The Option Conundrum in Tax Law: After All These Years, What Exactly is an Option?


Some of the latest financial products that have become prevalent on Wall Street defy easy categorization for tax purposes. Certain products, such as economic derivatives or weather derivatives, bear the trappings of options, but lack an underlying property component. Other products, such as credit default swaps, have option-type payouts, but are cast in the form of financial swaps. Which of these products are truly options and why? When and how to tax these instruments depends on proper resolution of this fundamental classification issue. With respect to credit default swaps, arguably the single most important product innovation on Wall Street in the last 20 years, hundreds of millions of dollars in potential tax liability (on cross-border swap payments) are riding on a resolution of this issue.

This article tackles a longstanding philosophical question which has modern-day resonance in the ongoing debate over the appropriate taxation of the latest generation of financial products. Relying on contract-law principles and economic risk analysis, the article revisits longstanding case law to fashion a modern-day definition for what constitutes an option. Ultimately, it resolves the question of whether the concept of an option properly encompasses non-property-based options, such as economic or weather derivatives, as well as contingent options, such as credit default swaps.

The article concludes by proposing a basis for differentiating between options and financial swaps, two product categories which have overlapping reach, allowing taxpayers to avoid undesired tax results by the simple expedient of selecting the desired form of transaction. While the article’s suggested approach would deprive taxpayers of the flexibility inherent in current law’s ambiguity, this flexibility conflicts with the government’s asserted interest in promoting neutrality in the taxation of financial products. Equally important, the financial products sector is more likely to thrive when uncertainties in the taxation of economically useful transaction are satisfactorily resolved.


Contracts | Taxation-Federal | Taxation-Transnational | Tax Law

Date of this Version

March 2006