United States: Proposed IRS Regulations That Would Allow Certain Exchange -Traded "Flex Options" And Certain OTC Options To Be Treated As "Qualified Covered Calls" For Purposes Of The Straddle Rules

On January 17, 2001, the Treasury Department and the Internal Revenue Service (the "IRS") issued certain proposed regulations that, if finalized as proposed, would permit certain exchange-traded equity options with flexible terms ("flex options") and equivalent over-the-counter ("OTC") options with a term of one year or less to be treated as "qualified covered calls." A taxpayer that owns stock and writes a qualified covered call is not generally subject to the straddle rules. The proposed regulations also would deny qualified covered call status for standardized exchange-traded options with a term of more than one year.  The proposed regulations are proposed to be effective for flex options and OTC options entered into on or after 30 days after the proposed regulations are finalized, and for standardized options with terms of more than a year entered into on or after 90 days after the proposed regulations are finalized.

In general, the proposed regulations, if finalized, would provide a helpful and appropriate expansion of the qualified covered call rules to permit taxpayers to write short-term flex options and OTC options (in addition to standardized exchange-traded options) in order to increase their yield – rather than reduce their risk of loss – without subjecting taxpayers to the adverse consequences of the straddle rules.

However, the proposed regulations would permit qualified covered call treatment only for options with a term of one year or less (although the IRS did request comments on the appropriateness of permitting longer-term options to be treated as qualified covered calls). In addition, in light of the new administration (and the changes in Treasury Department and IRS personnel that will accompany it), it is unlikely that the proposed regulations will be finalized in the near future (and quite possible that the proposed regulations will not be finalized until after 2001).¹

Taxpayers that enter into derivative arrangements which substantially diminish their risk of loss with respect to publicly-traded stock or securities or other "actively-traded personal property"² are generally treated as having entered into a "straddle" that subjects them to the "straddle rules."³

Section 1092, in combination with section 263(g), generally provides for four adverse tax consequences to a taxpayer that enters into a straddle. First, if the taxpayer disposes of a position in a straddle at a loss, the loss is deferred to the extent of any unrecognized gain in any offsetting positions that make up the straddle.⁴ Second, the holding period of any position in a straddle that has not been held for more than a year prior to becoming a position in the straddle is eliminated and a new holding period does not begin to accrue again until the straddle has been closed out.⁵ Third, any loss with respect to a straddle position is generally treated as a long-term capital loss if any other position in the straddle had been held for more than a year prior to becoming a position in the straddle.⁶ Finally, under section 263(g), net interest and carrying charges that are properly allocable to personal property which is part of the straddle must be capitalized, and realized only when the personal property is sold.⁷

A taxpayer that owns publicly-traded stock and writes a qualified covered call on that stock is not generally subject to the straddle rules.⁸ A qualified covered call is, in general, any option granted by a taxpayer to purchase stock held by the taxpayer (or stock acquired by the taxpayer in connection with the granting of the option) but only if (i) the option is "exchange traded,"⁹ (ii) the option is granted more than 30 days before the day on which the option expires,¹⁰ and (iii) the option is not a "deep in the money" option, which means that the option’s strike price must be equal to or greater than the highest available strike price that is less than the closing price of the stock on the business day before the date the option was granted, or the opening price of the stock on the day on which such option was granted if this price is greater than 110% of the closing price (the "applicable stock price").¹¹

The qualified covered call exception is available only for investors and traders for which gain or loss would be capital gain or loss,¹² and is not available for option dealers that write calls in connection with their activity of dealing in options.¹³ Moreover, the straddle cannot be part of a larger straddle.

Standardized options are now available with terms that are longer than one year. Because longer-term options generally provide for higher premiums and a greater risk of exercise than short-term options, the proposed regulations would prohibit options with a term of more than one year from being treated as qualified covered call.¹⁴ However, this absolute one-year rule would deny qualified covered call status for long-term options that by reason of a substantially higher strike price actually present lesser of a risk of exercise than a short-term option. A better rule would permit an option with a term of more than a year to be treated as a qualified covered call if the taxpayer can demonstrate (based on the Black-Scholes or other accepted option pricing model) that the option does not diminish the taxpayer’s risk of loss to any greater extent than a qualified covered call with a term of one year or less.

The proposed regulations would provide that a flex option is treated as a qualified covered call if:

• The option is exchange traded,¹⁵
• The option has a term of more than 30 days and not more than one year,¹⁶
• Premium is payable in a single fixed amount not later than five business days after the day on which the option is granted,¹⁷
• The strike price is a fixed amount payable in dollars at or within five business days of exercise,¹⁸
• A standard exchange-traded option is outstanding for the underlying equity,¹⁹
• The share price of the flex option is no lower than the lowest "qualified bench mark" for a standard exchange-traded option on the same stock having the same applicable exchange price,²⁰
• The taxpayer is an investor or a trader for which gain or loss would be capital gain or loss, and not an option dealer that writes calls in connection with activity of dealing in options.²¹

The proposed regulations would provide that an OTC option is treated as a qualified covered call if:

• The option is not traded on a national securities exchange registered with the SEC (i.e., it is an "over-the-counter option"),²²
• The option meets the same requirements for qualified covered call treatment that apply to flex options,²³
• The option is entered into with a person registered with the SEC as a broker-dealer under Section 15 of the Securities and Exchange Act of 1934 or an alternative trading system,²⁴ and
• The option meets the same requirements for qualified covered call treatment that apply to flex options.²⁵

1 On January 20, 2001, a 60-day moratorium was imposed on the publication of new regulations in the Federal Register. Memorandum for the Heads and Acting Heads of Executive Departments and Agencies From Andrew H. Card, Jr., Assistant to the President and Chief of Staff, 66 Federal Register 16 (January 24, 2001).

2 Actively-traded personal property generally means any personal property of a type that is actively-traded. Section 1092(d)(1).
All references to section numbers are to the Internal Revenue Code of 1986, as amended, or the Treasury regulations promulgated or proposed thereunder.

3More specifically, the straddle rules apply to "offsetting positions" with respect to "actively-traded personal property." Section 1092(c)(1) and (d)(1).
As discussed below, taxpayers that write qualified covered calls with respect to stock are not treated as having entered into a straddle.

4 Section 1092(a)(1).

5 Section 1092(b)(1); temporary Treasury regulations section 1.1092(b)-2T(a).

6 Section 1092(b)(1); temporary Treasury regulations section 1.1092(b)-2T(b).

7 Section 263(g). Proposed regulations were issued on January 17, 2001 that, if finalized as proposed, would broadly expand the interest and carrying charge capitalization rules applicable to positions in a straddles, and would deny current interest and other deductions on equity swaps, DECS^SM and other variable-share forward contracts, PHONES^SM, and other financial instruments used to hedge positions in publicly-traded stock and other actively-traded personal property. The proposed regulations would also provide significant guidance on the scope and application of the interest and cost capitalization rules. A separate memorandum, which is available upon request, describes those proposed regulations.

8 See section 1092(c)(4) (excluding stock and a qualified covered call from the definition of a straddle); section 263(g) (applying only to straddles, as defined in section 1092( c) ).
However, if the strike price of the qualified covered call is less than the applicable stock price (as defined in the text below), then the taxpayer’s holding period with respect to the stock is suspended (but not eliminated) during the period the qualified covered call is outstanding and, if the stock was held for more than a year when the qualified covered call is written, any loss on the qualified covered call is treated as long-term capital loss. Sections 1092(f).

9 Section 1092(c)(4)(B)(i). Exchange traded means traded on a national securities exchange which is registered with the Securities and Exchange Commission or other market which the IRS determines has rules adequate to carry out the purposes of the qualified covered call provisions.

10 Section 1092(c)(4)(B)(ii).

11 Sections 1092(c)(4)(B)(iii) (requiring that a qualified covered call not be a "deep-in-the-money option"), (C) (defining a deep-in-the-money option as an option whose strike price is lower than the lowest qualified bench mark), and (D) (defining lowest qualified bench mark); section 1092(c)(4)(G) (defining applicable stock price).
Special rules for determining the lowest qualified bench mark apply in three situations. First, in the case of an option that is granted more than 90 days before the date on which the option expires and for which the strike price exceeds $50, the lowest qualified bench mark is the second highest available strike price which is less than the applicable stock price. Section 1092(c)(4)(D)(ii). Second, in the case where the applicable stock price is $25 or less and but for the application of this rule the lowest qualified bench mark would be less than 85% of the applicable stock price, the lowest qualified bench mark is treated as 85% of the lowest applicable stock price. Section 1092(c)(4)(D)(iii). Third, in the case where the applicable stock price is $150 or less, and but for this rule the lowest qualified bench mark would be less than the applicable stock price reduced by $10, the lowest qualified bench mark is equal to the applicable stock price reduced by $10. Section 1092(c)(4)(D)(iv).
On January 21, 2000, the IRS issued regulations which provide that the lowest qualified bench mark for standardized options would not be affected by outstanding flex options with lower strike prices. Treasury regulations section 1.1092(c)-1. The January 21 regulations did not address whether flex options themselves could be treated as qualified covered calls.

12 Section 1092(c)(4)(B)(v).

13 Section 1092(c)(4)(B)(iv).

14 Proposed Treasury regulations section 1.1092(c)-2(a).

15 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(i); see also section 1092(c)(4)(B).

16 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(i); see also section 1092(c)(4)(B).
This one-year rule is subject to the same criticism as the one-year rule for standardized options.

17 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(ii).

18 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(ii).

19 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(iv). It is unclear whether this requirement applies only on the date the flex option is issued or over the entire term of the flex option.

20 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(i); proposed Treasury regulations section 1.1092(c)-1(c)(2), see also, section 1092(c)(4)(B).

21 Proposed Treasury regulations section 1.1092(c)-1(c)(1)(i); see also section 1092(c)(4)(B).

22 Proposed Treasury regulations section 1.1092(c)-3(c)(1).

23 Proposed Treasury regulations section 1.1092(c)-3(b).

24 An alternative trading system is, in general any system that (1) constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange and (2) does not (i) set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system, or (ii) discipline subscribers other than by exclusion from trading. Securities and Exchange Commission Rule 300(a), Adoption Release, 63 Federal Register 70922.

25 Proposed Treasury regulations section 1.1092(c)-3(c)(2).