Tax Analysts provides news, analysis, and commentary on tax-related topics including taxation of financial instruments. A financial instrument is a tradable asset that is evidence of ownership in an asset or gives parties a contractual right or obligation to receive or pay. Financial instruments can either be over-the-counter, meaning that the parties negotiate the terms of the contract, or they can be exchange traded contracts.

Tax treatment of the instruments vary widely depending on the instrument. Examples of derivative contracts include debt instruments, short sale contracts, forward contracts, future contracts, options, notional principal contracts, and hedges or straddles. Financial instruments can also include a combination of different types of instruments.

Payments under financial instruments can be capital or ordinary, both to the payor or payee, depending on the type of instrument. Payments under a notional principal contract generally are ordinary to the payor and payee. Interest under debt instruments are generally ordinary to the debtor and creditor. Options, by contrast, are generally the same character as the underlying asset, though Pilgrim’s Pride Corp v. Commissioner has caused some confusion in this area, particularly for options with a non-asset underlying, such as an index like LIBOR.

Some financial instruments are created to create economically similar outcomes with tax advantageous structuring. An example is a contract with dividend equivalent payments. In 2011, Congress implemented section 871(m) that is meant to implement withholding on payments under derivatives that are economically similar to dividend payments, which are generally subject to withholding. Treasury, however, has struggled to devise a system to determine when a derivative contract, such as an option or notional principal contract, is subject to the withholding rules. Currently, proposed regulations suggest a delta-based test.

Tax Notes Federal and Tax Notes Today Federal subscribers have free access to James M. Peaslee and David Z. Nirenberg, Federal Income Taxation of Securitization Transactions and Related Topics (Fifth Edition). The book is intended to serve as a practitioner’s handbook, addressing a range of topics that are important in a financially oriented tax practice, including the treatment of debt instruments and related financial instruments. Chapter 16 discusses when state law property interests are aggregated or separated for tax purposes, and covers many different types of financial instruments.