On November 22 2002 the Supreme Court handed down an important ruling regarding the tax treatment of options over shares that qualify for the participation exemption.
The Supreme Court ruled that if a corporate shareholder holds shares that qualify for the participation exemption and sells a call option over some or all of those shares (i) the call premium received is exempt, and (ii) the capital gain that is exempt under the participation exemption upon exercise of the option is limited to the call strike price less the cost basis of the shares.
The court held that if a corporate shareholder holds such shares and buys a put option over some or all of them, (i) the put premium paid is not deductible, and (ii) the capital gain that is exempt under the participation exemption upon exercise of the option is the put strike price less the cost basis of the shares.
Therefore, the difference between the fair market value of the shares at the time of the exercise of the (put or call) option, and the cost basis of those shares, is balanced with the premium and the result under the option. Thus, only the resulting balance falls under the participation exemption.
With regard to the (corporate) holder of a call option and the writer of a put option, a complementary treatment applies if the shares over which the option is written would, upon exercise, constitute a qualifying participation for the acquirer. Thus, the holder of the call option will not be permitted to deduct the premium paid. If the option is exercised, the cost basis of the shares acquired will be the sum of the premium paid and the strike price. If the option is not exercised, the premium remains non-deductible. The writer of a put option will not be taxable with respect to the premium received. The amount of the premium will, if the option is exercised, be deducted from the strike price, and the difference will be the cost basis of the shares in the hands of the acquirer of the shares. If the option is not exercised, the premium remains tax exempt.
It is irrelevant whether the options are listed on a stock exchange.
This ruling was one of the most important decisions rendered by the Supreme Court in 2002. It not only resolved the case at hand, but also gave an unusual general description of the tax consequences of options on shares.
The ruling is remarkable in the light of a previous decision rendered by the Supreme Court in 1996. From that decision, most authors concluded that a put premium received in respect of shares that constituted a qualifying participation would, upon the unused expiry of the put option, be taxable.
An important aspect of the ruling concerning the call option holder/put option writer is that if the option in question is not exercised, the premium paid/received is brought under the participation exemption, even though the taxpayer concerned never actually owned any of the shares over which the option is written. The same rule applies in case of sale of a call or put option.
However, if the shares over which the option is written would not, upon the exercise thereof, form part of a qualifying participation, the following will all be taxable:
- the call premium paid or the put premium received;
- the gain or loss upon exercise or alienation of the option; and
- the gain or loss upon a future sale of the shares.
The Supreme Court is not explicit on the timing of recognition of the taxable income and it may be assumed that in this respect the rules of sound business practice will apply.
While the Supreme Court did more than merely decide on the case submitted to it by trying to create a framework for greater clarity, a significant degree of uncertainty remains, as many possible situations have not been dealt with.
For further information on this topic please contact Waldo Kapoen or Jochem de Koning at Loyens & Loeff by telephone (+31 20 578 5785) or by fax (+31 20 578 5800) or by email ([email protected] or [email protected].