IRS Code Section 1260 and the Tax Treatment of Indices

​The Tax Treatment of Indices in the Modern Financial Marketplace, 68 Tax Law. 487 (2015), authored by Jeffrey D. Hochberg and Alexander P. Apostolopoulos, focuses on indices used in financial transactions, with an emphasis on derivatives' tax treatment. The background is a rapid expansion of investors taking positions in indices, which they employ in tracking performance across specific markets and classes of stock.

Among the most recognizable indices are those based on the Dow Jones Industrial Average (DJIA) and Standard & Poor's 500 Index (S&P 500). They gather together various equities, offering exposure to a representative range of companies listed within the specific market. This ensures that investments track broad-based market performance over time instead of single companies. Over the past two decades, new indices have arisen that forgo market specificity. They are not tied to the S&P 500 or DJIA but reflect investment strategies designed simply to outperform markets. 

Investors in indices typically employ mutual funds, which make the actual investments in component equities, or derivatives, which involve taking positions relative to the index as a whole. Derivatives bring a host of tax challenges, such as whether they should be looked through—that is, whether the derivative should be treated for tax purposes as if it relates to the underlying components of the index—or whether the derivative should be treated for tax purposes as relating to a notional index that is independent of the components of the index.

This tax issue also raises the policy question of whether it is appropriate and fair for a taxpayer that invests in a derivative with respect to an index to be sometimes taxed differently than if it had entered into a derivative with respect to the components of the index, as the authors note.

One key issue is Section 1260 of the Internal Revenue Code of 1986 and its constructive ownership rules. Under the statute, taxpayers who engage in "constructive ownership transactions" through certain derivative financial instruments with respect to a “financial asset” must treat excess long-term capital gains accrued from such transactions as ordinary income (i.e., the amount of gain that is in excess of the amount of long-term capital gain that the investor would have realized by holding the underlying asset). Additionally, an interest charge applies.

“Financial assets” includes interests in “pass-thru entities,” entities that can often generate a significant amount of ordinary income and short-term capital gain over the course of an investor’s ownership.

The authors describe a situation in which Section 1260 might not apply—when the derivative is treated as relating to a notional index independent of its components. This may be the case where the underlying index is comprised primarily of entities other than “pass-thru entities,” such as the S&P 500. While that index references some pass-thru entities (in particular, REITs), the percentage of such entities included therein is small, the index is governed by objective criteria that do not specifically relate to pass-thru entities, and the index is generally not considered a means by which to target a specific component investment.

On the other end of the spectrum would be an investment into a derivative that references ten specific hedge funds (which are “pass-thru entities”). The authors claim that Congress "presumably intended" that Section 1260 should apply to such derivatives since they present a potential loophole. Otherwise, such an investment would allow the conversion of short-term capital gains and ordinary income tied to the derivative into long-term capital gains with attendant tax advantages. 

Many cases fall between such extremes, and, in frequent situations, investors take positions in derivatives for reasons other than tax avoidance. It is simply not feasible to invest in numerous hedge funds and publicly traded partnerships (PTP) due to associated time, transaction costs, and minimum investor net worth and denomination requirements. Examples of such arrangements include exchange-traded notes (ETNs), which some practitioners hold are not subject to section 1260 primarily because they have "independent substance apart from their underlying components" despite being made up primarily of pass-thru entities. 

Other practitioners hold that such ETNs will likely have section 1260 applied to them. The uncertainty regarding ETNs and similar derivatives means that investors should closely study such investments regarding tax implications when taking substantial positions in them and should consult with their tax advisers regarding such investments.

Disclaimer: The information contained on this website does not create an attorney-client relationship nor should the information on this website be construed as legal advice. No attorney-client relationship exists until you have met with one of our attorneys and signed our retainer agreement formally retaining our firm. All situations differ - prior results do not guarantee a similar outcome. You should always consult the advice of a lawyer before making any decisions regarding any legal matters referred to herein. This website is intended to provide general information only.

Alexander Apostolopoulos

Shop