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."
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