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Firm Proposes Safe Harbor to Address Qualified Covered Call Exception to Straddle Rules

SEP. 24, 2013

Firm Proposes Safe Harbor to Address Qualified Covered Call Exception to Straddle Rules

DATED SEP. 24, 2013
DOCUMENT ATTRIBUTES
  • Authors
    Kramer, Andrea S.
    Pomierski, William R.
  • Institutional Authors
    McDermott, Will & Emery
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2013-24435
  • Tax Analysts Electronic Citation
    2013 TNT 205-15

 

September 24, 2013

 

 

Mr. Karl Walli

 

Senior Counsel -- Financial Products

 

Department of Treasury

 

1500 Pennsylvania Avenue, NW

 

Washington, D.C. 20220

 

 

Ms. Pamela Lew

 

Office of Associate Chief Counsel

 

Financial Institutions and Products

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington DC 20224

 

 

Dear Mr. Walli and Ms. Lew:

We are following up on our prior discussions regarding the qualified covered call ("QCC") exception to the straddle rules. As we discuss in the remainder of this letter, we are respectfully requesting that the Treasury Department issue guidance under Code § 1092(c)(4)(H) regarding the determination of the "applicable stock price" for a QCC in the case of "buy-write" covered calls, where an investor buys stock and simultaneously writes a call option against the newly purchased stock.

In particular, we are requesting guidance in the form of a safe-harbor that would allow a taxpayer that acquires shares in connection with the granting of a covered call option to treat the purchase price of such newly acquired shares as the "applicable stock price" for purposes of Code § 1092(c)(4)(G), provided the taxpayer satisfies certain identification and recordkeeping requirements. Such a safe-harbor would be consistent with the original purpose behind the straddle exception for QCCs, which recognizes that QCCs are undertaken primarily to enhance the investment return on stock and not to reduce the holder's risk of loss.

BACKGROUND

Code § 1092 defines a "straddle" as two or more offsetting positions in actively traded personal property. A taxpayer holds offsetting positions in personal property if there is a substantial diminution in the taxpayer's risk of loss from holding any position with respect to actively traded personal property by reason of holding one or more other positions with respect to actively traded personal property.1

When originally enacted in 1981, the straddle rules excluded stock from the definition of personal property, which meant that stock and offsetting positions in stock were exempt from all of the straddle rules. When the straddle rules were amended in 1984, certain -- but not all -- stock positions were brought into the straddle rules. These 1984 amendments included, however, an exception for stock offset by a QCC, as defined in Code § 1092(c)(4). Congress' intent in adopting the QCC exception, and the requirements of Code § 1092(c)(4), are described in greater detail below.

In 2004, Congress further narrowed the stock exception effective for positions established on or after October 22, 2004.2 Since 2004, stock can be part of a tax straddle if at least one of the offsetting positions is: (1) a position with respect to such stock; (2) a position with respect to "substantially similar or related property" (as defined in Treas. Reg. § 1.246-5); or (3) stock in a corporation formed or availed of to take positions in personal property which offset positions taken by any shareholder. Notwithstanding these 2004 amendments, QCCs continue to be exempt from the straddle rules if the requirements of Code § 1092(c)(4) are met.

1. Qualified Covered Calls

When the straddle rules were expanded in 1984 to include certain stock positions, Congress recognized that covered call writing should be exempt because such transactions are generally not entered into in order to reduce the taxpayer's risk of loss with respect to the underlying stock. Instead, such transactions are generally entered into in order to enhance the taxpayer's yield on stock. Accordingly, Congress provided that in certain circumstances, a taxpayer who writes a call option with respect to stock that the taxpayer either already owns or that the taxpayer acquires in connection with the granting of the option, is eligible for an exception from the straddle rules. In explaining the QCC exception, Congress stated that:

 

One widely used investment strategy that would be affected by the extension of the straddle rules to stock options involves writing call options on stock owned by the taxpayer. The committee believes that it may be appropriate to exempt these transactions where they are undertaken primarily to enhance the taxpayer's investment return on the stock and not to reduce the taxpayer's risk of loss on the stock. . . . The granting of a covered call option does not substantially reduce a taxpayer's risk of loss with respect to the underlying stock unless the option is deep-in-the-money. The bill contemplates that taxpayers can continue to write at-the-money and non-deep-in-the-money covered calls, without running afoul of the straddle rules.3

 

(Emphasis added.) Accordingly, subject to the "in-the-money" option rules of Code § 1092(f), which are discussed below, a QCC consisting of an option granted by the taxpayer to purchase either stock held by the taxpayer or stock acquired by the taxpayer in connection with the granting of the option, is exempt from the straddle rules if the requirements of Code § 1092(c)(4) are met.

QCCs are also exempt from the dividend holding period suspension rules that apply for purposes of determining whether a dividend is eligible to be treated as a qualified divided under Code § 1(h)(11)4 or is eligible for the corporate dividends received deduction under Code §§ 243, 244 and 245.5 To be treated as a qualified dividend or to be eligible for a dividends received deduction, the taxpayer must satisfy the stock holding period requirements under Code § 246(c). For these purposes, a taxpayer's holding period for stock is reduced during any period in which the taxpayer has diminished his risk of loss by reason of one of three situations. First, the taxpayer enters into an option to sell, is under a contractual obligation to sell, or has made (and not closed) a short sale of, substantially identical stock or securities. Second, the taxpayer is the grantor of an option to buy substantially identical stock or securities. Or third, the taxpayer diminishes his risk of loss on his stock position by holding one or more other positions with respect to "substantially similar or related property."6 An exception to these dividend holding period suspension rules is provided, however, for stock offset by a QCC, provided that the option is not subject to the "in-the-money" rules of Code § 1092(f).7 This means that a taxpayer who enters into a QCC that is not in-the-money at the time of grant does not interrupt its stock holding period under Code § 246(c) by reason of the granting of such option.

2. QCC Requirements

A QCC is a written (short) call option that meets six requirements.8 First, the option cannot be part of a larger straddle.9 Second, the option must be written by a taxpayer who either holds the underlying stock or purchased the stock in connection with the granting of the option.10 Third, the option must be traded on a qualified securities exchange, or must meet the rules set out in Treasury regulations for qualifying over-the-counter options.11 Fourth, the option must be granted more than 30 days prior to its expiration.12 Fifth, the option must have a strike price higher than the lowest "qualified benchmark" (that is, the option cannot be "deep-in-the-money," as defined).13 And sixth, the option cannot be granted by a dealer in connection with his activity of dealing in options.14

The fifth requirement means that a covered call option can be in-the-money at the time it is granted and still qualify for the QCC exception as long as it is not deep-in-the-money.

3. Deep-in-the-Money Determination

A "deep-in-the-money" option is defined in Code § 1092(c)(4) as an option with a strike (exercise) price lower than the lowest qualified bench mark. Except as otherwise provided for in special enumerated situations,15 the "lowest qualified bench mark" means the highest available strike price that is less than the applicable stock price. The "applicable stock price" is defined as the closing price of the optioned stock on the most recent day on which such stock was traded prior to the date on which the option was granted.16 If, however, the opening price of the optioned stock on the day the option is granted is greater than 110 percent of the closing price on the last previous trading date, the opening price of the stock is treated as the applicable stock price.17

These mechanical applicable stock price rules apply without regard to the actual market price of the underlying shares at the time the call option is granted.

4. Code § 1092(f)

Notwithstanding the general straddle rule exception for QCCs, if an option is in-the-money at the time of grant (but not deep-in-the-money), there will be certain consequences under Code § 1092(f) and under the dividend holding period rules of Code § 246(c)(4). Specifically, if a written call option that otherwise meets the definition of a QCC under Code § 1092(c)(4) is in-the-money at the time of grant, capital losses the taxpayer subsequently realizes with respect to the option are treated as long-term if, at the time the loss is realized, the underlying stock had been held for the long-term capital gains holding period.18 In addition, the holding period of the stock that is offset by the qualified covered call option (for long-term capital gains purposes) does not include the period during which the call option is outstanding.19 And, third, the option suspends the holding period of the stock for purposes of Code § 246(c).20

5. Regulatory Authority

Congress, in enacting the QCC exception, granted broad regulatory authority to Treasury to "prescribe such regulations as may be necessary or appropriate to carry out the purposes of the QCC exception.21 Such regulations "may include modifications to the provisions of this paragraph which are appropriate to take account of changes in the practices of option exchanges or to prevent the use of options for tax avoidance purposes." The 1984 House Report accompanying enactment of the QCC exception states that "the Secretary is granted broad regulatory authority to modify the provisions of the bill (e.g., to take account of changes in the practices of options exchanges or to prevent tax avoidance). The committee contemplates that the Secretary will prescribe rules for the determination of the applicable strike price if the options exchanges modify their benchmarks."

The Treasury has exercised its authority to modify the QCC rules on two prior occasions, extending QCC treatment to over-the-counter options and to certain equity options with flexible terms.22

REQUESTED GUIDANCE

As described above, Congress established the QCC exception from the straddle rules because it believed that, in certain circumstances, a taxpayer who grants a call option with respect to stock that the taxpayer already owns or acquires in connection with granting the option, does not substantially reduce the risk of loss with respect to the optioned stock. Congress established a "deep-in-the-money" standard to determine whether a written call option should be viewed as substantially reducing a taxpayer's risk of loss with respect to the optioned stock and, therefore, should be subject to the straddle loss deferral rules. In addition, while a QCC that is not deep-in-the-money is not a straddle, QCC's that are in-the-money at the time of grant are subject to the long-term capital loss and stock holding period suspension rules of Code § 1092(f), as well as the dividend holding period suspension rules of Code § 246(c)(4).

For purposes of determining whether a covered call is either deep-in-the-money or simply in-the-money, the option exercise price is compared to the applicable stock price. Code § 1092(c)(4)(G) defines the applicable stock price as the closing price of the relevant stock on the most recent day preceding the date on which the option is granted. However, if the opening price of such stock on the date on which the option is granted is greater than 110 percent of the closing price on the immediately preceding trading day, the applicable stock price is such opening price. Unfortunately, there appears to be no legislative history surrounding the adoption of the QCC exception that sheds any light on Congress' reasoning in defining the applicable stock price for this purpose.

As recognized by Code § 1092(c)(4) itself, covered call writing strategies can relate to either shares that are already owned or to shares that are newly acquired by the taxpayer in connection with the granting of the option. In the latter case, an investor buys stock and simultaneously writes a call option against the newly purchased stock. This strategy provides the investor with additional income in the form of the option premium, which compensates the investor for giving up the opportunity to benefit from potential increases in the value of the newly acquired stock above the exercise price of the written option.

Congress clearly adopted the QCC rules to permit covered call option writing as a strategy allowing taxpayers to enhance the yield on their stock investments without subjecting them to straddle tax consequences. Consistent with this intent, we are respectfully requesting that guidance be issued in the form of a safe-harbor that allows a taxpayer who acquires shares in connection with the granting of a covered call option to identify such newly purchased shares as part of the option and, in that case, to treat the purchase price for such shares as the "applicable stock price." We are requesting that the applicable stock price be determined by reference to the purchase price of such newly acquired stock for purposes of determining whether such covered call option satisfies the requirements of Code § 1092(c)(4) (i.e., is not deep-in-the-money), as well as for purposes of determining whether the QCC is in-the-money for purposes of Code §§ 1092(f) and 246(c)(4). This safe-harbor, as we propose it, would require the taxpayer to do two things. First, the taxpayer would need to identify the newly purchased shares and the written call option, together, before the close of business on the day the shares are acquired and the option is written. And second, the taxpayer would need to maintain adequate tax books and records to be able to show that if the call option is physically-settled, the gain or loss resulting from such physical settlement will be calculated utilizing the tax basis and holding period of the shares originally identified as being part of such covered call option transaction.

This safe harbor is consistent with Congress' purpose behind the QCC exception from the straddle rules. It would allow a taxpayer to identify shares that are acquired in connection with the granting of a covered call and further allow for the purchase price of such identified shares to be treated as the "applicable stock price" for purposes of Code § 1092(c)(4)(G). This proposal is consistent with Congress' purpose for providing the QCC exception because Congress recognized that QCCs are undertaken primarily to enhance the investment return on stock and not to reduce risk of loss. We are not aware of any abuses that could arise from providing such a safe-harbor for determining the applicable stock price provided the taxpayer satisfies the same-day identification requirements and maintains sufficient tax books and records to show that if the call option is physically-settled, the gain or loss resulting from such option is calculated utilizing the tax basis and holding period of the shares originally identified as being part of such covered call option transaction.

We hope the Treasury adopts this safe-harbor. It would be an important amendment to the QCC exemption by rationalizing the definition of applicable stock price.

Sincerely,

 

 

Andrea S. Kramer

 

312.984.6480

 

akramer@mwe.com

 

 

William R. Pomierski

 

312.984.7531

 

wpomierski@mwe.com

 

 

McDermott Will & Emery

 

Chicago, IL

 

FOOTNOTES

 

 

1 Code § 1092(c)(2).

2 American Jobs Creation Act of 2004, P.L. 108-357 (the "2004 Jobs Act").

3 H.R. Rep. No. 432, 98th Cong., 2d Sess. at 1266-68 (1983). See also General Explanation of the Tax Reform Act of 1984 (H.R. 4170, 98th Cong.; Public Law 98-369), Prepared by the Staff of the Joint Committee on Taxation (December 31, 1984) ("The granting of a covered call option does not substantially reduce a taxpayer's risk of loss with respect to the underlying stock unless the option is deep-in-the-money. The bill contemplates the taxpayers can continue to write at-the-money and non-deep-in-the-money covered calls, without running afoul of the straddle rules.").

4 "Qualified dividend income" is taxed to an individual taxpayer at the same rate as net capital gain under Code § 1(h)(11). Qualified dividend income does not include dividends received by a taxpayer that has not met the statutory holding period requirements of Code § 246(c), as modified by Code § 1(h)(11)(B)(iii).

5 Corporate taxpayers are generally eligible for a dividends received deduction under Code §§ 243, 244 and 245. However, no deduction is allowed under these dividends received deduction provisions to the extent that a corporate taxpayer has not met the statutory holding period requirements set out in Code § 246(c).

6See Code § 246(c)(4) and Treas. Reg. § 1.246-5.

7 Code § 246(c)(4) provides that "The preceding sentence shall not apply in the case of any qualified covered call (as defined in section 1092(c)(4) but without regard to the requirement that gain or loss with respect to the option not be ordinary income or loss), other than a qualified covered call option to which section 1092(f) applies."

8 Code § 1092(c)(4).

9 Code § 1092(c)(4)(A)(ii).

10See Code § 1092(c)(4)(B).

11See Code § 1092(c)(4)(B)(i) and Treas. Reg. § 1.1092(c)-3.

12See Code § 1092(c)(4)(B)(ii).

13See Code §§ 1092(c)(4)(B)(iii) and 1092(c)(4)(C). The term "qualified benchmark" is determined by comparing the highest available strike price of such options with the stock's recent fair market value and is a function of the option's time to maturity.

14 Code § 1092(c)(4)(B)(iv).

15 Special rules for determining the lowest qualified benchmark are provided for (1) options which have a period of more than 50 days and a strike price in excess of $50/share, (2) for options where the "applicable stock price" is $25 or less and (3) for options where the "applicable stock price" is $150 or less.

16 Code § 1092(c)(4)(G)(i). In the case of options with flexible terms, Treas. Reg. § 1.1092(c)-4 provides for an "adjustment factor" that takes the length of an option into account for options with terms greater than 1 year.

17 Code § 1092(c)(4)(G)(ii).

18 Code § 1092(f)(1).

19 Code § 1092(f)(2).

20 Code § 246(c)(4).

21 Code § 1092(c)(4)(H).

22See Treas. Reg. §§ 1.1092(c)-1 through -4. In exercising its regulatory authority under Code § 1092(c)(4)(H), the Treasury described the QCC exception as follows:

 

The special treatment for qualified covered calls was created because Congress believed that, in certain limited circumstances, a taxpayer who grants a call option does not substantially reduce his or her risk of loss with respect to the optioned stock. Congress established a mechanical test to determine whether a written call option could substantially reduce a taxpayer s risk of loss and, therefore, should be subject to treatment as one leg of a straddle. In order to be classified as a qualified covered call under this test, a call option must, among other things, be exchange-traded and not be deep in the money.

 

See Preamble to Prop. Reg. § 1.1092(c)-1, 63 F.R. 34616-34618 TD 8866 (98 TNT 127-26 98 TNT 127-26: IRS Proposed Regulations (PRO)).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Kramer, Andrea S.
    Pomierski, William R.
  • Institutional Authors
    McDermott, Will & Emery
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2013-24435
  • Tax Analysts Electronic Citation
    2013 TNT 205-15
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