Practitioners are Concerned About Proposed Regulations on Exempt Qualified Covered Call Options, Interest and Expense Capitalization

By Robert Gordon and Mark Fichtenbaum
Twenty-First Securities Corporation

Reprinted with permission from Derivatives Report, Copyright © 2001, Warren, Gorham & Lamont, Park Square Building, 31 St. James Avenue, Boston, MA 02116-4112. 1-800-950-1216.

Proposed regulations under Section 1092 would help investors, but a second set of proposals under Section 263 would hurt. Also, a recent Field Service Advice raises a red flag for investors entering into prepaid variable forward contracts involving appreciated securities.

Update: Under the American Jobs Creation Act of 2004, writing in-the-money calls suspends the holding period required to capture dividends or the DRD. See Tougher New Rules For Hedging Dividends.

Proposed regulations under Section 1092, issued earlier this year, would have an impact on investors who use options to hedge appreciated stock positions.¹  A second set of proposed regulations under Section 263, released at the same time, targets investors who borrow against hedged positions (whether hedged with options, or otherwise).²  This second set of proposed regulations also deals with investors who have either issued contingent debt or hedged an asset with a notional principal contract.  As discussed below, these latter regulations appear to go beyond the scope of the Code section under which they were promulgated. The issues they attempt to address would probably have been handled in a more cogent manner if the regulations had been issued under other Code sections.³

Also recently released is a December 2000 Field Service Advice Memorandum, FSA 200111011. While the FSA reaches questionable conclusions, it nonetheless may cause concern for investors who have entered into prepaid variable forward contracts to hedge a position in an appreciated security.

QCC EXCEPTION EXPANDED

The first set of proposed regulations deals with the definition of a qualified covered call (QCC). If a stock position is hedged by writing a call, a straddle will exist under the general rules of Section 1092.  However, if the call is a QCC, the stock and option will not be treated as a straddle. For a call to be a QCC under current law, it must (1) be traded on a national securities exchange, (2) be granted more than 30 days before the day the option expires, (3) not be a "deep in the money" option, and (4) not be granted by an options dealer. Under current law, therefore, any listed option that is "out of the money," with more than 30 days until expiration, and not written by a dealer, should meet the definition of a QCC.

Under Section 1092(c)(4)(H), Treasury is authorized to issue regulations to modify the QCC rules to take into account changes in the practices of option exchanges. At the time the QCC exception was enacted, options available on the national securities exchanges had a term of nine months or less. Since then, the exchanges began offering both options with standardized terms (LEAP options) and with flexible terms (Equity Flex options) that extend beyond one year.

The proposed regulations make clear that listed options with flexible terms are eligible for QCC treatment. In addition, if there are listed options outstanding on a stock, certain over-the-counter (OTC) options may also be treated as QCCs.⁴

While the IRS has expanded the definition of a QCC to include OTC options, it also has restricted the definition. The regulations would deny QCC treatment to those calls with more than one year to maturity.

If enacted in their present form, these regulations would have a major impact on investors who hedge stocks by selling calls on shares they own.⁵ While the proposed regulations would allow these investors to now use OTC options to hedge their stock, the term of all the hedging transactions could not exceed one year.

Most investors who hedge appreciated stock positions through the use of collars⁶ prefer to enter into transactions extending beyond one year. As such, these proposed regulations would cause all of these transactions to be treated as straddles, regardless of whether listed options or OTC options are used. The rules regarding flexible term and OTC options will become effective for options written 30 days or more after the final regulations are adopted. The rules regarding LEAP options will be effective 90 days after the final regulations are adopted.

CAPITALIZATION OF INTEREST AND CARRYING CHARGES

The second set of regulations deals, in part, with the capitalization of interest and carrying charges allocable to personal property that is part of a straddle.

IRS Perspective

The Preamble to the proposed regulations states that, because straddles necessarily involve positions that offset each other, the positions "carry" each other.  Based on this logic, the proposed regulations would include otherwise deductible payments or accruals on financial instruments that are part of a straddle as expenses that must be capitalized. These expenses would have to be capitalized along with the interest expense on indebtedness used to purchase or carry a straddle plus other deductible fees or expenses incurred in connection with the investors acquiring or holding personal property that is part of the straddle.

The regulations allocate interest expenses to a straddle under three scenarios. First, if the property was purchased with the proceeds of the borrowing, the interest expense must be capitalized. This rule would apply to cover a typical "cash and carry" transaction in which an investor borrows to purchase personal property, which is then sold forward.

The second scenario is one in which property that was not acquired with indebtedness becomes subject to a straddle and then is used to collateralize a liability. The interest expense on that liability would have to be capitalized to the property. This situation commonly occurs with highly appreciated securities not originally acquired with borrowed funds. The investor, wanting to hedge and diversify its holdings, may enter into a collar on the stock and borrow against the position. The investor would use the proceeds to purchase a diversified portfolio. The proposed regulations would require that the interest expense incurred on the debt be capitalized. To avoid such a result, the investor could hedge its appreciated stock position and use other property to serve as collateral for the loan. If the diversified portfolio consists of marginable securities, at least half of the loan could be collateralized by the new portfolio. With proper planning, the impact of this rule could be mitigated or eliminated completely.

Lastly, interest expense would have to be capitalized if the payments on the indebtedness are determined by reference to the value, or change in value, of the property that is part of the straddle. To subject these payments to Section 263(g), the debt instrument would have to be part of the straddle. Many commentators have stated that a debt instrument issued in U.S. dollars cannot be a position of the obligor in personal property that is part of a straddle. These regulations would make clear that debt is personal property that may be subject to the straddle rules.

Unjust and Uneconomical Results?

It is the authors' view that the third rule is a result of the questionable logic that positions of a straddle carry each other. Under this theory, if a taxpayer hedges a position with contingent debt, or with a notional principal contract, the interest incurred on the debt and the expenses incurred with the notional principal contract must be capitalized. These expenses are economically "losses" and would be better dealt with under the loss deferral rules of Section 1092. It is illogical to treat expenses relating to the change in value of a position that is part of a straddle as a carrying charge.

The payments on a notional principal contract that is hedging the value of personal property are not carrying charges. To the extent they are made due to the change in the property's value, they are “losses" that are incurred as part of the straddle. The Preamble realized that the proposed regulations may be expanding the definition of expenses subject to capitalization and have expressly asked for comments on whether the definition of "loss" for purposes of Section 1092 should be expanded to include expenses such as payments on a notional principal contract. A similar concern addresses the contingent payments on debt tied to the value of personal property. A question arises whether "interest" on these obligations should be treated as "losses” for Section 1092 purposes.

One of the many problems encountered by attempting to capitalize expenses that should be covered under Section 1092 is that unjust and uneconomical results may occur. Section 263 capitalizes all expenses incurred to carry a straddle. The "loss" being capitalized may exceed the unrealized gain on the other leg of the straddle. Section 1092, which was promulgated with the intent of matching gains and losses on straddles, would allow for the current deduction of the loss exceeding that gain. Since Section 263 was never intended to deal with losses, no such cap exists. Therefore, if Section 263 is expanded to cover expenses that are economically losses, unfair tax results may occur. There would be no justification to limit the loss beyond the amount of the unrealized gain.

While the proposed regulations add clarity to the way interest expense will be allocated to property acquired for debt or used to collateralize debt, they add confusion and illogical results when treating two or more positions of a straddle as carrying each other. These concerns would be much better served by expanding the rules under Section 1092 as opposed to trying to force a solution under Section 263.

FSA 200111011

Finally, the IRS recently published FSA 200111011, which arrives at some very questionable conclusions.  The FSA deals with a transaction that occurred in 1995, two years prior to the enactment of the constructive sale rules.⁷

Facts

In the transaction, the shareholders of Corporation A, through a grantor trust, generated capital by issuing a derivative security keyed to the market performance of the shares of Corporation A.  Each instrument entitled the buyer to fixed quarterly payments that generated a yield greater than the dividend yield on the underlying stock.  The instruments had a fixed term.  At expiration, the holders of the instruments would be entitled to receive shares of Corporation A.  Depending on the value of Corporation A on the maturity date, the number of shares that the holders of the instruments would receive would vary.  During the time the instruments were outstanding, the shareholders of Corporation A (the issuers of the instrument) retained rights to receive dividends and to vote.  The maximum number of shares that could be required to be delivered under the instruments was pledged to the Trust.  However, collateral consisting of U.S. Government obligations could be substituted.

In summary, the Corporation A shareholder sold an instrument that had fixed quarterly payments and at maturity would be redeemed into a varying amount of Corporation A, depending on the value of Corporation A shares on the maturity date.  While the transaction remained open, the shareholders retained the right to vote and to receive dividends.

IRS Conclusions

Even though the amount and identity of the shares that would ultimately be delivered weres unknown, and the shareholders retained the right to vote and receive dividends, the IRS concluded that the shares were sold at the time the instruments were issued.  The IRS felt that the retention of voting rights was inconsequential because the shareholders owned a majority interest in Corporation A even without including these shares.  The IRS also stated that annual distributions on the instruments exceeded the expected dividends on Corporation A, so that the instrument holders were receiving a payment in lieu of the dividends.  The IRS further held that the instrument holders bore the greater risk of loss and opportunity for gain on the shares than the shareholders.  Finally, the IRS noted that the instrument holder would receive actual shares of Corporation A and not cash (except for fractional shares).

FSA and Constructive Sale Rules

In 1997, the constructive sale rules were enacted.  Under these rules, appreciated securities will be deemed to be sold if a taxpayer enters into certain transactions, including when a taxpayer enters into a forward contract to deliver the appreciated securities.  For these purposes, a forward contract is a contract to deliver a substantially fixed number of shares (or cash) for a substantially fixed price.⁸

Since the enactment of these rules, many taxpayers have entered into prepaid variable forward contracts involving appreciated securities.  Under these agreements, the taxpayer receives an up-front payment of cash and delivers stock at a future date.  The investor will often put up the appreciated securities to serve as collateral.  The number of shares to be delivered will vary depending on the value of the stock at the agreement’s maturity.  As long as the difference in the number of shares to be delivered can vary by a meaningful amount, then a constructive sale should be avoided. From an economic viewpoint, these transactions closely resemble the facts in the FSA.

Interestingly, the FSA found that this transaction produced a "constructive" sale under a fact pattern that many (including the authors) believe would not be treated as a constructive sale under Section 1259. That section was enacted to prevent investors from entering into transactions that should be treated as immediate sales but were not under prior law. It is ironic that the transaction probably would not be treated as a constructive sale under Section 1259, which was specifically meant to deal with this type of transaction, and yet the FSA, which predates Section 1259, concluded otherwise. While many practitioners believe that this FSA has reached an incorrect conclusion, investors should take pause before entering into a prepaid forward contract involving appreciated securities.

1. REG-115560-99 (1/18/2001).

2. Proposed regulations issued primarily under Section 263 (REG-105801-00, 1/18/2001).

3. Many issues would have been better dealt with under Section 1092.  However, Section 1092 deals with losses, which are deductible under Section 165.  Interest expense is deductible under Section 163, and expenses incurred in connection with notional principal contracts are deductible under Section 162 or Section 212.

4. The OTC calls would have to be entered into with either a person registered with the SEC as a broker-dealer under section 18 of the Securities Act of 1934 or an alternative trading system under 17 C.F.R. section 242.30.

5. Robert Willens of Lehman Brothers pointed out how the IRS “somewhat arbitrarily” decreed that options extending beyond one year will no longer be QCCs.  Arvelund, “Another Parting Short: it Could Raise Options Traders’ Taxes” (Barrons, 1/22/01).

6. A collar is a transaction that limits the investor’s risk on the stock while capping the potential rewards.

7. Section 1259 dealing with constructive sales was enacted in July 1997.

8. Section 1259(d)(1).