Options Industry Blasts IRS Proposal

Proposed U.S. tax rules that target offshore hedge funds have come under fire by the options industry.

The U.S. Securities Market Coalition, a lobbying organization that represents the options exchanges and the Options Clearing Corporation, the Chicago Board Options Exchange, and the Securities Industry and Financial Markets Association, have all advised the U.S. Treasury to back away from imposing a dividend withholding tax on foreign options traders.

“If adopted as proposed,” Joe Corcoran, the OCC’s head of government relations, said at this year’s Options Industry Conference, “we believe the regulations could have a negative impact on the listed options market by curtailing their use by foreign persons.”

At issue is proposed Section 871(m) of the U.S. Tax Code which seeks to combat tax evasion by foreign investors in U.S. securities. The roots of the proposal go back to 2008 when the U.S. Senate published a report that claimed offshore holders of U.S. stocks were using equity swaps to mimic the benefits of stock ownership, but avoid taxes on dividends.

The new rule is part of the government’s sweeping Foreign Account Tax Compliance Act, or FATCA, which was enacted in 2010 as part of the Hiring Incentives to Restore Employment Act. FATCA primarily targets tax evasion by U.S. persons holding investments in offshore accounts.

While FATCA is mostly intended to require U.S. citizens and foreign banks to report assets held in foreign accounts, the aim of the Internal Revenue Service’s proposed Section 871(m) is to require U.S. brokers to withhold taxes on any portion of payments made to customers under certain stock derivative trades that are deemed the equivalents of dividends on the underlying stocks.

The fear is that brokers are collaborating with their foreign customers to evade U.S. withholding taxes on dividends. Under a typical arrangement, an offshore hedge fund with a stock position would temporarily sell the stock just after a dividend was announced; enter into an equity swap; and then, after the ex-dividend date, exit the swap position, and buy back the stock. The scheme supposedly allows the hedge fund to maintain economic exposure to the stock, capture the value of the dividend, yet avoid the 30 percent tax on the dividend.

Although proposed Section 871(m) primarily targets equity swaps and stock loan transactions, Treasury has extended it to options, forwards, and futures. That has alarmed the options industry. According to estimates by CBOE, foreign investors account for between 15 percent and 20 percent of the volume traded in U.S. listed options contracts. A study done last year by Tabb Group estimated that European investors accounted for 10 percent of listed volume.

The options industry argues the rule shouldn’t be applied to listed options contracts for two main reasons. First, unlike swaps, typical options trades do not confer the risks and rewards of stock ownership on the trader. A buyer of a call with a strike price that is out of the money—or higher than the price of the stock—by, say 10 percent, for instance, “does not participate in any upside in the stock until it has increased by 10 percent,” the Coalition told the IRS. At the same time, the holder’s downside is limited to the premium, the Coalition noted.

SIFMA echoed the Coalition in its letter to the IRS. Options are “in no sense economically equivalent to the actual ownership of equities,” SIFMA told the IRS.

Second, in the case of a listed, if not an over-the-counter, option, the broker is unable to determine the value of the dividend embedded in the premium. The pricing of listed options contracts involves multiple participants forecasting a variety of factors, including expected dividends, and the possibility that a buyer will exercise the option before the ex-dividend date, or the date upon which the stock starts trading without the dividend. “The broker,” the Coalition told the IRS, “has no way of determining the extent to which the dividend was priced into the premium.”

Concern by the options industry is great. If adopted, the rule would go into effect on January 1, 2013. CBOE told the IRS the rule would “preclude non-U.S. persons from engaging in many routine options transactions.” The Coalition told the IRS the proposed regulations “would have a disruptive effect on the options market.”

Indeed, foreign investors do have alternatives to U.S. options contracts. In Europe, for instance, warrants on U.S. stocks are an established and popular market.

“You can’t discount the market for European warrants on U.S. securities,” said Kevin Murphy, a managing director at Citigroup, in charge of electronic trading of options, at a conference earlier this year sponsored by the New York chapter of the Security Traders Association. “They are priced very similarly to U.S. options. It’s a competing product. They are very comfortable trading warrants on U.S. underlyings.”