Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
The Option Conundrum in Tax Law: After All These Years, What Exactly Is an Option?
Kevin J. Liss*
An option is typically described as a contract between two parties that provides one party the right, but not the obligation, to buy or sell an underlying property at a set price and date. In fact, most option contracts are explicitly labeled as such, with the contract by its terms providing one party the choice of whether or not to perform its side of the contract in exchange for an option premium. However, there have also been contracts that are styled as options, which bear the option label and terminology, but do not relate to the purchase or sale of property. Understandably, there is some question as to whether these contracts are properly viewed as options.
In certain other cases, property-based contracts that bear some economic resemblance to options are not labeled as options, including, inter alia, real estate contracts with earnest money deposits, personal seat licenses, loan commitment agreements, and even layaway plans offered by discount department stores. Query whether these contracts are properly regarded as options for tax purposes. The issue was litigated most recently in Federal Home Loan Mortgage Corp. v. Commissioner (Freddie Mac), a case that considered whether so-called “prior approval purchase contracts” between Freddie Mac and mortgage
originators were properly viewed as options for tax purposes.
One of the most enduring financial product innovations of the past decade, the credit default swap, has option-like features, but with a twist. Unlike more conventional options, this product requires resolution of a contingency prior to paying off. For that reason, some commentators have raised questions as to whether such a contingent product can truly qualify as an option. Since option premiums benefit from tax deferral, it may matter a great deal whether the contracts are properly viewed as options. Fortuitously, most of the new financial product innovations of the past few years generated relatively little investor interest, substantially alleviating the pressure to address their tax treatment. The credit default swap market, in contrast, has enjoyed spectacular growth, making resolution of the tax status of this product a matter of more than mere academic interest.
The international tax ramifications of the proper classification of credit default swaps have been a matter of longstanding interest, less so for issues of timing and deferral, than for withholding tax purposes. If the product is a bona fide option, cross-border payments may be made on a tax-free basis, but if it is better characterized as some other category of financial product, such as a guarantee or insurance, it might be fully subject to dreaded with holding or insurance excise taxes. In the ever burgeoning credit derivatives market, hundreds of millions of dollars have been riding on a favorable resolution
of this question, but no answer has ever been provided.
In all of these situations, to make that determination whether a contract or product is best viewed as an option, what is required is a common understanding
of what characteristics are essential to option classification. The challenge of identifying those characteristics is the focus of this Article.
*Director, PricewaterhouseCoopers; Columbia College (NY), B.A., 1984; Columbia Law School, J.D., 1988; New York University School of Law, L.L.M. (Taxation), 1994.