In late October 2011, the IRS released a technical advice memorandum1 addressing whether written call options continued to be options for federal income tax purposes after being restructured, whether such restructuring of the options resulted in a Section2 1001 event, whether the restructured options were hedging transactions, and lastly whether the taxpayer was permitted to realize the options’ losses upon closing.
The taxpayer (“Taxpayer”) at issue was a commodity producer that entered into a strategic hedge, but did not hedge as a general matter. When the price of Taxpayer’s commodity dropped in year 1, Taxpayer entered into a short prepaid forward contract to protect its downside exposure and used the proceeds to reduce its long-term debt. In addition, Taxpayer purchased European-style put options to protect against further price declines; these subsequently expired. Taxpayer also sold call options, which relinquished some of its upside opportunity associated with future sales of its commodities. The calls were not treated as hedges for financial accounting purposes and were marked-to-market periodically through Taxpayer’s income statement. After the puts expired worthless, in year 3, Taxpayer restructured its call options.3 The restructured call options differed from the original calls by requiring physical settlement, extending certain exercise dates, and adding a spot price delivery feature. Taxpayer did not treat the restructuring of the call options as an exchange under Section 1001 on its originally filed tax returns. In year 9, Taxpayer terminated its remaining delivery obligations under the restructured contracts and paid the relevant counterparties to close out the contracts while claiming an ordinary loss for tax purposes.
In its analysis, the IRS addressed several issues, including whether the call options continued to be options for tax purposes after they were restructured, such that the losses from the closing of those transactions were capital losses under Section 1234(b) and whether the restructuring of the call options caused those contracts to be materially modified under Section 1001, resulting in an exchange or deemed exchange at the time of the restructuring.
Taxpayer argued that Section 1234(b), which provides a character rule for closing transactions involving options on certain property, including commodities, and that, in the case of the grantor of the option, provides that gain or loss from any closing transaction with respect to, and gain on lapse of, an option in property shall be treated as a gain or loss from the sale or exchange of a capital asset held for not more than one year, is inapplicable as the contracts were not options following the restructuring. In addition, Taxpayer argued as a result of the restructuring, the call options were exchanged for bilateral contracts due to the addition of the spot price delivery feature which eliminated the counterparty’s “optionality.”
The IRS ruled that, even after the contracts’ restructuring, the contracts continued to have the key option elements, i.e., the counterparties had the right to acquire specified property (the commodity) at specified dates and for a specified price and the premium paid by the counterparties in year 1 was not reduced or refunded in any way. Thus, in form at least, the restructured contracts continued to have the essential elements of an option on property. As for the spot price delivery feature, the IRS determined it had little or no economic impact. The added feature did not upset or alter the apportionment of pricing risks that was established by the original call options. The IRS stated the fact that delivery was “required” should not preclude option treatment. The key distinction is not whether performance is legally required (as delivery is being assumed herein to have been if the contracts were not closed out in advance of expiration); it is whether the option holder was obligated to perform at that fixed price or suffer exposure or damages comparable to that which would be borne if it had committed to buying or selling at a fixed price. Unlike forwards or other bilateral property contracts, an option holder is not exposed to damages measured by the difference between the underlying option property’s value and the fixed option price. Since the counterparties involved were not obligated to take delivery under the restructured contracts at a fixed price (the only “obligation” was to take delivery at a spot price if the spot price was less than the fixed strike price), the restructured contracts continued to be options and their closing gave rise to capital losses under Section 1234(b).
A second issue addressed by the ruling was whether the restructuring of the call options caused those contracts to be materially modified under Section 1001, resulting in an exchange or deemed exchange at the time of the restructuring. The Tech Advice observes that there is limited formal guidance addressing the exchange or modification of non-debt instruments. However, the Tech Advice concludes that, as described above, Taxpayer’s modifications did not change the nature of the original call contracts. The IRS concluded that the addition of a physical delivery requirement was not a material change and that for fungible property that is readily traded, the obligation to take delivery does not generally constitute a meaningful right or obligation. The IRS also concluded that the nominal reduction in the strike price was not a material modification and that the strike price was not significantly reduced (the reduction percentage was redacted in the ruling) and was substantially greater than the market price at the time of modification. While the alteration of the delivery or expiration dates can have great significance, according to the IRS there were several mitigating factors on the impact of the expiration date changes, including that the contracts were nowhere near expiring and that the change of expiration date differed nominally from the prior relevant exercise date. In addition, most of the extensions were inside the taxable year of the original exercise dates. Based on the totality of the changes, the Tech Advice concludes that most of the restructured contracts did not materially differ in kind or extent from the original written options, so they were not deemed exchanged under Section 1001. However, there was one group of restructured contracts that were altered so that the original exercise dates were extended by a greater period of time. Although these call options still had the same number of years remaining, the Tech Advice concludes that the extension of the exercise period by an amount greater than a specified percentage (also redacted) and beyond the taxable year end of the original options is a material change in and of itself, resulting in an exchange under Section 1001.
In addition, Taxpayer also argued that the restructured calls were not hedging transactions under Section 1.1221-2 because they (i) were “primarily” entered into to “finance” the purchased puts or obtain favorable accounting treatment; (ii) did not substantially reduce pricing risk or risk of loss; and (iii) did not hedge the commodity it presently held. The IRS rejected Taxpayer’s assertions on the grounds that the restructured calls were entered into for the purpose of reducing risk, and the calls were a hedge of Taxpayer’s inventory. Finally, the IRS held that Taxpayer was not permitted to take losses on the restructured calls upon termination (during the year 9 closing transactions). Rather, in order to clearly reflect income under the Section 1.446-4 hedge matching rules, those losses should be taken into account during the same taxable year that the applicable calls were scheduled to expire.