Difficulty in Every Opportunity: TAM 201142020 Provides Insights on Deemed Exchanges and Hedging

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By Mark H. Leeds, Esq.  

Greenberg Traurig, LLP, New York, NY

When my children were small, I mischievously told them that I studied federal income tax law at Harry Potter's Hogwarts Academy. To embellish the story, I told them that Santa Claus was in my class. (Why not? In my kids' eyes, Santa and I are the same age: eternal.) Of course, they challenged both assertions and wondered out loud whether their father was mad. In a recent Internal Revenue Service (IRS) Technical Advice Memorandum (TAM), modified financial instruments undergo deemed exchanges and finds transactions not designated as hedges to be hedges. Things are sometimes not what they seem to be in real life as well as at Hogwarts. This insight describes the trials and tribulations of a commodity producer, likely a gold mining company, that experienced tax, as well as economic, challenges on its derivative transactions.

I. Facts Presented in TAM 201142020  

The TAM characterized the taxpayer as a "worldwide Commodity X producer." Since the TAM notes that Commodity X traded in "bullion," was readily traded and fungible, and gold is more interesting than Commodity X, this article will refer to Commodity X as gold.2 As would be expected, the taxpayer's financial performance was "highly sensitive" to gold prices. When it appeared that the spot price of gold would drop below the company's cost of extraction, the taxpayer entered into a prepaid forward contract to sell gold at the then current market price.3 

The taxpayer, in the same month in which it entered into the prepaid forward contract, purchased European-style put options over gold.4 These options were short-dated and expired worthless in the year purchased and the succeeding year. Although the put options were not identified as hedges, the taxpayer reported the losses sustained from the worthlessness of the put options as ordinary hedging losses.5

At approximately the same time that the taxpayer purchased the put options, it sold call options over gold. The sold call options were much longer dated (durations of 10 and 11 years) than the purchased put options. The taxpayer asserted that the reason why it sold the gold call options was to raise cash to acquire the put options described above. Indeed, the premiums received for the written call options were equal to the premiums paid for the purchased put options and the call options were sold to the same counterparties from whom the taxpayer purchased the put options. Based upon the author's experience, it is unlikely that cash exchanged hands when the options were acquired and sold and the premiums of the purchased and sold options were simply netted. The sold call options were not identified as hedges for federal income tax purposes, but were accounted for on the mark-to-market method for financial accounting purposes.

Two years after the purchased put options expired worthless, the sold call options were restructured to achieve better financial reporting. Specifically, the sold call options were amended to require physical delivery although the TAM recites that certain of the options already specified physical delivery. On certain of the sold call options, the counterparty was replaced and the option duration was extended for a number of years. In addition, strike price was changed from a specified amount to the lower of such specified amount and the fair market value of gold at the option's expiration date.6 Last, an automatic exercise feature was added. The taxpayer did not report any of these modifications as resulting in a taxable loss on the sold call options, although, at the time of these amendments, the fair market value of the sold call options in the taxpayer's hands was less than when the taxpayer sold them.

Nine years after the gold call options were sold, the taxpayer repurchased such call options. At this time, gold prices had increased substantially and the taxpayer incurred a significant expense in repurchasing the call options. Internal documentation prepared by the taxpayer referred to these repurchase transactions as "hedge terminations."

II. Characterization of the Restructured Sold Call Options  

The first issue considered in TAM 201142020 was whether the changes to the sold call option prices, including the change to the strike price to the lower of fair market value and a fixed price (from the same fixed price) caused the options to be more properly characterized as forward contracts than options. The IRS found that the changes did not cause the option to transform into a forward contract. The resolution of this issue was important because if hedge treatment was not available, the losses sustained on the repurchase of the call options would be characterized as capital losses.7 For corporations, capital losses can be problematic because capital losses are deductible only to the extent of capital gains8 and many corporations have difficulty in generating income that is characterized as capital gain.

On the other hand, if the restructured options were characterized as forward contracts, the loss on the termination of such contracts would have been an ordinary loss, even if hedge treatment was not available. A termination of a contract is not in and of itself a sale or exchange of the contract.9 Accordingly, the termination of the contract cannot give rise to a capital loss on the basis that the contract itself was a capital asset in the taxpayer's hands and it should be considered to have sold such contract. Section 1234A(1) of the Internal Revenue Code of 1986, as amended (the "Code") fills this breach by holding that a contract termination will be treated as gain or loss from the disposition of a capital asset, but only if the contract relates to a capital asset. The gold that was the subject of the modified gold call options would have been inventory in the hands of the taxpayer and, therefore, not a capital asset.10 Accordingly, if the rules relating to terminations of options not held as hedges did not apply, Code §1234A(1) would also been inapplicable.  In this case, the taxpayer's loss would have been ordinary in character.

The IRS, citing Drake, Inc. v. Comr., 3 T.C. 33, 37 (1944), and Rev. Rul. 78-182, 1978-1 C.B. 265, defined an option as a contract that "provides a holder with the right or privilege, in return for a premium, to buy or sell specified property at a specified price on or before a specified period of time." The IRS focused on the fact that the restructured contracts did not pass risk of loss on the referenced asset (gold) to the option holder.  In other words, if the price of gold increased, the option holder continued to benefit from its position under the contract because the restructured contract did not require the holder to pay more than the original strike price.

Conversely, if the price of gold fell prior to the expiration of the contract, the holder would never be asked to pay an amount in excess of the fair market value of the gold, because the strike price was equal to the lesser of fair market value of the gold and the original strike price. In essence, the parties layered a fair market value forward contract over the option and embedded this forward contract in the option. In the author's view (and contrary to the view expressed by the IRS in the TAM), it appears fairly clear that there were both an option and a forward contract within the single contract. There should not have been any gain or loss to either party from the termination of the forward contract, however, because in all events the strike price of such forward contract was fair market value, that is, a price that would have been fair to both parties.  Thus, the IRS was right in its result that the loss should be considered attributable to the option portion of the contract because, with the price of gold being in excess of the option strike price at the time of termination, the payment related to the fact that the option holder was forgoing its right to purchase the gold at less than its market price.

It was appropriate for the IRS to not attempt to bifurcate the forward contract from the option on to which it was engrafted because the exercise of the forward contract or option, respectively, would have annulled the rights under the other contract.11 Nonetheless, while acknowledging that there was both a fair market value forward contract and a fixed price option, given that a payment to terminate the forward contract has different federal income tax consequences than a termination of the option, the issue should become which right within the contract gave rise to the payment. Since, as analyzed in the preceding paragraph, the written call option gave rise to the taxpayer's loss, the provisions of the Code that govern option terminations (Code §1234(b)) should be determinative in characterizing the loss. Accordingly, the author believes that the IRS reached the right answer, even though the IRS's analysis rides roughshod over the fact that there was a forward contract created by the amendments to the contract.

III. The Deemed Exchange Issue  

The U.S. tax law has long been concerned with "substance over form." One manifestation of this concern has been in the area of contract modifications. In general, when the fundamental nature of a contract changes, the holder of the contract should be taxed as though he surrendered the "old" (pre-modified) contract for the "new" (post-modified) contract.12 The quintessential example of this rule is that the holder of a life insurance policy is considered to exchange the old policy for a new policy when there is a change in the insured life.13 Indeed, the IRS's analysis as to whether the changes to the options caused a deemed exchange of the options begins with a citation to this revenue ruling.

If the changes to the options triggered deemed exchanges, the taxpayer would have experienced losses on the contracts in the third year after issuance. The taxpayer did not originally report the changes as resulting in deemed exchanges, but amended its tax returns in connection with the audit to claim losses from the deemed exchanges. The IRS rejected this claim.

There are authorities addressing modifications on options and their tax consequences.14 Several cases and IRS guidance dealt with the issue whether an extension of the expiration date of an option constitutes the expiration of the old option and the issue of a new option, or whether the new option is a mere continuation of the old one. James S. Reily v. Comr., 53 T.C. 8 (1969), which is cited in the TAM, involved a series of six options to lease real estate in Louisiana. The taxpayer extended the maturity of the fifth option, and later sold, at a profit, the sixth option, which he had held for only five months and 18 days before selling it. In order to obtain long-term capital gain treatment on the sale, the taxpayer argued that the sixth option was a continuation of the prior, fifth option, which expired at the end of the same day that the new (sixth) option came into existence. The Tax Court held that: (1) what the taxpayer sold was the sixth option, with its own set of optionee rights, exercisable during a specified period; (2) at the time of the sale, the fifth option had long expired; (3) the sixth option was granted for a new consideration; and (4) the manner in which the sixth option was to be exercised was entirely different from the manner in which the fifth option was to be exercised.

The Tax Court emphasized that the period during which an option may be exercised "is of the essence. It goes to the very nature of an option." Further, each option recited that timing was, indeed, of the essence. The Tax Court was also assisted by the fact that the agreement under which the last option was sold recited that it had been granted on its stated date and did not characterize it as a continuation of a prior option.15 In Rev. Rul. 80-134,16 the IRS ruled that a gratuitous extension by the grantor of an option that at the original expiration date was worthless results in a new option and, therefore, is not effective to defer the taking into income of the option premium. The option was not expected to be exercised and had in substance lapsed.17

Turning to other types of modifications to options, Rev. Rul. 78-408, 1978-2 C.B. 203, involved an exchange of warrants issued by Y on Y corporation's stock for warrants issued by X on X corporation's stock in connection with a "B" reorganization in which corporation X acquired corporation Y by exchanging one X share for each Y share. The IRS ruled that the exchange is taxable even though the terms and conditions of the two warrants were identical.  The ruling focused on whether the exchange is within the scope of the reorganization, but implicitly holds that the exchange is a realization event. It should be noted that the exchange involved not only a substitution of X stock for Y stock as the optioned property but also a change in the issuer of the warrants.

The IRS, referencing these authorities, then considered whether the changes to the sold call options caused deemed exchanges of the options. First, it considered whether the layering of the fair market value forward contracts over the options was material.  It concluded that these changes were "legally and economically inconsequential." Given that there should be little to no value associated with the right to purchase a traded commodity at its fair market value, the IRS's holding on this point is sound.

The IRS next considered the reduction in strike prices of the options. The redactions in the publicly-released TAM make it is impossible to determine by how much the strike price was reduced. The IRS referred to the reduction as "nominal." Accordingly, it found that such reduction did not cause the options have undergone deemed exchanges.

Last, the IRS considered the effect of the extension of the duration of the option transactions. It began by paraphrasing from Reily, acknowledging that the "time factor or limitation in an option is of the essence. It goes to the very nature of an option." Certain of the options were modified to provide for delivery over staggered exercise dates that straddled the original exercise date. The weighted average of the delivery dates caused the restructured contracts to differ "nominally from the prior relevant exercise date." As a result, the IRS ruled that these modifications were not material to give rise to gain or loss.

The IRS's conclusion that the staggering of the exercise dates were not material enough to trigger a deemed sale or exchange seems erroneous. It appears to be the same position that the IRS lost so infamously in Cottage Savings Ass'n v. Comr., 499 U.S. 554 (1991). The trading prices of commodities are volatile by their very nature. The fact that the gold was deliverable days, weeks or months away from the original delivery date in and of itself is significant. The IRS's approach to determine the weighted average delivery date does not adequately address the fact that there is significant price risk with staggered delivery that is different than the price risk with the delivery on a single date. The author believes that such a change should have been considered a material modification that triggered a deemed exchange.

The IRS found that options extended for a period of years should be considered to have been exchanged by the parties for the "old" options. In other words, the IRS found deemed sales or exchanges on the options that were extended by a number of years. It cannot be determined from the TAM, however, how long the extensions were compared to original or remaining term to the options' maturity. As we'll see below, however, this was pyrrhic victory for the taxpayer.

IV. The Written Options as Hedging Transactions  

The next issue considered by the IRS was whether the sold call options were hedges. At first blush, one would think that the taxpayer would have argued for hedging treatment to ensure that its losses were ordinary and not capital. The fact that the IRS was asserting that the loss sustained from the written calls should not be allowed until the year in which they were scheduled to expire or be exercised, however, compelled the taxpayer to argue that the sold call options were not hedges.

The taxpayer made three arguments as to why the sold call options were not hedging transactions. First, it argued that it sold the call options to finance the purchased put options and not primarily for risk reduction purposes. Second, the taxpayer argued that the sold call options did not substantially reduce price risk. Last, it argued that it did not hedge gold in inventory.

One would have thought that the taxpayer's first argument was assisted by the fact that the period under issue preceded the change in definition of a hedge in applicable federal income tax rules from risk reduction to risk management.18 The sale of the right to purchase goods from the taxpayer at a fixed cost does not intuitively seem to reduce risk for the taxpayer. The IRS, however, expressed the view that the change in language did not have an impact on the analysis.

The taxpayer attempted to assert that a written option can serve a risk management function only to the extent that the taxpayer keeps the cash from the written option premiums. Since this taxpayer used the cash to fund its acquisitions of the purchased put options, the taxpayer asserted that the sold call options were financing transactions, not risk management or risk reduction transactions.  The taxpayer argued that the dedicated use of the cash showed that the transactions were not "primarily" used to manage risk within the meaning of Regs. §1.1221-2(b). The IRS refused to treat the use of the cash from the sale of the options as determinative in the characterization of a transaction as a hedging transaction.  Instead, the IRS argued the question is whether the sold options performed a risk management function.

The taxpayer extended its argument that the options were not hedges after the deemed exchange (occasioned by the extension of the duration of the options) on the ground that the "new" options were acquired to avoid adverse financial accounting treatment and not to manage risk. The IRS accepted that the restructuring was undertaken for such purpose. The IRS stated, however, that while this may have been the motivation for the restructuring, it did not detract from the fact that the taxpayer inured to a substantial economic benefit from the writing of the call options, that is, the receipt of cash. This cash receipt, regardless of the use to which it was put, served a risk management function for the taxpayer, according to the IRS.

The taxpayer next argued that writing a call option cannot serve a risk reduction purpose. The IRS first refuted the taxpayer's argument that the premium that it received was insubstantial by noting that the parties were acting at arm's length and were unrelated.  It then noted that congress had recognized that the premium received from written call options could very well reduce risk on long positions when it included deep-in-the-money call options within the class of transactions subject to the straddle rules.19 It is worth noting that the amended, now current, tax hedging regulations, specifically note that written options can be used to manage risk and therefore be treated as hedging transactions.20

The taxpayer's last argument as to why the written call options should not be treated as hedging transactions was the options related to gold that was not in the taxpayer's possession when it wrote the call options. The IRS rejected this argument first because Regs. §1.1221-2(b)(1) includes transactions that manage price risk of property to be held by the taxpayer as hedges. Second, the IRS noted that the taxpayer held "Commodity X Ingredient," presumably proven gold reserves. Last, the IRS recited that the seminal Corn Products case21 treated futures contracts as hedges of anticipatory inventory purchases.

V. Timing of the Hedging Loss  

The taxpayer argued that the losses from the deemed exchanges of the "old" options for the "new" options should have been permitted in the year in which the deemed exchange occurred. It further argued that it should be entitled to the losses from the termination of the options in the year in which it repurchased those options. In contrast, the IRS argued that no losses should be recognized until the taxable year in which the options were scheduled to be exercised or expire.

The hedging timing regulations provide deference to a hedge accounting method chosen by the taxpayer, provided that such accounting method clearly reflects income.22 Accordingly, the accounting method used must "reasonably match" the timing of income, deduction, gain, or loss from the hedging transaction with that from the hedged item. Given that the taxpayer apparently had not thought through its hedging issues for federal income tax purposes at the time it wrote the call options, it did not have a hedging policy in place as contemplated by the applicable IRS regulations.23 Furthermore, the IRS asserted that accounting for the hedges on a realization basis did not clearly reflect income because the stated term of the options showed that they were intended to reduce risk on inventory that would be sold in the years in which the options were exercisable. Accordingly, in order to match the losses from the hedges with the inventory to which they should be considered to be related, the losses were deferred until the years in which the options would have been exercisable if they had not been terminated earlier.

VI. Lessons Learned  

TAM 201142020 appears to have been issued in the context of a fairly contentious audit. The IRS has taken a fairly harsh position in deferring hedging losses. On the other side, the taxpayer may not have properly considered the tax accounting issues associated with the derivative transactions at the time that it entered into the options or when it restructured such contracts. The TAM points out the need for all taxpayers who use derivatives as risk or price mitigation tools to adopt a hedging policy that addresses the various permutations of outcomes at or before the acquisition of the contracts.

For more information, in the Tax Management Portfolios, see Shapiro, 188 T.M., Taxation of Equity Derivatives, and Needham and Brause, 736 T.M., Hedge Funds, and in Tax Practice Series, see ¶1620, Capital Assets.

  2 Although the article will refer to Commodity X as gold, the principles discussed in text would apply regardless of whether Commodity X was gold or any other type of commodity.

  3 A prepaid forward contract works like a traditional forward contract that settles in both directions when it matures, except that the taxpayer receives up front the discounted value of the cash it would receive upon a full physical settlement of the contract. TAM 201142020 recites that the taxpayer used the prepayment on the forward contract to pay down outstanding long-term debt.

  4 European-style options are options that are exercisable only at a date certain.

  5 It is likely that the taxpayer determined that it could treat the purchased puts as hedging transactions on the ground that its failure to designate the transactions as hedges was due to inadvertent error. See Regs. §1.1221-2(g)(2)(ii).  However, footnote 7 in the TAM provides that "[n]o opinion is expressed on the possible application of the inadvertent error exception to the type of circumstances herein or on Taxpayer's particular claim that is being raised years after it knew of its failure to identify."

  6 The exercise price of certain other options was lowered.

  7 Regs. §1.1221-2(g)(2)(i), (iii); Code §1234(b)(1).

  8 Code §1211(a).

  9 See, e.g., Comr. v. Starr Brothers, 204 F.2d 673 (2d Cir. 1953).

  10 See Code §1221(a)(1) (inventory is not a capital asset).

  11 See FSA 1999-1066 (7/2/99) ("A convertible debenture gives a holder two rights: the right to a monetary payment of the obligation and the right to receive shares of stock. These rights, however, are not two independently exercisable rights, both of which can be exercised, but rather these are alternative rights for which the exercise of one precludes the exercise of the other right. (Citation Omitted) Stated another way, the obligor has but one obligation, to which the holder has the right of two alternative modes of satisfaction—to receive a cash amount or to receive a designated number of shares of stock. Hence, a satisfaction of the conversion right effects a total satisfaction of the entire debenture obligation."). See also Regs. §1.1272-1(e), Regs. §1.1273-2(j) (the issue price of convertible debt instrument includes amount paid for conversion option); Chock Full O' Nuts Corp. v. U.S., 453 F.2d 300 (2d Cir. 1971) (holding that a convertible debt cannot be bifurcated into a debt instrument and an option).

  12 Regs. §1.1001-1(a).

  13 Rev. Rul. 90-109, 1990-2 C.B. 191.

  14 It is generally accepted that Regs. §1.1001-3 (the debt modification rules) do not apply to modifications of instruments other than debt instruments.

  15 See also Brown v. Comr., 56 T.C.M. 1568 (1989). The Tax Court repeated that in determining whether a taxpayer who has a series of options is entitled to long-term capital gain treatment on the sale of the last option, the court looks at: (1) whether the taxpayer sold the last option, with its own set of optionee rights, and whether it was exercisable during a specified period; (2) whether at the time of the sale, the prior option had long expired; (3) whether the last option was granted for a new consideration; and (4) whether the manner in which the last option was to be exercised was entirely different from the manner in which the prior option was to be exercised.

  16 1980-1 C.B. 187 (obsoleted by Rev. Rul. 86-9, 1986-1 C.B. 290, because of a change in §1032 relating to the treatment of premiums paid on stock warrants).

  17 See also PLR 9129002.

  18 See Code §1221(a)(7).  The definition of a "hedging transaction" (includes two elements: (i) it must be a transaction that a taxpayer enters into in the normal course of its trade or business, primarily to manage the risk of interest rate changes, price changes, or currency fluctuations; and (ii) the risk being managed must relate to ordinary obligations incurred or to be incurred, or borrowings made or to be made by the taxpayer.

  19 Code §1092(c)(4)(A).

  20 Regs. §1.1221-2(d)(1)(iii).

  21 350 U.S. 46 (1955).

  22 See Regs. §1.446-4(b) ("The method of accounting used by a taxpayer for a hedging transaction must clearly reflect income. To clearly reflect income, the method used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged. Taking gains and losses into account in the period in which they are realized may clearly reflect income in the case of certain hedging transactions… . In the case of many hedging transactions, however, taking gains and losses into account as they are realized does not result in the matching required by this section.").

  23 See Regs. §1.446-4(c).