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The Tax Angle On Single-Stock Futures & Narrow-Based Index Futures

25 Mar 2001

The Commodity Futures Modernization Act of 2000 authorizes trading, on a delayed basis, stock futures, meaning single-stock and narrow-based stock index futures, and options on such futures. As a result, the tax laws were also amended to make sure that stock futures would not get a tax advantage over equity products currently traded in both the over-the-counter and exchange-traded markets. With the CFMA changes to the tax laws, the tax treatment of stock futures is made similar to the current tax treatment of OTC and exchange-traded options on single stocks and narrow-based stock indices.


Narrow-Based Stock Indices

Under prior law, it was left to the Securities and Exchange Commission to determine whether a stock index met the statutory standards of what was referred to loosely as a broad-based or narrow-based index. Now, a narrow-based stock index is statutorily defined to assure SEC jurisdiction over an index that could be used as a surrogate for trading any of the individual stocks making up the index. In general, a narrow-based stock index is defined as an index comprised of nine or fewer stocks or, pursuant to a statutory calculation, an index where one or more of the stocks predominate the index. Under the CFMA, an index is narrow-based if any component stock comprises more than 30% of the index's weighting. Second, an index is narrow-based if the five highest weighted component stocks (in the aggregate) comprise more than 60% of the index's weighting. Or third, an index is narrow-based if the lowest weighted component stocks comprising (in the aggregate) 25% of the index's weighting have an aggregate dollar volume of average daily trading value of less than a designated amount (which varies based on the number of stocks in the index). Narrow-based indices are subject to joint regulation by the Commodity Futures Trading Commission and the SEC.


Section 1256 Contracts

Prior to legalizing stock futures, all futures contracts and options on futures traded on domestic commodity exchanges were taxed as so-called section 1256 contracts, subject to two special tax rules: the 60/40 Rule and the Mark-to-Market Rule. Under the 60/40 Rule, gains and losses from section 1256 contracts that are capital assets are netted for the year. Net gain or loss for the year is treated as 60% long-term and 40% short-term capital gain or loss. The time periods in which the taxpayer holds the contracts is irrelevant. This means that an investor who holds a section 1256 contract for less than one year is eligible for the 20% long-term capital gains rate on 60% of any resulting gain (which results in a maximum tax rate of 27.84% for non-corporate taxpayers).

The Mark-to-Market Rule applies to all section 1256 contracts, so that gains and losses on such contracts, open on the last day of the tax year, are treated as if sold on that day.

A section 1256 contract is defined as a regulated futures contract, foreign currency contract, nonequity option, or dealer equity option. An RFC is a contract traded on (or subject to) the rules of a qualified board or exchange, essentially, a U.S. domestic exchange, where the amount required to be deposited and the amount that may be withdrawn depends on a system of marking to market. A Standard & Poor's 500 futures contract is an example of an RFC.

A nonequity option is defined in a circular way as any exchange-traded option that is not an equity option. For these purposes, an equity option is an option on a single stock or a narrow-based stock index. Nonequity options basically include all forms of listed options traded on domestic exchanges, except for options on individual stocks or narrow-based stock indices. An option on the S&P 500 futures contract is an example of a nonequity option.

A dealer equity option is defined as an exchange-traded equity option held by an options dealer (who is registered with a securities exchange as a "market maker" or "specialist in listed options") if the option is traded on (or subject to) the rules of a qualified board or exchange. A further requirement is that the dealer equity option's value must be determined by reference to an individual stock, a group of stocks, or a stock index.


Treatment of Stock Options

Taxation under the 60/40 Rule is dramatically different from the tax treatment of single stock and narrow-based stock index options (both exchange-traded and OTC) held by investors. Code section 1234 provides that an investor receives short-term capital gain or loss on long positions (which grants the investor the option to purchase the underlying stock) held for less than one year and long-term capital gain or loss for options held for more than one year. An investor gets short-term capital gain or loss on a short position, without regard to how long the investor holds the position.


Treatment of Stock Futures

Before CFMA, all domestically traded futures contracts were RFCs treated as section 1256 contracts eligible for the 60/40 and Mark-to-Market Rules. All domestically traded options on futures contracts were non-equity options, which were also treated as section 1256 contracts. Single stock and narrow-based stock index options held by investors were not section 1256 contracts. Treating stock futures as section 1256 contracts, however, would have resulted in major tax differences between stock futures and options on individual stocks and narrow-based equity index options. Without amending the tax laws, an investor holding a stock future for less than one year would, in theory, have a tax advantage (due to the 60/40 Rule) over another investor holding an option (whether exchange-traded or OTC) on that same stock or on a narrow-based stock index option.

To ensure tax parity between stock futures and equity options, the tax laws were amended to provide similar tax treatment for these products. In the new act, section 1234B now provides that (except in the case of a "dealer" in stock futures) stock futures are taxed similar to equity options instead of similar to all other futures contracts. As such, stock futures are not section 1256 contracts and are not subject to the Mark-to-Market or 60/40 Rules. Stock futures are treated as "securities" for purposes of the tax mark-to-market accounting rules for securities dealers (in code section 475). As a result, for example, traders in stock futures could elect to have code section 475 apply to their trader activities.

Under new code section 1234B(a)(1), gains and losses from stock futures have the same character in the hands of the taxpayer as the property to which the stock futures contract relates. For investors, this means that gain or loss on stock futures is capital because stock is a capital asset for investors. For a long stock futures position (which obligates the holder to purchase the underlying property), any gain or loss is long-term or short-term, depending on the period in which the investor held the contract. For a short stock futures position, gain or loss is short-term, without regard to how long the investor holds the contract (unless the U.S. Department of Treasury issues regulations that provide otherwise).


Treatment of Certain Dealers

Because certain dealers currently get section 1256 treatment on their dealer equity options, the tax laws were also amended to provide comparable tax treatment for "dealers" in stock futures. The Treasury has been given until this coming July 1 to issue rules as to who qualifies as a dealer in stock futures. Because taxpayers that might otherwise qualify as stock futures dealers may not have the same legal obligations (to provide market liquidity) as dealers in equity options, Congress instructed the Treasury that the absence of a legal obligation to provide market-making functions cannot be the sole basis for precluding dealer status for stock futures if the relevant factors, including providing liquidity, indicate that the market functions of the trader are comparable to that of an equity options dealer.

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This week's Learning Curve is byAndrea KramerandWilliam Pomierski, partners atMcDermott, Will & Emery, in Chicago.

25 Mar 2001