Option on a Taxpayer’s Own Stock
Options on a taxpayer’s own stock are subject to special statutory rules. If a taxpayer grants an option to another party to purchase the taxpayer grants an option to another party to purchase the taxpayer’s stock and the option is purchased back by the taxpayer or lapses, the taxpayer has no gain or loss. There should also be no tax consequences if the option is cash-settled on the exercise date. Similarly, if the taxpayer grants an option allowing the purchaser to put the taxpayer’s stock back to the taxpayer, there should be no tax consequence on the repurchase or lapse of the option, or its cash settlement, although this latter rule is implied rather than explicitly provided in the statute.
Tax practitioners have assumed that if a taxpayer purchases a put or call option on its own stock, there should be no tax consequence upon lapse, or exercise of such an option, whether physically or by cash settlement, although authority for the conclusion is unclear. It has been suggested that because of the lack of authority on this point, taxpayers could argue that gains resulting from transactions relating to a taxpayer’s purchase of options on its own stock should be sheltered from taxation, while losses would be deductible, although this result clearly violates the spirit of the statute and would undoubtedly be challenged.
Wash Sales Rules
The Internal Revenue Code has had rules to prevent the recognition of tax losses using closely timed sales and repurchases of stock since 1921. However, in 1988, Congress introduced the same rule for the sale and repurchase of stock options. Section 1091 now provides that no loss is allowed from the sale of stock, or contracts or options to acquire or sell the stock if, within a period beginning 30 days before the sale, and ending 30 days after the sale, the taxpayer has acquired, or entered into a contract to acquire, substantially identical stock or contracts or options to acquire or sell stock.
There are some questions about what constitutes “substantially identical securities” in the context of option. One prominent commentator, adapting the seminal Black-Scholes options model to the tax law, suggest that options with maturity dates and/or strike prices that are different by more than a deminimis amount should not be considered substantially identical, although he cites a contrary GCM.
Character
Gain and loss associated with the sale, disposition, lapse, exercise, etc., of an option have the same character of the property which is the subject of the option. Therefore, if the equity interest to which the option relates is a capital asset in the taxpayer’s hands, the gain or loss from the options is cash or physically settled. If the option is an S1256 contract, i.e., a broad-based stock index option that fits within the definition of “nonequity options,” or a dealer equity options, its character will be 60% long term capital gain or loss and 40% short term capital gain or loss, irrespective of how long it has been held by the taxpayer, or what the character of the option or underlying property would otherwise be in the taxpayer’s hands. If the option is non-investment property in the hand of a securities dealer, or a hedge of ordinary property held by the dealer, gain and loss with respect to the option will be ordinary.
Withholding
There is no authority as to whether income received by a foreign person upon sales or cash settlement of an option, constitutes FDAP and is, therefore, subject to withholding tax. Moreover, there are no specific rules relating to the sourcing of income realized with respect to an option. The U.S treasury has authority to issues sourcing rules for options, forwards, and futures contracts, but this authority has not been exercised. Therefore, income realized under options, forwards and futures contracts is sourced under the general sourcing provision of the Internal Revenue Code. Under S865(a), income from the sale of personal property is sourced according to the residence of the taxpayer. In order for S856(a) to apply, the income must result from the sale of personal property. Under general principles, income from the cash settlement of an option or forward is not considered income from the sale of property. However, an argument could be made, based on an interpretation of the newly amended S1224A of the code, that to the extent that the option is a capital asset in the taxpayer’s hands, income from the expiration, lapse, or other termination of the option is income from the sale of such property. To the extent the option is an ordinary asset in the taxpayer’s hands, it is necessary to determine whether the income from the option is FDAP. There is, unfortunately, no clear guidance on this point. For many taxpayers, the question of withholding is resolved by Treaty rather than domestic law. Under the 1996 U.S Model Treaty, income from financial instruments not specifically covered by another Treaty article will be covered by Article 21 “Other Income” and will be subject to income tax only in the country of residence of the recipient. For taxpayers whose option gains or losses are generated by a business in dealing in such instruments, the income or loss may be covered by the “Business Profits” articles of the Model or other relevant treaty.
Tax Ownership
If a taxpayer purchases a call option with respect to stock, it will not be considered to own that stock until the option is exercised, and the holding period on the stock will not begin to run until that date. Similarly, the purchaser of a put option will not be considered to have sold the property until the option is exercised. However, if it is virtually certain that the option will be exercised, the option will be treated as contracting to sell/buy the stock on the strike date for the sum of the premium and the strike price
Timing
A taxpayer entering into a forward contract (i.e., a non-exchange traded contract) to buy or sell stock does not have to recognize gain or loss on the contract until it is terminated, assigned, offset, etc. i.e, there is no requirement to mark the contract to market or otherwise accrue the gain or loss until the contract is disposed of in some way.
If the taxpayer delivers the stock under the forward contract, it will recognize gain and loss at that time, in an amount equal to the difference between the amount received under the contract, and its basis in the stock. If that taxpayer purchases stock under the forward contract, the amount paid for the stock will become its basis in the asset, and no gain or loss needs to be recognized at the time that it accepts delivery of stock. If the taxpayer cash-settles the contract, either on or prior to the settlement date provided under the contract, gain and loss will be recognized at the time of the cash settlement. A taxpayer could offset its position under the forward contract by entering into an equal but opposite forward contract with another party. Under the common law, it is uncertain whether this kind of transaction would constitute a true termination giving rise to immediately recognizable gain or loss, because of the potentially different counter-party risks under the two forward contacts. Under the new constructive sales rules of 1259, entering into suck an equal and offsetting contract would almost certainly constitute a constructive sale, if the original forward contract were an “appreciated financial position.” Consequently, the taxpayer would be required to recognize taxable gain in the year of offset. To the extent that a taxpayer is a dealer in securities, it may be required to mark the forward contact to market, unless the contract is held by the taxpayer as an investment, or as a hedge of an investment.
Character
A forward contract on a stock is an executory contract. In general, in order to obtain capital gain or loss on a transaction, a taxpayer must have a sale or exchange of a capital asset. However, under a special statutory rule, gain or loss attributable to cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hand of a taxpayer, is treated as gain or loss from the sale of a capital asset. Except for forwarding contracts entered into by dealer in stock, most terminations and other disposals of forwarding contracts on stocks will fit within the latter rule and will generate capital gain or loss for taxpayers.
Withholding
As discussed, in order to determine whether income to a non-U.S person is subject to withholding tax, it has to be decided whether the income is sourced within or outside the U.S. Under S865(a) income from the sale of personal property is sourced according to the residence of the taxpayer. In order for S865(a) to apply, the income must result from the sale of personal property. Under general principles, income from the cash settlement of a forward contract is not considered income from the sale of a property. Under general principles, income from the cash settlement of a forward contract is no considered income from the sale of property. However, an argument could be to the extent that the forward contract is a capital asset in the taxpayer’s hands, income attributable to the cancellation, lapse, or other termination of the forward is income from the sale of such property. To the extent that the forward is an ordinary asset in the taxpayer’s hands, it is necessary to determine whether the income attributable to the settlement of the forward is FDAP. It could be argued the income received from a cash-settled forward contract is FDAP because there would be a high ratio of net income to gross income given the lack of significant deduction attributable to the income received. However, there is no authority on this point, and as for the discussion on the options, many of these issues will be resolved under the particular income tax treaty that governs the taxation of the parties to the transactions.
Tax Ownership: Entering into a forward contract of publicly traded property will not immediately transfer title to that property, since the legal title is necessary in order to deal with the property in the future. It generally will not transfer tax ownership, either.
Futures Contracts: Timing
Since there are no futures contracts on individual stocks in the U.S., the only relevant equity futures are index futures contracts, i.e., contracts in which one party pay and one party receives cash based on the change in the value of an index based on the prices of a portfolio of stocks. All such futures contracts are S1256 contracts. This means that they would have to be marked to market at year-end, and after various other termination events, and gain or loss would be taken into account at the time, as described above for options.
Character: All gain on S1256 contracts receive the same characterization, i.e., 60% long term capital gain and 40% short-term capital gain
Withholding: The discussion about forwarding contracts is equally applicable to futures contracts.
Tax Ownerships: The discussion above for forward contracts is equally applicable to futures contracts.
Swaps
Timing
Special rules have been promulgated by the Treasury to determine the correct timing for taking into account income and loss from a “notional principals contract.” Although the definition of “notional principal contract” is fairly broad, there are certain types of contracts which traders call “swaps” that would not fall within this definition. When assessing the tax is important to determine first whether it is a notional principal contract, and if not, what other characterization is appropriate.
A notional principal contract is defined in regulations as a financial instrument that provides for payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or promise to pay similar amounts. Equity swaps are explicitly listed as intended to be included in this definition. Several elements of this definition deserve further discussion: (1) a national principal contract only requires one party to make regular payments. As long as the other party makes some promise, or transfers other good consideration, there is no need for both parties to make regular payments. This sometimes occurs where one party agrees to make regular payments and there is a single payment between the parties at termination representing the appreciation/depreciation on an underlying stock. (2) A specified index can be a rate, price, or amount that is constant throughout the life of the contract or changes from period to period. It can also be an index that is based on current, objectively determinable financial information that is not within the center of any of the parties to the contract and is not unique to one of the parties’ circumstances (e.g., one of the party’s dividends, profits or the value of its stock.) (3) A notional principal amount is any specified amount of money or property that, when multiplied by a specified index, measured a part;y rights and obligation under the contract, but is not borrowed or loaned between the parties as part of the contract. The notional amount can vary over the term of the contract, provided that it is set in advance or varies based on objective financial information.
Most equity swaps will fall under this definition. However, certain types of swaps will not. For example, a contract with a notional principal of $1 million, in which one party receives, at the end of two years, the total return of the TOPIX (broad-based Japanese stock index) and pays the total return of a narrow basket of fifty Japanese stocks (Nifty-fifty). Since there is no “payment of amounts by one party to another at specified intervals,” the contract is no a notional principal contract. Although not completely clear, such a contract might be treated as an executory contract, with grains and losses taken into account on a realization basis.
Payments under notional principal contracts are taken into income under three different regimes, depending on whether they are “periodic” payments, “nonperiodic” payments, or “termination” payments. Periodic payments are payable at intervals of one year or less during the entire term of the contract, is based on a specified index and on a single notional principal amount or a notional principal amount that varies over the term of the contract in the same proportion as the national amount that measures the other party’s payments. Taxpayers are required to recognize the daily portion of a periodic payment for the taxable year to which that portion relates. This means that the total periodic payment due by each party is needed, they divided by the number of days in the payment period and then multiplied by the num.
The general rule is that income from a notional principal contract is sourced according to the residence of the recipient of the income. Therefore, if a U.S person makes a net payment to a foreign person under the swap, the payment will be sourced outside the U.S and will attract no withholding tax. However, if the income will be U.S source. If the foreign person makes a net payment to the U.S counter-party, the payment will generally be U.S sources.
Tax Ownership
There are many types of equity swaps on the market, and parties make various arrangements as to the types of periodic and final payments that are agreed to be made. It is common to see one party paying dividends periodically, and any appreciation in the value of the stock at termination, and the other party making an interest-like payment periodically, and making the counterparty whole for deprecation in the value of the stock at termination. In economic terms, this looks very much like a sale of the stock, since one party passes onto the other all the benefits of stock ownership and is insured against any detriments. However, even if the party paying the dividends and appreciation owned the stock which is the subject of the swap, if it retains the following rights with respects to the stock, it will probably still be considered the tax owner of the stock: the ability to sell, or otherwise deal with and use the shares; obtain information from the company; vote the shares; receive distributions upon liquidation; and receive dividends from the company.