TAM 200033004: index options and covered calls under the straddle rules

Plain-English summary

An insurance company held a diversified stock portfolio, bought put options on stock index futures, and sold call options on individual stocks. The dispute was whether these positions formed tax straddles that would defer losses under section 1092. The IRS advised that the regulatory substantial overlap test applies when deciding whether the portfolio and index puts are substantially similar or related property, including under the regulation's retroactive rule. On the stated facts, the portfolio and puts would not form a straddle under that special stock rule unless that test was met. The IRS also advised that any larger straddle involving the qualified covered calls should be tested one stock at a time, not against the portfolio as a whole.

Ruling snapshot

• Question: Which test applies to index puts and the stock portfolio, and how should a larger straddle involving covered calls be tested?
• Outcome: Advice given. Apply the substantial overlap test and examine the larger straddle stock by stock.
• Key authorities: IRC §§ 1092(c) and (d), 246(c)(4), and 263(g); Treas. Reg. §§ 1.1092(d)-2 and 1.246-5.

Full text (IRS public release)

                     INTERNAL REVENUE SERVICE
           NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                   May 1, 2000
Number:           200033004
Release Date:     8/18/2000
Index (UIL) Nos.: 1092.06-00, 1092.07-00
CASE MIS No.:     TAM-117588-99/CC:DOM:FI&P:B3

     Taxpayer’s Name:
     Taxpayer’s Address:

     Taxpayer’s ID No.:
     Years Involved:
     Date of Conference:

LEGEND:

Taxpayer       =

Number1        =

Year1          =
Year2          =

Date1          =
Date2          =
Date3          =
Date4          =
Date5          =
Date6          =
Date7          =

ISSUES:

     (1) For purposes of the special rule for stock in
§ 1092(d)(3)(B)(i)(II) of the Internal Revenue Code, does
§ 1.1092(d)-2(a) of the Income Tax Regulations apply to provide
that the phrase “substantially similar or related property” is
defined in § 1.246-5 when that phrase is applied retroactively
under the effective date rule in § 1.1092(d)-2(b)(2) (and the
phrase is not defined by the “mimics” standard in
§ 1.1092(d)-2(b)(2))?

     (2) Section 1092(c)(4)(A) of the Internal Revenue Code
provides an exception from straddle treatment for offsetting
positions consisting of qualified covered call options and the
optioned stock. Taxpayer holds a portfolio of stocks for which
Taxpayer has sold listed call options on certain of the stocks in
the portfolio which would be qualified covered call options under
TAM-117588-99                 - 2 -

§ 1092(c)(4)(A) but for the possible existence of a larger
straddle. Taxpayer has hedged against general market risk by
purchasing listed put options on S&P 500 index futures contracts.
The portfolio does not satisfy the “substantial overlap” test of
§ 1.246-5 with respect to the put options. Is the determination
whether the put options create a larger straddle with respect to
the call options and the optioned stock made on a stock-by-stock
basis?

CONCLUSIONS:

     (1) Yes. The effective date rule in § 1.1092(d)-2(b)(2)
causes the application of § 1.1092(d)-2(a) and thereby the
application of § 1.246-5. Thus, Taxpayer’s stock portfolio and
put options on S&P 500 stock index futures contracts do not
constitute a straddle (using § 1092(d)(3)(B)(i)(II)) unless the
“substantial overlap” test of § 1.246-5 is satisfied.

     (2) Yes. Under the circumstances described in the issue,
the existence of a larger straddle is tested on a stock-by-stock
basis rather than for the portfolio in the aggregate. Thus, the
determination whether there are offsetting positions under
§ 1092(c)(2) is made only for Taxpayer’s put options on the S&P
500 stock index futures contracts and for positions consisting of
the individual stocks on which Taxpayer sold call options.

FACTS:

     Taxpayer is a large mutual property and casualty insurance
company.

     In Year1, Taxpayer owned a diversified portfolio of common
stocks of unaffiliated domestic companies (the “Portfolio”). In
Year1 and Year2, Taxpayer owned approximately Number1 of the 500
stocks included in the S&P 500 index.

     Taxpayer entered into various option transactions to hedge
against a possible decline in the stock market. On Date1,
Taxpayer purchased listed put options on S&P 500 stock index
futures contracts (the “Index Put Options”). The Index Put
Options ran from Date1, until Date2.

     Taxpayer sold listed call options on S&P 500 stock index
futures contracts (the “Index Call Options”). The Index Call
Options were 3- to 5-month contracts that generally were in place
from Date3, until Date2.

     Taxpayer also sold listed call options on various individual
stocks in the Portfolio (the “Covered Call Options”). As Covered
TAM-117588-99                 - 3 -

Call Options were closed out due to expiration or sales of the
underlying securities, new Covered Call Options were sold. The
Covered Call Options were generally in place from Date4 until
Date5.

     The Index Put Options and Index Call Options will be
referred to as the “Index Options.” The Index Options and the
Covered Call Options will be referred to as the “Options.”

     On its amended Year1 federal income tax return and its Year2
federal income tax return, Taxpayer took the position that the
Options were not subject to the loss deferral rules of § 1092.
Accordingly, Taxpayer deducted the full amounts of losses
realized with respect to the expiration or early termination of
Covered Call Options. Taxpayer also deducted losses for Index
Put Options that were marked to market and included gains for
Index Call Options that were marked to market.

     The Revenue Agent took the position that some or all of the
stock in the Portfolio and some or all of the Options constituted
straddles to which the loss deferral rules of § 1092 applied.
The Revenue Agent’s primary argument was that the stock in the
Portfolio and the Index Put Options constituted a straddle. This
argument depended on a reading of § 1.1092(d)-2(b)(2) according
to which the determination whether the stock underlying the Index
Put Options (the S&P 500 index) constituted “substantially
similar or related property” with respect to the Portfolio should
be made using the “mimics” standard in § 1.1092(d)-2(b)(2) rather
than the “substantial overlap” test in § 1.246-5. The Revenue
Agent’s secondary argument was that the Covered Call Options, the
optioned stock, and an “allocable portion” of the Index Put
Options constituted a straddle. This argument depended on the
permissibility of treating the portion of the Index Put Options
relating to the optioned stock as a “position” for purposes of
§ 1092(d)(2).1



     1
        The Revenue Agent implicitly argued that the “allocable
portion” of the Index Put Options would cause the optioned stock
to qualify as personal property under § 1092(d)(1) through the
application of § 1092(d)(3)(B)(i)(I). That was unnecessary,
however, because the optioned stock is tentatively assumed to be
personal property when testing for the existence of a larger
straddle under § 1092(c)(4)(A)(ii). With respect to a possible
larger straddle, we find no support for the proposition that the
portion of an option or futures contract on a stock index
corresponding to a stock portfolio can be separated and treated
as a position for purposes of § 1092(d)(2).
TAM-117588-99                 - 4 -

     A presubmission conference was held on Date6. Taxpayer and
the Revenue Agent were advised that failure to respond to an
argument by the other side would be treated as an admission of
the argument. As a result of that policy, several arguments have
been accepted for purposes of this memorandum. Those arguments
are described in the following paragraph.

     The Revenue Agent argued without rebuttal that the Portfolio
and the Index Put Options satisfy the “mimics” standard of
§ 1.1092(d)-2(b)(ii). Taxpayer argued without rebuttal that the
Index Put Options do not constitute “substantially similar or
related property” with respect to the Portfolio as that phrase is
defined by the “substantial overlap” test in § 1.246-5 (through
the application of § 1.1092(d)-2(a)), that the Covered Call
Options are “qualified covered call options” for purposes of
§ 1092(c)(4)(A) unless the call options and the optioned stocks
are part of a larger straddle, and that the “larger straddle” in
§ 1092(c)(4)(A)(ii) must include another straddle in addition to
the smaller straddle.

     An adverse conference was held by telephone on Date7.
Taxpayer conceded that for purposes of the exception for
straddles consisting of qualified covered call options and the
optioned stock in § 1092(c)(4)(A), the existence of a “larger
straddle” is tested under the assumption that the optioned stock
is “personal property” as defined in § 1092(d)(1) because of the
application of § 1092(d)(3)(B)(i)(I). Taxpayer argued, however,
that the existence of a larger straddle involving the Index Put
Options and the optioned stock should be tested only on a stock-
by-stock basis.

LAW:

     Section 1092(c)(1) provides that the term “straddle” means
offsetting positions with respect to personal property.

     Section 1092(c)(2)(A) provides generally that a taxpayer
holds offsetting positions with respect to personal property if
there is a substantial diminution of the taxpayer’s risk of loss
from holding any position with respect to personal property by
reason of his holding one or more other positions with respect to
personal property (whether or not of the same kind).

     Section 1092(d)(1) provides that the term “personal
property” means any personal property of a type that is actively
traded.

     Section 1092(d)(3)(A) provides that the term “personal
property” generally does not include stock. Section
TAM-117588-99                 - 5 -

1092(d)(3)(B)(i)(I) and (II), however, provide that the term
“personal property” does include stock that is part of a straddle
at least one of the offsetting positions of which is (I) an
option with respect to such stock or substantially identical
stock or securities, or (II) under regulations, a position with
respect to substantially similar or related property (other than
stock).

     Section 1092(c)(4)(A) provides that offsetting positions
that would otherwise be a straddle shall not be treated as a
straddle if all the offsetting positions making up the straddle
consist of one or more qualified covered call options and the
stock to be purchased from the taxpayer under such options, and
the straddle is not part of a larger straddle. (Section
1092(c)(4)(B) defines the term “qualified covered call option.”)

     (A) IN GENERAL.–-If–-
          (i) all the offsetting positions making up any
     straddle consist of 1 or more qualified covered call
     options and the stock to be purchased from the taxpayer
     under such options, and
          (ii) such straddle is not part of a larger
     straddle,
     such straddle shall not be treated as a straddle for
     purposes of this section and section 263(g). [Emphasis
     supplied.]

     Section 246(c)(4)(C) provides that the holding periods for
stock determined for purposes of § 246(c) shall be appropriately
reduced for any period in which, under regulations, a taxpayer
has diminished his risk of loss by holding one or more positions
with respect to substantially similar or related property.

     Section 1.1092(d)-2(a) provides that for purposes of
§ 1092(d)(3)(B), the term “substantially similar or related
property” is defined in § 1.246-5. (Section 1.246-5(c) applies
the “substantial overlap” test to positions that reflect the
value of a portfolio of stocks.) The effective date rules for
§ 1.1092(d)-2 are contained in § 1.1092(d)-2(b):

           (b) Effective date--(1) In general. This section
     applies to positions established on or after March 17,
     1995.
           (2) Special rule for certain straddles. This
     section applies to positions established after March 1,
     1984, if the taxpayer substantially diminished its risk
     of loss by holding substantially similar or related
     property involving the following types of transactions–
TAM-117588-99                 - 6 -

          (i) Holding offsetting positions consisting of
     stock and a convertible debenture of the same
     corporation where the price movements of the two
     positions are related; or
          (ii) Holding a short position in a stock index
     regulated futures contract (or alternatively an option
     on such a regulated futures contract or an option on
     the stock index) and stock in an investment company
     whose principal holdings mimic the performance of the
     stocks included in the stock index (or alternatively a
     portfolio of stocks whose performance mimics the
     performance of the stocks included in the stock index).
     [Emphasis supplied.]

     Section 1.1092(b)-4T(b)(3) includes an example that assumes
that the stock of each of three corporations constitutes an
offsetting position with respect to options on a broad-based
stock index futures contract.

     The conference report to the Tax Reform Act of 1984
explained regarding § 1092(d)(3)(B)(i)(II) that:

          Offsetting positions, one of which is actively
     traded stock or an interest in such stock and one of
     which is a position in substantially similar or related
     property (other than stock) as determined under
     regulations, constitute a straddle subject to the loss
     deferral rule and other straddle rules, under the
     conference agreement. ... [T]he conferees intend that
     the regulations defining positions that are
     substantially similar or related to stock held by the
     taxpayer will apply to straddles described in the
     following paragraph only for positions established on
     or after March 1, 1984, and for positions not described
     in the following paragraph only on a prospective basis.

          A straddle consisting of stock and substantially
     similar or related property includes offsetting
     positions consisting of stock and a convertible
     debenture of the same corporation where the price
     movements of the two positions are related. It also
     includes a short position in a stock index RFC (or
     alternatively an option on such an RFC or an option on
     the stock index) and stock in an investment company
     whose principal holdings mimic the performance of the
     stocks included in the stock index (or alternatively a
     portfolio of stocks whose performance mimics the
     performance of the stocks included in the index).
     [Emphasis supplied.]
TAM-117588-99                 - 7 -

H.R. Conf. Rep. No. 98-861, at 907 (1984).

     The conference report to the Tax Reform Act of 1984 also
explained regarding § 246(c)(4) that:

          The substantially similar standard is not
     satisfied merely because the taxpayer (1) holds a
     single instrument that is designed to insulate the
     holder from market risks (e.g., adjustable rate
     preferred stock that is indexed to the Treasury bill
     rate), or (2) is an investor with diversified holdings
     and acquires an RFC or an option on a stock index to
     hedge general market risks.

H.R. Conf. Rep. No. 98-861, at 818 (1984).

ANALYSIS:

                            Issue (1)

     There are two plausible interpretations of § 1.1092(d)-2(b)
as it applies to a pair of positions such as the Portfolio and
the Index Put Options as in this case.

     Under the first interpretation, the positions are tested
under the “substantial overlap” test of § 1.246-5 (via
§ 1.1092(d)-2(a)) if they are established on or after March 17,
1995, but they are tested under the “mimics” standard of
§ 1.1092(d)-2(b)(2)(ii) (and not under § 1.246-5) if they are
established after March 1, 1984, and before March 17, 1995.

     Under the second interpretation, the positions are tested
under the “substantial overlap” test of § 1.246-5 if they are
established on or after March 17, 1995. They are also tested
under § 1.246-5 if they are established after March 1, 1984, and
before March 17, 1995, but only if they satisfy the “mimics”
standard of § 1.1092(d)-2(b)(2)(ii). Thus, the “mimics” standard
is merely a threshold test for the congressionally directed
retroactive application of the “substantial overlap” test.

     We believe that we are compelled to adopt the second
interpretation because the first interpretation conflicts with
established Internal Revenue Service usage of the phrase “this
section.” Under this established usage, the occurrences of the
phrase “this section” in § 1.1092(d)-2(b)(1) and (2) must both
refer to § 1.1092(d)-2 and thus invoke the operational rule in
§ 1.1092(d)-2(a). If the drafters had intended that the
occurrence of “this section” in § 1.1092(d)-2(b)(2) refer to that
paragraph (b)(2), they would have used the phrase “this paragraph
(b)(2).”
TAM-117588-99                 - 8 -

     In addition to the argument based on established usage,
there are several reasons to prefer the second interpretation to
the first interpretation. The first reason is that the first
interpretation requires inconsistent readings of the phrase “this
section” in subparagraphs (b)(1) and (b)(2). In subparagraph
(b)(1), the phrase must be read to refer to subsection (a),
whereas in subparagraph (b)(2), the phrase must be read to refer
to subparagraph (b)(2). On the other hand, the second
interpretation consistently reads the phrase to refer to
§ 1.1092(d)-2 and its operative rule in subsection (a).

     The second reason is that the first interpretation must
disregard the fact that subparagraph (b)(2) uses the phrase
“substantially similar or related property,” which it is
supposedly defining. This is not a problem for the second
interpretation, because it does not consider subparagraph (b)(2)
to be a definitional rule. The second interpretation considers
the “mimics” standard to be a threshold test for application of
the definition in subsection (a).

     The third reason is that the first interpretation allows the
phrase “substantially similar or related property” to have
different meanings for positions that are identical except that
one was established before March 17, 1995, and the other was
established on or after March 17, 1995. The conference report,
however, contains no such instruction. To the contrary, it
suggests that all positions that are established after March 1,
1984, and that meet the “mimics” standard should be subject to
the same definition. Thus, the first interpretation implies that
the regulations do not implement congressional intent.

     The fourth reason is that the first interpretation renders
§ 1.1092(d)-2 ambiguous. Under the first interpretation, it is
not clear which definition applies to a position that satisfies
the “mimics” standard but was established on or after March 17,
1995. Paragraphs (b)(1) and (b)(2) both apply, and the
regulation does not resolve the ambiguity. This is not a problem
for the second interpretation, because it applies the same
definition in any event and considers the “mimics” standard to be
a threshold test for retroactivity.

     The fifth reason is that the first interpretation implies
that the regulations fail to implement congressional intent to
provide a definition that includes certain specified positions.
It is apparent that Congress wanted the regulations to provide a
definition. Under the first interpretation, however, for
positions established after March 1, 1984, and before March 17,
1995, the regulations provide no definition but merely
recapitulate the requirements Congress placed on the definition.
TAM-117588-99                 - 9 -

This is not a problem for the second interpretation, because it
applies the same regulatory definition to positions established
during the retroactive period.

                            Issue (2)

     The legislative history of § 246(c)(4) indicated that the
“substantially similar” standard would not be met by a taxpayer
with a diversified stock portfolio who acquired a regulated
futures contract or an option on a stock index to hedge against
general market risk. Such a taxpayer has surely diminished his
risk of loss by holding that position in addition to his stock.
Thus, the legislative history must be read to say that such
diminution is not a kind of diminution for which Congress wished
to trigger a reduction in holding periods or is of insufficient
magnitude to trigger such a reduction.

     The congressional determination that hedging against general
market risk through the use of options on a stock index does not
warrant a reduction in holding periods under § 246(c) because the
diminution of risk of loss either is not of an abusive kind or is
of insufficient magnitude implies at least that such a diminution
might not be a “substantial diminution” for purposes of
§ 1092(c)(2)(A).

     We have found no explanation for the fact that the favorable
statement regarding diminution of general market risk was found
only in the § 246 legislative history and not also in the § 1092
legislative history. Thus, we are inclined to view diminution of
general market risk favorably for purposes of § 1092, but only in
those cases where it is most clearly appropriate to do so.

     Especially in light of § 1.1092(d)-2, the exception for
hedges of stock portfolios against general market risk using
options on stock indexes or futures contracts on stock indexes
must be limited, at the least, to cases in which there is no
diminution of risk of loss specific to the portfolio. Thus, the
exception is not available if the portfolio satisfies the
“substantial overlap” test of § 1.246-5 with respect to the
option. In addition, the exception is not available if the
option is in any way tailored to the portfolio. This “no
tailoring” requirement is more likely to be met if the option is
a listed option.

     Our understanding of the economics of Taxpayer’s
transactions is that Taxpayer purchased the Index Put Options to
protect the Portfolio from general market risk. The Portfolio
not only did not meet the “substantial overlap” test in § 1.246-5
but was very far from meeting it. Taxpayer wrote the Index Call
Options and the Covered Call Options in order to use the premiums
TAM-117588-99                - 10 -

it received on those calls to offset, or largely offset, the
premiums it paid to purchase the Index Put Options. Writing
calls on individual stocks in the Portfolio was less risky than
writing calls on S&P 500 futures contracts because it was
possible that the S&P 500 would rise by more than the individual
stocks in Taxpayer’s portfolio.

     Thus, there is no relation between the Index Put Options and
the Covered Call Options beyond the fact that the premiums
received on the Covered Call Options were intended to offset the
premiums paid to purchase the Index Put Options. This is very
different from a case in which a taxpayer purchases puts and
writes calls on the same individual stock, where those calls
would certainly be part of a larger straddle and thus would not
be qualified covered calls under § 1092(c)(4).

     Section 1.1092(b)-4T(b)(3) includes an example that assumes
that the stock of each of three corporations constitutes an
offsetting position with respect to options on a broad-based
stock index futures contract. That example thus implicitly
provides that the determination is made for each stock rather
than for the three stocks collectively.

     Thus, while the matter is not at all clear, we conclude that
under the facts of this case, the existence of a larger straddle
with respect to the Covered Call Options and the optioned stock
is tested against the Index Put Options on a stock-by-stock
basis.

CAVEAT:

     A copy of this technical advice memorandum is to be given to
the taxpayer. Section 6110(j)(3) provides that it may not be
used or cited as precedent.