Of Q4’s federal tax developments, one is already appearing regularly on structured products, and another provides taxpayers with an idea of how the IRS thinks basket option contracts fitting within two October 2015 notices should be treated for federal income tax purposes.5 A brief summary of each follows.
Extension of New Dividend Equivalent Rules
In September 2015, the IRS issued new final and temporary Treasury regulations under Internal Revenue Code Section 871(m) that cover dividend equivalent payments to nonresident aliens.6 Generally, the rules treat “dividend equivalents” paid under certain notional principal contracts and equity-linked instruments as U.S. source dividends; accordingly, they are subject to U.S. withholding tax if paid to a non-U.S. person. The initial release of the rules had an effective date that was graduated over 2015, 2016 and 2017. Contracts entered into in 2015 were exempt from the rules, contracts issued in 2016 were only subject to the rules if the contracts made payments in 2018 or onwards, and all contracts issued in 2017 were captured. The concern among issuers of financial contracts was that the short period between September and January 1, 2016 was not enough time to put in place the needed infrastructure to comply with the recordkeeping, determination and withholding requirements under the regulations.
On December 7, 2015, the Internal Revenue Service issued an amendment to the new dividend equivalent regulations to change this effective date.7 Now, the dividend equivalent regulations will only apply to any payment made on or after January 1, 2017, for any transaction issued on or after January 1, 2017. Thanks to the extension, issuers will have the full 2016 calendar year to develop the architecture that is needed to meet the requirements of the new regime.
IRS Ruling Describes How to Account for Notice 2015-73 and Notice 2015-74 Basket Option Contracts
On October 21, 2015, the IRS issued Notice 2015-73 and Notice 2015-74. These Notices revoked Notice 2015-47 and Notice 2015-48, respectively, and replaced them with new guidance.8 In addition to releasing the revised Notices, in November, the IRS released CCA 201547004, which elucidates the IRS’s view on how basket option contracts that fit within the Notices should be treated for federal income tax purposes.
There, the taxpayer purchased two options on a basket of hedge fund limited partnership interests from a bank, which the taxpayer’s designee could and did change over the life of the options. Consistent with the basket notices, the IRS concluded that the contracts did not constitute options because they did not function or have the economic characteristics of options. Since the contracts were not options, the IRS explained two different treatments for them. First, to the extent the bank held the referenced assets on the taxpayer’s behalf (including as a hedge for the options), the option contracts transferred ownership of the referenced assets to the taxpayer for tax purposes. Second, if the taxpayer could not be considered the owner of the referenced assets for tax purposes (for example, if the bank did not hold the limited partnership interests as a hedge) and the referenced asset was a passthrough entity, then the taxpayer would be subject to the constructive ownership provisions of Code Section 1260 with respect to the referenced asset. Additionally, the IRS stated that where the taxpayer has the discretion to change a basket and exercises that discretion, changes in the referenced basket could constitute a fundamental change in the option and result in a taxable deemed exchange for the taxpayer of the old options for new options.
If taxpayers choose to file amended returns pursuant to the new Notices for basket option contracts they have already entered into, CCA 201547004 provides a roadmap on how to treat those transactions.