REVENUE RULE 94-63

1994-2 C.B. 188, 1994-41 I.R.B. 5.

Internal Revenue Service
Revenue Ruling

SECTION 1256 CONTRACTS MARKED TO MARKET; NONEQUITY OPTIONS; WARRANTS

September 27, 1994

Section 1256. - Section 1256 Contracts Marked to Market

(See Also § 1234)

Section 1256 contracts marked to market; nonequity options; warrants. Cash- settled options that are based on a stock index and traded on (or subject to the rules of) a qualified board or exchange are nonequity options for purposes of section 1256 of the Code if the Securities and Exchange Commission determines that the stock index is "broad-based." For purposes of section 1256, warrants that are based on a stock index and that are economically, substantially identical in all material respect to options based on a stock index are treated as options based on a stock index.

ISSUES

(1) If the Securities and Exchange Commission (SEC) permits options based on a stock index to be traded on a national securities exchange but the Commodity Futures Trading Commission (CFTC) has not designated a contract market for a futures contract based on the stock index, then under what circumstances are the options treated as "section 1256 contracts" within the meaning of s 1256(b) 0of the Internal Revenue Code?

(2) For purposes of s 1256, are warrants based on a stock index treated as options based on a stock index?

FACTS

Situation 1. Exchange X is a national securities exchange registered with the SEC. Among the financial products listed on exchange X are options based on the ABC index, a stock index that represents companies from a diverse range of industry groups. Z corporation functions as a clearing agency for transactions on exchange X in ABC-index options.

The ABC-index options are structured as either "call" options or "put" options and have terms ranging from three weeks to five years. They can be exercised only on expiration (that is, they are European-style options), and they can be settled only in cash. The holder of a call option has a right to receive cash,based on the extent to which the ABC index on the exercise date is above a pre-stated value. The writer of a call option has an obligation to pay cash determined in the same way. A put option resembles a call option except that a holder's right to receive cash and a writer's obligation to pay cash are based on the extent to which the ABC index on the exercise date is below a pre- stated value.

Both a holder and a writer are needed to create an ABC-index option on exchange X, but once Z corporation accepts their transaction, the relationship between the holder and the writer terminates. Thereafter, under Z corporation's rules, the rights of the holder and the obligations of the writer run solely to Z corporation. In effect, Z corporation becomes the writer to every holder and the holder to every writer. The number of ABC-index options outstanding fluctuates, and the total that can be created is limited only by the number registered by Z corporation with the SEC.

Listing the ABC-index options required changing the rules of exchange X, and the proposed changes were filed with the SEC. An SEC order approving the changes, published in the Federal Register, expressly stated that the ABC index was "broad-based." Following publication, the ABC-index options began trading. At that time, the CFTC had not designated a market for a futures contract based on the ABC index.

Situation 2. Exchange Y is a national securities exchange registered with the SEC. Among the financial products listed on exchange Y are warrants based on the ABC index.

The ABC-index warrants resemble the ABC-index options described in Situation 1 in that the warrants are based on the ABC index, are European-style, are structured as "calls" or "puts," and are settled only in cash. The holder of a call warrant has a right to receive cash based on the extent to which the ABC index on the exercise date is above a pre-stated value. The writer of a call warrant has an obligation to pay cash determined in the same way. A put warrant resembles a call warrant except that a holder's right to receive cash and a writer's obligation to pay cash are based on the extent to which the ABC index on the exercise date is below a pre-stated value.

The ABC-index warrants differ from the ABC-index options in that all of the warrants have five-year terms and there are a fixed number of warrants outstanding. Moreover, all of the warrants were written by W corporation, which sold them in a manner that resembled an initial public offering. As the writer of the ABC-index warrants, W corporation is required by market rules to have substantial assets and earnings. Unlike the holder of an ABC-index option, the holder of an ABC-index warrant has a continuing relationship with the writer. Thus, upon exercising a warrant, the holder looks directly to W corporation for payment.

LAW AND ANALYSIS

Situation 1.

Section 1256 prescribes special rules for reporting gains and losses from "section 1256 contracts."

The financial products that qualify as "section 1256 contracts" are specified in s 1256(b). Among these are nonequity options.

Section 1256(g)(3) defines a "nonequity option" as any listed option that is not an equity option.

Under s 1256(g)(5), a "listed option" is any option (other than a right to acquire stock from the issuer) that is traded on (or subject to the rules of) a qualified board or exchange. Under s 1256(g)(7), the term "qualified board or exchange" includes a national securities exchange registered with the SEC.

An "equity option" is defined in s 1256(g)(6)(A) as (i) any option to buy or sell stock, or (ii) any option the value of which is determined directly or indirectly by reference to any stock (or group of stocks) or stock index. This definition, however, is subject to two exceptions. Under s 1256(g)(6)(B), an option with respect to a group of stocks or a stock index is not an "equity option" if (i) there is in effect a designation by the CFTC of a contract market for a futures contract based on that group of stocks or stock index, or (ii) the Commissioner determines that the option meets the requirements of law for contract market designation.

The statutory definition of the term "equity option" is meant to exclude options on "broad-based" stock indices (such as the Standard & Poor's 500 index). Instead, these options are meant to qualify as "nonequity options." H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 902 (1984), 1984-3 (Vol. 2) C.B. 156.

National securities exchanges are "self-regulatory organizations" as defined in s 3(a)(26) of the Securities Exchange Act of 1934 (the Exchange Act), 15 U.S.C. s 78c(a)(26) (1988). Under 9 19(b) of the Exchange Act, 15 U.S.C. s 78s(b) (1988), self-regulatory organizations must have SEC approval before adding, changing, or deleting any of their rules.

Listing a new stock index product on a national securities exchange requires changing the rules of the exchange. The proposed rule changes, therefore, must be filed with the SEC. The SEC reviews the proposed rule changes to determine whether they are consistent with the Exchange Act and, in particular, with s 6(b)(5) of the Exchange Act, 15 U.S.C. s 78f(b)(5) (1988). That section requires an exchange, among other things, to design its rules in a manner that prevents fraudulent and manipulative acts and practices. Under its general authority to approve the proposed rule changes, the SEC determines whether the underlying stock index is "broad-based." This determination is necessary because the regulatory treatment of products based on a "broad-based" index is different from that of products based on a "narrow-based" index. Specifically, if the SEC classifies an index as "broad-based," then an exchange that lists a derivative product based on the index is permitted to apply more favorable exchange rules regarding margin requirements and position and exercise limits.

Under s 2(a)(1)(B)(ii) of the Commodity Exchange Act (CEA), 7 U.S.C. s 2a(ii) (1988), the CFTC can designate a market for a futures contract based on a stock index if, among other regulatory conditions, the futures contract meets the following minimum requirements:

(1) The contract must provide for cash settlement;

(2) The contract must not be readily susceptible to manipulation or to being used to manipulate any underlying security; and

(3) The index must be predominantly composed of the securities of unaffiliated issuers and must reflect the market for all publicly traded securities or a substantial segment of the market.

These three requirements are meant to narrow the authority of the CFTC to designate a market for a futures contract based on a stock index. In particular, the CFTC is not to approve trading in this type of futures contract unless the underlying stock index is "broad-based." See H.R. Rep. No. 565, Part I, 97th. Cong., 2d Sess. 38 (1980).

Whenever a commodity exchange seeks to become a market for a futures contract based on a stock index, the CFTC must forward to the SEC a copy of the exchange's application. Section 2(a)(1)(B)(iv)(II) of the CEA, 7 U.S.C.A. s 2a(iv)(II)

If the SEC determines that the contract fails to satisfy the three requirements of s 2(a)(1)(B)(ii), 7 U.S.C. s 2a(ii) (1988), then the CFTC cannot designate the commodity exchange as a market for the contract. Consequently, the SEC examines stock indices not only for the purpose of approving options and warrants on those indices but also for the purpose of determining whether futures contracts on those indices satisfy the three requirements of s 2(a)(1)(B)(ii), 7 U.S.C. s 2a(ii) (1988).

The SEC uses the same analysis in determining both (1) whether a stock index underlying an option or warrant is "broad-based," and (2) whether a stock index underlying a futures contract is predominantly composed of the securities of unaffiliated issuers and reflects the market for all publicly traded securities or a substantial segment thereof. Thus, an SEC determination that a stock index is "broad-based" is equivalent to a determination that the index meets the third requirement of s 2(a)(1)(B)(ii) of the CEA, 7 U.S.C. s 2a(ii) (1988).

The ABC-index options are "listed options" under s 1256(g)(5) because the ABC-index options are traded on exchange X, a "qualified board or exchange" under s 1256(g)(7). Exchange X is a "qualified board or exchange,' because exchange X is a national securities exchange registered with the SEC.

The value of the ABC-index options is determined by reference to a stock index. The ABC-index options are, therefore, "equity options" under s 1256(g)(6)(A) unless (1) the CFTC has designated a contract market for a futures contract based on the ABC index, or (2) the Commissioner determines that the ABC-index options meet the requirements of law for contract market designation. Section 1256(g)(6)(B).

The CFTC has not designated a contract market for a futures contract based on the ABC index. Nevertheless, the Commissioner has an adequate basis to determine that the ABC-index options meet the three minimum requirements of s 2(a)(1)(B)(ii) of the CEA, 7 U.S.C. s 2a(ii) (1988). First, the ABC-index options provide for cash settlement. Second, the SEC has approved the rule changes needed to list the ABC-index options on exchange X, a national securities exchange. Under the Exchange Act, 15 U.S.C.A. §§ 78a-78ll, a national securities exchange must design its rules in a manner that prevents fraudulent and manipulative acts and practices. The SEC approval of the rule changes, therefore, is evidence that the ABC-index options are not readily susceptible to manipulation or to being used to manipulate any underlying security. Third, the SEC has determined that the ABC index is "broad-based." For reasons previously stated, this determination by the SEC is equivalent to a determination that the ABC index is predominantly composed of the securities of unaffiliated issuers and that the ABC index reflects the market for all publicly traded securities or a substantial segment thereof.

Under these circumstances, the Commissioner has sufficient grounds to determine that the ABC-index options meet the requirements of law for contract market designation under s 1256(g)(6)(B). If the Commissioner makes a determination, then the ABC-index options are not "equity options" under s 1256(g)(6)(A). Instead, they are "nonequity options" and, therefore, "section 1256 contracts." Moreover, the Commissioner would have sufficient grounds to make a determination even if the ABC-index options were American-style options (that is, if the options could be exercised at any time before expiration). Nothing in s 1256 requires a stock-index contract to be exercisable on a particular date.

Situation 2.

For purposes of s 1256, whether stock-index warrants are treated as stock- index options depends on the warrants' economic features. See Rev. Rul. 88- 31, 1988-1 C.B. 302. The warrants based on the ABC index that are traded on exchange Y are structured as "calls" and "puts." The holder of a call warrant has a right to receive cash based on the extent to which the ABC index on the exercise date is above a pre-stated value. The holder of a put warrant has a right to receive cash based on the extent to which the ABC index on the exercise date is below a pre-stated value. The writer of the warrants, W corporation, is obligated to make these cash payments. Because, economically, the warrants are substantially identical in all material respects to options based on a stock index, the warrants are treated as options based on a stock index for purposes of s 1256. Moreover, this conclusion would be the same even if the warrants were American-style warrants.

HOLDINGS

(1) For purposes of s 1256, the Commissioner hereby determines that:

Options that are based on a stock index and that are traded on (or subject to the rules of) a qualified board or exchange meet the requirements of law for contract market designation if (a) the options provide for cash- settlement, and (b) the SEC has determined that the stock index is a "broad- based" index. Therefore, these options are "section 1256 contracts."

(2) For purposes of s 1256, warrants that are based on a stock index and that are, economically, substantially identical in all material respects to options based on a stock index are treated as options based on a stock index.

PROSPECTIVE APPLICATION

Under s 7805(b), Holding (1) will not be applied to positions in warrants or options established on or before November 10, 1994, or before the SEC determines that the underlying index is "broad-based."

DRAFTING INFORMATION

The principal author of this revenue ruling is Marshall D. Feiring of the office of Assistant Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Feiring at (202) 622-3960 (not a toll-free call).

Rev. Rul. 94-63, 1994-2 C.B. 188, 1994-41 I.R.B. 5.