SECTION 2. BACKGROUND

The Commodity Futures Modernization Act of 2000, enacted as part of the Consolidated Appropriations Act, 2001 (Public Law 106–554, 114 Stat. 2763), authorizes the trading of securities futures

2002–7 I.R.B. 526 February 19, 2002

contracts, a new type of derivative financial product. In general, gain or loss is recognized on securities futures contracts upon disposition, and the character of that gain or loss is determined by newly enacted section 1234B of the Code.

The timing and character of gains and losses on dealer securities futures contracts (and options on such contracts), however, is determined under section 1256. Dealer securities futures contracts are subject to mark-to-market treatment, and gains or losses are treated as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss. Section 1256(a). For purposes of the application of section 1256 to dealer securities futures contracts (and options on such contracts), a person is a dealer if the Secretary of the Treasury determines that the person performs functions with respect to such options or contracts similar to the functions performed with respect to stock options by persons registered with a national securities exchange as a market maker or specialist in listed options.

In Notice 2001–27 (2001–13 I.R.B. 942), the Service and the Treasury Department requested comments and suggestions regarding both the substance of the required determinations and the manner in which they should be made. Numerous comments have been received regarding criteria that could be used to identify dealers in securities futures contracts (and options on such contracts). In addition, staff of the Service and Treasury initiated numerous conversations with both regulators and various exchanges. These ongoing conversations are expected to continue unabated.

The exchanges on which securities futures contracts and options may be traded, however, are still developing rules that will govern trading. In addition, certain of the regulatory requirements that will be imposed by the Securities and Exchange Commission and the Commodity Futures Trading Commission have not yet been issued in final form, and the rules promulgated by some exchanges may differ in important respects from those governing the trading of any other products.

During the current period, when trading rules are being developed, it is important for the Service and Treasury to pro

vide certainty for taxpayers while at the same time not constraining the development of trading structures for the new markets. Given the likely diversity of trading platforms and the potential for new trading models, the Service and Treasury have determined that encouraging exchanges to apply for case-by-case determinations while they are developing their trading rules is preferable to either writing general rules before the trading structures are known or waiting until the structures are finally established and then making the exchanges wait for a general rule to be crafted.

The issuance at this time of general guidance for determining dealer status would risk constraining the development of the structures for the new markets. On the other hand, if general guidance is not issued now, the absence of an interim process for securing dealer determinations could impair the ability of the exchanges to adapt their proposed trading systems to the requirements for achieving dealer status for market participants. As a result of the flexibility inherent in the process of obtaining a letter ruling, an exchange will have an opportunity, if it so desires, to make adjustments in its proposed trading practices should those be needed to secure dealer status for particular groups of traders.

Under the procedures set forth below, if an exchange is one on which securities futures contracts (or options thereon) are, or are expected to be, traded, the exchange may request a letter ruling that, based on its specific rules and facts and circumstances, certain persons trading such contracts (or options thereon) on the exchange will be treated as “dealers” under section 1256(g)(9).

The Service expects that, once it has reached a decision regarding the request for ruling, the same conclusion will be published in a revenue ruling, which will serve as general guidance. The Service and Treasury are committed to expedited processing for both the letter ruling and the revenue ruling.