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.
Rationalizing the Taxation of Options in the Age of Derivatives
Kevin J. Liss*
*Director, Price Waterhouse Coopers;
Columbia College, B.A., 1984; Columbia Law School, J.D., 1988;
New York University School of Law, LL.M.(Taxation), 1994
Although options are perhaps the best-known and oldest form of derivative, the proper taxation of options, from a doctrinal perspective, remains an unsettled area of law. Tax professionals have long questioned why option premiums should not be required to be taken into income in full at the time of payment, consistent with the tax treatment applicable to other types of prepayment. Many leading commentators believe, in contrast, that there is really a hidden borrowing element inherent in every payment of an upfront option premium that is inexplicably ignored by traditional tax accounting rules governing options. This widely-held notion has long been a source of angst among tax professionals because of the growing perceived schism between the tax accounting rules governing options and those relating to other types of financial products, where the trend has increasingly been in favor of recognizing an implicit financing component. The inability to reconcile the taxation of options with the tax treatment of other types of financial products contributes to a lingering sense of crisis in the taxation of financial instruments, leading to wide-ranging proposals on how to overhaul current law rules.
Despite these disparate views on the proper methodology governing the tax treatment of options, all sides seemingly agree that there is something fundamentally wrong with existing law. Compounding the problem, the case law is replete with confusion about the true nature of options and the underlying basis for their tax treatment. As a result, some of these precedents exacerbate the ambivalence among tax professionals about acquiescing in the ancien regime. Even commentators who support the current rules do so begrudgingly, in deference to the fact that current law rules may be so deeply entrenched in the tax edifice that it may be too late to change them.
The purpose of this Article is not to propose a bold new methodology for the taxation of option premiums, a field whose depths have been well-plowed by other commentators. On the contrary, it has the more modest goal of reassessing the extent to which deferred accounting for option premiums might plausibly be justified as being solidly grounded in traditional and long-accepted tax principles. In particular, the article challenges the perception that option premiums should properly be taken into income upon receipt, by analogy to authorities on advance payments and a number of other common law doctrines.
In arguing that option premiums should not be taken into income at the time of payment, this Article does not rely on the premise that an option premium is more properly viewed as an implicit loan from the option holder to the option writer.
Instead, this Article reexamines the historical basis for the deferred accounting treatment of option premiums and reassesses the continuing vitality of that approach in light of longstanding common law doctrines. In the course of its analysis, this article acknowledges the difficulties arising from an over reliance on the open transaction doctrine as the underlying basis for excluding option premiums from income. However, it finds that there is an alternative justification, by analogizing an option to a bet or wager. In the author's view, that analogy is quite apt, and provides a much firmer basis for deferred reporting of option premiums—without necessarily implicating the draconian tax rules applicable to conventional wagering. In the final analysis, the Article finds that the historical tax treatment holds up surprisingly well against the critiques of some of its leading detractors.
The Article begins with some historical perspective on early case law development and explores why options have never been recognized as a bona fide property interest separate and apart from interests in the underlying property. The Article questions the relevance of the open transaction doctrine to options taxation and highlights some of the problems entailed by over-reliance on that particular doctrine. The Article proceeds with an analysis of the unique issues raised by cash-settled options and explains why analogies to wagers furnish a more appropriate rationale for deferred accounting for option premiums.The Article also considers the role of contingent liabilities, matching rule principles, and expectations-based approaches to the taxation of options in providing further justification for the traditional approach. The Article then examines whether it is possible to reconcile the taxation of option premiums with longstanding doctrines such as the claim-of-right doctrine and prepaid services case law, and concludes that these authorities, properly understood, do not present doctrinal difficulties for a regime that applies deferred accounting for option premiums. Finally, the Article addresses the perception that options may properly be viewed as a wasting asset, a view which, if valid, would support amortizing an option premium over time. In the final analysis, taking into account the fundamental nature of an option, properly understood, the Article concludes that deferred accounting for option premiums is well-warranted, both conceptually, and in relation to each of the aforementioned longstanding principles of tax law.