Naked and covered in Monte Carlo: a reappraisal of option taxation.

An investor could use the put-call parity to create a synthetic bond. Bonds are the prototype for all fixed-return transactions. However, the put-call parity allows one to receive the economic return of a bond while paying tax on a contingent-return basis. An investor could replicate a bond by buying the stock, buying a put, and selling a call. (38) Why would a taxpayer do this? A true bond generates taxable interest income on an annual basis, whether or not the bond is sold. In contrast, the stock, put, and call have no tax consequences until the sale or (in the case of the put or call) exercise or expiration. (39)

Although a taxpayer can manipulate the timing of income using put-call parity, manipulating the character is more difficult. Before the enactment of section 1258, taxpayers might be able to convert the ordinary income received from bonds into the capital gains received from stocks and options. Section 1258 would now treat the synthetic bond as a "conversion transaction," resulting in ordinary-income treatment. Section 1258 would not, however, alter the timing of income on the synthetic bond. (40) As before, the synthetic bond would likely result in contingent-return treatment.

The put-call parity might also be used to achieve an effective short sale of stock. Rearranging the equation we see--

-S = p - c - B

In other words, one can replicate the short sale of stock by borrowing cash, buying a put, and selling a call.

Suppose that Maya currently owns 100 shares of stock, which has fair market value of $30 per share and an adjusted basis of $0. If Maya sold the stock she actually owns, then she would pay tax on $3000 of gain. Before 1997, Maya could have executed a "short sale against the box." (41) Rather than selling the shares she actually owns, Maya would execute a short sale over 100 shares of stock (selling 100 shares that were borrowed from a broker). In 1997, Congress enacted the constructive-sale rules of section 1259. (42) If an investor executes a short sale and also owns appreciated shares of the same stock, then he is deemed to have sold the owned stock (rather than the borrowed stock). The constructive-sale rules apply to a short sale or any comparable transactions that "have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain with respect to the [owned security]." (43) So, Maya would face taxable gain on the 100 shares of if she executes a short sale or a synthetic short sale, constructed with options. (44) Using put-call parity, Maya could create a synthetic short sale by buying a put, selling a call, and borrowing money. Using the notation introduced above, we describe a short sale (i.e., a negative share of stock) as follows:

-S = p - c - B

Again, suppose that the stock is worth $30 today, and Maya wants to execute a synthetic short sale. She would borrow $30, buy a put, and sell a call. The term of the put and call would have to be the same, and the exercise price of the each would have to be the future value of $30. So, if the term of the option is one year and the interest rate is 5%, the exercise price would need to be $31.54 (45) for both the call and the put. In conceptual terms, the long put and short call eliminates any risk of upward or downward movement in the stock for one year. The borrowing allows Maya to access the value of the owned stock today, rather than having to wait to sell it. The resulting synthetic short sale perfectly mimics a true short sale and would be taxed as a constructive sale under current law.

B. Equity Collars

In his 2001 article Frictions as a Constraint on Tax Planning, Dean Schizer notes how taxpayers can approximate a short sale against the box, but still avoid the constructive sale rules, with an equity collar. (46) Like the synthetic short sale, an equity collar combines a long put with a short call. The difference, however, is that the equity collar has a spread in exercise prices between the two options.

Let us return to Maya and her ABC stock currently worth $30. An equity collar might be a long put with an exercise price of $27 and a short call with an exercise price of $33. Here, there is a spread of $6 between the two exercise prices--probably enough of a spread to avoid the constructive sale rules. (47) The following illustrates the return on a short sale of ABC stock and the equity collar just described. The horizontal axis is the price of the stock in one year. The vertical axis is the gross return (above or below the current stock price of $30) on the transactions in one year.

The illustration shows how similar an equity collar is to a short sale. Despite the similarities, the short-sale triggers the constructive sale rules, whereas the equity collar does not.

[GRAPHIC OMITTED]

Economically, however, an equity collar is a partial short sale. This article will urge that the equity collar should be taxed as a constructive sale (regardless of the spread). Determining the actual extent to which an equity collar is a short sale (e.g., 50%, 75%) is no trivial matter. The put-call parity does not supply the answer to this question, because it deals only with long puts and short calls that perfectly replicate a short sale. In order to find the degree to which an equity collar replicates (however imperfectly) a short sale, one must turn to the Black-Scholes model and the model's key concept of "delta."

We can easily determine the initial short sale implied by the equity collar just described. The delta on the put is -0.2020 (48) and the delta on the call is -0.5658. (49) So, the delta on the collar is the sum of the two, or -0.7678. If the collar covered 10,000 shares, Maya has essentially executed a short sale over 7678 of those shares. Applying the constructive sale rules of section 1259 to the implicit short sale means that Maya would be treated as having sold up to 7678 shares of ABC stock. There are some serious (but surmountable) complications with this approach. One is that delta depends on the volatility of a stock, which is not readily determinable. Another is that delta is constantly fluctuating along with fluctuating stock prices. These issues are fully dealt with in Part VI.

C. Academic Proposals

Because of the size of the market for options and their use in tax avoidance, option taxation has attracted considerable attention from legal academics. This section summarizes some of the existing commentary, especially as it relates to the approach of this article.

1. Spanning Method

In his 1993 article, Taxing New Financial Products: A Conceptual Framework, Professor Strnad identifies universality and consistency as ideals that the tax system should strive to achieve in the taxation of financial transactions. (50) "Universality requires that the tax system specify a tax treatment for every possible transaction." (51) Universality gives taxpayers certainty about the tax treatment of transactions. The second goal is consistency. "A tax system is consistent if and only if every cash flow pattern has a unique tax treatment. In such a system, it is not possible to manipulate tax outcomes by repackaging cash flows into different financial vehicles." (52) The discussion of the put-call party in Part III.A showed the inconsistency of taxing options the same way as pure equity.

Professor Strnad notes that a bifurcation approach accomplishes the goals of universality and consistency. Bifurcation is accomplished as follows: First, we see if a transaction can be broken down into constituent parts. Second, we identify tax treatment of each part. Third, we aggregate the tax results on the constituent parts. This bifurcation approach is consistent and universal. Another favorable aspect of bifurcation is its continuity. A system is continuous if transactions that are nearly identical have nearly identical tax treatments. (53) Thus, "small changes in any [transaction] will not cause a 'jump' in the tax results." (54) Equity collars have a discontinuous tax treatment, because if the spread between the put and call is too narrow, they trigger the constructive sale rules. (55) As a result, small changes in the spread can cause large changes in the tax consequences.

Professor Strnad analyzes the taxation of options under a stylized model called the "spanning method," under which a stock that will take one of five known values in two years. (56) This model does not reflect the real world, and may well be incapable of capturing the effect that innumerable price fluctuations have on the performance of real-world options. Like Professor Strnad's spanning method, the delta-hedging model of this article relies on bifurcation to examine the taxation of options. The delta-hedging model improves upon the spanning method, however, by its ability to produce tax results for real-world options.

2. Quasi-Mark-to-Market Approach

Professor Hasen used delta hedging to support his proposal of what he calls a quasi-mark-to-market approach for taxing options. (57) Hasen recognizes that delta hedging produces results that are equivalent to actual options and would base the taxation of actual options on a hypothetical delta hedge. As in this article, Hasen's delta hedging model bifurcates a call option into stock and debt. Yet, Hasen's model departs from the bifurcation ideal by not taxing the stock component according to current law. Instead, Hasen would tax the stock component of the synthetic option by marking it to market.