Question

7. An investor holds a European call with strike Ke and maturity T on a non-dividend- paying asset whose current price is So. Suppose the investor can write a put with any strike strike price Kp, write a forward with any delivery price Kf, and can borrow any amount B at the risk-free rate if B is negative this is a loan). What are the conditions on Kp, Kf, and B that make this combination of positions a constructive sale (i.e. that have the same effect as selling the call)?

Answer 1

Section 1259
requires taxpayers to recognize gain with respect to certain
appreciated financial positions if the taxpayer engages in certain statutorily enumerated
transactions that have the effect of eliminating substantially all of a taxpayer’s risk of loss
and opportunity for gain, so-called “constructive sales.” Regulations can expand the
definition of a constructive sale to include other transactions that have “substantially the
same effect” as the statutorily enumerated transactions. In this report, we recommend
that, to the greatest extent possible, the Treasury Department2
provide objective standards
for evaluating whether or not a transaction is a constructive sale. Specifically, this report
contains the following primary recommendations:
• A relatively simple test should be used to evaluate whether a “costless
collar” (or nearly costless collar) is a constructive sale, taking into account
only the width and duration of the collar and not the volatility of the
underlying stock or other financial position;

• A put option or a short call option on an appreciated financial position (but
not both together) should not be treated as a constructive sale as long as
the option is not “in the money” (measured by forward prices in the case of
options longer than one year) and does not have a term longer than three years;
• The test for whether other positions (including in-the-money options and
options with a term longer than three years) give rise to a constructive sale
should be based on whether the value of those positions can be expected to
move inversely to the value of the appreciated financial position over a
significant range of prices and for a meaningful period of time; and
• Treasury should provide specific guidance in the regulations on the extent
to which they will apply retroactively, and should not merely state that the
regulations will apply retroactively where necessary to prevent abuse.

(A) enters into a short sale of the same or substantially identical property;
(B) enters into an offsetting notional principal contract8
with respect to the
sale or substantially identical property;
(C) enters into a futures or forward contract9
to deliver the same or
substantially identical property;
(D) in the case of an appreciated financial position that is a short sale or a
contract described in paragraphs (B) or (C) with respect to any
property, acquires the same or substantially identical property; or
(E) to the extent prescribed in regulations, enters into one or more other
transactions (or acquires one or more positions) that have substantially
the same effect as a transaction described in any of the preceding