The income tax implications of options, forwards and

THE INCOME TAX IMPLICATIONS OF OPTIONS, FORWARDS AND FUTURES
by
Henk Deist
presented in partial fulfilment
of the degree
MASTER OF COMMERCE
in
TAXATION
in the
FACULTY OF COMMERCE
at the
RAND AFRIKAANS UNIVERSITY
STUDY LEADER: PROF D COETSEE
PROF K JORDAAN
NOVEMBER 1996
CONTENTS
Extract in Afrikaans
Chapter 1: Introduction
1.1 Motivation for the research
1
1.2 Subject of the research
1
1.3 Purpose of the study
2
1.4 Research methods
2
1.5 Introduction to chapter content
2
Chapter 2: Definitions
2.1 Introduction
4
2.2 Derivatives
4
2.3 The forward contract
5
2.4 Futures
7
2.5 The option contract
2.6 Uses of options, futures and forwards
11
2.6.1 Hedging
11
2.6.2 Speculating
12
2.6.3 Investment
12
2.6.4 Arbitrage
12
2.7 Summary
12
Chapter 3: Hedging and synthetics
3.1 Introduction
14
3.2 Hedging
14
3.2.1 Hedging and tax symmetry
16
3.2.2 Difficulties in applying hedging rules
17
3.2.3 Classification criteria for hedges
18
3.2.4 Hedging rules in South Africa and abroad
20
3.2.5 Summary hedging
20
3.3 Synthetics
21
3.3.1 Introduction
21
3.3.2 Put-call parity
21
3.3.3 Dynamic Hedging
22
3.3.4 Summary synthetics
23
CONTENTS
23
3.4 Conclusion
Chapter 4: The character of the profit: Capital or Revenue
25
4.1 Introduction
26
4.2 General principles
4.3 Case law in respect of options
27
4.3.1 Disposal of the option itself
27
4.3.2 Profits on exercising the option
28
4.3.3 Options acquired in respect of services rendered
31
4.3.4 The option writer
31
4.4 Futures and forwards
34
4.5 Financial options futures and forwards
34
4.6 Conclusion
37
Chapter 5: Timing of the profit on revenue account
39
5.1 Introduction
39
5.2 General principles
5.3 Options
40
5.3.1 The option holder
40
5.3.2 The option writer
42
5.4 Forward contracts
44
5.5 Futures
45
5.6 Anti-avoidance
45
5.7 Conclusion
46
Chapter 6: Tax deductions
48
6.1 Introduction
6.2 General principles
48
6.3 The option holder
49
6.3.1 The option premium
49
6.3.2 The option as trading stock
53
6.3.3 Premium forming part of the cost of the underlying
57
6.3.4 Interest cost in financing the premium
59
6.4 The option writer
60
6.4.1 Losses incurred on settlement of the option
60
6.4.2 A claim for contingent future losses
61
64
6.4.3 The option writer: trading stock
ii
CONTENTS
64
6.5 Forwards •
6.6 Futures
64
6.7 Conclusion
65
Chapter 7: Legislation: Section 24 I and 24J
67
7.1 Introduction
7.2 Applicability of Section 24J
67
7.3 Introduction to Section 24 I
70
7.4 The forward exchange contract
71
7.4.1 Forward exchange contract in respect of stock or revenue items
71
7.4.2 FEC's and capital assets
77
7.4.3 Applicability to other forward contracts
80
7.5 Foreign currency option contracts
81
7.5.1 Comparison with general principles
81
7.5.2 Applicability to other option contracts
84
7.6 Conclusion
85
Chapter 8: The consultative document on financial arrangements
8.1 Introduction
86
8.2 Applicability
86
8.3 Timing of income and expenditure
87
8.4 Hedging
88
88
8.5 Specific proposals
8.5.1 Futures and forwards
88
8.5.2 Options
89
8.6 Conclusion
89
Chapter 9: Conclusion
9.1 Introduction
90
9.2 Definitions and related terminology
90
9.2.1 Definitions
90
9.2.2 Hedging
90
9.2.3 Synthetic transactions
91
9.3 The General Tax Principles
91
9.3.1 Capital and Revenue
92
9.3.2 Timing
92
9.3.3 Tax deductions
93
iii
CONTENTS
9.4 Current and proposed legislation
93
9.5 Conclusion
94
List of sources
Books
95
Publications by organisations
96
Seminar attended
96
State Publications
97
97
Interviews
97
Articles
Dictionary
97
Table of Cases
99
iv
UnTREKSEL
DIE INKOMS7EBELAS77NG IMPLIKASIES VAN OPSIES EN 7ERMYNKON7RAK7E
Inleiding
Die skripsie hanteer die inkomstebelasting implikasies verbonde aan opsies en termynkontrakte
hetsy dit op 'n beurs verhandel word al dan nie.
Die studie word gedoen in drie dele. Die eerste gedeelte definieer die instrumente wat binne die
bestek van die skripsie val asook sekere begrippe uniek aan afgeleide instrumente. Die tweede
gedeelte bespreek die belastingimplikasies van die instrumente aan die hand van die algemene
belastingbeginsels. Ten slotte word die huidige beskikbare wetgewing in the vorm van Artikel
241 en 24J van die Inkomstebelastingwet, No. 58 van 1962 soos gewysig ("die Wet") bespreek
en daar word ook verwys na moontlike toekomstige ontwikkelinge. 'n Opsomming van die
belangrikste gevolgtrekkings wat in die onderskeie dele bereik is, word vervolgens uit een gesit.
Definisies en begrippe
Afgeleide instrumente kan basies verdeel word in instrumente wat baseer is op die opsiekontrak
en ander instrumente wat baseer is op die termynkontrak. Die studie fokus op die basiese opsie
en termynkontrak en die meer gesofistikeerde instrumente soos ruiltransaksies ("swaps") en
opsies op ruiltransaksies val buite die bestek van die studie.
Persone het verskillende motiewe wanneer hulle transaksies in afgeleides aangaan. Die
hoofmotiewe van belegging, spekulasie, die benutting van ongelykhede tussen die fisiese en die
afgeleide markte ("arbitrage") en verskansing word bespreek. Dit blyk dat dit onwaarskynlik is
dat iemand kan "bele" in 'n opsie of termynkontrak op dieselfde wyse as wat 'n mens sou bele
in 'n aandeel of effek. Die studie illustreer egter hoe "kunsmatige" posisies deur kombinasies
van afgeleides en effekte of aandele geskep kan word, wat soortgelyke implikasies van belegging
in aandele of effekte het.
Verskansing is 'n baie algemene motief by die aangaan van afgeleide transaksies en daarom
word daar 'n afsonderlike hoofstuk afgestaan waarin dit definieer word en die probleme
verbonde daaraan bespreek word.
Die inkoinsiebelasting impliA -asies van opsies en termynkontrakte
tJi ttreksel
Algemene belastingbeginsels
Die algemene belastingbeginsels word bespreek deur te verwys na die aard en tydsberekening van
die inkomstes en uitgawes wat geassosieer word met opsies en termynkontrakte.
Ondeiskeid Nissen kapitaal en inkomste (Aaid)
Die belastingpligtige kan 'n wins maak deur of die opsiekontrak te verkoop of deur dit uit te
oefen. Beide gevalle word ondersoek in die studie en daar word onderskeid getref tussen die
opsiehouer en opsieskrywer asook tussen gevalle waar daar 'n fisiese onderliggende bate is en
gevalle waar die vereffening bloot in kontant geskied.
Die regspraak dui aan dat by die onderskeid tussen die kapitale of inkomste aard van winste op
opsiekontrakte die bedoeling van die belastingpligtige tydens die verkryging van die opsie van
deurslaggewende belang is. Die feit dat die belastingpligtige die opsie uitoefen en onmiddelik
daarna die onderliggende bate verkoop, is nie op sig self 'n aanduiding dat daar 'n verandering
in bedoeling van die belastingpligtige plaasgevind het nie. Op soortgelyke wyse is die bedoeling
van die belastingpligtige met verkryging van 'n termynkontrak die belangrikste faktor om te
oorweeg om die aard van die wins op 'n termynkontrak te bepaal.
Winste met die uitoefening of verkoop van termynkontrakte of opsies waar die onderliggende
bate nie gelewer kan word nie (vereffening geskied in kontant), sal normaalweg van 'n
inkomste aard wees. "Kunsmatige" belegging kan as 'n kapitale argument aangevoer word, maar
die waarskynlik meer suksesvolle argument sal wees dat 'n kapitale bate verskans word.
Aangesien die doel van verskansing is om 'n wins te maak om 'n verlies op 'n ander posisie tee
te werk, kan daar argumenteer word dat verskansing, hetsy dit inkomste of kapitaal verskans, 'n
skema van winsbejag is. Daar bestaan egter voldoende gesag dat die quid pro quo van die
inkomste die aard daarvan bepaal. Dit is op grond hiervan dat die wins uit die opsie of
termynkontrak die karakter van die posisie wat verskans word aanneem.
Tydsberekening van inkomste
inkomste word in die algemeen belas wanneer dit ontvang word of toegeval het. Op grond van
hierdie beginsel is daar geen toevalling onder 'n opsie of termynkontrak alvorens die kontrak
nie uitgeoefen of verkoop word nie. Uitsondering is in die geval van beursverhandelde
termynkontrakte waar toevalling plaasvind wanneer die beweging in kontant omgesit word
vi
Die inkomstebelastilw implikasies van opsies en termynkontrakte
Ui ttreksel
deur middel van die merk tot mark proses. In die geval van die opsieskrywer word die premie
vir eie voordeel "ontvang" en is belasbaar met ontvangs ten spyte van 'n moon tlikheid van
toekomstige verliese wat aangegaan mag word.
Posisies kan egter afgesluit word deur gelyke maar teenoorgestelde kontrakte uit te neem.
Winste kan dan manipuleer word deur die verlies posisie te realiseer voor jaareinde en die wins
posisie eers te gelde te maak na jaareinde. Inkomste kan so uitgestel word omdat die algemene
beginsels van ontvang of toegeval nie die unieke eienskappe van afgeleide instrumente in ag
neem nie. Die belastingstelsel sal dus al hoe meer moet beweeg na 'n merk tot mark beginsel
waarin alle oop posisies van belastingpligtiges teen markwaarde by belasbare inkomste ingesluit
moet word. Die belastingstelsel sal ook meer en meer posisies moet integreer om die
ekonomiese werklikheid van die transaksie te belas.
Altrek -kings
Opsiepremies behoort aftrekbaar te wees wanneer dit aangegaan word, tensy dit van 'n kapitale
aard is. Dit sal geld waar die opsie aangegaan is om die prys van 'n kapitale bate vas te pen.
Verliese gelei by die vervaldatums van termynkontrakte behoort ook aftrekbaar te wees behalwe
waar sulke verliese van 'n kapitale aard is. Die marges betaalbaar in verband met
beursverhandelde termynkontrakte is nie aftrekbaar nie, aangesien dit nie 'n uitgawe, maar 'n
verhaalbare deposito is.
Artikel 24C van die Wet blyk nie van toepassing te wees op die skrywer van 'n opsiekontrak se
toekomstige verpligting onder 'n oop kontrak nie.
Opsiekontrakte aangegaan met 'n winsmotief word as voorraad beskou, terwyl die vraag of
termynkontrakte voorraad is nie relevant is nie, aangesien daar geen koste is om in ag te neem
nie.
Wetgewing en toekomstige ontwikkeling
Die huidige beskikbare wetgewing is in die vorm van Artikel 241 en 24J van die Wet. Die studie
bespreek die toepaslikheid van Artikel 24J. Daarna word Artikel 241 bespreek deur dit te vergelyk
met die algemene belastingbeginsels en te oorweeg watter van die beginsels wat in die artikel
gebruik word, op ander nie- buitelandse valuta opsies en termynkontrakte toegepas kan word.
vii
Die inkomstebelasting implikasies van opsies en tennynkontrakte
Uittreksel
Artikel 24J is nie van toepassing op afgeleides nie, behalwe moontlik in die geval van sekere
rente ruiltransaksies ("swaps") wat buite die bestek van die skripsie val.
Die twee belangrikste verskille tussen Artikel 241 en die algemene belastingbeginsels is dat gees
onderskeid tussen kapitaal en inkomste getref word nie, en die erkenning van 'n premie op 'n
termynkontrak. Die erkenning van 'n premie op 'n termynkontrak is gedoen om die
belastinghantering en rekeningkundige hantering van termynkontrakte te versoen. Die
probleem met wetgewing wat die rekeningkundige hantering probeer navolg, is die
voortdurende verandering in rekeningkundige praktyke. Die nuutste voorstelle vir die
rekeningkundige hantering van termynkontrakte doen juis weg met die premie.
Sekere van die beginsels van Artikel 241 kan toegepas word op ander termynkontrakte waarvan
die merk tot mark beginsel waar instrumente nie as 'n skans gebruik word nie, die belangrikste
een is.
Ten slotte word 'n oorsig oor die "Consultative document on financial arrangements" gegee.
Die onderliggende beginsel in die dokument is merk tot mark. Die beginsel word verwelkom, as
dit gepaard gaan met reels vir die indentifisering van verskansingsposisies
Gevolgtrekking
Die studie wys die unieke eienskappe van afgeleide instrumente uit wat nie bevredigend deur
algemene belastingbeginels aangespreek word nie. Die oplossing le in wetgewing wat poog om
die ekonomiese werklikheid van die transaksie te belas eerder as om met die tradisionele
kunsmatige reels die belasbaarheid van die item te reguleer.
viii
CHAPTER ONE
PVTRODUCHON
1.1 Motivation for the research
On the commodity and financial markets of the world, prices, interest rates and currency
exchange rates often fluctuate unpredictably over relative short periods. Managers of many
types of businesses have therefore increasingly began to seek means of protecting their
organisations against disruptive price and rate fluctuations. It is precisely in this area where
derivatives play a major role (Kelly, 1993:13). Apart from protecting or hedging a business,
derivatives are also used by investors and speculators (refer Chapter 2).
The use of derivatives for the reasons mentioned above has become widespread over the past 15
years (SAICA & ACTSA, 1995:28). However, the tax laws in most countries and also in South
Africa, date back to before derivatives came into general use. In certain instances, this lead to
considerable uncertainty in determining how gains and losses associated with these
instruments should be taxed. These uncertainties and inconsistencies present real difficulties to
organisations which seek to use derivatives to manage risk in their businesses. Confusion can
discourage them from pursuing commercially sensible risk management strategies. It is
therefore no wonder that the Group of Thirty's Global Derivatives Study Group recommended
in its document on practices and principles of derivatives published in July 1993 that
"legislators and tax authorities are encouraged to review and, where appropriate amend tax laws
and regulations that disadvantage the use of derivatives in risk management strategies"
(1993:23). The document refers to the inconsistent or uncertain tax treatment of gains and
losses on the derivatives in comparison with the gains and losses that arise from the risks being
managed.
It is against this background of uncertainty that the need for research was identified.
1.2 Subject of the research
The subject of the study is the income tax implications arising from options, forwards and
futures. These instruments together with a host of other instruments are
1
Income Tax Implications of Options. fontards and /inures
Chapter 1
Introduction
collectively referred to as "derivatives". The option and forward contracts are the most basic
instruments which form the basis of all other derivatives. The study is limited to these
"building blocks" of derivative instruments which are generally used in the financial world
(interest rates, foreign currency, shares) but which may also be used in ordinary buying or
selling of commodities. Therefore the distinction is sometimes made between financial
derivatives and other derivatives. The study includes both types as the principles to be applied
in determining the income tax consequences are the same in both instances. The dissertation
deals with South African tax law and refers to other tax jurisdictions where relevant.
1.3 Purpose of the study
The purpose of the study is not to clarify all uncertainties pertaining to the tax treatment of
options, futures and forwards, but to discuss the income tax treatment of these instruments in
the RSA in terms of the general income tax principles, the current relevant income tax
legislation and expected future legislation. A comparison will be made between the general
income tax principles and the current tax legislation and how the principles of current
legislation may be extended in future. Problems and shortfalls will be highlighted in all
instances and suggestions for improvement will be made.
1.4 Research methods
Literature such as books and articles in periodicals were reviewed. Other research methods
included the review of reports issued by various organisations and committees, interviews and
the attendance of courses on the subject.
1.5 Introduction to chapter content
The dissertation commences with a chapter defining options, forwards and futures and to
establish who the taxpayer is. He may be a hedger, speculator or investor.
Chapter 3 expands on the concept of hedging and how a person may be able to create a
synthetic position by combining different financial positions. These are important concepts to
be aware of, as they create unique problems in the traditional distinction between revenue and
capital and determining the timing of the income (i.e. when the income will become taxable).
2
Income Tax Implications of Options, forwards andfitawes
Chapter 1
Introduction
Chapters 4 to 6 are devoted to the general tax principles. Chapter 4 discusses the fundamental
distinction between the capital or revenue nature of the income associated with the
instruments.
Once the income has been classified as of a revenue nature, the next question to be answered is
when the income will be taxable. This is considered in Chapter 5 where the timing of income
on revenue account is discussed.
The discussion of the general tax principles is concluded in Chapter 6 with a discussion of the
various tax deductions available to the holder and issuer of the instruments.
In Chapter 7 the current relevant tax legislation laid down in Section 241 and 24J of the
Income Tax Act No. 58 of 1962 as amended ("the Act") are discussed and compared with the
general tax principles. Chapter 8 discusses possible future developments set out in the
consultative document on financial arrangements published by the Tax Advisory Committee.
Finally a summary is made and a conclusion reached in Chapter 9.
3
CHAPTER TWO
Definitions
2.1 Introduction
Before anything can be said about the tax implications arising from options, forwards and
futures, these terms have to be defined and explained. The instruments have to be analysed
into various components as different tax implications may arise from the different
components. It is also necessary to know how a taxpayer may use these instruments in his
business as it may also effect the tax treatment of the item. The purpose of this chapter is to
provide this information in sufficient detail to form the basis of the chapters to follow.
Options, forwards and futures all belong to the broad category of financial arrangements
commonly known as "derivatives", which is defined in the next paragraph.
2.2 Derivatives
The Oxford Dictionary (1988:217) defines the term as "derived from a source .... a thing that is
derived from another". This implies that a derivative cannot exist without a source. From the
definition it is very likely that the source will play an important role in determining the tax
consequences of the derivative.
The importance of the source is confirmed by the Global Derivatives Study Group's definition
of a derivative transaction being a "bilateral contract or payments exchange agreement whose
value derives, as its name implies, from the value of an underlying asset or underlying reference
rate or index" (1993:28). The following observations can be made with regard to the definition:
— The source is here referred to as the "underlying" which is the more commonly used term.
— Also clear from this definition is that the underlying does not have to be a "real" asset.
Mention is made of a reference rate or index which may be the source from which the
derivative derives its value. Indeed, the underlyings in practice include interest rates,
exchange rates, commodities, equities and other indices (Global Derivative Study Group,
1993:28).
4
Income Tax kapla:talons of Options, forwards and fiaures
Chapter 2
Definitions
— As far as the contract or agreement is concerned, it may be informal. In the Consultative
document on financial arrangements published by the Tax Advisory Committee in
September 1994, derivatives include "a non-contractual, legally unenforceable understanding
as well as an enforceable contract" (1994:13).
The important role of the underlying in determining the tax consequences of the derivative is
also confirmed by Plambeck, Rosenbloom & Ring (1995:661) in their summary of the Fiscal
Association's world wide congress on the taxation of derivative instruments. They mention the
example of derivatives with foreign currency underlyings being taxed differently from
derivatives with equity underlyings.
There is a whole range of derivatives, but they can be built up from two basic types of
instruments, namely the option and the forward (Global Derivative Study Group, 1993:28).
The forward contract is defined next.
2.3 The Forward contract
The simplest derivative is the forward contract. It obligates one counterparty to buy and the
other to sell a specific amount of the underlying at a specific price on a date in the future. The
buying and selling process is done by means of physical delivery or it can be cash settled
(Global Derivative Study Group, 1993:30).
Forward contracts are customised, i.e. the terms of each contract is tailored to fit the particular
needs of the buyer and seller. They are so called "over the counter" derivatives, in other words
not standardised (Global Derivative Study Group, 1993:30).
Based on their underlyings, forwards can be classified into three categories: foreign exchange
(forward exchange contracts or "FECs"), interest rates (forward rate agreement or "FRAs") and
forward commodity contracts (Consultative Document, 1994:82).
Parties enter into forward agreements "flat" (Plambeck, et al. 1995:661), i.e. no cash is
exchanged on entering into the agreement. On maturity, if the price of the underlying is
higher than the contract price, the buyer makes a profit. If the price is lower, the buyer suffers a
loss. In both cases the seller is in the opposite position. Thus, the change in the value of a
forward contract is roughly proportional to the change in value of its underlying (figure 2.1)
(Global Derivative Study Group, 1993:30).
5
Income Tax Implications of Options, finwards andfittures
Chapter 2
Definitions
Figure 2.1
Value of a Forward Contract
Value of a Forward for a
Buyer of the Contract
Gain
Price of Underlying
/act Price
Loss
As no upfront payment is made when entering into the contract, the only element of the
forward contract to consider from a tax point of view, is the profit or loss on maturity of the
.agreement. The issues in this regard are:
Can the profit be said to be of a capital nature.
When does the income accrue to the profit maker.
Is the loss incurred tax deductible.
When is the loss actually incurred.
It is worthwhile to note that the price of the forward contract (the contract price) is not always
determined by estimating the future price of the underlying. It can be determined by the
current price of the underlying plus the cost of carrying the underlying to the settlement date
(Plambeck, et al. 1995:662; Kelly, 1995:174).
The basic forward contract can be expanded to form swap transactions. As the name implies, a
swap transaction obligates the two parties to the contract to exchange a series of cash flows at
specified intervals known as payment or settlement dates (Global Derivative Study Group,
1993:31). As said previously, the building block of the swap is a forward. An interest rate swap
for example, can therefore also be seen as a bundle (or strip) of forward rate agreements. If a
company wants to fix its interest rate for a year's borrowings, it can either enter into four FRA's
of three months each or enter into a swap contract for one year. Although there is a
relationship between forwards and swaps, the arrangements are sufficiently different to warrant
a separate discussion on swaps . The dissertation will not deal with the area of swap agreements.
6
Income Tax Implications of Options, forwards and fittures
Chapter 2
Definitions
The terms of forwards may be standardised and exchanged on a recognised exchange, in which
case they are called "futures". The characteristics of the futures contract are discussed in the
following paragraph.
2.4 Futures
The basic form of a futures contract is similar to that of a forward contract: A future obligates
its owner to buy a specified underlying at a specified price on the contract maturity date (or
settle the value in cash) (Global Derivative Study Group, 1993: 32). The differences between
forwards and futures are:
— The future is exchange traded, i.e. the contract terms describing the quantity and quality of
the underlying, the time and place of delivery, and the method of payment are fully
standardised. Price is the only variable to be determined (Global Derivative Study Group,
1993:32)
— All con tracts are sold to and bought from the clearing house which means that the purchaser
of a future is concerned only with the creditworthiness of the clearing house, and not that of
the original seller of the future (Kelly, 1993: 167). This also means that any futures
transaction may be closed out at any time before maturity by entering into an equal but
opposite contract. The participant can cut his losses or take his profits without negotiating
with the counterparty (Global Derivative Study Group, 1993:32).
Contracts are marked to market on a daily basis, changes in value are settled daily and buyers
and sellers are required to post margins as collateral for these settlement payments (Global
Derivative Study Group, 1995:32). The margins consist of the initial margin, the maintenance
margin and the variation margin. The initial and maintenance margins are fully refundable
deposits and attract interest at market-related rates and are refunded at close-out. The
variation margin represents the settlement of daily profits/losses on a futures contract, arising
from the mark to market procedure (First Derivatives, Interest Rate Products, 1995:12).
In addition to the tax consequences of the profit or loss on settlement of the future (as was the
case with forwards), the tax implications of the margins have to be considered. More
specifically whether the initial, maintenance and variation margins are tax deductible and
whether the interest earned on these deposits are taxable.
7
Income Tax Implications of Options, forwards andfittures
Chapter 2
Definitions
Forward based derivatives have now been defined. The next group of derivatives are option
based derivatives of which the option contract is the most basic form.
2.5 The option contract
The other derivative building block is the option contract. In exchange for payment of a
premium, an option contract gives the option holder the
right but not the obligation to buy
(call option) or sell (put option) the underlying (or settle the value for cash) at a price, called
the strike price, during a period or on a specific date (Plambeck,
et al. 1995:663). Thus, the
owner of the option may choose not to exercise the option and let it expire. The buyer benefits
from favourable movements in the price of the underlying but is not exposed to the
corresponding losses. The seller of the option (writer) receives the premium as income, but is
exposed to an unlimited loss (Global Derivatives Study Group, 1995:32).
Figure 2.2 illustrates the pay - off profile of an option contract. The heavily shaded line is
composed of its "intrinsic" value, i.e. the pay - off on the option at expiration which is the
difference between the price of the underlying at the time the option is exercised and the strike
price, plus the "time" value, i.e. the value attributable to the volatility in the underlying over
the remaining life of the option. The "hockey stick" profile shown by the other line reflects the
intrinsic value of the option (Global Derivative Study Group, 1995:32).
8
Income Tax Implications of Options, forwards and fittures
Chapter 2
Definitions
Figure 2.2
Value of an Option Contract
Gain
Value of Call
Option to Buyer
Time
Value
Intrinsic Value
Price of the
Underlying
Strike Price
Loss
From this discussion, in my view the option contract can be analysed into the following
components, each with its own tax implications (the following chapters will be commenced by
refering back to these components):
The option premium paid by the holder and received by the writer. The tax issues to
consider are:
Is the option premium paid by the holder tax deductible.
Is the option contract trading stock in the hands of the holder.
Is the option premium received by the writer gross income and when did it accrue.
Is the option contract trading stock in the hands of the writer.
At any point in time, the option writer has a potential cost which will be incurred when the
holder exercises his option. Assuming that the option premium is gross income in the hands
of the writer, the question arises whether there is any tax relief available to the option writer
for the potential costs to be incurred against the premium received.
9
Income Tax Implications of Options. Artvards. and/Mures
Chapter 2
Definitions
The profit made by the holder on exercising or selling the option. In this regard:
When does the profit accrue to the holder. On entering into the option contract, or on
exercising the option contract. Where the underlying has been acquired in terms of a call
option, the further question arises as to whether there is an accrual on exercising the
option or only when the underlying is eventually sold.
Can the profit on exercising or selling an option contract be said to be of a capital nature.
The tax consequences for the writer of the option when exercised by the holder. When the
option is exercised it will lead to a payment being made (cash settlement) or the purchase or
sale of the underlying.
Option contracts may be over the counter or exchange traded. Options are traded on the
Traded Option Market ("TOM") of the Johannesburg Stock Exchange.
The basic option contract can be parcelled to form caps, floors and collars. Caps, floors and
collars are created by combining the forward rate agreement and a put or call option. It may
protect an investor against declining interest rates or a borrower against a rise in interest rates.
An option on a swap is called a "swaption" and options may also be taken out on futures
(Global Derivative Study Group, 1993:33). The dissertation will be limited to a discussion of the
basic option contract. The various combinations are beyond the scope of the discussion.
Table 2.1 below prepared by the Global Derivatives Study Group (1993:29) provides an overview
of the various derivative contracts available. It has been adjusted to cater for the South African
situation.
10
Income Tax Implications of Options, forwards andfittures
Chapter 2
Definitions
Table 2.1
Derivative Contracts
Forwards
Privately Negotiated Exchange traded
futures (SAFEX)
Forwards (OTC)
All share index
Forward
Commodity
Contracts
All gold index
Forward Foreign
Exchange Contracts
Industrial index
Forward Rate
Agreements (FRA's)
11% Eskom 168
Currency Swaps
2008
3 months Bankers'
Interest rate Swaps
Acceptance
Dollar gold price
Commodity Swaps
Equity Swaps
Weekly all share
index
Options
Privately Negotiated Exchange Traded
Options (JSE) .
Options (OTC)
-
Commodity
Options
Listed shares
Currency Options
All shares index
Equity Options
All gold index
FRA Options
Industrial index
Caps, Floors, Collars
Swap Options
Bond Options
As said in the introductory paragraph, it is also important to understand how options, forwards
and futures are used by taxpayers in their businesses. The chapter is now concluded with a
discussion on the possible uses of options, forwards and futures.
2.6 Uses of options, futures and forwards
The motive for entering into a certain transaction may play an important role in determining
the tax consequences. Without attempting to provide a list of the various strategies a taxpayer
may follow with regard to derivatives, the main uses of options, forwards and futures are given
below.
2.61 Hedging
Fledging is to reduce the risk of loss arising from adverse movements in interest rates, exchange
rates and prices in respect of existing or anticipated positions by taking an offsetting position in
the futures or options market (Boynton, Lindsay & Lloyd, 1995:60).
Hedging is the subject of Chapter 3 where it will be discussed in more detail.
11
Income Tax haplications ol'Options, 'inwards andAttires
Chapter 2
Definitions
2.62 Speculating
Speculators transact in the derivative market purely in the hope of realising profit. Hedgers and
investors rely on speculators to assume counterpositions to the positions they themselves wish
to take in the market. The presence of speculators in derivative markets to provide liquidity is
considered vital for the effective functioning of these markets (Kelly, 1995:171).
2.63 In
Derivative markets offer investors the opportunity to invest "synthetically" in financial and
commodity markets via derivatives, as an alternative to investment in the actual physical asset
or commodity as such. Investment companies, insurance companies, pension funds and unit
trusts are examples of possible investors. For example, it may be easier from a liquidity
viewpoint to buy and sell futures based on an index of shares rather than the shares
themselves; the transaction costs relating to futures may also be less than those on shares
(Kelly, 1995:171). Due to the short term nature of futures and options a long term investment
can only be achieved by means of continuous roll-over of the specific instrument (Lategan,
1993:65). There is however the risk that, from a tax point of view, the derivative is not seen as
an asset of a capital nature in its own right. The creation of synthetic positions using
derivatives are discussed in Chapter 3.
2.6.4 Arbitrage
Arbitrage in the context of derivatives is the purchase and sale of the same asset in different
markets - for example, buying in the cash market and selling simultaneously in the futures
market or vice versa. The objective of the arbitrageur is to profit without incurring risk by
acting on price differentials that may arise from time to time in these separate but related
markets (Kelly, 1995:171). It is purely a form of speculation.
2.7 Summary
The option, future and forward has now been defined and the possible motives of taxpayers
namely hedging, speculating, investing and arbitrage has been described. Various tax issues
were raised which will be discussed in the following chapters.
12
Income Tax Implications of Options. forwards andfiaures
Chapter 2
Definitions
Before the specific tax issues are discussed, the following chapter is devoted to the concepts
introduced in this chapter namely "hedging" and the "synthetic" positions that may be created
by using derivatives. These are important concepts to be understood when tackling the issues of
distinguishing between revenue and capital receipts and establishing the timing of taxation.
13
CHAPTER THREE
Hedging and synthetics
3.1 Introduction
As said in the previous chapter, it is very important to understand the motive of a taxpayer to
enter into a transaction. Hedging and synthetics are two unique characteristics of derivatives
which are important to understand as they create certain problems for the general tax system.
3.2 Hedging
Hedging was mentioned in Chapter 2 (refer paragraph 2.6.1) as one of the uses of futures,
options and forwards. In that chapter the purpose of hedging was described as reducing the
risk of loss through adverse price movements in interest rates, commodity prices, exchange
rates or share prices. It involves the taking of a position which is equal but opposite to an
existing or anticipated position in the physical market.
Examples of situations where a taxpayer would hedge are:
(De Klerk, 1989: 232)
Hedging the value of an asset: The taxpayer owns an asset which he intends to sell in future
and wishes to hedge against a possible reduction in the price.
Hedging intended acquisition: The taxpayer anticipates the acquisition of an asset and
wishes to fix the price of the asset to protect himself against possible price increases.
Hedging income against adverse price movements:
The taxpayer has a floating rate liability and wants to hedge himself against rising interest
rates; or
The taxpayer earns variable rate interest income on an investment and wishes to hedge
himself against declining interest rates.
14
Income Tax Implications of Options, Ant•rds and futures
Chapter 3
Hedging and synthetics
— Hedging against illiquid markets, i.e. the unavailability of buyers or sellers at a reasonable
price.
The use of futures to hedge against an anticipated rise in interest rates can be best illustrated by
way of an example: (Example of Boynton, et al. 1995: 60 adjusted for the South African
situation.)
In March, a corporate treasurer forecasts the necessity to take out a loan of R 4 million for three
months starting in September. He is concerned that interest rates may have risen from the
current level and in order to protect him against this possibility, he takes a short position in
interest rate futures as a hedge (i.e. he sells interest rate futures such as BA futures).
Say the nominal value of one contract is R 1 million, he sells four contracts at a contract rate of
10.3% (by selling contracts he puts himself in the position of a borrower of money at 10.3%).
In September, the three month loan for R 4 million is taken up with actual interest rates having
risen to 10.8%. The market value of the futures contracts will have fallen in line with the rise in
interest rates to, say 10.85%. The treasurer is therefore able to sell futures at 10.3% and buy
back at 10.85%. The net cost amounts to:
Actual interest cost:
R 4 million X 10.8% x 3/12
R 108 000
Gain on futures:
Four contracts x price movement of 0.55% (10.85% - 10.3%)
x R 1 million nominal value x 3/12
(R 5 500)
Effective interest costs
R102 500
Effective interest rate
10.25%
The effective interest rate is 0.5% lower than the 10.3% contracted rate due to a difference
between the futures market and the actual cash market interest rate.
15
Income Tax Implications
of Options, forwards and jtttures
Chapter 3
Hedging and synthetics
Apart from the important role hedging plays in distinguishing between the capital and revenue
nature of the income, it is also essential to tax the hedging instrument and the position being
hedged in a similar fashion to prevent an unwarranted benefit or detriment for either the
taxpayer or the Government (Plambeck, et al. 1995:668). From the taxpayer's point of view,
what may be an effective hedge on a pre tax basis, may not be so on an after tax basis. To
achieve an after tax effective hedge, the hedger should strive for tax symmetry (Plambeck,
et al.
1995:675).
3.2.1 Hedging and tax symmetry
Tax symmetry may be best illustrated by the following example. Assume a taxpayer wishes to
hedge the principle amount of a foreign currency denominated liability to acquire a capital
asset using a foreign currency option contract. Assume that a foreign currency loss of R 25 is
incurred and a R 20 profit made on the foreign currency option contract - net loss of R 5 on a
pre-tax basis. If the loss is held to be of a capital nature and thus not deductible and the profit
on the foreign currency option contract of a revenue nature an additional R 7 loss (35% of R
20) will be suffered and the hedge will therefore no longer be effective on an after tax basis.
This is referred to as a character mismatch (Plambeck, et al. 1995:675)
Other mismatches may also happen. A timing mismatch can occur when the transaction
hedged and the hedge instrument are not taxed in the same tax period. This can typically be
the case where the taxpayer enters into "straddle" transactions, i.e. where the taxpayer enters
into equal but opposite transactions (e.g. buying a call and a put option at the same strike
price) (Kelly, 1993:209). Following a price movement, the loss position is closed out to realise
the loss for tax purposes. The profit position is not yet realised and therefore not taxable at that
stage. Subsequent to year-end, the profit position is closed out to recoup the loss realised before
year-end. In more complex transactions, two sets of positions (i.e. two "straddles") may be
taken which will result in two loss positions that are realised before year- end, to be countered
by the closing out of the two profit positions subsequent to year-end. The purpose of hedging
rules in these circumstances is to recognise that the loss positions are hedged and requiring
that the losses may only be deducted in the year the gains on the off - setting positions are
taxed. The UK tax system caters for "staddle" transactions (May, 1995:128). (The example
assumed losses and profits to be tax deductible and taxable only when realised - refer to
Chapters 5 and 6).
16
Income Tax Implications of Options, forwards and futures
Chapter 3
Hedging and synthetics
The Consultative document on financial arrangements (1994:66) mentioned in Chapter 2 also
refers to circumstances in which hedging rules are necessary. In terms of the proposals in the
document, tax symmetry is not achieved where the underlying position is taxed on the
"accrual method" and the hedging instrument taxed on the "market valuation" method. The
proposals in this document are discussed in Chapter 8.
Due to the potential of timing, character or source mismatches, tax systems world wide attempt
to introduce hedging rules to specify under what circumstances a hedge may be said to exist.
In some instances it is easy to identify the position or transaction being hedged and the
instrument used to achieve this. There are however a number of situations in practice which
result in difficulties in applying hedging rules.
3.2.2 Difficulties in applying hedging rules
These potential problems are discussed by Boynton
et al. (1993:8) and some are also mentioned
in the Consultative document on financial arrangements (1994: 69). They can be summarised
as follows:
Active hedging.
The decision to hedge or not and how much to hedge may be taken on
more than one occasion throughout the existence of the position being hedged. Treasurers
review their position regularly as they argue that overhedging is just as inappropriate as not
hedging any exposures. A hedge may thus cover less than 100% of the risk. The question
arises at what stage does "active hedging" become speculative dealing and therefore does not
warrant special tax treatment.
Portfolio hedging.
A portfolio of transactions is very often hedged by a single hedge
transaction instead of a separate hedging transaction for every individual transaction. When
portfolios are hedged in this way it may be more difficult to establish whether the hedge
transaction actually reduces an exposure to a risk. Difficulties may also arise in identifying
the hedge where the hedging instrument is not a derivative of the underlying position (for
example where a foreign currency asset is used to hedge a foreign currency liability.)
Hedging anticipated transactions. In Chapter 2 it was mentioned that taxpayers may wish
to hedge an anticipated acquisition or disposal. The question arises how committed the
transaction should be to qualify as an anticipated transaction.
17
Income Tax Implications of Options, fin-wards and futures
Chapter 3
Hedging and synthetics
Hedging economic exposures. The link between the exposure and the hedge may become
remote and cause abuse of the hedge accounting rules. For example a South African
manufacturer only selling in the local market, but with its main competition in the form of
a manufacturer in Botswana, may argue that he is exposed to pula exchange rate
fluctuations as his competitiveness in the market is linked to the price of the goods
produced by the company in Botswana (e.g. a strengthening of the rand against the pula
means cheaper imports from Botswana). If this is also excepted as hedging, the definition
becomes extremely wide.
Superseded or redundant hedges. A hedging transaction can be closed out before or after the
underlying position is closed out. Where the hedge is no longer effective or the position
being hedged no longer exists or the intention of entering into the transaction has changed,
hedge tax treatment should be discontinued.
Due to the problems mentioned above, very definite criteria will have to be set to identify a
transaction as a hedge for tax purposes to avoid abuse of such treatment.
3.2.3 Classification criteria for hedges
From an accounting point of view, Accounting Statement 208 of the South African Institute of
Chartered Accountants (1991: par19) suggests the following classification criteria:
The transaction forms part of a non-trading portfolio
The position to be hedged is specifically identifiable and exposes the enterprise to price or
interest rate risk.
High correlation is probable at inception and is achieved on an ongoing basis to eliminate or
substantially eliminate the risk of loss from the hedged position.
The transaction is specifically designated as a hedge.
Apart from the first requirement, the same requirements for a hedge are listed in E 48 (IASC,
1994: 658), an International Exposure Draft on Financial Instruments. A summary of common
requirements world - wide to recognise an item as a hedge appears in the Fiscal Association's
World Conference on the taxation of derivatives (Plambeck, et al. 1995:676). They are:
Clear identification of the hedge and the underlying transaction
The presence of risk and volatility
18
Income Tax hnplications of Options, fonvards and/Mures
Chapter 3
Hedging and synthetics
Negative correlation between price movements of the underlying and the hedging
instrument
Maintenance of the correlation throughout the hedge
Contemporaneous identification
Liquid hedging instruments
Effective reduction of the risk of variation of value affecting the hedged item
The hedged item may either be existing or anticipatory
Identification of risk must take other positions into account
Homogeneity of groups of hedged items
The hedging instrument may not be of a type marked to market
The last requirement that the instrument may not be of the type marked to market will
probably not be applicable in South Africa. Derivatives are normally used as hedging
instruments and both Section 241 of the Act and the Consultative document on financial
arrangements (1994: 62) require mark to market revaluation of these instruments.
In my view, the international requirements were established to address some of the problems
associated with hedges mentioned in paragraph 3.2.2. Some of the links between the
requirements and the problems identified are as follows:
Clear and contemporaneous identification addresses the problem of hedging general
economic risks and portfolio hedging.
Effective reduction of risk and negative price correlation sets clear requirements as to what a
hedge should achieve, and maintaining that correlation throughout the period implies that
hedge tax treatment should be discontinued when the underlying position no longer exists.
The effective reduction of risk is further emphasised by the requirement that other positions
must also be considered. A transaction may pose no or little risk if the total position is taken
into account. If there is no risk, there can be no hedge instrument. On the one hand
portfolio hedging poses a difficulty in identifying the hedge, but on the other hand hedge
accounting may also be abused when the total portfolio does not present a risk to be
hedged.
The international requirements allows anticipatory transactions to be hedged, although it
does not specify the extent of commitment needed to qualify as an anticipated transaction.
19
Income Tar Implications Options, lanyards and jiaures
Chapter 3
Hedging and synthetics
To classify a transaction as a hedge the taxpayer would have to demonstrate a sufficiently close
link between the underlying investment or liability and the future, forward or option. If a
taxpayer's foreign liability exposure is say R 1 million rand, but he has forward contracts or
currency option contracts of say R 2 million rand, it would be difficult to claim that they were
all entered into for hedging purposes (Pappenheim, 1991:185).
3.2.4 Hedging rules in South Africa and abroad
The Consultative document on financial arrangements (1994:64) refers to the 1994 edition of
KPMG's International Tax Survey on Derivatives where it was found that only 11 out of 24
countries surveyed have issued guidance on what constitutes a hedge for tax purposes. In all
cases however, the treatment of the transaction depends on whether it is undertaken as a hedge
or not.
In South Africa, the only criteria are those used for accounting purposes. Section 241 of the Act
does not specifically introduce the concept of hedging but the treatment of the forward
exchange contract depends on whether the forward is "matched or related". This is a definite
move towards distinguishing between speculative and hedging transactions. This will be
discussed further in Chapter 7.
3.2.5 Siunmary - hedging
The following conclusions can be reached from the discussion on hedging:
Where hedge accounting is not accepted, asymmetric taxation of the hedge and the
underlying can lead to distortions.
It is recognised world wide that gains or losses from instruments used to hedge should be
treated in the same way as the position being hedged. It is important for South Africa reentering the world markets to have an equitable tax treatment in this area.
The process of identifying hedged positions may be problematic. The Consultative
document concludes that foreign jurisdictions will be consulted at a later stage to determine
whether practical difficulties can be overcome. In my opinion, to prevent or minimise the
classification problems, hedging will have to be defined in a narrow sense. The word
20
Income Tax hnplications of Options, .fonvards and futures
Chapter 3
Hedging and synthetics
"hedging" is used very casually from a trading point of view, but from a tax point of view it
should be much narrower.
3.3 Synthetics
3.3.1 Introduction
Modern financial theory permits one category of assets to be replicated by using another
(Warren, 1993:464, Plambeck, et al. 1995: 669). Two such situations are called put-call parity
and dynamic hedging. The concepts will be illustrated for the purpose of identifying the
challenges the tax system faces when taxing these items.
3.3.2 Put-call parity
The principle can be best illustrated by way of the example given by Warren (1993:466). Say
Investor A is the holder of a put option to sell shares during any time during the year for R 130
and he also owns the share at a cost price of R 130. If at the end of the year, the shares are
worth more than R 130, the investor would be the owner of the shares at the higher value. If
not, he would exercise his put option and receive R 130. Investor B purchases a zero coupon
bond for
R 110 to receive R 130 at the end of the year and also buys a call option to acquire shares for
R 130. At the end of the year, he will receive a R 130 from the zero. If share prices are higher, he
would exercise his call and acquire the shares for R 130. If share prices are lower, he would own
R 130. No matter what happens to the value of the stock, put or call, A and B will be in
identical situations at year - end.
The equation which can be derived from the above example is that a share (S) plus a put option
to sell shares at Rx (Px) equals the position of having a zero coupon bond which produces Rx
(Zx) plus a call option to buy shares at Rx (Cx) (Warren, 1993:466):
S + Px Zx + Cx
By applying simple mathematics, the equation can be produced in a different form:
S = Zx +Cx - Px
21
Income Tax implications o/ Options, forwards and fiattres
Chapter 3
Fledging and synthetics
Put in words the equation states that to own a share is equal to owning a zero coupon bond
producing Rx, being a holder of a call option to acquire shares at Rx and writing an option to
buy shares at Rx. The equation is simplified by ignoring transaction costs, credit risk and
assuming it is European options (i.e. it may only be exercised on a specific date). The
relationship may not appear obvious at first, but an example may once again illustrate the
equation. Investor A acquired a share for R 110. Investor B purchased a zero at R 110 producing
R 130 at year end, owns an option to bUy shares at R 130 and has a written option to buy shares
at R 130. If the shares are worth R 140 on exercise date of the options, B would utilise the R 130
from the bond to acquire the shares worth a R 140 at the option strike price of R 130 and thus
be in the same position as A owning the shares. Should the shares only increase to R 120, he
would have to buy the shares at R 130 (under his written option) using the proceeds from his
zero coupon bond, but the shares will only be worth R 120 (as is the case of investor A).
What does this mean? It means that whereas a holder of a share could argue that the profit
derived from the disposal of the share is of a capital nature (for instance where it is a listed
share held for 5 years in terms of Section 9B of the Act) whereas the holder of the synthetic
position (the right hand side of the equation) is taxed on the interest earned on this zero
coupon bond and will most probably be taxed on the profit derived from exercising the call
option. From a timing point of view, the profit on disposal of the share is only taxed on
disposal (if at all taxable), whilst the right hand side of the equation is taxed on the yield to
maturity basis (zero coupon bond - Section 24J of the Act) and on each exercising of an option.
Apart from put-call parity, "dynamic hedging" can also be used to create a "synthetic" position.
3.3.3 Dynamic hedging
Again, the example given by Warren (1993:468) best illustrates the concept. Investor A wants
to buy shares and therefore acquires a call option at R 120. If the market price of the share is
R 200 at strike date, his call is worth R 80. If the share's market value is R 100, his call is
worthless. Investor B has the same intention but instead of acquiring a call option, he intends
to borrow money to acquire shares.
To also be in a net gain position of R 80 when share prices are R 200, he borrows R 73 at 10%,
adds R 23 out of his own pocket and buys shares for R 96 (80% of the current market price of
R 120). If share prices are R 200, his entitlement is R 160 (80% of R 200) and he owes R 80 (R 73
+ R7 interest) under the debt arrangement, putting him in the same position as the holder of a
22
Income Tax Implications ofOptions. Anturds and flaw -es
Chapter 3
Hedging and synthetics
call option. If shares are worth R 100, B's portion is worth R 80 which he uses to pay off his
debt and he is also in a nil position as is the case with the call holder. The amount to be
borrowed and how many shares to acquire can be determined mathematically. The R 23 paid
by B in the example would be equal to the option premium paid by A. The example illustrates
that at any point in time there is a combination of borrowing and shareholding which equals
the outcome of holding an option as long as the minimum share price always covers the debt.
Debt and shareholding are most probably going to be taxed differently to a call option in terms
of timing and character.
Put-Call parity and dynamic hedging are only two of many equations which may be created by
combinations of derivatives. At the Fiscal Association's International Conference on the
Taxation of Derivative Instruments (Plambeck, et al. 1995:669) a number of these equations
were identified. It is not necessary to list them all, as the principle is illustrated by the
examples.
3.3.4 Summary - synthetics
Equivalent investment positions may be taxed differently because the yield to maturity regime
(Section 24J) may apply only to the one side of the equation. The one side of the equation may
be seen as a capital transaction, and the other not. Taxpayers could use this to their advantage
for example: If an investor holds shares, a synthetic negative holding in shares can be created
by issuing a zero coupon bond, writing a call option and buying a put option (Warren 1993:
471) (this is achieved by restating the formula given in par. 3.3.2.). No matter what share prices
do, the investor's net cash flow will be NIL as he has two completely offsetting positions. For
tax purposes, the interest on the zero coupon bond is deductible on a yield to maturity basis
(Section 24J) which will not be set off by gains until the disposition of the stock and the
options.
3.4 Conclusion
The chapter dealt with the definition of hedging, highlighted certain problems with
identifying hedged positions and illustrated how certain classification criteria may address some
of these problems. A summary of the conclusions reached on hedging is on page 20.
23
Income Tax Implications of Options, fonturds andJiattres
Chapter 3
Hedging and synthetics
This was followed by illustrating the concept of "synthetics" and showing that equivalent
investment positions (i.e. with the same net cash flow before tax) may be taxed differently. An
example to illustrate this, was given in paragraph 3.3.4 above.
In the following chapters dealing with the capital/revenue distinction and the accruing of
income from options, forwards and futures it will be noted that the general tax principles are
not adequate to prevent the abovementioned results and that the tax system is challenged to
some how respond to cater for these positions. Some possible responses will be mentioned in
the chapters to follow.
The next chapter is the first of those dealing with the general tax principles, i.e. the distinction
between capital and revenue.
24
CHAPTER FOUR
The character of the profit: Capital or revenue
4.1 Introduction
As discussed in Chapter 2, profit on forwards, futures and options are basically derived by
buying or selling the underlying at a contracted price which differs favourably from the price of
the underlying. In the case of options, the premium paid must be deducted from the profit to
determine the net profit. This chapter investigates the nature of the profit before deducting the
premium and attempts to identify the circumstances under which this profit may be claimed to
be of a capital nature. The Act does not use the word "profit", but refers to "income". In the
case of options, forwards and futures, the "income" referred to in the Act is analogous to
"profit" as defined in this paragraph.
The following questions raised in Chapter 2 are addressed in this chapter:
Can the profit derived from an option, a forward or future contract be claimed to be of a
capital nature.
Can the option premium received by the option writer be regarded to be of a capital nature.
The questions are addressed as follows:
A discussion of the general principles in distinguishing between the revenue or capital
nature of a receipt.
An overview is given of South African case law dealing with the disposal of option contracts
and the exercising of option contracts.
The nature of the option premium received by the writer is debated.
The principles established in the case law dealing with options are applied to futures and
forwards.
25
Income Tax Implications
of Options, forwards andAttires
Chapter 4
The character of the profit: Capital or Revenue
— The capital or revenue nature of profits derived from financial options, futures and forwards
is considered, i.e. where delivery of the underlying asset is not possible.
4.2 General principles
Although there is no comprehensive statutory definition to distinguish between capital and
revenue receipts, the tests laid down by the Courts have become well established. The primary
test to determine the nature of the receipt is the taxpayer's intention in acquiring the asset. If
it was acquired as an investment, to produce income in the form of "fruits", e.g. interest or
dividends, the proceeds on its disposal will be regarded to be of a capital nature. If it was
acquired for resale in a scheme of profit making, the proceeds will be regarded to be of a
revenue nature (Pappenheim, 1991: 177; Lategan, 1993:65; SAICA, 1992:5 ). The analogy of the
"tree" and its "fruits" used to distinguish capital from revenue was used in CIR v Visser (8 SATC
271, 1937 TPD 77). Immediately, one is confronted with a problem in applying this distinction
where options, forwards and futures are at stake. These instruments do not produce "fruits" in
the form of interest or dividends. They can only produce income by reference to the
underlying asset or by selling the instrument itself.
The test to distinguish between capital and revenue was described as follow in Overseas Trust
Corporation v CIR (2 SATC 71, 1926 AD 444):
"Where an asset was realised at a profit as a mere change of investment there was
no difference in character between the amount of enhancement and the balance of
the proceeds. But where the profit was, in the words of an eminent Scotch Judge,
(see Californian Copper Syndicate v Inland Revenue 41, Sc. L.R. p. 694), "a gain
made by an operation of business in carrying out a scheme for profit making" then
it was revenue derived from capital productively employed, and must be income".
The test does not require a specific distinction between the "tree" and the "fruits" but poses the
question whether the taxpayer has entered into a scheme of profitmaking or not. This test has
been applied on a number of occasions to determine the character of an option receipt or
accrual involving "real" assets, i.e. where physical delivery was possible. The cases will now be
discussed.
26
Income Tax Implications of Options. forwards andAttires
Chapter 4
The character of the profit: Capital or Revenue
4.3 Case law in respect of options
4.3.1 Disposal of the option itself
. As early as 1936 the Courts acknowledged the fact that an option can be a capital asset
depending on the intention of the taxpayer. In ITC 369 (9 SATC 310) the taxpayer acquired
half a share of an option to acquire mineralised ground. The right so acquired was later sold to
another person, and the proceeds were regarded to be of a capital nature. The Court ruled that:
"/iJhe appellant was not a dealer in options, and he was not a dealer in shares.
Therefore, he cannot be assessed on the proceeds alleged to have arisen out of such
a sale."
In ITC 640 (15 SATC 229) the taxpayer was a speculative builder who gained by selling an
option to purchase a property at a profit of 4 562 pounds. In view of the short period the
option was held and the fact that a substantial portion of the purchase price of the property
would have to be borrowed on exercising the option, the profit was seen as revenue. This was
the case, even though it was an isolated transaction.
In ITC 798 (20 SATC 219) the taxpayer acquired options with the view to sell them at a profit.
This was realised by selling the options at cost price for a 15% share in a company, and
subsequently selling the 15% share for cash and shares in another company. The Court held
that the cash and shares received were in fact part of the consideration for the options and as
the options were acquired with a profit making motive, the profit was taxable.
Thus, the cases dealing with the buying and selling of options, applied exactly the same
principles valid for the buying and selling of any other property. The dominant intention of
the taxpayer determines whether the option is to be regarded as a capital asset or trading stock
(refer to the investing and speculating uses of options and futures in Chapter 2).
The focus on intention was stated by Wessels JA in his well known dictum in CIR v Stott (3
SATC 253, 1928 AD 252):
"It was unnecessary to go as far as to say that the intention with which an article or
land was bought was conclusive as to whether the proceeds derived from a sale were
taxable or not: It was sufficient to say that intention was an important factor and
27
Income Tax Implications of Options, forwards and Jittures
Chapter 4
The character of the profit: Capital or Revenue
unless some other factor interVened...it was conclusive in determining whether it
was capital or gross income."
The same focus on intention exists where the option holder exercises his option and thereafter
disposes of the acquired asset. However, there have been differences on the stage at when the
taxpayer's intention should be determined (Byala, 1993:102). This issue will be discussed in the
following section.
4.3.2 Profits on exercising the option
In ITC 1208 (36 SATC 80) the taxpayer leased a farming property near Salisbury for 12 months
with the right to renew the lease for a further period of 5 years and an option to purchase the
property. It was always his intention to farm and in pursuing this objective, he carried out
various development schemes and built and equipped his house on the farming property, even
though he would not be reimbursed for improvements by the lessor. His wife suffered from
asthma and her condition was aggravated by the use of insecticides in farming Operations. For
this reason, he sold the property and thereafter exercised the option to purchase resulting in a
profit of $ 8 893. The profit was held to be of a capital nature and the President of the Court
commenting on the fact that the house was sold before the option was exercised said:
"Two further points remain for consideration. It was submitted that because the
appellant sold the property and not the option right and because he had made the
decision to sell the property before he exercised the option it should be held that
he had changed his intention in respect of the right or alternatively that he had
bought the property as stock-in trade. I am unable to accept these submissions. It
seems to me that if the appellant had, in the circumstances described, sold the
option right he would have sold a capital asset. And I do not think that the asset
which he sold can be regarded in a different light. It was essentially the same asset
that he had held for some years. It seems to me, therefore, appropriate to determine
the character of the property that he sold by reference to his intention in respect of
the option right"
In this case the option was held to be a capital asset and the fact that the exercising of the
option and the sale of the subject matter thereof took place shortly after each other, did not
matter.
28
Income Tax Implications of Options, forwards andAttires
Chapter 4
The character of the profit: Capital or Revenue
Similarly in ITC 1312 (42 SATC 188), the character of the profit did not change due to an
option being introduced as the method of realising a capital asset. The taxpayer acquired shares
in a property holding company as an investment and later granted an option to a potential
buyer to acquire the property owned by the company. The option holder exercised the option
resulting in a substantial profit on the sale of the property. The Commissioner's contention
that there was a change of intention due to the option being granted for the sale of the
property, was rejected and the profit was held to be of a capital nature.
Contrary to the above mentioned cases, it was considered (obiter) in 'SAM' v COT (42 SATC 1,
1980(2) SA 75 (ZR)) that exercising an option by the option holder and the subsequent
disposal of the subject matter thereof indicated a change of intention. The facts were that the
taxpayer (A Co) obtained an option to purchase two mining claims from a Mr C, which was to
endure for a period in excess of a year. During the option period the company expended
approximately $100 000 in testing the claims for their economic value. Later, having
difficulties in raising finance to conduct profitable mining operations, A Co and outside
investors created a further company (B Co). The options were subsequently exercised and the
claims sold to the B Co at a profit of $ 160 407 which the Commissioner sought to tax. The
Court confirmed the assessment on the basis that the taxpayer was unable to convince the
Court of his dominant investment motive and that at most he had mixed intentions on
acquiring the mining claims. Counting against the taxpayer was the fact that he had no
practical knowledge of the capital that would be acquired to achieve the alleged purpose of
mining operations and also that he depleted the resources of the company by drawings as
shareholder and save for one instance, made no serious attempt to raise loans. In my view, this
formed the ratio decidendi of the case and its is based on well established principles. It is
however Goldin J's further remarks (obiter) concerning options and the exercise thereof that
have been the subject of much criticism. After saying that in view of the fact that the taxpayer
could not convince the Court of a dominant investment motive and that it was perhaps
unnecessary to comment on the exercising of the option, he said:
"If instead of taking up an option to acquire a capital asset an option is exercised
for the purpose of selling the subject matter thereof, then it can be said that there
had been a change in intention. In other words, the original intention for
obtaining the option was incapable of fulfillment, and the choice before the option
holder can be, as in this case, either to let the options lapse or to take them up for
purposes of selling the assets acquired. In my view, in such a situation, irrespective
of the fact that the option was acquired for the purpose of obtaining a capital asset,
29
Income Tax Implications ofOptions, forwards and
Chapter 4
The character of the profit: Capital or Revenue
when that ceases to be possible and the option is exercised in order to sell the
property thus acquired, the option is then exercised and the property is then
acquired as a scheme of profit making"
The court thus focused on the intention of the taxpayer at the time the option was exercised,
despite reference by Council of the taxpayer to a case in Canada where it was held that the
intention of the taxpayer should be established at the time the options were acquired (also in
line with ITC 1208 discussed above). Considering the intention of the taxpayer at the time the
option is exercised, to my mind, produces different results from the situation where the
transaction is concluded without making use of an option contract. If for example, the taxpayer
acquired the property directly as a capital investment, spent $100 000 on feasibility studies,
could not obtain finance and sold the property as a result of that, the proceeds would probably
have been held to be of a capital nature. The problem with SAM's case was that the form of the
transaction was considered more important than the substance (Emslie, 1988:531). The
substance of the transaction was that the property could not be developed by Co A and had to
be sold to Co B. The fact that the method of realisation of the capital asset took the form of
exercising an option and selling the subject matter thereof should not have affected the
substance of the transaction. One, should however keep in mind that in SAM's case it is
doubtful whether the taxpayer would have been able to prove an investment motive even if his
intentions were considered at the right time, i.e. when he acquired the options.
The first South African decision to regard SAM's case wrong in law was Matla Coal Ltd v CIR (48
SATC 223, 1987 (1) SA 108 (A)) (Byala, 1993:102). Matla Coal had originally acquired various
options and mining rights over certain coal fields. After a number of years and negotiations,
these were eventually sold to Eskom for R 9 365 000 which amount the Commissioner sought
to tax. In deciding that the coal rights were held as capital assets and not as trading stock, the
Court ruled that, in determining the intention with which the coal rights were acquired by
Matla Coal Ltd, regard must be had to the time when the prospecting contracts containing the
options were entered into. Corbett JA said:
"There is no doubt that mining and mineral rights; like any other property, may he
acquired and held by a taxpayer with a view to exploiting the rights themselves as
income producing capital assets."
Further support for this approach can be found in ITC 1427 (50 SATC 25) where the appellant
leased a farm for five years with an option to purchase either the farm or the shares in the
30
Income Tax Implications ofOptions, forwards and futures
Chapter 4
The character of the profit: Capital or Revenue
company who owned the farm at an annually escalating price. After having effected certain
improvements to the farm and commencing farming operations on a small scale, he was
approached by several agents to sell the farm. He finally agreed to sell the shares in the farm for
R 700 000 at a profit of R 491 873 after exercising his option. Following Matta Coal's decision,
Kirk-Cohen J held that the appellant's intention at the time the option was acquired was the
starting point of the inquiry. His finding in the specific case was that the option had been
acquired with the intention of holding the rights thereunder as capital assets and that no
change in intention had occurred since that date. The appellant had merely disposed of his
rights when presented with a highly favourable offer. Again viewing the option contract not as
a separate transaction, but merely as the manner in which the transaction was concluded, KirkCohen expressed himself as follows:
"Die uitoefening van die opsie was slegs die wyse waarop die verkoop beklink is en
is nie 'n afsonderlike of nuwe skema vir winsbejag nie."
This case was clearly a victory for the substance of the transaction over the form (Emslie,
1988:531).
4.3.3 Options acquired in respect of services rendered
Any amount "in cash or otherwise" received by or accrued to a taxpayer in respect of services
rendered falls within the general gross income definition and more specifically due to the
requirements of paragraph (c) of the said definition. Section 8A of the Act regulates the timing
of the inclusion in income by an employee who received options in marketable securities.
The revenue nature of share options granted to employees in respect of services rendered was
confirmed in ITC 691 (16 SATC 505).
Up to now, the position of the holder of the option has been discussed. The position of the
option writer will now be reviewed.
4.3.4 The option writer
If the option is written over a real asset held as a capital asset, the option premium received will
similarly be of a capital nature (Byala, 1994:8). As early as 1935 it was held in ITC 321 (8 SATC
236) that:
31
Income Tax Implications of Options. fonvards and futures
Chapter 4
The character of the profit: Capital or Revenue
"... a receipt of option money for the right to purchase land or mineral rights is a
receipt of a capital nature."
The decision was followed in ITC 962 (24 SATC 651) where a taxpayer wrote an option for the
sale of certain farms owned by him at a stipulated price. The Court held that these proceeds
would normally be of a capital nature, but because the option premium took the form of an
annuity, it fell within the special inclusion par (a) of the gross income definition and was
therefore taxable. In ITC 721 (17 SATC 485) an option premium was received by a property
owner for granting the right to a potential lessee to enter into a lease contract should the
current tenant vacate the property. It was held that the amount was received as a result of
capital productively employed in the taxpayer's business and should be included in gross
income.
A problem frequently experienced by option writers is that they intend to dispose of a capital
asset by granting an option to purchase but they also grant the right of use of the asset during
the option period. Whilst the option premium assumes the character of the capital asset, the
amount received for the right of use of the asset is taxable. In ITC 652 (15-SATC 373) an option
to purchase a gold mine and the right to prospect and sample the mining property was granted
by the taxpayer for a consideration described as "rental" in the agreement. The "rental" paid
was however to be set off against the strike price of the option. The taxpayer argued that the
"rental" received was therefore part of the selling price of the property. Due to a stipulation in
the agreement, that it may not be cancelled other than by exercising the option until at least
3000 pounds was received in the form of rental, the Court held that the agreement was a lease
with an option to buy and not a sale contract subject to a suspensive condition regarding the
passing of ownership.
Similar circumstances prevailed in COT v Rezende Gold and Silver Mines (Pvt) Ltd (37 SATC 39,
1995(1) SA 968 (RAD)). The "rental" received during the option period was regarded as taxable,
even though it was deducted from selling price of the property, on the basis that the character
of the receipts should be determined when received and does not subsequently change when
otherwise applied.
However in two other cases, namely ITC 321(8 SATC 236) already mentioned and in SIR v
Struben Minerals (28 SATC 248, 1966 (4) SA 582 (A) ) the option premium as well as the
32
Income Tax Implications of Options, forwards and
Chapter 4
The character of the profit: Capital or Revenue
amount received for the right to prospect for minerals were regarded to be of a capital nature.
Quoting from the Struben Minerals case:
"In Income Tax Case No. 321, 8 SATC 236, the Special Court, in construing an
agreement which provided for a right to prospect and an option to purchase
mineral rights, found that the sums sought to be taxed constituted 'one conjoint
and indivisible consideration for all the benefits given by the agreement; and that
inasmuch as that consideration was received in respect both of the prospecting
rights and the option to purchase the mineral rights, it was a receipt of a capital
nature The right to prospect and the right to buy are complementary, and the
one is as indispensable as the other in the normal contract of sale of mineral rights.
In order therefore to sell the mineral rights attaching to 'The Willows' the
respondent had to grant the mining company an option to purchase those rights,
and in order to make it possible for the option to be exercised it had to grant the
right to prospect for the minerals. The payment for the latter right is a normal
incident of the contract of sale."
Thus, in the one case, the granting of the right of use of the property was an absolute necessity
to enable the sale of the capital asset, whereas in another it was merely a rental. Furthermore,
the wording of the contracts played a decisive role in determining the nature of the income.
It has now been established that option premiums received in respect of capital assets are of a
capital nature. However, the question arises whether the option premium could form part of
the recoupment of allowances claimed in respect of the asset in terms of Section 8(4)(a), where
the option is in fact exercised and it leads to the disposal of the underlying capital asset. My
view is that the premium was received for the granting of a right and not in respect of the
disposal of the capital asset. The recoupment would therefore be limited to the difference
between the strike price of the option (limited to the original cost price of the asset) and the
tax value of the asset. An exception will be where the option strike price is reduced by the
option premium paid, in which case the right was in reality granted for no consideration by the
option writer and the "premium" was meant to form part of the disposal price of the asset.
The option writer can also write an option to acquire a capital asset. It is submitted that the
character of the option premium will not change depending on whether the intention of
writing the option is to buy or sell a capital asset. The fact that it is a capital asset, should make
33
Income Tax Implications crlOptions, forwards andfittures
Chapter 4
The character of the profit: Capital or Revenue
the option premium of a capital nature. Following the same reasoning as in the disposal of
capital assets, the premium received should not form part of the acquisition cost of the asset.
Where financial options are cash settled, the intention of the option writer would be to "take
the money and run" (Byala, 1994:44), i.e. to bank the premium as income. If the option is
written on trading stock, the same intention is present. In these cases the option premium is of
a revenue nature and the only question left to ask is when will it be taxable. The issue of
timing is discussed in Chapter 5.
4.4 Futures and forwards
Parties entering into futures or forward transactions where the underlying is a deliverable, incur
a profit or loss on early close out or at maturity of the contract. The character of the profit can
be established in much the same way as the Courts determined that of profit made on
exercising option contracts discussed in par 4.3 above. If the intention of entering into a
scheme of profit making can be ascertained after consideration of all the objective factors, the
profit will be of a revenue nature. Court cases dealing with forwards are mentioned in the
following paragraph.
4.5 Financial options, futures and forwards
The next step is to apply the principles to financial derivatives. It is submitted that it is more
difficult to motivate a capital intention for a financial derivative. The most significant hurdle is
the absence of the element of physical delivery (ability to acquire the underlying asset) from
the formal options traded on the TOM or the futures traded on SAFEX. Where over the counter
instruments provide for delivery, the real asset precedents become directly relevant (Byala,
1993:103).
In cases where a real asset is the underlying, the Courts have viewed the option as part of a
bigger transaction in distinguishing between capital and revenue. With financial options or
other financial derivatives with non-deliverables as underlyings, the derivative transaction must
be seen as a transaction in its own right.
Due to their very nature, financial options, futures and forwards are short term. In South Africa
the longest term for these instruments is generally 9 months, although instruments for longer
terms are available. This necessitates a continuing roll-over of option positions to hedge long
34
Income Tax Implications of Options. forwards and Attires
Chapter 4
The character of the profit: Capital or Revenue
term portfolios or to create a long term investment in these derivatives. This as well as the fact
that gains/losses on exchange traded instruments are actively settled on a daily basis, makes it
more difficult to argue that these instruments are of a capital nature (Lategan, 1993:65;
Pappenheim, 1991:183; SAICA, 1992:5). Taxation ruling IT 2228 (1985: par 32) issued by the
Australian Taxation Office on exchange traded futures states that : ".. it is unlikely that a
person who enters into futures contracts will claim that the contract represents an investment
as shares might do." However, it was said in Chapter 2 and illustrated in Chapter 3, that a
person may synthetically invest in the derivative market instead of the physical market due to
cheaper transaction cost, lower cash outflow etc. A taxpayer should therefore be able to prove
that he had an investment motive in say shares or bonds, but that he decided to invest in this
asset by holding a combination of positions which is equivalent to the holding of a share or
bond investment (refer Chapter 3 - synthetics). Currently, I think it would be very difficult for
a taxpayer to prove this as the tax system does not recognise "portfolio" effects of holding
derivatives in conjunction with other positions. This was also the conclusion reached by
Plambeck et al. (1995:668) in their summary of the taxation of derivative instruments
internationally. The answer to this problem is not evident. To require taxpayers to disclose
integrated positions would be administratively onerous on them and on Inland Revenue to
enforce. Furthermore, the equivalencies are not always as precise as those illustrated in Chapter
3. Internationally, tax systems have already identified certain integrated positions such as
"straddles" (refer Chapter 3) to be netted for tax purposes (e.g. USA/UK) (Warren, 1993:474).
An argument much more likely to succeed than synthetic investment for claiming that a gain
on a financial derivative is of a capital nature, is the one frequently used that when a capital
asset is being hedged, the profit derived from the derivative should also be of a capital nature.
(Hedging and the problems of identifying hedges were discussed in Chapter 3.) What is the
hedger's intention when entering into a hedging transaction. A hedger does not protect his
upside, only his downside. He therefore enters into the transaction with the purpose of
realising a profit equal to or greater than the expected loss arising from the position being
hedged. Judged in isolation, this appears to be nothing short of a scheme of profit making
(Lategan, 1993:65; SAICA, 1992:28; Bullard, 1990:36).
However, South African courts have in some instances deviated from the approach of "profit
making scheme" when determining the character of income (SAICA, 1992:28). In South
African Marine Corporation v CIR (20 SATC 15, 1955(1) SA 654(C)) the issue was the normal
tax position of foreign exchange profits on revenue transactions (before the introduction of
Section 241). In finding for the Commissioner, it was held that:
35
Income Tax hnplications of Options, fonvards andftaures
Chapter 4
The character of the profit: Capital or Revenue
"[The conversion... is not merely part of the appellant's trading structure but is an
integral part of the appellant's business operations in carrying out a scheme of
profit making: in my judgment such transmissions of money to and from America
.constitute transactions on revenue account, and exchange profits or losses (as also
hank charges) attendant upon such transmissions have a revenue character" (own
emphasis).
In Plate Glass and Shatterproof Industries (Finance Company) Ltd v SIR (41 SATC 103, 1979(3)
SA 1124 (T)) it was confirmed that foreign exchange differences would be taxable or deductible
depending on whether the underlying loan was held as fixed or floating capital. While
derivatives and foreign exchange differences differ materially, the ratios of these cases make it
clear that gains associated with revenue transactions will themselves be of a revenue nature and
the same principle applies to capital transactions. In a case (ITC 1498, 53 SATC 260) dealing
with forward exchange contracts ( thus a derivative), the contract was taken out by the
taxpayer to protect the company from adverse exchange rate movements on the purchase of a
new printing press. Because of the declining exchange rate of the rand against the dollar, the
settlement of the forward exchange contract resulted in a net cash inflow of R 957 634. The
taxpayer used the printing press as a capital asset. Jennett J held this receipt to be of a capital
nature:
"It can be accepted that in acquiring the Harris Off-Set Press the appellant acquired
a capital asset - New State Areas Ltd v Commissioner for Inland Revenue 1946 AD
610 at 62113J- and the loan or money spent in acquiring the printing press must be
capital expenditure. Having regard for our acceptance of Mr Beaumont's evidence,
we are not dealing with PI taxpayer trafficking in exchange and there is no reason
why the foreign exchange contracts which relate to the repayment of the loan for
the purpose of acquiring the printing press should not assume the character of their
orioinating cause, namely, the capital expenditure, cf Commissioner for Inland
Revenue v Brown Bros Ltd 1955 (2) SA 165 (T)fifown emphasis).
The issue in Tuck v CIR (50 SATC 98, 1987(2) SA 219(T)) was to determine the quid pro quo of
the receipt to determine the character of the income. A single originating cause could not be
established in this case, and therefore apportionment took place. Once more this is proof of
the originating cause test.
36
Income Tax Implications of Options, forwards andAttires
Chapter 4
The character of the profit: Capital or Revenue
The Courts have focused on the nature of the asset/transaction which ultimately led to the
contract being entered into to establish the nature of the profit or loss, and not the intention
in relation to the contract (SAICA, 1992:28). The derivative was not perceived in complete
isolation, but the courts looked towards the underlying transaction to determine its nature.
When looking at the originating cause in assessing the nature of a gain or loss, intention in the
equation is replaced by motive (SAICA, 1992:29; Lategan, 1993:66). Applying this principle,
where the investor's motive is purely to cover or limit an exposure or to bridge a situation on
hand ( in other words a hedge is entered into), the gain made on the option, forward or future
should be of a capital nature if the position hedged is of a capital nature. (Badenhorst, 1990:23;
Pappenheim, 1991:185; Bullard & Lawlor,1993:25).
4.6 Conclusion
The taxpayer can profit by selling or exercising an option contract. In this chapter, both
scenario's were considered by distinguishing between the position of the option writer and
option holder. The scenario's were further distinguished between cases where physical delivery
is possible and cases where transactions are merely cash settled (financial options).
I have summarised the major conclusions reached in this chapter in figure 4.1 on the next
page. The decision tree shows that where the underlying can be physically delivered ("real"
assets) the Courts have laid down the rule as determining the intention of the taxpayer on the
date the option was acquired. In the case of financial options, in my opinion, the only capital
argument that the taxpayer could offer is that of synthetic investment. If one looks at the
originating cause of the profit to determine its nature, hedging capital assets will result in a
profit of a capital nature.
As far as futures and forwards are concerned, the same principles applies. Futures and forwards
may be used to hedge capital positions in which case the profit resulting from these
instruments may be said to be of a capital nature. Where real assets form the underlying of the
future or forward, the intention of the taxpayer plays a decisive role in determining the
character of the revenue. In the next chapter, the timing of the income on revenue account is
discussed.
37
Income Tax Implications of Options,.fi)nvards and/Mures
Chapter 4
The character of the profit: Capital or Revenue
Figure 4.1
Capital/Revenue distinction option contracts
Options
"Real" Assets
Option Holder
Intention at the
time the option
was acquired
determines the
nature of gain on
exercising the
option.
Financial Options
Option Writer
Write
over
capital
itemcapital
Write
over
trading
stockIncome
Option Writer
Option Holder
Intention
Originating
cause
"Investment"Capital
Hedging criteria
are met
38
Hedge
Revenue
Hedge
Capital
Income
Capital
Revenue
CHAFFER FIVE
TIMING OF PROFITS ON REI/ENUE ACCOUNT
5.1 Introduction
Once it has been established that the profit derived from the option, forward or future is of a
revenue nature, the next question is when does it become taxable. This chapter investigates the
timing of income on revenue account applying the general tax principles. Different timing
rules are suggested in Section 241 of the Act and the Consultative document on financial
arrangements (1994:21 e.v.) which will be discussed later.
The following issues identified in Chapter 2 form the subject of this chapter:
The timing of the profit made by the holder of an option contract on exercising or selling
the option, i.e.
At what stage does the profit accrue to the holder. On entering into the option contract,
or on exercising the option contract.
Where the underlying has been acquired in terms of a call option, the further question
arises as to whether there is an accrual on exercising the option or only when the
underlying is eventually sold.
When is the option premium taxable in the hands of the option writer.
When does the income accrue to the profit maker under a forward or futures contract.
5.2 General principles
General tax principles require income to be taxed when "received by or accrued to" in terms of
the definition of gross income. An amount is "received by" a taxpayer if it is received by him
on his own behalf for his own benefit (Geldenhuys v CIR ,14 SATC 419, 1947(3) SA 256 (C)).
Over the years the meaning of "accrued to" has been fine tuned by the Courts to mean
"become unconditionally entitled to" (CIR v People's Stores (Walvis Bay) (Pty) Ltd, 52 SATC 9,
39
Income Tax Implications of Options, Forwards and Futures
Chapter
Timing of profits on revenue account
1990(2) SA 353(A)). It is important to note that the entitlement to the income must be
unconditional before an accrual can take place. In the People Stores case there is no reference to
an "unconditional right", but the facts imply it. Further support for this statement can be
found in Hersov 's Estate v CIR (21 SATC 106, 1957(1) SA 471 (A)) where the judge, after
quoting a passage from Lategan v CIR (2 SATC 16, 1926 CPD 203) where it was stated that
"accrued" merely meant "become entitled to", said:
"I may also point out that in La tegan's case the accrual that was there held to have
taken place was not subject to any condition. In the present case the accrual was
subject to the condition that Hersov's death took place before the winding-up of
the company. Until Hersov's death it was not certain whether anything would
accrue to anybody under clause 2(c), for if before his death the company had been
wound up that clause would not have come into operation."
The general principles will now be applied to options, forwards and futures.
5.3 Options
5.3.1 The option holder
The first issue is whether there is an accrual on the date the option is acquired by the option
holder.
In an English case Abbott v Philbin (Inspector of Taxes) [1960] (2 All ER 763 (HL)) an option
was granted to an employee to acquire shares in his employer company for services rendered. It
was held to be taxable in the year the option was granted, as it was immediately exercisable. In
Mooi v SIR (34 SATC 1, 1972(1) SA 675 (A)) certain conditions had to be met before the
taxpayer had the right to exercise an option to acquire shares at a fixed price in his employer
company for services rendered. The case was decided before the introduction of par (i) of the
gross income definition and Section 8A to the Act. The Court acknowledged that on the date
the option was granted, there could have been an accrual (as in Abbott's case) had the option
been immediately exercisable. However, due to the heavy conditions that had to be met before
the option could be exercised, "the right acquired by [the] appellant .... lacked any inherent
attribute of income". Once these conditions were met and the option became exercisable, the
Court held that the difference between the market value on that date and the price payable by
40
Income Tax Implications of Options. For yards and Futures
Chapter 5
Timing of profits on revenue account
the employee had accrued to him, although he had not exercised the option on that date and
he had another three years in which to do so. If the market value of the shares dropped below
the strike price of the option, before he exercised the option, the taxpayer would not have
gained any benefit.
Based on the cited cases, the question arises whether there is an accrual on the date any option
is acquired provided that it is exercisable. In my view, the distinguishing factor in the above
mentioned cases is that they dealt with services rendered. Once a taxpayer becomes entitled to
a right in respect of services rendered, a money value must be assigned to that right to
determine the amount to be included in gross income. The assigning of a monetary value to
the benefit was central for many years to schemes of "fringe benefit" remuneration in which
the non convertibility of the benefit to cash - or sometimes the difficulty of its conversion - led
to the conclusion that the benefit could not be taxed (Clegg, 1991:8). This led to the
introduction of the Seventh Schedule to the Act.
The fact that a trader has purchased an in the money option, does not imply that something
has accrued to him, before the option is exercised. The underlying's price could still move in
any direction, which could mean that no profit does in fact accrue to the option holder. This is
confirmed by Byala (1993:106) when he says:
"It should be noted that unrealised gains will not attract normal tax, since there is
no receipt or accrual in terms of the 'gross income' definition: the taxpayer has no
unconditional right to the unrealised gain, because a further fluctuation in
financial prices may result in an eroding of all profits."
The option trader's situation can be compared with an ordinary purchaser of stock. There can
be no accrual until the stock is sold. Where services are rendered, the holder of a potential
profitable right granted to him for such services can be compared to an ordinary employee
receiving a salary cheque at the end of the month. The right accrues to him at the same time a
salary cheque would have accrued to him. (Note that subsequent to these cases Section 8A of
the Act has been introduced which fixes the time of accrual of options in marketable securities
in respect of services rendered on the date the options are exercised.)
The next question is whether there is an accrual once the option has been exercised. Where
options are cash settled, this is clearly the case. The same goes for put options where the
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Income Tax Implications of Options, Forwards and Futures
Chapter 5
Timing of profits on revenue account
underlying is sold and money is received in lieu thereof. The only question remaining is call
options where the holder acquires the underlying and physical delivery takes place. There are
conflicting views on this issue. As far as the option trader is concerned Byala (1993:102) says
that "the taxpayer's intention was to speculate in options and he cannot defer a taxable accrual
by simply changing the form of the contract. At the expiry date of the option contract, he has
experienced a gain, and it is irrelevant whether he chooses to take this gain in the form of cash
or by the purchase of a security at below market value." He quotes Lace Proprietary Mines Ltd v
CIR (9 SATC 349, 1938 AD 267) as authority for saying that receipts or accruals may be in forms
other than cash. Pappenheim (1991:189 ) also dealing with the tax implications of option
dealers holds the opposing view that "until the underlying instrument is subsequently disposed
of there would appear to be no receipt or accrual." The South African Institute of Chartered
Accountants agree with the latter view in a sub-committee's report on the taxation treatment
of futures and options (1992:11 ) . An argument supporting the former view is that the option
contract as a separate transaction came to an end after it had been exercised. However, the
South African courts have in all the cases cited viewed the option contract as part of a bigger
transaction and not entirely in isolation (refer to the cases discussed in Chapter 4). In the case
of the call option where the underlying is acquired, even though the option transaction has
come to an end, the total benefit derived from the transaction is still conditional. Its final
outcome is dependent on whether the acquired underlying can be sold at a price higher than
the strike price. Then in my view, based on the Hersov and Mooi court cases, there can be no
accrual until subsequent disposal of the underlying.
5.3.2 The Option Writer
The option writer physically receives the option premium on the transaction date. The
question is thus not one of accrual, but rather whether it has been received for tax purposes.
The meaning of "received by" has been debated in the Courts. In Geldenhuys v CIR (supra) it
was held that it meant "received by the taxpayer on his own behalf or for his own benefit". CIR
v Genn & Co (Pty) Ltd (20 SATC 113, 1955(3) SA 293(A)) confirmed this in stating that " it
certainly is not every obtaining of physical control over money or money's worth that
constitutes a receipt". These cases refer to the situation where money is received as an agent or
in trust for someone else. That is certainly not the case with option premiums.
In the case of an option premium there is always a contingent liability that could be incurred
when the option is exercised by the holder. The question is whether such a liability could have
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Income Tax Implications of Options. Forwards and Futures
Chapter 5
Timing of profits on revenue account
the effect of deferring the receipt until the option has expired or has been exercised. Pyott Ltd
v CIR (13 SATC 121, 1945 AD 128), Brookes Lemos Ltd v CIR (14 SATC 295, 1947(2) SA 976(A))
and Greases (SA) Ltd v CIR (17 SATC 358, 1951(3) SA 518 (A)) dealt with the situation where
money was received against which the companies had an obligation to repay the money if the
containers were returned by the customer. In all three cases it was held that the money was
received as intended by the gross income definition. The following passage from the Brookes
Lemos case summarises the findings:
"The appellant was not a trustee holding the deposits on account of the. customers
as security for the return of the bottles. There was no obligation to return the
container resting on the customer and the deposit was not a security in the nature
of a pledge given to secure performance of such an obligation: - ,Consequently the
seller was in no sense a trustee or pledgee. On the contrary the deposits became the
absolute property of the Company and they could use them as they pleased,. and
the fact that they had undertaken an obligation to pay to such of their customers as
returned containers an amount equivalent to the amounts which they had paid as
deposits on similar containers did not constitute the Company a trustee with regard
to those deposits".
In ITC 1346 (44 SATC 31) a lecturer received a salary while on sabbatical, subject to the proviso
that it would have to be repaid if he did not resume his post. He subsequently resigned his
position and repaid the amount received. The Court held that the contingent liability to repay
the salary was irrelevant in determining whether the salary was a gross income receipt.
The position of an option writer is very similar to that of the taxpayers involved in the cases
cited above. He takes physical control of the money, uses the money as he pleases, but has an
obligation to buy or sell the underlying at a loss if the holder exercises the option. Therefore an
option premium received will always constitute gross income (except where it is of a capital
nature). The only question remaining is whether the taxpayer can obtain relief by claiming a
Section 24C allowance for losses to be incurred in future. This issue will be discussed in the
next chapter in which the deductions available to the option holder and writer are considered.
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Income Tax Nolications (dOptions, Forwards and Futures
Chapter 5
Timing of profits on revenue account
5.4 Forward contracts
Forward contracts do not call for any payments to be made before expiry of the contract. The
contract can only be closed out by arrangement with the counterparty. Until time of close out
or maturity of the contract, there appears to be no receipt or accrual for the holder or issuer of
the forward contract (Coetsee, 1995:12, Byala, 1994: 50). As forwards are privately negotiated,
one should however examine the contract to determine whether it makes provision for daily
accrual of profits and losses.
Per definition of forwards in Chapter 2, the contract price of a forward is calculated by the
current price of the underlying plus the cost of carrying the underlying to maturity. This
implicit periodic compounding of carrying costs is not recognised earlier for tax purposes. In
fact, most tax systems internationally defer this cost to the point where the contract matures
(Plambeck, et al. 1995:678). However, by adopting Section 241 of the Act South Africa has
introduced the concept of a "premium" on a forward exchange contract, which recognises the
carrying cost of a forward contract over the term of the contract. This will be investigated in
Chapter 7.
A situation may arise where the maturity date of a forward contract is extended into another
accounting period. The question is whether the accrual took place in the old or the new
accounting period. By extending the maturity date of the contract, the eventual profit or loss
on the contract is still unknown on the date of modification and at the end of the tax year. In
terms of the meaning of "accrual" there can be no accrual in the old accounting period, except
if the terms of the modification guarantees the profit in terms of the original agreement, and
merely defers the payment date. In some countries such as Japan, Norway, France, Sweden and
Switzerland modification creates a realisation event to prevent deferral of profits for tax
purposes (Plambeck, et al. 1995: 679). The theory is that the original position was concluded
and a new position established.
A forward contract may also be closed out by entering into an equal but opposite forward
contract before the original contract matures. In my view, general tax principles do not cater
for the crystallisation of a profit (or a loss) in this way, as the two contracts are viewed
separately. The accrual will only take place on maturity of each contract.
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Income Tax Implications olOptions, Forwards and Futures
Chapter 5
Timing of profits on revenue account
5.5 Futures
Due to the mark to market system of futures on SAFEX, gains made by the taxpayer will be
credited daily to his margin account: He may withdraw the money and spend it. In view of the
cases discussed in par. 5.3.2, the money has been unconditionally received by the taxpayer and
should be included in his gross income. The profits so taxed in year one, may be completely
wiped out by subsequent losses in year two. The taxpayer would have to claim the losses in the
year they were incurred. For this reason, countries such as Belgium, Switzerland and the United
States do not treat exchange rules as realisation events (i.e. the final profit is taxed and not the
daily up or down movement resulting from the mark to market mechanism) and forwards and
futures contracts are taxed in the same manner (Plambeck,
et al., 1995:679)
Interest received by the taxpayer on his margins will be taxable as and when it is credited him.
Prior to the 1996 amendments, the interest did not accrue on a day to day basis in terms of
Section 24J of the Act as the margins fell beyond the definition of an "income instrument". In
terms of an amendment to Section 24J effective from the date of promulgation of the 1996
Income Tax Amendment Act (3 July 1996), interests accrues on a day to day basis in respect of
all "instruments" as defined if the taxpayer is a
company. An instrument is defined as "any
form of interest-bearing arrangement" and includes "any deposit with a bank or other financial
institution." The margins deposited by the corporate taxpayer would thus fall within this
definition and interest thereon accrues on a day to day basis.
5.6 Anti avoidance
It was shown in par. 5.4 how profits can be deferred to tax purposes by extending the maturity
date of the contract or to enter into equal and opposite contracts (i.e. the old position is not
cancelled, it is merely off set by another position). In Chapter 3 in the discussion of hedging,
tax deferral by using "straddles" was identified. Deferral of income can also take place by
"synthetics" as illustrated in Chapter 3. It is clear from the discussion of general tax principles,
that these principles are not sufficient to prevent such avoidance. One solution to the problem
may be the identification of off-setting positions so that a gain be taxed once it has been fixed
by the taking of an off-setting position. As mentioned with the capital/revenue distinction,
identification of such positions may be problematic. Another solution would be to require
mark to market revaluation of all positions. Using this mechanism it would not be possible to
defer unrealised gains. Many countries have followed this principle, as it is also normally used
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Income Tax Implications of Options. Forwards and Futures
Chapter 5
Timing of profits on revenue account
for accounting purposes. It will be seen in future chapters that South Africa is also moving in
that direction by the introduction of Section 241 to the Act and the proposals of the
Consultative document on financial arrangements (1994: 1 e.v.). Some other solutions are
suggested by Warren (1993:476-483), inter alia, the charging of a higher than normal tax on
realisation of the profit to compensate for the fact that tax was not paid throughout the life of
the instrument during which the profit was built up. The higher tax percentage is calculated
mathematically and assumes constant accrual of the profit, which is obviously not always true.
However, the mark to market approach seems to be the most practical solution, as it is used for
accounting purposes in most instances.
5.7 Conclusion
This chapter discussed the question of when the profit made from an option, forward or future
contract becomes taxable. Firstly, the general principles were discussed. The general principles
were then applied to the option holder and there after to the option writer. The timing of the
profits on revenue account for fowards and futures was discussed next by applying the general
tax principles. Finally, certain problems with the general tax principles were discussed that
may lead to tax avoidance.
To summarise, the various conclusions reached in this chapter concerning the accrual of profits
on revenue account are the following:
Paragraph (i) of the gross income definition and Section 8A of the Act is now regulates the
accrual of options granted for services rendered.
Profits accrue to option holders on exercising the option, the only possible exception being
to exercise a call option in the event of physical delivery , in which case there appears to be
no accrual until disposal of the underlying.
Option premiums received falls into gross income when received unless of a capital nature.
In the case of forwards there is apparently no accrual until maturity of the instrument.
However, in my view legislation should cater for the position where the maturity dates of
the forwards are amended or a position is closed out by an equal but opposite forward
contract. In terms of general tax principles the positions are judged in isolation and there
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Income Tax Implications of Options. Forwards and Futures
Chapter 5
Timing of profits on revenue account
may be no accrual in such cases, although the substance of the events is a close out of the
transaction and therefore it should be deemed to be a realisation of the transaction.
As futures are settled on a daily basis, any income so received will fall within gross income.
Interest on margin accounts accrues on a yield to maturity basis in terms of Section 24J of
the Act as from 3 July 1996 as far as corporate taxpayers are concerned. Individuals pay tax
on the interest as and when credited to their margin accounts, which will most probably
also be on a day to day basis.
Timing rules in terms of general tax principles do not cater for hedging transactions.
Therefore, timing mismatches may occur as the hedged position and the hedging
instrument could be taxed in different periods.
The manipulation of profits which is possible under the general principles governing the
accrual of income, lead to the proposals in the Consultative document on financial
arrangements (1994: 1 e.v.) requiring an accrual or mark to market system. The. proposals are
discussed in Chapter 8. Furthermore, Section 241 of the Act requires mark to market
calculations of foreign exchange forwards and option contracts in certain instances (see
Chapter 7). In my opinion the mark to market procedure closely reflects the economic
reality of the transaction and prevents manipulation of profits and losses except to the
extent that the method of calculating the market value can be manipulated. It may lead to
tax on unrealised profits in certain instances, but it could also lead to unrealised losses being
deductible.
In the final chapter where the general tax principles are discussed, tax deductions available in
respect of options, futures and forwards will be considered.
47
CHAPTER SIX
TAX DEDUC 1 IONS
6.1 Introduction
The previous chapters were concerned with the taxability of profits derived from option,
forward and futures activities by discussing the requirements of the gross income definition.
Finally, the tax deductions available in respect of the option, forward and future need to be
considered in terms of the general tax principles.
Turning to the questions raised in Chapter 2, the following are addressed in this chapter:
Is the loss incurred on maturity of a forward or future contract tax deductible and when is it
deductible.
In the case of a futures contract , are the margins paid tax deductible.
Is the option premium paid tax deductible, if so when can it be deducted and must the
Option holder account for it as trading stock, if not exercised or sold before year - end.
Are the payments made or losses incurred by the option writer when the option is exercised
tax deductible.
Is there any tax relief for option writers for contingent future losses on unexercised options.
6.2 General principles
In the absence of specific legislation (other than the legislation dealt with in Chapter 7),
taxpayers must seek to deduct losses, margins and premiums in terms of the so called "general
deduction formula." The provisions this formula are contained in Section 11(a) read with
Section 23 of the Act.
Section 11 (a) allows "for the purpose of determining the taxable income derived by any person
from carrying on any trade within the Republic" a deduction in respect of "expenditure and
losses actually incurred in the Republic in the production of the income, provided such
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Income Tax Implications of Options, Forwards and Future's
Chapter 6
Tax deductions
expenditure and losses are not of a capital nature". For purposes of the discussion it is assumed
that the taxpayer carries on a trade within the Republic.
The most important proviso's of Section 23 is contained in Subsection (g) disallowing moneys
expended "to the extent to which such moneys were not laid out or expended for the purposes
of trade" and Subsection (1) disallowing expenditure if it is incurred in respect of "amounts
received or accrued which do not constitute income as defined in section one".
These proviso's are applied to options, futures and forwards as follows:
6.3 The option holder
The only cost incurred from the option holder's point of view, is the premium paid when
entering into the option contract and other transaction costs. As the option holder would not
in practice exercise his option if it would result in a loss, the deductibility of losses is not
considered here. He may furthermore borrow money to finance the payment of option
premiums, in which case the deductibility of the interest incurred should be considered.
63.1 The option premium
Section 11(a) requires an expense to be actually incurred, in the production of income and not
of a capital nature. These three requirements will now be discussed in turn.
Firstly the option premium must be actually incurred. It is not a deposit or loan , but it is an
expense actually paid and therefore actually incurred (Pappenheim, 1991: 188).
Secondly, the premium must be incurred in the production of income. As far as the production
of income test is concerned, Watermeyer AJP established the test in Port Elizabeth Electric
Tramway Co Ltd v CIR (8 SATC 13, 1936 CPD 241) as follows:
"Now, as pointed out above, income is produced by the performance of a series of
acts, and attendant upon them are expenses. Such expenses are deductible
expenses, provided they are so closely linked to such acts as to be regarded as part of
the cost of performing them The purpose of the act entailing expenditure must
49
Income Tax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
be looked to. If it is performed for the purpose of earning income, then the
expenditure attendant upon it is deductible."
It has already been established in earlier chapters that options may be entered into with the
intention of speculating, investing ("real" assets) or hedging and that either capital or revenue
items may be hedged. In speculating or hedging revenue items, the intention of the option
holder is clearly to produce income which is taxable and therefore should easily pass the
production of income test. There is a direct link between the expenditure and the income.
In hedging a capital asset, the profit derived from the option would be of a capital nature. The
direct link is thus between the expense and non taxable income and therefore at first glance,
the premium does not appear to produce income as defined. The Courts have however not
always required such a direct link, but rather a link between the expenditure and the income
earning trade in general. A further quotation from the PE Tramway case reads:
"It follows that provided the act is bona fide done for the purpose of carrying on the
trade which earns the income the expenditure attendant on it is deductible." (Own
emphasis)
Watermeyer CJ expanded on this in Joffe & Co v CIR (13 SATC 354, 1946 AD 157):
'All expenditure, therefore, necessarily attached to the performance of the operations
which constitute the carrying on of the income-earning trade, would be deductible and
also all expenditure, which, though not attached to the trading operations of necessity,
is yet bona fide incurred for the purpose of carrying them on, provided such payments
are wholly and exclusively made for that purpose and are not expenditure of a capital
nature." (Own emphasis)
It is submitted that an option premium paid to hedge the value of a capital asset (much like an
insurance premium) is a bona fide expense incurred in carrying on the income earning trade.
The link between the expense and the income earning trade is sufficient to pass the test cited
above (Byala 1993:142).
The only other question to consider is the situation where the option does not in fact produce
any income. It was ruled in Sub-Nigel Ltd v CIR (15 SATC 380, 1948(4) SA 580(A) ) that the
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Income Tax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
purpose of the action entailing expenditure must be looked at. If it is performed for the
purpose of earning income (whether or not that income is actually earned), the expenditure
attendant upon it will be deductible.
Finally, if the option premium is of a capital nature, it will not be deductible. The test to
determine whether an expense is of a capital nature was formulated in New State Areas v CIR
(14 SATC 155, 1946 AD 610) after considering a number of other cases:
"The conclusion to be drawn from all of these cases seems to be that the true
nature of each transaction must be enquired into in order to determine whether
the expenditure attached to it is capital or revenue expenditure. Its true nature is a
matter of fact and the purpose of the expenditure is an important factor; if it is
incurred for the purpose of acquiring a capital asset for the business it is capital
expenditure even if it is paid in annual instalments; if; on the other hand it is in
truth no more than part of the cost incidental to the performance of the income
producing operations, as distinguished from the equipment of the income
producing machine, then it is a revenue expenditure even if it is paid in a lump
sum."
As part of his income earning operations an option trader and hedger of revenue items, enters
into option contracts. The premium paid should therefore not be of a capital nature.
Taxpayers paying option premiums to hedge the value of existing capital assets do so to protect
their income earning structure, but it is not expended in creating, acquiring or enhancing an
income earning structure (Byala, 1993: 143). The words used by the Courts to describe capital
expenditure are "acquire" or "create" as opposed to "protect". The Court gave an indication of
the nature of insurance premiums paid to. insure capital assets (much the same as option
premiums paid to protect the value of capital assets), but gave no final decision on the matter
in the Sub - Nigel case mentioned earlier when Centlivres JA said:
"..moneys spent by way of premiums to insure capital assets against fire may
constitute expenditure of a non-capital nature, although the proceeds of any such
fire policy would be receipts of a capital nature. This seems to be the view held in
England. See Usher's Wiltshire Brewery, Ltd. v Bruce (1914 (1) K.B. 357 at p. 367•
1915, A.C. 453 at pp. 457, 465, 471, 474). On this point I express no opinion."
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Income Tax Implications of Options. Fortturds and Futures
Chapter 6
Tax deductions
The fact that the profit generated from the option used to hedge an existing capital asset is of a
capital nature, should not prevent the deduction of the premium, as expenses are deductible in
terms of the "general deduction" provisions which are totally independent from the gross
income definition determining the taxability of income. In practice, insurance premiums to
insure capital assets are allowed as deductions from income by Inland Revenue.
In conclusion I hold the view when options are utilised as an instrument to hedge the value of
existing capital assets, the premium paid should still be deductible as it is more closely linked to
the income earning operations than to the income earning structure of the taxpayer.
However, options may also be used by taxpayers to acquire capital assets. As previously said,
hedging may also take the form of fixing the future acquisition price of assets. If the future
transaction being hedged is the acquisition of a capital asset, the premium paid may be
regarded to be incurred in creating or acquiring an income producing structure. The option
premium can be so closely linked to the purchase of a capital asset, that it assumes the capital
character of the asset. The option is viewed as part of a whole transaction and not in isolation.
On viewing the option in isolation, one could argue that the option itself does not produce a
stream of earnings, but only results in a once off contingent payment, and is therefore not of a
capital nature. However, as mentioned on a number of occasions, the Courts in South Africa
viewed the option contract as part of a bigger transaction. In the case under consideration, it is
part and parcel of the acquisition of a capital asset which produces a stream of future earnings.
The option premium paid in this situation can be compared to overseas travelling expenses
incurred to acquire capital assets which are normally regarded as being of a capital nature. In
my view, the option premium would be of a capital nature in this case.
In light of the view expressed earlier, that it is highly unlikely that financial options (i.e. non
deliverables as underlyings) could be regarded as investments, the premiums of these options
should always be of a revenue nature except when they are used to hedge the acquisition of a
capital asset.
Having determined when the option premium is deductible, the following issues remain to be
considered:
— Are unexercised option contracts trading stock in the hands of the option trader.
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Income Tax Implications of 0711011S. Forwards and Futures
Chapter 6
Tax deductions
— If a call option is exercised and the underlying is acquired, does the premium paid form part
of the cost of the underlying.
The former issue will be discussed in the next paragraph, whilst the latter is discussed in
paragraph 6.3.3.
6.3.2 The option contract as trading stock
As discussed in paragraph 6.3.1 option traders will be able to claim the option premium as a tax
deduction. However, they may have to include the unexercised and unexpired options at yearend in trading stock. The definition of trading stock in the Act can be presented in two parts:
"anything produced, manufactured, purchased or in any other manner acquired by
a taxpayer for purposes of manufacture, sale or exchange by him or on his behalf;
or
[anything] the proceeds from the disposal of which forms or will form part of his
gross income,
but does not include a foreign currency option contract and a
forward exchange contract as defined in section 241(1)"
Although the definition starts with the word "includes" it has been held in De Beers Holdings
(Pty) Ltd v CIR (47 SATC 229, 1986(1) SA 8(A)) that the definition is intended to be exhaustive.
There is certainly not clarity amongst tax experts on whether all option contracts acquired on
revenue account fall within the definition of trading stock or not (SAICA 1992:33). To open the
debate, it should be noted that the specific exclusion of foreign currency option contracts and
forward exchange contracts was done after the introduction of Section 241 to the Act. The fact
that the legislator deemed the specific exclusion of these items necessary, in my view indicates
that he must have thought that there was at least a possibility of classifying these items as
trading stock, in which case there would have been a conflict between the proviso's of Section
241 requiring market valuation and Section 22 of the Act requiring a valuation at cost less
certain deductions.
Apart from the specific exclusions in the definition, the question still remains whether all
options are trading stock in the hands of the option trader. This will be discussed in the
following paragraphs.
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Income Tax Implications olOptions, Forwards and Futures
Chapter 6
Tax deductions
An option would fall into the meaning of "anything" as the definition of trading stock
includes corporeal and incorporeal property (Meyerowitz, 1995:55). The option is not produced
or manufactured, but it is either purchased or acquired "in any other manner".
The next requirement is that it must be acquired for the purposes of manufacture, sale or
exchange. As manufacturing is clearly not relevant, the question is whether an option trader
acquires an option for the purpose of sale or exchange. A dealer may either sell his Option
contract or exercise it to make a profit. According to Pappenheim (1991:189) "...in the hands of
a dealer the intention to sell rather than exercise the option appears likely, given that so few
options are in fact exercised." Accordingly, where the holder of the option has the intention to
sell his options, such options held by him and not yet disposed of at year-end will fall within
the first part of the definition of trading stock . SAICA (1992:33) expresses doubt as to whether
options traded on the Johannesburg Stock Exchange can be sold:
"It would appear as though the rights inherent in an option are never transferred
from one party to another by means of a sale. Rather new rights are granted each
time a transaction takes place."
If this is the case, one would have to look at the second part of the definition to determine
whether such options are to be included in trading stock. (See paragraph below where the
second part of definition is discussed).
Where options are acquired for the purpose of exercising the option, the question is whether
exercising it can be viewed as a sale or an exchange. The term "sale" is defined by Coaker and
Zefferett (1984:177) as a "consensual contract whereby it is agreed that a certain commodity
shall be exchanged for a fixed price." If the price consists of anything other than money, the
contract is not one of sale but an exchange. Exercising the option leads to a process of sale or
exchange in that the underlying asset is either acquired or disposed of (physically or in cash),
but it does not lead to a sale or exchange of the item in question, namely the option contract.
The intention in this case is not to sell or exchange the option contract as trading stock, but to
enter into a sale or exchange by exercising the rights in terms of the option contract. A similar
view is held by Stocken (1991:18) when he states that the process of delivery of the underlying
instrument in the case of futures (which is very similar to the exercising of an option) should
not be regarded as a process of exchange. According to Pappenheim (1991:186) " the exercise
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Income Tax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
of an option is neither a sale nor an exchange". It can therefore be concluded that where an
option is acquired with the intention of exercising it, it is not trading stock in terms of the
first part of the definition of trading stock.
However, the second part of the definition requiring anything "the proceeds from the disposal
of which forms or will form part of his gross income" to be included in trading stock should
also be considered. According to the Oxford Dictionary (1988:233) "disposal" means "to get rid
of or to deal with" So defined "disposal" has a much wider meaning than sale or exchange
and may include settlement by way of exercising the option (Stocken 1991:18). The Court held
in the De Beers case mentioned earlier that the second part of the definition did not refer to a
hypothetical disposal, but that the intention to dispose of the item should always be there on
acquisition of the item. Although "sale" or "exchange" may not always be intended by the
option holder, "disposal" will always be intended, and on "disposal" the proceeds will be
included in gross income in the case of an option trader. The fact that the option holder will
probably not "dispose" of the option in cases where the option never reaches a stage where it is
"in the money", is of no consequence as the definition only requires the "purpose" to be that
of sale, exchange or disposal. On this basis all options entered into under a scheme of profit
making, be it with the purpose of selling the option or exercising the option, will in my
opinion fall within the definition of trading stock (i.e. either under the first or second part of
the definition). This is supported by Byala (1993:105) when he says that "an option purchased
under a scheme of profit-making will fall directly into this definition (its proceeds will form
part of the trader's gross income) and thus into the s 22 regime." It is also supported by the
Report of the Committee of Investigation into the Development of Futures Transactions in
South Africa (1988:147).
The next issue to decide on, is the value of the trading stock to be included. In this regard
Section 22(3) of the Act determines:
"For the purposes of this section the cost price at any date of any trading stock in
relation to any person shall be the cost incurred by such person, whether in the
current or any previous year of assessment in acquiring such trading stock, plus,
subject to the provisions of paragraph (b), any further costs incurred by him up to
and including the said date in getting such trading stock into its then existing
condition and location, but excluding any exchange difference as defined in
section 241(1) relating to the acquisition of such trading stock."
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Income Tax Implications olOptions. Fonvards and Futures
Chapter 6
Tax deductions
The only cost incurred by the taxpayer is the option premium and thus the value of the trading
stock at year-end would be equal to the option premium paid. If however, options on hand at
year-end are "out the money", the taxpayer would•Want to reduce the value so included in
taxable income, as the options have no intrinsic value. In this regard the cost price of the stock
may be reduced in terms of Section 22(U of the Act by "such amount as the Commissioner
may think just and reasonable as representing the amount by which the value of such trading
stock, not being shares held by any company in any other company, has been diminished by
reason of damage, deterioration, change in fashion, decrease in the market value or for any
other reason satisfactory to the Commissioner." As an option holder is not a shareholder as
defined, the option trader will therefore be able to claim unrealised losses in terms of this
subsection. The claim for a reduction in the cost price of the option is based on a decrease in
market value. Since the claim for a reduction is subject to the discretion of the Commissioner,
the taxpayer would have to prepare and justify a market valuation of the option. In this regard,
he should comply with the requirements of Practice Note 36 (based on the outcome of ITC
1489(53 SATC 99)) which may be summarised as follows:
Taxpayers are required to disclose the basis on which their stock has been valued in their
income tax return;
Where stock has been valued at a value lower than cost, the taxpayer must state this, submit
reasons for it and indicate how the lower value was arrived at;
If stock has been written off on a fixed, variable or any other basis, not representing the
actual value by which it has been diminished (for example where it is impractical to value
individual items of stock), the write-off will not be accepted without reasonable justification
for the basis used.
In the case of options widely traded, the market value of the option should be readily available
from the clearing houses. In other cases (such as over the counter options) an acceptable
finance model to determine the market value should be used - for example the Black-Scholes
model. Market value is defined in Section 241 of the Act in respect of foreign currency option
contracts as either the value consistently used for accounting purposes or if such a value is not
used for accounting purposes, the intrinsic value of the option. Section 241 is discussed in the
next chapter. Finally, it should be remembered that "in the money" options are not revalued
56
Income Tax Implications of Options. Forwards and Futures
Chapter 6
Tax deductions
higher than cost price , as the gain has not yet accrued to the taxpayer as discussed in Chapter
5.
6 3. 3. Premium forming - part of the cost of the underlying
In paragraph 6.3.1 it was concluded that the option premium is deductible in the hands of the
option trader. The situation may arise where the option is exercised and the underlying asset
acquired. It was further concluded in Chapter 5 that the profit made by the option holder in
the form of acquiring the underlying at below market value has not accrued to the holder until
subsequent disposal of the underlying.
The further question is, if the underlying acquired represents trading stock in the hands of the
option holder and has not yet been disposed at the end of the year of assessment, at what value
should the underlying so acquired be brought to account. If the underlying is valued at the
strike price plus the option premium, the taxpayer effectively did not get a deduction for the
premium in that tax year. Based on the conclusion reached earlier that the option contract is
trading stock in itself and that it has been disposed of by means of exercising the option, there
are grounds to argue that the premium paid should not be added to the cost of the underlying.
The value of the underlying for tax purposes will be the strike price (Pappenheim 1991:190). As
the definition of the cost of trading stock specifically excludes exchange differences defined in
Section 241(1) (refer page 55), this will certainly be the case with premiums on foreign currency
option contracts.
On the other hand, it has been argued up to now that the option contract is normally viewed
as part of a larger transaction (refer page 31, page 42). Therefore, the premium may without
difficulty be regarded as "any further costs incurred .... in getting such trading stock into its
then existing condition and location" in terms of the definition of the cost of trading stock
referred to above. Section 22(3)(b) of the Act defines the "further costs" as costs in terms of
generally accepted accountancy practice. My view would be that, to be consistent with the
philosophy of a larger transaction, the option premium should be added to the cost of the
underlying for purposes of valuing the underlying as trading stock.
The other possible scenario is that the acquired underlying represents fixed capital in the hands
of the option holder. Having concluded earlier that the option premium paid in these instances
is of a capital nature, the next question is whether the option premium may form part of the
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Income Tax Implications of Options. Forwards and Futures
Chapter 6
Tax deductions
acquisition cost of the asset for purposes of claiming the allowances in terms of Section 11(e)
or Section 12C of the Act.
Section 11(e) deals with the "value" of machinery, plant, implements, utensils or articles , and
when such items are not acquired free of charge, the value of the item should be determined by
reference to its cost. Cost is defined as "the cost which, in the opinion of the Commissioner, a
person would, if he had acquired such machinery, implements, utensils and articles under a
cash transaction concluded at arm's length on the date on which the transaction for the
acquisition of such machinery, implements, utensils and articles was in fact concluded, have
incurred in respect of the direct cost of the acquisition of such machinery, implements, utensils
and articles, including the direct cost of the installation or erection thereof" (Own emphasis) .
Having exercised the option, the taxpayer has in fact obtained the asset at lower than market
value on the transaction date. Had he acquired the asset on that date at arm's length in a
normal cash transaction, he would have paid more than the option strike price. This seems to
suggest that the taxpayer may use the market value of the asset for purposes of Section 11 (e)
which could be even higher than the strike price plus the option premium. However, in ITC
1546 (54 SATC 477) where a taxpayer acquired fixtures and fittings for R 17 000 with a market
value of R 120 000 the Court held that the wear and tear must be calculated on the R 17 000
and not the R 120 000. The decision is criticised by Huxham and Haupt (1996:108) as the
decision implies that where an asset with a market value of say R 1000 has been acquired for R
10, the wear and tear must be calculated on R 10, but where it has been acquired for no
consideration, the wear and tear may be calculated on R 1 000. Be that as it may, based on the
ITC 1546 (supra) decision, the taxpayer should use the direct cost of acquisition. Where an
option contract has been taken out specifically to acquire a capital asset, the premium is in my
view sufficiently closely connected to the acquisition of the asset to form part of the "direct
cost of acquisition".
Section 12C determines the cost at the lesser of actual costs or the direct cost of acquisition
under an arm's length transaction, i.e. very similar to the definition of Section 11(e). Therefore,
as in the case of Section 11(e), the premium may be regarded as part of the "direct cost of
acquisition" of the asset.
It is interesting to note that the definition of cost of capital assets in Section 11(e) and 12C
does not contain an exclusion of exchange differences defined in Section 241(1) similar to the
exclusion contained in Section 22(3) in the case of trading stock.
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Income Tax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
6.3.4 Interest costs in financing the premium
When money is specifically borrowed to finance the acquisition of option contracts rendering
income of a capital nature, the interest does not appear to be incurred in the production of
income and therefore not deductible. It was said earlier that the option premium would still be
in the production of income if a sufficient link between the premium paid and the general
income earning operations can be established. The test to be applied in respect of interest is
however that where a direct link can be established between the interest and what it effects, the
direct link should be used to determine whether the interest is in the production of income,
and not the general link to income earning operations. The general link may be used by
institutions such as banks. The position is summarised in CIR v Standard Bank of South Africa
(Limited) (47 SATC 179, 1985(4) SA 485(A)):
"More .specifically, in determining whether interest (or other like expenditure)
incurred by a taxpayer in respect of moneys borrowed for use in his business is
deductible in terms of the general deduction formula and its negative counterparts
in the Act, a distinction may in certain instances have to be drawn between the
case where the taxpayer borrows a specific sum of money and applies it to an
identifiable purpose, and the case where, as in the instance of the Society in the
Allied Building Society case and the Bank in the present case, the taxpayer borrows
money generally and upon a large scale in order to raise floating capital for use in
his (or its) business. In the former type of case both the purpose of the expenditure
(in the form of interest) and what it actually effects can readily be determined and
identified: a clear and close causal connection can be traced. Both these factors are,
therefore, important considerations in determining the deductibility of the
expenditure. In the latter type of case, however, and more particularly in the case of
institutions like the Society and the Bank, there are certain factors which prevent
the identification of such a causal connection and one cannot say that the
expenditure was incurred in order to achieve a particular effect. All that one can say
is that in a general sense the expenditure is incurred in order to provide the
institution with the capital with which to run its business; but it is not possible to
link particular expenditure with the various ways in which the capital is in turn
utilized." (Own emphasis)
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Income Tax hnplications of Options, Font
and Futures
Chapter 6
Tax deductions
6.4 The option writer
The option writer would want to deduct the losses incurred when the option is exercised by the
option holder. Furthermore, he would want to obtain relief for the contingent liability for
unexpired and unexercised options at year-end in respect of which option premiums have been
included in taxable income.
6.4.1 Losses incurred on settlement of the option
The same principles used to determine whether an option premium is deductible may be used
to establish whether a loss on settlement of the option is deductible in the hands of the option
writer. One generally refers to the option premium as "expenditure", whilst in the option
writer's case one would say that a "loss" is incurred on the exercising of the option by the
holder. The difference between "expenditure" and "losses" was considered not be of any
significance in Joffe and Co. (Pty) Ltd v CIR (supra).
Applying the principles, an option writer with a speculative intention or the intention of
hedging revenue items by writing options, should be able to deduct losses incurred as being in
the production of income not of a capital nature. (Byala 1994:44 , Pappenheim, 1991: 190).
Exercising an option contract may lead to an acquisition or disposal of the underlying asset by
the writer where the option is not settled in cash. For example in the case of a written put
option for trading stock, the writer will have to buy the trading stock when the option is
exercised by the holder. The example given was trading stock, but it may also be a capital asset.
— Underlying asset is trading stock
A normal disposal of trading stock arises in the case where exercising the option leads to the
writer having to dispose of the underlying trading stock already in his possession (covered
call option). He has already been taxed on the option premium received. On the option
being exercised, the disposal of the trading stock gives rise either to a taxable profit or tax
deductible loss.
In the case where it was a "naked" call option, (i.e. the holder does not own the underlying
stock) the option writer will be forced to buy the asset at market value and sell at the lower
option strike price. The loss so incurred is speculative of nature and tax deductible.
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Income Tax Implications of Options. Forwards and Futures
Chapter 6
Tax deductions
With a written put option, the writer acquires the underlying trading stock at higher than
market value. If the loss has not yet realised by year-end by means of the subsequent
disposal of the trading stock so acquired, the rules regarding the valuation of trading stock
as discussed earlier would enable the writer to claim any loss for tax purposes as a
diminution in the value of trading stock on hand (Pappenheim, 1991: 191).
– Underlying asset is a capital asset
The exercising of the option contract by the holder may also lead to the disposal of a capital
asset by the writer (written call option). If a profit is made, there may be a recoupment of
capital allowances previously claimed (Section 8(4)(a) of the Act) and the balance of the
profit is capital (also refer Chapter 4, par 4.3.4, page 33).
If exercising the option leads to a loss on disposal of the capital asset, the loss will only be
deductible if the requirements of Section 11(o) of the Act are met (scrapping allowance).
A capital asset may also be acquired in terms of a written put option. The strike price will
then form the cost price of the asset (see Chapter 4 par. 4.3.4, page 33) for purposes of
claiming asset allowances. The loss incurred due to the acquisition of the capital asset at
higher than market value will thus only be deductible over a number of years via capital
allowances.
6.4.2 A claim for contingent future losses
As long as any written options are "in the money" or "at the money", the writer will incur a
loss on its disposal (i.e. when it is exercised). The writer is however taxed on receipt of the
option premium (refer Chapter 4 par 4.3.4). The question is whether a future expenditure
allowance can be claimed in terms of Section 24C of the Act. Future expenditure is defined by
the section as:
"an amount of expenditure which the Commissioner is satisfied will be incurred
after the end of such year—
(a) in such manner that such amount will be allowed as a deduction from income
in a subsequent year of assessment; or
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Income Tax Implications of Options, Fonvatyls and Futures
Chapter 6
Tax deductions
(b) in respect of the acquisition of any asset in respect of which any deduction will
be admissible under the provisions of this Act. "(Own emphasis)
The conditions for the allowance are:
The taxpayer's income must include an amount received or accrued to him by means of a
contract. In the case of the option writer, the option premium has been included in his
income in terms of the option contract and thus satisfies this criteria.
Secondly, the amount must be used by the taxpayer to finance the future expenditure which
will be incurred in performing his obligations under the contract. The option writer will use
the option premium in financing the loss on disposal of the option contract. However, the
requirement which has to be considered is that the future expenditure must be of a type
that "will be incurred". The loss in question is contingent on the holder exercising the
option. On this basis it has been held that the application of Section 24C is doubtful.
(Pappenheim, 1991:190).
Section 24C is very often used in practice to claim future expenditure in terms of a warranty
provided by the taxpayer, in which case goods will be repaired free of charge should they
become faulty within a certain period. The claim is generally based on a history of costs
incurred in respect of goods repaired under warranty. It cannot be accepted that the repair costs
under the warranty provided "will be incurred". It will only be incurred, if a customer returns
faulty goods. History has proven goods to be returned, and on that basis the claim is allowed. If
one compares that to the situation of the option writer, there is a similarity. The loss "will be
incurred" if the option holder exercises the option. The likelihood of the option holder
exercising the option can be determined by forecasting expected market conditions up to the
expiry date of the option. The shorter the time to the expiry date, the more likely that an "in
the money" option will be exercised.
However, in a recent court case (ITC 1601, 58 SATC 172) this practice seems to have been
overturned. It should be kept in mind that Section 24C is a discretionary allowance not subject
to objection and appeal. The decision can only be reviewed by the Court, i.e. to determine
whether the Commissioner has applied his mind to the issues and facts before him and the
knowledge he possessed at the time. The mere unreasonableness of the Commissioner is not
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Income Tax Implications at Options. Forwards and Futures
Chapter 6
Tax deductions
sufficient ground for reviewing the decision. In reviewing the Commissioner's decision in ITC
1601 the Court held that:
".. the Commissioner for Inland Revenue will not be satisfied in terms of s 24C that
future expenditure will be incurred where there is only a contingent liability; there
must be a clear measure of certainty as to whether the expenditure in contention is
quantified or quantifiable and the onus that Appellant bears here is to satisfy the
Commissioner that the agreements relied upon will lead to deductible expenditure
in the following year of assessment."
It was further held that the provision was not enacted to provide a deduction for possible
"comebacks" or unforeseen contingencies as that would be contrary to the provisions of
Section 23(e) of the Act disallowing the deductibility of income carried to any reserve fund.
One of the important factors which lead to the court's decision was that the warranty costs
were recoverable or partly recoverable under contract from the appellant's suppliers and
therefore a granting of the allowance would also be contrary to the provisions of Section 23(c)
of the Act (at page 80).
My experience in practice is that taxpayers still claim a Section 24C allowance for future
warranty costs even after ITC 1601 and distinguish their case by the fact that they have no
counter claim from their suppliers.
Although there is a similarity between the position of a warranty supplier and a option writer,
in my view it would be extremely difficult to provide a history of losses incurred on exercising
of options, as market conditions are much more volatile than customers returning faulty goods
under warranty. I believe the findings of the court in ITC 1601 makes this even more difficult.
I recommend that legislation should defer the accrual of the option premium until the option
is exercised. This is practice in countries such as Germany (Plambeck, et al., 1995: 680).
Alternatively, mark to market accounting (the recommendation in Chapter 5) will also provide
a solution to the problem as the option writer will be able to revalue his open position and
claim any losses resulting from the revaluation (or include profits).
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Income lax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
6.4.3 Option writer: Trading stock
As options written will result in a negative value if treated as trading stock, it should not be
treated as such, nor should it be set off against the value of options acquired (SAICA, 1992:12).
6.5 Forwards
Edgars Stores Limited v CIR (50 SATC 81, 1988(3) SA 876(A)) confirmed that expenditure is
actually incurred when the taxpayer has incurred "an unconditional legal obligation". Before
the contract is settled, the losses can not be said to be unconditional.
The underlying of the forward contract will mainly determine whether the losses incurred are
in the production of income not of a capital nature. As in the case of option premiums, the
losses should generally be in the production of income (refer Chapter 6 par 6.3.1). The losses
may however be of a capital nature where it creates or enhances an income producing structure
(refer Chapter 6 par 6.3.1). Similar to options, this may be the case where forwards have been
used in the acquisition of a capital asset, for example where a foreign exchange forward is taken
out to hedge against exchange rate movements on the import of a machine (before
introduction of Section 241).
6.6 Futures
The only difference between forwards and futures is the timing of the deductibility of the
losses. As futures are settled daily by the mark to market procedure, losses are paid in cash and
are as such actually incurred (Edgars Stores Limited v CIR (supra)).
The initial and maintenance margins payable in respect of futures contracts are fully refundable
deposits on which interest is earned. They are therefore not expenditure or losses and are not
deductible.
The question as to whether futures and forwards are to be regarded as trading stock seems to
have no practical significance. Even if they are regarded as trading stock, they will be included
at a nil value (SAICA, 1992: 8). No premium is paid as is the case with options. As far as futures
are concerned, Stocken (1991:18) states, inter alia, that futures can not he included in the
64
Income lax Implications o/ Options, Forwards and Futures
Chapter 6
Tax deductions
second part of the definition of trading stock as is the case with options, as there are no
amounts to be included in gross income on disposal of the contract as all profits and losses
have already been taken into account before disposal via the mark to market mechanism.
6.7 Conclusion
The tax deductions available in respect of options, futures and forwards were discussed in this
chapter in terms of general tax principles. As usual the positions of the option holder and
writer were separately considered. Reference has been made to Section 241 of the Act on a
number of occasions. The relevant proviso's of this section will be discussed and compared in
the next chapter. The following provides a summary of what have been concluded in this
chapter:
Option premiums, losses on futures and forwards and losses incurred by the option writer
are generally deductible except in cases where they are of a capital nature.
Options entered into with a purpose of profit making fall within the definition of trading
stock and should be valued at the lower of cost or net realisable value.
Futures and forwards do not appear to fall within the definition of trading stock. This is of
academic interest as there is no cost to be taken into account.
The premium paid should be added to the cost of the acquired capital asset or trading stock.
This is based on viewing the option contract as part of a larger transaction. If it is argued
that the option contract as a separate transaction has ended, the acquired underlying should
be valued at strike price.
Interest incurred directly in financing options which result in profits of a capital nature will
not be deductible.
The option writer would not be able to claim a Section 24C allowance for future losses in
respect of option premiums included in income. It is recommended that legislation be
introduced to defer the recognition of the option premium until it is exercised.
Alternatively, mark to market accounting would allow the writer to claim future contingent
losses.
65
Income Tax Implications of Options, Forwards and Futures
Chapter 6
Tax deductions
— The initial and maintenance margin paid in respect of futures are not expenditure or losses
and are therefore not deductible.
This concludes the discussion on the tax treatment of options, futures and forwards applying
the general tax principles. In the following chapter the current available legislation will be
scrutinised and compared to the general tax principles.
66
CHAPTER SEVEN
L•GISLA770N: SECHON 241 and 241
7.1 Introduction
In the previous chapters, the tax treatment of options, forwards and futures have been
discussed where the general tax principles were applied without considering any specific tax
legislation that may be relevant. Currently, the only legislation specifically dealing with items
of this nature are Section 241 and 24J of the Act. The applicability of Section 24J will be
discussed first followed by a discussion on the proviso's of Section 241. A comparison will be
drawn with the general tax principles. It will also be considered whether the principles of
Section 241 can be applied to other options and forwards. In Chapter 8 the suggestions made in
the Consultative document on financial arrangements will be added to the comparison to
complete the picture.
7.2 Applicability of Section 24J
Section 24J applies to the incurral of "interest" in respect of an "instrument" (i.e. to the issuer
of an instrument) issued after 15 March 1995. For instruments issued on or before 15 March
1995, it is applicable with effect from 14 March 1996. The difference between "interest"
incurred by means of the method suggested by Section 24J and interest actually deducted in
respect of these instruments prior to 14 March 1996 should be adjusted for on "redemption" or
"transfer" of the instrument.
As far as the accrual of interest is concerned (i.e. by the holder of an instrument:), the same
dates apply, but only in respect of "income instruments". However, as from the date of
promulgation of the 1996 Income Tax Amendment Act ( 3 July 1996), the definition of
"income instruments" is no longer relevant to corporate taxpayers, ie interest now accrues to
companies in respect of "instruments".
Therefore, to determine whether options, forwards and futures are included, the definition of
"interest" and "instrument" needs to be examined. (Note that the definition of "income
instrument" will not be examined as it is much narrower than "instrument" and only applies
to persons other than companies.)
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Income Tax hnplications of Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
"Instrument" is defined as:
"any form of interest-bearing arrangement; whether in writing or not, includingany stock, bond, debenture, bill, promissory note, certificate or similar
arrangement;
any deposit with a bank or other financial institution;
any secured or unsecured loan, advance or debt;
any acquisition or disposal of any right to receive interest or the obligation to
pay any interest, as the case may be, in terms of any other interest-bearing
arrangement; or
any repurchase agreement or resale agreement."
The definition specifically excludes lease agreements and agreements in respect of which the
holder is entitled to a Section 24(2) allowance (i.e. suspensive sale allowance).
The last specific inclusion (the repurchase or resale agreement) warrants further explanation. A
repurchase agreement comes about when A obtains money from B via the disposal of an asset
to B subject to an agreement in terms of which A undertakes to acquire that asset from B at a
future date. According to Meyerowitz (1996:22) this also includes the situation where B has the
option to require A to repurchase the asset. The asset to be repurchased does not have to be the
specific one disposed of, but it may also be an equivalent asset. Where a company issues bonds
to A and B on the same terms, interest rates and price, and A disposes of its bond to B on the
agreement that A will purchase the bond issued to B at some future date, the Section is
applicable. A repurchase agreement by a third party C falls beyond the definition of a
repurchase agreement. The money obtained by A via the disposal of the asset under these
circumstances is deemed to be a loan. Where A is said to have entered in a repurchase
agreement in the example, B would have entered into a resale agreement.
Having regard to the definition of an option, forward and future set out in Chapter 2, they do
not appear to fall within the specific inclusions (a) to (e) mentioned in the definition of an
instrument.
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Income l'ax Implications of options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
If options, forwards and futures are not included in the specific inclusions, it needs to be
considered whether they fall into the general definition. The general definition includes any
form of "interest-bearing arrangements". Section 24J defines "interest" as including a fixed or
variable rate of interest payable regularly, irregularly or in a lump sum and includes
instruments issued at a discount or premium. Any arrangements involving the payment of
"interest" is therefore an "instrument" by definition. In my view, options, forwards and futures
do not seem to be included in this broad definition. By definition (refer to Chapter 2), they are
not arrangements in terms of which interest is payable or receivable.
It may be however, that interest rates form the underlying of either a forward (forward rate
agreement) or a future (BA futures) or options (options on forward rate agreements). Also the
more complex derivatives (beyond the scope of the dissertation) such as interest rate swaps or
interest rate caps, floors and collars are based on notional principles and interest rates to
determine their cash flows.
Where interest rates form the underlying of derivatives the question arises whether they fall
under Section 24J. In my opinion, if there is an interest bearing loan or investment being
hedged by an interest rate derivative, the loan or the investment itself will be an "interestbearing arrangement" and fall within the provisions of Section 24J. The derivative used to
hedge the interest rate exposure, is not an "interest-bearing arrangement", as it is the
underlying loan or investment resulting in the payment or receipt of interest and not the
derivative. The cash flow (profit/loss) arising from the derivative is determined by reference to a
notional principle and a contracted rate, but is not "interest" as defined. Currently there is no
legislation regulating the taxability of the cash flows from these derivatives and the general
principles set out in the previous chapters will apply. Further support for this argument, is that
the Consultative document on financial arrangements (1994:11/15) includes "debt
arrangements" (i.e. an "interest-bearing arrangement") and "debt derivatives" separately. It
therefore implies that "derivatives" are not included in the definition of a "debt arrangement".
It is due to this reason, that a timing mismatch can occur when a Section 24J "instrument" is
hedged by a derivative. This also leads to the problem illustrated in Chapter 3 (par. 3.2.2) of a
Section 24J "instrument" being created synthetically without Section 24J being applicable.
Tudhope (interviewed 1996) is of the opinion that certain swap arrangements structured to
create certain tax advantages may fall within the definition of "instruments". In terms of these
arrangements, a fixed interest payment is swapped for the receipt of variable rate payments as
69
Income Tax Implications of Options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
with a normal interest rate swap, but the fixed rate payer pays the interest in advance to obtain
the tax deduction and only accounts for the variable rate payments as and when they accrue.
The payment of the fixed interest rate interest in advance, may be regarded as a loan on which
variable rate interest is received. The question whether such an arrangement may be regarded
as an "instrument" as defined is not pursued further as such an arrangement is beyond the
scope of the study.
Having concluded that Section 24J is generally not applicable to derivative instruments, the
relevant proviso's of Section 241 will now be considered.
7.3 Introduction to Section 241
Firstly, it should be noted that as far as options, futures and forwards are concerned, Section 241
is only applicable to a forward exchange and to a foreign currency option contract. The
legislation thus only covers the situation of foreign exchange as an underlying. Where foreign
exchange is not the underlying of an option or forward, the general principles set out in the
previous chapters must still be applied.
Foreign exchange is, however, a very common underlying and the treatment suggested in this
section can be compared to the general tax principles. Furthermore the question as to whether
legislation can be introduced in which the Section 241 principles are applied to Options and
forwards with underlyings other than foreign exchange, will also be considered.
The comparison to general tax principles and the application of Section 241 principles to other
options and forwards are treated as follows in the remainder of this chapter:
— Forward exchange contracts (7.4):
In respect of revenue transactions - anticipated and already incurred - comparison with
general tax principles (7.4.1).
In respect of capital transactions - how do they differ from revenue transactions comparison with general tax principles (7.4.2).
Which principles as set out in 7.4.1 and 7.4.2 can be applied to other forwards (7.4.3).
70
Income Tax Implications of Options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
- Foreign Currency Option Contracts (7.5):
Comparison to general principles (7.5.1)
Which principles set out in 7.5.1. can be applied to other option contracts (7.5.2).
7.4 The forward exchange contract
7.4.1 Forward exchange contracts in respect of trading stock or revenue items
A forward exchange contract ("FEC") is defined in the section as what is generally understood
thereby. One person agrees with another to exchange currency at a future date at a specified
exchange rate (the "forward rate").
The amount in foreign currency owed by or to a person in respect of a forward exchange
contract is a separate "exchange item".
As pure speculation in FEC's is not allowed in South Africa (exchange control regulation
10(1)(c)), one would always consider the tax implications arising from the FEC in conjunction
with the loan, advance or debt being hedged. Important though is that the loan, advance or
debt and the FEC are separate "exchange items".
Against the background that FEC's may only be used for hedging, the legislation should be
evaluated against the conclusions reached in Chapter 3 on hedging, namely:
Problems in identifying hedged positions.
Tax symmetry of the hedge (i.e. the forward) and the position being hedged.
Fledging is not specifically defined in the section, but the concept is applied by the section
depending on whether it is an anticipated transaction or a transaction already concluded.
Anticipated transactions are covered by the definition of an "affected forward exchange
contract" (Section 241) which is a FEC entered into to serve as a hedge for a loan, advance or
debt where such loan, advance or debt has not been incurred or has not yet accrued to the
71
Income Tax Implications qf Options. Fonvards and Futures
Chapter 7
Legislation: Section 241 and 24J
taxpayer before the end of the year of assessment. Furthermore, such loan, advance or debt will
be used by the taxpayer to acquire any asset or finance any expense (or will arise from the sale
of an asset or the finance of an expense) in terms of an agreement entered into by the taxpayer
before the end of the year of assessment.
The "ruling exchange rate" in respect of an "affected forward exchange contract" is the forward
rate on both the transaction date and the date it is translated. This means that no exchange
differences arise before the underlying debt is incurred.
Commonly found in practice is the placing of stock orders before year end and taking forward
cover in respect of these orders. It is submitted that an order will suffice as an "agreement"
envisaged in the definition of an "affected forward exchange contract". No exchange difference
would thus arise in respect of these FEC's. From an accounting point of view, the "significant
risks and rewards of ownership" (AC 112, par 16) have not passed, and therefore no transaction
is recorded. The only accounting effect would be the disclosure of foreign exchange contracts
not related to any specific balance sheet item as required by par 54 of AC 112. The result of all
this is that the tax and accounting treatment achieves the same result, ie no adjustment, albeit
in different manners.
It is worthwhile to note that the definition of an "affected forward exchange contract" was
only amended in the 1996 Income Tax Amendment Act (effective from 3 July 1996) to cater for
anticipated revenue transactions. Prior to that date FEC's taken out for anticipated revenue
transactions had to be revalued at a market related forward rate. This gave rise to either a gain
or loss that could not have been off set by a gain or loss arising from the revaluation of the
underlying loan, advance or debt. The amendment is welcomed as it clearly did not make sense
to limit the hedging of anticipated transactions to capital transactions.
A FEC "related" or "matched" to a transaction already concluded is regarded as a hedge for that
transaction depending on the rate at which the loan, advance or debt is recorded. Judging from
the dependence on the accounting treatment, an underlying philosophy seems to have been to
bring the tax treatment of FEC's in line with the accounting treatment.
From an accounting point of view, a taxpayer may record the loan, advance or debt at the spot
rate or forward rate. Where the loan, advance or debt is utilised to finance a specific asset or
expense (e.g. stock), the asset or expense may also be recorded at the spot or forward rate.
72
Income Tax Implications gl'Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
Therefore, there may be a difference between the rate the asset (or expense) and the loan,
advance or debt is recorded, which gives rise to a "premium" or "discount". In line with the
principle of equalisation of the accounting and tax treatment of FEC's, this "premium" or
"discount" is also recognised from a tax point of view. This is the first fundamental difference
from general tax principles, as a "premium" or "discount" is an accounting concept which has
been introduced to tax law via legislation. The following five combinations of recording are
possible, each with its own tax implications:
Record the asset (e.g. stock) and the debt at the spot rate and no translation of the debt to
the forward rate is done at year end.
Record the asset (e.g. stock) and the debt at the forward rate.
Record the asset (e.g. stock) at the spot rate specified in the FEC and the debt at the forward
rate and recognise the difference as a premium or discount.
Record the asset (e.g. stock) at the spot rate specified in the FEC and capitalise a portion of
the premium to the cost of the asset and record the debt at the forward rate. The difference
between the value of the asset and the debt is a premium or discount.
Record the asset (e.g. stock) and the debt at the spot rate and translate the debt to the
forward rate at year end.
Option 1 is not available to taxpayers having to comply with Generally Accepted Accounting
Practice ("GAAP") (AC 112, par 32). Option 5 would generally not be applicable as the debt is
normally recorded at the FEC rate as opposed to translated at year end. GAAP compliers have to
meet certain requirements in terms of par. 31 of AC 112 before Option 2 may be used. Non
GAAP options are included, as the Act obviously also caters for taxpayers not obliged to
comply with GAAP.
Next, the five alternatives will be discussed in more detail and a numeric example will be given.
All the options are discussed on the assumption that there is a "translation date" (i.e. a
financial year end) before the transactions are realised.
Option One
This option, which is not available for GAAP compliers, is where the asset and the debt is
recorded at the spot rate and no translation of the debt to the forward rate is done. Section 241
in this instance requires a "mark to market" procedure in respect of the FEC which results in
73
Income Tax Implications of Options. For
and Futures
Chapter 7
Legislation: Section 241 and 24J
gains being included in taxable income and losses being deducted before realisation, which
represents a fundamental difference from general tax principles. In terms of the draft practice
note on Section 241 issued by Inland Revenue (1994:13), the market related forward rate may be
determined by quotation from the bank or adding the unexpired portion of the premium on
the FEC to the spot rate at year-end. My interpretation of the practice note is that the taxpayer
may perform both calculations every year and choose the most advantageous one.
The underlying debt must be translated at the year end spot rate. The gain/loss on the FEC will
be opposite to the gain/loss on the underlying debt, but not necessarily equal due to a
difference between the movement in spot and forward rates. The difference will only exist up
to realisation. Ideally (as discussed in Chapter 3), such timing mismatches should not occur
between a hedge and its underlying. It must be remembered however, that because the debt is
not translated or recorded at the forward rate, the FEC is not viewed as a hedge for the
underlying loan, advance or debt. It is required that the taxpayer illustrates his intention to
use the FEC as a hedge by recording the loan, advance or debt at the forward rate.
Option Two
Here, both the stock and the debt are recorded at the forward rate. In this scenario the ruling
exchange rate for both the debt and the FEC is the forward rate on translation date. On
realisation, the exchange differences are equal and opposite. Consequently there are no net
exchange differences and total tax symmetry between the hedge and the underlying position is
achieved.
It is however important to note that the requirements are very specific to utilise this option.
The definition of "ruling exchange rate" in Section 241 determines firstly that a "related or
matching" FEC must have been entered into to hedge the loan, advance or debt and secondly
that the forward rate of this FEC must have been used to record the loan, advance or debt. In
practise certain problems could be encountered.
Firstly, the amount of cover taken and the amount of the loan, advance or debt could be
different. Quite often "blanket cover" is taken, where a group of FEC's covers the whole order
book. In my opinion, the fact that the amount of cover taken is higher or lower than the
amount of the loan, advance or debt should not prevent the FEC from being "related" or
"matched" to the loan, advance or debt.
74
Income Tax Implications of Options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
Secondly, the loan, advance or debt is sometimes not recorded at the specific FEC rate, but at
some calculated average for the "pool" of FEC's, and no translation to specific FEC rates is done
at year end. Here, in my opinion, the rate specified in the FEC is not used to record the loan,
advance or debt and one would have to apply to the Commissioner to approve the calculated
average FEC rate as an "alternative rate" in terms of the definition of "ruling exchange rate". If
such approval is not obtained, the ruling exchange rate on transaction date will be the spot
rate, and the translations of option 1 will be required.
In my opinion, the hedging requirements of Section 241 may be a bit narrow in this regard and
could be extended to include recording at an average FEC rate, provided it is used for and
accepted in terms of GAAP (ie without approval by the Commissioner).
Option Three
In terms of this option, the asset is recorded at the spot rate specified in the forward contract
and the debt at the forward rate. The difference between the two rates is the premium. The
premium is a separate deduction in this scenario in terms of S 241(4)(b). Before the introduction
of Section 241, stock was valued at spot rate at year end in accordance with the court's decision
in Caltex Oil (SA) Ltd v SIR (37 SATC 1, 1975(1) SA 665(A)). Generally, compared to this
treatment the deduction of the "premium" on a day to day basis favours the taxpayer, as it is
deductible on a day to day basis regardless of the fact that it is only realised when the stock is
paid for. Total tax symmetry exists between the underlying (the dect) and the hedge (FEC)
with the "premium" concept being introduced to the benefit of the taxpayer.
There may be a technical difference between the tax and accounting treatment of the recording
of the asset (e.g. stock). AC 112 par 28 allows the stock to be recorded at the spot rate specified
in the FEC even where the FEC is not taken out on transaction date but "before or immediately
after" transaction date. The premium would thus always be the difference between the recorded
value of the asset and the debt. Section 241(4)(b) refers to "such loan, advance or debt was
recorded on transaction date at the forward rate.... but such asset...was recorded at the spot
rate" (own emphasis). To harmonise the tax and accounting treatment fully in these instances
the section should, in my opinion, read ".... but such asset...was recorded at the spot rate
[specified in the FEC as allowed in terms of GAA11". Currently, if the asset was not recorded at
spot rate on transaction date (due to the fact that the FEC was not taken out on transaction
75
Income Tax hnplications of Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
date), the Commissioner should theoretically approve it as an "alternative rate" in order to be
acceptable from a tax point of view.
This option is illustrated by numeric example below.
Option Four
As with Option 3 the asset is recorded at the spot rate specified in the FEC, but with the pre
transaction date portion of the premium being capitalised to the asset. The capitalisation of the
premium should not change the fact that it is still a deductible premium as defined in S
241(4)(b). Exchange differences are specifically excluded from the value of stock by Section
22(3) (refer Chapter 6 page 55). Of course, the same problem as referred to in Option 3 may
arise, i.e. that the asset is not recorded at the spot rate on transaction date, but at the spot rate
specified in the FEC.
Option Five
Here, the asset and debt is initially recorded at spot rate. The debt is then translated at the
forward rate at year end. Normally, the recording of the debt is done at the forward rate and
therefore no translation to the forward rate at year end is necessary. However, this option may
occur where the transaction was initially uncovered (and hence recorded at spot) and later on
the taxpayer decided to cover the transaction and translate the debt at the forward rate.
In this instance, the translation of the debt to the forward rate would include a "premium" or
"discount". The "premium" or "discount" is deductible over the term of the FEC in terms of
Section 241(5).
Numeric example
As the preferred accounting treatment in terms of AC 112 is option 3, this option will be
illustrated by numeric example.
Facts:
The facts are taken from an example given by Huxham and Haupt (1996:332).
76
Income Tax Implications of Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J .
On 1 August 1995 ("transaction date"), A imports goods from USA costing $ 100 000. The
amount is payable on 31 January 1996 (transaction is "realised"). The company's year-end is 31
December 1995 ("translation date"). The company entered into a FEC on 1 August 1995 to buy
$ 100 000 on 31 January 1996 at R 3.50 ("the forward rate"). "Spot rate" (i.e. the quoted
exchange rate for delivery within two business days) on 1 August 1995 is R 2.80, on 31
December 1995 it is R 3.00 and on 31 January 1996 it is R 3.65. The "market related forward
rate" for a one month FEC on 31 December 1995 is R 3.55.
Year end
Section 241
General tax principles
31 December 1995:
Cost of sales
$ 100 000 x 2.80
(R 280 000)
FEC:
$ 100 000 x (3.50 -3.50)
(Nil)
No effect
Debt:
$ 100 000 x (3.50 - 3.50) =
(Nil)
No effect
"Premium" day to
$ 100 000 x (2.80 - 3.50) =
day
70 000 x153/184 =
(R 58 207)
$ 100 000 x 3
(R 300 000)
Not recognised
31 December 1996
FEC:
$100 000 x (3.65- 3.50)
R 15 000
$100 000 x (3.65 -3.50) R 15 000
Debt:
$100 000 x (3.50-3.65)
(R 15 000)
$100 000 x (3.65-3.00) (R 65 000)
Remaining premium
70 000 - 58 207
(R 11 793)
Total gain/(loss)
(R 350 000)
(R 350 000)
74.2 FEC's and capital assets
In addition to the issues regarding FEC's discussed in par 7.4.1, there are certain unique issues
affecting FEC's taken out to hedge loans etc. for the acquisition of capital assets. They are the
distinction between income of a capital and revenue nature, Section 241(7) and the cost price
of the asset for purposes of Section 12C. These three issues will now be discussed in turn.
Capital vs revenue
In the discussion of general tax law it was concluded that the profit or loss on a forward
contract would assume the character of the underlying position. Therefore if the underlying
asset was a capital asset, the profit or loss would be of a
77
capital nature.
Section 241 however,
Income Tax Implications of Options. Fonvards and Futures
Chapter 7
Legislation: Section 241 and 24J
overrules the capital/revenue distinction by stipulating that all exchange differences will be
included or deducted from income derived from carrying on any trade within the Republic.
No character mismatches are therefore possible between the underlying position and the hedge
as both will be deemed to be of a revenue nature. In my opinion it is however crucial that
legislation should not alter the fundamental distinction between revenue and capital. Even
though there is tax symmetry, the gain/loss on a hedging instrument does not always exactly
match the gain or loss from the underlying position. By deeming these differences to be of a
revenue nature, a net tax gain or net tax loss could result, which would not have been the
situation had the fundamental distinction in our tax law remained intact. The capital/revenue
distinction remains important, even in countries with a tax on capital gains. The overruling of
the capital/revenue distinction by Section 241 seems to be in contrast with other amendments
and proposals. Section 24J did not interfere with the capital revenue distinction, and similarly
the Consultative document on financial arrangements (1994:4) stipulates that the proposals of
the document do not interfere with general tax principles other than regulating the timing of
deductions and accruals. There would be major inconsistencies where foreign exchange
derivatives are deemed to be of a revenue nature, whilst in the case of derivatives with different
underlyings, the distinction is again required. The only other alternative to achieve
consistency, would be to regard all profits and losses on all derivative instruments of a revenue
nature, which would certainly lead to inequitable results. The fundamental principles of tax
certainty versus tax equity seems to be in conflict with each other in this case, but to my mind,
equitable tax results should be given priority.
Section 241(7)
Section 241 does however differentiate between FEC's in respect of revenue items and FEC's in
respect of capital goods via Section 241(7). It is applicable to any exchange differences arising
from a ITC that has been entered into to serve as a hedge in respect of a loan, advance or debt
to be utilised for the acquisition, installation, erection or construction of any machinery, plant,
implement, utensil, building or improvements to any building or any intellectual property as
contemplated in Section 11 (gA) of the Act. It determines that any exchange differences and
the premium/discount on such contracts are not deductible until the relevant asset has been
brought into use for purposes of the taxpayers trade. This requirement defers the deduction of
exchange differences until the asset is brought into use which could mean that even though
78
Income Tar Implications crl. Options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
repayment of the loan commenced and the differences are realised, they are not deductible
until the plant, etc. has been brought into use.
Cost price
As far as the cost price of the capital asset is concerned, the problem discussed under option 3
above concerning the spot rate at which the stock is recorded for accounting purposes, also
causes difficulties in the case of capital assets. For purposes of Section 12C of the Act, the cost
price of an asset is:
"the cost which a person would, if he had acquired the said asset under a cash
transaction... on the date on which the transaction for the acquisition of the said asset
was in fact concluded, have incurred in respect of the direct cost of acquisition of the
asset; including the direct cost of installation... "(Own emphasis)
The date on which the transaction was in fact concluded (defined in Section 241 as the date the
debt is actually incurred) differs-from the date on which the FEC has been taken out where the.
FEC is taken out "prior to" or "immediately after" the transaction date. From a tax point of
view the spot rate on transaction date should be used, whilst from an accounting point of view
the spot rate stipulated in the FEC may be used (AC 112 par 28). There may therefore be a
difference in the cost price for accounting and tax purposes unless the rate is accepted by the
Commissioner as an "alternative rate".
Finally, it is worthwhile to mention that the taxpayer should be better off adopting an
accounting policy as set out in option 3 (ie recording the asset at spot rate) rather than option 2
(recording the asset at forward rate) above in respect of capital assets. The draft practice note on
Section 241 seems to suggest that the use of the forward rate "is possible", but not obligatory
where the forward rate has been used for accounting purposes. So interpreted the taxpayer may
still use the spot rate to record the asset for tax purposes, even though the forward rate has
been used for accounting purposes. It is not clear from the section whether this is in deed so.
The effect of recording the asset at the forward rate is that there will be no "premium" and the
cost of the asset for purposes of Section 12C or 11(e) will be the cost at the forward rate. Thus
from a tax point of view the accounting policy of recording at spot instead of the forward rate
is more advantageous to the taxpayer as the premium is deductible over the period of the FEC
(once the asset has been brought into use) in stead of over 5 years (3 years from 1 July 1996) via
79
Income Mx Implications olOptions. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
the claiming of Section 12C allowances. Some companies follow the policy of capitalising pre production interest (including premiums) to the cost of the asset and amortising the balance
remaining after the asset has been brought into use. I contend that as long as the original
recording of the transaction was done at the spot rate, subsequent capitalisations should not
affect the deductibility of the premium.
7. 4.3 Applicability to Other forward contracts
The principles of Section 241 relating to forward exchange contracts are now summarised and
their applicability to other forwards are discussed:
The inherent carrying cost of the underlying (i.e. the premium) is recognised on a day to
day basis if it is recognised for accounting purposes. There are two aspects to this principle.
Firstly, the tax treatment depends on the accounting treatment. This seems to be the
direction in which tax legislation for financial instruments is moving towards (refer also the
Consultative document on financial arrangements - Chapter 8). In my opinion, the
accounting treatment attempts to recognise the economic reality of the transaction which is
a more sensible approach than trying to fit the transaction into the artificial definitions of
gross income and expenditure of the Act. However, it does have the downside of ever
changing accounting statements (AC 112 referred to earlier is already in the process of
changing in the form of Exposure Draft 109[ SAICA, 1997]) and loosely worded definitions
and rules that cannot be used as tax legislation. To draft more precise legislation and still
achieve the accounting result is not always an easy task. In conclusion, I believe that the
principle of legislating to tax the substance of the transaction is a sound principle
established in Section 241 which could be extended to other forwards. The legislation should
however be drafted more precise than accounting statements.
Secondly, the concept of a premium is probably unique to foreign exchange contracts. A
forward rate agreement or a forward to purchase a commodity does not have a premium and
therefore this concept would not apply.
There is no distinction between revenue and capital. The desirability of removing this
distinction was discussed under par 7.4.2. It may not be equitable to remove this distinction
in all cases.
80
Income Tax Implications of Options, For
and Futures
Chapter 7
Legislation: Section 241 and 24J
All differences in respect of capital items are deferred until the capital item has been brought
into use. This principle is sound and can easily be applied to other forwards.
If no hedging exists as defined, the forward must be revalued at a market related forward
rate. This is a principle that can be widely applied to other forward contracts. The "mark to
market" procedure is also advocated in the Consultative document on financial
arrangements (refer Chapter 8).
Hedging:
Section 241 only deals with the hedging of a loan, advance or debt. Effectively forward
cover is taken out by the taxpayer to fix the future amount of a loan, advance or debt
owed by him or to him. It does not deal with the hedging for example of assets such as a
share portfolio or other investments. In this respect the principles of Section 241 must
still be extended by future legislation to cater for the hedging of assets.
Section 241 deals with the hedging of future transactions by stipulating that any profit or
loss in respect of the hedge be postponed until the item being hedged has been recorded.
This is totally in line with the principle of tax symmetry of hedging discussed in Chapter
3 and should certainly be extended to all other forward contracts.
Section 241 does not deal with the hedging of income or expenses such as the hedging of
interest rates. Future legislators would thus not be able to derive any assistance from
Section 241 in this regard.
7.5 Foreign currency option contracts
7.5.1. comparison with general tax principles
In summary Section 241 stipulates the following in connection with foreign currency option
contracts:
81
Income Tax Implications of Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
The legislation (in the definition section) defines a foreign currency option contract,
intrinsic value and option strike rate. The definitions are in line with those in Chapter 2,
where options were defined.
"Market value" is further defined as the market related valuation method used consistently
for accounting purposes (such as the Black-Scholes Model) or if it is not used, the option's
intrinsic value. The intrinsic value can however not be less than R Nil.
The foreign currency option contract can either be entered into or an existing one may be
purchased (in terms of the definition of "transaction date").
It is realised once the option is exercised or the contract has expired without being exercised
or it has been disposed of (in terms of the definition of "realised").
The "ruling exchange rates" in respect of a foreign currency option contract are as follows
(in terms of the definition of "ruling exchange rate"):
On transaction date: R Nil
Translation date: The market value divided by the foreign currency amount
Realisation date: The market value divided by the foreign currency amount or the
amount received or accrued in respect of its disposal divided by the foreign currency
amount.
Section 24I(4)(a) prescribes that an amount paid to acquire an option contract or the
premium paid in respect of the contract is fully tax deductible. Section 241(7) stipulates that
the deduction will be deferred if it relates to a capital asset until the asset has been brought
into use.
No distinction is made between capital and revenue (S 241(2)).
Option contracts are deemed not to be trading stock (definition of "trading stock" in the
Act).
— No specific provision is made for cases where the option contract is used as a hedge for an
underlying position. The option contract should in all cases be restated at market value. The
underlying loan, advance or debt will however always require revaluation to spot in terms of
82
Income Tax Implications of Options. Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
Section 241. The revaluation of the option contract and the underlying should therefore
always be in opposite directions, but not necessarily of the same quantum. Two examples
are given:
Where a market related valuation method is used (such as Black & ScholeS); the gain on
the option contract will probably be higher than the loss on the *underlying position.
Where there is a gain on the underlying position, the option contract can only be
devalued to R Nil where the taxpayer uses the intrinsic value.
In both these instances, timing mismatches may therefore occur.
An example may once again illustrate the difference between Section 241 and general tax
principles. (Example taken from the draft practice note on Section 241 Annexure C page 5)
A taxpayer concludes a foreign currency option contract on 01/01/95 in terms of which the
right to purchase $ 80 000 on 30/06/1995 at a strike rate of R 3.40 is obtained. He pays a
premium of R 4 000. The taxpayer uses a market related valuation method and according to
this method the option is worth R 5 200 (intrinsic and time value) on its 28 February year end.
The option is exercised on 30/06/1995 and the dollars obtained are sold on the same day at
spot.
Date
Exchange rate
1/1/95
3.40
28/2/95
3.45
30/6/95
3.60
General tax principles
Section 241
28 February 1995:
-4 000
-4 000
Year end valuation
5 200
4 000
Net gain 1995
1 200
0
Premium
28 February 1996:
-4 000
Opening stock
Profit on exercise:
(3.60-3.40)* 80 000 = 16 000
16 000
5 200
0
Now taxable
10 800
16 000
TOTAL
12 000
12 000
Intrinsic value
Less already taxed
83
Income Tax Implications ql'Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
The following comparisons can be made between the general tax principles and Section 241:
Unrealised gains are not taxed in terms of general tax principles, but is taxble in terms of
Section 241.
Options on revenue account are treated as trading stock in terms of general tax principles
(refer Chapter 6), but was specifically excluded from the definition of trading stock after the
introduction of Section 241.
In this example the taxpayer acquired the underlying and immediately disposed thereof.
Therefore there is no question of an accrual in terms of general tax principles. Where
however, the underlying is acquired, it was previously concluded that there appears to be no
accrual until subsequent disposal of the underlying. Section 241 deems the exercising of the
option as a realisation event.
From a tax point of view, it may be more advantageous for the holder of an option not to
adopt an accounting policy whereby options are revalued. Thereby unrealised gains will not
be taxable. Writers of options may want to use a market related revaluation method to
deduct the unrealised losses on open option positions which are "in the money". Option
writers will thus be taxed on option premiums received, but will be able to claim future
losses via the market valuation method. The problem of claiming a Section 24C allowance is
surmounted in this way.
Apart from not distinguishing between capital and revenue and the possibility of timing
mismatches, the legislation in my view appears to result in an equitable tax treatment.
7.5.2 Applicability to other option contracts
The principles established by Section 241 for option contracts can directly be applied in respect
of other option contracts. The consultative document (1994:91) also proposes a market
valuation method to be adopted for option contracts.
84
Income Tax Implications of Options, Forwards and Futures
Chapter 7
Legislation: Section 241 and 24J
7.6. Conclusion
The current available legislation is in the form of Section 241 and 24J. The chapter discussed the
applicability of Section 24J and thereafter discussed Section 241 by comparing it with the
general tax principles and considering whether the principles applied there in can be extended
to forwards and options with underlyings other than foreign exchange.
It was concluded that Section 24J is not applicable to derivatives save for possibly in the case of
certain specifically structured swap agreements which fall beyond the scope of the dissertation.
In comparing Section 241 to general tax principles, the two most significant differences were
found to be the overruling of the capital/revenue distinction and the recognition of a
premium on a forward exchange contract. The overruling of the capital/revenue distinction is
not recommended especially where its principles are expanded to other derivatives and forward
contracts. The introduction of the premium was done merely to bring the accounting and tax
treatment of forward exchange contracts in line. The problem with basing tax legislation on
accounting principles, is ever changing accounting rules. Already new accounting proposals do
away with the premium concept.
The principles applied to the foreign exchange derivatives may in certain instances be extended
to other derivatives (refer 7.4.3), the most important one being the mark to market principle.
Section 241 requires options to be revalued in all cases, but allows intrinsic value as market
value where a valuation is not done for accounting purposes. Forwards are only revalued if they
are not used as an hedge.
The hedging of a loan, advance or debt is clearly defined and a distinction is made between
anticipated transactions and transactions already concluded. Section 241 does however not deal
with the hedging of assets or interest rates.
In the following chapter the recommendations made in the consultative document on
financial arrangements are discussed.
85
CHAPTER EIGHT
CONSUL7A77V• DOCUMENT ON FINANCIAL ARRANGEMENTS
8.1 Introduction
The tax advisory committee published the Consultative Document on Financial Arrangements
(here after referred to as the "document") in September 1994. In this pre-final chapter the
proposals in this document are briefly looked at. It is basically a copy of a document released
by the Treasurer of the Commonwealth of Australia entitled "The Taxation of Financial
Arrangements: A Consultative Document." The committee however deviated from the
Australian approach in a few areas (Consultative Document on financial arrangements, 1994:2).
8.2 Applicability
The document does not list products to which it is applicable, but rather defines the
characteristics a specific product should have to be a financial arrangement. Greater flexibility
is achieved in this way. The financial arrangements affected by the document is debt
arrangements and derivatives (Ibid, 1994:4). For the purpose of the dissertation, the latter's
definition is of importance. Derivatives are defined as an arrangement whereby a person has a
right or obligation in relation to another instrument or arrangement (Ibid, 1994:15). An
arrangement is broadly defined and includes a non-contractual, legally unenforceable
understanding as well as an enforceable contract (Ibid, 1994:13). Therefore over the counter
derivatives, however informal they may be, are included. The document is restricted to
derivatives based on a debt arrangement or an interest rate variable or an index made up of a
number of commodities or equities (Ibid, 1994:16).
The definition of a financial arrangement is extremely wide but certain items such as ordinary
equity are however not included by the definition. Certain other items are also specifically
excluded, the most important one for purposes of the dissertation is foreign exchange
transactions. Derivatives based on foreign exchange rates (such as currency option contracts
and forward foreign exchange contracts) are not covered by the document as they are
specifically dealt with in Section 241 of the Act (Ibid, 1994:18) (refer Chapter 7).
86
Income Tax Implications of Options, Forwards and Futures
Chapter 8
Consultative document on financial arrangements
Although the document is not applicable to foreign exchange underlyings, it will be seen that
many of the principles laid down in Section 241 are applied to non-foreign exchange
derivatives. However, as concluded in Chapter 7, some of the concepts introduced in
Section 241 are unique to foreign exchange transactions and were introduced specifically to
bring the income tax treatment in line with generally accepted accountancy practice.
8.3 Timing of income and expenditure
Very importantly, it is stated on page 4 of the document that "it is not recommended that the
proposed accrual approach should, other than regulating the timing of deductions and accruals,
interfere with the general tax principles." In Chapter 7 it was noted that Section 241 overruled
this principle by deeming income and losses to be of a revenue nature. This is therefore the first
major difference between the proposals of the document and Section 241.
Essentially the document proposes that the general principles determining the timing of
income and expenditure should be replaced by an accrual system recognising the economic
reality of the transaction, rather than an artificially determined timing of income and
expenditure. In this regard reference is made to the compounding accrual method (assuming a
constant interest rate), the straight line accrual method (assuming a constant interest) and the
"mark to market" method (Ibid, 1994:22). The document recommends the use of the
compounding accrual method and states that other methods may be used where the results do
not materially differ from those under the compounding accrual method and there is no
significant deferral of tax (Ibid, 1994: 33). As far as the market value method is concerned the
following rules apply (Ibid, 1994:33):
The market value should be used where the compounding accrual method is inappropriate
or impractical, i.e. in the case of derivatives.
Taxpayers have the option to use the market value method for instruments forming part of
an actively traded portfolio.
As far as derivatives are concerned, the mark to market method is recommended. This is in line
with Section 241 requiring mark to market revaluations with the exception of currency forwards
used for hedging purposes.
87
Income Tax Implications of Options. Forwards and Futures
Chapter 8
Consultative document on financial arrangements
Section 24 I and a subsequent practice note defined market value as either the actual market
value (market related forward rate) where there is an active market or the estimated market
value (i.e. the method of adding unamortised forward points to the spot al year end or
accepting generally accepted valuation methods such as Black and Scholes in the case of
options). The same reasoning is followed in the document in accepting either the actual. or
estimated market value (Ibid, 1994:59).
8.4 Hedging
The fact is recognised that the introduction of hedging rules are conceptually important, but
the implementation of such rules are not recommended as they are "practically difficult to
legislate for or administer" (Ibid, 1994: 6). Due to the fact that derivatives are often used to
hedge other financial positions, the proposals could result in a situation where the derivative is
taxed on a "mark- to- market" basis and the underlying on the "compounding accrual method"
and this will obviously lead to profits and losses on the derivative and the underlying position
being taxed in different periods. This is due to the fact that the gain in market value of the
derivative will be taxed (e.g. the option contract), but no deduction will be allowed for the
decrease in market value of the underlying position (e.g. the R 150 stock) (Ibid, 1994:66).
Character mismatches are not mentioned in the document, as the document is only concerned
with the timing of income and expenditure (Ibid, 1994:4).
The document concludes on the subject of hedging by stating that hedging rules need to be
implemented on a limited basis and that foreign jurisdictions will be investigated before any
recommendations are made (Ibid, 1994:71).
8.5 Specific proposals
8.5.1 Futures and forwards
As futures are traded on exchanges, prices can be determined directly and therefore "mark to
market" treatment is suggested (Ibid, 1994:80).
Only forward rate agreements ("FRA's") are discussed - forward exchange contracts and forward
commodity contracts fall beyond the scope of the document (Ibid, 1994: 82). As there is no
active market in FRA's, a formula to establish the estimated market value of a FRA is proposed.
88
Income Tax Implications of Options. Forwards and Futures
Chapter 8
Consultative document on financial arrangements
Alternatively, the taxpayer may use a rate obtained from a bank to do a mark to market
revaluation (Ibid, 1994:84). The differences between the suggested treatment of FRA's and the
treatment of FEC's in Section 241 are that:
Hedging is not catered for and
There is no "premium" in the case of FRA's
8.5.2 Options
The premium paid for the option is treated as the "initial market value" of the option and
requires the difference between the option premium and the closing market value to be taxed
at the end of a year of assessment (Ibid, 1994: 91). It therefore effectively allows the premium
as a deduction, but it should be kept in mind that it does not express an opinion on the capital
nature of the premium. Market value can be determined either by reference to the Traded
Option Market or estimating the market value by using a generally accepted valuation method
(Ibid, 1994:91). The differences between this treatment and that in Section 24 I are as follows:
Section 241 deems the premium to be of an income nature and taxable or tax deductible.
Section 241 accepts the intrinsic value of the option as the market value of the option where
the taxpayer does not use a generally accepted valuation method for accounting purposes,
while the document requires the time value of the option to be included in the market
value estimation at all times.
8.6 Conclusion
Clearly, market valuation methods are favoured in the document when it comes to derivatives.
Due to the lack of constant cash flows in derivatives it is very difficult to tax them on an
accrual basis. This principle was accepted in Section 241, except for accounting for the
"premium" of a forward contract on an accrual basis. The importance of moving towards a
mark to market basis was illustrated by the tax deferrals which are possible under general tax
principles (refer Chapter 3 and 5).
Although hedging is discussed, no conclusion is reached on the matter.
In the final chapter a summary will be given of the conclusions reached in the various chapters.
89
CHAPTER NINE
CONCLUSION
9.1 Introduction
The dissertation considered the tax implications of the option, forward and future contract. It
dealt with the issue in three parts namely defining the instruments and related terminology
(chapter 2 - 3), discussing the tax implications applying general tax principles (chapter 4 - 6)
and finally discussing specific and proposed legislation (chapter 7 - 8). A summary of the
conclusions reached in each part is provided below.
9.2 Definitions and related terminology
9.2.1 Definitions
The definition chapter illustrated that derivatives are built up from two basic types of
instruments namely the option contract and the forward contract. The study focused on the
basic option and forward and the more sophisticated instruments such as swaps and swaptions
fell outside the scope of the study.
The various motives a person may have when entering into a derivative transaction were
discussed. The main purposes were identified as investment, speculation, arbitrage and
hedging. It appeared unlikely that a person can invest in an option or forward in the same way
one can invest in a share or a bond. The study did however illustrate how a synthetic position
may be created by holding a combination of derivatives and shares or bonds, which have
similar implications of holding an investments in shares or bonds only. Due to their
significance in understanding derivatives, a separate chapter was devoted to hedging and
synthetics.
9.2.2 Hedging
Hedging was found to be a common motive for entering into derivative transactions. Problems
were identified in defining a hedge. It was therefore said that:
— The tax system should formulate rules by means of which a hedging transaction can be
identified to achieve tax symmetry between the hedge and the underlying position. The tax
systems of foreign jurisdictions may prove to be quite helpful.
90
Income Tax Implications of Options, Forwards and Futures
Chapter 9
Conclusion
The hedging rules would have to be fairly strict to prevent any possible misuse of hedging
provisions.
Section 241 of the Act and the Consultative document on financial arrangements was tested
against the above mentioned criteria of tax symmetry and clear identification in Chapters 7
and 8.
My conclusions in this regard were that:
Section 241 (after the 1996 amendment) successfully implemented hedging rules in respect
of foreign exchange forwards. As far as foreign currency option contracts are concerned,
timing mismatches may still be possible.
The proposals in the Consultative Document on Financial Arrangements cannot be
implemented, before proper hedging rules have been introduced as the proposals in their
present form, will lead to timing mismatches.
9.2.3 Synthetic transactions
Chapter 3 illustrated two ways of creating a position equal to the holding of equity or debt by a
combination of a derivative and other positions. In the chapters on capital and revenue and the
timing of the taxable income, it was seen that general tax principles do not recognise the joint
effect of the various positions, but treat each separately which could lead to an unwarranted
benefit for the state or the taxpayer. As far as timing is concerned, there are ways of addressing
the problem, e.g. requiring a mark to market revaluation. With the distinction between
revenue and capital it is more difficult and the only obvious solution appears to be the
integration of positions. This is however a challenged posed to the tax system that has not yet
been addressed satisfactorily.
9.3 The general tax principles
The general tax principles were discussed by referring to the nature and timing of the income
and expenditure associated with options and forwards.
91
Income Tax Implications ul'Options. Forwards and Futures
Chapter 9
Conclusion
9.3.1 capital and Revenue
The taxpayer can profit by selling or exercising the option contract. Both scenario's were
considered by distinguishing between the position of the option writer and option holder. The
scenario's were further distinguished between cases where physical delivery was possible and
cases where transactions were merely cash settled.
The case law indicates that the intention of the taxpayer at the time the option is acquired is
the most important factor in distinguishing between the revenue or capital nature of the
income. The fact that the taxpayer exercises an option and sells the underlying asset
immediately there after is not conclusive evidence of a change in intention by the taxpayer. In
a similar way, the intention of the taxpayer is an important factor in determining the nature of
the profit on a forward contract.
Profits on exercising option contracts where the underlying cannot be delivered (transaction is
cash settled) will generally be of an income nature. Synthetic investment can be raised as a
capital argument, but probably the more successful argument would be that a capital asset was
hedged. Because the purpose of hedging is to make a profit in order to counter the loss on
another position, one could argue that hedging is a scheme of profit making, regardless of
whether a capital or revenue asset is hedged. There is however sufficient authority in the case
law that the character of the income is determined by its quid pro quo. Based on this, the profit
derived from an option or forward assumes the character of the position being hedged.
9.3.2 Timing
Income is generally taxed when received by or accrued to the taxpayer. Based on this, there
appears to be no accrual until exercising or disposal of the contract. An exception arises in the
case of futures where accrual takes place on the daily cash settled mark to market procedure.
In the case of an option premium received, the writer receives the premium for his own benefit
and it is taxable despite the possibility of a future loss which may be incurred.
92
Income Tax Implications of Options, Forwards and Futures
Chapter 9
Conclusion
General timing rules do not adequately handle situations unique to derivatives such as the
taking of equal but opposite positions, deferring the maturity date, "straddles", hedging and
"synthetics". A mark to market procedure of all pbsitions. appears to be the most practical
solution to the problem.
9.3.3 Tax deductions
Option premiums should be deductible when incurred, except where it is of a capital nature.
This is the case where the option was entered into to fix the price of a capital asset.
Losses incurred on the expiry of a forward contract should also be tax deductible, unless it is of
a capital nature. The margins paid in respect of futures are not deductible as they are not
expenditure, but refundable deposits.
The most significant shortcoming in current tax law is the failure to provide relief for the
option writers' contingent liability under open options. This could again be addressed by
allowing the option writer's position to be marked to market. With foreign currency option
contracts, Section 241 already allows this where the taxpayer uses an acceptable market
valuation method.
Option contracts entered into with a profit motive fall into the definition of trading stock,
whilst the question whether futures are trading stock appears to be irrelevant as there is no cost
to take into account. Once a derivative is required to be marked to market, it should specifically
be excluded from the definition of trading stock to avoid conflict with the provisions of Section
22 of the Act.
9.4 Current and proposed tax legislation
The current available legislation comes in the form of Section 241 and 24J of the Act. The
dissertation discussed the applicability of Section 24J and thereafter discussed Section 241 by
comparing it with the general tax principles and considering whether the principles applied
there in can be extended to forwards and options with underlyings other than foreign
exchange..
93
Income Tax Implications
of Options, Forwards and Futures
Chapter 9
Conclusion
Section 24J is not applicable to derivatives save for possibly in the case of certain specifically
structured swap agreements which fall beyond the scope of the dissertation.
In comparing Section 241 to general tax principles, the two most significant differences were
found to be the overruling of the capital/revenue distinction and the recognition of a
premium on a forward exchange contract. The overruling of the capital/revenue distinction is
not recommended especially where its principles are expanded to other derivatives and forward
contracts. The introduction of the premium was done merely to bring the accounting and tax
treatment of forward exchange contracts in line. The problem with basing tax legislation on
accounting principles, is ever changing accounting rules. Already new accounting proposals do
away with the premium concept.
The principles applied to the foreign exchange derivatives may in certain instances be extended
to other derivatives, the most important one being mark to market where the instrument is
not being used as a hedge.
Finally, an overview of the Consultative document of financial arrangements was given. The
most significant proposal made in the document is the mark to market procedure. This
procedure is welcomed if it can be combined with a set of hedging rules.
9.5 Conclusion
Legislators and regulators world wide have battled to deal with the unique features of
derivatives. It is very clear from this study is that in certain instances general tax principles are
inadequate to deal with these unique features. Section 241 and the proposals of the consultative
document go some way to address the problems, but this study pointed out certain problems
that still needs to be addressed by legislation. 1 believe it would be difficult to draft legislation
which will remove all uncertainty in all possible instances. Some form of subjective judgement
will most probably always be necessary - but that is what keeps life interesting.
94
LIST OF SOURCES
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CLEGG, DJM 1991: Tax law through the cases; first edition. South Africa:Juta.
COAKER, JF & ZEFFERETT, DT 1984: Willie and Millin's Mercantile Law of South Africa; 18th
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DANZINGER, E & STACK, EM 1995: Tax handbook 1995-6; fifth edition.
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Income Tax Implications of Options, Forwards and Futures
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PUBLICATIONS BY ORGANISATIONS
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THE INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE 1994: Exposure Draft 48.
THE SOUTH AFRICAN INSTITUTE OF CHARTERED ACCOUNTANTS 1992: Report by a subcommittee of the taxation committee - tax treatment of futures and options
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Income Tax Implications of Options, Forwards and Futures
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STATE PUBLICATIONS
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SOUTH AFRICA: The Department of Finance: Draft practice Note on Section 241.
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TUDHOPE, R 1996: Interview in respect of the tax treatment of forwards and options by Nedcor
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PAPPENHEIM, A 1995: Interview in respect of tax issues pertaining to options and forwards in
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ARTICLES
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Income Tax Implications of Options. Forwards and Futures
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DICTIONARY
HAWKINS, JM 1988: The Oxford paperback dictionary; Third Edition. USA: Oxford University
Press.
TABLE OF CASES
Special Court Cases:
ITC 321 (8 SATC 236)
ITC 369 (9 SATC 310)
ITC 640 (15 SATC 229)
ITC 652 (15 SATC 373)
ITC 691(16 SATC 505)
ITC 721(17 SATC 485)
ITC 798 (20 SATC 219)
ITC 962 (24 SATC 651)
ITC 1208 (36 SATC 253)
ITC 1312 (42 SATC 188)
ITC 1346 (44 SATC 31)
ITC 1427 (50 SATC 25)
ITC 1489 (53 SATC 99)
ITC 1498 (53 SATC 260)
ITC 1546 (54 SATC 477)
99
Income Tax Implications of Options, Forwards and Futures
List of sources
ITC 1601(58 SATC 172)
AD Cases:
Abbott v Philbin (Inspector of Taxes) [1960] (2 All ER 763 (HL))
Brookes Lemos Ltd v CIR ,14 SATC 295 1947 (2) SA 976 (A)
Caltex Oil SA Ltd v SIR , 37 SATC 1, 1975(1) SA 665 (A)
CIR v Genn & Co (Pty) Ltd ,20 SATC 113, 1955(3) SA 293 (A)
CIR v People's Stores (Walvis Bay) (Pty) Ltd, 52 SATC 9, 1990(2) SA 353 (A)
CIR v Standard Bank of South Africa Ltd ,47 SATC 179, 1985(4) SA 485(A)
CIR v Stott ,3 SATC 253, 1928 AD 252.
CIR v Visser , 8 SATC 271, 1937 TPD 77.
COT v Rezende Gold and Silver Mines (Pvt) Ltd ,37 SATC 39, 1995(1) SA 968(RAD)
De Beers Holding (Pty) Ltd v C1R ,47 SATC 229, 1986(1) SA 8(A)
Edgars Stores Limited v CIR ,50 SATC 81, 1988(3) SA 876(A)
Geldenhuys v CIR ,14 SATC 419, 1947(3) SA 256(C)
Greases (SA) Ltd v CIR ,17 SATC 358, 1951(3) SA 518(A)
Hersov's Estate v CIR ,21 SATC 106, 1957(1) SA 471(A)
Joffe & Co v CIR ,13 SATC 354, 1946 AD 157.
Lace Proprietary Mines Ltd v CIR , 9 SATC 349, 1938 AD 267.
Matla Coal Ltd v CIR ,48 SATC 223, 1987 (1) SA 108 (A)
Mooi v SIR ,34 SATC 1, 1972(1) SA 675 (A)
New State Areas v CIR ,14 SATC 155, 1946 AD 610.
Overseas Trust Corporation v CIR ,2 SATC 71, 1926 AD 444.
Plate Glass and Shatterproof Industries (Finance Company) Ltd v CIR ,41 SATC 103, 1979(3) SA
1124 (T)
Port Elizabeth Electric Tramway Co. Ltd v CIR ,8 SATC 13, 1936 CPD 241.
Pyott Ltd v CIR ,13 SATC 121, 1945 AD 128.
SAM v COT ,42 SATC 1, 1980(2) SA 75(ZR)
SIR v Struben Minerals ,28 SATC 240,1966 (4) SA 582 (A)
South African Marine Corporation v CIR ,20 SATC 15, 1955(1) SA 654 (C)
Sub- Nigel Ltd v CIR , 15 SATC 380, 1948(4) SA 580 (A)
Tuck v CIR ,50 SATC 98, 1987(2) SA 219 (T)
WH Lategan v CIR ,2 SATC 16, 1926 CPD 203.
100