IV. APPLICATION OF GENERAL TAX RULES TO PARTICULAR OPTIONS
A. Plain-Vanilla index option
In general, under a plain-vanilla index option, the holder is entitled to received a payment determined with reference to the difference in the value of a certain index, from the inception of the contract through the term of the contract. These options can be exercised only at expiration (European-style options), and these options can be structured as either call options or put options. The holder of a call option has a right to receive cash, based on the extent to which the index on the exercise date is above a pre-stated value. The writer of a call option has an obligation to pay cash in an amount determined the same way. A put option resembles a call option except that a holder’s right to receive cash and a writer’s obligation to pay cash are based on the extent to which the index on the exercise date is below a pre-stated value.
Assuming that neither counterparty is a dealer, the premium paid to enter into this option will not necessarily be includible in income (nor allowed as deduction) in the year it is paid. The premium will not be accounted for until the option is either exercised, lapses, or is otherwise terminated. Upon the occurrence of any of these events, the option holder will generally recognize gain or loss equal to the amount received less the amount paid for the option (i.e. the premium). The option write will have gain or loss equal to the amount of the option premium received less the cash settlement payment. If the options are Section 1256 contracts or the option holder is a dealer, gain, or loss will generally be determined upon the earlier of (1) the holder’s taxable year-end or (2) the lapse, exercise, or termination of the option.
The timing of loss recognition can be affected by the existence of underlying assets/liabilities to which the option can be regarded as being related. If the option and an underlying assets/liability constitute a straddle. within the meaning of Section 1092, the recognition of loss could be disallowed. If an investor believes that she or he may have a straddle, the investor should identify the positions as offsetting positions, as from the day that the straddle is established. In addition, if the option is held as part of an identified hedging transaction, the timing of income and loss recognition may be altered so as to match the timing of the hedged property.
The character of any gain or loss recognized by an option holder will depend on whether these index options are Section 1256 contracts. If these options are exchanged-traded and based on a broad-based stock index, the options will likely be subject to the mark-to-market rules of Section 1256. As a result, the holder will have 60 per cent long-term and 40 per cent short-term capital gain or loss upon exercise, lapse, or termination of the option, regardless of the holding period of the option. The option write, however, will continue to have short-term capital gain or loss if the option writer is not a dealer. If the option writer is a dealer, she or he should have ordinary gain or loss.
If these options are non-Section 1256 contracts, the holder of the option will have long-term or short-term capital gain or loss, depending on the period that the holder held the option unhedged, and subject to the application of the straddle rules. The option writer will have short-term capital gain or loss, assuming that the writer is not a dealer. As noted above, there is substantial uncertainty as to the proper sourcing of gains recognized with respect to options. While gain is generally sourced to the residence of the recipient, it is recommended that an investor seek expert advice in making the determination of how to source gains and losses. If the gain is attributable to a US trade or business, the income will be subject to tax in the United States.