Character differences can also result if the option holder is a dealer, the option holder is a trader that has made an election under Section 475(f) or the option is held as part of an identified hedging transaction. Under these circumstances, gains and losses will generally be ordinary and not capital.
As mentioned above, there is substantial uncertainty as to the proper methodology for sourcing gains and losses recognized under option contracts. General practice sources gain based on the residence of the recipient; however, there is no express statutory or regulatory authority to support this position. Under this rule, if an option holder is a non-resident and not a dealer, income recognized with respect to the expiration, exercise, or sale of an option should be sourced in accordance with the residence of the holder. In this case, income should be foreign-source income and not subject to tax in the United States, unless the income is received in connection with a US trade or business.
III. OPTIONS SUBJECT TO THE SECTION 1256 MARK-TO-MARKET REGIME
Section 1256 contracts are subject to a special mark-to-market system of income and loss recognition. Section 1256 requires a taxpayer to recognize gain or loss from a Section 1256 contract as from the last day off here or his taxable year, by treating such contract as if it were sold at a price equal to its fair market value as from such date. In addition, a special character rule applies to treat any gain or loss with respect to a Section 1256 contract as 60 percent long-term capital gain or loss and 40 per cent as short term capital gain or loss, regardless of the taxpayer’s actual holding period with respect to the Section 1256 contract. Section 1256 contracts include “non-equity options” and any “dealer equity option”. Excluded from Section 1256 treatment are foreign currency transactions that qualify as a “988 hedging transactions”, “hedging transactions”, and securities subject to dealer mark-to-market rules under Section 475(a).
A non-equity option is any “listed option: that is not an “equity option”. A listed option is any option (other than a right to acquire stock from the issuer of the stock) that is traded on (or subject to the rules of) a qualified board or exchange. An equity option is any option to buy or sell stock or any option the value of which is determined directly or indirectly by reference to any stock (or groups of stocks) or stock index, except for certain indexes where (1) there is a designation by the Commodity Futures Trading Commission (referred to as the CFTC) of a contract market for a contract based on such group of stocks or stock index (i.e. a broad-based index) or (2) the IRS determines that the option meets the legal requirements for such a designation. For example, Standard and Poor’s 500 Index (referred to as the S&P 500) is a broad-based index, as compared to the Dow Jones Utilities Average Index, which is a narrow-based index.
Thus, for purposes of Section 1256, options that are traded in (or subject to the rule of) a qualified board or exchange, provide for cash-settlement, and are based on a stock index that has been characterized as a “broad-based” index, are likely to be Section 1256 contracts. A dealer equity option is, with respect to an “options dealer”, any listed option that is:
- an equity option;
- purchased or granted by such options dealer in the normal course of her or his activity of dealing in options; and
- listed on the qualified board or exchange on which such options dealer is registered.
The mark-to-market rules of Section 1256 explicitly provide that, in general, gain or loss from trading Section 1256 contracts is characterized as capital gain or loss, rather than ordinary gain or loss. These rules do not apply to any Section 1256 contracts that are part of a hedging transaction if any loss connected with the transaction would be characterized as ordinary. The determination of whether gain or loss would be ordinary is made without regard to whether the taxpayer is actively engaged in dealing or trading Section 1256 contracts.