'IHE 'JRXATIOFT OF I"FROM OPTION 

WRITING BY "RESIDENTS 

David E. Sbrt 

University of Southern California Law Center 

CrrA Paper 15 August 1976 

Office of Tax Analysis

U.S. TreaSUry DepartIEnt, 1104 

Washingtmn, D. C. 20220 

Issued: May 1977 
TABLE OF CONTENTS 

Page 

I. Introduction ................. 1 

I1. Basis of Taxability .............. 3 

I11. Modification of HR 12224 ........... 9 

IV. Withholding Tax on Nonresidents ........ 13 

V . Internatinal Implications of the U.S. 

Withholding Tax .............. 20 

VI . Revenue Estimate ............... 21 
1 

I. INTRODUCTION 

Legislation was introduced in early 1976 by 

Representative Mikva (D. Illinois) to close an unintended 

tax loophole involving the writing of call options. HR 

12224, enacted as Act Sec. 2136(b) of the Tax Reform Act of 

1976, reclassifies profits realized by writers upon the 

repurchase or lapse of their options from ordinary income to 

short-term capital gains. In so doing, it eliminates the 

loophole previously enjoyed by some domestic investors, and 

produces an estimated revenue gain of $10 million. 

However, HR 12224 also effectively exempts option 

premium income paid to nonresidents from U.S. taxation, at 

an estimated loss of $50 million (by comparison with what 

would be collected if such income were subject to U.S. tax). 

During the initial consideration of HR 12224 by the Ways and 

Means Committee, the belief was expressed that there was 

uncertainty regarding whether or not option writing income 

paid to nonresidents was subject to tax in the U.S. It was 

also suggested that it would be administratively impossible 

to implement a withholding tax on option premium income paid 

to nonresidents. In my view, neither of these contentions 

is entirely valid. Based on an examination of the 

characteristics of option premium income, it seems clear 

that the 30 percent withholding tax imposed under sections 

87% and 881 of the Internal Revenue Code should apply. 
2 

Further, the Office of International Operations of the IRS 

has indicated in writing that the 30 percent tax should be 

withheld. While the administrative aspects of this matter 

are complex, they are not insurmountable. The following 

presentation indicates: (1) the basis for assessment of tax 

at source on option premium income; (2) the modifications to 

HK 12224 which would be necessary to preserve the short-term 

capital gain treatment of this type of income when paid to 

domestic investors while retaining the right to withhold tax 

at source when paid to nonresidents: (3) the most promising 

means for implementation of a withholding tax; and (4) a 

brief explanation of,the $50 million revenue estimate. 
3 

11. BASIS OF TAXABILITY 

To justify the implementation of a U.S. withholding tax 

on option premium income paid to nonresidents, it must be 

shown that such premiums fall within the category of income 

subject to the nonresident withholding tax, and that the 

premium income is attributable to U.S. sources. 

The relevant sections of the Internal Revenue Code, 

sections 871, 881, and 1441, specify that "premiums" are to 

be included among the various types of income subject to the 

nonresident withholding tax. For example, section 871 

reads: 

"There is hereby imposed for each 

taxable year a tax of 30 percent of 

the amount received from sources 

within the United States by a 

nonresident alien individual as-­

(A) interest (other than original issue 

discount as defined in section 1232(b)),

dividends, rents, salaries wages, premiums,

annuities, compensation, remunerations, 

emoluments, and other fixed or determinable 

annual or periodical gains, profits, and 

income,. . " 

While it could be argued that the authors of these 

provisions did not specifically intend option premiums to be 

covered by this definition, income from option writing is 

in fact commonly termed "premium income". The use of the 

word "premium" to describe income paid to option writers 

stems not simply from an arbitrary convention adopted by the 

investment community. Rather, the nature of options 
4 

is in many ways similar to that of insurance policies, and 

payments to insurance underwriters have historically been 

referred to as "premiums". The holder of an option in 

effect purchases insurance which guarantees that within a 

specified time period he will be able to acquire a certain 

security at a set price, regardless of how great the rise in 

the market value of the security may be. The United States 

has a longstanding position of taxing insurance premiums 

paid to nonresidents. Section 4371 imposes a tax on various 

types of insurance, indemnity bonds, annuity contracts and 

reinsurance policies. While this levy has technically 

been classified as an excise tax, it has always been treated 

with income taxes for treaty purposes, and is in fact based 

on gross premium income paid to foreign insurers. Thus, to 

the extent that call options resemble insurance contracts, 

there is a clear precedent for the imposition of a tax at 

source based on the amount of gross income being paid. 

Regulation 1.1441-2 (a), defining the phrase 'Ifixed or 

determinable annual or periodical income," also points to 

the conclusion that option writing income is subject to 

withholding: 

"Income is determinable whenever there is a basis of calculation by which the amount 

to be paid may be ascertained. 

The income need not be paid

annually if it is paid periodically; that is to say, from 

time to time, whether or not 

at regular intervals. 
5 

Option premium income is determinable: at the time of 

exercise, expiration, or repurchase, the definite amount of 

the writer's gain or loss may be calculated. It is also 

periodical, in that it is paid "from time to time", even 

though not at regular intervals. Revenue Ruling 58-479, 

1958-2 C.B.60, clarified that income is "fixed or 

determinable annual or periodical" even if it is paid in one 

lump sum at one time with no expectation that any related 

payments will subsequently be made. The particular case 

established the taxability of a prize awarded by an art 

institute to a nonresident artist. Such a payment would not 

be determinable at the time the work of art was created or 

even at the time it was entered in the competition, 

paralleling the uncertainty regarding the income an option 

writer will eventually receive. Only at the end of the 

venture, after the judging, could the amount of the prize 

income be determined; similarly, only upon exercise, 

expiration, or repurchase can option premium income be 

determined. Further "periodical" payments to the artist 

would only result if additional works were entered in 

subsequent competitions, again paralleling the situation 

with respect to option writers, who continue to receive 

income periodically only if additional options are written. 

It might be advanced that option premium income is 

analogous to payments received upon the disposition of 

personal property, which, under existing law, are not 
6 

subject to U.S. taxation when paid to nonresidents. The 

thrust of this argument is based on the contention that 

options, like other securities, fall within the category of 

assets known as personal property. However, the writer of 

an option does not transfer any asset, personal property or 

otherwise, at the time of the sale of the option. Instead, 

the writer agrees to render the service of delivering a 

security at a specified price at some future time, upon 

instruction from the party to whom the option was sold. Prior 

to the passage of HR 12224, all pertinent legal doctrines 

provided that option premium income could not be categorized 

as income resulting from the disposition of personal 

-I/

property . Thus, profits which a writer realizes could be 

categorized more accurately as personal service income or 

insurance premiums than as proceeds from the disposition of 

personal property. And while there is some validity to the 

analogy between writing an option contract and performing a 

personal service, without exception the U.S. taxation 

authorities have categorized option premiums as investment 

income, rather than earned income. Therefore, the procedures 

which have been implemented to tax earned income derived from 

1/ For example, Revenue Ruling 63-183, 1963-2 C.B. 285, and - the Chicago Board Options Exchange Rulinq, 9 CCH Std. Fed 

Tax Hptr. 54739.201 (1974), state that the income realized 

in the closing transaction is not considered attributable to 

a sale or exchange. 
7 

U.S. sources by nonresidents are not apposite to this rather 

unique form of investment-personal service income. 

In order to impose a tax on option premium income, it 

must be clearly established that such income is derived from 

sources within the United States. From a technical standpoint, option premium income is always paid from a U.S. 

source, regardless of the domicile of the holder, since 

writers directly sell their options to and receive their 

premiums from the Options Clearing Corporation, a U.S. 

entity. (The Clearing Corporation, in turn, issues an 

identical security to the holder so that its asset (acquired 

from the writer) offsets the liability (issued to the 

holder). ) 

In conclusion, the most cogent justification for a U.S. 

source rule is the analogy between option writing income and 

insurance premiums. The role of the writer of call options 

is very much the role of an insurer. The writer guarantees 

to the holder that he will not suffer financial loss as a 

result of an increase in the market price of a security 

prior to his acquisition of that security, in exchange for a 

predetermined premium. Whenever foreign entities derive 

insurance premiums from within the U.S., such income is 

deemed attributable to sources within the United States. 

Similarly, when insurance coverage is provided through the 

vehicle of a call option, the income remitted to the 
8 

nonresident insurer in compensation for such services should 

be deemed attributable to sources within the United States. 

Section 863 authorizes the Secretary of the Treasury or 

his delegate to prescribe regulations specifying the 

determination of source for items of income not enumerated 

in sections 861(a) or 862(a). As option premium income is 

not referred to in either of those sections, the way is 

clear for Regulations to be promulgated providing for the 

attribution of option income to sources within the United 

States. 
9 

111. MODIFICATION OF H.R. 12224 

HR 12224 characterizes option writing income as 

short-term capital gain (or loss), regardless of the period 

for which the option is written and regardless of whether or 

not the option is exercised. The sole exception is in cases 

where the security underlying an option which is exercised 

has been held by the writer for a period of time longer than 

six months, in which case long-term capital gain (or loss) 

results. The characterization provided by HR 12224 ensures 

that U.S. residents cannot offset option writing losses 

against ordinary income. However, this domestic loophole 

could be closed in another way, without exempting option 

income paid to nonresidents from U.S. taxation. 

Under the alternative approach, the classification of 

profits from option writing could be changed back to 

ordinary income, as it was before the inclusion of HK 12224 

in the Tax Reform Act of 1976, but option-derived ordinary 

losses would only be deductible against option-derived 

ordinary income, and against capital gains (whether or not 

option-derived). Further, capital losses incurred in option 

investments would be deductible against ordinary optionderived income, as well as capital gains. Excess optionderived ordinary losses would be includible in the $1,000 

per year deduction against ordinary income provided by 

section 1211(b), and could be carried forward indefinitely-­

the same as short-term capital losses. 
10 

This alternative treatment would have the following 

effect in the three examples of option investments presented 

in the Committee Report on HR 12224 (94-1192): 

Writing a covered out-of-the-money 

*

o tion. Suppose Ford Motor Company

is selling for 57-1/4 (as it was 

on April 2, 1976) and someone writes a 

call for 100 shares at 60 expiring

October 16. On April 2 this option sold 

at a premium of 4. Assume the writer 

also buys 100 shares of Ford stock at 57-1/4. 

If the market price of the stock rises, the loss on the 

option would remain ordinary loss, but would only be 

deductible against the full amount of the gain on the 

underlying security. For example, if the price of Ford 

increased to 70, the gain on the stock (long-term capital 

gain) would be 32-3/4. The loss on the option would be 6. 

(10 repurchase cost less 4 premium.) This would be 

deductible from the full 12-3/4, for a net capital gain of 

6-3/4 (3-3/8 if long-term), the correct taxable amount if it 

is accepted that the actual amount of economic gain should be 

the basis for taxation. 

If the value of Ford declined to 50, the capital loss 

on the stock would be 7-1/4, while the ordinary income gain 

from the option premium would be 4. The amount of the 

capital loss would be allowed to offset the ordinary income 

so that net capital loss would be 3-1/4 (7-1/4 - 4), (1-5/8 
11 

if long term), which could be used to offset other option 

derived income or capital gains in the same taxation year, 

or carried forward. 

ExamDle 2. 

Writing covered in-the-money options. 

Assume that on April 2, 1976, an individual buys 

100 shares of Ford at 57-1/4 and writes a call 

option for 100 shares of Ford with an October 16 

expiration date and a striking price of 45. This 

option sold for a premium of 12-3/4 on April 2. 

If the market price for Ford stock rises to 70, the 

capital gain is 12-3/4, while the ordinary premium loss is 

12-1/4 (25 repurchase cost less 12-3/4 premium), which when 

deducted from the capital gain leaves the correct amount, 

1/2, as taxable income. 

With a price decline to 50, capital gain on the stock 

is l/2, if delivered upon exercise at 45. 

If the price of Ford falls to 40, the loss on the stock 

is 17-1/4, while the premium income is 12-3/4. The loss 

would be allowed to offset the premium, leaving 4-1/2 (2-1/4 

if long term) as excess capital loss. 

ExamDle 3. 

Option spreads. A "spread" consists of writing 

one option and buying another option on the same 

underlying stock. Suppose someone writes a call 

option on April 2, 1976, to buy 100 shares of Ford 

stock at 45 for a premium of 12-3/4 and on the same 

date buys an option to buy 100 shares of Ford at 50 

for a premium of 9-1/2. Both options have expiration

dates of October 16, and the price of Ford stock was 

57-1/4 on April 2. 
12 

If the price of the underlying stock increases to 70, 

ordinary loss on the 45 is 12-1/4, (25 - 12-3/4); while 

capital gain on the 50 is 10-1/2, (20 - 9-1/2). The 

ordinary loss completely offsets the capital gain, and a 

1-3/4 point loss remains to offset other capital gains or 

option-derived income, for inclusion in the section 1211 

$1,000 allowance, or to be carried forward. 

If the value of Ford falls to 40, the loss on the 50 is 

9-1/2 (capital), while the gain on the 45 is 12-3/4 

(ordinary). The 9-1/2 point loss partially offsets the 

ordinary gain, leaving net taxable ordinary income of 3-1/4 

points, which is the actual amount of economic gain. 

Essentially, the proposed modifications would leave the 

tax treatment of option income for domestic investors the 

same as proposed by HR 12224, but without classifying the 

income as short-term capital gain. This modification would 

retain the taxable status of option writing income when it 

is paid to nonresidents. In order to avoid possible 

confusion, section 861 might also be amended to state that 

premium income realized from the writing of options in the 

U.S. by nonresidents is allocable to sources within the 

United States. Alternately, this could be accomplished by 

the issuance of a Regulation, pursuant to section 863. 
13 

IV. WITHHOLDING TAX ON NONRESIDENTS 

The most administratively simple procedure for 

implementation of a tax on option premium income paid to 

nonresidents would be to impose a withholding tax on gross 

premium payments. Accepted accounting definitions recognize 

the realization of income from option writing only upon 

repurchase, exercise, or expiration. Therefore, a withholding tax on gross payments would be imposed not on 

income, but on gross receipts. Accordingly, the rate of the 

tax should be reduced from the customary 30 percent in order 

to reflect the fact that the basis upon which it is applied 

considerably exceeds the customary definition of option 

writing income. Since it is estimated that the ratio of 

gross premiums to net income is of the order of 2.6:1, an 

appropriate rate for the withholding tax would be approximately 10 percent. On average, a 10 percent tax on gross 

receipts would represent approximately the same level of 

taxation as a 30 percent tax levied on income realized at 

the close of the transaction. 

Many option writers will realize losses on their 

transactions. They might be required to deliver an 

underlying security at less than its market value, or they 

might repurchase the option for a premium greater than that 

received at the time of writing. Therefore, it seems 

appropriate to permit a "net income election" for option 

writing income paid to nonresidents, paralleling the 
14 

election provided for by sections 871(d) and 882(d) for real 

estate income. In other words, a 10 percent withholding tax 

would be applied to gross premiums, but nonresidents would 

be permitted a net income election. One provision of the 

section 871(d) alternative net income computation is the 

requirement that once the election has been made, it may not 

be revoked except with the consent of the Secretary or his 

delegate. Since the objective of a net income election is 

to offer more equitable--not necessarily more favorable--tax 

treatment to nonresident investors, the extension of this 

"lock-in" feature to the option net income election may be 

appropriate. It is difficult to determine the precise 

revenue impact of the net income election. However, by 

including a "lock-in" provision, its use would be confined 

to those for whom the withholding tax would otherwise create 

an unfair burden. 

Since any profits resulting from an option which is 

exercised are classified as capital gains, adherence to the 

same principles which require the withholding of tax from 

ordinary income calls for the exemption from tax of all 

profits realized upon exercise of an option. Consistency is 

one of the primary thrusts of this proposal for a revision 

of tax policy regarding option income paid to nonresidents, 

Since all gains and losses accruing to domestic investors 

upon the exercise of outstanding options are classified as 
15 

capital gains (long- or short-term depending on the duration 

of the holding period for the underlying security), the same 

treatment must be afforded nonresident option writers. It 

is well settled that capital gains realized by nonresidents 

are not subject to U.S. taxation: although section 861(a) 

attributes gains resulting from the disposition of 

securities within the United States to U.S. sourcesl 

Regulation 1.1441-2(a)f3) specifies that the proceeds of 

such sales do not constitute "fixed or determinable annual 

or periodical income", and hence, that such income is exempt 

from the withholding tax. While this will in fact lead to 

the realization of some income free of tax, its effect on 

revenues will be minimal, since only a small percentage of 

all options written are ever exercised. The brokerage 

commissions incurred in exercising an option far exceed the 

transaction cost of realizing the same amount of gross 

profit through the secondary market. Therefore, options are 

usually only exercised in specialized cases, to wit: a 

holder whose primary purpose in purchasing the options is to 

acquire a substantial holding of the underlying security 

without bringing about unfavorable upward price movements, 

or a covered writer wishing to dispose of a large holding of 

the underlying security. If profits realized upon exercise 

were to be included in taxable income, losses arising from 
16 

exercise would presumably have to be allowed as deductions, 

under the net income election. Therefore, exclusion from 

the tax base of gains and losses realized upon exercise 

should have only a negligible overall impact on the revenue 

estimate. The imposition of withholding tax on gross option 

writing premiums would not represent the first time tax was 

withheld from a payment other than net income. According to 

Revenue Ruling 72-87, 1972-1 C.B. 274, the full amount of a 

distribution which is partly attributable to earnings and 

profits and partly attributable to the disposition of 

capital assets is subject to withholding tax pending the 

determination of the proportion exempt as proceeds of sale 

or exchange, at which time a claim for partial refund is 

permitted. Even with interest or dividends, deductions for 

Such necessary expenses directly prerequisite to the 

production of income as brokerage commissions and 

safe-keeping fees are not allowed. The justification for 

the reduction in the rate of withholding tax is that while 

the difference between gross and net income may be 

relatively small for most other types of payments subject to 

the tax, viz. interest and dividends, it is quite 

sub$tantial in the case of option premium income. It would 

be unjust to impose a 30 percent tax on gross payments. By 

combining the lower-rqte withholding tax with a net income 

election, administrative expenses can be held at an 
17 

acceptable level, without the sacrifice of basic equity 

considerations. 

In order to minimize administrative expenses, the 

optimal method of implementation of a nonresident 

withholding tax should allocate as many of the collection 

procedures as possible to the brokerage firms, rather than 

to the Internal Revenue Service. The Office of 

International Operations of IRS has expressed the opinion 

that the present wording of section 1441 of the Code may be 

interpreted as requiring, in this instance, that the brokers 

assume liability for collection of the tax. 

An alternative proposal for implementation of a tax on 

option premium income paid to nonresidests calls for 

calculation by the brokers of net income arising from each 

option written, at the time of exercise, repurchase, or 

expiration of the option, and the withholding of 30 percent 

from this net income figure as tax. This is to say that tax 

would not be assessed until a closing transaction (or 

expiration) has taken place, and the net amount of income 

becomes determinable. Concededly, the brokerage industry 

would find this solution more complex than a 10 percent tax 

on gross receipts; but the nonresident investors might 

perceive this plan more favorably, in view of its decided' 

equity advantages. Specifically, the security underlying a 

covered option and the margin deposited with the broker with 
18 

respect to a naked option might be held as collateral to 

assure payment of tax liability upon realization of income 

(that is, upon expiration or repurchase). Due to the 

volatile nature of the call option market, substantial 

margin requirements have been adopted by the brokers for 

accounts engaging in option writing. The Options Clearing 

Corporation Prospectus states: 

"Brokers generally require Options

writers to enter into margin agreements

which give the broker a lien on securities and other assets held in the margin 

account. It 

I am proposing that these arrangements, which were designed 

to assure that securities could be delivered to meet the 

exercise of outstanding options, be extended to assure 

payment of tax liability upon termination of the option 

through repurchase qr expiration. In the case of naked 

writing, the amount of the tax liability would be withheld 

from the margin, with the balance being returned to the 

investor. In the case of covered writing, the investor 

would normally be given the opportunity of remitting the 

appropriate amount of tax in cash to the broker. However, 

if he failed to do so, the broker would have control of the 

underlying security, and would be able to dispose of the 

security in the market in order to obtain the funds 

necessary to fulfill the investor's tax liability. Any 

excess proceeds from the disposition of the underlying 

security would of course be remitted to the investor. 
19 

By withholding tax from the option writer's margin or 

underlying security, more equitable treatment can be 

afforded to the foreign investor with respect to option 

spreads. If a withholding tax is deducted directly from the 

gross premiums received, cash flow problems could result, as 

the number of spreads per given capital expenditure is 

decreased. This reduction in the rate of return drastically 

discriminates against the foreign investor. However, under 

the "net income withholding" proposal, neutrality between 

domestic and foreign investors is maintained. 
20 

V. INTERNATIONAL IMPLICATIONS OF THE U.S. WITHHOLDING TAX

Securities exchanges abroad might begin offering 

options identical to those traded in the U.S. in response to 

the implementation of a withholding tax. In the past, the 

exchanges have been reluctant to trade in options already 

offered on another exchange, but a U.S. withholding tax 

might be a sufficient impetus to overcome these inhibitions. 

However, since the U.S. withholding taxes are generally 

creditable against foreign income taxes, the implementation 

of the tax in the U.S. should not, in itself, create a major 

incentive for the development of foreign option markets. In 

the unlikely event that the possibility of foreign 

competition did materialize to the detriment of the existing 

U.S. option exchanges, the rate of the withholding tax could 

always be reduced by action of Congress, to a level 

sufficiently low as to preclude the profitable operation of 

the foreign exchanges. The creation of competing foreign 

markets would have a negative impact on revenues, but the 

potential extent of that effect is impossible to estimate. 

Given the improbability that such developments will take 

place in the foreseeable future, any modification of the 

revenue estimate does not appear to be justified. 
-- 

21 

VI. REVENUE ESTIMATE 

A procedure has been developed to estimate the revenue 

which would result from the implementation of a withholding 

tax on option premium income paid to nonresidents. First, 

the annual opening sales volume was determined this 

figure reflects only sales of options by their initial 

writers, and excludes resales by option holders. Next, 

random sampling was used to estimate the average price of an 

option. Multiplying these two figures gives the aggregate 

value of opening option sales for one year. By comparing 

foreign option commissions with domestic option commissions 

for several major brokerage firms, the proportion of 

nonresident participation in U.S. option markets was 

determined. Taking this percentage of the figure obtained 

in the previous step indicates the gross amount of premiums 

paid to nonresident option writers. Based on data compiled 

to date, this figure is $436 million. 

In order to determine net income, the Merrill Lynch 

projection of a 15 percent return on underlying capital was 

scaled down to 10 percent and was applied to the New York 

Stock Exchange Composite Index of stock prices, which was 

$55.57 on July 2, 1976, to give an expected annual income 

from covered option writing of $5.56 per share. Since each 

option exists for an average of 4-1/2 months, 2-2/3 options 

on each share would have to be written each year to yield an 
22 

income of $5.56 so that average net income per option would 

be $2.085. Multiplying this value by the estimated number 

of nonresident opening option sales indicates an aggregate 

net income figure of $169 million. Tax assessed at the rate 

of 30 percent on this amount would yield about $50 million 

per year in revenue. Approximately the same revenue figure 

would result from the taxation of gross premiums at the rate 

of 10 percent (see Tables 1 and 2). 

In view of the widely-held expectation that option 

trading volume will increase in the future, it seems 

probable that actual tax collections may reach even higher 

levels. Total U.S. tax withheld from income paid to 

nonresidents during the year 1972 amounted to over $217 

million. Collection of $50 million from withholding on 

option premiums would increase that figure by 23 percent. 

While investment in call options may be somewhat less 

salient than investment in stocks and bonds, the revenues 

that can accrue from the taxation of option premium income 

paid to nonresidents is far from negligible. Implementation 

of the tax according to the procedures outlined herein will 

result in both equity for the investor, and a substantial 

increase in nonresident tax revenues for the Treasury. 
23 

Table 1: Gross Income Derivation 

Annual Opening Sales 

Average Option Price 

Opening Sale Value 

Nonresident Participation 

Nonresident Opening Sale Value 

1,195 million options 

$5.38 

$6,431 million 

6.78 percent 

$436 million 
24 

Table 2: Net Income Derivation 

Annual Opening Sales 

Nonresident Participation 

Nonresident Opening Sale Volume 

Profit per Option 

Nonresident Net Income 

Tax Revenue (at 30%) 

1,195 million options 

6.78 percent 

81 million 

$2.09 

$169 million 

$50 million