On July 8, 2015, the Internal Revenue Service (the “IRS”) identified as reportable transactions certain derivative contracts that reference a basket of assets. The transactions identified by the IRS are referred to by the IRS as “basket option contracts” or “basket contracts.” In these transactions, a purchaser enters into a contract that is denominated as an option, a notional principal contract (e.g., a swap), a forward contract or other derivative contract with a counterparty to receive a return based on the performance of a notional basket of referenced assets (the “reference basket”). The reference basket may include (1) “actively traded personal property” (e.g., publicly traded stock), (2) interests in hedge funds or other entities that trade securities, commodities, foreign currency or similar property, (3) securities, (4) commodities, (5) foreign currency or (6) similar property or positions in such property. The purchaser or a designee named by the purchaser will either determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets. While the contract remains open, the purchaser has the right to request changes in the assets in the reference basket or the specified trading algorithm.
The purchaser generally takes the position that short-term gains and interest, dividend and other ordinary periodic income from the performance of the reference basket is deferred until the instrument terminates and, if the instrument is held for more than one year, that the entire gain is treated as longterm capital gain. According to the IRS, the purchaser may be using the instrument to inappropriately defer income recognition, convert ordinary income and short-term capital gain into long-term capital gain and/or avoid U.S. withholding tax.
Anyone who has participated in a basket option contract, basket contract or substantially similar transaction is now subject to certain IRS reporting obligations. The following parties are generally considered participants by the IRS and are, therefore, subject to these reporting obligations: (1) the purchaser, (2) if the purchaser is a partnership, any general partner of the purchaser, (3) if the purchaser is a limited liability company, any managing member of the purchaser and (4) the counterparty.
Each participant in a basket option contract, basket contract or substantially similar transaction that was in effect on or after January 1, 2011 must report the transaction to the IRS, provided that the period of limitations did not end on or before July 8, 2015. If a participant has already filed its tax return for a year in which it participated in a basket option contract, basket contract or substantially similar transaction and the period of limitations has not ended, the participant needs to report the transaction to the IRS by November 5, 2015. Significant penalties and an extended statute of limitations may apply if a reportable transaction is not timely reported. In addition to the reporting obligations, a participant in a reportable transaction must also retain copies of all material documents and other records relating to the transaction.