The Large Business and International (LB&I) Division of the Internal Revenue Service (IRS) announced its first 13 issue-based campaigns on January 31, 2017. As discussed in a prior Eversheds Sutherland Legal Alert, these campaigns focus on tax issues that, in LB&I’s view, pose a substantial risk of non-compliance and address those issues using a varied, flexible set of strategies.
One of the 13 campaigns addresses certain financial arrangements, often used by hedge funds, which purportedly convert gains that would otherwise be short-term or ordinary into long-term capital gains (the Basket Transactions Campaign). On February 6, 2017, LB&I released audit guidelines in a new Practice Unit focused on examinations of these and substantially similar arrangements.
Basket Transactions Defined
IRS Notice 2015-74 describes basket contracts generally as certain financial arrangements that are typically established between a hedge fund or high net worth individual (the taxpayer) and a bank. The instrument may be a forward, an option, a notional principal contract or other derivative agreement. The instrument’s return is based on the return of an underlying notional collection of assets (the reference basket), which can include securities, commodities, foreign currency, hedge fund interests and similar property.
At the inception of the contract, the taxpayer makes an up-front payment to the bank as collateral. The bank typically uses this cash, combined with significant leverage, to purchase the assets in the reference basket to hedge against its obligations to the taxpayer. In many of these contracts, the taxpayer has functional authority to either change the assets in the reference basket or adjust a trading algorithm that chooses the assets throughout the term of the agreement. The bank makes trades parallel to these adjustments to maintain its hedge. The contract may also contain several mechanisms designed to manage the bank’s risk, including provisions allowing voluntary termination by either party, requiring the taxpayer to provide additional collateral in certain circumstances, and triggering automatic termination if the reference basket’s value drops below a certain threshold.
The basket contract’s stated term is more than one year. At maturity, it will be cash settled. The value of the contract will be determined by the change in the value of the reference basket and any other income generated by the assets that were held in the reference basket throughout the term of the contract.
According to the IRS, in the abusive form of these agreements, the taxpayer would have realized short-term capital gains or losses as it bought and sold assets if it owned the reference basket directly, but instead takes the position that it may defer all gains from the basket contract until the instrument reaches maturity or is sold. The taxpayer bases this position on the open transaction doctrine. Additionally, because the holding period in derivatives contracts is typically determined by the taxpayer’s holding period in the contract itself, and not on the underlying assets, the taxpayer takes the position that all of the gains from the reference basket are properly classified as long-term even if the asset was not held in the basket for more than one year.
In addition to basket contracts generally, IRS Notice 2015-73 describes a specific subset of basket contracts – basket option contracts. An instrument qualifies as a basket option contract if it has the characteristics of a basket contract described above, the taxpayer treats the instrument as an option, and “substantially all of the assets in the reference basket primarily consist of actively traded personal property.”
Eversheds Sutherland Observation: Though the abuse targeted is relatively narrow, the definition of basket transactions is fairly broad, and LB&I may target financial contracts that are not abusive in addition to the ones that are. Taxpayers should carefully review their financial arrangements, both existing and planned, to determine whether additional scrutiny by LB&I is likely.
Prior Guidance on Basket Transactions
Basket transactions have drawn scrutiny for a number of years. As early as 2010, the IRS has examined some of these transactions and argued against the tax benefits claimed by taxpayers on a number of theories. As reported in a prior Eversheds Sutherland Legal Alert, in 2014, these arrangements drew the attention of the Subcommittee on Investigations of the Senate Committee on Homeland Security and Government Affairs. The subcommittee recommended that the IRS pursue fraudulent iterations of these arrangements more forcefully.
As discussed in a prior Eversheds Sutherland Legal Alert, in early 2015, the IRS issued two notices, one addressing basket contracts generally and one focused on basket option contracts. In October 2015, the IRS responded to comments on the previous notices by releasing two additional notices narrowing the definitions of basket contracts and basket option contracts. These notices are the latest IRS guidance on the proper treatment of basket contracts. Notice 2015-74 classifies all basket contracts as Transactions of Interest. Notice 2015-73 classifies basket option contracts as Listed Transactions.
Eversheds Sutherland Observation: Taxpayers that enter into transactions that resemble basket contracts face two risks. The risk that the transaction will be found to be abusive is primary, but even if the contract is legitimate, the taxpayer may have an obligation to disclose the transaction because basket contracts are Transactions of Interest and basket option contracts are Listed Transactions. It is possible that disclosures have been filed with the IRS by both taxpayers that have entered into basket contracts and their advisers and that the IRS has already identified taxpayers that will be audited.
On January 31, 2017, LB&I released its first 13 issue-based campaigns, including the Basket Transactions Campaign. The description of this campaign states, in its entirety:
This campaign addresses structured financial transactions described in Notices 2015-73 and 74, in which a taxpayer attempts to defer and treat ordinary income and short-term capital gain as long-term capital gain. The taxpayer treats the option or other derivative as open until a barrier event occurs, and, therefore, does not recognize or report current period gains. The gains are deferred until the contract terminates, at which time the overall net gain is reported as a Long Term Capital Gain. LB&I has developed a training strategy for this campaign. The treatment streams for this campaign will be issue-based examinations, soft letters to Material Advisors and practitioner outreach.
The Basket Transactions Campaign indicates that LB&I is addressing both the Listed Transactions and the Transactions of Interest discussed above and working to distinguish these transactions from non-abusive financial instruments.
LB&I Audit Guidance
On February 6, 2017, LB&I created a new Practice Unit specifically focused on basket transactions. The unit contains audit guidelines that LB&I will use to evaluate these contracts. This guidance provides that auditors will examine five issues related to transactions that resemble basket contracts.
1. Whether the basket transaction is properly characterized as an option or other derivative for federal income tax purposes.
LB&I will examine basket transactions to determine whether a particular taxpayer’s arrangement has enough substantive characteristics of options or other derivative contracts to be classified as such for tax purposes. For example, the auditor will attempt to determine whether there is a real chance that the holder of the derivative will or will not exercise the instrument at maturity. While the choice will be theoretically available, other agreements or situational factors may compel the holder to exercise or not exercise the option in virtually all cases; in such cases, the instrument will not be treated as a derivative for tax purposes. The examiners will analyze the contract and related documents, issue information document requests (IDRs), conduct taxpayer interviews and examine the taxpayer’s tax returns to investigate these issues.
2. If the contract is not properly characterized, whether the taxpayer is the beneficial owner of the reference basket for tax purposes.
If the instrument is found not to be an option or other derivative, LB&I will attempt to determine whether, based on all of the facts and circumstances, the taxpayer has the benefits and burdens of ownership in the reference basket. The auditors will examine which party covers the different expenses associated with holding the reference basket, which party ultimately benefits from the income from and appreciation of the assets, which party substantively bears the risk of loss, and several other factors that evince beneficial ownership. To make these determinations, the investigators will review transaction documents, issue IDRs, and interview the taxpayer and third parties. The Practice Unit instructs the auditors to look beyond the formal rights of the parties and analyze whether the actual practices employed matched the form of the transaction.
3. If the taxpayer is not the beneficial owner, whether IRC section 1260 applies to determine that the taxpayer had gain from constructive ownership of the reference basket.
LB&I will attempt to determine whether the reference basket assets meet the terms of IRC section 1260; if they do, any gains will be classified as ordinary. IRC section 1260 is primarily intended to govern the tax treatment of hedge fund derivatives and is therefore fairly narrow. Though the IRS may expand the reach of this section through regulations, currently, the rules only apply to instruments that give the holder approximately dollar-for-dollar exposure (such as forwards, long positions in notional principal contracts and zero cost collars) to the assets held by passthrough entities. The auditors will examine the terms of the basket contract to determine whether the basket contract is a constructive ownership transaction.
4. Whether changes to the assets in the reference basket during the year result in taxable dispositions under IRC section 1001 throughout the term of the contract.
In its guidance, LB&I proposes two separate lines of reasoning through which changes to the reference basket could be treated as dispositions. First, the taxpayer may be viewed as having separate contractual rights in each security in the reference basket. If this is the case, the elimination of an asset from the basket terminates a distinct contractual interest, resulting in a realization event under IRC section 1001. Alternatively, LB&I may argue that each adjustment to the contents of the reference basket should be viewed as a material change in the overall terms of the contract. Such a change would constitute a realization event under the “hair trigger” test established by the U.S. Supreme Court in Cottage Savings Ass’n v. Comm’r. To establish a factual basis for these arguments, the examiners will review the basket contract, track adjustments to the reference basket, issue IDRs and conduct interviews with the taxpayer and third parties.
5. Whether a change in accounting method under IRC section 446 occurs if it is determined that the basket transaction can no longer be treated as an option or other derivative.
If the examiners determine that the basket contract should not be treated as an option or other derivative, the taxpayer’s treatment of the contract in prior years must be corrected. The Practice Unit states that this correction may constitute a change in accounting method described in IRC section 446. For example, corrections to the way that the taxpayer should report the timing of realization and the character of gains or losses may be considered changes in accounting method. If a change in accounting method occurs, the taxpayer must make adjustments pursuant to IRC section 481 to reconcile its past erroneous reporting positions with the proper ones. The auditors will review the contract and the assets in the reference basket, issue IDRs and interview the taxpayer to determine whether a change in accounting method has occurred and, if one has, to calculate the necessary adjustments.
Eversheds Sutherland Observation: These guidelines illustrate LB&I’s approach to issue campaigns that provide for examinations. The auditors are instructed to thoroughly address all of the issues related to this type of transaction, but in many cases, they will not focus on many other aspects of a taxpayer’s financial affairs. In other words, the audits will be deep, but narrow. Because LB&I is clearly communicating which issues are likely to be examined, taxpayers have the opportunity to proactively identify potential vulnerabilities and prepare to address them in a cost-effective way.