When I had five years left on my home mortgage, I refinanced into a 30-year variable rate mortgage that was fixed for the first five years (a so-called "5-year ARM"). The rate that is applicable for the initial five years is very low. It's my intention to repay the entire mortgage balance over the initial five years when the low rate is guaranteed. It's my view, however, that the 30-year stated term gives me a "free option."1
Specifically, if I wanted relief from the high payments associated with trying to repay the full balance over five years, I could make the minimum payments required to repay the mortgage over the stated 30-year term. There is no explicit option in the mortgage but, to me, this embedded option is very valuable. Options are frequently found in the eye of the beholder. Unfortunately for hedge fund managers that have entered into certain option contracts over the funds that they manage, however, in AM 2010-005, the Internal Revenue Service (IRS) refused to provide option treatment for such contracts.
The federal income stakes on any given call option transaction can be significant. If the contract were treated as a call option, no gain or loss would be recognized until the sale or expiration of the option (assuming cash settlement) and all of such gain or loss would be long-term capital gain (or loss).2 In contrast, if the option is pierced and treated as ownership of the underlying assets by the option holder, all gains, losses, income and deduction currently passes through to the option holder (optionee). In the case of most hedge funds, a significant portion of this income is likely to consist of ordinary income items and short-term capital gains, ineligible for a lower tax rate. Thus, the option holder would suffer both timing and character disadvantages. In AM 2010-005, the IRS concluded that this less than optimal tax treatment was warranted on a transaction cast as an option.
- Description of the Call Option Contract
In AM 2010-005, released in final form on November 12, 2010, the IRS considered the following call option contract. A United States partnership (HF) entered into a 2-year call option contract with a publicly-traded United Kingdom bank ("Bank").3 HF is described as a hedge fund manager. The property referenced by the call option is a so-called "managed account." A managed account is a brokerage account maintained by the Bank into which a number of stock (and possibly commodities and derivatives as well) positions are placed.4 The contents of the managed account is referred to as the "Reference Basket." At the inception of the option, the value of the managed account was $10x. HF paid a $1x premium for the option. AM 2010-005 recites that the option premium was not determined with reference to options pricing models.
The option was an "American-style option." Specifically, HF had the right to exercise the call option at any time. In addition, HF had the right to elect cash settlement instead of tendering the option strike price and actually acquiring the Reference Basket. The economics of cash settlement was more favorable to HF than a physical exercise of the option.
If the option was physically exercised, the option strike price would be $10x, that is, the initial fair market value of the managed account positions. In other words, at inception, viewed through the physical exercise terms, the option was not “in the money” by any amount. The cash settlement right caused the option to be “in the money” by the amount of the $1x premium paid by HF for the option by providing that the $1x strike price would be added to the base cash settlement amount. More specifically, the base calculation for the cash settlement amount was equal to the excess of (i) the sum of (x) all gains (realized and unrealized) on the managed account positions and (y) all income paid on the managed account positions during the option duration over (ii) the sum of (x) all commissions and other costs of maintaining and trading by the managed account and (y) an interest charge on $9x "financed" by the Bank. The $1x strike price was then added to the cash settlement amount and, if the cash settlement amount was negative (but not by more than $1x), HF would receive cash equal to the negative value (but not by more than the $1x option premium).
The option was subject to a "knock-out" feature. Under the knock-out feature, if the value of the Reference Basket fell to $9x, the Bank had the right to terminate the option. To the IRS, the knock-out feature caused the option to appear to function like a leveraged acquisition of the positions in the managed account.5 If the value of the Reference Basket fell by the $1x amount of "equity" that HF had in such account, absent the ability by the Bank to cancel the transaction, all further losses would be borne by the Bank. Thus, the ability to terminate the option if the Reference Basket incurred losses protected the Bank against loss. Furthermore, the Bank had the right to direct HF to reduce risk on trading in the managed account, as described below.
Trading in the managed account was undertaken by the general partner (the GP) of HF pursuant to an Investment Management Agreement (the IMA). The IMA limited GP's ability to trade by specifying investment limitations. The Bank followed all of GP's trading instructions and allowed GP to exercise voting rights for the Referenced Basket. The GP received a de minimis fee of .01% of the value of the Reference Basket for these services. If, however, losses on the Reference Basket approached $1x, the Bank had the right to direct GP to undertake trading in a manner designed to minimize such losses.
As is true in so many areas of the tax law, the fact that the parities called the contract an option does not ensure that it will be taxed as such.6 The IRS, citing Saviano v. Commissioner, 80 T.C. 955, 970 (1983), aff'd, 765 F.2d 643 (7 th Cir. 1985), held that options have two defining characteristics: (1) a continuing offer to do an act, or to forebear from doing an act, which does not ripen into a contract until it is accepted; and (2) an agreement to leave the offer open for a specified period of time. A contract will be treated as an option only if the option holder's cost of failure to exercise the option is lower than the holder's potential liability had he or she instead entered into and breached a contract to buy or sell the underlying property. See Halle v. Commissioner, 83 F.3d 649, 655-56 (4th Cir. 1996) (comparing potential buyer's liquidated damages with seller's expected damages in event of buyer's default to determine whether contract is option versus sale). The IRS found in AM 2010-005 that neither of these features were present. There was no continuing offer to act because the interaction of the cash settlement formula and the knock-out feature caused the economic arrangement to be the equivalent of a leveraged purchase. Furthermore, the IRS found that there was no open offer because GP's rights to vary the Referenced Basket was inconsistent with the fact that an option must reference specific property at a defined price.
- The Lack of a Continuing Offer
In U.S. Freight Co. v. United States, 422 F.2d 887 (1970), the taxpayer desired to acquire an option over stock held by third parties (the "Pauls"). The Pauls refused to grant an option to the taxpayer. Instead, the parties entered into a contract for the taxpayer to acquire the stock for $9,420,000. The taxpayer paid $500,000 to the Pauls as a down payment. The Pauls were entitled to keep the deposit as liquidated damages if the taxpayer failed to pay the purchase price in full. Such liquidated damages, however, did not alleviate the taxpayer of its obligation to close the sale. As a result of business pressures, the taxpayer decided not to proceed with the sale. As a result, the Pauls kept the $500,000 down payment. The Pauls did not seek to enforce the contract or sue for further damages.
The taxpayer claimed an ordinary business expense deduction for the loss of its $500,000 down payment. The IRS claimed that the loss was a capital loss. One of the bases for the IRS's position was that the arrangement was tantamount to an option and the rules governing losses from option transactions should apply. The court found that the contract arrangement provided the parties with bilateral rights and obligations. The existence of the liquidated damages provision did not alleviate the taxpayer from performance of its obligation to purchase the stock. Accordingly, the contractual arrangement was held not be subject to the taxation rules for options.
After citing U.S. Freight, supra and Halle v. Comm'r, supra (similar to U.S. Freight), the IRS found in AM 2010-005 that a call option exists for tax purposes when "holder has a real choice to allow the option to lapse; if the contract imposes a cost for failure to exercise that places the holder in a similar economic position to a party obligated to buy, then the holder lacks the choice not to buy." The IRS then noted that the Bank had the right to force the option to terminate if the value of the Reference Basket fell by more than 10%. From this, the IRS concluded that HF was in the same position as a person who was obligated to purchase the Reference Basket.
The IRS's argument that no continuing offer to purchase exists is not its strongest position that the contract should not be treated as an option. The issue as to whether it would have been reasonable for HF to walk away from the option is best seen in light of Revenue Ruling 82-150, 1982-1C.B. 110. In this ruling, the IRS held that an option that cost $70x and with a strike price of $30x over stock with a value of $100x was a leveraged acquisition of the underlying stock because the optionee had "assumed the risks of an investor in equity." In the case considered in AM 2010-005, however, in the author’s view, an option premium equal to 10% of the value of the Reference Basket in no way appears to be so deep in the money as to warrant the conclusion that there is no optionality to contract.7 Accordingly, the IRS’s analysis on the point that there is not continuing option seems to stretch to reach its conclusion.
- Control Over the Reference Basket
In the author's view, the IRS was on much stronger ground when it attached the option-like nature of the managed account contract on the ground of optionee control over the Reference Basket. Initially, however, the IRS felt the need to find that the GP was acting on behalf of HF. Although not explicitly mentioned, the IRS's need on this point most likely stems from a line of cases originating with Comm'r v. Moline Properties, 138 F.2d 388 (5th Cir. 1942). Moline is frequently cited for the proposition that the separate existence of a corporation will be respected, provided that the corporation is not acting as an alter ego of its owners. On this point, the IRS concluded that GP was acting as an alter ego of HF because it did not charge an arm's length fees under the IMA. It is also important to note that GP was a partner in HF and its activities benefited HF and itself directly.
The IRS's analysis on the effect of HF's control over the Reference Basket is somewhat convoluted, but comes out in the right place. First, it begins with the observation that even if the transaction were treated as an option, each substitution of an asset within the Reference Basket would likely be considered to be so significant as to trigger a recognition of gain or loss on that portion of the option. If a trading strategy had any degree of velocity (turn-over), this conclusion alone essentially would require that the option be marked-to-market. Thus, any deferral or conversion benefits would be lost. In light of the holding of Revenue Ruling 90-109, 1990-2 C.B. 191 (finding the change in insured under a life insurance policy was so significant that there was a deemed exchange of the "old" policy for a "new" policy), the IRS's conclusion on this issue seems correct. In short, an option over stock "Y" is different than an option over stock "X" and a substitution of stock Y for stock X should trigger a deemed exchange of the option.8 It would be interesting to understand how taxpayers in the position of HF intended to address this issue even if the transaction withstood treatment as an option.9 It would be an oxymoron for a transaction to be treated as a call option when the reference asset is within the control of the option holder because the option writer would be allowing the other side of his financial wager to "stack the deck" against him. In other words, a person who writes a long call option is betting that the reference asset will not appreciate by as much as the premium s/he is being paid. The option writer wants the option to expire worthless, so s/he can keep the premium and not part with the referenced property or its value. Why then would the option writer provide the option holder with the ability to facilitate appreciation in the referenced assets? In the author's view, this analysis alone supports the conclusion that this transaction may have challenges in being treated as an option.
- So, Now What?
The IRS, following its conclusion that the transaction was not an option, then weighed between whether the transaction should be treated as a forward contract, which would have allowed HF to obtain both deferral and conversion, or as the current ownership of the Reference Basket by HF. The IRS cited two recent cases, Anschultz v. Comm'r, 135 T.C. No. 5 (2010) and Calloway v. Comm'r, 135 T.C. No. 3 (2010), to conclude that the transaction should be treated as the current ownership of the Reference Basket by HF.10 More on point, however, is the discussion of Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1984). In Christoffersen, a taxpayer was treated as the owner of various mutual funds held within a variable life insurance contract because of his right to direct the ownership of the mutual funds. Analytically, Christoffersen and HF are in the same position. HF and the taxpayer in Christoffersen have the direct control over property ostensibly owned by another person, but to which the ostensible owner has the obligation to turn over the full investment performance of such property to the party exercising such control. In such cases, the U.S. federal income tax law has been reluctant to treat the ostensible owner as the tax owner.
The IRS cast the inquiry in three parts: (a) did HF have the full opportunity for trading gains and losses? (b) did HF have substantially all of the risk of loss over the Reference Basket and (c) did HF have complete dominion and control over the Reference Basket. The economics of the cash settlement feature provided HF with have the full opportunity for trading gains and losses. In the view of the IRS, the knock-out feature protected the Bank against loss and, therefore, HF had all of the risk of loss. The IMA provided GP and, hence, HF, with control over Reference Basket. Accordingly, the IRS found that HF should be treated as the owner, for federal income tax purposes, of the Reference Basket.