IRS Notices on Basket Option Contracts

1 Jan

The Treasury Department issued three Notices in 2015 concerning a structured financial transaction (a “basket transaction”), in which a taxpayer attempts to defer income recognition and convert short-term capital gain and ordinary income to long-term capital gain using a contract denominated as an option contract, notional principal contract, forward contract or other derivative contract. IRS Notices 2015-47, 2015-73 and 2015-74.

Taxpayers take the position that, if the basket transaction is held for more than one year, the gain realized upon the disposition of the contract is long-term capital gain. Taxpayers defer reporting income from the performance of the reference basket until the transaction terminates. The character of the income generated by the reference basket, such as, short-term capital gain, interest income, dividend, is purportedly converted to long-term capital gain.

IRS Notices 2015-73 and Notice 2015-74 both address basket transactions, The difference between the two Notices is the type of contract used and the assets in the reference basket.

The Service finds these deferrals and conversions to be inappropriate. In some cases, taxpayers also may be mischaracterizing the form of the transaction to avoid IRC section 1260, on gains from constructive ownership transactions. Under section 1260, if a taxpayer has gain from a constructive ownership transaction with respect to any financial asset and such gain would be treated as a long-term capital gain, the gain is treated as ordinary income to the extent it exceeds the net underlying long-term capital gain There is an interest charge on the deferral of gain recognition. “Financial asset” for this purpose means (i) any equity interest in any pass-thru entity, and (ii) to the extent provided in regulations, (a) any debt instrument, and (b) any stock in a corporation which is not a pass-thru entity.

A taxpayer is treated as having entered into a constructive ownership transaction if she (i) holds a long position under a notional principal contract with respect to the financial asset, (ii) enters into a forward or futures contract to acquire the financial asset, (iii) is the holder of a call option, and is the grantor of a put option, with respect to the financial asset and such options have substantially equal strike prices and substantially contemporaneous maturity dates, or (iv) to the extent provided in regulations, enters into other transactions that have substantially the same effect.

There is an exception for positions which are properly marked to market.

A person is treated as holding a long position under a notional principal contract with respect to any financial asset if she (i) has the right to receive credit for substantially all of the investment yield (including appreciation) on the asset for a specified period, and (ii) is obligated to provide credit for substantially all of any decline in the value of the asset.

The Service may also challenge the taxpayer’s position in basket transactions under judicial doctrines, such as substance over form, or under IRC section 1001, the basic charging provision for capital gains. The Service may question whether the taxpayer’s method of accounting is permissible under section 446, and whether a section 481(a) adjustment may be warranted. In addition, the Service may challenge claimed tax benefits under sections 871, 881 and 882 on withholding and [], and under other provisions of the Code; and assert failure to comply with reporting obligations associated with investments in passive foreign investment companies, and withholding and reporting obligations.

The Treasury Department and the Internal Revenue Service also believe that a basket option contract is a “tax avoidance transaction”. Transactions in effect on or after January 1, 2011, that are substantially similar to a basket option contract are identified as “listed transactions” for purposes of Treas. Reg. § 1.6011-4(b)(2) and IRC §§ 6111 and 6112, as of October 21, 2015.

Under § 1.6011-4, every taxpayer who has participated in a “reportable transaction” and who is required to file a tax return must file a disclosure statement in prescribed form. A reportable transaction includes a “listed transaction”, i.e., a transaction that is substantially similar to a transaction that the Service has determined to be a tax avoidance transaction and has identified as such in guidance.

A taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance that lists the transaction, or if the taxpayer merely has reason to know that her tax benefits are derived directly or indirectly from such consequences or strategy. “Tax benefits” is defined broadly for this purpose.

A reporting shareholder of a foreign corporation participates in a listed transaction, if the foreign corporation would be considered to participate in the transaction if it were a domestic corporation. This deeming rule applies “only” for the reporting shareholder’s first taxable year within which ends the first taxable year of the foreign corporation in which it participates in the transaction, and for the shareholder’s five succeeding taxable years. A “reporting shareholder” includes a United States shareholder (generally, a 10% shareholder by votes or value) in a controlled foreign corporation.

A transaction is “substantially similar” to a listed transaction, if the subject transaction is expected to obtain the same or similar types of tax consequences and is either factually similar or based on a similar tax strategy. Tax opinions obtained are not considered relevant to this determination; and “substantially similar” must be broadly construed in favor of disclosure, e.g. a transaction involving different entities or Internal Revenue Code provisions may still be “substantially similar”.

The disclosure statement consists of Form 8886, “Reportable Transaction Disclosure Statement”. The taxpayer must describe the expected tax treatment and all potential tax benefits, any tax result protection (as defined), and identify the transaction in sufficient detail for the Service to be able to understand the tax structure and the identity of all parties. A statement that information will be provided upon request is not considered complete disclosure. Disclosure under other regulations does not excuse compliance with these provisions, except for certain ruling applications.

Notice 2015-47 first alerted taxpayers about responsibilities from involvement with these transactions. Industry participants complained that interpretational difficulty could cause taxpayers to file disclosure unnecessarily.

Notice 2015-73 revoked the earlier Notice, and provides additional details on the types of transactions intended. The new Notice describes the tax benefits that identify the transaction as a listed transaction, i.e., a deferral of income into a later taxable year, or a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

The Service may also challenge these transactions under other tax provisions and general tax principles.

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