain or loss located? Source, either 
foreign or domestic, affects whether the income is taxed by the U. S., 
whether foreign tax credits are available, or whether withholding 
taxes apply. 

Source: GAO analysis of IRS publications and tax research. 

[End of table] 

While the source of gains and losses resulting from financial 
derivatives is generally that of the residence of the recipient, the 
tax rules for timing and character are more complicated. As stated 
above, some of these tax rules depend on the type of financial 
derivative product. For example, nonequity options not held to hedge a 
transaction are taxed under section 1256 of the Internal Revenue Code 
(IRC), which requires that the timing of gains and losses are marked- 
to-market at the end of the tax year, and that the character of gains 
and losses is treated as 60 percent long-term capital and 40 percent 
short-term capital.[Footnote 10] Equity options held by dealers are 
also taxed under section 1256. However, for equity options not held by 
dealers, the timing rules are that gains and losses are not realized 
until the contract matures. Depending on the option's term, the 
character is either 100 percent short-term capital gain or loss or 100 
percent long-term capital gain or loss. 

Some tax rules for character also depend on the underlying reference 
item, regardless of the transaction type. An example of this is a 
foreign currency contract (known as a section 988 transaction), which 
may be ordinary or capital depending on a variety of factors outlined 
in IRC section 988. The gains or losses on a section 988 transaction 
are ordinary to the extent they are due to changes in exchange rates. 
However, the taxpayer may elect capital treatment in certain instances 
if the contract is a capital asset in the hands of the taxpayer and 
not part of an offsetting position, also known as a straddle. 

Other timing and character rules are based on the purpose of the 
transaction, such as transactions used for hedging, which are 
generally treated as ordinary and timed according to the hedged item. 
[Footnote 11] Regardless of the type of transaction or reference item, 
if the transaction qualifies as a hedge, these rules apply. 

There are also timing and character rules that are based on the type 
of taxpayer. For example, the rules under IRC section 475 apply to 
dealers in securities and, if they elect, commodities dealers and 
traders in securities or commodities, who must generally mark-to-
market securities or commodities under IRS section 475 and recognize 
gains and losses annually.[Footnote 12] The character of these gains 
and losses is ordinary. Since a securities dealer is typically one of 
the two parties involved in a financial derivative transaction, this 
often results in different tax treatment for both sides of the 
transaction. The dealer would generally mark-to-market annually the 
gains and losses from a financial derivative contract and treat the 
income or losses as ordinary, while the other party to the transaction 
would be taxed depending on the factors described in this section. 

Finally, the rules for the timing and character of financial 
derivatives can also vary for different types of payments within a 
single financial derivative transaction. For example, periodic 
payments in a NPC are treated differently than nonperiodic payments. 
Periodic payments are taxed as ordinary income and recognized annually 
on an accrual basis like interest payments. Nonperiodic payments must 
be amortized and recognized as ordinary income over the life of the 
contract. However, early termination payments in a NPC are recognized 
for timing purposes when they occur, and they give rise to capital 
gain or loss if the underlying item is capital. In contrast, 
nonperiodic, contingent payments do not have defined treatment; the 
tax rules only require taxpayers to account for the payments in a 
manner consistent with other tax positions. Proposed regulations 
issued in 2004 stated that taxpayers could use a noncontingent swap 
method to determine the timing and character of these payments or 
elect mark-to-market treatment.[Footnote 13] 

There are a number of anti-abuse rules that can supersede the tax 
rules described above, which further complicate the tax treatment of a 
transaction. Many sections of the tax code exist for the sole purpose 
of applying additional rules for certain transactions, including IRC 
sections 1091 (wash sales), 1092 (straddles), 1233 (short sales), 1258 
(conversion transactions), 1259 (constructive sales), and 1260 
(constructive ownership transactions). For example, under IRC section 
1092, for two or more transactions that are offsetting positions, 
known as a straddle, a realized loss on one position is currently 
deductible only to the extent that the loss exceeds unrecognized gains 
in any remaining offsetting positions. A second example involves 
constructive sales, or transactions that are treated as sales for tax 
purposes even though ownership in the property may not have legally 
transferred. Constructive sales include when a taxpayer enters into a 
short sale of the same or substantially identical property, an 
offsetting notional principal contract with respect to the same or 
substantially identical property, or a futures or forward contract to 
deliver the same or substantially identical property. Under IRC 
section 1259, taxpayers are considered as having sold a position at 
fair market value on the date of the constructive sale. 

The tax rules for character, timing, and source described above can be 
challenging for both taxpayers and IRS to apply. Where these rules 
overlap or contradict one another, they can create gray areas that 
allow the same economic outcome to be taxed differently. Even anti- 
abuse rules, some of which IRS and tax experts believe are largely 
effective, can contribute to the uncertainty because determining when 
to apply them can be difficult. 

Financial Derivative Transactions with Economically Similar Positions 
Can Have Inconsistent Tax Treatments: 

One basic principle of taxation commonly used to evaluate the tax 
treatment of financial derivatives is consistency, meaning that 
transactions with equivalent economic outcomes are taxed the same. The 
tax rules for financial derivatives with equivalent economic outcomes 
are not always consistent, in part because of their piecemeal 
development over time as well as the difficulty of developing tax 
rules for products that are constantly changing. For some types of 
financial derivatives, similar transactions can fall under different 
tax rules, particularly if the transactions do not fit well into the 
tax categories of the existing tax code. 

While the pretax economic outcome of a taxpayer using a financial 
derivative and actually holding the financial asset underlying the 
derivative may be the same, due to the inconsistent tax treatment of 
derivatives, the after-tax outcome can be starkly different. The 
flexibility in financial derivative contracts allows them to be used 
to mimic different economic positions. By combining the basic building 
blocks of financial derivatives highlighted in table 1, together with 
traditional instruments like debt and equity, taxpayers can virtually 
create any synthetic position that allows the same economic returns as 
the reference item without actually owning the reference item. 
Financial derivatives therefore allow users, in many circumstances, to 
structure transactions to alter the timing, character, and source of 
gains and losses to produce more tax-favorable results. For example, 
through financial derivatives taxpayers can defer gains or accelerate 
losses, change ordinary income into capital gains or vice versa for 
losses, or alter the source of the gains to avoid paying withholding 
taxes.[Footnote 14] While permitting taxpayers to elect a more 
favorable tax treatment is not uncommon, when they have done so using 
financial derivatives, the result has at times been disallowed by 
Congress. In other cases, IRS and Treasury have successfully 
challenged during audit or in litigation taxpayers' treatment of 
financial derivatives. 

In certain instances, financial derivative transactions can be used to 
produce equivalent economic outcomes that have different tax results 
because one financial derivative can fall under numerous tax rules. 
One prominent example of this is the credit default swap (CDS), which 
first appeared on the market in the early 1990s. As is shown in figure 
3, in a CDS, the buyer pays a periodic fee to the seller in return for 
compensation if a specified credit event occurs to a reference item. 
The reference item may be bonds or loans from a corporate entity, 
sovereign debt, an asset, or an index of these. The credit event may 
be default, bankruptcy, debt restructuring, or any number of events 
related to the significant loss in value of the underlying reference 
item. 

Figure 3: Credit Default Swap: 

[Refer to PDF for image: illustration] 

Reference Entity: 

Protection buyer: Periodic payment to: Protection seller. 

Protection seller: Does credit event occur? 
If no: No payment; 
If yes: Cash or physical settlement to Protection buyer. 

Sources: GAO and IRS publications. 

[End of figure] 

Although CDSs became prominent in the market in the 1990s, their tax 
treatment has remained uncertain. In the absence of guidance, 
taxpayers do not take a uniform treatment of CDSs, instead selecting 
the tax position that is most favorable. Taxpayers commonly elect NPC 
treatment for CDS transactions. As discussed previously, different 
payments from a NPC have different character treatments, and CDS users 
can take advantage of these differences to lower their tax liability 
when one party in the transaction is neutral to the tax results. For 
example, in a situation when a taxpayer holds a CDS that has 
appreciated in value and the other party is a dealer, rather than hold 
the contract until maturity and pay ordinary rates on the income, the 
taxpayer can terminate the contract early. By doing so the taxpayer 
receives a termination payment of the same economic value but pays 
lower long-term capital gains rates. Experts that we interviewed 
stated that the inconsistent treatment of CDSs increases compliance 
risk for taxpayers. In the final guidance, Treasury and IRS may 
determine that the tax treatment of CDSs does not align with how a 
taxpayer elected to treat a CDS now, and there is a risk that a 
different treatment could be imposed on transactions entered into 
prior to the new guidance. 

Financial derivatives also allow taxpayers to take advantage of the 
inconsistencies between asset classes, such as differences in 
deductions between payments on debt and equity. Taxpayers have done 
this with one type of financial derivative, by coupling a forward 
contract with the issuance of debt, which is one type of a mandatory 
convertible security. Mandatory convertibles are a broad class of 
securities linked to equity that automatically convert to common stock 
on a specific date, and allow the issuer to raise capital that is 
treated as debt in financial statements. However, interest payments on 
the issuance can be deducted, which would not be possible with 
dividend payments on a more traditional equity security. In the 
transaction, a corporation issues units of the security that consist 
of two components: a forward contract to purchase the corporation's 
equity, and debt in the form of the corporation's note. The purchaser 
of the unit pledges the note back to the corporation as collateral to 
pay the settlement price of the forward contract. If the note and the 
forward are treated as a single hybrid instrument for tax purposes, 
the single instrument resembles an equity position, and payments on 
such a position would not be deductible. Currently the note and the 
forward can be separated for tax purposes under certain circumstances, 
in which case the corporation can deduct all payments on the note as 
interest payments on debt, despite the presence of the forward 
contract.[Footnote 15] 

Financial derivatives also have allowed taxpayers to mimic the 
ownership of assets such as equities, while achieving a lower tax 
liability than direct ownership of those assets. One example of this 
was the disparate treatment of dividend payments on U.S. equity and 
dividend-equivalent payments from a total return equity swap (equity 
TRS), held by foreign entities. Foreign entities must pay 30 percent 
withholding taxes on any dividends received from U.S. sources because 
the dividend is considered U.S.-source income.[Footnote 16] However, 
until recently payments from a swap based on that U.S. asset would not 
be subject to withholding taxes, as swaps are sourced to the residency 
of the recipient of swap payments, the foreign entity in the case of 
the equity TRSs that attempt to avoid withholding taxes. In order to 
avoid withholding taxes on dividends, a foreign entity would enter an 
equity TRS, replacing the dividends with dividend-equivalent payments 
that arise from the swap. In this transaction, a U.S. financial 
institution pays the foreign entity a cash-flow equivalent to the 
dividends of a given stock plus any appreciation in the stock price, 
while the foreign entity pays a floating interest rate used to enter 
into the agreement plus any stock depreciation. The contract results 
in the foreign entity mimicking stock ownership without paying 
withholding tax by taking advantage of differences in source rules for 
dividend payments and dividend-equivalent payments. The use of equity 
TRS by foreign entities to avoid withholding had become standard 
practice since the 1990s, until the Hiring Incentives to Restore 
Employment (HIRE) Act statutorily required withholding on dividend-
equivalent payments (see figure 4)[Footnote 17]. For tax years before 
the enactment of the HIRE Act, IRS is challenging equity TRS 
transactions through the examination process, arguing that they were 
used to improperly avoid withholding taxes. In addition, IRS issued an 
Industry Director Directive on January 14, 2010, to assist IRS agents 
to identify and develop cases with questionable equity TRS 
transactions. 

Figure 4: Cross-Border Total Return Equity Swap: 

[Refer to PDF for image: illustration] 

U.S. financial institution: Equity value appreciation + Dividend 
equivalent to Foreign entity. 

Foreign entity: Equity value depreciation + Floating interest rate to 
U.S. financial institution. 

U.S. equity: Equity value appreciation + Dividend payment to U.S. 
financial institution. 

Source: GAO. 

[End of figure] 

Another example where taxpayers have used the inconsistent tax 
treatment between financial derivatives and direct ownership of the 
underlying asset was the case of a variable prepaid forward contract 
(VPFC) held in combination with a share-lending agreement. Taxpayers 
attempted to use this transaction to defer income by mimicking a sale 
of equity without recognizing the gains for tax purposes. When 
taxpayers sell an appreciated security, they must pay short-term or 
long-term capital gains taxes upon sale. However, over the past 
decade, taxpayers have used VPFCs to monetize gains in a security's 
value without paying taxes at the time of the sale. In situations 
where VPFCs have been used for this purpose, taxpayers agree to sell a 
variable number of shares to the other party in the transaction, 
usually an investment bank, at an agreed-upon date, typically 3 to 5 
years in the future. VPFCs are customized to the investor and an 
option to cash-settle is usually included in the contract. The number 
of shares delivered (or the cash value thereof) is based on a formula 
involving the stock price on the contract's expiration date.[Footnote 
18] The dealer typically pays the taxpayer between 75 percent and 85 
percent of the market value of the shares up front that is not 
required to be repaid. By manipulating differences in timing rules, 
the VPFC thus closely mimics the sale of stock, but the income is not 
recognized for tax purposes until the contract matures. Because of the 
variability in the number of deliverable shares, the transaction 
avoids anti-abuse rules that do not permit deferred recognition of 
prepaid sales (see figure 5).[Footnote 19] 

Figure 5: Variable Prepaid Forward Contract: 

[Refer to PDF for image: illustration] 

Investment bank: Up-front cash payment to Taxpayer. 

Taxpayer: Cash payment or delivery of shares at maturity to Investment 
bank. 

Source: GAO analysis of IRS publications. 

[End of figure] 

While holding a VPFC, taxpayers still retain control of the underlying 
asset. To earn a greater return on the VPFC as discussed above, 
taxpayers sometimes couple the VPFC with a share-lending agreement. 
This type of agreement stipulates that taxpayers lend shares to the 
investment bank to sell, invest, or use in other ways the shares in 
its course of business. In this manner, the taxpayers have transferred 
substantially all of the attributes of owning the shares, but have 
argued that the shares have not been sold for tax purposes (see figure 
6). 

Figure 6: Variable Prepaid Forward Contract and Share-Lending 
Agreement: 

[Refer to PDF for image: illustration] 

Investment bank: Up-front cash payment to Taxpayer. 

Taxpayer: Cash payment or delivery of shares at maturity to Investment 
bank; 
Shares lent at start of contract. 

Source: GAO analysis of IRS publications. 

[End of figure] 

The current tax treatment is not the only possible method of taxing 
financial derivatives, and experts have suggested a number of 
alternatives that they believe would adopt a more consistent view of 
financial derivatives and potentially reduce abuse. For example, one 
common idea is to require mark-to-market treatment on all financial 
derivatives for all taxpayers, meaning that all gains and losses from 
financial derivatives would be recognized at the end of each tax year, 
and to treat all such income as ordinary income. While this approach 
would result in higher tax burdens for some, proponents cite benefits, 
which include reduced compliance costs and potential for abuse. This 
report does not evaluate this approach or any other alternative 
approaches, which would require significant changes to the tax code. 
We have previously developed criteria for establishing a good tax 
system, which include equity; economic efficiency; and simplicity, 
transparency, and administrability.[Footnote 20] Consistency, the 
criterion used in this report, is related to simplicity, 
administrability, and economic efficiency. While the examples above 
describe issues that arise from inconsistent tax rules, any 
alternative approach would involve tradeoffs among these criteria. In 
considering the effects of alternative tax rules on economic 
efficiency, IRS and several experts told us that one potential effect 
of any alternative with less favorable tax outcomes could be that 
certain financial sector activity might leave the United States. 
Because of their unique position to define policy and administer the 
tax code, Treasury and IRS are in the best position to recommend an 
alternative approach to the taxation of financial derivatives. 

Challenges Slow the Development of Guidance on Financial Derivatives 
Increasing Uncertainty and Potential for Abuse: 

In their role of implementing tax laws enacted by Congress, Treasury 
and IRS play the crucial role of translating tax laws into detailed 
regulations, rules, and procedures. When application of the law is 
complex or uncertain, as is often the case for financial derivatives, 
guidance is an important tool for addressing tax compliance and 
emerging abusive tax schemes. Particularly when financial derivative 
products are new, how financial derivative products should be taxed 
under the current tax regime can be unclear. However, Treasury and IRS 
face a number of challenges in developing guidance for financial 
derivatives that may delay completion of guidance. Although taxpayers 
are accustomed to exercising judgment when taking a tax position for 
their transactions, the lack of clarity for many derivatives can lead 
to heightened compliance risk and abuse. 

Taxpayers we interviewed said that Treasury and IRS have not issued 
guidance on a number of financial derivative tax issues that have a 
significant impact on their decision making. For example, before the 
passage of the HIRE Act in 2010, the last guidance IRS issued on 
transactions that avoid withholding taxes on dividends similar to 
cross-border equity TRSs were final regulations in 1997.[Footnote 21] 
During the past two decades, the use of equity TRSs to avoid 
withholding taxes grew as many taxpayers interpreted the lack of tax 
guidance as IRS's approval of the tax treatment of the transaction. 

Similarly, IRS has not issued final regulations on contingent swaps 
since the proposed regulations in 2004, and finalized guidance on the 
appropriate tax treatment of CDSs has not been issued since a notice 
requesting comment on their tax treatment in 2004 (see figure 7 for a 
timeline). This leaves taxpayers with little clarity on how to treat 
gains or losses from a swap payment dependent on a contingency. 
Contingent swaps are swaps that contain contingent nonperiodic 
payments determined by the occurrence of a specified event, such as 
the price movement of an underlying asset.[Footnote 22] CDSs are a 
special type of a contingent swap, where the triggering event is a 
credit event, such as the default of debt issued by a third party. 
According to IRS, the only requirement for taxpayers is that they 
clearly reflect income in their method of accounting for these 
transactions. IRS first issued a notice soliciting comments on the tax 
treatment of contingent swap payments in 2001, which eventually led to 
a first round of proposed regulations in 2004. These proposed 
regulations offer two accounting methods: (1) mark-to-market 
treatment, or (2) annually projecting the expected value of the 
contingent payment and paying the appropriate tax as if it were a 
nonperiodic, noncontingent payment, known as the noncontingent swap 
method. After issuing the proposed regulations in 2004, IRS has gone 
through several internal iterations of draft regulations without 
issuing final regulations on contingent swaps. 

Figure 7: IRS Actions on Contingent Swaps and CDS: 

[Refer to PDF for image: timeline] 

Credit default swaps first appear and become prominent, early 1990s. 

2000: 
IRS receives taxpayer request for guidance on credit default swaps. 

2001: 
Notice requesting comments on contingent swaps (Notice 2001-44). 

2004: 
Proposed regulation on contingent swaps (NPRM, 69 Fed. Reg. 8886[A]); 
Notice requesting information on credit default swaps (Notice 2004-52). 

2007: 
Second draft of proposed regulation on contingent swaps (internally 
within IRS and Treasury). 

2010: 
Third draft of proposed regulation on contingent swaps (internally 
within IRS and Treasury. 

Source: IRS. 

[A] Notice of Proposed Rulemaking (NPRM). 

Note: In 1996, Treasury and IRS issued their first finalized 
regulations on contingent payments for any financial instrument, which 
addressed contingent payment debt instruments. 61 Fed. Reg. 30,133 
(June 14, 1996). Although the regulations helped frame IRS and 
Treasury's thinking on contingent swaps, these regulations are not 
included in the timeline because they did not specifically address 
contingent swaps. For additional details see appendix II. 

[End of figure] 

IRS first learned of CDSs in a request for a private letter ruling 
from a taxpayer in 2000. However, IRS did not issue any guidance on 
CDSs until 2004, when it requested information from taxpayers on four 
alternative treatments. In the absence of finalized guidance, the 2004 
notice allows taxpayers to place CDSs in one of four distinct tax 
categories for financial instruments.[Footnote 23] Experts and 
practitioners told us that the tax treatment for CDSs is unclear, the 
alternatives do not necessarily arrive at the same tax liability, and 
taxpayers do not uniformly use one of the alternatives. The lack of 
guidance has resulted in taxpayers choosing different tax treatments, 
and according to some taxpayers we interviewed, deferring income 
recognition even when they are reasonably certain of gains. Taxpayers 
and experts that we interviewed also stated that the inconsistent 
treatment of CDSs increases the tax compliance risk they face because 
Treasury and IRS may determine that the final tax treatment of CDSs 
will not align with how some taxpayers are treating CDSs now and that 
determination may be applied to transactions entered into in prior 
years. 

The absence of guidance on contingent swaps and CDSs affects IRS's 
ability to assess tax liability and address potential abuse. When exam 
teams in IRS identify a potentially abusive financial derivative used 
by a taxpayer, they have a number of resources to understand the tax 
effects and determine the appropriate tax liability. IRS has 
specialists in financial instruments that regularly assist revenue 
agents, as well as IRS attorneys who provide specialized legal advice. 
When an IRS exam division determines that a potential abuse has a 
large enough scale to warrant the necessary resources to address 
broadly, there are multiple avenues to raise the issue beyond the 
particular exam. One of these avenues is the issuance of guidelines by 
an IRS exam division to field examiners, such as an Industry 
Directive, as was the case with cross-border equity TRSs.[Footnote 24] 
Another mechanism is a request for nonprecedential guidance from IRS's 
Chief Counsel in the form of a legal memorandum to IRS staff. Issues 
can also be developed into a series of cases for litigation. For 
issues that are broad enough, Chief Counsel can eventually issue 
published guidance, which differs from the previous options in that it 
typically has a broader legal application. The other alternatives are 
not generally legally binding on IRS or taxpayers, except with regard 
to the taxpayer involved. As another example, for VPFCs with share-
lending agreements, IRS has issued guidance from exam divisions and 
Chief Counsel, and has also developed a number of cases for 
litigation.[Footnote 25] 

IRS and Treasury issue guidance in the form of regulations, revenue 
rulings, revenue procedures, notices, and announcements as well as 
other types of guidance. IRS Chief Counsel and Treasury's Office of 
Tax Policy have established a prioritization schedule for developing 
and issuing guidance, known as the Priority Guidance Plan (PGP). 
[Footnote 26] The PGP is issued each year and identifies the guidance 
projects that are the current IRS and Treasury guidance priorities to 
be completed over a 12-month period that runs from July 1st to June 
30th of that PGP year. The PGP is available to the public on IRS's 
website, and is updated periodically to include additional guidance 
project priorities and identifies which guidance projects have been 
completed up to that point. However, periodic updates to the PGP do 
not identify guidance projects that have been removed from the plan 
without having any guidance issued. Not all guidance projects being 
worked on are on the PGP, and a number of pieces of guidance affecting 
derivatives were not PGP projects. For example, Notice 2002-35, which 
addressed tax shelters using NPCs, was not on the PGP before it was 
published. The PGP serves as both a public statement of the guidance 
taxpayers can expect to receive over a 12-month period and an internal 
prioritization of resources within IRS and Treasury. Given the pace at 
which derivative markets evolve, timely guidance that addresses tax 
issues is important to reduce uncertainty and opportunities for 
abusive tax strategies. However, Treasury and IRS face a number of 
challenges that are discussed below that may delay the completion of 
guidance. 

Between 1996 and 2010 IRS and Treasury Did Not Complete One-Fourth of 
the Priority Guidance Projects That Involved Financial Derivatives: 

We analyzed 53 projects that involve financial derivatives that IRS 
and Treasury have placed on the PGP since 1996, and found that one-
fourth of the projects were not completed (see table 2).[Footnote 27] 
Almost all of the guidance projects that were completed were published 
within 2 years of first appearing on the PGP.[Footnote 28] 

Table 2: Completion Rate of Financial Derivative Guidance Projects, 
1996-2010: 

Complete: 
Count: 39; 
Percentage: 74. 

Incomplete: 
Count: 14; 
Percentage: 26. 

Total: 
Count: 53; 
Percentage: 100. 

Source: GAO analysis of IRS data. 

[End of table] 

Of the 53 projects on the PGP, IRS and Treasury completed just over 
half (29) within their first year on the plan, and removed 5 that were 
not completed. Of the 19 projects that remained on the plan for 2 
years or longer, just under half of those (9) were completed and 3 
were not completed and removed. Only 1 of the 7 projects that were on 
the PGP for 3 or more years was completed as of the end of the 2010 
PGP year (June 30, 2010). Some of the PGP projects that were removed 
or not completed from 1996-2010 dealt with tax issues related to the 
case studies described above on contingent swaps and equity TRSs. 
Figure 8 presents the completion rates for projects related to 
financial derivatives on the plan for 1 or more years. 

Figure 8: Completion Rates of Financial Derivative Guidance Projects, 
1996-2010: 

[Refer to PDF for image: line graph] 

Year on plan: 1; 
Hazard rate: 55%. 

Year on plan: 2; 
Hazard rate: 47%. 

Year on plan: 3 or more; 
Hazard rate: 14%. 

Source: GAO analysis of IRS data. 

[End of figure] 

We found, that on the basis of our analysis, projects not issued 
within 3 years were more likely to be regulations, and related to more 
complex issues. Four projects that were on the plan for 4 years or 
longer without being completed were regulations addressing 
particularly controversial and complicated issues, including (1) 
capitalization of interest and charges in straddles under IRC section 
263(g), (2) constructive sales rules under IRC section 1259, (3) 
contingent payments in notional principal contracts, and (4) elective 
mark-to-market accounting for certain qualifying taxpayers under IRC 
section 475. While it is important for IRS and Treasury to finalize 
guidance on these projects to provide clarity to IRS and taxpayers, 
there are a number of challenges involved, including the patchwork 
structure of the relevant tax rules and other issues discussed below. 
These challenges can make it difficult to issue guidance on the tax 
treatment of financial derivatives within the 12-month time frame 
established in the PGP. 

Challenges Specific to Financial Derivatives Slow the Guidance Process: 

While some reasons for the delay in the issuance of guidance on 
financial derivatives are common to all guidance projects, financial 
derivatives have characteristics that present challenges to IRS and 
Treasury. Overcoming these challenges requires time and resources, 
which can cause significant delays in issuing guidance that addresses 
the concerns facing taxpayers and IRS. 

The transactional complexity of many derivative products and the 
complex tax rules governing them make it difficult to determine 
appropriate tax treatment: 

The growing sophistication of financial derivatives and the complex 
tax rules governing them have made it difficult for Treasury and IRS 
to resolve issues not addressed in legislation or existing guidance. 
On the one hand, financial derivative products can involve multiple 
transactions and entities, or terms can be altered to reach different 
tax results. These factors impede IRS's ability to identify a 
product's economic outcome, business purpose, and the applicable tax 
rules. The complexity of VPFCs is one example where IRS concluded and 
the courts agreed that some claimed tax results of the transactions 
were improper, depending on the entities involved and what other 
contracts the VPFCs were coupled with. On the other hand, multiple tax 
rules can apply to the same financial derivative product depending on 
certain factors such as the type of taxpayer, the underlying asset, 
and the context in which the product is being used. Treasury and IRS 
often spend years working through these complexities, and at times 
have been unable to reach a consensus. 

The tax treatment of gains and losses that are contingent on a 
particular event is an example of an issue that Treasury, IRS, and 
private sector experts have identified as particularly difficult to 
resolve. Treasury and IRS legal counsel have devoted considerable 
resources--as of April 2011 IRS alone had logged nearly 7,800 staff 
hours over a 9-year period--to determine the appropriate treatment of 
contingent swap payments, but have been unable to reach a consensus. 
Despite being on the PGP every year since 2004, when proposed 
regulations were issued, Treasury and IRS have been unable to 
establish the appropriate treatment of contingent nonperiodic payments 
in final regulations in large part due to the complexity of the timing 
and character issues, as well as other issues discussed earlier. CDSs 
have also been the subject of considerable analysis by Treasury, IRS, 
and experts on the appropriate tax treatment. Since issuing a notice 
in 2004, IRS has not issued any guidance on how CDSs should be treated 
for tax purposes. During this time, the structure of CDS products has 
diversified from products that were referenced to a single entity to 
products based on a pool of obligations, such as an index and others 
that are rolled into more complex products. IRS and Treasury have not 
established the appropriate treatment of a basic CDS product, a 
necessary first step in determining the tax treatment of more complex 
CDS products. 

Some financial derivatives have been developed to take advantage of 
new guidance in ways unintended by IRS: 

The timeliness of Treasury and IRS guidance is also affected by 
concerns that issuing new guidance could provide new opportunities for 
tax abuse. This is especially true for financial derivatives, as they 
can easily be altered to achieve a desired tax effect. IRS told us 
that whether it issues further guidance depends on a careful 
consideration of the possible unintended effects that guidance might 
have, and that Treasury and IRS must carefully evaluate potential 
guidance changes to help ensure that while addressing problems in one 
area they do not raise issues in another. One example of guidance that 
Treasury and IRS issued that had unintended consequences was IRS 
Notice 97-66, which dealt with withholding taxes on dividend-
substitute payments. Certain payments made by a domestic entity to a 
foreign entity may be subject to a 30 percent withholding tax, 
depending on source rules for that type of payment. Dividend payments 
made from owning equity and dividend substitute payments made from a 
securities loan are subject to withholding tax. Prior to the passage 
of legislation in 2010, some taxpayers and representatives took the 
position that dividend-equivalent payments made from an equity TRS 
were not subject to withholding tax.[Footnote 29] IRS had begun 
challenging the equity TRS transaction based on judicial doctrines 
before the 2010 legislation was enacted. 

When Treasury finalized the regulations for dividend-substitute 
payments in 1997, tax practitioners were concerned that the 
regulations could result in the cascading of withholding taxes in 
cases where the same shares of equity were lent between two foreign 
parties. As seen in figure 9, in this transaction, the actual dividend 
and the dividend-substitute payment would be subject to withholding 
tax, resulting in withholding tax exceeding the 30 percent withholding 
rate. 

Figure 9: Cascading Withholding Taxes through Equity Securities Loan: 

[Refer to PDF for image: illustration] 

Foreign Entity A: U.S. equity loan to Foreign Entity B. 

Foreign Entity A: Dividend substitutes (withholding tax) to Foreign 
Entity B. 

U.S. Equity to Foreign Entity B (dividends). 

Foreign Entity A loans U.S. equity to Foreign Entity B. The U.S. 
equity pays out dividends to Foreign Entity B, which then pays dividend 
substitutes to Foreign Entity A as part of the securities loan. Both 
the actual dividend payment and the dividend substitute payment would 
be subject to withholding tax. IRS Notice 97-66 would only subject the 
dividend payment and not the dividend substitute payment to 
withholding tax in this transaction to avoid the overwithholding issue. 

Source: GAO analysis. 

[End of figure] 

In response, IRS issued Notice 97-66, intended to avoid cascading 
withholding on instances described in the example above. However, some 
financial institutions took the position that a literal reading of the 
IRS notice meant that a dividend-substitute payment made between two 
foreign parties located in jurisdictions subject to the same 
withholding rate was not subject to any withholding tax. As seen in 
figure 10, in this transaction, the dividend-equivalent payment would 
not be subject to withholding tax because of 1991 Treasury regulations 
and the dividend-substitute payment would not be subject to 
withholding tax based on the taxpayer's interpretation of IRS Notice 
97-66. As stated above, Congress eventually disallowed the avoidance 
of dividend withholding through this transaction with the passage of 
the HIRE Act. 

Figure 10: Combining a Total Return Equity Swap and an Equity 
Securities Loan: 

[Refer to PDF for image: illustration] 

Foreign Entity A: U.S. equity loan to Foreign Entity B; 
Foreign Entity B: Floating interest to U.S. Bank. 

U.S. Bank: Dividend equivalents (no withholding tax) to Foreign Entity 
B; 
Foreign Entity B: Dividend substitutes (no withholding tax) to Foreign 
Entity A. 

U.S. Equity to U.S. Bank (dividends). 

Foreign Entity A loans U.S. equity to Foreign Entity B and then 
Foreign Entity B enters into a total return equity swap with a U.S. 
bank, after selling the U.S. equity it was loaned so that it would not 
have to pass on dividend payment. The U.S. bank pays Foreign Entity B 
a dividend-equivalent, payment of equal value to the dividends as part 
of the total return equity swap, and Foreign Entity B pays Foreign 
Entity A a dividend substitute payment as part of the securities loan. 
The dividend-equivalent payment would not be subject to withholding 
tax based on Treasury regulations and the dividend substitute payment 
would not be subject to withholding tax based on the taxpayer’s 
interpretation of IRS notice 97-66. 

Source: GAO analysis. 

[End of figure] 

This example and others have made Treasury and IRS aware of the 
importance of weighing the need for guidance with the potential that 
new guidance may also provide new opportunities for taxpayers to 
aggressively reduce their tax liability by altering the structure of a 
transaction. The ability of financial market participants to react 
quickly to guidance means that Treasury and IRS have to consider the 
unintended effects that may occur when issuing guidance. As indicated 
in the example above regarding Notice 97-66, the time it takes 
Treasury and IRS to identify and mitigate any tax avoidance strategies 
that arise from issuing guidance can take a number of years.[Footnote 
30] While timeliness is an important factor for issuing guidance, 
taking steps to ensure the effectiveness and the desired results of 
the guidance are also important factors for IRS and Treasury to 
consider. 

The rapid growth of the financial derivatives market increased the 
potential economic impact of guidance: 

The considerable growth in financial derivatives markets has increased 
the potential economic effects of guidance issued by Treasury and IRS. 
IRS officials have said that in preparing guidance they do not 
consider the number of taxpayers taking a certain tax position on a 
financial derivative product, but rather they base their decisions on 
tax rules established in the IRC, Treasury regulations, and judicial 
doctrine. However, in light of the size of a product's market, 
officials told us that it is important to consider the economic 
effects of their guidance decisions. Economic consequences of concern 
identified by officials and experts include losing financial business 
overseas to countries with more business-friendly tax regimes. 

An example of one of the economic risks facing IRS and Treasury 
surfaced during the process of issuing guidance on how withholding 
taxes should apply to cross-border derivative payments. When Treasury 
and IRS considered requiring withholding on cross-border equity TRSs 
in 1998, Congress, IRS, and Treasury faced numerous concerns from 
taxpayers that this would limit foreign investment in the U.S. 
[Footnote 31] Withholding has also been a concern for cross-border 
CDSs. In terms of notional amount outstanding, the U.S. share of the 
global CDS market has, on average, been about one-third of the total 
market since the end of 2004. IRS staff and private sector experts 
have said that subjecting CDSs to withholding tax presents a risk that 
investors will move their business overseas. IRS officials said that 
this has been a major impediment in the resolution of whether 
withholding tax should apply to CDSs, particularly in light of the 
rapid growth of the credit derivatives market. 

Staff turnover, legal authority, and enforcement responsibilities have 
delayed the progress of financial derivative guidance projects: 

As Treasury and IRS work through the many complexities of issuing 
guidance for financial derivatives, they also must deal with 
institutional factors such as staff turnover, legal authority, and the 
different roles of Treasury and IRS that can delay the issuance of 
guidance. Staff turnover at IRS and Treasury can bring current market 
knowledge from the private sector; however, this turnover can also 
sometimes affect the timeliness of guidance. New staff typically have 
to familiarize themselves with the issues raised in ongoing guidance 
projects, may have a different perspective on the issues raised in the 
projects, or may believe the project should have a different priority. 

Determining whether Treasury and IRS have the necessary authority to 
take certain positions can also delay the development of guidance 
projects. Treasury and IRS have at times been reluctant to explore and 
ultimately issue guidance to resolve tax issues when there is concern 
about whether IRS has the legal authority to require a certain tax 
treatment for financial products. For example, although many experts 
consider mark-to-market treatment the most appropriate resolution for 
contingent swap payments, IRS had concerns about whether it could 
require taxpayers to follow mark-to-market treatment for contingent 
swap payments. 

IRS's enforcement responsibilities can also affect the time it takes 
to complete guidance projects. Treasury and IRS may want to issue 
guidance on a certain issue, but if IRS is currently conducting 
litigation or auditing on that issue it may be difficult to consider 
alternative guidance positions when IRS has already taken a position 
in an audit or in court. For example, one of the reasons that Treasury 
and IRS did not attempt to address gaps in existing guidance on VPFCs 
with new guidance was because IRS was litigating the issue and did not 
want to publish guidance that might affect IRS's case. 

Delayed Guidance Increases Compliance Risk and Costs, among Other 
Negative Consequences: 

Delays in the issuance of guidance on financial derivatives have 
substantial negative consequences for both taxpayers and IRS, which 
are summarized in table 3. However, IRS and Treasury may also benefit 
by not issuing timely guidance. The ambiguity that results from a lack 
of clear guidance could make taxpayers less willing to take risky tax 
positions because of the concern that IRS may determine the position 
is abusive in the future. 

Table 3: Negative Consequences of Delayed Guidance on Financial 
Derivatives: 

Consequences for taxpayers: 
* Uncertainty; 
* Imperfect market competition; 
* Reduced confidence in tax system. 

Consequences for IRS: 
* Increased time and resources in audits and litigation; 
* Opportunities for tax abuse; 
* Negative reputation. 

Source: GAO analysis of interviews with Treasury, IRS, and tax experts. 

[End of table] 

For taxpayers, one of the main tax-related consequences is the 
increased compliance risk associated with uncertainty. (For an example 
see the sidebar on Exchange-Traded Notes.) For example, if no clear 
guidance exists on how to treat a transaction for tax purposes, 
taxpayers must come up with their own position, which may be different 
than IRS's approach and present increased compliance risk. Tax 
positions may also differ among taxpayers, which causes a consistency 
problem for both taxpayers and IRS. In developing tax positions where 
no clear guidance exists, taxpayers often look to other sources of 
information provided by IRS and Treasury that lack the legal status of 
finalized guidance. Tax experts said that they prefer written guidance 
to informal statements made by agency officials at conferences, which 
do not necessarily represent IRS's official position on a transaction. 
In addition, taxpayers rely on nonprecedential advice that IRS issues 
to either individual taxpayers or to IRS exam teams.[Footnote 32] If 
IRS disagrees with a taxpayer's position, the taxpayer is at risk of 
either penalties or litigation costs if the taxpayer decides to 
challenge the agency. If guidance is later issued that affects 
positions taken by taxpayers retroactively, this could put taxpayers' 
current positions at risk of being noncompliant, although officials 
said it may be unlikely that Treasury and IRS would do this, as long 
as the taxpayer's method was reasonable and consistently applied. 

[Side bar: 
Exchange-Traded Notes: 
The case of exchange-traded notes (ETN) is an example of the increased 
compliance risk associated with uncertainty. ETNs are contractual 
obligations, traded on an exchange, which generally provide investors 
the right to receive a return that is based on changes in the value of 
an index. ETNs are sold, or issued, by financial institutions to 
investors in the form of debt instruments. The investor makes a 
prepayment to the issuer of the ETNs for a payment at maturity based 
on the performance of the index. In this sense, an ETN is a prepaid 
forward contract traded on an exchange. Economically, an ETN produces 
a similar investment and risk profile as an exchange-traded fund (ETF) 
that all may track the same index, with the exception that the ETN 
investor is exposed to the risk of the issuer. For tax purposes, 
however, ETFs differ from ETNs. In order to track an index, ETFs must 
yearly rebalance the shares they hold and investors must generally pay 
capital gains taxes on shares sold. In addition, the shares held by 
ETFs may pay dividends, for which the holder must pay taxes even if 
the dividends are reinvested into the underlying shares. Investors in 
an ETN, on the other hand, generally treat all gains and losses 
generated by the ETN as a prepaid forward contract. This means ETNs 
are treated as open transactions and any gains or losses would not be 
recognized until the ETN is traded or redeemed. In 2007, IRS issued 
guidance requiring ETNs on foreign currency to accrue interest income 
that is taxed at ordinary rates, but the general tax treatment of 
returns on ETNs has not been established by IRS and Treasury.[Footnote 
33] The market has grown considerably since 2006, when ETNs first 
appeared. Developing guidance on ETNs has been listed as a priority by 
IRS and Treasury since 2009. As of August 2011, 170 ETNs had assets of 
almost $16 billion. One of the major attractions to ETNs is their 
beneficial tax treatment, and the delay in issuance of guidance could 
put an increasingly large number of taxpayers at risk of 
noncompliance. End of side bar] 

Another consequence that the absence of guidance results in is 
imperfect market competition. According to market participants, 
because most derivatives are not tax driven, contracts may be executed 
even if the tax results are unclear. Taxpayers may look for other 
parties in a transaction who are willing to take on the additional tax 
risk, resulting in what one expert called a "race to the bottom" as 
parties vie for business by taking on riskier tax positions. In 
addition, all of these issues can reduce taxpayers' confidence in the 
fairness of the tax system. 

For IRS, one negative consequence of delays in guidance on financial 
derivatives is increases in time and resources spent on examinations 
and litigation. Without clarity on a tax issue, audit teams must often 
spend more resources examining the tax results of derivative 
transactions, which may include requesting advice from IRS Chief 
Counsel, often a time-consuming process. IRS staff told us that having 
clear, timely guidance can significantly reduce the amount of time and 
uncertainty revenue agents and IRS counsel encounter resolving tax 
issues during an exam. If taxpayers and revenue agents have divergent 
views on tax positions, a technical advice memorandum or other legal 
memorandum may be requested, which can increase the amount of time in 
exam. If IRS is unable to issue guidance on a transaction, they may 
pursue a litigation strategy, which itself can take years and require 
a great deal of resources from both IRS and the taxpayer. 

Another negative consequence for IRS is that in the absence of 
guidance taxpayers may attempt to take positions that may be abusive. 
(For an example see the sidebar on Variable Prepaid Forward 
Contracts.) For both cross-border equity TRSs and VPFCs, delays in 
guidance from IRS led to the transactions becoming more widespread 
throughout the market. The burden may be increased on exam teams to 
address a greater number of completed transactions. Delays in issuing 
guidance can also put IRS's reputation at risk. Tax experts and 
practitioners that we spoke with expressed frustration at the delay in 
the issuance of guidance on financial derivatives and in the lack of 
information on the status of guidance projects, which negatively 
affected their perspectives of IRS. 

[Side bar: 
Variable Prepaid Forward Contracts: 
The case of variable prepaid forward contracts (VPFC) is an example of 
the negative consequences to both taxpayers and IRS of delayed 
guidance. In 2003, IRS issued Revenue Ruling 2003-7, which addressed 
what IRS thought was the most prevalent form of VPFCs. The ruling 
allowed taxpayers to use VPFCs to defer income for tax purposes, 
avoiding capital gains rules under IRC section 1001 and constructive 
sale rules under IRC section 1259. However, it was not until after the 
issuance of the revenue ruling that the agency became aware of the 
coupling of VPFCs with a share-lending agreement, described in the 
text above and which taxpayers had been using since at least 2000 to 
monetize their assets while claiming that there was no sale for tax 
purposes. IRS did not publish further guidance to address the newly 
identified transaction. Further, exam teams had to wait approximately 
2 years before a technical advice memorandum (TAM) was issued, which 
gave them the legal support to challenge this practice. Although TAMs 
are public, taxpayers can not rely on them as legal precedent. Because 
of the shortcomings of IRS’s initial guidance and IRS’s inability to 
quickly issue new guidance, taxpayers were led to believe their 
transactions would not be challenged. For the same reasons, IRS exam 
teams were limited in their ability to take action against what they 
considered and IRS ultimately judged to be an improper tax result. End 
of side bar] 

Taxpayers are Unaware of the Status of Guidance Projects for Financial 
Derivatives: 

IRS and Treasury guidance priorities may change due to a number of 
factors, including changes in legislation, policy, market 
circumstances, and management agendas. Taxpayers need to know about 
these changes when they affect their tax planning and business 
decisions. As discussed earlier, one-fourth of derivative guidance 
projects were not completed between 1996 and 2010, and tax experts and 
practitioners that we spoke with were not aware of the status and 
prioritization of many of these guidance projects. Tax experts and 
practitioners stated that information about the status of projects was 
not publicly available, and they often only knew about a project's 
status through informal statements made by IRS and Treasury officials 
at conferences and other meetings. IRS will purposely keep some 
guidance projects off the public list when the issue is legally 
sensitive and could negatively affect IRS's efforts in an audit or 
litigation if the guidance projects were publicly announced. 

The current system for communicating the PGP does not allow IRS to 
effectively communicate the status of guidance projects to taxpayers. 
For most years since 1996, IRS has issued periodic updates on its 
website to the PGPs after initial plans were released, listing 
projects that were added or completed during the year. All PGPs, 
whether initial or updated, are potentially subject to change. 
However, because projects can be added to the PGP at any time without 
an accompanying change in the publicly available plans, changes in 
guidance prioritization are not always clearly communicated to 
taxpayers. In addition, PGPs do not include target completion dates, 
something IRS uses internally, which would give taxpayers a clearer 
timeframe for expecting guidance. Therefore, taxpayers lack clarity as 
to when they can expect guidance on issues that IRS and Treasury have 
publicly stated are priorities. While there may be challenges and 
risks in communicating more detailed information and updated status, 
particularly when there may be unanticipated setbacks in the 
development of guidance, other federal agencies routinely do so. 

Providing status information for PGP projects would require IRS to 
maintain reliable internal monitoring data on guidance projects. IRS 
Chief Counsel uses a data management system, Counsel Automated Systems 
Environment - Management Information System (CASE-MIS), to track 
progress of guidance projects and monitor interim milestones in 
project lifecycles. CASE-MIS has been available since 1996, and was 
modified in 2008. The effectiveness of this system has been critiqued 
multiple times over the past 10 years by the Treasury Inspector 
General for Tax Administration, and in response IRS has made 
improvements to the monitoring of projects in the database.[Footnote 
34] In our own review of data used by IRS to monitor guidance 
projects, we found a number of data reliability issues that may impede 
the agency's ability to effectively monitor guidance projects in order 
to report status to taxpayers. Most notable, the current status and 
target date of projects are not consistently recorded correctly for 
all projects. In addition, discerning when a project moved onto the 
PGP, its date of publication, and when or why it was removed without 
publication is difficult. This information is essential for IRS and 
Treasury to effectively manage the guidance process and to communicate 
project status to taxpayers. Although status information can be 
collected manually, the electronic management system is intended to 
improve efficiency and reporting capability by avoiding time-consuming 
manual data collection and processing. Since 2008, IRS has been taking 
steps to improve the effectiveness and reliability of CASE-MIS, 
including the issuance of staff memorandums and closer attention to 
reliable data entry, with the purpose of increasing efficiency, 
productivity, and decision making.[Footnote 35] 

Opportunities Exist for IRS to Leverage Information from SEC and CFTC 
on Financial Derivatives: 

IRS Does Not Systematically or Regularly Communicate with SEC or CFTC 
on Financial Derivatives: 

Currently, IRS does not systematically or regularly communicate with 
SEC or CFTC on financial derivatives. IRS's 2009-2013 Strategic Plan 
lists strengthening partnerships across government agencies to gather 
and share additional information as key to enforcing the law in a 
timely manner to ensure taxpayers meet their obligations to pay taxes. 
SEC's and CFTC's oversight role for financial derivative markets make 
them key agencies for IRS to partner with on financial derivatives. 
Both regulatory agencies told us that opportunities may exist to share 
additional information on financial derivatives with IRS. However, 
IRS's ability to share taxpayer information with other federal 
agencies is limited under IRC section 6103, which governs the 
confidentiality of taxpayer data. IRS officials say that the lack of 
reciprocal information sharing is an impediment to effective 
collaboration with SEC and CFTC. 

IRS has occasionally received information from SEC on financial 
derivatives that were suspected of being used for abusive tax 
purposes. Such information, however, is received only on an ad hoc 
basis, either through requests initiated by IRS or referrals from SEC. 
SEC officials told us that when potential tax abuses have been 
identified and shared with IRS, the SEC examiner involved in the case 
typically had some tax expertise or had worked with IRS in the past. 
For example, in 2008, SEC examiners discovered a strategy employed by 
hedge funds to structure short-term capital gains into long-term 
capital gains through the use of options. This information was 
referred to IRS because SEC staff believed that IRS may conclude that 
the structuring of transactions in this manner may result in an 
incorrect treatment of capital gains. IRS said that this information 
was essential to the eventual development and issuance of related 
guidance.[Footnote 36] However, agency officials told us that SEC and 
CFTC examiners often do not have tax expertise. As a result, potential 
tax abuses may not be identified and shared with IRS. 

Information from SEC and CFTC Could Help IRS Identify New Products, 
Emerging Trends, and Relevant Issues: 

The proliferation of financial derivatives present a challenge for IRS 
in identifying potential abuses and ensuring timely guidance addresses 
the full range of financial derivative products. In recent years, new 
uses of financial derivative products have been introduced, and 
abusive uses have spread faster as technology developments have made 
it easier to create new products. 

In the past, IRS met regularly with a group of federal agency 
officials, including those from SEC and CFTC, academics, and other 
market experts, to discuss financial products, including financial 
derivatives, and market trends. The group was established by an 
academic institution and met for about 10 years beginning in 1990, and 
participants joined the group by invitation. IRS and others who were 
part of the group told us that academic sponsorship encouraged both 
federal agency and private sector experts to join the group and 
candidly share information on new financial derivative products and 
uses. According to Treasury officials, regularly participating in 
these meetings with officials from SEC and CFTC and the private sector 
helped them to (1) identify new financial derivatives, (2) improve 
their understanding of these new products, (3) become aware of 
regulatory schemes that may have tax implications, and (4) make 
contacts with other knowledgeable agency officials and experts in 
financial derivative products. IRS told us that understanding all 
sides of a financial derivative transaction, both tax and regulatory, 
helps to clarify the purpose of the transaction and reveal potential 
tax abuse. Since the group disbanded after the academic sponsorship 
dissolved, there has been no regular, coordinated communication 
process for sharing information on financial derivatives between IRS 
and SEC and CFTC. According to IRS officials, such a process could 
help IRS ensure they are fully using all available information to 
identify and address compliance issues and abuses related to financial 
derivatives. 

In addressing problems in financial markets that emerge quickly, we 
have found that collaboration between federal agencies is especially 
important for federal agencies to maximize performance and identify 
and resolve problems faster.[Footnote 37] IRS officials told us that 
they typically uncover new financial derivative abuses during an 
audit, meaning by the time IRS identifies the financial derivative 
product, and issues guidance, the market for a financial derivative 
product can be relatively large and developed. SEC may identify new 
products and emerging trends in financial derivatives trading before 
IRS because new products on exchanges must be approved by SEC before 
they can be traded, and others may be disclosed in financial 
statements. According to IRS officials, improved collaboration could 
help IRS more quickly identify and analyze emerging financial trends 
and new products in the financial derivatives market before taxpayers 
even file their tax returns. 

According to IRS officials, having a more regular way to obtain 
information about certain sales reported to SEC in disclosures of 
insider trading could have sped IRS's identification of the use of 
VPFCs with share-lending agreements. When taxpayers deferred income 
recognition by not considering a VPFC and share-lending agreement as 
constituting a sale on their tax return, some taxpayers reported the 
transaction as a sale for SEC purposes. IRS officials obtained this 
information, but had they been regularly and systematically 
communicating with other agency officials on financial derivatives, 
problems with these transactions may have been identified earlier. IRS 
officials believe that because certain information on financial 
derivatives may be reported for both regulatory and tax purposes, 
reviewing certain types of transactions collaboratively with SEC and 
CFTC could help IRS better identify abuse. For example, IRS told us 
that certain information on financial derivatives from SEC Form 4s, 
which relate to insider trading, and 10Ks have been useful for 
identifying new financial derivative products and potential tax issues. 

Federal banking regulators, such as OCC, also have information on 
financial derivatives. Although the federal banking regulators do not 
oversee derivatives markets, their oversight of banking institutions 
includes evaluations of risks to bank safety and soundness from 
derivatives activities. For example, as we reported in 2009, their 
oversight captures most CDS activity because banks act as dealers in 
the majority of transactions and because they generally oversee CDS 
dealer banks as part of their ongoing examination programs.[Footnote 
38] Furthermore, as OCC-regulated banks may only engage in activities 
deemed permissible for a national bank, the agency periodically 
receives requests from banks to approve new financial activities, 
including derivatives transactions. Information collected during these 
reviews may provide IRS with information on financial derivatives. 

As we were completing our audit work, IRS officials told us that they 
had recently begun developing plans to have regular meetings with SEC 
to discuss new products and emerging issues related to financial 
derivatives. In previous work, we have established best practices on 
interagency coordination to help maximize results and sustain 
collaboration.[Footnote 39] These best practices suggest that agencies 
should look for opportunities to enhance collaboration in order to 
achieve results that would not be available if they were to work 
separately. Federal agencies can enhance and sustain collaborative 
partnerships and produce more value for taxpayers by applying the 
following eight best practices: 

1. Define and articulate a common outcome. 

2. Establish mutually reinforcing or joint strategies. 

3. Identify and address needs by leveraging resources. 

4. Agree on roles and responsibilities. 

5. Establish compatible policies, procedures, and other means to 
operate across agency boundaries. 

6. Develop mechanisms to monitor, evaluate, and report on results. 

7. Reinforce agency accountability for collaborative efforts through 
agency plans and reports. 

8. Reinforce individual accountability for collaborative efforts 
through performance management systems. 

These best practices would support a collaborative working 
relationship between the IRS and SEC and CFTC. While we generally 
believe that the application of as many of these practices as possible 
increases the likelihood of effective collaboration, we also recognize 
that there is a wide range of situations and circumstances in which 
agencies work together. Following even a few of these practices may be 
sufficient for effective collaboration. 

Conclusions: 

Although financial derivatives enable companies and others to manage 
risks, some taxpayers have used financial derivatives to take 
advantage of the current tax system, sometimes in ways that courts 
have later deemed improper or Congress has disallowed. The tax code 
establishes broad categories for financial instruments, such as debt, 
equity, forwards, and options, each with its own tax rules governing 
how and when gains and losses are taxed. However, as new financial 
derivative products and uses are developed, they could be similar to 
multiple tax categories, and therefore IRS and taxpayers must choose 
different tax treatments. In certain instances, this has allowed 
economically equivalent outcomes to be taxed inconsistently. Without 
changes to the approach to how financial derivatives are taxed, the 
potential for abuse continues. Experts have suggested alternative 
approaches that they believe would provide more comprehensive and 
consistent treatment. However, each alternative would present 
tradeoffs to IRS and taxpayers, including tradeoffs to simplicity, 
administrability, and economic efficiency. This report does not 
address or evaluate alternatives for taxing financial derivatives. 
Because of their unique role in defining policy and administering the 
tax code, Treasury and IRS are best positioned to study and recommend 
an alternative approach to the taxation of financial derivatives. 

Outside of any comprehensive changes to the current approach to the 
taxation of financial derivatives, one way that Treasury and IRS 
address potential abuses and provide clarity to tax issues is through 
its taxpayer guidance. The lack of finalized guidance has negative 
consequences for both IRS and taxpayers, including uncertainty that 
inhibits IRS staff during audits and litigation and leaves taxpayers 
uncertain about whether they have appropriately determined their tax 
liabilities. However, challenges that IRS and Treasury face in 
developing guidance for financial derivatives, including the risk of 
adverse economic effects of guidance changes and the complexity of 
financial derivative products, have resulted in some PGP projects 
taking longer than the 12-month period established in the plan. As 
such, uncertainty is heightened because taxpayers may not be aware 
when projects are going to take longer than the 12-month period and 
IRS does not provide public updates to the PGP as changes occur to 
project status, priorities, and target dates. 

The growth in the complexity and use of financial derivatives presents 
another challenge for IRS. IRS sometimes identifies new financial 
derivative products or new uses of existing products long after they 
have been introduced into the market. Consequently, IRS is not always 
able to quickly identify and prevent potential abuse. One way to 
identify new products or new uses of products in a timelier manner 
could be through increased information sharing with SEC and CFTC given 
their oversight role of financial derivative markets and products. Our 
prior work suggests that there may also be opportunities for bank 
regulators to share any knowledge of derivatives that they gain. This 
would be consistent with IRS's goal of strengthening partnerships 
across government to ensure taxpayers meet their obligations to pay 
taxes. 

Recommendations for Executive Action: 

To better ensure that economically similar outcomes are taxed 
similarly and minimize opportunities for abuse, the Secretary of the 
Treasury should undertake a study that compares the current approach 
to alternative approaches for the taxation of financial derivatives. 
To determine if changes would be beneficial, such a study should weigh 
the tradeoffs to IRS and taxpayers that each alternative presents, 
including simplicity, administrability, and economic efficiency. 

To provide more useful and timely information to taxpayers on the 
status of financial derivative guidance projects, the Secretary of the 
Treasury and the Commissioner of Internal Revenue should consider 
additional, more frequently updated reporting to the public on ongoing 
projects listed in the PGP, including project status, changes in 
priorities, and target completion dates both within and beyond the 12- 
month PGP period. 

To more quickly identify new financial derivative products and 
emerging tax issues, IRS should work to improve information-sharing 
partnerships with SEC and CFTC to better ensure that IRS is fully 
using all available information to identify and address compliance 
issues and abuses related to the latest financial derivative product 
innovations. IRS should also consider exploring whether such 
partnerships with bank regulatory agencies would be beneficial. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Secretary of the Treasury 
and the Commissioner of Internal Revenue for review and comment. 
Treasury disagreed with our first recommendation to undertake a study 
that compares the current approach to alternative approaches for the 
taxation of financial derivatives. Treasury cited a body of literature 
written by academics, practitioners, and others that considers the 
subject. Treasury also mentioned that Congress has resources 
available, such as the Joint Committee on Taxation, which could advise 
them about alternative approaches to the taxation of financial 
derivatives. Treasury said that its resources would be better spent 
drafting and issuing guidance on these subjects. Treasury also noted 
that it is available to assist the Ways and Means Committee and the 
Finance Committee in any undertaking concerning alternative approaches 
to the taxation of financial derivatives. 

In our report, we describe how the current approach to the taxation of 
financial derivatives results in inconsistent tax consequences for 
transactions that produce similar economic outcomes. We cite the 
existing body of literature and alternatives to the current approach 
of taxing financial derivatives proposed by some tax experts and 
practitioners that they believe would adopt a more consistent and 
comprehensive view of financial derivatives and potentially reduce 
abuse. However, no consensus has emerged on these issues from existing 
literature or from the resources available to Congress. As the tax 
policy setting body for the executive branch, the Treasury Department, 
in consultation with IRS, is uniquely suited to weigh the alternative 
approaches and, along with Congress, make judgments as to which is 
best for the economy, tax administration, and the proper application 
of sound tax principles. While Treasury states it would rather focus 
on guidance development to address tax compliance and emerging abusive 
tax schemes, the current piecemeal development of guidance as well as 
the difficulty of developing tax rules for new products has presented 
challenges and opportunities for abuse. We believe that as the locus 
of tax policy expertise in the executive branch, Treasury has a 
responsibility to make proposals to overcome the deficiencies to the 
current approach to taxing financial derivatives. Towards that end, we 
recommended Treasury should undertake a study that compares the 
current approach to alternative approaches to the taxation of 
financial derivatives. Regardless of whether Treasury decides it needs 
a study to make such proposals, achieving a more comprehensive 
approach is the desired end. 

IRS and Treasury disagreed with our second recommendation to provide 
more timely and useful information to taxpayers on the status of 
financial derivative guidance projects. IRS said that while it firmly 
supports transparency in the regulatory process, officials do not 
believe that the additional reporting recommended would be worth the 
additional resources such reporting would require. They believe that 
the annual updates provide an appropriate measure of the status of 
projects. Treasury also said that it would be difficult to provide 
precise predictions of when guidance would be issued and that 
attempting to pinpoint the timing of when guidance might be released 
would not necessarily be that helpful. 

We agree that it is important for IRS and Treasury to balance the 
usefulness of additional reporting on the status of priority guidance 
projects with any additional administrative burden. However, Treasury 
and IRS also need to ensure that taxpayers have sufficient information 
to make intelligent decisions. In this report, we describe that one- 
fourth of financial derivative guidance projects on Treasury and IRS's 
PGP were not completed between 1996 and 2010. A number of the guidance 
projects that were not completed were on the PGP for 3 or more years, 
and tax experts and practitioners that we spoke with said they were 
not aware of the status and prioritization of many of these guidance 
projects. In recommending more frequent updates to the public on 
priority guidance projects, we recognize the difficulty in estimating 
how long the development of a particular piece of guidance may take. 
Our recommendation did not envision pinpointing the timing of when 
guidance may be released, but rather being timelier in officially 
revising estimates when the agencies know that announced time frames 
are no longer realistic. When it becomes likely that a project on the 
PGP will not be completed in the plan year because of delays or a 
change in priorities, the public should be alerted. Tax experts and 
practitioners we interviewed said that information about the status of 
projects was not publicly available, and that they often only knew 
about a project's status through informal statements made by IRS and 
Treasury officials at conferences and other meetings. Such information 
on the status of guidance projects should be provided to all 
interested taxpayers as part of formal periodic updates to the PGP. 
Some of this information is already available in IRS's internal 
guidance tracking database and providing it would, therefore, likely 
add little additional administrative burden for the agencies. 

IRS agreed with our third recommendation to improve information-
sharing partnerships with the SEC and CFTC. IRS said that they 
recognize the benefits of systematically gathering and sharing 
information that would identify new financial products and the 
potential for abusive tax avoidance transactions. 

IRS's and Treasury's letters commenting on our report are presented in 
appendix III and IV. IRS also provided technical comments, which we 
incorporated as appropriate. 

As we agreed with your office, unless you publicly announce the 
contents of this report earlier, we plan no further distribution of it 
until 30 days from the date of this report. At that time, we will send 
copies of this report to the Chairmen and Ranking Members of other 
Senate and House committees and subcommittees that have appropriation, 
authorization, and oversight responsibilities for IRS. We are also 
sending copies to the Commissioner of Internal Revenue, the Secretary 
of the Treasury, the Chairman of the IRS Oversight Board, and the 
Director of the Office of Management and Budget. Copies are also 
available at no charge on the GAO website at [hyperlink, 
http://www.gao.gov]. 

If you or your staffs have any questions or wish to discuss the 
material in this report further, please contact me at (202) 512-9110 
or brostekm@gao.gov. Contact points for our offices of Congressional 
Relations and Public Affairs may be found on the last page of this 
report. GAO staff members who made major contributions to this report 
are listed in appendix V. 

Signed by: 

Michael Brostek: 
Director, Tax Issues Strategic Issues: 

[End of section] 

Appendix I: Additional Methodology Details: 

Criteria to Evaluate How Well the Tax System Addresses Financial 
Derivatives: 

To evaluate the tax rules for financial derivatives, our criterion was 
consistency, meaning that economically similar transactions are taxed 
similarly. We identified this criterion through interviews with tax 
experts and a review of research articles on the taxation of financial 
derivatives. This was the most commonly mentioned criterion by these 
sources, and also the most applicable to our objectives. We evaluated 
the tax effects of financial derivatives based on testimonial 
evidence, academic studies, and our analysis of four financial 
derivative case studies. These case studies included cross-border 
total return equity swaps, variable prepaid forward contracts, credit 
default swaps, and contingent swaps. Through interviews with 
Department of the Treasury (Treasury) and Internal Revenue Service 
(IRS) staff, former Treasury staff, and other tax experts, we 
identified how the transactions were structured, when IRS first 
recognized these transactions, and all guidance issued by Treasury and 
IRS on these issues. We also identified the challenges of issuing 
timely guidance and the consequences for IRS and taxpayers due to 
delayed or absent guidance. Based on these case studies, we applied 
the criterion of consistency to highlight how the structure of these 
transactions was not in line with the criterion. 

Criteria and Methodology to Evaluate the Issuance of Published 
Guidance Related to Financial Derivatives: 

To evaluate IRS's and Treasury's ability to publish timely guidance on 
emerging financial derivative tax issues, we analyzed guidance 
projects from Treasury and IRS's Priority Guidance Plan (PGP). We also 
performed an in-depth study of four case studies of specific financial 
derivative transactions that have had delayed guidance. According to 
Treasury and IRS, the PGP is used each year to identify and prioritize 
the tax issues that should be addressed through regulations, revenue 
rulings, revenue procedures, notices, and other published 
administrative guidance. The PGP focuses resources on guidance items 
that are most important to taxpayers and tax administration. To 
measure the timeliness of guidance on financial derivative tax issues, 
we used the criterion established by Treasury and IRS that guidance 
projects on the PGP are intended to be published within the 12-month 
period of the PGP year. 

We reviewed the projects included on the PGP from 1996 to 2010, the 
years for which IRS had electronic records available. We submitted a 
data request to IRS Chief Counsel from their Counsel Automated Systems 
Environment-Management Information System (CASE-MIS), which the agency 
uses to track the development of guidance projects. We searched the 
database for projects, focusing primarily on the units within Chief 
Counsel that work closest with financial derivatives. We selected 
projects whose description mentioned either a type of derivative in 
particular (future, forward, swap/notional principal contract, or 
option), a section of the Internal Revenue Code that directly affects 
financial derivatives, or a use or abuse of financial instruments that 
typically involves derivatives (such as hedging or straddles). In 
reviewing the data from CASE-MIS, we encountered some data issues, 
such as the same guidance project showing up more than once on the 
same PGP year or guidance projects with start dates after their 
publication date, among other issues, which led us to conclude that 
the CASE-MIS data were unreliable for an analysis of all guidance 
projects, which did not allow a comparison of derivative projects to 
nonderivative projects. However, we did determine that the use of CASE-
MIS data was sufficiently reliable to analyze the subset of projects 
dealing with financial derivatives alone. This is because the small 
number of derivative projects allowed us to address and resolve 
individually each of the data issues we encountered, something not 
feasible for the much larger dataset of all PGP guidance projects. 
After identifying the financial derivative guidance projects based on 
the criteria above we submitted the list to IRS Chief Counsel for 
their verification. They identified additional projects we had not 
found in our prior searches, some of which did not meet our criteria 
for selecting projects or our scope and were not included. In total, 
we identified 53 guidance projects in the PGP related to financial 
derivatives. 

To analyze the timeliness of the identified projects, we calculated 
completion rates for projects that were completed within the 1-year 
criterion, and rates for projects that were completed at any point. 
These calculations only included projects that were on the plan before 
the current PGP year. To take account of the fact that guidance 
projects can be censored (i.e., have not yet been completed within the 
time frame of the study or were dropped from the PGP before they had a 
chance to be completed), we estimated completion rates over time using 
hazard rates. Hazard rates calculate the rate at which projects are 
complete in a period, given that they were open at the start of that 
period, and therefore allow us to adequately account for censored 
projects. In the report, we refer to hazard rates as completion rates. 
The small sample size does not allow us to draw conclusions on the 
process for issuing guidance in IRS and Treasury more generally beyond 
financial derivatives or the time period under study. 

To further examine the IRS and Treasury guidance process and evaluate 
the challenges that IRS and Treasury face when issuing guidance on 
financial derivatives, we selected four financial derivative case 
studies that have been on the PGP and have been highlighted in 
interviews with Treasury, IRS, and tax practitioners as financial 
derivative transactions that presented tax abuse or tax compliance 
concerns. The case studies that met this criterion included contingent 
payment swaps, credit default swaps, variable prepaid forward 
contracts, and cross-border total return equity swaps. For each of the 
four case studies, we interviewed IRS and Treasury officials and other 
tax experts, and analyzed research on the taxation of derivatives, to 
discuss the identification and progression of these transactions as 
guidance projects, the challenges IRS and Treasury face issuing 
guidance on these transactions, and the consequences IRS and taxpayers 
face from a lack of guidance. 

[End of section] 

Appendix II: Financial Derivative Priority Guidance Projects: 

Description of guidance projects: 1; Information reporting 
requirements for securities futures contracts; 
Guidance published: Notice 2003-8; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 2; Tax shelter using options to 
shift tax basis; 
Guidance published: Notice 2001-45; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: Yes. 

Description of guidance projects: 3; Tax shelter using foreign 
currency straddle; 
Guidance published: Notice 2002-50; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 4; Tax shelter using foreign 
currency straddle; 
Guidance published: Notice 2002-65; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 5; Tax shelter using foreign 
currency options; 
Guidance published: Notice 2003-81; 
Years on PGP: 1; 
First year on PGP: 2003; 
Completed: Yes. 

Description of guidance projects: 6; Tax shelter using S corporations 
and warrants; 
Guidance published: Notice 2004-30; 
Years on PGP: 1; 
First year on PGP: 2003; 
Completed: Yes. 

Description of guidance projects: 7; Tax shelter using options to 
toggle grantor trust status; 
Guidance published: Notice 2007-73; 
Years on PGP: 1; 
First year on PGP: 2007; 
Completed: Yes. 

Description of guidance projects: 8; Exchange traded notes (prepaid 
forward contracts); 
Guidance published: Notice 2008-2; 
Years on PGP: 1; 
First year on PGP: 2007; 
Completed: Yes. 

Description of guidance projects: 9; Overwithholding and U.S. tax 
avoidance from dividend-substitutes payments; 
Guidance published: Notice 2010-46; 
Years on PGP: 1; 
First year on PGP: 2009; 
Completed: Yes. 

Description of guidance projects: 10; Clarification of notional 
principal contract abuses; 
Guidance published: Notice 2006-16; 
Years on PGP: 1; 
First year on PGP: 2005; 
Completed: Yes. 

Description of guidance projects: 11; Contingent payments in notional 
principal contracts; 
Guidance published: Notice 2001-44; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: Yes. 

Description of guidance projects: 12; Valuation under §475; 
Guidance published: Announcement 2003-35; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 13; Exchange-traded equity options 
without standard terms; 
Guidance published: Final regulations, 65 Fed. Reg. 3812; 
Years on PGP: 1; 
First year on PGP: 1999; 
Completed: Yes. 

Description of guidance projects: 14; Character of hedging 
transactions; 
Guidance published: NPRM, 66 Fed. Reg. 4738; 
Years on PGP: 1; 
First year on PGP: 2000; 
Completed: Yes. 

Description of guidance projects: 15; Character of hedging 
transactions; 
Guidance published: Final regulations, 67 Fed. Reg. 12863; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: Yes. 

Description of guidance projects: 16; Exchange-traded equity options 
without standard terms; 
Guidance published: NPRM, 66 Fed. Reg. 4751; 
Years on PGP: 1; 
First year on PGP: 2000; 
Completed: Yes. 

Description of guidance projects: 17; Exchange-traded equity options 
without standard terms; 
Guidance published: Final regulations, 67 Fed. Reg. 20896; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: Yes. 

Description of guidance projects: 18; Dealer to dealer assignment of 
notional principal contracts; 
Guidance published: Final regulations, 63 Fed. Reg. 4394; 
Years on PGP: 1; 
First year on PGP: 1997; 
Completed: Yes. 

Description of guidance projects: 19; Securities futures contracts 
under §1256(g); 
Guidance published: Revenue Procedure 2002-11; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: Yes. 

Description of guidance projects: 20; Safe harbor in valuing 
securities and commodities for broker-dealers under section 475; 
Guidance published: Revenue Procedure 2007-41; 
Years on PGP: 1; 
First year on PGP: 2006; 
Completed: Yes. 

Description of guidance projects: 21; Classifying exchange as 
Qualified Board of Exchange for §1256; 
Guidance published: Revenue Ruling 2007-26; 
Years on PGP: 1; 
First year on PGP: 2006; 
Completed: Yes. 

Description of guidance projects: 22; The effect of collars on 
qualified covered calls status; 
Guidance published: Revenue Ruling 2002-66; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 23; Classifying exchange as 
Qualified Board of Exchange for §1256; 
Guidance published: Revenue Ruling 2010-3; 
Years on PGP: 1; 
First year on PGP: 2009; 
Completed: Yes. 

Description of guidance projects: 24; Classifying exchange as 
Qualified Board of Exchange for §1256; 
Guidance published: Revenue Ruling 2009-24; 
Years on PGP: 1; 
First year on PGP: 2009; 
Completed: Yes. 

Description of guidance projects: 25; Exchange traded notes (prepaid 
forward contracts); 
Guidance published: Revenue Ruling 2008-1; 
Years on PGP: 1; 
First year on PGP: 2007; 
Completed: Yes. 

Description of guidance projects: 26; Contracts that provide total-
return exposure on a commodity index; 
Guidance published: Revenue Ruling 2006-1; 
Years on PGP: 1; 
First year on PGP: 2005; 
Completed: Yes. 

Description of guidance projects: 27; Notional principal contracts 
that hedge debt instruments; 
Guidance published: Revenue Ruling 2002-71; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 28; Variable prepaid forward 
contracts; 
Guidance published: Revenue Ruling 2003-07; 
Years on PGP: 1; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 29; Definition of dealer in 
securities futures contracts; 
Guidance published: Revenue Ruling 2004-94 and Revenue Ruling 2004-95; 
Years on PGP: 1; 
First year on PGP: 2004; 
Completed: Yes. 

Description of guidance projects: 30; Credit default swaps; 
Guidance published: Notice 2004-52; 
Years on PGP: 2; 
First year on PGP: 2003; 
Completed: Yes. 

Description of guidance projects: 31; Valuation under §475; 
Guidance published: NPRM, 70 Fed. Reg. 29663; 
Years on PGP: 2; 
First year on PGP: 2003; 
Completed: Yes. 

Description of guidance projects: 32; Valuation under §475; 
Guidance published: Final regulations, 72 Fed. Reg. 32172; 
Years on PGP: 2; 
First year on PGP: 2005; 
Completed: Yes. 

Description of guidance projects: 33;Exchange-traded equity options 
without standard terms; 
Guidance published: NPRM, 63 Fed. Reg. 57636; 
Years on PGP: 2; 
First year on PGP: 1997; 
Completed: Yes. 

Description of guidance projects: 34; Mark-to-market accounting for 
commodities dealers and electing traders in securities and commodities 
under §475; 
Guidance published: NPRM, 64 Fed. Reg. 4374; 
Years on PGP: 2; 
First year on PGP: 1998; 
Completed: Yes. 

Description of guidance projects: 35; Capitalization of interest and 
carrying charges in straddles; 
Guidance published: NPRM, 66 Fed. Reg. 4746; 
Years on PGP: 2; 
First year on PGP: 2000; 
Completed: Yes. 

Description of guidance projects: 36; Treatment of interest rate swaps 
in arbitrage restrictions on tax-exempt bonds; 
Guidance published: NPRM, 72 Fed. Reg. 54606; 
Years on PGP: 2; 
First year on PGP: 2006; 
Completed: Yes. 

Description of guidance projects: 37; Accounting for unidentified 
hedging transactions; 
Guidance published: Revenue Ruling 2003-127; 
Years on PGP: 2; 
First year on PGP: 2002; 
Completed: Yes. 

Description of guidance projects: 38; Classifying exchange as 
Qualified Board of Exchange for §1256; 
Guidance published: Revenue Ruling 2009-4; 
Years on PGP: 2; 
First year on PGP: 2007; 
Completed: Yes. 

Description of guidance projects: 39; Contingent payments in notional 
principal contracts; 
Guidance published: NPRM, 69 Fed. Reg. 8886; 
Years on PGP: 4; 
First year on PGP: 1999; 
Completed: Yes. 

Description of guidance projects: 40; Definition of foreign currency 
contracts under §1256(g)(2)[A]; 
Guidance published: Notice 2007-71; 
Years on PGP: 2; 
First year on PGP: 2004; 
Completed: No. 

Description of guidance projects: 41; Prepaid forward contracts under 
§446; 
Guidance published: No guidance issued; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: No. 

Description of guidance projects: 42; Application of §1256 to certain 
derivative contracts[B]; 
Guidance published: No guidance issued; 
Years on PGP: 1; 
First year on PGP: 2010; 
Completed: No. 

Description of guidance projects: 43; Dividend-equivalent payments 
under section 871(M) (following HIRE Act)[B]; 
Guidance published: No guidance issued; 
Years on PGP: 1; 
First year on PGP: 2010; 
Completed: No. 

Description of guidance projects: 44; Effect of credit risk on swap 
valuations under §475; 
Guidance published: No guidance issued; 
Years on PGP: 1; 
First year on PGP: 2000; 
Completed: No. 

Description of guidance projects: 45; Straddles with uneven positions; 
Guidance published: No guidance issued; 
Years on PGP: 1; 
First year on PGP: 2001; 
Completed: No. 

Description of guidance projects: 46; Treatment of interest rate swaps 
in arbitrage restrictions on tax-exempt bonds; 
Guidance published: No guidance issued; 
Years on PGP: 2; 
First year on PGP: 2004; 
Completed: No. 

Description of guidance projects: 47; Equity derivatives; 
Guidance published: No guidance issued; 
Years on PGP: 2; 
First year on PGP: 2000; 
Completed: No. 

Description of guidance projects: 48; Exchange traded notes (prepaid 
forward contracts)[B]; 
Guidance published: No guidance issued; 
Years on PGP: 3; 
First year on PGP: 2008; 
Completed: No. 

Description of guidance projects: 49; Securities lending and other 
withholding tax; 
Guidance published: No guidance issued; 
Years on PGP: 3; 
First year on PGP: 2002; 
Completed: No. 

Description of guidance projects: 50; Constructive sale rules under 
§1259; 
Guidance published: No guidance issued; 
Years on PGP: 4; 
First year on PGP: 1998; 
Completed: No. 

Description of guidance projects: 51; Capitalization of interest and 
carrying charges in straddles; 
Guidance published: No guidance issued; 
Years on PGP: 5; 
First year on PGP: 2002; 
Completed: No. 

Description of guidance projects: 52; Mark-to-market accounting for 
commodities dealers and electing traders in securities and commodities 
under §475; 
Guidance published: No guidance issued; 
Years on PGP: 5; 
First year on PGP: 2002; 
Completed: No. 

Description of guidance projects: 53; Contingent payments in notional 
principal contracts[B]; 
Guidance published: No guidance issued; 
Years on PGP: 7; 
First year on PGP: 2004; 
Completed: No. 

Source: GAO analysis of IRS data. 

[A] This project was completed in 2007, when it was no longer on the 
Priority Guidance Plan (PGP). To be designated as completed for our 
analysis, a project must be completed while on the PGP. 

[B] Guidance has not been issued for these projects, although they 
were still on the PGP as of the end of June 30, 2010. 

[End of table] 

[End of section] 

Appendix III: Comments from the Internal Revenue Service: 

Department Of The Treasury: 
Deputy Commissioner
Internal Revenue Service: 
Washington, D.C. 20224: 

September 2, 2011: 

Mr. Michael Brostek: 
Director, Tax Issues: 
Strategic Issues Team: 
U.S. Government Accountability Office: 
441 G Street, N.W. 
Washington, DC 20548: 

Dear Mr. Brostek: 

Thank you for providing your draft report, Financial Derivatives: 
Disparate Tax Treatment and Information Gaps Create Uncertainty and 
Potential' Abuse (GAO-11750), for our review and comments. We 
appreciate the time your GAO Team spent reviewing our relevant tax 
rules and guidance projects to address the taxing of financial 
instruments. 

We agree with your recommendation to improve information sharing 
partnerships with the Securities and Exchange Commission (SEC) and 
Commodity Futures Trading Commission (CFTC). As your report indicates, 
our 2009-2013 Strategic Plan includes planned actions to continue to 
strengthen our partnership with other government and bank regulatory 
agencies to more quickly identify new financial derivative products 
and emerging tax issues. The Large Business and International (LB&I) 
Division has had several meetings with the SEC regarding investment 
funds. We recognize the benefits of systematically gathering and 
sharing information that would identify new financial products and the 
potential for abusive tax avoidance transactions. 

Our specific responses to all of your recommendations are enclosed. If 
you have any questions, please contact me at (202) 622-6860, or your 
staff may contact Floyd Williams, Director, Office of legislative 
Affairs at (202) 622-3720. 

Sincerely, 

Signed by: 

Steven T. Miller: 
Deputy Commissioner for Services and Enforcement: 

Enclosure: 

[End of letter] 

Recommendation 1: 

To better ensure that economically similar outcomes are taxed similarly 
and minimize opportunities for abuse, the Secretary of the Treasury 
should undertake a study that compares the current approach to 
alternative approaches for the taxation of financial derivatives. To 
determine if changes would be beneficial, such a study should weigh
the tradeoffs to IRS and taxpayers that each alternative presents, 
including simplicity, administrability, and economic efficiency. 

Management Response: 

The Secretary of the Treasury will address this recommendation in a 
separate response to the GAO draft report. 

Recommendation 2: 

To provide more useful and timely information to taxpayers on the 
status of financial derivative guidance projects, the Secretary of the 
Treasury and the commissioner of the IRS should consider additional, 
more frequently updated reporting to the public on ongoing projects 
listed in the Priority Guidance Plans (PGP), including project status,
change in priorities, and both target completion dates within and 
beyond the 12-month PGP period. 

Management Response: 

The IRS firmly supports transparency in the regulatory process, and 
through the priority guidance plan (PGP) and its regular updates 
provides notice to the public of the projects on which Treasury and 
the IRS are focusing their resources. In addition, Treasury and
IRS officials routinely speak at meetings and public conferences about 
guidance projects, and those appearances are widely reported in the 
tax press. This activity provides the public with continual insight 
into the guidance plan progress. 

The IRS does not believe that the additional reporting recommended 
would be constructive or necessary. We believe that the annual updates 
provide an appropriate measure of the status of projects. The 
additional reporting recommended will not provide taxpayers with 
information that, on balance, justifies the additional administrative 
burden on the government, particularly given that the existing process 
provides a substantial amount of transparency. 

Recommendation 3: 

To more quickly identify new financial derivative products and 
emerging tax issues, the IRS should work to improve information 
sharing partnerships with SEC and CFTC to better insure that the IRS 
is fully using all available information to identify and address 
compliance issues and abuses related to the latest financial 
derivative product innovations. The IRS should also consider exploring 
whether such partnerships with bank regulatory agencies would be 
beneficial. 

Management Response: 

We agree with this recommendation. The IRS will consider ways to 
improve information sharing with the SEC and CFTC regarding financial 
derivatives, particularly in the area of new products. The IRS will 
also consider whether partnerships with banking regulatory agencies 
would be beneficial. 

Appendix IV: Comments from the Department of the Treasury: 

Department Of The Treasury: 
Washington, D.C. 20220: 

September 2, 2011: 

Mr. Michael Brostek: 
Director, Tax Issues: 
Strategic Issues Team: 
U.S. Government Accountability Office: 
441 G Street, NW: 
Washington, DC 20548: 

Dear Mr. Brostek: 

We appreciate the effort that went into GAO's draft report titled 
"Financial Derivatives: Disparate Tax Treatment and Information Gaps 
Create Uncertainty and Potential Abuse" and the understanding of 
complex issues that it conveys. We are pleased to respond to the
recommendations contained in the draft report. 

The "Recommendations for Executive Action" section of the report sets 
forth two recommendations for the Secretary of the Treasury. The first 
recommendation is that "the Secretary of Treasury should undertake a 
study that compares the current approach to alternative approaches for 
the taxation of financial derivatives." There is already a substantial 
body of literature written by academics, practitioners, and others 
that considers this subject. For example, reports prepared by the 
American Bar Association, the New York State Bar Association, and 
industry trade groups routinely discuss the issue of alternative ways 
to address the taxation of derivatives. Moreover, Congress has also 
conducted hearings and engaged in other activity related to financial 
derivative taxation, and has available to it its own resources,
including the Joint Committee on Taxation, that could advise about 
alternative legislative approaches. Rather than generate yet another 
study that considers how derivatives should be taxed, Treasury 
believes that its resources would be better spent drafting and issuing 
guidance on these subjects. The Treasury Department is, of course, 
always available to assist the Ways and Means Committee and the 
Finance Committee in any undertaking concerning alternative
approaches to the taxation of financial derivatives. 

The second recommendation is that "the Secretary of the Treasury and 
the Commissioner of the IRS should consider additional, more 
frequently updated reporting to the public on ongoing projects listed 
in the [priority guidance plan], including project status, changes in 
priorities, and both target completion dates within and beyond the 12-
month period." The Treasury Department firmly believes in and supports 
transparency in the regulatory process, and through the priority 
guidance plan (PGP) and its regular updates provides notice to the 
public of the projects on which Treasury and the IRS are focusing 
their resources. In addition, Treasury and IRS officials routinely 
participate in and speak at Bar Association meetings and public 
conferences about guidance projects, and those appearances are widely 
reported in the tax press. This activity provides the public and 
practitioners with continual insight into the guidance plan progress.
However, the Treasury Department does not believe that the additional 
reporting recommended in the report would be constructive or 
necessarily be worth the additional administrative resources such 
reporting would require. In light of the fluid nature of the 
development of guidance it would be very difficult to provide precise 
predictions of when guidance would be issued. In addition, it is not 
clear whether attempting to pinpoint the timing when guidance might be 
released would necessarily be that helpful. It is our experience that 
legitimate tax planning is not materially affected by the current 
approach of communicating guidance activity through the POP, and that 
the existing process provides a substantial amount of transparency to
the public. 

We appreciate the opportunity to comment on the draft report, and look 
forward to working with you in the future. 

Sincerely, 

Signed by: 

Mark J. Mazur: 
Deputy Assistant Secretary (Tax Analysis): 

[End of section] 

Appendix V: GAO Contact and Staff Acknowledgments: 

[End of section] 

GAO Contact: 

Michael Brostek, (202) 512-9110 or brostekm@gao.gov: 

Staff Acknowledgments: 

In addition to the contact named above, the following staff made 
significant contributions to this report, Jay McTigue, Assistant 
Director; Kevin Averyt; Timothy Bober; Tara Carter; William Cordrey; 
Robin Ghertner; Colin Gray; George Guttman; Alex Katz; Natalie Maddox; 
Matthew McDonald; Edward Nannenhorn; Jose Oyola; Andrew Stephens; 
Jason Vassilicos; and James White. 

[End of section] 

Glossary: 

Bifurcation:
The process of dividing a financial instrument into its component 
parts. 

Constructive Ownership Transaction:
Under Internal Revenue Code (IRC) section 1260, gains from 
constructive ownership transactions are taxed as ordinary income and 
not capital gains to the extent that such gains exceed the net 
underlying long-term capital gains and impose accompanying interest 
charges. Section 1260 applies to derivatives that stimulate the return 
of certain assets, such as a hedge fund or another pass-though entity 
by offering the holder substantially all of the risk of loss and 
opportunity for gain from the underlying asset. 

Constructive Sale:
A transaction where a taxpayer attempts to obtain economic gains from 
the sale of an appreciated position without legally transferring 
ownership and triggering taxable income. IRC section 1259 contains 
rules that affect the treatment of gains from constructive sales. 

Contingent Swap:
A swap contract in which a payment is contingent or otherwise 
conditional on some event occurring during the period of the contract. 

Conversion transaction:
A transaction that generally consists or two or more positions taken 
with regard to the same or similar investments, where substantially 
all of the taxpayer's return is attributable to the time-value of the 
taxpayer's net investment in the transaction. IRC section 1258 
contains rules for the treatment of conversion transactions. 

Credit Default Swap (CDS):
Bilateral contract that is sold over-the-counter and transfers credit 
risk from one party to another. The seller, who is offering credit 
protection, agrees, in return for a periodic fee, to compensate the 
buyer, who is buying credit protection, if a specified credit event, 
such as default, occurs. 

Fair Value:
See gross positive fair value. 

Forward:
A privately negotiated contract between two parties in which the 
forward buyer agrees to purchase from the forward seller a fixed 
quantity of the underlying reference item at a fixed price on a fixed 
date. 

Future:
A forward contract that is standardized and traded on an organized 
futures exchange. 

Gross Positive Fair Value:
The sum total of the fair values of contracts owed to commercial 
banks. Represents the maximum losses banks could incur if all other 
parties in the transactions default and the banks hold no collateral 
from the other party in the transaction and there is no netting of the 
contracts. 

Hedging:
The process whereby an entity will attempt to balance or manage its 
risk of doing business or investing. 

Mark-to-Market:
For tax purposes, under mark-to-market rules, any contract held at the 
end of the tax year will generally be treated as sold at its fair 
market value on the last day of the tax year, and the taxpayer must 
recognize any gain or loss that results. 

Mandatory Convertible:
Security linked to equity that automatically converts to common stock 
on a prespecified date. 

Notional Principal Contract (NPC):
According to section 1.446-3 (c)(1)(i) of title 26, Code of Federal 
Regulations, a financial instrument that provides for the payment of 
amounts by one party to another at specified intervals calculated by 
reference to a specified index upon a notional principal amount, in 
exchange for specified consideration or a promise to pay similar 
amounts. 

Notional Amount:
Total notional amount represents the amount of the reference items 
underlying financial derivative transactions, and is the amount upon 
which payments are computed between parties of financial derivatives 
contracts. Notional amount generally does not represent money 
exchanged, nor does it represent the risk exposure. 

Option:
Contracts that gives the holder of the options the right, but not the 
obligation, to buy (call option) or sell (put option) a specified 
amount of the underlying reference item at a predetermined price 
(strike price) at or before the end of the contract. 

Over-the-Counter Derivatives:
Privately negotiated financial derivative contracts whose market value 
is determined by the value of the underlying asset, reference rate, or 
index. 

Short Sale:
This type of transaction occurs when a taxpayer borrows property 
(often a stock) and then sells the borrowed property to a third party. 
If the short seller can buy that property later at a lower price to 
satisfy his or her obligation under the borrowing, a profit results; 
if the price rises, however, a loss results. IRC Section 1233 contains 
rules that can affect the treatment of gains and losses realized on 
short sales. 

Straddle:
The value of offsetting positions moves in opposite directions so a 
loss on one position is cancelled out by the gain on an offsetting 
position. IRC Section 1092 contains rules that can affect the 
treatment of straddles. 

Total Return Equity Swap:
A contract that provides one party in the transaction with the total 
economic performance from a specified reference equity or group of 
equities and the other party in the transaction receives a specified 
fixed or floating cash flow that is not related to the reference 
equity. A cross-border total return equity swap is a contract that 
occurs between a domestic and foreign party. 

Variable Prepaid Forward Contract (VPFC):
Agreement between two parties to deliver a variable number of shares 
at maturity (typically 3 to 5 years) in exchange for an up-front cash 
payment, which generally represents 75 to 85 percent of the current 
fair market value of the stock. The VPFC usually has a cash settlement 
option in lieu of shares at maturity. 

Wash Sale:
A wash sale is when a taxpayer acquires a stock or security within 30 
days of selling a substantially similar stock or security; under IRC 
section 1091, the taxpayer is not generally permitted to claim a loss 
on such a sale. 

[End of section] 

Footnotes: 

[1] A glossary of terms is provided at the end of the report. 

[2] Cross-border total return equity swaps were used to avoid paying 
withholding tax on dividend payments to foreign entities, and were 
addressed by the Hiring Incentives to Restore Employment (HIRE) Act. 
Pub. L. No. 111-147 § 541, 124 Stat. 71, 115-117 (2010). Variable 
prepaid forward contracts coupled with a share-lending agreement were 
used to defer income recognition, and were addressed in Anschutz Co. 
v. Commissioner. 135 T.C. No. 5 (July 22, 2010). 

[3] GAO, Understanding the Tax Reform Debate: Background, Criteria, 
and Questions, [hyperlink, http://www.gao.gov/products/GAO-05-1009SP] 
(Washington, D.C.: Sept. 1, 2005). 

[4] See GAO, Results-Oriented Government: Practices That Can Help 
Enhance and Sustain Collaboration among Federal Agencies, [hyperlink, 
http://www.gao.gov/products/GAO-06-15] (Washington, D.C.: Oct. 21, 
2005). 

[5] Total notional amount represents the value of the reference items 
underlying financial derivative transactions, and is the amount upon 
which payments are computed between parties of derivatives contracts. 
Notional amount does not represent money exchanged, nor does it 
represent the risk exposure. For example, one party in an interest 
rate swap pays a 3 percent fixed rate on a notional amount of 
$100,000, making payments of $3,000 per period. The other party in the 
interest rate swap would pay a variable rate on the same notional 
amount in exchange for the fixed-rate payment of $3,000. These two 
payments are netted and the positive balance is received by one party. 
The fair market value of all open derivatives contracts reports the 
value of all trades should they be closed at the time of valuation, 
and is often used to gauge counterparty credit risk exposure. 

[6] See GAO, Financial Regulation: A Framework for Crafting and 
Assessing Proposals to Modernize the Outdated U.S. Financial 
Regulatory System, [hyperlink, http://www.gao.gov/products/GAO-09-216] 
(Washington D.C.: Jan. 8, 2009) and Financial Crisis Inquiry 
Commission, The Financial Crisis Inquiry Report: The Final Report of 
the National Commission on the Causes of the Financial and Economic 
Crisis in the United States (Washington, D.C.: January 2011). 

[7] The losses assume no netting of the contracts and that the bank 
holds no collateral from the other parties in the contract. 

[8] In this report we use IRS's definition of guidance, which includes 
regulations, although regulations and guidance are typically 
considered separate and distinct categories. 

[9] Internal Revenue Code (IRC) section 6110 requires public access to 
rulings, determination letters, technical advice memoranda, and Chief 
Counsel advice with any taxpayer identification information redacted. 

[10] In other circumstances, if a taxpayer holds an investment for 
more than 1 year, any capital gain or loss is a long-term capital gain 
or loss. If a taxpayer holds the investment 1 year or less, any 
capital gain or loss is a short-term capital gain or loss. Tax rates 
on long-term capital gains are generally lower than short-term capital 
gain rates and vary depending on the taxpayer's income. 

[11] 26 U.S.C. § 1221(a)(7), (b)(2); 26 C.F.R. §§ 1.446-4, 1.1221-2. 

[12] Under a mark-to-market approach, a dealer or electing trader 
would be treated as though it had sold its securities at the end of 
each taxable year for fair market value and then repurchased the 
securities as of the beginning of the following taxable year at the 
same price. The dealer or electing trader would thus be taxed annually 
on unrealized appreciation in the securities, and its basis in the 
securities would be increased to avoid double taxation of that 
appreciation upon maturity or an actual disposition. If the value of 
the securities declined, the dealer or electing trader generally would 
be entitled to claim the unrealized loss. 

[13] Under proposed regulations, the noncontingent swap method 
requires taxpayers to project the expected amount of contingent 
payments, to take into account annually the appropriate portions of 
the projected contingent amounts, to reproject the contingent amounts 
annually, and to reflect the differences between projected amounts and 
reprojected amounts through adjustments. 69 Fed. Reg. 8886 (Feb. 26, 
2004). 

[14] Besides the lower tax rate applied to long-term capital gains, 
there is an additional economic benefit of deferring taxes paid 
associated with the time value of money. Each year a taxpayer defers 
paying tax on income, that income can be invested in a risk-free asset 
and increase in value. Assuming tax rates do not change, the tax owed 
on the original income does not increase. The taxpayer in effect pays 
less tax in real dollars each year he or she is allowed to defer 
income recognition. IRC requires accrual of this increase in value for 
debt instruments, but not equity. 

[15] See IRS Revenue Ruling 2003-97. For these tax results to hold, 
the transaction must have specific legal characteristics, as described 
in the ruling. 

[16] 26 U.S.C. §§ 871(a)(1)(A), 881(a)(1). The 30 percent withholding 
tax, which is typically withheld at the source, is not imposed in all 
circumstances, such as when the income is from certain portfolio debt 
investments or when a tax treaty sets a different rate. 

[17] Pub. L. No. 111-147, § 541, 124 Stat. 71, 115-117 (2010), 
codified at 26 U.S.C. § 871(m). 

[18] The variable nature of the contract mitigates the downside risk 
at the expense of a cap on gains for both parties. As a simplified 
example: if a share is originally worth $100, and the VPFC relates to 
10,000 shares of stock, the seller of the VPFC may agree to deliver 
10,000 shares if the share price is less than $100, the number of 
shares worth $1,000,000, if the share prices is between $100 and $125, 
or 10,000 shares, less the number of shares worth $250,000, if the 
price rises above $125. 

[19] See IRC section 1259 rules on constructive sales. 

[20] See GAO-05-1009SP. 

[21] 62 Fed. Reg.53, 498 (Oct. 14, 1997). 

[22] According to proposed regulations, a contingent nonperiodic 
payment is "any nonperiodic payment other than a noncontingent 
nonperiodic payment," which in turn is "a nonperiodic payment that 
either is fixed on or before the end of the taxable year in which a 
contract commences or is equal to the sum amounts that would be 
periodic payments if they are paid when they become fixed." 69 Fed. 
Reg. 8886, 8893 (Feb. 26, 2004). 

[23] Notice 2004-52 describes CDS as similar to a NPC, an option, an 
insurance contract, and a financial guarantee. 

[24] See LMSB-4-1209-044 Industry Directive on Total Return Swaps Used 
to Avoid Dividend Withholding Tax, issued January 14, 2010. 

[25] In 2006, the Pre-Filing and Technical Guidance office within the 
Large and Mid-Size Business (LMSB) division issued an Emerging Issue 
Paper. In 2008, LMSB issued Coordinated Issue Paper LMSB-04-1207-077. 
Starting in 2004, IRS has entered into litigation against at least 
three separate taxpayers, in relation to these issues. 

[26] The PGP is also known as the Guidance Priority List or the 
Business Plan. 

[27] IRS Chief Counsel's database which tracks guidance projects, 
Counsel Automated Systems Environment-Management Information System 
(CASE-MIS), only has data available going back to 1996. 

[28] See appendix II for list of the 53 priority guidance projects. 

[29] Dividend substitute payments on U.S. equity made when a foreign 
owner loans the equity securities to a U.S. entity are sourced similar 
to a transferred security according to 1997 regulations, meaning they 
are also subject to the 30 percent withholding tax when payments are 
made to foreign entities. (Treas. Reg. 1.861-3(a) (6), adopted by T.D. 
8735, 11-6-97) However, according to 1991 regulations, the source of 
dividend-equivalent payments made from a total return equity swap is 
determined by the residence of the taxpayer, so a U.S. entity making 
payments to a foreign entity does not need to withhold taxes. (Treas. 
Reg. 1.863-7(b), adopted by T.D. 8330, 1-11-91). 

[30] After the passage of HIRE Act, enacted March 18, 2010, IRS 
replaced Notice 97-66 with Notice 2010-46. 

[31] See the proposed rules regarding trading safe harbors. 63 Fed. 
Reg. 32,164 (June 12, 1998). 

[32] Nonprecedential advice includes Private Letter Rulings (PLR), 
Technical Advice Memorandums (TAM), and Chief Counsel Advice (CCA). 
PLRs and TAMs are issued to taxpayers and exam teams and are only 
binding on the IRS and the taxpayer in the specific circumstances 
addressed. CCA is issued to exam teams and is not legally binding. 

[33] See IRS Revenue Ruling 2008-1 and IRS Notice 2008-2. 

[34] See Treasury Inspector General for Tax Administration (TIGTA) 
2010-10-106: Chief Counsel Can Take Actions to Improve the Timeliness 
of Private Letter Rulings and Potentially Reduce the Number Issued; 
TIGTA 2008-10-075: The Published Guidance Program Needs Additional 
Controls to Minimize Risks and Increase Public Awareness; and TIGTA 
2003-10-081: Improvements to the Office of Chief Counsel's Published 
Guidance Process Would Enhance Guidance Provided to Taxpayers and the 
Internal Revenue Service. 

[35] See, for example, Chief Counsel Notices CC-2011-009: File 
Maintenance and Management Information System Requirements, issued on 
March 11, 2011. 

[36] IRS Chief Couns. Mem. AM2010-005 (Oct. 15, 2010). 

[37] See [hyperlink, http://www.gao.gov/products/GAO-06-15]. 

[38] See [hyperlink, http://www.gao.gov/products/GAO-09-397T]. 

[39] See [hyperlink, http://www.gao.gov/products/GAO-06-15]. 

[End of section] 

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