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Nothing can be certain but delta and taxes

As tax accounting firms spring to life and TurboTax ups its marketing, so too is the Options Clearing Corporation working on taxes. The OCC’s concern does not rest with income taxes, but rather section 871(m) of the Internal Revenue Code.

The code, which is set to tax foreign entities on U.S. equity options trades under certain conditions, could have a negative effect on the use of options overseas, an audience the options industry has worked hard to bring into U.S. options markets.

“Our concern is that complying with these final regulations is so complicated that firms might just decide not to allow their foreign customers to trade listed options,” said Joe Corcoran, head of government relations at the OCC. “The firms are, I’m sure, looking at it and saying, ‘How much revenue do I get from these foreign customers’ and ‘How much is it going to cost me to make system changes’ and ‘Is it really worth it to make these system changes to accommodate these final regulations.’”

Here’s what up. Section 871(m) regards taxing dividend equivalent payments to foreign parties that arise from derivatives linked to stock of a U.S. issuer. Options fall into the 871(m) basket, if they meet certain qualifications.

The code’s origins stem from the practices of some banks and foreign hedge funds in the early 2000s that engaged in so-called yield-enhancement strategies. Funds would transfer their stock to a bank, and then enter into an equity swap with the bank before the stock’s ex-dividend date, thus maintaining the same exposure and getting a substitute dividend without having to pay withholding tax.

When the Senate Permanent Subcommittee on Investigations released a report on the practice in 2008, it led to the 871(m) code — essentially a loophole closure. Within the language of 871(m), the IRS and Treasury have the mandate to include other instruments that offer similar exposure to dividends as the above equity swap circumstance. The 871(m) regulations have since gone through a series of revisions and comment periods before the final version was released in September 2015. The OCC submitted a comment letter at the end of February 2016 outlining issues with the final form of 871(m).

The regulations pertaining to options are novel in their reliance on delta to determine whether a contract falls under its purview. (Delta is a ratio that compares the price movement of the underlying to the price movement of the derivative. For example, a delta of .70 means a contract will move 70 cents per every dollar the underlying moves.) The use of delta makes sense. If a contract has a high delta, then it replicates its underlying very closely, and would garner similar benefits to holding the stock.

When the 2013 proposals came out, for an option to fall under 871(m) it had to have a delta of .70 or higher. The OCC, in tandem with the U.S. Securities Markets Coalition, advocated for a delta of .90-.95 — the final regs of September 2015 put the delta at .80 or higher.

The rest of the tale is not thematically different from the regulatory issues that have challenged the industry since the financial crisis: seeking a balance between reflecting economic reality without putting an undue compliance burden on firms.

The crux of the matter lies in when and how to calculate the delta. Calculating the delta the moment a foreign entity enters a trade, which is what the IRS and Treasury currently have on the books, is “exceedingly difficult for the firms to do,” Corcoran said. Firms do not currently do this and would have to update their systems to comply with 871(m).  

Now that the regulations are in final form there is little wiggle room for adjustments. But the OCC has an idea how to simplify the test, as it already aggregates and distributes end-of-day delta. As such, they are advocating that firms use those end-of-day delta calculations for the next trading day so they already know which options series fall under 871(m). Corcoran said clearing members are in favor of that approach.

Another component of the delta dilemma, is that it does not allow for net delta calculations. So, if someone enters into a complex contract, say a spread contract, where they are long a contract with a .9 delta and short a contract with .4 delta, the net exposure is .5 delta. But that is not how the contract would be viewed under 871(m). How firms will adapt is still unclear.

871(m), which applies to more derivatives than just options, is set to go into effect in 2017.

In the meantime, OCC is looking for practical solutions that will help non-US firms comply and remain customers in the US options markets.

 

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