What is an option?
The grant of an option over a specified asset essentially provides the grantee with a right to acquire an asset from the grantor (call option) or dispose of an asset to the grantor (put option) at a specified future time and at a specified price (the exercise price). The grantee will pay an amount (the option premium) to the grantor to obtain the benefit of an option. The grantee may, of course, choose to allow the option to lapse instead of exercising it. Note that the seller will retain the option premium regardless of whether the right is actually exercised – it is non-refundable.
Why is an option arrangement typically used?
An option agreement is a common arrangement in respect of leases, shares and real property.
The option arrangement provides certainty to the grantee by locking-in the price at which a particular asset may either be sold or purchased. The grantee thereby reduces exposure to risk within otherwise potentially volatile markets. The option arrangement also provides an opportunity for the grantee to, for example, purchase an asset at a future point undervalue.
How does an option work?
To illustrate the workings of an option arrangement, note the following example specifically related to a call option scenario.
On 1 October 2023, Ellie pays $20 as option premium to acquire an option to buy a single share in Stephen Pty Ltd on 1 January 2024 for $50. The market value of the share at this time is $45.
After significant growth in the business, the share market price at 1 January 2024 has increased significantly to $100. Ellie could exercise the option and acquire the asset for $50, sell it on-market for $100 and effectively make a $50 profit (less the option fee of $20 and any other transaction costs).
If the value of the share market price on 1 January 2024 was $30, it would not make sense for Ellie to exercise the option as the shares would be cheaper to acquire on the market (i.e. $30 at market compared with $50 if the option was called in).
As mentioned, the option fee is a sunk cost and is not refunded if the option is not exercised.
Taxation implications of options generally
The rules relating to options can be found in Division 104, Division 116, Division 134 and Division 130-B of the Income Tax Assessment Act 1997.
It is useful to understand that an option in respect of underlying asset is treated as a separate CGT asset from the underlying asset itself. In this way, CGT will apply when the option is dealt with e.g. by being granted, exercised or lapsing. Furthermore, a CGT asset which is acquired by exercising a call option at a date post-CGT – but where the call option was originally granted pre-CGT – will be deemed to have been acquired post-CGT, not pre-CGT when the option was acquired.
Note that an asset acquired by exercising an option must be held for at least 12 months (from the time the option is exercised) in order for the CGT discount to apply.
Taxation implications on granting an option
When an option is granted, CGT event D2 occurs for the grantor. The grantor makes a capital gain to the extent the capital proceeds from the grant e.g. the option fee exceeds the expenditure incurred to grant the option (‘incidental costs’) e.g. legal fees incurred for advice relating to granting the option. Conversely, a capital loss arises where the expenditure incurred exceeds the capital proceeds.
Note that any capital gain or loss from granting the option will be disregarded if the option is actually exercised. The implication of this is that any capital gain or loss from the grant of an option will need to be included in the taxpayer’s tax return and that tax return subsequently amended to exclude the capital gain or loss if the option is ultimately exercised. Of course, an amended return is only necessary if the exercise of an option occurs in an alternative income year to the year of grant.
Take the following example demonstrating the tax implications of granting a call option (assuming that option is not ultimately exercised). Ciana grants to James an option to buy Ciana’s shares in Brooke Pty Ltd for $100,000. The option fee is $5,000. Ciana incurs $1,000 in obtaining legal advice on the option agreement. James decides not to exercise the option. Ciana makes a capital gain of $4,000 under CGT event D2. That is, $5,000 for the option fee less $1,000 for incidental costs.
Take the following example demonstrating the tax implications of granting a put option (assuming that option is not ultimately exercised). Ciana grants to James an option that Ciana will buy James’ shares in Brooke Pty Ltd for $150,000. The option fee is $5,000. Ciana incurs $1,000 in obtaining legal advice on the option agreement. James decides not to exercise the option. Ciana makes a capital gain of $4,000 under CGT event D2. Remember that the capital gain under CGT event D2 is calculated as capital proceeds less incidental costs. Here, the capital proceeds include the $5,000 option fee. The incidental costs include $1,000 in legal fees.
Taxation Implications on Exercise of an option
If a granted option is exercised, the following CGT events occur:
CGT event C2 regarding cancellation, surrender and similar endings. This event is triggered because the exercise of the option effectively ‘ends’ the option.
CGT event A1 regarding disposal of a CGT asset. This event is triggered because there is a change of ownership to the asset underlying the option.
Generally, in this scenario CGT event A1 applies with precedence and the taxation consequences of event C2 being triggered are disregarded. However, note that Division 134 of the ITAA contains special rules to modify the usual method of calculating the capital gain or loss over CGT asset which is acquired or disposed of following the exercise of an option. These special rules are flagged below.
The taxation implications of exercising an option are as follows:
For a call option:
For the grantor, CGT event A1 occurs. Remember that a capital gain from CGT event A1 is calculated as ‘capital proceeds’ less the asset ‘cost base’. The capital proceeds include the exercise price and the option premium. The cost base includes the price of the shares when originally purchased by the grantor plus any other usual cost base inclusions e.g. non-deductible interest. Remember that because the option is exercised, the grantee’s gain or loss earlier recognised under CGT event D2 will need to be disregarded. This may require an amendment to a prior year tax return.
For the grantee, a CGT asset is acquired. The cost base and reduced cost base of that acquired asset includes the exercise price and the option premium paid.
As an example of a call (buy) option, take Ciana who grants James an option at a option premium of $2m to acquire her property for $10m. James pays Ciana the $2m and later exercises the option. For Ciana (as grantor) CGT event A1 occurs. Her relevant capital gain is calculated as capital proceeds less cost base. Here, capital proceeds for the property are $10m being the sale proceeds plus the $2m option fee. The cost base is unknown on the facts here but would need to be determined to calculate Ciana’s capital gain. For James (as grantee) the cost base of the property is $12m. This includes $2m for the option fee plus $10m being the acquisition price of the property.
As an alternative example, take Stephen who grants Brooke an option (involving an option premium of $2,000) to buy Stephen’s shares in Stephen Pty Ltd for $40,000. Stephen’s shares have a cost base of $30,000. Brooke pays the option fee and later exercises the option. For Stephen (as grantor), CGT event A1 occurs. The capital gain is calculated as capital proceeds less cost base. Here, the capital proceeds are $40,000 as proceeds of the shares sold plus $2,000 for the option premium paid. The cost base of the disposed shares is $30,000. Therefore, Stephen’s capital gain is $12,000 ($40,000 + $2,000 – $30,000). For Brooke (as grantee) the cost base of the acquired shares includes the $40,000 exercise price plus $2,000 for option premium. CGT will not apply for Brooke until she sells those shares (or another CGT event is triggered in relation to those shares).
For a put option:
For the grantor, a CGT asset is acquired. The cost base and reduced cost base of the CGT asset includes the exercise price reduced by the option fee.
For the grantee, CGT event A1 occurs. The grantee’s cost base and reduced cost base for the CGT asset includes the option fee paid and the price of the underlying asset which is being disposed, along with any other usual cost base inclusions. Remember that the cost base of an asset consists of 5 categories of costs. That is, the cost base is not limited to the original purchase price of an asset.
As an example of a put (sell) option, assume that Ciana grants James an option for James to sell his house to her for $10m at an option premium of $2m. James originally acquired the property for $6m. James pays the option fee and later exercises the option. Ciana pays him the $10m exercise price. For Ciana (as the grantor), a CGT asset is acquired. The cost base and reduced cost base of the property is $8m being the $10m exercise price less the $2m option fee.
For James (as the grantee) CGT event A1 happens. The capital gain is calculated as capital proceeds less cost base. James’ capital proceeds include $10m as the proceeds from the disposal of the property. James’ cost base includes the $2m option fee, plus $6m as the original acquisition price of the property. Therefore, James has a capital gain of $2m ($10 – $2m – $6m). The CGT discount may be available to James to reduce the calculated gain.
Renewing or extending an option
The renewing or extension of an option is not considered to be an exercise of the original option. Rather, the renewed or extended option is treated as a new option that is a separate CGT asset and which commences when the first option expires. CGT event C2 or C3 occurs on expiry of the original option and CGT event D2 occurs on grant of the new option. The result is that the grantee of the call option may not add the original option fee to the cost base of the asset and the grantor of a put option may not deduct the option fee from the cost base.
Disposal or lapse of option
If the grantee of an option disposes of that option, CGT event A1 will occur and a capital gain or loss will arise. If the grantee of an option allows an option to lapse or expire, CGT event C2 or C3 will occur and a capital gain or loss will arise.
Exceptions to the above rules
The above-described tax treatment of options and the rules to calculate capital gains and losses may be superseded by alternative rules in certain circumstances.
For example, the above rules will be superseded by the rules in Subdivision 130-B where the taxpayer is an equity holder who issued with rights to acquire shares or units at no cost.
In a similar way, the above rules to calculate gains and losses will be superseded where the option binds the grantor to acquire or dispose of foreign currency. Options related to foreign currency are dealt with under the forex rules in Division 775.
In a similar way, the above rules to calculate gains and losses will be superseded where the options are granted to employees under an employee share scheme. The alternative rules are contained in Division 83A.
Finally, this article assumes that the asset underlying the option is held on capital account. Tax outcomes will vary where property is held as trading stock or on revenue account.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.