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Should the Reduction in a Listed Option Premium for an Estimated Dividend be Treated as a Dividend Equivalent Payment under 871(m)?
March 10, 2014
The 2013 871(m) proposed regulations have left many in the hedge fund, trading and securities industries up in arms. I recently pointed out here that the regulations as drafted would subject some single stock futures to withholding.  I did not focus on listed options, but I recently read a great comment by the U.S. Securities Markets Coalition which basically highlights the same problem for options.  In this blog entry, I’d like to lay out my 2c on this issue. What is the problem? The problem is that the formula for calculating the premium on listed options includes an estimate for future dividends.  This is similar to the SSF formula.  So, generally when a dividend paying stock company declares a dividend, the price of the stock goes down. Call options pricing formulas reflect this fact by reducing the premium for the option by the amount of the estimated dividend due to the fact that the owner of the call option would not be entitled to the dividend if it exercises the option.  The math is based on a variation of the Black-Scholes model and is, frankly, beyond me but the core principle makes sense.  If I do not get to keep the dividend on the long underlying asset, I should pay less for the derivative based on that asset.

The way the regulations are written would require withholding on foreign long call holders of US dividend paying stocks that have a delta of over .7 at time of purchase.  That, according to the US Securities Markets Coalition, is a lot of calls.  Withholding will be required even if there is no actual payment associated with the estimated dividend as long as the withholding agent has custody over the taxpayer’s funds.  I am not going to repeat or belabor the points raised in the Coalition comment but I would like to posit that a reduction in a call option premium, arguably, ought to neither be treated as a payment nor income.  The logic of the proponents that this reduction in premium should be taxable as a dividend and subject to withholding appears to be that by virtue of the reduced price, the call writer is actually getting the benefit of the dividend, which in turn should be taxed and subject to withholding.  In other words, if a call would have cost me $2.5, or $250 for 1 contract of a 100 share lot, and the expected dividend is $.5, then I have a payment and dividend income of $50 for this contract because my call purchase premium was at a discount. Is this the same as if I was to receive $50 in dividend? To me at least, it is not.

If I recall correctly the fundamentals of federal income taxation that I studied many years ago, a core tenet and a prerequisite to the recognition of “income” is accession to wealth. In other words, “income” is something that increases the taxpayer’s wealth.  If I have $10,000 in my bank account and the bank pays me $50 of interest, my wealth went up to $10,050. Save for some other rule that prevents recognition of income, I have $50 of interest income.  In this situation I am in a better economic position as compared to my position before I got the $50. Moreover, the economic increase in my overall wealth is readily ascertainable, it is $50. This concept is based on old Supreme Court cases such as Comr. v. Glenshaw Glass Co., 348 U.S. 426 (1955). The IRS has adhered to this theory as recently as year 2013 (e.g. CCA 201307005). Let’s continue this example in the option context and dividend equivalents.  Say, that I had in my account $10,000.  With this $10,000 I can buy a dividend paying stock XYZ or buy a call option on the same stock.  Say the expected dividend on XYZ is $50 and the actual dividend is $50.  If I just buy the stock, I’ll have in my account stock XYZ plus $50 of cash when the dividend is paid out.  If one were to look at the dividend payment as the transaction at issue, it is clear that I have accession of wealth of $50. Before the dividend transaction all I had was the XYZ shares, which I acquired for $10,000. After the transaction, I have the XYZ shares plus the $50 cash.  It is easy to reason that my wealth went up by $50 and that I should be subject to tax and withholding on $50. Not only did my wealth go up, but clearly I received a payment from a third party.

Now, instead of doing this, I decide that I’ll by an option on XYZ with a strike price of 100. Since this is a 100 share lot, I have to pay $10,000 to acquire the XYZ shares at expiration if I want to own the shares.  The option premium on this dividend paying stock generally would be $2.50 or $250 for the lot.  However, because I don’t get to receive the $50 dividend if I acquire the shares at expiration, my premium is instead $200. What happens at expiration if the option is in the money? If I settle physically, my $200 premium goes to the seller of the call, I pay $10,000 and I acquire XYZ without the dividend. In other words, I was out of pocket $10,200 and I have XYZ shares.  I made two payments to one or two counterparties (depending on whether the call was covered or not). No counterparty made a payment to me.  Moreover, in this particular transaction, the option pricing determines only one thing, it determines by how much my existing wealth is going to go down, not by how much my existing wealth goes up.  In exchange for having the opportunity to own XYZ for $10,000 my wealth either goes down by $200 or $250. Nowhere in this transaction do I have the benefit of having the XYZ shares and my bank account going up by $50. All I basically get in this transaction is the benefit of my bank account going down by $200 instead of by $250.  The reasoning here is not that much different from the reasoning of why a relief of a guarantee is not taxable. The Tax Court has long held that a relief of a guarantee does not increase the guarantor’s net worth; it merely prevents it, pro tanto, from being decreased (Landreth v. Comr., 50 T.C. 803 (1968)). The same goes for generally a bargain purchase not being taxable to the bargain buyer.  This is not income, and not being income, I don’t see a reason why it should be subject to withholding as a dividend equivalent payment.  It is not a payment either since nowhere in this transaction did I receive anything from anybody other than the XYZ shares, which I will own by the way at their ex-dividend FMV.

Maybe I am missing something here but it seems to me that Treasury is trying to collect revenue from foreigners from whom no revenue should be due. If the above transaction would have been in the domestic context, the stakes are not that high. The $50 of discount on the option premium would be picked up as capital gains when the stock is sold (i.e. the basis will be $50 less, or $10,200 as compared to the tax basis if the taxpayer paid the full premium of $250). For foreign investors, however, the opportunity to capture this reduction as income does not exist because nonresidents are generally not subject to U.S. tax on the disposition of stock.  So, to me at least, it seems that Treasury is trying to shoehorn millions of routine option transactions carried out by foreigners who have no clue about Black-Scholes or whether estimated dividends are included or excluded into their premium computation into the grasp of the long arm of U.S. withholding.  I can’t speak for the option market as a whole, but in my humble experience many foreign option traders have no clue about U.S. dividend withholding rules either, much less plan to avoid them by using options.  Most use options either as insurance, directional speculative play or delta neutral spread play.  Treating foreign option traders as dividend withholding evaders makes little sense to me.
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Tags: options and dividend equivalents, Section 871(m), Section 871(m) proposed regulations