Parties that enter into “basket option contracts” and “basket contracts” should be aware that the IRS is likely to challenge such transactions and that they have a new obligation to report the transactions to the IRS or face penalties.

Background

The Internal Revenue Service (IRS) issued two notices on July 8 indicating that certain structured transactions are considered “reportable transactions” because they have the potential for tax avoidance. Participants in these transactions, and some advisers, are required to disclose certain information pertaining to the transactions to the IRS. These transactions generally involve financial contracts entered into between banks and hedge funds under which the hedge funds receive a return based on a basket of assets that varies over time based on requests by the hedge funds (or their managers) or based on a trading algorithm.

In June, the US Senate Committee on Finance’s ranking minority member Senator Ron Wyden (D-OR) sent a letter to the Department of the Treasury (Treasury) urging it and the IRS to shut down these “basket” transactions because they enable taxpayers to convert short-term capital gains to long-term capital gains. In March, the Senate Committee on Finance’s Democratic staff issued a report calling for the IRS and Treasury to identify the transactions as reportable transactions. However, these types of transactions are not new. The IRS has been aware of the transactions for some time and issued an internal legal memorandum discussing them in 2010.

Hedge funds and banks that have entered (or intend to enter) into any transactions that resemble the ones described below should carefully read this LawFlash and contact Morgan Lewis for additional assistance in understanding whether they are affected by these notices.

“Basket Option Contracts” Are Now “Listed Transactions”

Notice 2015-47, 2015-30 IRB 1, provides that a “basket option contract” is now a “listed transaction” (i.e., a type of “reportable transaction”) if it was put into effect on or after January 1, 2011. A basket option contract is one in which a taxpayer purchases an option from a counterparty where the return is based on a referenced basket’s performance (generally traded securities) and the taxpayer or a specified trading algorithm changes the assets in the reference basket. Notice 2015-47 indicates that the purposes of the transactions may be an attempt by the taxpayer to convert ordinary income and short-term capital gains into long-term capital gains or to defer income recognition. The IRS also asserts that taxpayers are using the basket option contract transaction to avoid applying the constructive ownership rules or to avoid US tax liability with respect to non-effectively connected income for non-US persons and entities. The IRS has indicated that it may challenge such transactions on grounds of agency by disregarding the existence of the option, by arguing substance over form, or by arguing that changes to the basket are tax recognition events.

Under the notice, any transaction that is “the same” or “substantially similar” (terms that are broadly construed) to the one described is deemed to be a listed transaction. A transaction will be treated as the same or substantially similar to the transaction described if

  1. the transaction is denominated as an option contract;
  2. substantially all of the assets in the reference basket primarily consist of actively traded personal property as defined under § 1.1092(d)-1(a);
  3. the purchaser of the option or the purchaser's designee either have the right to (a) determine the assets in the reference basket both at the inception of the transaction and periodically over the term of the transaction or (b) select or use a specified trading algorithm under its control to determine the assets in the reference basket; and
  4. the purchaser of the option, the purchaser's designee, or the specified trading algorithm actually changes one or more of the assets in the reference basket during the term of the basket option contract.

Consequences of a Listed Transaction

Because basket option contracts are now listed transactions, any person who buys a basket option contract, any general partner of a partnership who buys such a contract, any managing member of a limited liability company who buys such a contract, and any counterparty to such a contract must disclose to the IRS his or her participation in the transaction and certain other details of the transaction. This information is generally disclosed by including Form 8886 in the tax return or amended tax return for each taxable year in which the taxpayer participated in the transaction. In addition, a participant in a listed transaction may be required to send a disclosure statement to the IRS Office of Tax Shelter Analysis.

Disclosure obligations are also imposed in respect of transactions in effect on or after January 1, 2011, even if returns have already been filed, if the statute of limitations for assessment of tax remains open. Failure to comply with these disclosure rules could result in significant penalties to participants and advisers. In addition, failure to comply may result in an extension of the time during which the IRS can assess a tax, and under certain circumstances, such an extension may apply to assessments unrelated to any unsatisfied reporting requirement. “Material advisers” to these transactions also have disclosure and record maintenance obligations.

Very generally, a “material adviser” is a person who

  1. provides advice that relates to a tax aspect of a transaction that causes the transaction to be reported to the IRS,
  2. receives or expects to receive a threshold amount of fees, and
  3. the taxpayer enters into the transaction.

“Basket Contracts” Are Now Considered “Transactions of Interest”

The IRS also issued Notice 2015-48, 2015-30 IRB 1, which, although similar to Notice 2015-47, is much broader as well as different in some key respects. First, Notice 2015-48 identifies “basket contracts” without reference to “options” and indicates that basket contracts may also include certain notional principal contracts, forward contracts, and other derivatives. Unlike Notice 2015-47, there is no explicit definition of what is “substantially similar” to a basket contract, adding subjectivity to the already broad scope notice, which is consistent with the regulations that require the term “substantially similar” to be broadly construed in favor of disclosure. Second, any such basket contract is now considered a “transaction of interest,” which means that the transactions are also “reportable transactions” subject to reporting requirements similar to those for listed transactions described above. Transactions that are substantially similar to basket contracts are also identified as transactions of interest. Third, the effective date is earlier for basket contracts—the notice applies to transactions entered into on or after November 2, 2006 and in effect on or after January 1, 2011 that are the same as, or substantially similar to, the transactions described in Notice 2015-48.

Disclosure obligations for transactions listed in the notices went into effect on July 8, which means that any participants or advisers to such transactions may have immediate obligations (within 90 calendar days of the notices) to report to the IRS prior and ongoing transactions covered by the notices.