Good Intentions, Unintended Consequences: Tax Reform Threatens Options Market

By Callie Bost, TABB Group

Originally published on TABB Forum

New rules on the taxation of derivatives could have negative consequences on listed options demand, raise costs for the industry and ultimately reduce trading volume.

Stringent regulations on risk-taking and capital have been the bane of options traders’ existence over the past several years. Soon, they’ll have another obstacle to worry about: new rules on the taxation of derivatives.

Two tax proposals and one recently passed tax regulation could curb pockets of volume in the US listed options market and create compliance headaches for brokerages.

These proposals are part of Washington’s promise to simplify the U.S. tax system, eliminate loopholes, and save money both for individuals and businesses. On the surface, the plans present constructive goals; but in practice, they could have negative consequences on listed options demand, raise costs for the industry and ultimately reduce trading volume.

One proposal could impede one of the fastest-growing demographics of the options market: flow from individual retirement accounts (IRAs). The Department of Labor’s (DOL’s) fiduciary rule, which is expected to be implemented this year, is intended to safeguard investors’ retirement accounts from advisors’ conflicts of interest through a broader definition of a fiduciary under the Employee Retirement Income Security Act (ERISA). However, if the proposal is enacted, it could categorize brokerages as fiduciaries, which would require them to drastically change their business models and limit them from trading listed options. Self-directed investors who employ common options strategies, such as buying puts and selling covered calls, could be stripped of these resources.

A plan introduced by former House Representative David Camp could hold severe consequences for all listed options traders. The Tax Reform Act of 2014, also known as the Camp Proposal, promises sweeping tax reform through simpler individual income and business tax systems, lower tax rates for most individuals, and fewer tax breaks and incentives. The rule proves challenging for the options market through its language on the uniform taxation of derivatives. Currently, it would require all options positions on stock to be labeled as mark-to-market, and all gains on the stock would be treated and taxed as ordinary income. If enacted, the Camp Proposal could turn trading straddles into a tax nightmare for investors and discourage them from prudently protecting their portfolios.

Tax reform in the U.S. will also have international repercussions. Section 871(m) of the Internal Revenue Code, which was finalized in September 2015, will establish a withholding tax for foreign investors trading equity derivatives connected to U.S. securities around their dividend payout dates. The plan was created out of concern that overseas traders were dodging the withholding tax on U.S. securities’ dividend payouts through carefully timed equity swaps. While the rule provides guidelines on what kinds of options can be subject to the withholding tax, its language is somewhat ambiguous and leaves interpretation up to brokerages that are required to track and report their customers’ tax statuses. Foreign investors will likely have to reduce their U.S. options trading to avoid unnecessary and overwhelming taxation once the rule comes into effect next year.

While Washington’s intentions for tax reform are well-meaning, the secondary effects of these rules are harmful for options market participants. Ultimately, these plans punish investors who have been using listed options in a responsible manner and present unnecessary stumbling blocks for the whole industry.