XIII. Taxation of Credit Options
Credit options are over-the-counter contracts between counter-parties which are customized to meet the specific credit-related hedging or investment objectives for the user. There are many varieties of credit options. For the purposes of this article, we will focus on credit put options.
Under a credit put option, the purchaser pays the writer a fixed premium in a lump sum or periodically. The put purchaser acquires the right, exercisable upon a predetermined credit event (e.g. credit downgrading or default), to sell the put writer the reference asset for its fave amount plus any accrued and unpaid interest.
At the time an option is purchased, the purchaser cannot deduct the cost of entering into the option and the writer cannot include in income the gain from selling the options. The taxable events occur at the time the option is sold. exchanged, exercised, or allowed to expire. If the put purchaser exercises the option, the cost of the option is reduced from the amount realized upon the sale of the underlying property. On exercise, the put writer decreases its basis in the security purchased by the amount of the premium received in the opening sale. If the put purchaser allows the option to expire, the option is deemed to be sold or exchanged on the date of expiration at this time the purchaser is allowed to deduct the premium and transaction cost paid to acquire the option, and the writer recognizes income equal to the net premium received.
B. Integration of underlying security and credit put options
If the purchaser of the put option owns the underlying debt instrument, it may be possible to integrate the two instruments for timing and character purposes. Integration can be accomplished if the put is exercisable upon a default, allowing a yield-to-maturity calculation.