On July 8, the Internal Revenue Service (IRS) issued two notices (Notice 2015-47, 2015-30 IRB 1, and Notice 2015-48, 2015-30 IRB 1) targeting the use of Basket Option Contracts and Basket Contracts as tax avoidance transactions or possible tax avoidance transactions. Similar transactions have recently been the subject of informal IRS guidance and Congressional scrutiny. See Legal Alert: Congress Scrutinizes Hedge Funds’ Use of Financial Derivatives. As discussed in more detail below, the IRS believes that hedge funds and high-net-worth individuals have been using these contracts to inappropriately defer and lower or avoid taxes. Notice 2015-47 identifies Basket Option Contracts as listed transactions for purposes of Treas. Reg. §. 1.6011-4(b)(2) and IRC §§ 6111 and 6112. Notice 2015-48 identifies Basket Contracts as transactions of interest for purposes of Treas. Reg. §. 1.6011-4(b)(6) and IRC §§ 6111 and 6112. As a result of these designations:

  • Taxpayers participating in these transactions and any substantially similar transactions:
    • Will be required to disclose their participation to the IRS,
    • Will be exposed to significant penalties for failing to make the required disclosures, and
    • May have extended periods for assessment of any taxes if they fail to disclose these transactions.
  • Taxpayers that have an understatement in tax attributable to these transactions are subject to additional penalties with limited defenses.
  • Material advisers to such transactions must also make required disclosures to the IRS and comply with list maintenance requirements.

Sutherland Observation: Given the broad definition of “substantially similar” in Treas. Reg. § 1.6011-4, these two notices are potentially applicable to a wide swath of structured products. As a result, hedge funds and other investors in structured products will need to carefully consider whether they are required to disclose their investments in such products as a result of these notices to avoid penalties for nondisclosure and other potentially negative consequences.

As described in Notice 2015-47, a Basket Option Contract is a contract that is denominated as an option to receive a return based on the performance of a notional basket of referenced actively traded personal property, such as securities. The counterparty for such contracts is generally a financial institution, and the counterparty may hold the referenced property although it is not required to do so. While the option contract remains open, the option holder has the power to determine the assets that comprise the reference basket. A Basket Option Contract will have a stated term of longer than one year but will contain provisions to allow either party to terminate any time with proper notice. If the property in the reference basket were acquired directly by the option holder, the option holder would generally recognize ordinary income or short-term capital gain upon disposition of the property. Under a Basket Option Contract, the option holder takes the position that any gain from the performance of the reference basket is deferred until the contract terminates and, since a Basket Option Contract is typically held for more than a year, the entire gain is treated as a long-term capital gain when the Basket Option Contract is closed.

Basket Contracts as described in Notice 2015-48 are very similar to Basket Option Contracts, the differences being that: (i) a Basket Contract does not necessarily have to be denominated as an option; and (ii) assets in the reference basket can include assets such as securities, commodities, foreign currency or similar property, and interests in entities that trade such property, rather than just actively traded personal property.

The Treasury Department and the IRS are concerned that hedge funds, high-net-worth individuals and other taxpayers are using Basket Option Contracts and Basket Contracts to inappropriately defer income recognition and convert ordinary income and short-term capital gain into long-term capital gain. The Treasury Department and the IRS are also concerned that Basket Option Contracts may be used to mischaracterize transactions so as to avoid (i) application of IRC § 1260 (constructive ownership transactions), (ii) U.S. tax liability under IRC §§ 871, 881, and 882, (iii) tax and reporting obligations with respect to investments in passive foreign investment companies, and (iv) withholding and reporting obligations under Chapters 3 and 4 of the IRC. The IRS stated that it will assert one or more arguments to challenge the parties’ tax characterization of a Basket Option Contract or a Basket Contract, including: (1) that the counterparty, in substance, holds the assets in the reference basket as an agent of the option holder and that the option holder is the beneficial owner of the assets for tax purposes; (2) that the Basket Option Contract is not an option for tax purposes; (3) that changes to the assets in the reference basket during the year materially modify the Basket Option Contract and result in taxable dispositions of the contract under IRC § 1001 at the time of such changes; and (4) that the option holder owns separate contractual rights with respect to each asset in the reference basket such that each change to the assets in the basket results in a taxable disposition of a contractual right under section 1001 with respect to the asset affected by the change.

Basket Contracts are identified as transactions of interest, whereas Basket Option Contracts are required to be reported as listed transactions. Given the similarities between the two types of contracts, it may be difficult to determine whether a particular contract would have to be reported as a listed transaction or as a transaction of interest. Notice 2015-48 provides that if a contract would be treated as both a Basket Option Contract and a Basket Contract, it is treated as a Basket Option Contract that is a listed transaction.

For purposes of both notices, the following parties are treated as participating in the transaction: (i) the purchaser of the Basket Option Contract or Basket Contract, (ii) if the purchaser of the Basket Option Contract or Basket Contract is a partnership, any general partner of the purchaser, (iii) if the purchaser of the Basket Option Contract or Basket Contract is a limited liability company, any managing member of the purchaser, and (iv) the counterparty to the Basket Option Contract or Basket Contract. 

The notices are effective on a retroactive basis. As a result, taxpayers must disclose pursuant to Treas. Reg. § 1.6011-4 for each taxable year that they participated in any Basket Option Contracts or Basket Contracts (or any substantially similar transactions) that were in effect on or after January 1, 2011 (and that were entered on or after November 2, 2006, in the case of Basket Contracts), provided that the statute of limitations for the assessment of tax had not ended on or before July 8, 2015, the release date of the notices. Generally, the required disclosure is filed with the taxpayer’s tax return for the year in which it participated in the transaction. If a taxpayer is required to disclose a transaction for a year in which the taxpayer has previously filed its return, the taxpayer must file a separate disclosure statement with the IRS within 120 days after July 8, 2015.