D. Look-back index option
Under a look-back index option, the highest value of the index over the contractual period is compared at the initial value in order to determine the percentage variation to be used in calculating the pay-off under the option contract.
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 a 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 losses equal to the amount received less the amount paid for the option (i.e the premium). The option writer 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 asset/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 position 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 board-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 writer,