There are special character and timing rules for option deals, and there rules generally provide that income or loss from the options will be ordinary. Furthermore, dealers are generally required to mark-to-market positions that are held at year-end. Options traders are able to make an election under Section 475(f) that would also alter the timing and character of options transactions. In general, if a trader makes a Section 475(f) election, a position held at year-end will be mark-to-market, and gains and losses will be ordinary rather than capital.
Special timing and character rules also apply to options that are part of a hedging transaction. With respect to the character of gain or loss on an acquired or written option that is identified as being part of a hedging transaction, the regulations provide that gain or loss on a short sale or option that is part of a hedging transaction is generally ordinary income or loss. In addition, if a transaction is identified as a hedging transaction under Treas. Reg. Section 1.1221.-2, the timing of gain and loss recognition will be governed under Tres. Reg. Section 1.446-4, which generally requires the matching of the timing of gain and loss recognition under a hedge with the item being hedged.
Non-resident person may be subject to withholding if they received certain types of US-source income. An applicable income tax treaty may override the general rule. Source-Based jurisdiction applies to fixed or determinable periodic amounts realized from US sources by no-resident foreign persons. Residence-based jurisdiction generally extends to citizens and residents, domestic corporations, and the foreign person doing business in the United States. The tax imposed on a source basis is a 30 per cent withholding tax on US-sources gross income. In contrast, the tax applied to the worldwide income of citizens, residents, and domestic corporations and to the income effectively connected with the US trade or business of non-resident foreign persons is a graduated-rate, self-assessed tax on net income.
There is substantial uncertainty as to the source of payments under option contracts. While Treasury is authorized to promulgate regulations governing the source of gain from the disposition of forwarding contracts, futures, options, and other financial products, no such regulations have been issued to date. Absent express statutory or regulatory guidance, general practice sources the gain on the disposition of an option contract according to the residence of the person receiving the gain. Thus, capital gain income recognized by a foreign recipient would be foreign-source gain and, as a result, not subject to tax in the United States unless the foreign holder is engaged in a US trade or business. If the gain is effectively connected with a US business or US real estate, a non-resident taxpayer will be subject to graduated tax rates under the residence-based sourcing rules.
Income tax treaties affect US taxation of derivative financial instruments only in the limited situation in which a derivative produces US-source income for a foreign person. In those situations, however, an applicable tax treaty can provide considerable protection to residents of a treaty country who do not have a US permanent establishment.