By William M. Paul and Steve Rosenthal

Originally published in the November/December 2001 issue of the Journal of Taxation of Financial Institutions

Taxpayers should exercise “due diligence” before trading index options and futures if there is any doubt as to the tax status of the index.

Late last year, Congress passed the Commodity Futures Modernization Act (CFMA), which for the first time permits trading of futures contracts on individual stocks and "narrow-based security indexes" (collectively "stock futures"). At the same time, Congress amended the Code to provide tax rules for these new financial products. While the advent of stock futures has received substantial attention, including on the tax front,¹ one aspect of these changes that has gone relatively unnoticed is the effect on the tax status of exchange-traded index options and (to a lesser extent) index futures.

As explained below, the dividing line between options and futures on broad-based indexes, which are treated as Section 1256 contracts under the Code, and options and futures on narrow-based indexes, which are not, is now tied to the CFMA's definition of a "narrow-based security index”. Under that definition, an index can fluctuate between broad-based and narrow-based, creating instability and potential confusion with respect to the tax status of options and futures on the index.

Background

In the world before CFMA, things were (relatively) simple. The CFTC regulated trading of futures con­tracts and the SEC regulated trad­ing of securities. Under the Shad-Johnson accord,² trading of equity-related futures contracts was limited to futures on broad-based stock indexes. The dividing line between broad-based and narrow-based was somewhat nebu­lous and was tied to whether the index represented a substantial segment of the market or was subject to manipulation. As part of the procedure for authorizing trading of a futures contract on a stock index, both the CFTC and the SEC had to agree that the index was broad-based. Once the SEC and CFTC had determined that an index was broad-based, that deci­sion was generally not revisited.³

Thus, before CFMA, equity-­related futures were limited to broad-based indexes. Like other futures contracts, all index futures were "section 1256 contracts," subject to 60/40, mark-to-market tax treatment. In order to provide "tax parity," exchange-traded options on broad-based indexes received similar treatment under Section 1256. In contrast, exchange-traded options on narrow-based indexes, like options on individual stocks, were generally not treated as Section 1256 contracts.⁴ For purposes of deter­mining the tax status of an index option, an index was considered broad-based if the CFTC had authorized a futures contract on the index or if the requirements for such authorization were met.⁵

The CFMA

In enacting the CFMA, Congress has now authorized trading in stock futures. The CFMA resolved the dispute between the SEC and CFTC over who would regulate stock futures in what some might call a classically Washington manner, providing that stock futures - i.e., futures on individual stocks and futures on narrow-based indexes - are to be jointly regulated by the SEC and CFTC. The CFTC, however, retains exclusive jurisdiction to regulate broad-based index futures.

The CFMA provides a '`mechanical" definition of a narrow-based index to replace the "qualitative" definition under Shad-Johnson. The CFMA's definition of narrow-based index includes a series of quantitative tests tied to the composition of the index. An index is narrow-based if (1) it has nine or fewer stocks, (2) any single stock in the index comprises more than 30% of the index on a weighted basis, (3) any five stocks together comprise more than 60% of the index on a weighted basis, or (4) the lowest weighted stocks compromising 25% of the index have aggregate average daily trading volume of under $50 million.⁶ If any of these tests are met, the index is narrow-based unless one (or more) of a series of exceptions applies. Any security that is not narrow-based under this definition is considered broad-based.

The exceptions to the general definition of a narrow-based security index include a "status preservation rule" that preserves broad-based status for index futures that have traded for at least 30 days as broad-based index futures but that become narrow-based under the general definition.⁷ This rule is designed to mitigate the effects of fluctuations within the index that could otherwise cause a future on the index to become subject to joint SEC/CFTC jurisdiction as a future on a narrow-based index.

Associated Tax Law Changes

The enactment of the CFMA changed the regulatory landscape and thus necessitated a modification of the associated tax rules.⁸ Tax legislation enacted contemporane­ously with the CFMA amended existing law in order to preserve the policy of "tax parity" for index options and futures.⁹ As was true before CFMA, options and futures on broad-based indexes are Section 1256 contracts. The newly authorized futures on narrow-based indexes, like options on narrow-based indexes, are not Section 1256 contracts.

Significantly, Section 1256 was amended to incorporate the CFMA's definition of "narrow-based security index."¹⁰ The CFMA definition is codified in both the Securities Exchange of Act of 1934 (the "1934 Act") and the Commodity Exchange Act.  For reasons that are not clear, the tax definition is tied to the definition as incorporated in the 1934 Act. Thus, the tax rules "piggy-back" on the CFMA's definition of narrow-based security index, including the status preservation rule described above, as embodied in the 1934 Act.

What Does All This Mean?

While the changes described above have resulted in a form of "tax parity" between competing index options and index futures, that parity is incomplete. In addition, the attempt to maintain parity has introduced instability, and potential confusion, into an area that was previously relatively stable.

First, these changes had an immediate, and largely unnoticed, impact on the tax statutes of certain exchange-traded index options. Because the CFMA's definition of a narrow-based index, as incorporated into Section 1256, is more limited than the Shad-Johnson definition, certain indexes that were previously treated as narrow-based became broad-based under the new definition. The effective date of this change was December 21, 2000, the date President Clinton signed the legislation into law. As a result, certain index options that were not previously Section 1256 contracts, became Section 1256 contracts last December 21.  It appears that a number of index options may have `flipped' from narrow-based to broad-based status on that date.

A second consequence of these legislative changes is that the tax status of an index option or index future is subject to change going forward. The mechanical tests adopted by CFMA, and incorporated into Section 1256, include such factors as the relative market capitalization and average trading volume of component stocks in the index.¹¹ As these factors change over time - and recent market movements have caused some dra­matic changes - an index that was broad-based, based on CFMA's definition, may become narrow-based under that definition (and vice-versa) with a corresponding change in tax status.

As explained above, the CFMA includes a status preservation rule that preserves the broad-based status of an index that becomes narrow-based under CFMA's general definition of a narrow-based index.  Somewhat curiously, there is no comparable status preservation rule for a narrow-based index that becomes broad-based. In other words, if a futures contract is trading on an index that is narrow-based and, because of changes in market capitalization or trading volume of the component stocks (or other factors), the index becomes broad-based, the tax status of the futures contract changes.¹²  Similarly, if an option is traded on the index, its status for tax purposes will also change.

Finally, although the CFMA's general definition of a narrow-based index applies equally to index options and index futures, the rule preserving the status of a broad-based index that otherwise becomes narrow-based applies only if there is a futures contract on the index. As a result, the tax status of an index option that becomes narrow-based under the general definition depends upon whether there is a corresponding futures contract on the same index. If a futures contract is traded on the same index, and the index remains broad-based under the status preservation rule, then an option on the index will remain broad-based just as long as the futures contract on the index remains broad-based. However, if no futures contract exists, then an option on an index that was previously broad-based and becomes narrow-based under the general definition will apparently become a narrow-based index option for tax purposes on the first day the index is narrow-based. Moreover, the tax status of the index option could change on a daily basis as the market capitalization of the component stocks change.

Because the tax status of index options and futures is tied to the definition of narrow-based index in the 1934 Act, rules adopted by the SEC relating to that definition could ameliorate some of the instability and confusion described above. However, in recently released final rules, the SEC took the position that it does not have authority under the statute to address these issues.¹³ Taxpayers should, therefore, exercise some "due diligence" before trading index options and futures if there is any doubt as to the tax status of the index.  It would also be helpful if IRS and Treasury would provide guidance on how to treat index options or futures whose tax status changes after a taxpayer has entered into the position and before it is closed out.

¹ See Nijenhuis, “New Tax Rules for Securities Futures Contracts Enacted," 14 Taxation of Financial Institutions 4 (May/June 2001).

² Sec 49 Fed Res. 1884 (January 24, 1984).

³ The SEC and CFTC, however, did not always see eye-to-eye on whether an index was broad-based under Shad-Johnson. Although the two commissions had informally agreed that no index with fewer than 23 stocks would qualify as broad-based, the CFTC and the futures exchanges chafed at this limitation. In 1999, the Chicago Board of Trade successfully challenged the SEC's attempt to hold the line with respect to the Dow Jones Transportation Index (20 stocks) and the Dow Jones Utilities Index (15 stocks) in Board of Trade v. SEC, 187 F.3d 713 (7th Cir. 1999).

⁴ Options specialists and market-makers receive Section 1256 treatment on these options.

⁵ See Section 1256(g)(6)(B), prior to amendment by the Community Renewal Tax Relief Act of 2000.

⁶ See Section 3(a)55(B) of the Securities Exchange Act of 1934.

⁷ This rule provides that the index will be considered broad-based as long as it is not narrow-based for more than 45 days in the following three months.

⁸ For example, now that futures on narrow-based indexes are permitted, the tax rules can no longer treat an index as broad-based merely because the CFTC has authorized trading of a future on the index.

⁹ Community Renewal Tax Relief Act of 2000 § 401.

¹⁰ With respect to index options, see Section 1256(g)(6)(B). With respect to index futures, see Sections 1256(b) (flush language), 1256(g)(9)(C) and 1234B(C).

¹¹ For example, as noted above, an index is narrow-based if the average daily trading volume of the lowest weighted stocks comprising 35% of the index falls below $50 million.

¹² Although the CFTC recently adopted a rule that preserves narrow-based status, that rule has no effect for tax purposes because the Tax definition is tied to the definition of narrow-based index as incorporated in the 1934 Act.

¹³ See SEC Release No. 34-4472 (August 20, 2001).  The SEC did, however, adopt a rule that preserves the status of a broad-based index when a futures contract has traded on the index for fewer than 30 days and certain requirements are met. See Exchange Act Rule 3a55-2, adopted in SEC Release 34-44724.

William M. Paul is a partner at Covington & Burling and Steven M. Rosenthal is a partner at Miller & Chevalier.  Both are in Washington, D.C. and both are members of the editorial advisory board of this Journal.

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".