NEW DEVELOPMENTS IN
EQUITY DERIVATIVES
William M. Paul
June 6, 2001
BACKGROUND
• Shad-Johnson Accord limited equity-related
futures contracts to futures on broad-based indexes • Commodity Futures Modernization Act of 2000
authorizes trading of “security futures,” including:
– Single stock futures
– Narrow-based index futures – Options on those futures
KEY DATES
• August 21, 2001 – Principal-to-Principal
Trading
• December 21, 2001 – Retail Trading
• December 21, 2003 – Trading in Options on
Stock Futures
REGULATORY FRAMEWORK
• Joint regulation by SEC/CFTC
• Product can trade on securities exchange,
commodities exchange or alternative
trading system
TAXES
• What model should apply?
– Futures model – Options model – Stock model
• Policy decision: treat single stock futures comparably to listed equity options
– Not like other futures contracts – Generally not § 1256 contracts – “Level playing field”
• 60/40 treatment limited to “dealers” in stock futures
NON-DEALER TAX TREATMENT
• Comparable to listed equity options
– Not treated as a commodities future, but as a security – Character
• Gain or loss from sale or exchange is capital if gain or loss on underlying would be capital. § 1234B.
• Gain or loss from cancellation, lapse, expiration or other
termination is capital if the securities future is a capital asset in hands of the taxpayer. § 1234A.
• Gain or loss from short security future will be short-term regardless of holding period
– Compare options: gain/loss on long call or long put can be long-term; gain/loss on short call or short put is short-term regardless of holding period
NON-DEALER TAX TREATMENT
• Holding Period:
– Because not treated as commodities future, holding period for long-term gain/loss is 12 months, not 6 months. See § 1222 (flush language)
– If long security future is physically settled, purchaser tacks holding period
• More favorable than “no tacking” rule applicable to options
NON-DEALER TAX TREATMENT
• Timing:
– No gain or loss on entering into stock futures contract
– No gain or loss to purchaser on exercise if physically settled
– Gain or loss to seller if physically settled, and to both parties if cash settled
ANTI-ABUSE RULES
• Short-Sale Rule of § 1233
– Long security future treated like long stock position – So if have long security future and enter short sale of
underlying, § 1233(b) will apply
– Because not a commodity future, the rule that commodity futures are not substantially identical if they call for delivery in different months does not apply
• Wash Sale Rule
– Expanded to include options or contracts to acquire stock that can be settled in cash (or property other than the underlying stock)
• Straddle Rules
DEALER ISSUES
• Who should be treated as stock futures dealer?
– Must perform functions similar to options market-maker
– Making two-sided markets v. providing liquidity
• Headed Toward Very Odd System
– Dealers governed by § 1256 – mark-to-market, 60/40 treatment
– Active traders will likely elect 475 to avoid straddle and wash sale headaches
WILL THE PRODUCT
SUCCEED?
• Constructive Sale rules limit utility as hedge
of appreciated stock
• Push for the product has come from the
supply side, not the demand side
• Lots of interest from the exchanges
– CME, CBT and CBOE have announced joint venture
BACKGROUND
• Before CFMA, equity-related futures limited to broad-based indexes (e.g., S&P 500)
• These futures, like all other futures before CFMA, are § 1256 contracts
– Mark to market, 60/40 treatment
• Options on broad-based indexes are classified as “nonequity options” and are also § 1256 contracts
– Tax parity with competing futures contracts
– Options on narrow-based indexes not § 1256 contracts
• Definition of broad-based index for options tied to whether CFTC had authorized a futures contract on the index or if the requirements for such
CFMA
• CFMA now authorizes trading in futures on narrow-based indexes
• CFMA also includes an objective definition of “narrow-based index”
– E.g., 9 or fewer stocks
• Futures on narrow-based indexes are not § 1256 contracts,while futures on broad-based indexes remain § 1256 contracts
– Same rule for index options traded on exchange
• Tax rules for determining if index option is a § 1256 contract can no longer look to whether CFTC has
NEW TAX DEFINITION
• § 1256(g)(6) incorporates definition of narrow-based index enacted in CFMA
– § 3(a)(55) of Securities Exchange Act of 1934
• This new definition became effective December 21, 2000
• Immediate impact on tax status of certain index options
– Some index options that were narrow-based under Shad Johnson became broad-based over night
UNCERTAINTIES AND
HEADACHES
• Status of index can change as a result of change in market capitalization or average trading volume of component stocks
– More of a problem for options than futures
• Unclear how IRS will administer from perspective of § 1256
• Application of Reg. § 1.246-5(c) where individual stock offset by “broad-based index” consisting of fewer than 20 stocks
QUALIFIED COVERED
CALLS
Qualified Covered Calls
• What is a Qualified Covered Call (“QCC”)?
– Written call option on stock held or acquired – Traded on exchange
– At least 30-day term
Qualified Covered Calls
• Benefits of QCC Status
– Not subject to general straddle rules of Section 1092
– Subject to modified straddle rules
• Year-end rule
• If in-the-money when written:
– Suspend holding period in stock
Qualified Covered Calls
• Proposed QCC Regulations – Expanders
– Extend QCC status to FLEX options – Prop. Reg. § 1.1092(c)-1
• Deep-in-the-money determination based on standardized strike price intervals
– Extend QCC treatment to OTC options – Prop. Reg. § 1.1092(c)-3
• Tight definition of qualifying options
– “The only payments permitted with respect to the option are a single fixed premium paid not later than 5 business days after the day on which the option is granted, and a single fixed strike price stated as a dollar amount that is payable at (or within 5 business
Qualified Covered Calls
• Proposed QCC Regulations – Tightener
– No QCC status if option has term longer than one year
• Applies to LEAPS, FLEX and OTC options
• Larger premiums possible even if not deep-in-the-money
Qualified Covered Calls
• Example 1
– Stock price $50, volatility 50% – Premium for at-the-money call
• 90-day option = $4.80 • 2-year option = $14.56
• Example 2
– Stock price = $50, volatility = 50%
– Premium for 6-month, $45 option = $9.55 – Premium for 1½ year, $60 option = $9.07
Qualified Covered Calls
• Over-reaction?
– Additional risks of using long-dated calls
• Option price may move independently of stock price • Greater risk of loss on stock
• Possible modifications to limit potential for
increased risk reduction
– Limit premium to specified percentage of stock price
PROPOSED REGULATIONS
UNDER SECTIONS 263(g)
BACKGROUND
• Section 1092 defers “losses” to extent of unrealized gains in offsetting positions with respect to actively traded
personal property
– Reg. § 1.1092(b)-5T(d) defines “loss” as a loss under § 165(a) – Does not apply to interest expense or expenses deductible under
§§ 162 or 212
• Section 263(g) requires capitalization of interest and
carrying charges properly allocable to personal property that is part of a straddle
– Includes interest on indebtedness incurred or continued to purchase or carry personal property
• Similar language in § 265(a)(2), Rev. Proc. 72-18
THE PROBLEM
(from Treasury’s Perspective)
• Taxpayers began issuing debt-like instruments
that (may) exploit gaps in coverage of existing
law
• DECS
– Interest-bearing deposit plus “kinky” forward on portfolio stock held by issuer
– Debt used for general corporate purposes, not to purchase or carry the portfolio stock
THE PROBLEM
(from Treasury’s Perspective)
• PHONES
– Contingent payment debt instrument with embedded position in portfolio stock held by issuer
– Accrue OID based on comparable yield, pay only small coupon
– Issuer (arguably) does not have “position in personal property” with respect to its own debt
– OID accruals not losses under § 165
– Debt used for general corporate purposes
• Uncertainty over treatment of payments on equity swap offset by stock
THE (PROPOSED) SOLUTION
• Prop. Reg. § 1.1092(d)-1(d): Issuer has position
in personal property if one or more payments
under the debt instrument are linked to the value
of personal property (or a position with respect to
personal property)
• Proposed regulations under 263(g) would require
capitalization of periodic payments on
instruments such as DECS, PHONES and equity
swaps
PROBLEMS WITH THE
(PROPOSED) SOLUTION
• § 263(g) approach technically cumbersome
– § 263(g) linked to “personal property” that is part of a straddle
– § 1092 applies to positions with respect to actively traded personal property
– IRS felt constrained to say that debt (PHONES) is not
personal property of the issuer, even though it is a position under § 1092
• Therefore cannot allocate interest cost to the PHONES
– Leads to strained reading of “carry” and Byzantine logic to get to result IRS wants
