[Federal Register Volume 63, Number 122 (Thursday, June 25, 1998)]
[Proposed Rules]
[Pages 34616-34618]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16848]


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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