[Federal Register Volume 67, Number 82 (Monday, April 29, 2002)]
[Rules and Regulations]
[Pages 20896-20901]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-9929]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8990]
RIN 1545-AX66


Equity Options With Flexible Terms; Qualified Covered Call 
Treatment

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final 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 final regulations provide guidance to 
taxpayers writing equity call options.

DATES: Effective Date: These regulations are effective April 29, 2002.
    Applicability Date: For dates of applicability, see 
Secs. 1.1092(c)-1(c), 1.1092(c)-2(d), 1.1092(c)-3(c), and 1.1092(c)-
4(g).

FOR FURTHER INFORMATION CONTACT: Pamela Lew, (202) 622-3950 or Viva 
Hammer, (202) 622-0869 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    On January 18, 2001, the IRS published in the Federal Register 
proposed regulations (REG-115560-99, 66 FR 4751) addressing various 
issues concerning qualified covered call (QCC) options under section 
1092(c)(4). No requests to speak at a public hearing were received, and 
no public hearing was held.
    The proposed regulations provide that equity options with flexible 
terms (FLEX options) 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 over-the-counter 
(OTC) options may be QCC options so that OTC options that are 
economically similar to FLEX options may receive the same tax treatment 
as FLEX options. 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 (SEC) as 
a broker-dealer or alternative trading system and meets the same 
requirements for QCC treatment that apply to FLEX options.
    The proposed regulations further provide that equity options with 
standardized terms with maturities of longer than one year cannot be 
QCC options.
    Comments were requested about the proposed one-year limit for all 
QCCs, including a discussion of time limitations in general. If a 
commentator recommended a time limitation greater than one year or 
recommended that there be no time limitation, a detailed, comprehensive 
description of possible solutions to the problem of increased risk 
reduction caused by longer term options was requested. Commentators 
were also asked to address the administrability of any proposed 
solutions.
    After revisions to take into account several of the comments 
submitted, the proposed regulations are adopted by this Treasury 
decision.

Summary of Principal Comments

    Four commentators responded to the request for comments. Two of the 
commentators addressed only the proposed 1-year limitation applicable 
to all QCC options. A third commentator addressed the proposed 1-year 
limit as well as a number of other issues. The fourth commentator 
focused on issues other than the proposed 1-year limitation.

One-Year Term Limitation

    A number of commentators object to the proposal to limit QCC 
treatment to options with a duration of one year or less. These 
commentators note that the statute does not contain any limitation on 
the maximum term for QCCs and argue that a one-year limitation would be 
overly harsh. Among other things, they note that a strict one-year rule 
would preclude QCC status for even out-of-the-money options. One 
commentator notes that section 1092(c)(4) does not remove a QCC option 
completely from the straddle rules. Paragraphs (c)(4)(E) and (f) of 
section 1092 provide special limitations on QCCs for recognition of 
loss and suspension of holding period.\1\ This commentator suggests 
that these rules limit the extent to which longer-term QCCs would lead 
to results inconsistent with the purposes of section 1092.
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    \1\ Under section 1092(c)(4)(E), the exception for QCCs does not 
apply to a covered call that would otherwise qualify for the 
exception if one leg is disposed of at a loss in one year, gain on 
the other position is includible for a later year, and less than 30 
days has elapsed between these transactions. Under section 1092(f), 
if a taxpayers grants an in-the-money QCC, then loss on the call is 
treated as long-term capital loss if gain on the underlying stock 
would be long-term capital gain. In addition, the holding period is 
suspended for the period during which the taxpayer is the grantor of 
the option.
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    In response to the request in the preamble to the proposed 
regulation for alternative regimes to address the increased risk 
reduction created by longer-term options, two commentators suggest an 
adjustment to the ``applicable stock price'' to reflect forward pricing 
concepts. These commentators suggest that the unadjusted applicable 
stock price, as determined on the date the option is granted, be 
multiplied by a simple adjusting factor to produce an

[[Page 20897]]

applicable stock price adjusted for the passage of time. For each 
additional term year, the factor would be increased by 5%. For example, 
the factor for a one-to-two year option would be 105%, and the factor 
for a two-to-three year option would be 110%. The adjusted applicable 
stock price would then be used to determine the applicable benchmarks 
and the lowest permitted QCC strike price. The commentators prefer, 
however, no limitation on the term of QCC options.

Clarification of ``Single Fixed Strike Price''

    Proposed Sec. 1.1092(c)-1(c)(1)(ii) requires a QCC option to have 
``a single fixed strike price stated as a dollar amount.'' One 
commentator suggests that this phrase does not account for adjustments 
to the strike price due to certain corporate events, such as stock 
splits, stock dividends, spin-offs, mergers, or substantial cash 
dividends that reduce the market value of the stock by at least 10%. 
For example, a strike price might not be considered fixed if the 
underlying stock split two-for-one and the option's strike price were 
adjusted to one-half of its original strike price. The commentator 
recommends that the language be modified to account for these events.

Clarification That the Lowest Qualified Benchmark for a FLEX Option Is 
the Same as for an Equity Option With Standardized Terms

    Proposed Sec. 1.1092(c)-1(c)(2)(i) provides that to determine 
whether a FLEX option is deep in the money, the taxpayer must use the 
same lowest qualified benchmark that is used for a standardized option 
on the same stock having the same applicable stock price. One 
commentator argues that the language in the proposed regulation is 
ambiguous. The commentator suggests that the language in the proposed 
regulation be changed to provide that the lowest qualified benchmark 
for a FLEX option is equal to the lowest available strike price at 
which a standardized call option can be written without being deep in 
the money.

Requirement That an Equity Option With Standardized Terms Exist at the 
Time an Equity Option With Flexible Terms or Qualifying Over-the-
Counter Option Is Written

    Under Sec. 1.1092(c)-1(c)(1)(iv) of the proposed regulation, a FLEX 
option can be a QCC option only if ``[a]n equity option with 
standardized terms is outstanding for the underlying equity.'' Under 
exchange rules, trading in a FLEX option cannot be authorized unless 
trading in a standardized option on the same stock has been authorized. 
Although a commentator believes it unlikely that a FLEX option would be 
written on a stock for which there were no outstanding standardized 
options, the commentator sees no reason to impose this restriction. 
Thus, the commentator recommends that the word ``available'' be 
substituted for the word ``outstanding.''

Clarification of ``Equity Option With Standardized Terms'''

    Under proposed Sec. 1.1092(c)-1(d)(3), an equity option with 
standardized terms is defined as ``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.'' One commentator notes that there is no definition of ``equity 
option'' and wonders whether the definition of equity option in section 
1256(g) applies here. That definition would include options on narrow 
based indexes. In addition, because an equity option with standardized 
terms is defined as a negative (i.e., anything that is not a FLEX 
option), if the exchanges approve a new option product that does not 
meet the definition of FLEX option, that product might meet the 
definition of a standardized option, thus affecting the application of 
the regulations for FLEX options. The commentator did not provide 
alternative regulatory language.

Clarification of ``Entered Into With''

    Under proposed Sec. 1.1092(c)-3(c)(2)(i), a qualifying OTC option 
must be ``entered into with'' a person registered with the SEC as a 
broker-dealer. One commentator is concerned that this phrase implies 
that the broker-dealer must act as a principal in the transaction. The 
commentator requests that the language be modified to say that the 
broker-dealer may be a principal to the transaction or may serve as an 
agent.

Add Banks to the List of Parties With or Through Whom a QCC May Be 
Transacted

    One commentator requests that banks be added to the list of parties 
with or through whom a QCC transaction may be effected. The commentator 
notes that under the Gramm-Leach-Bliley Act, Public Law 106-102, 113 
Stat. 1338 (1999), banks will be required to interpose a broker-dealer 
registered with the SEC in transactions with customers who are not 
``qualified investors.'' Banks will be permitted to function as broker-
dealers with respect to ``qualified investors.''
    The commentator suggests defining a bank as a ``bank within the 
meaning of section 3(a)(6) of the Securities Exchange Act of 1934 and 
the regulations adopted thereunder.'' The commentator argues that any 
such bank would be subject to a banking regulatory authority within the 
United States and would generally be subject to record-keeping 
requirements.

Explanation of Provisions

Limitation of Option Term

    As originally enacted in 1981, section 1092 did not apply to stock 
or to options on stock. In the legislative history to the Tax Reform 
Act of 1984, the House Ways and Means Committee stated that taxpayers 
had attempted to exploit the exemption from the loss-deferral rule for 
exchange-traded stock options to defer tax on income from unrelated 
transactions. H. Rep. No. 432, 98th Cong., 2d Sess. 1266 (1984). The 
Committee stated that a typical abusive stock option straddle 
``involves the acquisition of `deep-in-the-money' offsetting option 
positions. Regardless of whether the value of the underlying stock 
increases or decreases, one option position will result in a loss that 
can be realized for tax purposes, while the other position results in a 
gain of approximately equal size that can be deferred until the next 
year.'' Id. In response to these concerns, Congress generally ended the 
exemption from the straddle rules for stock and exchange-traded 
options.
    The House Ways and Means Committee noted, however, that the 
extension of the straddle rules to stock options and stock would affect 
the widely used investment strategy of writing call options on stock 
owned by the taxpayer. The Committee stated that it might be 
appropriate to exempt transactions that were 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. Congress therefore amended 
section 1092 to permit a taxpayer owning stock and writing a covered 
call option generally to avoid straddle treatment if certain conditions 
were met. One condition was that the strike price of the call could not 
be less than a statutorily-prescribed level relative to the market 
price of the underlying stock. In establishing this exception to the 
straddle rules, Congress granted the Secretary broad regulatory 
authority to modify section 1092 to take account of changes in the 
practices of options exchanges or to prevent tax avoidance.
    Since 1984, numerous changes have occurred in the practices of 
options

[[Page 20898]]

exchanges. In 1984, no exchange-traded option had a term of greater 
than nine months. By contrast, certain exchange-traded options 
currently may have terms of up to 33 months. In light of these changes, 
the IRS and Treasury have considered certain economic characteristics 
of qualified covered call transactions as they relate to the risk 
reduction effects of longer-term options.
    One way of looking at the risk reduction effect of a covered call 
option focuses on the day-to-day (or intra-day) relative changes in 
value of the stock and the option. In general, the values of stock and 
a written call option on the stock vary inversely when viewed from the 
perspective of the person owning the stock and writing a call option. 
Each movement in the stock price produces a movement in the value of 
the written call that, at least partially, offsets the change in value 
of the long position in the stock.
    Modern option pricing literature describes this relationship 
between the change in value of the underlying stock and the change in 
value of the option using the parameter ``Delta''. If a change in value 
of the stock results in an equal movement in the value of the option, 
Delta equals 1. If the change in value of the option is less than the 
change in value of the stock, then Delta is less than 1. From the 
perspective of a call option writer, because of the inverse 
relationship between changes in stock price and changes in option value 
described above, Delta represents the amount of offset that a change in 
stock value has upon the value of the written call option. Delta values 
vary with a number of factors, including the extent to which the option 
is in or out of the money and the term of the option. All else being 
equal, longer-term options have higher Delta values and, therefore, 
have a greater risk reduction potential than short-term options with 
respect to movements in stock prices.
    Another economic characteristic of longer-term covered call options 
is increased potential for the immediate recognition of a stock loss 
and the deferral of any gain arising from a related option. As noted 
above, when section 1092(c)(4) was enacted, no qualified covered call 
option had a term of more than nine months, and the mismatch for a QCC 
thus could not have spanned more than one taxable year. With the advent 
of longer-term options, the potential for a mismatch between a loss and 
the deferral of related income can extend over many taxable years, 
which may not have been contemplated by Congress when the QCC 
provisions were enacted.
    After reviewing taxpayers' comments received in light of these 
economic considerations, the IRS and Treasury have decided to adopt a 
forward pricing approach for the determination of the applicable stock 
price for an option with a term greater than 12 months. To determine 
the applicable stock price for an option with a term greater than 12 
months, taxpayers are required to multiply the statutory applicable 
stock price by a factor, which represents a noncompounded two percent 
per quarter increase in the applicable strike price. Based on certain 
assumptions regarding the volatility of the underlying stock and the 
risk-free interest rate, the use of such factors for options with a 
relatively short term (i.e., 33 months or less) will produce Deltas 
that are generally similar to those for a nine-month option with no 
adjustment to the applicable strike price. Because no exchange-traded 
option currently has a term of more than 33 months, and because the 
application of the approach set forth above to options with terms 
longer than 33 months may permit the use of such options for tax 
avoidance, the IRS and Treasury believe that it would be inappropriate 
to extend this approach to such options. Thus, no option will 
constitute a qualified covered call option if it has a term of greater 
than 33 months. Additional guidance about the maximum term limit may be 
provided by the Commissioner in guidance published in the Internal 
Revenue Bulletin. This could occur, for example, if the option 
exchanges commence trading of equity options with standardized terms 
that expire more than 33 months after the date of issuance.
    The definition of a QCC option also affects a number of other Code 
sections. These are generally provisions that require a taxpayer to 
bear economic risk with respect to an asset for purposes of 
establishing a requisite holding period in the asset. See sections 
246(c)(1), 852(b)(4)(C), 857(b)(8)(B), 901(k)(5), 1059(d)(3), and 
1259(c)(3)(A)(iii). The IRS and the Treasury have taken into account 
the interaction of the QCC qualification rules and these other Code 
sections in light of the risk reduction potential of longer-term 
options. If, however, experience suggests that longer-term QCC options 
are being exploited to achieve risk reduction while allowing taxpayers 
to establish holding periods in ways that are inconsistent with another 
Code provision (e.g., section 1259), the IRS and Treasury may 
reconsider the issue of term limitations for QCCs, either generally for 
purposes of section 1092 or specifically for purposes of such other 
Code provision.

Clarification of ``single fixed strike price''

    After consideration of the comment submitted, a definition for 
``single fixed strike price'' is added at Sec. 1.1092(c)-4(d), 
providing that adjustments to the strike price for certain significant 
corporate events subsequent to the writing of the option will not cause 
the option to fail the requirement of a single fixed strike price. The 
definition is intended to cover adjustments to the strike price made 
under Section 11 of Article VI of the Options Clearing Corporation By-
Laws.

Clarification That the Lowest Qualified Benchmark for a FLEX Option Is 
the Same as for an Equity Option With Standardized Terms

    After consideration of the comment submitted, examples have been 
added at Sec. 1.1092(c)-2(c)(2)(ii) to clarify that the lowest 
qualified benchmark for a FLEX option is the same as the lowest 
qualified benchmark for an equity option with standardized terms on the 
same stock having the same applicable stock price.

Requirement That an Equity Option With Standardized Terms Exist at the 
Time an Equity Option With Flexible Terms or Qualifying Over-the-
Counter Option Is Written

    After consideration of the comment submitted, the language is 
finalized as proposed.
    This provision was inserted in the proposed regulation for two 
reasons. The first reason was to provide benchmarks for FLEX options. 
Because FLEX option strike prices can be written in one penny 
intervals, without this provision every FLEX option would be deep-in-
the-money if the strike price were one penny less than the applicable 
stock price. By tying every FLEX option to a standardized option, the 
benchmarks are the strike prices set by the exchanges for standardized 
options. For this purpose, an authorized standardized option would 
suffice.
    The second reason underlying this provision is to facilitate the 
discovery of attempts to use off-market pricing of FLEX options or 
qualifying OTC options as a method of effecting collateral 
transactions. If a FLEX option or qualifying OTC option were written 
for an off-market premium, that would warn of the potential for the 
existence of one or more other transactions. For example, a qualifying 
OTC option might be written by a corporation and held by a shareholder. 
If the premium were

[[Page 20899]]

excessively low compared to that for a standardized option on that same 
stock, the additional value received by the holder might be 
appropriately characterized as a dividend. Thus, with an outstanding 
standardized option on the same stock, the existence of an excessively 
low premium for a FLEX option would be more transparent.

Clarification of ``Equity Option With Standardized Terms''

    After consideration of the comment submitted, a new definition for 
``equity option with standardized terms'' is provided at 
Sec. 1.1092(c)-4(b). The factors listed in this section were based on 
the rules of the exchanges establishing required provisions of 
exchange-traded equity options.

Clarification of ``Entered Into With''

    After consideration of the comment submitted, a clarification is 
added to Sec. 1.1092(c)-4(c)(2)(i) to explain that the broker-dealer 
may be a principal to the transaction or can serve as an agent.

Add Banks to the List of Parties With or Through Whom a QCC May Be 
Transacted

    After consideration of the comment submitted and review of the 
recordkeeping requirements of 12 CFR 12.3, 12 CFR 208.34, and 12 CFR 
344.4, banks that are required to comply with these recordkeeping 
requirements are added to the list of parties with or through whom a 
qualifying over-the-counter option may be transacted.

Other Provisions

    Section Sec. 1.1092(c)-1 was redesignated Sec. 1.1092(c)-2 to 
facilitate the insertion of the general term limitations applying to 
all QCC options. The definitions in former Sec. 1.1092(c)-1(d) were 
moved to Sec. 1.1092(c)-4 to facilitate consolidation of definitions 
that apply to QCC options.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. Pursuant to section 
7805(f) of the Internal Revenue Code, the notice of proposed rulemaking 
was submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.
    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 the only category of 
small entities likely to be affected are small broker-dealers or small 
federally-regulated financial institutions who may be included among 
the financial intermediaries implementing the changes effected by these 
regulations. The requirements contained in these regulations do not 
impose more than a minimal compliance burden because the required 
changes in computer programs and back office procedures are 
insignificant. In addition, 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. 
Therefore, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required.

Drafting Information

    The principal authors of these regulations are Pamela Lew, Office 
of Associate Chief Counsel (Financial Institutions and Products) and 
Viva Hammer, Office of Tax Policy (Department of Treasury). 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is 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 in part 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).
    Section 1.1092(c)-4 also issued under 26 U.S.C. 1092(c)(4)(H). * 
* *


    Par. 2. Section 1.1092(c)-1 is redesignated as Sec. 1.1092(c)-2.

    Par. 3. A new Sec. 1.1092(c)-1 is added to read as follows:


Sec. 1.1092(c)-1  Qualified covered calls.

    (a) In general. 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 qualified covered call option and owning the optioned stock 
is not treated as a straddle under section 1092 if certain conditions, 
described in section 1092(c)(4)(B), are satisfied. Section 
1092(c)(4)(H) authorizes the Secretary to modify these conditions to 
carry out the purposes of section 1092(c)(4) in light of changes in the 
marketplace.
    (b) Term limitation--(1) General rule. Except as provided in 
paragraph (b)(2) of this section, an option is not a qualified covered 
call unless it is granted not more than 12 months before the day on 
which the option expires or satisfies term limitation and qualified 
benchmark requirements established by the Commissioner in guidance 
published in the Internal Revenue Bulletin (see 
Sec. 601.601(d)(2)(ii)(b) of this chapter).
    (2) Special benchmark rule for an option granted not more than 33 
months before the day on which the option expires--(i) In general. The 
12-month limitation described in paragraph (b)(1) of this section is 
extended to 33 months provided the lowest qualified benchmark is 
determined using the adjusted applicable stock price, as defined in 
Sec. 1.1092(c)-4(e).
    (ii) Examples. The following examples illustrate the rules set out 
in paragraph (b)(2)(i) of this section:

    Example 1.  Taxpayer owns stock in Corporation X. Taxpayer 
writes an equity option with standardized terms on Corporation X 
stock through a national securities exchange with a term of 21 
months. The applicable stock price for Corporation X stock is $100. 
The bench marks for a 21-month equity option with standardized terms 
with an applicable stock price of $100 will be based upon the 
adjusted applicable stock price. Using the table at Sec. 1.1092(c)-
4(e), the applicable stock price of $100 is multiplied by the 
adjustment factor 1.12, resulting in an adjusted applicable stock 
price of $112. Using the bench marks for an equity option with 
standardized terms with an adjusted applicable stock price of $112, 
the highest available strike price less than the adjusted applicable 
stock price is $110, and the second highest strike price less than 
the adjusted applicable stock price is $105. Therefore, a 21-month 
equity call option with standardized terms on Corporation X stock 
will not be deep in the money if the strike price is not less than 
$105.
    Example 2. Taxpayer owns stock in Corporation Y. Taxpayer writes 
an equity option with standardized terms on Corporation Y stock 
through a national securities exchange with a term of 21 months. The 
applicable stock price for Corporation Y stock is $13.25. The bench 
marks for a 21-month equity option with standardized terms with an 
applicable stock price of $13.25 will be based upon the adjusted 
applicable stock price. Using the

[[Page 20900]]

table at Sec. 1.1092(c)-4(e), the applicable stock price of $13.25 
is multiplied by the adjustment factor 1.12, resulting in an 
adjusted applicable stock price of $14.84. Using the bench marks for 
an equity option with standardized terms with an adjusted applicable 
stock price of $14.84, the highest available strike price less than 
the adjusted applicable stock price is $12.50. However, under 
section 1092(c)(4)(D), the lowest qualified bench mark can be no 
lower than 85% of the applicable stock price, which for Corporation 
Y stock is $12.61 (85% of the adjusted applicable stock price of 
$14.84). Thus, because the highest available strike price less than 
the adjusted applicable stock price for an equity option with 
standardized terms is lower than the lowest qualified bench mark 
under section 1092(c)(4)(D), the lowest strike price at which a 
qualified covered call option can be written is the next higher 
strike price, or $15.00. Therefore, a 21-month equity call option 
with standardized terms on Corporation Y stock will not be deep in 
the money if the strike price is not less than $15.

    (c) Effective date. This section applies to qualified covered call 
options entered into on or after July 29, 2002.

    Par. 4. Section 1.1092(c)-4 is added to read as follows:


Sec. 1.1092(c)-4  Definitions.

    The following definitions apply for purposes of Secs. 1.1092(c)-1 
through 1.1092(c)-3:

    Par. 5. Section 1.1092(c)-2 is amended as follows:
    1. Paragraph (b) is revised.
    2. Paragraph (c) is added.
    3. The paragraph in Sec. 1.1092(c)-2 indicated in the first column 
is redesignated as a paragraph in Sec. 1.1092(c)-4 as indicated in the 
second column as follows:

------------------------------------------------------------------------
            Sec.  1.1092(c)-2                    Sec.  1.1092(c)-4
------------------------------------------------------------------------
(d)(1) introductory text.................  (a) introductory text
(d)(1)(i) introductory text..............  (a)(1) introductory text
(d)(1)(i)(A).............................  (a)(1)(i)
(d)(1)(i)(B).............................  (a)(1)(ii)
(d)(1)(i)(C).............................  (a)(1)(iii)
(d)(1)(i)(D).............................  (a)(1)(iv)
(d)(1)(ii) introductory text.............  (a)(2) introductory text
(d)(1)(ii)(A)............................  (a)(2)(i)
(d)(1)(ii)(B)............................  (a)(2)(ii)
(d)(2)...................................  (f)
------------------------------------------------------------------------

    4. Paragraph (d) is revised.
    5. Paragraph (e) is removed.
    The revisions and additions read as follows:


Sec. 1.1092(c)-2  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) and 
Sec. 1.1092(c)-1 (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, as 
defined in Sec. 1.1092(c)-4(d), that is payable entirely at (or within 
5 business days of) exercise;
    (iii) An equity option with standardized terms is outstanding for 
the underlying equity; and
    (iv) The underlying security is stock in a single corporation.
    (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) Examples. The following examples illustrate the rules set out 
in paragraph (c)(2)(i) of this section:

    Example 1. Taxpayer owns stock in Corporation X. Taxpayer writes 
an equity call option with flexible terms on Corporation X stock 
through a national securities exchange for a term of not more than 
12 months. 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 strike price less than the applicable stock price is $70, 
and the second highest strike price less than the applicable stock 
price is $65. Therefore, an equity call option with flexible terms 
on Corporation X stock 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.
    Example 2. Taxpayer owns stock in Corporation Y. Taxpayer writes 
a 9-month equity call option with flexible terms on Corporation Y 
stock through a national securities exchange. The applicable stock 
price for Corporation Y stock is $14.75. Using the bench marks for 
an equity option with standardized terms with an applicable stock 
price of $14.75, the highest available strike price less than the 
applicable stock price is $12.50. However, under section 
1092(c)(4)(D), the lowest qualified bench mark can be no lower than 
85% of the applicable stock price, which for Corporation Y stock is 
$12.54. Thus, because the highest available strike price less than 
the applicable stock price for an equity option with standardized 
terms is lower than the lowest qualified bench mark under section 
1092(c)(4)(D), the lowest strike price at which a qualified covered 
call option can be written is the next higher strike price, or 
$15.00. This $15.00 strike price requirement for a qualified covered 
call option applies to equity options with flexible terms, equity 
options with standardized terms, and qualifying over-the-counter 
options.
    Example 3. Taxpayer owns stock in Corporation Z. On May 8, 2003, 
Taxpayer writes a 21-month equity call option with flexible terms on 
Corporation Z stock through a national securities exchange. The 
applicable stock price for Corporation Z stock is $100. The bench 
marks for a 21-month equity option with standardized terms with an 
applicable stock price of $100 will be based upon the adjusted 
applicable stock price. Using the table at Sec. 1.1092(c)-4(e), the 
applicable stock price of $100 is multiplied by the adjustment 
factor 1.12, resulting in an adjusted applicable stock price of 
$112. The highest available strike price less than the adjusted 
applicable stock price is $110, and the second highest strike price 
less than the adjusted applicable stock price is $105. Therefore, a 
21-month equity call option with flexible terms on Corporation Z 
stock will not be deep in the money if the strike price is not less 
than $105.

    (d) Effective date--(1) In general. Except as provided in paragraph 
(d)(2) of this section, this section applies to equity options with 
flexible terms entered into on or after January 25, 2000.
    (2) Effective date for paragraphs (b) and (c) of this section. 
Paragraphs (b) and (c) of this section apply to equity options with 
flexible terms entered into on or after July 29, 2002.

    Par. 6. Section 1.1092(c)-3 is added to read as follows:


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 that is registered with the Securities and Exchange 
Commission or other market that 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, as defined in Sec. 1.1092(c)-4(c), is

[[Page 20901]]

a qualified covered call option if it meets the requirements of 
Secs. 1.1092(c)-1 and 1.1092(c)-2(c) after using the language 
``qualifying over-the-counter option'' in place of ``equity option with 
flexible terms''. For 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) Effective date. This section applies to qualifying over-the-
counter options entered into on or after July 29, 2002.

    Par. 7. Section 1.1092(c)-4 is further amended as follows:
    1. Newly designated paragraphs (a)(1)(iv), (a)(2) introductory 
text, and (a)(2)(i) are revised.
    2. Paragraphs (b), (c), (d), (e), and (g) are added.
    The revisions and additions read as follows:


Sec. 1.1092(c)-4  Definitions.

* * * * *
    (a) * * *
    (1) * * *
    (iv) Any changes to the Security Exchange Act Releases described in 
paragraphs (a)(1)(i) through (iii) of this section that are approved by 
the Securities and Exchange Commission; or
    (2) That is traded on any national securities exchange that is 
registered with the Securities and Exchange Commission (other than 
those described in the Security Exchange Act Releases set forth in 
paragraph (a)(1) of this section) and is--
    (i) Substantially identical to the equity options described in 
paragraph (a)(1) of this section; and
* * * * *
    (b) Equity option with standardized terms means an equity option--
    (1) That is traded on a national securities exchange registered 
with the Securities and Exchange Commission;
    (2) That, on the date the option is written, expires on the 
Saturday following the third Friday of the month of expiration;
    (3) That has a strike price that is set at a uniform minimum strike 
price interval, that is established by the applicable national 
securities exchange registered with the Securities and Exchange 
Commission, and that is not less than $1.00; and
    (4) That has stock in a single corporation as its underlying 
security.
    (c) 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--
    (i) A broker-dealer, acting as principal or agent, who is 
registered with the Securities and Exchange Commission under section 15 
of the Securities Act of 1934 (15 U.S.C. 78a through 78mm) and the 
regulations thereunder and who must comply with the recordkeeping 
requirements of 17 CFR 240.17a-3; or
    (ii) An alternative trading system under 17 CFR 242.300 through 17 
CFR 242.303; or
    (iii) A person, acting as principal or agent, who must comply with 
the recordkeeping requirements for securities transactions described in 
12 CFR 12.3, 12 CFR 208.34, or 12 CFR 344.4.
    (d) Single fixed strike price means a strike price that is fixed, 
determinable, and stated as a dollar amount on the date the option is 
written. An option will not fail to have a single fixed strike price 
if, after the date the option is written, the strike price is adjusted 
to account for the effects of a dividend, stock dividend, stock 
distribution, stock split, reverse stock split, rights offering, 
distribution, reorganization, recapitalization, or reclassification 
with respect to the underlying security, or a merger, consolidation, 
dissolution, or liquidation of the issuer of the underlying security.
    (e) Adjusted applicable stock price means the applicable stock 
price, as defined in section 1092(c)(4)(G), adjusted for time. To 
determine the adjusted applicable stock price, the applicable stock 
price, which is determined in accordance with the rules in section 
1092(c)(4)(G), is multiplied by an adjustment factor. The adjustment 
factor table is as follows:

------------------------------------------------------------------------
                  Option term (in months)
------------------------------------------------------------  Adjustment
            Greater than                  Not more than         factor
------------------------------------------------------------------------
12.................................  15....................         1.08
15.................................  18....................         1.10
18.................................  21....................         1.12
21.................................  24....................         1.14
24.................................  27....................         1.16
27.................................  30....................         1.18
30.................................  33....................         1.20
------------------------------------------------------------------------

* * * * *
    (g) Effective dates. (1) Except for paragraph (a)(2) of this 
section, paragraph (a) of this section applies to equity options with 
flexible terms entered into on or after January 25, 2000. Paragraph 
(a)(2) of this section applies to equity options with flexible terms 
entered into on or after July 29, 2002.
    (2) Paragraphs (b), (c), (d), and (e) of this section apply to 
equity options entered into on or after July 29, 2002.
    (3) Paragraph (f) of this section applies to equity options entered 
into on or after January 25, 2000.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: April 12, 2002.
Mark A. Weinberger,
Assistant Secretary of the Treasury.
[FR Doc. 02-9929 Filed 4-26-02; 8:45 am]
BILLING CODE 4830-01-P