B. Asian index option and Asian-end index option
The holder of an Asian index option is entitled to receive a cash payment determined with reference to the percentage difference between the value of a certain index at the inception of the option contract and the average of the value of the index over a certain period of time. An end-end index option. In general, the option is tied to the value of the underlying index for a period of time, and then the values of the index are averaged for the remaining part of the contractual period.
Assuming that neither conuterparty is a dealer, the premium paid to enter into either of these options 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 either the option is 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 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 if 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, that 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 option are Section 1256 contracts. If these options are exchange traded and based on a broad-based stock index, the options will likely be subject to the mark-to-market rules of Sections 1256. As a result, the holder will have 60 per cent long-term and 40 per cent 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.