Tax Consequences of Using Listed Equity Derivatives in Managing a Stock Portfolio
By Robert Gordon and Mark Fichtenbaum
Twenty-First Securities Corporation
Originally published in Derivatives: July/August 1996.
Reprinted with permission from Derivatives Report, Copyright © 1996, Warren, Gorham & Lamont, Division of RIA, 395 Hudson Street, New York, NY 10014. 1-800-431-9025.

Using derivatives to hedge stock portfolios can affect the tax treatment on the disposition of positions, and the short-against-the-box proposal may require rethinking of some standard techniques.

Many portfolio managers keep well-balanced portfolios of stocks.  There are many reasons why these managers use derivatives in managing a large equity portfolio, such as to hedge the portfolio, to skew the portfolio to certain sectors (technology), to distinguish between growth and cyclical stocks, and to avoid selling a portion of an existing portfolio.  Using derivatives as a substitute for reconstituting a portfolio gives rise to many tax consequences, however.

DIVIDENDS-RECEIVED DEDUCTION

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 Rules For Hedging Dividends.

Derivatives may affect the dividends- received deduction.  Under IRC Section 243(a), a corporation can deduct 70% of the amount of dividend income it receives if certain criteria are met.  Section 246(c) provides that the stock of the corporation paying the dividend must be held for at least 46 days.  Congress was concerned that taxpayers could eliminate substantially all of the risk from holding the equity, in effect turning the positions into essentially debt or quasi-debt, and therefore should not be entitled to include the days in which the hedge is in place in determining whether the 46-day holding period is satisfied.  Hedging a portfolio of stock with a position in an option, futures contract, forward contract, or swap based on an index of stock may cause a suspension of the holding period in the underlying portfolio.¹

Overlap Test

In determining whether the risk of loss in holding the portfolio has been so substantially reduced as to require a suspension of the holding period, Treasury determined to use a test based on the overlap between the stocks held and the stocks comprising the index.²  The general rule of Reg.1.246-5(c) (1)(iii)(B) is that the holding period of the portfolio is suspended only if there is at least a 70% overlap between the value of the stocks in the portfolio and the index.  The calculation to determine whether the overlap exists is contained in Reg. 1.246-5(c)(1)(iii).  The investor compares its portfolio with the portfolio which would make up the underlying contract on the index.  A sub-portfolio is created which is made up of the lesser of (1) the amount of shares held by the investor, or (2) the amount of shares that stock represents in the index.  If the value of the sub-portfolio is 70% or greater of the value of the stocks making up the index, then the holding period of the investor's stocks included in the sub-portfolio is tolled for purposes of the 46-day holding requirement.  In performing the test, a percentage of the value of the index may be used in constructing the sub-portfolio.

Example.  An investor owns 69% of the value of each stock comprising one futures contract on an index and hedges the portfolio with a position in the futures contract.  By using 69% of the underlying value of the futures contract, a sub-portfolio is created with a 100% overlap.  The holding period of the entire portfolio is disallowed for purposes of the dividends-received deduction.

Since the test measuring the overlap is purely mathematical and not subjective, an investor can plan to avoid the 70% overlap and maintain the holding period in the portfolio.  If an investor can hedge the risk in its portfolio with either an OEX option (S&P 100) or an option on the S&P 500, a different tax result can occur depending on the contract used.  Since the OEX is made up of 100 stocks and the S&P 500 is made up of 500 stocks, the investor may flunk the 70% test on the OEX but pass it on the S&P 500.

If, economically, the two contracts can be used to hedge the portfolio, use of the S&P 500 would have a better after-tax result than the OEX.  If both contracts would cause the taxpayer to have the holding period disallowed, it might be easier to adjust the portfolio to avoid flunking the test on the S&P 100 than on the S&P 500, since a position in a fewer number of securities would have to be adjusted in order to pass the test.

Anti-abuse provision overrides overlap test.  An anti-abuse provision in Reg. 1.246-5(c)(1)(vi) overrides the 70% overlap test.  This provision applies if both:

1. The portfolio of stocks and the hedge virtually track each other.

2. A principal purpose for entering into the hedge was to acquire tax benefits greatly in excess of the pre-tax economic profit earned from the transaction.

Since rules already exist under Section 246A that essentially prohibit leveraging of dividend-paying stock, it is not possible in the normal course of business for the tax benefits to be greatly in excess of the pre-tax economic profit earned from the transaction.  However, exceptions can be crafted.

STRADDLES

A straddle is, under Section 1092(c), the holding of two or more positions in personal property in which the holding of one substantially diminishes the risk of loss in holding the other.  Unfortunately, there is no definition of "substantially diminishes the risk of loss" in either the Code or the Regulations.  Based on Regulations proposed in 1995, a position in a portfolio of stocks or a single stock, along with a position in an index future, option, or other derivative, can be part of a straddle.³  Any position that causes a suspension of holding period for purposes of the dividends-received deduction makes up a straddle.  There may, however, be situations in which there is a sufficient reduction in the risk of holding a stock or portfolio to invoke application of the straddle rules without requiring suspension of the holding period for purposes of the dividends-received deduction.  This would be true of a portfolio of stocks hedged by a position in an index in which there is less than a 70% overlap between the index and the portfolio, but where the correlation between the two is virtually 100%.

There are many implications to an investor if a straddle has been established.  First, any losses realized on the closing of a position in a straddle, or recognized due to a mandated marking to market at year-end, will be deferred to the extent of any unrealized gains in the other leg of the straddle.⁴  An investor may create straddles when hedging the risk in its portfolio by use of derivatives.  If the portfolio increases in price, so that a loss is incurred on the derivative, the loss is deferred to the extent of unrealized gain in the portfolio, until the gain is recognized.  It is unclear when this gain is recognized and, thus, when the loss may be taken.  The major unanswered question is whether the index and the portfolio are to be treated as large homogeneous positions or whether they should be disaggregated for these purposes.

Example.  A portfolio being hedged has a total unrealized gain from both the time prior to the hedge being entered into, and until the hedge is closed, of $ 100,000.  The loss on the hedge is $20,000.  One of the stocks in the portfolio made up 5% of the portfolio and also has $5,000 of unrealized gain.  When that stock is sold, the remaining portfolio has an unrealized gain of $95,000.  If the portfolio and the hedge are treated as large homogeneous assets, then none of the $20,000 deferred loss maybe recognized when the single stock is disposed of.  If, however, the two are disaggregated for these purposes, then 5% or $1,000 of the deferred loss may be recognized when that stock was disposed.

Another complexity in such an example arises when the portfolio's $100,000 net unrealized gain is composed of both unrealized gains and unrealized losses.  Since losses are deferred only to the extent of unrealized gains, if the positions are disaggregated, a portion of the loss realized on closing the hedge would be recognized immediately for tax purposes. To the extent that an investor consistently uses derivatives as an alternative to the actual disposition of the underlying securities, because this is either more efficient or less expensive, then the losses on the closing of the hedge may effectively be deferred permanently.  All gains upon the closing of the hedges are, however, taxed at the time of recognition.

Mixed straddle election.  The investor can make certain elections as to how to treat the straddle.  If the positions qualify, the investor can use the mixed straddle account elections.⁵  Under this election, all of the positions in the account are marked to market daily.  The tollgate charge for making this election is that all unrealized gains or losses must be recognized when the account is established.  Since all the positions are marked to market throughout the year, there will be no unrealized gains.  Thus, the loss deferral rules, along with the issues they raise, disappear.

Avoiding Section 1256.  Another election available to the investor is to elect to have Section 1256 contracts not subject to that section.  This allows the investor not to have to mark the derivative to market at year-end.  Avoidance of the year-end mark allows the investor to avoid the problem of having to include the income currently while having to defer any losses.  The 60/40 capital gain/loss treatment is also lost.

Identifying specific straddles.  Investors may also identify specific straddles.⁶  In identified straddles, all realized gains must be recognized while realized losses are deferred to the extent of unrealized gains in the other legs of the straddle.  Holding period does not accrue on the positions in the straddle for long-term capital gains purposes.  Furthermore, all holding period on an asset, prior to the time it is made part of a straddle is eliminated unless the asset was held for enough time so that its disposition would result in either long-term capital gain or loss.

CHANGES IN MARKETS

Events in the marketplace have created anomalies of which investors should be aware.  In the last few months, for instance, the options exchanges have begun to use strike prices that are in 2½ -point intervals as opposed to 5-point intervals.  This may have severe tax effects for investors who do covered call writing.

In determining whether the holding period of stock must be suspended for purposes of the dividends-received deduction and whether a straddle exists, the strike price of the call is crucial.  Generally, if the call is more than one strike price "in the money" then the holding period must be suspended and a straddle exists during the time that the call is outstanding.⁷  Therefore, prior to the change in strike price availability, an investor owning a stock with a market value of $49 per share was allowed to write a call with a strike price of $45 without a negative tax result.  However, because a call option with a strike price of 47½ is now available, writing the $45 call will have negative tax implications.  This is a strange result in that the investor has the same amount of risk reduction appropriate to avoid the negative tax results as when Congress initially enacted the rules but, due to the actions of the options exchanges, now suffers detrimental tax results.  Treasury has authority under Section 1092(c) (4) (H) to change the rules due to the action of the exchange and should do so to afford investors the same level of risk reduction they had when the statute was originally drafted.

Futures Contracts on Indexes The determination of whether an option based on the value of an index of stocks qualifies as a Section 1256 contract depends on whether a futures contract could exist on such an index.  The CFTC has authority to designate a futures contract on an index of stocks only if it is found that the stocks making up the index are of a general nature and are not narrowly based.  When an exchange decides to list a new option, it must seek approval from the SEC.  In this procedure the SEC designates the index as one that is either based on a general basket of stocks or one that is narrowly based.  Depending on the classification, the tax classification follows.8 Options on technology stocks.  Both the Pacific and American options exchanges have option contracts based on a group of technology stocks.  The Pacific exchange options were, however, classified as being derived from a general basket of stocks, while the American exchange options were classified as being based on a narrow basket of stocks.  This difference in classification was due solely to the manner in which the exchanges drafted their request and not because the makeup of one index differs much from the other. For tax purposes, however, the Pacific options are treated as Section 1256 contracts, which means that they must be marked to the market at year-end.9  Also, all gains and losses on such contracts are 60% long-term and 40% short-term under Section 1256(a)(3) regardless of holding period and whether such gains and losses are from long or short positions. The American exchange options, in contrast, are not Section 1256 contracts and are not marked to market.  All of the gains or losses are either short-term or long-term, based upon the holding period of the option.  Regardless of holding period, any gain or loss from short positions will be treated as short-term unless overridden by a specific rule (i.e., being part of a straddle). To the extent options hedge the risk of technology stocks in an existing portfolio and a straddle exists, then the use of the Pacific options would give the investor the choice of electing to use a mixed straddle account election.  A similar transaction in the American exchange option would not qualify for such an election.

Note: A December 21, 2000 law rendered obsolete the system of tax classification described here.  For more current information on the tax classification of options, see Good News for Index Investors.

Hedging with individual stock options.  Another anomalous result occurs when an investor chooses to hedge a portfolio with a series of individual stock options as opposed to an index option.  One investor owns all 20 stocks comprising the Major Market Index and hedges the portfolio by writing individual call options on each of the 20 stocks.  Another investor achieves a similar hedge of the portfolio simply by writing a call option on the entire index.  While both strategies use the listed options exchange to accomplish similar economic results, the tax results vary.

The use of individual calls allows an investor to use strike prices that will not create a straddle or cause a diminishing of the holding period for purposes of the dividends-received deduction.  No specific rules allow an investor to use index options with a specific strike price to avoid these rules.  While a strong argument exists not to reduce the holding period of the stocks when an "at the money” or "out of the money" call option is used, it is much more difficult to argue that the straddle rules should not apply.  The reason for this is that while the calls may not substantially diminish the risk of loss from holding the stock, holding the stock certainly diminishes the risk from holding the short call position.¹⁰  Therefore, it is easier to plan for tax results by using individual calls as opposed to an index option.

The second difference between hedging with individual call options as opposed to hedging with the entire index is that if "deep in the money" calls are used, then a straddle would exist in either case.  The use of the index option creates a mixed straddle while the use of the individual options does not.

Synthetically creating a portfolio.  A third difference between hedging with individual call options and hedging with an index arises if an investor synthetically creates a port- folio through use of options.  The investor can purchase calls and write puts with identical strike prices and maturity dates on each of the individual stocks in the index.  On the other hand, the investor can purchase calls and write puts on the index with identical strike prices and maturity dates.

In both cases, the investor synthetically creates the same basket of stocks. In the first case, the gains and losses with respect to the calls will be either long-term or short-term capital gains or losses depending on the length of the holding period.  The gains on the puts will be short-term regardless of holding period.  Where the investor purchases calls and writes puts on the index with identical strike prices and maturity dates, any gains and losses will be 60% long-term and 40% short-term capital gain or loss.  Obviously the straddle rules do not apply in these transactions because the holding of a call and the writing of a put with identical strike prices and expiration dates do not offset the risk of each other.

Effect of leverage.  To the extent an investor with a large portfolio uses leverage, additional complexities arise.  If the investor is a corporation, to the extent that a dividend paying stock is leveraged a portion of the dividends-received deduction is disallowed.  Instead of using a 70% dividends-received deduction, the percentage used is (a) 70% multiplied by (b) the ratio of the cost of the stock not leveraged over the total cost of the stock.  The amount of the reduction in the dividends-received deduction cannot, under Section 246A(e), be greater than the interest expense incurred on the debt to carry the stock.

If the stock is also part of a straddle, then another rule comes into play.  Interest expense incurred to carry a position in a straddle must be capitalized under Section 263(g).  A corporate investor who hedges a leveraged dividend-paying stock with a derivative is subject to both rules.  Therefore, a portion of the dividends-received deduction is disallowed and the interest expense must be capitalized.  Since a non-corporate investor is not entitled to the dividends-received deduction, it capitalizes the interest expense incurred to carry the stock position.

LEGISLATIVE PROPOSALS

Section 1259 became law effective June 9, 1997.

It appears that, due to the publicity received to the initial public offering of Estee Lauder Companies, Inc., legislation was proposed to eliminate the tax benefits associated with a short-against-the-box or equity-swap strategy.¹¹  This proposed legislation (to create Section 1259) would not just affect short-against- the-box and equity-swap transactions.  Where an investor removes substantially all of the risk of loss and substantially all of the potential for profit from a portion or all of its portfolio of stocks by use of a derivative, the proposal would probably apply.  Under the proposal, entering into a derivative would cause a constructive sale of the underlying portfolio.  This could have a disastrous effect on mutual funds that use derivatives to temporarily hedge a portion of their portfolios.  In order to qualify as a regulated investment company, for tax purposes, certain requirements must be satisfied.

The Government repealed Section 851(b)(3) (also known as the “short three rule”) for tax years beginning after August 5, 1997.

One requirement under Section 851(b)(3) is that no more than 30% of the company’s income be derived from gains of securities that are held for less than three months.  Therefore a company could inadvertently lose qualification as a RIC by, hedging its portfolio in such a manner as to cause a constructive sale of the stock.  The proposed legislation is silent as to whether the constructive sale rules apply for all purposes of the Code or just for gain recognition, but the above result is possible.

Another area in which the constructive sale rules could cause unanticipated results is one in which a dividend-paying stock has been held for more than 46 days.  Under current law, once the 46-day holding period has been met, the stock may be hedged and all subsequent dividends will still qualify for the dividends-received deduction.  Under the constructive-sale rules, the stock may be deemed to have been sold and repurchased on the date the hedge was entered into.  In this case, the investor will have to satisfy a new 46-day holding period before future dividends received on the stock will qualify for the dividends-received deduction.  Since the establishment of the hedge caused the constructive sale to occur, no holding period will accrue on the stock for purposes of the dividends-received deduction until the hedge is disposed of.  Thus, the constructive-sale proposed legislation may affect any situation where the length of holding period is relevant.

Section 246(c)(1)(A) is now law effective for dividends received or accrued after September 4, 1997.

New holding period for each dividend.  Another proposal that would affect the use of derivatives and the dividends-received deduction is one in which an investor must satisfy a new 46-day holding period for each dividend.  As noted, under current law, once a stock has met the 46-day holding period requirement, it may be hedged in any manner the investor wishes, and the holding period requirement for the dividends-received deduction will continue to be met.  Under the proposal, there would have to be a constant monitoring of stock and its hedges to determine if the holding period requirement is satisfied.  It would be possible to have some dividends qualify, and later dividends not qualify.

CONCLUSION

Many investors hold large portfolios and use derivatives to either completely or partially hedge them.  Under current law, those investors must determine whether they have created a tax straddle or jeopardized the receipt of their dividends-received deduction or the accrual of holding period.  They must also be aware that different strategies to accomplish identical or similar economic results can receive disparate tax treatment. Under current proposals, certain hedging transactions could result in dispositions for tax purposes with potentially catastrophic results.

NOTES:

¹  Reg. 1.246-5(a).

²  Reg. 1.246-5(c ).  A more quantitative approach could have looked at the correlation between the portfolio held and the stock index.

³  Prop. Reg. 1.1092(d)-2.

⁴  Section 1092(a)(1).

⁵  Section 1092(b)(2)(A)(i)(II).  The major condition is that at least one of the positions in the straddle be a Section 1256 contract while another position is not.

⁶  Section 1092(b)(2)(A)(i)(I).

⁷  Sections 246(c )(4) and 1092(c )(4).

⁸  Rev. Rul 94-63, 1994-2 CB 188.

⁹  Section 1256(a)(1).

¹⁰ Under Section 1092(c), a straddle exists when the holding of one position (stock) substantially diminishes the risk of loss in another position (short index call).

¹¹ A short-against-the-box strategy is one in which an investor sells short an equivalent amount of stock that the investor currently owns.  See Scarborough, “Proposal Would Tax Short-Against-the-Box Sales, But May Encourage Alternatives That Use Derivatives,” 1 DERIVATIVES 217 (May/June 1996).


 

This article and other articles are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".