Taxation treatment of options

The tax paper below contains a discussion of the taxation treatment of options, prepared by Patrick Broughan, Taxation Partner at Ernst and Young, Melbourne. 

Any advice or recommendation (including relating to financial products) should be obtained from an Australian Financial Services Licensee or other professional adviser. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) suffered by anyone acting or refraining from acting as a result of this material is accepted by ASX.

Summary

The tax implications of options trading depend on the type of trading conducted:

  • Trading in options
  • Speculating in options
  • Hedging or investing using options

Trading in options

A trader in options, in the eyes of the tax office, will be a person who routinely and systematically buys and sells options with an expectation of making a profit. This may be determined by frequency of trading, evidence of use of a trading system and/or professional advisers or other similar factors.

There are two approaches for the assessment of traders for tax on income derived from options trading. These are the due and payable/due and receivable method, and the net profit or loss method.

The due and payable/due and receivable method assesses each purchase as a cost and each sale as income. The net profit or loss method assesses the closing profit and loss from an option position(s).

The two methods of tax accounting usually give the same result. However, there are important timing issues where open option contracts straddle year-end.

Premium income received from writing options is considered assessable income on the due and receivable basis; effectively income is generated on T+1. Once the option expires there is no further tax implication.

If the option is exercised, this will be reflected in the traded price of the underlying share and will be accounted for as the share trade.

For LEPOs and cash settled options, the net profits approach is the preferred tax method. For other options the due and payable method of calculation is generally thought to be more appropriate.

Speculating in options

A speculator is very similar to a trader, except that a speculator may not trade as frequently. Determining whether a person is a speculator may depend on frequency of trades, whether the trading is only occasional but is part of a larger business enterprise or whether a trade has been made solely with a view to profit. The tax treatment of a speculator is calculated on a net profit basis.

Hedging in options

A hedge is a method of reducing the risk of a position. With reference to options, a purchased option used to hedge held shares would be treated as a deductible expense against the position. Any future sale of that option would be assessed as income. Where it involves effectively lowering the purchase price of the shares, the transaction would be assessed under Capital Gains Tax.

Franking Credits

Another point of note for options taxation is in relation to franking credits. To be entitled to franking credits you need to have held the shares "at risk" for a period of at least 45 days during the dividend period. This "at risk" definition is calculated by the ATO via the net delta of the position. According to the tax office you will only be entitled to the franking credits if the net position has a positive delta of 0.3 (or 30% at risk). The net position is calculated by adding the deltas of your long and short positions in respect of the shares.

This will vary depending upon the level of hedging undertaken, eg, if you bought a deep in the money Put option (with a delta of -0.9) to protect the underlying shares, then you would have a net delta position of 0.1. This is 1 for the stock plus -0.9 for the put, meaning you effectively have only 10% of the position at risk and would not be entitled to the franking credits.

On the other hand, if you decided to purchase an at the money Put (with a delta of -0.6), then you would have a net delta position of 0.4 and you would be entitled to the franking credits.

Read the Ernst and Young paper - The Holding Period and Related Payment Rules: 45 Days to Offset. (PDF 154KB)

Taxation treatment of Options  - March 2006

Read the Ernst and Young paper - Taxation Treatment of Options(PDF 282KB)