Equity Options with Flexible Terms;
Qualified Covered Call Treatment

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-115560-99] RIN 1545-AX66

TITLE: Equity Options with Flexible Terms; Qualified Covered Call
Treatment

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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 several years after the
enactment of the qualified covered call rules. The proposed
regulations would provide guidance to taxpayers writing equity call
options. This document also provides notice of public hearing on
these proposed regulations.

DATES: Written and electronic comments and requests to appear and
outlines of topics to be discussed at the public hearing scheduled
for May 9, 2001, at 10 a.m., must be submitted by April 18, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-115560-99), room
5226, 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:M&SP:RU (REG-115560-99),
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 of the IRS Home Page, or
by submitting comments directly to the IRS Internet site at
http://www.irs.gov/tax_regs/regslist.html. The public hearing will
be held in the IRS Auditorium, 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, Guy
Traynor, (202) 622-7180, (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On June 25, 1998, the IRS published in the Federal Register proposed
regulations (REG-104641-97, 63 FR 34616) addressing whether strike
prices available for equity options with flexible terms affect the
definition of a qualified covered call (QCC) under section 1092(c)
(4) for equity options with standardized terms. No requests to speak
at a public hearing were received, and no public hearing was held.

The proposed regulations provided that strike prices available for
equity options with flexible terms do not affect the bench marks
used to determine whether equity options with standardized terms are
eligible for QCC treatment. That provision was adopted as
§1.1092(c)-1 of the final regulations (TD 8866), published in
the Federal Register for January 25, 2000 (65 FR 3812).

The regulatory text of REG-104641-97 did not address whether an
equity option with flexible terms is itself eligible for QCC
treatment. The preamble to the proposed regulations, however, did
request comments about whether equity options with flexible terms
should be eligible for QCC treatment and, if eligible, what bench
marks should apply. In light of the comments received, consideration
was also given to the treatment of over-the-counter options and
standardized options with terms of more than one year. After
consideration of the written comments, this NPRM proposes
regulations addressing the eligibility for QCC treatment of equity
options with flexible terms, over-the-counter options and
standardized options with terms longer than one year.

QCC Treatment

Section 1092(c) defines a straddle as offsetting positions with
respect to personal property. Under section 1092(d)(3)(B)(i)(I),
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 QCC option
and owning the optioned stock is not treated as a straddle under
section 1092 if certain conditions are satisfied.

The legislative history of section 1092 indicates that QCCs were
excepted from the loss deferral rule for straddles because "they are
undertaken primarily to enhance the taxpayer's investment return on
the stock and not to reduce the taxpayer's H.R. Rep. No. 432,
98th Cong., 2d risk of loss on the stock".

Sess. at 1266-68 (1983). To qualify as a QCC, a covered call must,
among other things, be exchange traded and not be deep in the money.
An option is exchange traded if the option is traded on a national
securities exchange that is registered with the Securities and
Exchange Commission or on some other market that the Secretary
determines has rules adequate to carry out the purposes of the QCC
provisions. An option is deep in the money if the strike price of
the option is lower than the lowest qualified bench mark for the
stock at the time the option is written.

Section 1092(c)(4)(H) grants the Secretary of the Treasury the
authority to prescribe regulations to carry out the purposes of the
QCC exception, including regulations modifying the provisions of the
exception as appropriate to take account of changes in the practices
of options exchanges.

The introduction of exchange-traded equity options with flexible
terms is one such change. Unlike equity options with standardized
terms, equity options with flexible terms can have strike prices at
other than fixed intervals and have other than standardized
expiration dates. Options exchanges have also introduced
standardized options with longer terms.

In response to the request for comments, two comments were received.
One commentator argued that equity options with flexible terms
should not be eligible for QCC treatment. This commentator noted
that in 1984, when section 1092(c)(4) was enacted, only equity
options with standardized terms were traded on the national
exchanges and that it is likely that Congress did not intend to
include customizable options within the definition of a QCC. This
commentator also pointed out that equity options with flexible terms
were developed to compete with over-the- counter (OTC) options,
which are not eligible for QCC treatment. The commentator suggested
that excluding equity options with flexible terms from QCC treatment
would avoid a competitive imbalance from different tax treatment for
competing products.

The second commentator stated that, as a matter of statutory
analysis, equity options with flexible terms are already eligible
for QCC treatment. This commentator argued that QCC treatment is
appropriate if the taxpayer is using the option to increase the
yield on its stock investment and not to reduce the risk of loss on
its stock. In support of this point, the commentator noted that
nothing in the applicable legislative history suggests that Congress
intended to limit the QCC option exception to standardized options.
Alternatively, this commentator argued that because equity options
with flexible terms were designed to compete with OTC options,
regulations should be promulgated allowing OTC options to qualify
for QCC treatment on the same terms as exchange-traded equity
options with flexible terms.

Explanation of Provisions

Equity Options with Flexible Terms and Qualifying OTC Options After
consideration of the comments received, the proposed regulations
provide that equity options with flexible terms may be QCC options
as long as they satisfy the general rules for QCC treatment
described in section 1092(c)(4), are not for a term of longer than
one year, and meet other specified requirements. In addition, an
equity option with standardized terms must be outstanding for the
underlying equity. For purposes of applying the general rules, the
bench marks will be the same as those for an equity option with
standardized terms on the same stock having the same applicable
stock price.

The proposed regulations also provide that certain OTC options may
be QCC options so that OTC options that are economically similar to
equity options with flexible terms may enjoy the same tax benefits
as equity options with flexible terms. Specifically, the proposed
regulations provide that an OTC option is eligible for QCC treatment
if it is entered into with a person registered with the Securities
and Exchange Commission as a broker-dealer or alternative trading
system and meets the same requirements for QCC treatment that apply
to equity options with flexible terms.

QCC Status for Equity Options with Standardized Terms In the process
of considering the proper treatment for equity options with flexible
terms, the IRS examined QCC status in general. At the time that
Congress enacted section 1092(c)(4), options available on the
national securities exchanges had a term of nine months or less.
Congress did not include in the legislative history any guidance on
the effect of the time value of money upon the strike price.

Subsequent to the enactment of section 1092(c)(4), the national
securities exchanges began offering certain standardized options
with expiration dates that are 12 or more months after the date
entered into. The longer term of these options may reduce the
taxpayer's risk of loss on its stock position because of the time
period involved.

Increased risk reduction through the use of long term options
applies equally to equity options with flexible terms, OTC options,
and equity options with standardized terms. The proposed regulations
therefore provide that a one-year term limit also applies to equity
options with standardized terms. Comments are requested on this
issue, including a discussion of time limitations in general, as
well as the appropriateness of a one- year cutoff.

If QCC treatment should apply to longer-term options, it may be
appropriate to change the deep-in-the-money standard to prevent the
increase in risk reduction. A comment recommending a time limitation
greater than one year or recommending that there be no time
limitation should also provide detailed, comprehensive descriptions
of possible solutions to the problem of increased risk reduction.
Comments should also address the administrability of any proposed
solutions.

Proposed Effective Date

These regulations would apply to options entered into on or after 30
days after the date that the Treasury decision adopting these rules
as final regulations is published in the Federal Register.

Regulations concerning time limitations for equity options with
standardized terms would be prospective in nature and would apply to
transactions entered into on or after 90 days from the date of
publication of the final regulation promulgating such rules.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It is
hereby certified that these regulations will not have a significant
economic impact on a substantial number of small entities. This
certification is based upon the fact that these regulations do not
impose any recordkeeping or reporting requirements and therefore
impose minimal compliance costs, if any, upon any small entities
that may be affected. Because equity options with standardized terms
will not be eligible for QCC treatment if such options have a
duration of more than 1 year, some taxpayers may lose substantive
tax benefits. This certification is further based upon the
understanding that such taxpayers will not include a substantial
number of small entities. Comments are specifically requested on the
question of whether a substantial number of small entities (as
opposed to large entities or individual investors) will suffer a
significant economic impact under these regulations. Therefore, a
Regulatory Flexibility Analysis under the Regulatory Flexibility Act
(5 U.S.C. chapter 6) is not required. 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 or electronic comments (a
signed original and eight (8) copies, if written) that are submitted
timely (in the manner described in the ADDRESSES portion of this
preamble) to the IRS. The IRS and Treasury request comments on the
clarity of the proposed regulations and how they may be made easier
to understand. All comments will be available for public inspection
and copying. A public hearing has been scheduled for May 9, 2001, at
10 a.m., in the IRS Auditorium, Internal Revenue Building, 1111
Constitution Avenue NW., Washington DC. Due to building security
procedures, visitors must enter at the 10th Street entrance located
between Constitution and Pennsylvania Avenues, NW. In addition, all
visitors must present photo identifications to enter the building.
Because of access restrictions, visitors will not be admitted beyond
the immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the
building access list to attend the hearing, see the "FOR FURTHER
INFORMATION CONTACT" section of this preamble.

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 and an outline of the topics to be discussed and the time
to be devoted to each topic (signed original and eight (8) copies)
by April 18, 2001. 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
Associate 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
entries in numerical order to read as follows:

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

Section 1.1092(c)-2 also issued under 26 U.S.C.1092(c)(4)(H).
Section 1.1092(c)-3 also issued under 26 U.S.C.1092( c)(4)(H).

* * *

Par. 2. Section 1.1092(c)-1 is amended as follows:

1. Paragraphs (b) and (d)(1)(ii) introductory text are revised.

2. Paragraphs (c) and (d)(3) are added.

3. Paragraph (e) is revised.

The revisions and addition read as follows: §1.1092(c)-1 Equity
options with flexible terms.

* * * * *

(b) No effect on lowest qualified bench mark for standardized
options. The availability of strike prices for 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 an
equity option with standardized terms.

(c) Qualified covered call option status--(1) Requirements. An
equity option with flexible terms is a qualified covered call option
only if--

(i) The option meets the requirements of section 1092(c)(4)(B)
(taking into account paragraph (c)(2) of this section);

(ii) The only payments permitted with respect to the option are a
single fixed premium paid not later than 5 business days after the
day on which the option is granted, and a single fixed strike price
stated as a dollar amount that is payable entirely at (or within 5
business days of) exercise;

( iii) The option is granted not more than 1 year before the day on
which the option expires; and

(iv) An equity option with standardized terms is outstanding for the
underlying equity.

(2) Lowest qualified bench mark--

(i) In general. For purposes of determining whether an equity option
with flexible terms is deep in the money within the meaning of
section 1092(c)(4)(C), the lowest qualified bench mark under section
1092(c)(4)(D) is the same for an equity option with flexible terms
as the lowest qualified bench mark for an equity option with
standardized terms on the same stock having the same applicable
stock price.

(ii) Example. The following example illustrates the rules set out in
paragraph (c)(2)(i) of this section: Example. Taxpayer owns stock in
Corporation X. Taxpayer writes an equity call option with flexible
terms on Corporation X stock through a national securities exchange.
The applicable stock price for Corporation X stock is $ 73.75. Using
the bench marks for an equity option with standardized terms with an
applicable stock price of $73.75, the highest available bench mark
less than the applicable stock price is $70, and the second highest
bench mark is $65. Therefore, an equity call option with flexible
terms on Corporation X with a term of 90 days or less will not be
deep in the money if the strike price is not less than $70. If the
term is greater than 90 days, an equity call option with flexible
terms on Corporation X will not be deep in the money if the strike
price is not less than $65.

(d) * * *

(1) * * *

(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 (d)(1)(i)
of this section) and is--

* * * * *

(3) Equity option with standardized terms means an equity option
that is traded on a national securities exchange registered with the
Securities and Exchange Commission and that is not an equity option
with flexible terms.

(e) Effective date--

(1) In general. Except as provided in paragraph (e)(2) of this
section, this section applies to equity options with flexible terms
entered into on or after January 25, 2000.

(2) Special effective date for paragraph (c). Paragraph (c) of this
section applies to equity options with flexible terms entered into
on or after 30 days after the date that the Treasury decision
adopting these regulations is published in the Federal Register.

Par. 3. Section 1.1092(c)-2 is added to read as follows:

§1.1092(c)-2 Equity options with standardized terms.

(a) One-year limitation. An equity option with standardized terms
(as defined in §1.1092(c)-1(d)(3)) is a qualified covered call
only if--

(1) The option meets the requirements of section 1092(c)(4)(B); and

(2) The option is granted not more than 1 year before the day on
which the option expires.

( b) Effective date. This section applies to equity options with
standardized terms entered into on or after 90 days after the date
that the Treasury decision adopting these regulations is published
in the Federal Register.

Par. 4. Section 1.1092(c)-3 is added.

§1.1092(c)-3 Qualifying over-the-counter options.

(a) In general. Under section 1092(c)(4)(B)(i), an equity option is
not a qualified covered call option unless it is traded on a
national securities exchange which is registered with the Securities
and Exchange Commission or other market which the Secretary
determines has rules adequate to carry out the purposes of section
1092(c)(4). In accordance with section 1092(c)(4)(H), this
requirement is modified as provided in paragraph (b) of this
section.

(b) Qualified covered call option status. A qualifying over-the-
counter option is a qualified covered call option if it meets the
requirements of §1.1092(c)-1(c) after substituting "qualifying
over-the-counter option" for "equity option with flexible terms".
For the purposes of this paragraph (b), a qualifying over the
counter option is deemed to satisfy the requirements of section
1092(c)(4)(B)(i).

(c) Qualifying over-the-counter option. For the purposes of this
section, qualifying over-the-counter option means an equity option
that--

(1) Is not traded on a national securities exchange registered with
the Securities and Exchange Commission; and

(2) Is entered into with a person registered with the Securities and
Exchange Commission as--

(i) A broker-dealer under section 15 of the Securities Act of 1934
and the regulations thereunder; or

(ii) An alternative trading system under 17 CFR 242.300 et seq.

(d) Effective date. This section applies to qualifying over-the-
counter options entered into on or after 30 days after the date that
the Treasury decision adopting these regulations is published in the
Federal Register.

Robert E. Wenzel  
Deputy Commissioner of Internal Revenue.   

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