Rev. Rul. 82-150: Deep-in-the-money options

In Rev. Rul. 82-150, the IRS holds that a sale of a deep-in-the-money option was, in substance, not an option but a completed sale of the referenced stock for purposes of the foreign personal holding company rules.
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Rev. Rul. 82-150


Must A include in gross income for 1980 any portion of the undistributed foreign personal holding company income of foreign corporation FX?


A, an individual, is a citizen of the United States. On January 1, 1980, B, a nonresident alien individual in foreign country FC, set up foreign corporation FX. B funded FX with 100,000x dollars and received in return all of the authorized stock of FX. A then paid B 70,000x dollars for an option to purchase all the FX stock. The option may be exercised at A's discretion at any time. The price payable by A under the option is 30,000x dollars.

After its formation FX used the 100,000x dollars with which it was capitalized to invest in stocks and securities of corporations. All income received by FX during 1980 was foreign personal holding company income within the meaning of section 553 of the Internal Revenue Code. FX did not distribute any of its income, but reinvested it in additional stocks and securities of corporations.

A and FX are calendar year taxpayers.


Under section 552(a) of the Code, for a corporation to be a foreign personal holding company (FPH) a certain percentage of its gross income must be FPH income as defined by section 553 and more than 50 percent in value of its outstanding stock must, at any time during its taxable year, be owned directly or indirectly by or for not more than five individuals who are citizens or residents of the United States (United States group).

Section 551(a) of the Code provides that if a corporation is an FPH then its undistributed FPH income will be included in the gross income of a citizen or resident of the United States who owns stock in the FPH (United States shareholder). The United States shareholders must include in their gross income their distributive shares of that proportion of the undistributed FPH income for the taxable year of the corporation which is equal in ratio to that which the portion of the taxable year up to and including the last day on which the United States group with respect to the corporation existed bears to the entire taxable year.

Because 100 percent of FX's gross income is FPH income as defined in section 553, FX will be an FPH if at any time during its taxable year a United States group existed. A will constitute a United States group if A owned, directly or indirectly, more than 50 percent in value of FX's outstanding stock at any time during 1980.

The constructive ownership rule expressed in section 554(a)(3) of the Code provides that, if A has an option to acquire stock, then that stock Will be considered as owned by A. However, section 551(a) applies only to those United States shareholders who actually own stock of the FPH.

It has long been a principle of federal tax law that the substance of a transaction and not its form will determine the federal income tax consequences of the transaction. Commissioner v. Court Holding Company, 324 U.S. 331 (1945), 1945 C.B. 58; Rev. Rul. 61-18, 1961-1 C.B. 5, 6-7. In form, A acquired an option to purchase for 30,000x dollars an asset worth 100,000x dollars. Stock, which represents the ownership or equity of a corporation, is a risk investment and to purchase stock means to assume the risks of an investor in equity. See John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946), 1946-1 C. B. 190, 195; Zilkha and Sons, Inc. v. Commissioner, 52 T.C. 607, 613 (196.9), acq., 1970-1 C.B. xvi. By obtaining the right to purchase for 30,000x dollars stock worth 100,000x dollars, A has assumed the risks of an investor in equity. In substance, 100 percent of the funds used to capitalize FX and, hence, 100 percent of the funds at risk have been or will be furnished by A. Depending upon the success or failure of FX, it is A's investment, not that of B, that will appreciate or depreciate. A has assumed the benefits and burdens of the ownership of FX stock and, therefore, the sale of FX stock to A has been completed. See Tennessee Natural Gas Lines, Inc. and Subsidiary v. Commissioner, 71 T.C. 74, 83 (1978), acq., 1979-2 C.B. 2.


Under the facts presented, A is considered the actual owner of 100 percent of the stock of FX for the entire calendar year. Therefore, A constitutes a United States group, making FX an FPH. Because FX is an FPH, A, as a United States shareholder, must include as a dividend in gross income for 1980 A's pro rata share (100 percent) of FX's undistributed FPH income.

The above analysis regarding A's actual ownership of FX stock is equally applicable to determinations under section 951 of the Code.

As the owner of the stock of FX, A is required to file certain returns, such as the information returns prescribed under sections 6035 and 6046 of the Code (Forms 957, 958, 959, 2952, and 3646, as applicable) and the regulations thereunder. Failure to file the returns mentioned above Will subject A to criminal and civil penalties as provided in sections 6679, 7203, 7206, and 7207.

Because the holding of this revenue ruling is based on the application of the doctrine of "substance over form" it will be applied whenever the substance of the transaction is the purchase of stock, not an option.

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