Equity Options Without Standard Terms; Special Rules and Definitions

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104641-97]

RIN 1545-AV48

Equity Options Without Standard Terms; Special Rules and

Definitions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations providing guidance

on the application of the rules governing qualified covered calls. The

new rules address concerns that were created by the introduction of new

financial instruments after the enactment of the qualified covered call

rules. The proposed regulations will provide guidance to taxpayers

holding qualified covered calls. This document also provides notice of

public hearing on these proposed regulations.

DATES: Written comments must be received by September 23, 1998.

Requests to speak (with outlines of oral comments) at the public

hearing scheduled for November 4, 1998, must be submitted by October

14, 1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-104641-97), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-104641-97), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. Alternatively, taxpayers may submit comments

electronically via the Internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Pamela

Lew, (202) 622-3950; concerning submissions and the hearing, Michael L.

Slaughter, Jr., (202) 622-7190, (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 1092(c) defines a straddle as offsetting positions with

respect to personal property. Under section 1092(d)(3), stock is

personal property if the stock is part of a straddle that involves an

option on that stock or substantially identical stock or securities.

Under section 1092(c)(4), however, writing a qualified covered call

option and owning the optioned stock is not treated as a straddle for

purposes of section 1092.

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.

Section 1092(c)(4)(C) defines a deep-in-the-money option as an

option whose strike price is lower than an allowed bench mark. Under

section 1092(c)(4)(D), this bench mark is generally the highest

available strike price for an option that is less than the applicable

stock price, as defined in section 1092(c)(4)(G). The Internal Revenue

Code provides other bench marks under specified circumstances.

At the time the qualified covered call definition was written,

listed options were available only at standardized maturity dates and

strike price intervals. This fixed-interval system was a basic

assumption of the Congressional plan for qualified covered calls and,

more specifically, was the foundation for the definition of a deep-in-

the-money option.

Certain options exchanges have begun to trade put and call equity

options with flexible terms. The terms that are flexible include strike

price, expiration date, and exercise style (that is, American,

European, or capped). Except

[[Page 34617]]

as noted below, the strike price is denominated in the smallest

interval available on the options exchanges, which is currently \1/8\

of one dollar. To minimize the market impact of options contract

expirations, equity options with flexible terms may not expire within 2

business days of equity options with standardized terms. Equity options

with flexible terms are generally intended for institutional and other

large investors.

Questions have been raised as to whether the strike prices

established by equity options with flexible terms might establish the

lowest qualified benchmark under section 1092(c)(4)(D) for all equity

options, including those with standardized terms. The following example

illustrates this concern. If a stock is currently selling for $62,

equity options with flexible terms and option periods of not more than

90 days could have a strike price of $61 \7/8\. If the strike prices

from equity options with flexible terms were taken into account in

determining if a 90-day equity option with standardized terms is deep

in the money, any option being sold for less than $61 \7/8\ would be

deep in the money. Because the strike prices for an equity option with

standardized terms are set in $5 intervals, the highest strike price

less than the current selling price for an equity option with

standardized terms would be $60. Thus, any in-the-money equity option

on the stock that had standardized terms would be deep in the money

(for purposes of section 1092(c)(4)).

Explanation of Provisions

The proposed regulations provide that the strike prices established

by equity options with flexible terms are not taken into account in

determining whether equity options that are not equity options with

flexible terms are deep in the money. Thus, the existence of strike

prices established for equity options with flexible terms does not

affect the lowest qualified bench mark, as determined under section

1092(c)(4)(D), for an equity option with standardized terms. The

proposed regulations define equity options with flexible terms as those

equity options described in certain specified SEC releases, including

any changes approved by the SEC to these releases.

The regulations will allow some taxpayers, primarily institutional

and other large investors, to engage in certain exchange-based

transactions that are currently unavailable to them and will permit

other investors to continue doing business under section 1092 without

regard to the existence of the institutional product.

The proposed regulations do not address whether an equity option

with flexible terms is eligible for qualified covered call treatment

under section 1092(c)(4). Comments are requested on the following

issues: (1) whether equity options with flexible terms should be

eligible for qualified covered call treatment under section 1092(c)(4);

(2) whether there should be uniform rules governing the bench marks for

equity options with flexible terms and standardized options; and (3) if

uniform rules are not appropriate, what bench marks should apply to

equity options with flexible terms.

Proposed Effective Date

These regulations apply to equity options with flexible terms

entered into on or after the date that the Treasury Decision adopting

these rules as final regulations is published in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (preferably a

signed original and eight (8) copies) that are submitted timely to the

IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for Wednesday, November 4,

1998, beginning at 10:00 a.m. The hearing will be held in Room 2615,

Internal Revenue Building, 1111 Constitution Avenue NW., Washington DC.

Because of access restrictions, visitors will not be admitted beyond

the Internal Revenue Building lobby more than 15 minutes before the

hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit written comments by September 23, 1998 and submit an outline of

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by October 14, 1998.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Pamela Lew, Office of

Assistant Chief Counsel (Financial Institutions and Products). However,

other personnel from the IRS and Treasury Department participated in

their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.1092(c)-1 also issued under 26 U.S.C. 1092(c)(4)(H). *

* *

Par. 2. Section 1.1092(c)-1 is added to read as follows:

Sec. 1.1092(c)-1 Equity options with flexible terms.

(a) Effect on lowest qualified bench mark for other options.

The existence of strike prices established by equity options with

flexible terms does not affect the determination of the lowest

qualified bench mark, as defined in section 1092(c)(4)(D), for any

option that is not an equity option with flexible terms.

(b) Definitions. For purposes of this section:

(1) Equity option with flexible terms means an equity option--

(i) That is described in the following Securities Exchange Act

Releases--

(A) Self-Regulatory Organizations; Order Approving Proposed Rule

Changes and Notice of Filing and Order Granting Accelerated Approval of

Amendments by the Chicago Board Options Exchange, Inc. and the Pacific

Stock Exchange, Inc., Relating to the Listing of Flexible Equity

Options on Specified Equity Securities, Securities

[[Page 34618]]

Exchange Act Release No. 34-36841 (Feb. 21, 1996); or

(B) Self-Regulatory Organizations; Order Approving Proposed Rule

Changes and Notice of Filing and Order Granting Accelerated Approval of

Amendment Nos. 2 and 3 to the Proposed Rule Change by the American

Stock Exchange, Inc., Relating to the Listing of Flexible Equity

Options on Specified Equity Securities, Securities Exchange Act Release

No. 34-37336 (June 27, 1996); or

(C) Self-Regulatory Organizations; Order Approving Proposed Rule

Change and Notice of Filing and Order Granting Accelerated Approval of

Amendment Nos. 2, 4 and 5 to the Proposed Rule Change by the

Philadelphia Stock Exchange, Inc., Relating to the Listing of Flexible

Exchange Traded Equity and Index Options, Securities Exchange Act

Release No. 34-39549 (Jan. 23, 1998); or

(D) Any changes to the SEC releases described in paragraphs

(b)(1)(i)(A) through (C) of this section that are approved by the

Securities and Exchange Commission; or

(ii) That is traded on any national securities exchange which is

registered with the Securities and Exchange Commission (other than

those described in the SEC Releases set forth in paragraph (b)(1)(i) of

this section) or other market which the Secretary determines has rules

adequate to carry out the purposes of section 1092 and is--

(A) Substantially identical to the equity options described in

paragraph (b)(1)(i) of this section; and

(B) Approved by the Securities and Exchange Commission in a

Securities Exchange Act Release.

(2) Securities Exchange Act Release means a release issued by the

Securities and Exchange Commission. To determine identifying

information for releases referenced in paragraph (b)(1) of this

section, including release titles, identification numbers, and issue

dates, contact the Office of the Secretary, Securities and Exchange

Commission, 450 5th Street, NW., Washington, DC 20549. To obtain a copy

of a Securities Exchange Act Release, submit a written request,

including the specific release identification number, title, and issue

date, to Securities and Exchange Commission, Attention Public

Reference, 450 5th Street, NW., Washington, DC 20549.

(c) Effective date. These regulations apply to equity options with

flexible terms entered into on or after the date that the Treasury

Decision adopting these regulations is published in the Federal

Register.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-16848 Filed 6-24-98; 8:45 am]

BILLING CODE 4830-01-U