Structured notes are financial products currently available in the marketplace. The return an investor will receive is tied to a commodity price, stock, basket of securities, or other reference index. It is a derivative product because its value is derived from the value of another financial instrument.
These are quite popular (with brokers) due to
the high embedded commission rates (3%) in comparison to bullet bonds or CDs (1% or less). These complicated securities are sold by some of America's most respected institutions, even though most ordinary investors do not really understand what they are buying or how they should account for it.
What should you do when it comes to tax reporting time?
First you have to read the prospectus. The US Federal Income Taxation section will tell you the tax accounting treatment that applies to your specific investment. However, many people do not do this because the relevant information is buried in a 200 page prospectus that is indecipherable to the average person.
We attempt here to outline for you in simple terms the tax treatment for one structured product which is representative of this type of investment. You still must read your prospectus to see if the tax method for your particular investment differs.
If it is a zero coupon note with a structured payment at the end of the term, it is a fairly straight-forward matter. You just add the OID (original issue discount) reported on your annual Form 1099 to your original cost to determine your adjusted cost basis each year.
But what if it is not classified as a zero coupon structured note? Let's look at an actual example.
The investment "Morgan Stanley Global Medium Term Series F Senior Notes Protected Buy-Write Securities due 12/23/2011 Based on the Performance of the 2006-4 Dynamic Reference Index" with CUSIP 61748A221 is one example of this type of structured note. Payments were possible throughout the term of the note based on a formula tied to the reference index, so it was not a zero coupon structured note. This particular investment reported OID (Original Issue Discount) interest income to its owners each year of the five-year term but only made partial cash payments in two of the years before it matured at par value. The OID taxable income reports were based on the market rates of interest that prevailed at the time of issuance--over 5%.
The relevant tax advice section is found on page S-26 in the section entitled "Notes Linked to Commodity Prices, Single Securities, Baskets of Securities or Indices"
"The U.S. federal income tax consequences to a U.S. Holder of the ownership and disposition of a note that has principal or interest determined by reference to commodity prices, securities of entities affiliated or not affiliated with us, baskets of those securities or indices will vary depending upon the exact terms of the note and related factors. Unless otherwise noted in the applicable pricing supplement, such notes will be subject to the same U.S. federal income tax treatment as optionally exchangeable notes."
This advice points you to page S-21 for "Optionally Exchangeable Notes" and the sub-topic "Adjustments to Interest Accruals on the Notes" found on page S-22:
"If a U.S. Holder receives in a taxable year actual payments with respect to the optionally exchangeable note that, in the aggregate, are less than the amount of projected payments for that taxable year, the U.S. Holder will incur a net negative adjustment under the contingent debt regulations equal to the amount of such deficit. This net negative adjustment:
• will first reduce the U.S. Holder s interest income on the optionally exchangeable note for that taxable year;
• to the extent of any excess, will give rise to an ordinary loss to the extent of the U.S. Holder s interest income on the optionally exchangeable note during prior taxable years, reduced to the extent such interest was offset by prior net negative adjustments; and
• to the extent of any excess after the application of the previous two bullet points, will be carried forward as a negative adjustment to offset future interest income with respect to the optionally exchangeable note or to reduce the amount realized on a sale, exchange or retirement of the optionally exchangeable note."
What does this mean in plain English? It means that first you list on Form 1040 Schedule B the OID interest income amount that was reported to you on Form 1099-OID. Then you list a deduction for the interest (dividend) that was not collected in cash, for net interest income of zero in this case.
I can guarantee you that is not what many investors did, however. Many taxpayers reported the OID as taxable income with no offsetting net negative adjustment. Tax was overpaid for the past five years and now the note has matured at par value with no appreciation in value--an economic loss. This situation can be corrected by filing amended returns to deduct the net negative adjustments, but you can only go back three years. Each year "stands on its own" in the tax world.
Your adjusted cost basis at maturity is your beginning purchase amount plus all the OID less the cumulative net negative adjustments that should have been reported.
Here is a copy of the actual prospectus for the structured note described above for readers who like to dig in to the details.