Deferred put-option premiums are not deductible interest

Plain-English summary

An insurer bought put options to hedge variable-annuity guarantees and paid the premiums in installments over several years. Although it obtained dealer quotes for hypothetical up-front premiums and calculated a time-value component, the contracts consistently characterized the transactions as options and the payments as premiums; they provided for interest only upon default. Chief Counsel concluded that the deferred payment obligation was not genuine indebtedness and no part of the premium was deductible as interest under § 163. Rules bifurcating certain notional principal contracts and imputing interest on deferred sales did not apply to these options.

Ruling snapshot

• Question: Is any time-value portion of deferred put-option premium payments deductible as interest under § 163?
• Outcome: Advice given
• Key authorities: IRC §§ 163 and 483; Treas. Reg. §§ 1.446-3(g) and 1.483-1(c)(3)(v)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201442052
       Release Date: 10/17/2014
       CC:FIP:B06:ADubert                              Third Party Communication: None
       POSTF-147552-13                                 Date of Communication: Not Applicable

UILC: 163.00-00

date: May 29, 2014

 to:   Teri L. Jackson
       Attorney (St. Paul)
       (Large Business & International)

from: Patrick E. White
Senior Counsel
(Financial Institutions & Products)

subject: Option Premium Not Treated as Part Interest

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       LEGEND

       S             =      -------------------------------------------------
       P             =      ---------------------------------
       A             =      --
       B             =      ---
       C             =      -------------------------------------

       ISSUE

       Whether a portion of the deferred premium payments made by S on its purchased
       options is deductible as interest under § 163 of the Internal Revenue Code?

       CONCLUSION

       No portion of the deferred premium payments made by S is deductible as interest
       expense under § 163.

       FACTS

POSTF-147552-13 2

S was a member of an affiliated group of corporations whose common parent is P. P
and S file U.S. consolidated income tax returns. S, an insurer, wrote variable annuity
contracts with minimum guarantee provisions during the years at issue. As part of its
strategy of hedging the minimum guarantees, S purchased put options. Those options
were subject to the terms of standard ISDA master agreements. The parties
memorialized each separate transaction in confirmations.

The master agreements called for interest payments only when a party defaulted on the
performance of any payment obligation prior to the termination of the transaction. The
confirmations indicated that S was obligated to pay a series of premium payments,
generally beginning A months after the effective date and extending over a period of
years (often B years); in exchange, S obtained the right to cash settle at maturity of the
option for the difference between the then-value of C and a specified strike price.

The confirmations labeled each transaction as a “European Put Option” and
characterized S’s obligation to make payments (either monthly or semi-annually) as
premium payments. Nothing in the confirmations or agreements indicated that the
parties viewed any part of the deferred option premiums as interest payments on
indebtedness. Further, the master agreements provided that they constituted the entire
agreement and understanding of the parties and superseded all oral communications
and prior writings.

In some or all instances, S obtained separate dealer quotes in order to estimate the
amount it would have paid if the agreements had required S to make a single premium
payment at inception of the options. S used that amount to estimate for Federal income
tax purposes a time value charge associated with paying the premium over the life of
the options.

LAW AND ANALYSIS

Transactions Were Options -- Not Indebtedness

Taxpayers generally are bound to their characterizations of their transactions. See
Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).
The Service, however, is not necessarily so bound and can make adjustments to reflect
a transaction’s true substance. Gregory v. Helvering, 293 U.S. 465, 469-70 (1935);
Knetsch v. United States, 364 U.S. 361, 366 (1960); Interlochen Co. v. Commissioner,
232 F.2d 873, 877 (1956) (“[T]he Commissioner or the courts may look through the form
of a transaction to the substance thereof,” but the choice to disregard its classification of
a transaction “does not lie with the taxpayer”).

For Federal income tax purposes, it is well-settled that an option premium is deferred
and accounted for as part of gain or loss upon settlement. In Rev. Rul. 58-234, 1958-1
C.B. 279, the Service explained that “[i]t is manifest, from the nature and consequences
POSTF-147552-13 3

of ‘put’ or ‘call’ option premiums and obligations, that there is no Federal income tax
incidence on account of either the receipt or payment of such option premiums, i.e.,
from the standpoint of either the optionor or the optionee, unless and until the options
have been terminated, by failure to exercise, or otherwise, with resultant gain or loss.”
See also, Rev. Rul. 78-182, 1978-1 C.B. 265 (the cost of a put is carried in a deferred
account as a capital expenditure made in a transaction that is not yet complete.); Rev.
Rul. 71-521, 1971-2 C.B. 313 (premium cost “should be carried to a deferred account as
a capital expenditure made in an incomplete transaction entered into for profit.”) See
also, Virginia Iron Coal & Coke Co. v. Commissioner, 37 B.T.A. 195 (1938), affd, 99
F.2d 919 (4th Cir. 1938) (installment premium payments were held to only be
appropriately accounted for upon lapse of the option).

Section 163(a) permits as a deduction all interest paid or accrued within the taxable
year on genuine indebtedness. Indebtedness is an “existing, unconditional, and legally
enforceable obligation for the payment of a principal sum.” Howlett v. Commissioner,
56 T.C. 951, 960 (1971); see also Gilman v. Commissioner, 53 F.2d 47, 50 (8th Cir.
1931); Old Colony Railroad v. Commissioner, 284 U.S. 552 (1932); Deputy v. DuPont,
308 U.S. 488 (1940). Section 163 requires actual indebtedness; while an indebtedness
is necessarily an obligation, not all obligations of a taxpayer are considered
indebtedness within the meaning of § 163. Deputy v. Du Pont, 308 U.S. at 497.

The confirmations described S as paying premium, not interest, to the relevant
counterparties in return for the cash settlement rights granted. The confirmations and
master agreements refer to each arrangement as an option, not as indebtedness.
Nothing in the confirmations or master agreements indicated that the parties viewed any
part of the premiums as interest payments or considered S’s obligation to make
premium payments to be indebtedness.

In fact, the parties only contemplated paying interest under the arrangements if one of
the parties failed to timely pay amounts due under the contract. Thus, the parties did not
consider the premium to be interest, as generally required for such payments to be
considered interest under § 163. Midkiff v Commissioner, 96 T.C. 724, 738 (1991), affd.
sub nom. Noguchi v. Commissioner, 992 F.2d 226 (9th Cir. 1993).

In Koch v. Commissioner, 67 T.C. 71 (1976), acq. 1980-2 CB 1, the Tax Court
specifically rejected the Service’s argument (similar to that made here by S) to treat
deferred option premium as interest. In Koch, the Service argued that call option
premium received by the taxpayer was interest income that was currently includible
where the premium was paid in installments over a number of years and expressed as
percentage of the option purchase price. The Tax Court rejected the Service’s
assertion that the periodic premium payments should be treated as interest income as
there was no indebtedness by the optionee to the taxpayer in the ordinary sense of the
word. Citing Sterling G. Howlett v Commissioner, 56 T.C. 951, 960 (1971), the Tax
Court stated, “[a]n indebtedness has many times been held by us to be an ‘existing,
unconditional, and legally enforceable obligation for the payment of a principal sum.’”
POSTF-147552-13 4

Koch v. Commissioner, 67 T.C. at 83. See also, Rev. Rul. 63-183, 1963-2 C.B. 285
(Service observed that it is clear that an open-end investment fund’s receipt of option
premium cannot be considered interest or other § 851 income).

P’s characterization of the premium as being part interest is in direct conflict with the
parties’ written confirmations treating each transaction as a put option and payments by
S as premium.

Interest Is Not Imputed Under Relevant Authorities

P cites § 1.446-3(g)(4) of the Income Tax Regulations as support for its treatment of the
agreements as containing an embedded loan. P notes that, pursuant to the regulation,
a notional principal contract (NPC) containing a significant, nonperiodic payment is
treated as two separate transactions consisting of an on-market, level payment NPC
and a loan. The provision requires the parties to account for the loan separately from
the NPC payments. P reasons that the bifurcation required by this regulation generally
supports comparable treatment of its deferred option premium payments.

By its terms, § 1.446-3(g)(4) addresses the tax treatment of NPCs, not options, making
it irrelevant. In fact, the more relevant provision, if any, under these rules is § 1.446-
3(g)(3). That provision notably provides that the general open transaction rules of
taxation for options apply to options to enter into NPCs.

In some limited circumstances, the Code and regulations require the imputation of
interest, but those circumstances do not exist here. Congress enacted § 483 to
specifically address installment sale transactions where the deferred purchase price
effectively was adjusted to compensate for the absence of stated interest. Soloman v.
Commissioner, 570 F.2d 28 (1977). More specifically, § 483 requires the imputation of
interest on deferred purchase price payments associated with a sale or exchange of
property. However, deferred premium option payments are not covered, as § 483 does
not apply to any payment under an option to buy or sell property. Treas. Reg. §1.483-
1(c)(3)(v); cf. Rev. Rul. 75-563, 1975-2 C.B. 199 (§ 483 applied to a contract that was
an option in form only because in substance the arrangement was a sale with deferred
purchase price paid).

Based on the above, we do not believe that P properly treated the premium paid as
deductible interest expense. P’s position is inconsistent with § 163 and the authorities
on option treatment. Further, the limited authority on which P relies has no bearing on
options.

No opinion is expressed on the application of § 1.446-4 to any income, deduction, gain
or loss arising from the option transactions.

Please do not hesitate to contact us if you require further assistance in this matter.