Copyright 2004 Tax Analysts Tax Notes Today JANUARY 27, 2004 TUESDAY

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1 Page 1 Copyright 2004 Tax Analysts Tax Notes Today JANUARY 27, 2004 TUESDAY DEPARTMENT: News, Commentary, and Analysis; Special Reports CITE: 2004 TNT LENGTH: words HEADLINE: 2004 TNT THE TAX TREATMENT OF CONTINGENT OPTIONS. (Section Constructive Ownership) (Release Date: JANUARY 23, 2004) (Doc (17 original pages)) CODE: Section Constructive Ownership ABSTRACT: Matthew A. Stevens, Alston & Bird, discussed the tax treatment of financial instruments that take the form of options but prohibit the exercise of the option unless a specified event occurs. SUMMARY: Published by Tax AnalystsTM Matthew A. Stevens is currently a partner at Alston & Bird LLP. The author would like to thank Dale Collinson, Paul Jacokes, Gregory May, and Marie Milnes-Vasquez for their helpful comments on earlier drafts of this article. Ascertaining whether a particular financial instrument is an option is important not only for determining the tax treatment of payments made under that instrument, but also for determining the tax consequences of other transactions in which the taxpayer may have engaged. This article discusses the tax treatment of financial instruments that take the form of options but prohibit the exercise of the option unless a specified event occurs. While anumber of cases and rulings have dealt with the taxation of contingent options in the contexts of particular transactions, the existing authorities have not set forth acomprehensive theory for analyzing these instruments. In this article, the author proposes a framework for determining the tax treatment of contingent options. To that end, the article first gives several examples of contingent options. Second, the article analyzes the cases and rulings that govern the treatment of contingent options. Third, the article applies the principles of the cases and rulings to the examples of contingent options referred to above. Finally, the article concludes that whether a particular contingent option would be treated as an option for tax purposes would depend largely on the policy considerations that are relevant to the code provision for which the determination was being made. (C) 2004 Matthew A. Stevens. All rights reserved. AUTHOR: Stevens, Matthew A. Alston & Bird LLP GEOGRAPHIC: United States

2 Page 2 REFERENCES: Subject Area: Corporate taxation; Financial instruments tax issues; Tax policy issues; Tax system administration issues TEXT: Release Date: JANUARY 23, 2004 Published by Tax AnalystsTM Matthew A. Stevens is currently serving as Special Counsel to the Chief Counsel for the Internal Revenue Service. This article represents the views of the author, and not necessarily those of the Office of Chief Counsel, the Internal Revenue Service, or the Treasury Department. The author would like to thank Dale Collinson, Paul Jacokes, Gregory May, and Marie Milnes-Vasquez for their helpful comments on earlier drafts of this article. Ascertaining whether a particular financial instrument is an option is important not only for determining the tax treatment of payments made under that instrument, but also for determining the tax consequences of other transactions in which the taxpayer may have engaged. This article discusses the tax treatment of financial instruments that take the form of options but prohibit the exercise of the option unless a specified event occurs. While a number of cases and rulings have dealt with the taxation of contingent options in the contexts of particular transactions, the existing authorities have not set forth a comprehensive theory for analyzing these instruments. In this article, the author proposes a framework for determining the tax treatment of contingent options. To that end, the article first gives several examples of contingent options. Second, the article analyzes the cases and rulings that govern the treatment of contingent options. Third, the article applies the principles of the cases and rulings to the examples of contingent options referred to above. Finally, the article concludes that whether a particular contingent option would be treated as an option for tax purposes would depend largely on the policy considerations that are relevant to the code provision for which the determination was being made. Introduction I. Examples (C) 2004 Matthew A. Stevens. All rights reserved. * * * * * Table of Contents II. The Contingent Option Authorities A. Overview B. The Timing Cases C. The Section 318 Authorities

3 Page 3 D. Cash-Settled Options III. Analysis Conclusion Introduction Determining whether a particular financial instrument is an option for U.S. federal income tax purposes can be important for several reasons. First, the timing and character of payments made with respect to options are determined under a unique set of rules. For example, while payments received by a taxpayer without any restrictions on disposition are generally includable in income when they are received,/1/ a payment received in return for writing an option need not be included in the taxpayer's income until the option is exercised, lapses, or is otherwise terminated./2/ Second, the existence of an option can affect the treatment of another transaction. For example, suppose a taxpayer holds stock in a corporation and the corporation purchases all of that stock from the taxpayer. The transaction will generally be treated as a sale of the stock. If, however, the taxpayer also owns an option to acquire stock of the same corporation, the redemption of stock by the corporation may be treated as a dividend under sections 302 and 318 of the Internal Revenue Code of 1986 (the code). While neither the code nor the regulations provide a general definition of an option, case law has defined an option for tax purposes as consisting of two components: (1) a continuing offer to do or to forbear from doing something and (2) an agreement to leave this offer open for a specified or reasonable period of time./3/ Thus, if A agrees to sell B a share of common stock of Company X at any time within the next six months for a fixed price equal to the current market price of that share, this transaction clearly satisfies the definition of an option and would be treated as such for tax purchases. Many other instruments, however, while cast in the form of options by the parties, provide that the holder may not exercise the option until the occurrence of a specified contingency. This article will attempt to shed some light on the treatment of these instruments, which I refer to for convenience as "contingent options."/4/ Part I provides four examples of contingent options, along with a brief discussion of the possible tax consequences to the parties of entering into them. Part II explores the cases and rulings in this area. It concludes that, even though the courts have adopted a rule to the effect that a contingent option is not an option for tax purposes, the determination of whether a contingent option is treated as an option should largely depend on the policy considerations relevant to the application of the code provision for the purpose of which the determination is being made. Part III explores how a court would likely treat each of the four examples discussed in Part I in light of both the rule that seemingly bars contingent options from being treated as options and the policy considerations involved in each example. I. Examples Example 1. A taxpayer writes a knock-in call option on December 31 of Year 1. Under the terms of this option, the buyer of the option pays the taxpayer an up-front premium in return for the right, but not the obligation, to buy a share of Company X stock on June 30 of Year 2 for $ 100, but only if the price of Company X stock equals at least $ 105 per share on the exercise date. The taxpayer is a domestic corporation that does not use a mark-to-market method of accounting for tax purposes (for example, under section 475) with respect to the call option premium. As noted above, an amount received by a taxpayer under a claim of right is generally treated as income on receipt./5/ However, a taxpayer who receives an option premium must place the amount of the premium in a suspense account until the option is exercised or lapses, or the option is otherwise terminated./6/ Is the contingent option described in this example an "option" for these purposes, thus entitling the taxpayer to defer inclusion of the premium, or does the generally applicable claim of right doctrine apply instead? Example 2. The facts are the same as in Example 1, except that here the taxpayer is the buyer, rather than the

4 Page 4 writer, of the option. The taxpayer in this example also owns one share of Company X common stock, in which he has a basis of $ 140. The taxpayer sells the stock on December 31 of Year 1 for its fair market value of $ 100 per share, and simultaneously buys the knock-in call option described in Example 1. Section 1091(a) provides that if a taxpayer sells stock and, within the 61-day period starting 30 days before the sale date, enters into an option to acquire such stock, the taxpayer's loss will be disallowed. Does the option described in this example constitute "an option to acquire" Company X Stock within the meaning of section 1091? Example 3. Two unrelated U.S. corporations form a foreign corporate subsidiary to jointly manufacture automobiles. One corporation has an option to sell all of its stock to the other corporation for a fixed price on a date three years in the future, but only if the price of steel on that date is greater than 125 percent of the currently projected future price of steel on that date. The foreign subsidiary incurs foreign income tax and pays a dividend out of its earnings and profits. Section 901(k) provides in pertinent part that if a U.S. corporate shareholder of a foreign corporation receives a dividend from a foreign corporation, the deemed-paid foreign tax credit generally available with respect to such dividend will be disallowed if the stock with respect to which such credit is claimed is not held for at least 16 days beginning on the 15th day before the ex-dividend date. In determining whether this holding period requirement is satisfied, the rules of section 246(c)(4) apply./7/ Section 246(c)(4) and Treas. reg. section (d)(2) provide that the holding period of stock will not include any day on which the taxpayer has an option to sell that stock. Does the existence of the contingent option constitute an "option to sell" for this purpose, thus rendering unavailable the foreign tax credit?/8/ Example 4. A U.S. bank enters into a contract with a foreign investor, under which the U.S. bank has the right, but not the obligation, to sell a particular debt instrument issued by a U.S. obligor (the reference obligation issuer) to the foreign investor for an amount equal to the face value of the instrument plus accrued but unpaid interest. The contract provides, however, that the U.S. bank may exercise this right only if the credit rating of the reference obligation issuer falls below investment grade. In return, the U.S. bank must pay the foreign investor a single up-front amount equal to 2.5 percent of the principal amount of the bond. The foreign investor is located in a jurisdiction that does not have an income tax treaty with the United States. U.S. withholding tax generally is imposed on the payment of fixed or determinable annual or periodical income (FDAP) from sources within the United States./9/ However, no withholding tax is imposed on the payment of option premiums./10/ Does the contingent option in this example constitute an option, thus rendering the up-front payment made by the taxpayer exempt from income tax, or is the contingent option properly treated as another type of instrument, thus potentially subjecting that payment to U.S. withholding tax at a rate of 30 percent? A. Overview II. The Contingent Option Authorities To analyze whether each of the contingent options discussed in Part I should be treated as an option, it is helpful to examine the treatment of contingent options in cases and rulings. These authorities can usefully be divided into three major categories. The first and most important category deals with situations in which the Service has asserted that a contingent option premium must be included in income in the year received, while the taxpayer asserts that inclusion must await the exercise, lapse, or other termination of the option (the timing cases). The second category deals with whether a contingent option is treated as an option to acquire stock for purposes of section 318. The third category deals with situations in which the holder of the option does not have the right to receive the underlying property, but does have the right to receive cash. In general, the cases in each category present a fundamental difficulty for one seeking to determine whether a contingent option is an option for tax purposes. All of the cases that have considered whether a contingent option is an option for tax purposes have answered this question in the negative, and have done so using sweeping language. The outcomes, however, appear to have been driven in each case by the court's desire to reach a particular result based on the policy considerations relevant to that case. The use of broad language and result-oriented nature of the decision

5 Page 5 make it difficult to evaluate the precedential value of the case in fact situations that differ from those in the decided cases. Nonetheless, it is with these cases that the analysis must begin. B. The Timing Cases The bulk of the common-law authorities relevant to the treatment of contingent options deals with whether a taxpayer who has written an option must include in income the premium in the year received, or whether the taxpayer may wait until the option is exercised, lapses, or is otherwise terminated. Because the basic rule providing for the deferral of option premium received with respect to noncontingent options is somewhat counterintuitive, it is useful briefly to review the history of this deferral rule before examining the cases that bear directly on the treatment of contingent options./11/ 1. The deferral rule. The seminal case dealing with the timing of the inclusion of option premiums is Virginia Iron Coal & Coke Co. v Commissioner./12/ There, the taxpayer in 1930 granted an option to acquire for a specified price all of the stock of its subsidiary or all of the assets of that subsidiary. The premiums for the option were due approximately at annual intervals. Premiums payable before 1935 would reduce the amount of the purchase price due under the option, while premiums payable after 1934 would not reduce the purchase price. The option holder was not obligated to continue to pay the premiums, but it could not recover premiums already paid if it let the option lapse. The taxpayer received the final payment in 1932 and the option lapsed in The issue between the taxpayer and the Service was whether the taxpayer was required to include the premiums in income in 1930 and 1931, when they were received, or in 1933, when the option lapsed. The Fourth Circuit held that the payments could not be subjected to tax until the option had finally lapsed, reasoning that: [a]t the time the payments were made it was impossible to determine whether they were taxable or not. In the event the sale should be completed, the payments became return of capital, taxable only if a profit should be realized on the sale. Should the option be surrendered it would then become certain, for the first time, that the payments constituted payments in the year in which they were made. That is, it would be impossible to determine, at the time the payments were made, whether they would ultimately be treated as part of a sale transaction. In the absence of such determination, it would be impossible to determine whether the payments should be treated as capital gain, ordinary income, or return of capital. Thus, the result in Virginia Iron was driven by the court's decision to view the payment of the option premium as part of a potential future purchase of the underlying property. The outcome in Virginia Iron was scarcely compelled. The court made the analysis appear easy by implicitly assuming that if the purchase transaction occurred, the option premium should be treated as part of the amount realized in that transaction. Once this assumption had been made, deferral was the only sensible decision. The validity of this assumption, however, is worth examining. The court could instead have reasoned that when the premium was received by the writer, there was no assurance that the option would ever be exercised and the underlying property would be purchased. Any such purchase pursuant to the option would have been the result of an independent decision by the option holder, made possibly many years after the premium had been paid. The court could have reasoned that the option writer had received this amount under a claim of right, with no limitation as to its disposition. Under this view, it would be more appropriate under North American Oil Consolidated v. Burnet/13/ to treat the option as income in the year of receipt. Presumably, this would be ordinary income, because at the time of receipt, there would have been no sale or exchange of a capital asset, nor would any sale or exchange necessarily follow. Under this view, if a subsequent sale had occurred, the option premiums would not, of course, been treated as part of the sale proceeds, because they

6 Page 6 would already have been included in income./14/ In Rev. Rul ,/15/ the Service adopted the Virginia Iron rule to the effect that the inclusion of an option premium must await the exercise, lapse, or other termination of the option writer's obligation under the option. The Service justified the deferral rule by noting that the optionor assumes an obligation to buy or to sell certain property, and that "since the optionor assumes such obligation, which may be burdensome and is continuing until the option is terminated, without exercise, or otherwise, there is no closed transaction nor ascertainable income or gain realized by an optionor upon mere receipt of a premium for granting such an option." The Service noted that the optionor might pay the optionee to be released from its obligation under the option, and that the amount thus paid could exceed the amount received by the optionor. In summary, then, the Service appears to have viewed the existence of a deferral rule as stemming from the existence of a contingent liability that offset the premium received, and that prevented the transaction from being closed for tax purposes. This result has since been affirmed by a number of court cases, in particular Koch v. Commissioner./16/ It is interesting to examine the position of the Court in Virginia Iron and of the Service in Rev. Rul in light of the "claim of right" doctrine spawned by North American Consolidated Oil v. Burnet. In that case, an amount received by a taxpayer in a given year and held by that taxpayer under a "claim of right" was includable in that year, notwithstanding that the taxpayer might be called on to refund that amount in a later year. This doctrine would appear to be broad enough to encompass the receipt of an option premium, because the writer of the option is generally free to deal with the premium as he sees fit and, at least in the case of a physically settled call option,/17/ the writer would never be required to return it. Yet the Service ruled to the contrary in Rev. Rul ,/18/ the courts have generally not applied the claim of right doctrine to option premiums,/19/ and Congress has never legislated to the contrary. Why? The answer may lie in the fact that, as discussed in the next paragraph, an option transaction will often produce quite different character consequences than the typical "claim of right" case. If a taxpayer is required to include an amount under the claim of right doctrine and is then subsequently required to return the funds, the taxpayer would generally have ordinary income in the first year, followed by a deduction against ordinary income in the second year, because the amount received is not treated as part of a sale transaction. By contrast, if a taxpayer were required to include a call option premium on receipt as ordinary income and the option were subsequently exercised, the taxpayer would have included as ordinary income an amount that would have increased long-term capital gain or reduced long-term capital loss if it had been taken into account as part of the sale proceeds (assuming the underlying asset was a capital asset and had been held for the requisite period). In this situation, a rule that option premiums were includable immediately on receipt would have caused the taxpayer to have paid tax at ordinary income rates rather than capital gain rates./20/ During much of the development of tax law, rate differentials between capital gain and ordinary income were quite substantial./21/ The tax system (the courts, Congress, and the Service), confronted with the prospect of requiring current inclusion of option premium as ordinary income, followed by a larger capital loss or a smaller capital gain on an eventual sale, may have decided that deferral would be the better answer, even if the deferral would in some cases prove to have been unwarranted. Thus, potential character mismatch may have been viewed as one reason to remove option premiums from the general "claim of right" doctrine. Contributing to this character-based policy consideration may have been the fact that, before the 1980s, time value of money concepts were largely ignored by tax policy makers./22/ Accordingly, deferral was more available than currently under legal doctrines such as "wait and see" for contingent debt instruments/23/ and "open transaction" for sales such as those in Burnet v. Logan./24/ For this reason, the tax system may have been less concerned about the taxpayer's tax- deferred use of the funds than it would be if the rules governing options were being written today on a blank slate. Whatever the rationale for treating an option premium as subject to deferral in the case of a noncontingent option, that deferral rule generally constitutes black-letter law for option premiums./25/ 2. Right of first refusal. As noted above, in Virginia Iron, the court treated a call option premium as potentially constituting a portion of the sale proceeds of the underlying property, and, given the impossibility of knowing how the premium should be treated while the option was outstanding, permitted deferral of the option premium. In Rev. Rul.

7 Page , the Service appeared to adopt a broad "contingent liability" theory to justify the rule that the writer of an option could defer the inclusion of premium income until the option was exercised, lapsed, or was the subject of a closing transaction. One might have thought, given these principles, that the writer of a contingent option would be treated similarly to the writer of the options described in Virginia Iron and Rev. Rul However, as the following discussion indicates, the decided cases have held that the writer of a contingent option does not qualify for the same deferral benefit for which the writer of a noncontingent option qualifies. Moreover, the courts have justified this decision by concluding that a contingent option does not constitute an option for tax purposes. In the context of the cases involving the timing of the inclusion of option premium, this issue first arose in the context of a right of first refusal. The first case to deal with whether a right of first refusal constituted an option was Holmes v. Commissioner./26/ There, the taxpayer owned a substantial block of stock in a bank. One of the other large shareholders wished to sell his stock. The taxpayer located a buyer, negotiated the purchase price with the buyer, and assisted the buyer in obtaining financing to buy the stock. The purchase price had originally been agreed as $ 263,500, but was subsequently reduced to $ 211,500 through the negotiations among the taxpayer, the buyer, and the seller. Contemporaneously with the completion of the purchase transaction, the taxpayer and the buyer entered into an agreement pursuant to which each gave the other a right of first refusal on the sale of his shares and the buyer paid the taxpayer $ 52,500. Even though the agreement bound the buyer to the same extent as the taxpayer, the taxpayer did not give any consideration to the buyer in return for entering into the right of first refusal agreement. The agreement provided that it would expire at the end of 20 years, unless earlier terminated by agreement of the parties. The taxpayer argued that he was not required to include the $ 52,500 in income until the right of first refusal lapsed or was otherwise terminated; the Service responded that the existence of the contingency prevented an option from existing for tax purposes. The Tax Court agreed with the Service that the right of first refusal did not constitute an option for U.S. federal income tax purposes. The Tax Court quoted Williston on Contracts for the proposition that an option "is the creation of an obligation by which one binds himself to sell and leaves it discretionary with the other party to buy."/27/ The court then stated that an option "creates an irrevocable offer on the part of the owner and at the same time grants the purchaser a choice of whether or not to buy the property at the specified price within the specified time. In other words, an option is a contract by which the owner of property agrees with another that he shall have the right to buy the property at a fixed price within a time certain."/28/ Applying this definition to the facts of the case, the Tax Court pointed out that the obligation of each party to the right of first refusal was contingent on that party's having received an offer to purchase the stock from a third party. The Tax Court concluded that "the agreement in the instant case did not inflexibly bind petitioner to offer his stock for sale to [the buyer] for a stated price within a fixed time period."/29/ Thus, the Tax Court held that the taxpayer had not issued an option, and was not entitled to defer receipt of the premium beyond the year of receipt./30/ Because the Tax Court interpreted the deferral rule as applying only to "options," the court's holding that the right of first refusal was not an option enabled it to conclude that the taxpayer was not entitled to defer inclusion of the amount he had received for granting the right. As a policy matter, it is hard to understand why the differences between rights of first refusal and options justified the court's statement that an unconditional obligation was necessary for an option to exist. That is, in Virginia Iron and Rev. Rul , at the time the taxpayers in those authorities received the premium, it was not possible to know whether it should be taxed as capital gain or ordinary income. Exactly the same statement could be made about the amount received by the taxpayer in Holmes in connection with his issuance of the right of first refusal. If the right were ultimately exercised, the amount received would arguably constitute part of the sale price of the property, and if were not exercised, it would constitute ordinary income. A straightforward application of the principles articulated in Virginia Iron and Rev. Rul , then, would suggest that a payment received pursuant to a right of first refusal should be entitled to deferral in the same manner as a premium on a noncontingent option. By implicitly rejecting this argument, the Tax Court in effect declined to view the amount received by the taxpayer as potentially part of a future sales transaction. In effect, the Tax Court applied the principles of North American Consolidated Oil to the amount received by the taxpayer for granting the right of first refusal. Why did the

8 Page 8 Tax Court take this approach? It appears that the Tax Court rejected option treatment in Holmes at least in part because it believed that the option premium of $ 53,500 represented compensation for services performed by the taxpayer. Under the right of first refusal agreement, both the buyer and the taxpayer were bound to the same degree, yet the buyer purportedly paid the taxpayer to enter into this agreement. This lack of symmetry, when both sides were equally bound under the right of first refusal agreement, suggests that the buyer actually made the payment in return for something else. Since the taxpayer was heavily involved in the negotiation of the transaction as an intermediary, performed services for both sides, and wound up receiving -- under the right of first refusal agreement -- the exact amount by which the originally negotiated purchase price had been reduced, it likely seemed reasonable to the court to treat the payment as made to compensate the taxpayer for his services. The Tax Court also dealt with a right of first refusal in Saviano v. Commissioner./31/ There, the taxpayer, as part of a tax shelter, had deposited $ 8,000 with a tax shelter promoter in return for a mineral claim on gold-bearing land. He then wrote a purported call option on the gold for $ 32,000. However, the option written by the taxpayer did not impose on him an absolute obligation to mine or sell any gold; rather, it obligated him to sell the gold to the option holder for a fixed price if he sold it at all. The taxpayer also paid $ 40,000 to a mining contractor to prepare the claim for the extraction of the gold. The taxpayer did not include any of the option premiums in income, but did claim a deduction under section 616 for the full $ 40,000 mine development expense. The Tax Court stated the general definition of an option for tax purposes (a continuing offer to do something or to forbear from doing something, and an agreement to hold the offer open for a fixed or reasonable period of time)./32/ It then held that because the offer made by the taxpayer did not create in the option holder an unconditional power of acceptance, the generally applicable rule governing the taxation of option premiums did not apply. While the facts in Saviano were not described as clearly as those in Holmes, the court was clearly motivated by its belief that it was inappropriate to permit deferral of the inclusion of the option premium while allowing an immediate deduction for the mine development expenses. Thus, the outcome in Saviano appears to have been based on a principle of matching a deduction with the related income. The court may also have believed that Saviano simply involved a tax shelter transaction with no real economic substance./33/ The decisions in Holmes and Saviano may also be understood in terms of the contingent liability theory asserted in Rev. Rul Recall that the revenue ruling based its conclusion that deferral was proper on the existence of a continuing and burdensome, although contingent, obligation on the part of the taxpayer to deliver the subject property. In the case of a right of first refusal, however, one of the contingencies necessary to trigger a liability on the part of the taxpayer is within the control of the grantor of the right (the contingent option writer). That is, unless and until the owner of property subject to a right of first refusal decides to sell that property and receives a valid offer to buy it, the option holder has no right to acquire the property and the option cannot be exercised. In essence, the option writer has substantial control over the creation of a liability as long as he is content to hold the underlying property./34/ The decisions in Holmes and Saviano that no option existed could be justified, then, on the grounds that (1) policy considerations specific to each case (for example, the compensatory element present in Holmes) required the elimination of deferral and (2) the grantor's ability to avoid the creation of a liability prevented the court from concluding that a contingent liability existed. 3. Old Harbor Native Corporation. The deferral principle that was established in Virginia Iron and Rev. Rul and limited in Holmes and Saviano was further eroded in Old Harbor Native Corporation v. Commissioner./35/ In that case the taxpayer was a corporation that owned various surface rights in certain government- owned land. The taxpayer and the Department of the Interior (DOI) contemplated entering into an agreement under which the taxpayer would transfer these surface rights back to the government in exchange for the subsurface rights in other government-owned land (specifically, the Alaska National Wildlife Refuge (the ANWR)). The agreement, however, was contingent on congressional approval and in particular on congressional approval of drilling for oil in the ANWR. Before finalizing its

9 Page 9 agreement with the DOI, the taxpayer granted Texaco the privilege to elect to lease the subsurface rights in the ANWR that the taxpayer would obtain from the government if the agreement with the government went into effect. Texaco could terminate its lease with the taxpayer if the legislation was not enacted by a specified date. As consideration for these privileges, Texaco paid the taxpayer specified sums of money. The taxpayer contended that these sums were not includable in income in the year received, because they were option premiums. The Service contended that the agreement between the taxpayer and Texaco was not an option agreement and that the amounts received by the taxpayer were includable in income on receipt. The court agreed with the Service that the agreements between the taxpayer and Texaco were not options. The court said that: an option has historically required (i) a continuing offer to do an act, or to forbear from doing an act, which does not ripen into a contract until accepted; and (ii) an agreement to leave the offer open for a specified or reasonable period of time. The primary legal effect of an option is that it limits the promisor's power to revoke his or her offer. An option creates an unconditional power of acceptance./36/ The court also said the proposed agreement was subject to various contingencies outside of the taxpayer's control and that two of these contingencies were never met. Thus, the court concluded that the lease agreements did not contain an unconditional right for Texaco to lease a subsurface right in the ANWR that the taxpayer owned or had a vested right to receive, and that the lease agreements were not options. Significantly, the court also mentioned in a footnote its belief that the payments Texaco made to the taxpayer were not made in their entirety for the privilege of electing to lease the subsurface rights in the ANWR that the taxpayer might have received from the government. Among other things, it found that the taxpayer received part of those payments in consideration for its agreement to promote the legislation relating to the ANWR./37/ For one wishing to argue that a contingent option should be treated as an option for tax purposes, Old Harbor presents a greater challenge than any of the other authorities cited in this article. Read literally, the court's reference to "subsurface rights in the ANWR that the taxpayer owned or had a vested right to receive" could suggest that a call option written on a publicly traded stock could be a contingent option, and the premium not qualified for deferral, if the taxpayer did not own or have a legal right to receive from a third party the underlying publicly-traded stock. Even if one does not go that far (and it is unlikely that the Tax Court actually would, regardless of the language it used), the case at first blush appears to represent a major expansion of the principle articulated in the right of first refusal cases typified by Holmes. As discussed above, Holmes dealt with a fact pattern in which the option holder's rights could be triggered by an event (a decision by the option writer to sell to a third party) that was, at least as a legal matter, wholly within the control of the option writer. Also, as discussed above, the taxpayer in Holmes had the power to defer the inclusion of the premium for a substantial period with relatively little disruption of his business activities as long as he did not want to sell the underlying property. By contrast, in Old Harbor the contingencies that would create an unconditional obligation on the part of the taxpayer were, at least as a formal matter, beyond its control./38/ Moreover, unlike in Holmes, in Old Harbor the holder of the option (Texaco) had the right to terminate the agreements and thereby trigger the inclusion of the premium income, if the legislation was not enacted by a particular date. Thus, if the contingent option in Old Harbor had been treated as an option for tax purposes, the taxpayer in that case would have had less control over the timing of the inclusion of the premium than the taxpayer in Holmes had had. As will be discussed in Part IV, a broad interpretation of Old Harbor would have interesting consequences in a variety of contexts, and it seems likely that at least some of these consequences would not comport with good tax policy. It is, however, possible to construe Old Harbor more narrowly. Given that the taxpayer was expected to promote the legislation opening the ANWR to drilling, and given that the court indicated that the payments Texaco made to the taxpayer were made in part for agreeing to promote this legislation, it is possible to read the case as turning on the

10 Page 10 implicit factual finding that the main contingencies in the case were in fact within the control of the taxpayer after all, and that the taxpayer was in effect being compensated for its services (lobbying to promote the legislation). That is, the court may have believed that if the taxpayer did not promote the legislation, the legislation would not be passed, and the taxpayer would have no obligation to Texaco. If this interpretation of Old Harbor is correct, the case could be seen as following Holmes; both would stand for the proposition that a contingent option is not an option for tax purposes if the option writer is, at least to some extent, being compensated for services and the option writer has a substantial degree of control over whether a liability comes into existence under the option./39/ C. The Section 318 Authorities The next set of authorities to be considered involves the question of whether a contingent option constitutes an option for purposes of the section 318 option attribution rules. In Rev. Rul , C.B. 124, the issue was whether certain warrants and convertible debentures were to be treated as options for purposes of applying the option attribution rules of section 318(a)(4). The revenue ruling did not indicate that the warrants or the convertible debentures contained any contingencies that would have to be satisfied before being exercised. The issue appeared to turn on whether the fact that the issuer of the underlying stock was also the issuer of the warrants and convertible debentures could somehow prevent the warrants and convertible debentures from qualifying as options for purposes of applying section 318(a)(4). The Service ruled that: in order for a warrant to acquire stock to qualify as an option, the holder must have the right to obtain the stock at his election. When this right to acquire stock exists, warrants or convertible debentures are not realistically different from options as referred to in section 318(a)(4) of the Code. In each instance, stock may be acquired at the election of the shareholder and there exist no contingencies with respect to such election. Accordingly, under these circumstances, the warrants and the debentures which are convertible into stock constitute options to acquire stock within the meaning of section 318(a)(4) of the Code./40/ (emphasis added) While the conclusion is surely correct, it is not clear why the ruling emphasized the holder's ability to obtain the stock at his election (that is, without restrictions), given the absence of any facts suggesting that any restrictions might be present. Because of the absence of such facts, the language in the ruling arguably constitutes dicta. For this reason, if not for the subsequent authorities that cited it, Rev. Rul would likely have little importance in analyzing the tax consequences of contingent options. The Service clarified Rev. Rul in Rev. Rul /41/ There the Service ruled that a requirement for a fixed period of time to elapse before the exercise of the option did not prevent the holder of the option from being viewed as having a right to receive the subject property at his election. The Service reasoned that: in enacting section 302(b)(2), Congress intended not only that certain specific limitations be met at the time of the transaction, but also that the circumstances of the redemption offer some assurance that the redeemed shareholder will sustain the required contraction of equity with a degree of permanence. Here, the option not only meets the literal wording of section 318(a)(4) but also prevents the transaction from meeting the intent underlying section 302(b)(2).

11 Page 11 Rev. Rul is significant to the tax treatment of contingent options primarily because it is the only case or administrative authority that explicitly suggests it is appropriate to take into account the policy rationale underlying option treatment in determining whether a contingent option should be treated as an option for tax purposes. As will be seen in the following part, in many circumstances, a policy-based analysis is necessary to reduce the likelihood that inappropriate results will be obtained by either the taxpayer or the Service. Two factors, however, tend to detract from the importance Rev. Rul has in determining the treatment of contingent options. First, the option described in that ruling is contingent only in the sense that the imposition of a delay before the option can be exercised clearly prevents the option holder from obtaining the underlying property at any time before the expiration of the option. This delay is arguably not a contingency at all, because there is nothing contingent about the passage of time. Thus, it is not clear that the ruling can be analogized to the types of contingent options discussed in the examples in Part I. Second, it is not clear whether the ruling should be read to indicate that an option would always be treated as such for tax purposes without regard to how much time must elapse before the option can be exercised. In the case of an option that provided for a very long time before exercise was permitted (for example, 30 years), it could be contended that the option should not be treated as an option for tax purposes./42/ The fact that the revenue ruling does not explicitly preclude the Service from making this assertion reduces its usefulness to one arguing that a contingent option should be treated as an option. Only a single case has come close to dealing explicitly with the tax treatment of contingent options for purposes of section 318. In Insilco Corp. v. Commissioner,/43/ the taxpayer owned 66 percent of the outstanding stock in a corporation called Times Fiber; the rest of the stock was publicly traded. A newly formed corporation with no significant assets (LPL) sought to acquire Times Fiber. LPL initially proposed to pay Insilco cash and LPL stock in exchange for Insilco's Times Fiber stock. LPL, however, wanted to obtain a step-up in the basis of Times Fiber's assets. Accordingly, the parties structured the deal as consisting of the following individual transactions to permit LPL to qualify for a section 338 election with respect to the assets of Times Fiber. First, Times Fiber made a self-tender to purchase the Times Fiber stock held by the public for $ per share. Second, Insilco sold all of its Times Fiber stock to LPL for $ per share, or approximately $ 96 million. Third, Insilco paid $ 20 million to LPL to purchase 200,000 shares of LPL preferred stock. Fourth, Insilco and five other investors paid $ 8 million to acquire LPL common stock. Fifth, LPL acquired the remaining shares of Times Fiber stock (the publicly traded shares) for $ by means of a merger. All of the transactions closed on the same date. On its original tax return, the taxpayer reported the transaction as a sale of its Times Fiber stock for $ 96 million. Later, however, the taxpayer attempted to characterize the transactions as a single integrated transaction described in sections 304 and 351. This would have permitted the taxpayer to claim a dividends-received deduction with respect to the net $ 75 million in cash it received. However, it also would have denied the buyer the basis step-up it had bargained for, because its acquisition of the Times Fiber stock would not have occurred pursuant to a "qualified stock purchase."/44/ To establish that sections 304 and 351 applied, the taxpayer needed to establish that it had control of both corporations (LPL and Times Fiber) at the time the cash and stock were received. In support of its position, the taxpayer argued that it had an option to purchase a controlling portion of LPL's stock because, on the closing date, it had the unconditional right to acquire 100 percent of the LPL preferred stock, the aggregate value of which represented more than 50 percent of the total value of all classes of LPL stock./45/ The court rejected this argument. In doing so, it first held that the well-known Danielson/46/ doctrine bound the taxpayer to treat the sale of the Times Fiber stock as separate from the purchases of the LPL stock. The taxpayer argued that Danielson did not apply, because it was not seeking to recast the facts of its transaction, but was instead attempting to correct a mistake of law. That is, the taxpayer contended that it constructively owned all of the stock of LPL at the time it sold the Times Fiber stock to LPL, because its obligation to acquire such stock should be treated as an option. The court rejected this argument as well. It first quoted Rev. Rul as providing that, "to qualify as an option, the holder must have the right to obtain the stock at his election... [with] no contingencies with respect to such election," and then held that it was not required to consider the taxpayer's contention regarding the applicability of the

12 Page 12 section 318(a)(4) option attribution rule because the contention had not been timely made. The court then stated: [i]n any event, the contract to purchase the preferred shares cannot be considered an unconditional option because [the taxpayer's] agreement to purchase $ 20 million worth of LPL preferred shares was conditioned on other transactions, most notably [the taxpayer's] agreement to sell its Times Fiber shares to LPL and the merger of Times Fiber into LPL./47/ While this statement clearly indicates that a contingent option cannot be treated as an option for purposes of section 318, three aspects of Insilco reduce or eliminate the statement's precedential value. The first aspect is the court's clear hostility to the taxpayer's attempt to treat the transaction as a tax-free exchange, given that the taxpayer had originally agreed with the buyer to structure it as a sale so that the buyer could achieve a section 338 basis step-up. The second aspect is the court's explicit statement that it would not consider the taxpayer's section 318 argument because it was not timely raised. The third aspect is the apparent absence of any actual contingency in this transaction. It appears from the statement of the facts that the sale of the Times Fiber stock and the purchase of the LPL stock were virtually simultaneous events; it is not clear what event could eliminate the taxpayer's legal right to obtain the preferred and common stock of LPL. Additionally, one would have thought that the court could have reached the same result by holding that the taxpayer had not only the right, but also the obligation, to purchase the LPL preferred stock, and that such a bilateral contract does not constitute an option for purposes of section 318./48/ Taking this approach, however, would have required the court to conclude that, while section 318 provides that the holder of an option to acquire stock will be treated as the owner of that stock, it does not require the holder of a long position under a forward contract to be treated as the owner. Because this result is economically irrational, the court may have believed it would be better to justify its conclusion on other grounds. D. Cash-Settled Options The final category of authorities deals with cash-settled options. A cash-settled option generally may be defined as any option that on exercise settles in cash or property other than the underlying property, or that could be so settled at the option of one or both parties./49/ This article, however, will focus on cash-settled options that either are mandatorily cash-settled or are cash-settled at the option of the issuer. To understand why these two subsets of instruments arguably may not qualify as options for tax purposes, consider Saunders v. United States./50/ There, the taxpayer was a real estate developer who, after extensive negotiations, successfully organized a group of investors (collectively, the Owners) to acquire real estate. The Owners then wrote an option to the taxpayer that gave him the right, for a five- year period, to purchase a 20 percent undivided interest in the portion of the property that had not been sold at the time the option was exercised on payment of 20 percent of the Owners' investment in the subject property. However, the option provided that, at any time prior to exercise, it could be repurchased by the Owners for a fixed amount of cash. The taxpayer then transferred a partial interest in the option to others. When the taxpayer exercised the option, the Owners elected to exercise their right of defeasance, and the taxpayer received his share of the fixed amount of cash. He claimed capital gain treatment for the cash under section 1234(a); the Service contended that the amount was paid to the taxpayer as compensation for the performance of services, and that the amount therefore constituted ordinary income. While the district court upheld the taxpayer's position, the Ninth Circuit held that, as a result of the existence of the defeasance provision, the owners of the property: were not bound to sell and convey; they were afforded an alternative. And for that reason the [option] did not create a "privilege or option" entitled to be afforded capital

13 Page 13 gains treatment by [section 1234(a)]. That section is limited in application to unilateral agreements which are inflexibly binding upon the purported vendor./51/ Accordingly, the court held, the cash received by the taxpayer was treated as ordinary income under the extinguishment doctrine. The court also noted that within 10 months after the Owners purchased the property for $ 6,756,000, they sold it in essentially unchanged condition for $ 10,800,000. Thus, the Court concluded, "the [option] was essentially illusory as an obligation to convey and that what the parties in reality intended... was the eventual implementation of [the defeasance provision]." In another place in its opinion, the Court concluded that the option "was not a commitment by the grantors to sell an interest in real property, but instead was in reality a bare promise to pay money cleverly clothed in deceptive legal garb in an effort to effect a tax saving."/52/ One can clearly see why the court sought to find that the cash received by the taxpayer was ordinary income rather than capital gain. As noted above, the taxpayer in Saunders had performed substantial services in organizing the group of investors to acquire the property, yet had received no compensation other than the option (for which he had paid only a small amount of cash). Thus, the court might have justified its conclusion on the ground that the payment served the economic function of compensating the taxpayer for performing services. The court did not do this, however. Instead, it used the "not bound to sell and convey" language quoted above, which can be read to suggest that if the writer of an option has the right or obligation to repurchase the option for cash,/53/ the option should not be treated as an option for tax purposes. This case should not be interpreted this broadly, however, for three reasons. First, the court's use of the terms "bare promise to pay" and "essentially illusory as an obligation to convey" strongly suggests that the court believed there was no real uncertainty as to whether the option would be exercised and, once exercised, cash settled. If in fact the option was substantially certain to be exercised and, once exercised, the subject property was substantially certain to be repurchased, then the Service and a court should have the power under general tax principles to treat it as a promise to pay cash rather than an option./54/ Of course, the payment of cash in return for the performance of services would be treated as ordinary income under section 61. Second, a broad reading of the court's statement that the Owners had not granted an option because they "were not bound to sell and convey; they were afforded an alternative" because of their right to cash-settle the option could lead to troubling results in other transactions. For example, suppose A owns a share of Company X stock, which currently has a value of $ 100 per share. B believes the value of Company X stock will likely increase to $ 130 within the next two years, but not above that. A believes that the value of Company X stock will likely not increase in value over the next two years, but that if it does increase, the price will likely exceed $ 130 per share. Each party would like to enter into a derivative transaction that maximizes its potential for profit, given its economic outlook regarding the Company X stock. There are several ways the parties could accomplish this. First, A and B could enter into a transaction in which A writes a European-style call option to B that permits B to purchase Company X stock in two years for $ 100, and B could sell a call option back to A that would give A the right to repurchase that option for $ 30. Second, A could write an option as above, and then could buy from B an option to acquire the Company X stock from B at a price of $ 130 after B has exercised his option. Third, A could write an option to B that would allow B to acquire the Company X stock for a price equal to $ 100 plus $ 1 for every dollar by which the value of the Company X stock exceeded $ 130 on the exercise date. From an economic perspective, these three transactions achieve substantially the same result. Each allows B to benefit from the increase in the value of the Company X stock between $ 100 and $ 130, and allows A to benefit from any increase above that point. Yet if one applies literally the broad "not bound to sell or convey" language used in Saunders, the first method of structuring the transaction (the option-on-an-option) would appear to result in a transaction that does not constitute an option for tax purposes, because A has the right to prevent B from acquiring the Company X stock. The second method of structuring the transaction (the sale and immediate repurchase of the Company X stock) may result in the contingent option being treated as an option for tax purposes if the court respects the temporary possession of the Company X stock by B. The last method would clearly pass muster under Saunders,

14 Page 14 because B can absolutely obtain the stock at his option, albeit for a contingent price. As a business matter, the first method may be the most advantageous, because unlike the second method, it does not require the formalities and expenses of a second sale of the Company X stock, and unlike the third method it does not require a valuation of the stock prior to exercise of the option. No tax policy rationale would be served by requiring the parties to structure their transaction using the second or third methods; nor should the parties (or one of them) be allowed to escape the collateral consequences (for example, under section 318) of having purchased or written an option by using the first method. Third, a broad reading of the "not bound to sell or convey" language in Saunders would also be inconsistent with Rev. Rul /55/ There, a corporation issued investment units, each of which consisted of one share of common stock and one contingent payment right. Each contingent payment right entitled its holder to a single payment, two years after issuance, which varied inversely with the value of the issuer's common stock. At its election, the issuer could make the payment by paying cash, by transferring a number of shares of common stock having a value equal to that cash, or with a combination of stock and cash. Thus, unlike a physically settled put option with respect to its stock, the issuer of the right could never be compelled to purchase any share of its stock. In analyzing the transaction, the Service cited section 1234(c)(2)(A) for the proposition that, for purposes of section 1234(a) and (b), a cash settlement option will be treated as an option to buy or sell property. The Service then noted that the holder of the contingent payment right was in an economic position identical to the holder of a put with respect to the underlying stock, and concluded that the contingent payment right was a cash settlement put option. Notwithstanding the fact that neither Rev. Rul nor section 1032 refers to cash-settled options, but refers only to options to acquire property, the Service went on to rule that the deferral rule of Rev. Rul applied to the premium the holder paid to acquire the cash-settlement option and that section 1032 applied to prevent the issuer from recognizing any gain or loss on the issuance, lapse, or repurchase of the contingent property rights. Rev. Rul thus indicates that, contrary to the broad language used in Saunders and other cases, the fact that the option holder's receipt of the underlying property is contingent on the decision of the option writer not to settle in cash does not prevent the option from being treated as an option for tax purposes./56/ Apart from Saunders, the definitions of an option in many of the other cases cited above could also be cited in support of treating a cash-settled option as not constituting an option for tax purposes (although those cases did not involve cash-settled options and are therefore less analogous factually)./57/ Many statutory provisions also refer to "an option to acquire" without any reference to the possibility of a cash settlement./58/ Moreover, the fact that Congress has clearly provided rules dealing with cash-settled options in some provisions (for example, sections 1091(f) and 1234(c)(2)) lends some weight to the argument that the general definition of an option excludes cash- settled options. As can easily be imagined, however, any such argument would, if successful, allow a wide range of inappropriate results that would favor the taxpayer in some contexts and the Service in others, and, for that reason, it is highly unlikely that a court would accept it. Before moving from the review and analysis of specific authorities to analyze the examples set forth in Part I, it may be useful to summarize the impact of those authorities. Holmes, Saviano, Old Harbor, Insilco, and Saunders (collectively, the Cited Cases) all contain broad language suggesting that contingent options are not to be treated as options for purposes of determining the timing of the inclusion of option premiums (Holmes, Saviano, and Old Harbor), the character of income from a termination payment (Saunders), and the treatment of the contingent option for section 318 attribution purposes (Insilco). The broad language contained in each of these cases, however, is neither necessary nor sufficient to justify the result. Rather, while the result in each of the Cited Cases seems justifiable (with the possible exception of Old Harbor) those results appeared strongly motivated by the policy underlying the substantive tax provision at issue (including the potential tax avoidance inherent in the transaction). For example, the decision in Holmes appeared motivated by a desire to stop the taxpayer's attempt to defer compensation income and convert it to capital gain. In Saunders, it was the potential conversion of compensation income to capital gain that troubled the court. In Saviano, it was the potential timing mismatch between income and deductions, as well as the context of the transaction as a tax shelter. The court in Old Harbor appeared to have based its decision on the desire to avoid allowing the taxpayer to defer income. Finally, the court in Insilco did not appear to be concerned about the taxpayer's avoidance

15 Page 15 of a substantive tax rule, but rather was focused on the Danielson- type concerns of unfair change in position and post-transactional tax planning. Although in each case the court did decide the case consistently with its broad statement that contingent options are not treated as options for tax purposes, it appears that the policy considerations in each case played a critical role in reaching that result. III. Analysis The Cited Cases all state broadly that contingent options are not options for tax purposes; no case holds to the contrary. Yet, it is reasonable to believe that if a court were dealing with fact patterns other than those in the decided cases, the court would be inclined to give as much weight to the underlying policy concerns as the courts in the Cited Cases apparently gave. This part deals with the issue of how a court might reconcile this conflict between the broad language in the Cited Cases and the policy issues raised by each of the examples described in Part I. In weighing the likelihood of success of each party's position in the examples, this Article assumes that the result in each example is independent of the result in all other examples, so that the answer in Example 2, for example, is not dependent on a court decision having been reached in the case described in Example 1. Example 1. A taxpayer writes a knock-in call option on December 31 of Year 1. Under the terms of this option, the buyer of the option pays the taxpayer an up-front premium in return for the right, but not the obligation, to buy a share of Company X stock on June 30 of Year 2 for $ 100, but only if the price of Company X stock equals at least $ 105 per share on the exercise date. The taxpayer is a domestic corporation that does not use a mark-to-market method of accounting for tax purposes (for example, under section 475) with respect to the call option premium. The taxpayer takes the position under the rules generally applicable to options that it is not required to include the call option premium in its income until the year in which the option is exercised, lapses, or is otherwise terminated. However, the existence of the knock-in feature could render the option contingent, and therefore disqualify it for option accounting under the Cited Cases. As a technical matter, it is difficult to distinguish the Cited Cases here, because the legal context of this case (the determination of the proper year in which to include in income a call premium) is the same as the legal context in three of the Cited Cases (Holmes, Saviano, and Old Harbor). The taxpayer can point out that there are no services being performed by the call writer here, unlike in Saunders, Holmes, and Saunders, and no concern about matching income with expenses or with post-transactional tax planning, as in Saviano and Insilco, respectively. These distinctions may lessen the force of those cases to some degree. The taxpayer could also make at least three affirmative arguments in support of option treatment. First, the concerns first raised in Virginia Iron regarding the uncertainty of the proper treatment of the premium at the time of receipt are present with equal force here. That is, at the time the premium was received, it was not possible for anyone to know whether the option would ultimately be exercised, in which case the premium would become part of the amount realized on the sale of the underlying stock, or whether the option would ultimately lapse, in which case the premium would be treated as short-term capital gain. Second, the "contingent liability" theory set forth in Rev. Rul would also apply with equal force here. By writing the option, the taxpayer could be viewed as undertaking a contingent liability to deliver the stock under certain circumstances. The fact that these circumstances were not wholly in the control of the option holder (through a decision to exercise the option) would not make the liability more contingent from the perspective of the option writer in any meaningful respect. Contrast this example with Holmes, in which the circumstances that could trigger a liability on the part of the taxpayer to sell (the intention to accept an offer from a third party to buy) were, at least as a legal matter, within the option writer's control. Third, the taxpayer could argue that if the knock-in option is not an option for purposes of determining whether the premium may be deferred, it also cannot be an option for purposes of determining whether the holder's loss is deferred under section 1091, as is relevant for Example 2. This, the taxpayer could contend, could produce results that are absurd, or at least plainly inconsistent with the intent of Congress in enacting section 1091./59/ On the other hand, the taxpayer's first argument could also have been made in Holmes and Old Harbor, and neither

16 Page 16 court mentioned it while reaching a contrary result. Thus, one might argue, the Virginia Iron rationale simply does not apply when the option is contingent. As to the second argument, relating to the contingent liability theory, one may attempt to minimize its force by stating that Rev. Rul was not mentioned in any of the decided cases and should not be extended beyond the facts in that ruling. Regarding the third argument, it could be pointed out that the hypothetical case involving section 1091 is not before the court, and that the court therefore need not rule on it./60/ On balance, it would appear that the taxpayer would likely be required to include the contingent option premium in income upon receipt. Example 2. The facts are the same as in Example 1, except that here the taxpayer is the buyer, rather than the writer, of the option. The taxpayer in this example also owns one share of Company X common stock, in which he has a basis of $ 140. The taxpayer sells the stock on December 31 of Year 1 for its fair market value of $ 100 per share, and simultaneously buys the knock-in call option described in Example 1. At first glance, the knock-in option in this example would appear to constitute "an option to acquire stock" under section If it were, then the loss realized by the taxpayer on the sale would be deferred under that section. The taxpayer might argue, however, that the option is contingent, and therefore not treated as an option for income tax purposes, because he did not have an absolute right to purchase the stock./61/ Instead, the taxpayer has the right to purchase the stock only if the market price is at least equal to $ 105. What result? As noted above, the Cited Cases would favor the taxpayer. However, the court may distinguish the Cited Cases on the ground that those cases were motivated by the policy issues discussed above, including the potential for inappropriate tax avoidance, and that those cases did not deal with section 1091 or the policies underlying that code section. Moreover, at least two policy arguments support making a distinction between the knock-in call option described in this example and the transactions described in the Cited Cases. First, the purpose of section 1091 would be completely frustrated if the taxpayer's knock-in option were not treated as an option for tax purposes. That is, the taxpayer would be allowed a loss with respect to stock notwithstanding the fact that, by holding the call option, the taxpayer will benefit from upward movement in the stock price if the price increases above $ 105. As part of this contention, one might argue that section 1091 would certainly apply if the option were a noncontingent option with a strike price of $ 105, and that the option in Example 1 provides more upside potential to the taxpayer than such a noncontingent option provides because of the lower strike price. After all, one might argue, the taxpayer's acquisition of this option undermines the purpose of section 1091 to at least as great a degree as would the acquisition of a noncontingent option with a strike price of $ 105, and should not receive more favorable treatment for purposes of section 1091 than would the acquisition of such a noncontingent option. Second, if the taxpayer wins on the facts of Example 2 on the grounds that the option is contingent, one might logically infer that an option in which the knock-in price is equal to the strike price must also be considered contingent. Yet it would be difficult to justify a distinction between (i) an option that cannot be exercised if the strike price exceeds the spot price on the exercise date and (ii) an option that can be exercised regardless of the spot price on the exercise date (that is, a garden-variety option), but that will not be exercised if the strike price exceeds the spot price on such date, simply because the option holder can acquire the stock more cheaply in the market. Thus, one might conclude, the contingent option with a knock-in price that exceeds the strike price should also not be treated as contingent. The taxpayer could contend that the Cited Cases should not be distinguished on the ground that they all involve timing, character, or section 318 issues, rather than the wash sale rules under section Any such distinction, the taxpayer would argue, could result in a multiplicity of definitions of "option" for tax purposes, which could lead to confusion and difficulties in administering the tax law. On the other hand, a multiplicity of definitions may be inevitable in light of the varying purposes for which the definition of "option" is relevant. On balance, given a court's ability to distinguish the Cited Cases as a technical matter, and given at least two potent policy arguments favoring the Service, it is likely that the contingent option here would be treated as an option, and that the wash sale rules would apply to disallow the taxpayer's loss.

17 Page 17 Example 3. Two unrelated U.S. corporations form a foreign corporate subsidiary to jointly manufacture automobiles. One corporation has an option to put all of its stock to the other corporation for a fixed price on a date three years in the future, but only if the price of steel on that date is greater than 125 percent of the currently projected future price of steel on that date. The foreign subsidiary incurs foreign tax, and pays a dividend out of its earnings and profits. If the contingent option is treated as an "option to sell" under section 246(c)(4), then the foreign tax credit would be unavailable under section 246(c) (acting through section 901(k)). The taxpayer, however, may assert that the contingency prevents the option from being treated as an "option to sell" under section 246(c)(4). What result? The taxpayer could rely on the statements in the Cited Cases to the effect that a contingent option is not treated as an option for tax purposes. In addition, the taxpayer could argue that, just as the Service in Rev. Rul looked to the purpose of section 318 in determining that an option with a nonexercise period would still be treated as an option, so should a court look to the purpose of Section 901(k) and 246(c) in determining whether the contingent option described in Example 3 constitutes an option for purposes of those code sections. The taxpayer could further contend that treating the contingent option as not being an option is entirely consistent with the policy underlying sections 901(k) and 246(c)(4)(C). That provision is intended to disallow the tax benefit accompanying dividends where the taxpayer has diminished its risk of loss on the underlying stock by holding one or more other positions (that is, positions other than the stock) with respect to substantially similar or related property. Property generally will not be substantially similar or related to stock unless, among other things, changes in the fair market value of the stock are reasonably expected to approximate, directly or inversely, changes in the fair market value of the substantially similar or related property or a fraction or multiple of that fair market value./62/ This "reasonably expected to approximate" standard permits taxpayers to engage in some risk reduction as long as the risk is not eliminated or substantially eliminated./63/ Here, while the taxpayer's risk of loss on the stock is reduced by holding the contingent put option, it is not eliminated or substantially eliminated. Because the result sought by the taxpayer finds technical support in the Cited Cases and does not contravene the intent of Congress in enacting sections 246(c) and 901(k), the taxpayer appears to have an edge in contending that the contingent option should not be treated as an option to sell the underlying securities. Example 4. A U.S. bank (U.S. Bank) enters into a contract with a foreign investor, under which U.S. bank has the right, but not the obligation, to sell a particular debt instrument issued by a U.S. obligor (the reference obligation issuer) to the foreign investor for an amount equal to the face value of the instrument plus accrued but unpaid interest. The contract provides, however, that U.S. Bank may exercise this right only if the credit rating of the reference obligation issuer falls below investment grade. In return, U.S. Bank must pay the foreign investor a single up-front amount equal to 2.5 percent of the principal amount of the bond. The foreign investor is located in a jurisdiction that does not have an income tax treaty with the United States. If the up-front payment constitutes FDAP, in the absence of a treaty, it would be subject to U.S. withholding tax at a rate of 30 percent. U.S. Bank, the taxpayer in this Example 4, could contend, however, that the contract is a put option and that put option premiums are not subject to withholding tax./64/ U.S. Bank could attempt to distinguish the Cited Cases on grounds analogous to those described above to argue that its contingent option should be treated as an option for tax purposes (for example, that those cases did not involve liability for withholding taxes and that the policies implicated in those cases are not relevant to the treatment of its option). It is not clear whether that argument would be successful. As an important backup argument, however, U.S. Bank could also argue that the principles of Bank of America v. United States/65/ require a decision in its favor. There, the Court of Claims held that some acceptance commissions received by a bank were foreign-source income because the taxpayer received those payments in return for accepting the credit risk of, and performing credit administration for, a foreign bank, and accordingly constituted foreign-source income. In effect, the payments were seen as analogous to interest because the substance of the activity that generated the income was the taxpayer's subjecting its assets to the credit risk of another, which was the sine qua non of a bank's business. Extending this principle here, the holder of the contingent option (U.S. Bank) could argue that, even if the contingent option does not technically meet the requirements of an option, it serves the same function and purpose as an option. That is, both the contingent option described in this Example 4 and a noncontingent put option are designed to transfer to the option writer certain risks with respect to the underlying property. In both cases, the option writer is accepting these risks in return for the payment of a fixed amount

18 Page 18 up front. Under this theory, it would be irrelevant that the sole risk being taken by the foreign investor is the credit risk of a U.S. borrower, while one who writes a noncontingent put option on a debt instrument may also be taking on interest rate, currency, and other risks. In response to this, one might argue that the risk taken by the taxpayer in this example is analogous to the risk taken by the taxpayer in the Bank of America case. In Bank of America, the taxpayer was a U.S. taxpayer who took on the credit risk of a foreign bank, and the payments received by the taxpayer were therefore held to have a foreign source. Here, the credit risk assumed by the foreign investor reflects the risk of a U.S. borrower (the reference obligation issuer), and one could argue from this that the payments made to compensate the foreign investor for assuming this risk should therefore be considered to be sourced in the United States. Viewed differently, every interest payment can be considered to consist of two components: an amount equal to the risk-free rate of return, which compensates the lender for the loss of use of its funds, and a credit risk premium, which compensates the lender for the risk that it might not be repaid./66/ Here, only the credit risk premium is being paid, because the foreign investor still has the full use of its money. It could be argued that the fact that only the credit risk portion is being paid should not prevent such portion from being analogized to interest for sourcing purposes. This argument suffers from at least two flaws. First, the payment in Bank of America that was analogized to interest was a payment actually made by the party whose credit risk was being taken (the foreign bank). By contrast, in Example 4, the taxpayer is making the up-front payment to induce the foreign investor to take on the credit risk of a third party, not the taxpayer's own credit risk. This factual disparity makes it more difficult to view the up-front payment as being analogous to the credit risk portion of an interest payment and correspondingly easier to view the up-front payment as analogous to an option premium. Second, the hypothetical argument set forth above contains an internal inconsistency. On one hand, one would have to contend that the up-front payment is U.S.-source because, like interest, it reflects the credit risk of a U.S. borrower. On the other hand, one would also have to argue (correctly) that the payment by the U.S. taxpayer is not actually interest (because it was not made in consideration of the use or forbearance of money), and so the portfolio interest exception to withholding does not apply. While it is not logically inconsistent to conclude that the up-front payment should be sourced like interest (and therefore is U.S.-source), but is not actually interest (so that the portfolio interest rules do not apply), is also not this conclusion particularly satisfying. In evaluating whether any relevant tax policy is furthered or offended by treating the contingent option in Example 4 as an option for withholding tax purposes, a court may consider whether the taxpayer could have avoided withholding tax by structuring its transaction in alternative ways. This inquiry seems especially appropriate here, given the Service's position in Rev. Rul that it is appropriate to take into account the purpose of the underlying code section in determining whether a particular financial instrument should be treated as an option. Here, it appears that there were other routes available to the taxpayer. For example, the taxpayer could have sold the reference obligation to the foreign investor in return for an installment note secured by the reference obligation. In that case, the taxpayer would not be making any payment to the foreign investor, but instead would be receiving foreign-source income from the foreign investor on the installment note. Obviously, no withholding tax would have been imposed on such payments. Nor would the reference debt issuer have been required to withhold tax from the interest payments made on the reference obligation, assuming the parties to the transaction satisfied the registration requirements of the portfolio interest rule./67/ As a second example, the taxpayer and the foreign investor could, at least as a theoretical matter, have avoided the up-front payment and instead provided for fixed periodic cash payments to be made to the foreign investor and for periodic cash payments to be made to the U.S. taxpayer that were equal to the change in the value of the reference debt obligation that were solely due to changes in credit spreads occurring since the last periodic payment date. If the parties had done this, the transaction would have been treated as a notional principal contract instead of an option./68/ In this case, the net premium payments would have been treated as foreign- source income,/69/ and thereby exempted from withholding tax. It is true that both of these alternative means of structuring the transaction could have raised significant nontax issues. If the taxpayer had used the first alternative of structuring the transaction, the taxpayer would have had to transfer the reference debt obligation to the foreign investor. This might have damaged the taxpayer's business

19 Page 19 relationship with the reference obligation issuer. If the taxpayer had used the second alterative of structuring the transaction, the value of the debt instrument would have to have been determined at every periodic payment date according to a complex formula. This might have resulted in a valuation dispute between the parties. The provision for physical settlement at the end of the term avoided this possibility. The taxpayer could contend, however, that while both of these alternative structures would have significantly affected the business deal, each would have permitted the avoidance of withholding tax. No policy goal would be served, the taxpayer might conclude, by forcing it to structure the transaction in a manner that is substantially less advantageous from a business perspective. Based on the foregoing, while the question would be a close one, a court would likely uphold option premium treatment for the up-front payment described in Example 4./70/ Conclusion While the Cited Cases appear to state a broad rule of law to the effect that contingent options are not options for tax purposes, a careful reading of the cases suggests that they should not be understood to stand for such a general rule. Indeed, the literal application of this rule would produce inappropriate results in a variety of contexts. Accordingly, notwithstanding the language of the Cited Cases, the determination of whether a contingent option is treated as an option to sell or to buy property should depend largely on the policy considerations relevant to the application of the code provision for the purpose of which the determination is being made. FOOTNOTES /1/ See North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932) (amount is includable in income where taxpayer receives amount under claim of right without restriction as to its disposition, even though, in a year following receipt, an obligation to return that amount may exist). /2/ Rev. Rul , C.B. 265, 267. /3/ Saviano v. Commissioner, 80 T.C. 955, 969 (1983), aff'd 765 F.2d 643 (7th Cir. 1985); see also Koch v. Commissioner, 67 T.C. 71, 82 (1976), acq C.B. 1; Drake v. Commissioner, 3 T.C. 33 (1944), aff'd 145 F.2d 365 (10th Cir. 1944). /4/ By using this term, I obviously do not intend to make any implication as to whether such instrument does in fact qualify as an option under the code. This nomenclature is simply a convenient way to refer to the instrument the status of which is at issue. /5/ See North American Oil Consolidated v. Burnet, note 1 supra. /6/ See Rev. Rul , note 2 supra. /7/ Section 901(k)(5). /8/ The holding period of stock is also reduced during any period in which a taxpayer has diminished its risk of loss by holding one or more positions with respect to substantially similar or related property. Section 246(c)(4)(C) and Treas. reg. section This rule may apply regardless of whether the "substantially similar or related property" also constitutes an option. However, a taxpayer will not be considered to have diminished its risk of loss on its stock by holding a position with respect to substantially similar or related property unless changes in the fair market value of the stock and the positions are reasonably expected to vary inversely. Example 3 assumes that many other factors could cause the price of the stock to rise or fall apart from changes in the price of steel. Accordingly, the question whether the foreign tax credit is allowable in Example 3 turns solely on whether the option described therein constitutes an "option" under section 246(c)(4)(A).

20 Page 20 /9/ Treas. reg. section (a). /10/ Treas. reg. section (b)(2)(i). /11/ Because this article focuses on the special case of contingent options, its analysis of the history and policy underlying the general deferral rule is necessarily somewhat truncated. For an interesting discussion of these issues, see Bruce Kayle, "Realization Without Taxation? The Not-So-Clear Reflection of Income From an Option to Acquire Property," 48 Tax L. Rev. 233 (Winter 1993). /12/ 99 F.2d 919 (4th Cir. 1938). /13/ Note 1 supra. /14/ For a fuller argument for including option premiums as ordinary income on receipt under certain circumstances, see Calvin H. Johnson, "Taxing the Income From Writing Options," Tax Notes, Oct. 14, 1996, p /15/ C.B /16/ 67 T.C. 71 (1976). /17/ In the case of a physically settled call option, once the writer has received the option premium, he cannot be compelled to return the cash to the holder, although he may of course be required to deliver the underlying property. By contrast, in the case of a put option or a cash-settled call option, the writer may be required to pay to the holder an amount of cash that exceeds the option premium, thereby eliminating the income received on the writing of the option. Thus, it is much easier to argue that the writer of a put option or a cash-settled call option should be viewed as having a contingent liability than the writer of a physically settled call option. /18/ Rev. Rul distinguished North American Consolidated Oil by noting that that case involved the receipt of "earnings." /19/ But see Estate of Gordon v. Commissioner, 17 T.C. 427 (1951), aff'd per curiam 201 F.2d 171 (6th Cir. 1952) (when taxpayer leased property for 25 years with option to purchase, premium includable in income on receipt under claim of right doctrine). Estate of Gordon predates Rev. Rul and Koch. /20/ Such a rule, however, would not have affected the character of income or loss realized if the option lapsed or was the subject of a closing transaction. Before the Tax Reform Act of 1976, gain or loss from the lapse of an option or from a closing transaction was generally treated as ordinary income or loss. See H. Rep. No (Conf.), 94th Cong., 2nd Sess. 544 (1976), reprinted in (Vol. 3) C.B. 807, 948. /21/ From 1954 to 1978, for example, section 1202 provided a deduction equal to 50 percent of the taxpayer's net capital gain. /22/ This may have been due to the lower level of economic sophistication that was prevalent before the 1970s, to the fact that interest rates were relatively low and stable (thus reducing the cost of deferral to the government and the benefits of deferral to the taxpayer), or to both factors in combination. /23/ See 1220 Realty v. Commissioner, 21 T.C.M. (CCH) 360 (1962), aff'd in part and rev'd in part 322 F.2d 495 (6th Cir. 1963) (when accrued interest on debt instrument need not be paid if principal paid off by the end of the fifth year after interest, issuer would not be permitted to deduct accrued but unpaid interest); Utility Trailer Mfg. v. United States, 212 F. Supp. 773 (S.D. Cal. 1962) (accrued interest reflecting adjustment for inflation could not be deducted under all events test). /24/ 283 U.S. 404 (1931) (when taxpayer transferred property in exchange for contract, and market value of