Equity Options With Flexible Terms;
Special Rules & Definitions

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8866] RIN 1545-AV48

TITLE: Equity Options With Flexible Terms; Special Rules and
Definitions

AGENCY: Internal Revenue Service (IRS), Treasury

ACTION: Final regulations.

SUMMARY: This document contains final regulations providing guidance
on the application of the rules governing qualified covered calls.
The new rules address concerns that were created by the introduction
of new financial instruments after the enactment of the qualified
covered call rules. The final regulations will provide guidance to
taxpayers writing qualified covered calls.

EFFECTIVE DATE: These regulations are effective January 25, 2000.

FOR FURTHER INFORMATION CONTACT: Pamela Lew of the Office of
Assistant Chief Counsel (Financial Institutions and Products), (202)
622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

On June 25, 1998, the IRS published in the Federal Register proposed
regulations (REG-104641-97, 63 FR 34616) addressing whether strike
prices available for equity options with flexible terms affect the
definition of a qualified covered call (QCC) under section 1092(c)
(4) for equity options with standardized terms. No requests to speak
at a public hearing were received, and no public hearing was held.

Two written comments were received. These comments focused on
whether equity options with flexible terms should be eligible for
QCC treatment. After considering these comments, the IRS and
Treasury have decided to address the eligibility of equity options
with flexible terms and certain other equity options for QCC
treatment in other forthcoming guidance. One of the comments also
suggested a clarifying change to the text of the proposed
regulations. After revising the regulation to take into account this
comment, the proposed regulations are adopted by this Treasury
decision.

Explanation of Provisions

Section 1092(c) defines a straddle as offsetting positions with
respect to personal property. Under section 1092(d)(3), stock is
personal property if the stock is part of a straddle that involves
an option on that stock or substantially identical stock or
securities. Under section 1092(c)(4), however, writing a QCC option
and owning the optioned stock is not treated as a straddle for
purposes of section 1092.

In order to be a QCC, a call option must, among other things, be
exchange-traded and not be deep in the money. An option is deep in
the money if the strike price of the option is lower than the lowest
qualified bench mark for the stock. This bench mark is generally the
highest available strike price for an option on the stock that is
less than the applicable stock price.

At the time the QCC provisions were enacted, exchange-traded options
were available only at standardized maturity dates and strike price
intervals. This fixed-interval system was a basic assumption of the
Congressional plan for QCCs and, more specifically, was the
foundation for the definition of a deep-in-the- money option.

Certain options exchanges have begun to trade equity options with
flexible terms. Unlike standardized exchange-traded options, these
options could have strike prices at other than fixed intervals. For
this reason, there is concern that the strike prices established for
equity options with flexible terms could impact the bench-mark
system for standardized exchange-traded options.

The proposed regulations provide that strike prices established by
equity options with flexible terms are not taken into account in
determining whether options that are not equity options with
flexible terms are deep in the money. Thus, the existence of strike
prices established by equity options with flexible terms does not
affect the lowest qualified bench mark, as determined under section
1092(c)(4)(D), for an equity option with standardized terms.

One commentator was concerned that usage of the phrase A existence
of strike prices established by equity options without standardized
terms @ might be interpreted as requiring actual trading at a
particular strike price. The commentator suggested that the
regulation be modified to discuss the availability of a strike price
for equity options with flexible terms rather than the existence of
a strike price established by equity options with flexible terms.
This suggestion has been incorporated into the final regulation.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations and,
because the regulations do not impose a collection of information on
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6)
does not apply. Pursuant to section 7805(f) of the Internal Revenue
Code, the notice of proposed rulemaking was submitted to the Chief
Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.

Drafting Information

The principal author of these regulations is Pamela Lew, Office of
Assistant Chief Counsel (Financial Institutions and Products).
However, other personnel from the IRS and Treasury Department
participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of
Amendments to the Regulations Accordingly, 26 CFR part 1 is amended
as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows: Authority: 26 U.S.C.
7805 * * *

Section 1.1092(c)-1 also issued under 26 U.S.C. 1092(c)(4)(H). * * *

Par. 2. Section 1.1092(c)-1 is added to read as follows:
�1.1092(c)-1 Equity options with flexible terms. (a) In general.
Section 1092(c)(4) provides an exception to the general rule that a
straddle exists if a taxpayer holds stock and writes a call option
on that stock. Under section 1092(c)(4), the ownership of stock and
the issuance of a call option meeting certain requirements result in
a qualified covered call, which is exempted from the general
straddle rules of section 1092. This section addresses the
consequences of the availability of equity options with flexible
terms under the qualified covered call rules.

(b) No effect on lowest qualified bench mark for standardized
options. The availability of strike prices for equity options with
flexible terms does not affect the determination of the lowest
qualified bench mark, as defined in section 1092(c)(4)(D), for an
option that is not an equity option with flexible terms. (c)
[Reserved]. (d) Definitions. For purposes of this section B

(1) Equity option with flexible terms means an equity option--

(i) That is described in any of the following Securities Exchange
Act Releases--

(A) Self-Regulatory Organizations; Order Approving Proposed Rule
Changes and Notice of Filing and Order Granting Accelerated Approval
of Amendments by the Chicago Board Options Exchange, Inc. and the
Pacific Stock Exchange, Inc., Relating to the Listing of Flexible
Equity Options on Specified Equity Securities, Securities Exchange
Act Release No. 34-36841 (Feb. 21, 1996); or

(B) Self-Regulatory Organizations; Order Approving Proposed Rule
Changes and Notice of Filing and Order Granting Accelerated Approval
of Amendment Nos. 2 and 3 to the Proposed Rule Change by the
American Stock Exchange, Inc., Relating to the Listing of Flexible
Equity Options on Specified Equity Securities, Securities Exchange
Act Release No. 34-37336 (June 27, 1996); or

(C) Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Notice of Filing and Order Granting Accelerated Approval
of Amendment Nos. 2, 4 and 5 to the Proposed Rule Change by the
Philadelphia Stock Exchange, Inc., Relating to the Listing of
Flexible Exchange Traded Equity and Index Options, Securities
Exchange Act Release No. 34-39549 (Jan. 23, 1998); or

(D) Any changes to the SEC releases described in paragraphs (d)(1)
(i)(A) through (C) of this section that are approved by the
Securities and Exchange Commission; or

(ii) That is traded on any national securities exchange which is
registered with the Securities and Exchange Commission (other than
those described in the SEC Releases set forth in paragraph (d)(1)(i)
of this section) or other market which the Secretary determines has
rules adequate to carry out the purposes of section 1092 and is--

(A) Substantially identical to the equity options described in
paragraph (d)(1)(i) of this section; and

(B) Approved by the Securities and Exchange Commission in a
Securities Exchange Act Release.

(2) Securities Exchange Act Release means a release issued by the
Securities and Exchange Commission. To determine identifying
information for releases referenced in paragraph

(d)(1) of this section, including release titles, identification
numbers, and issue dates, contact the Office of the Secretary,
Securities and Exchange Commission, 450 5th Street, NW., Washington,
DC 20549. To obtain a copy of a Securities Exchange Act Release,
submit a written request, including the specific release
identification number, title, and issue date, to Securities and
Exchange Commission, Attention Public Reference, 450 5th Street,
NW., Washington, DC 20549.

(e) Effective date. These regulations apply to equity options with
flexible terms entered into on or after January 25, 2000.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: 1/17/2000
Jonathan Talisman
Acting Assistant Secretary of the Treasury

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