[Federal Register Volume 66, Number 12 (Thursday, January 18, 2001)]
[Proposed Rules]
[Pages 4751-4754]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1294]


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DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-115560-99]
RIN 1545-AX66


Equity Options With Flexible Terms; Qualified Covered Call 
Treatment

AGENCY: Internal Revenue Service (IRS), Treasury.

[[Page 4752]]


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 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 
Sec. 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 risk of loss on the stock.'' 
H.R. Rep. No. 432, 98th Cong., 2d 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

[[Page 4753]]

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 * * *


[[Page 4754]]


    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:


Sec. 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:


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

    (a) One-year limitation. An equity option with standardized terms 
(as defined in Sec. 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.


Sec. 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 Sec. 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.
[FR Doc. 01-1294 Filed 1-17-01; 8:45 am]
BILLING CODE 4830-01-P