United States: IRS Issues Notices Covering "Basket Option" And "Basket Contract"

On July 8, 2015, the IRS issued Notice 2015-47 and Notice 2015-48, which designated  "basket option" transactions as listed transactions and "basket contract" transactions as  transactions of interest. The Notices state that the Service is concerned that taxpayers  may be using basket options and basket contracts to defer income recognition and  convert ordinary income and short-term capital gain into long-term capital gain, among  other potential abuses.

Notice 2015-47

Notice 2015-47 identified transactions that it referenced to as "basket option contracts"  and any substantially similar transactions as "listed transactions."¹⁷  A basket option  contract is described as a contract denominated as an option between a taxpayer and its  counterparty (a bank) with a stated term of more than one year. Under the contract, the  taxpayer pays an amount to the bank upfront, and the bank promises to pay the taxpayer  a return based on the performance of a notional basket of actively traded property,  reduced by a fee to compensate bank for entering into the contract. The contract typically  terminates automatically if the reference basket value decreases by an amount that  approaches the amount of the upfront payment. In addition, either party may terminate  the contract at any time with proper notice.

The components of the basket are determined by the taxpayer (or its designee) or by an  algorithm selected by the taxpayer or designee. During the contract term, the taxpayer may request changes to the basket components or the algorithm, subject to the bank's  right to reject certain requested changes. In practice, the bank generally accepts the  taxpayer's requests. The bank typically acquires the basket components as a hedge of its  risk under the contract and acquires and disposes of the basket components as changes to  the reference basket are made.

The taxpayer takes the position that short-term gains and ordinary income with respect  to the referenced property are not includible in income by the taxpayer; rather, the  taxpayer reports long-term capital gain with respect to the termination of the option  contract. The Notice states concern that such treatment is inappropriate and identifies  basket option contracts and substantially similar transactions as listed transactions. For  this purpose, the Notice states that a transaction is considered substantially similar to a  basket option contract if: (i) the transaction is denominated as an option contract;  (ii) substantially all of the assets in the referenced basket primarily consist of actively  traded personal property as defined under Section 1.1092(d)-1(a); (iii) the purchaser of  the option or the purchaser's designee has the right to: (1) determine the assets in the  reference basket both at inception and periodically over the term of the transaction, or  (2) select or use a specific trading algorithm under its control to determine the assets in  the reference basket and (iv) the purchaser of the option, the purchaser's designee or the  specified trading algorithm actually changes one or more of the assets in the reference  basket during the term of the basket option contract.

Notice 2015-48

Notice 2015-48 identified transactions that it referred to as "basket contracts" and any  substantially similar transactions as "transactions of interest." The basket contract  transactions bear some similarities to the basket options designated as listed transactions  in Notice 2015-47, but need not be denominated as options (and instead may be  denominated as any type of derivative contract), and may reference non-actively traded  property. Pursuant to the Notice, the basket contracts identified as transactions of  interest entitle a taxpayer to receive payments based on the return of a referenced basket  of assets, which may include hedge fund interests, securities, commodities, foreign  currency or similar property, that is determined by the taxpayer, its designee or a trading  algorithm selected by the taxpayer or its designee. During the term of the contract, the  taxpayer or its designee has the right to request changes in this reference basket assets or  the specified algorithm, which the counterparty generally accepts. To manage its risk  under the basket contract, the counterparty typically acquires all or substantially all of the  reference basket of assets. Notice 2015-48 does not specifically define when a transaction  is substantially similar to the transaction of interest described in the Notice. However,  Treas. Reg. § 1.6011-4(c)(4) states that a transaction is substantially similar if it: (i) is  expected to obtain the same or similar types of tax consequences as the transaction of  interest, and is either (A) factually similar, or (B) based on the same or similar tax strategy. Generally, the term "substantially similar" must be broadly construed in favor of  disclosure. 

Notice 2015-47 applies to transactions in effect on or after January 1, 2011. Notice  2015-48 applies to transactions entered into on or after November 2, 2006 and in effect  on or after January 1, 2011. Participants in the Notice transaction include the purchaser of  the contract, any general partners or managing members of a contract purchaser that is a  partnership or LLC and the counterparty to the contract.

Taxpayers involved in transactions that fall under either Notice must disclose the  transaction, under Section 6011, for each taxable year in which the taxpayer participated  in the transaction for which the statute of limitations had not run on or before July 8,  2015. Disclosure is required within 120 days of the issuance of the Notices (i.e., by  November 5, 2015). Material advisors (as defined under the Code) who made a tax  statement on or after January 1, 2011 with respect to such transactions have a duty to  register under Section 6111 and a duty to maintain an investor list under Section 6112.

Potential Penalties

The penalties for failure to disclose, register and maintain a list can be substantial. The  penalty under Section 6707A for failure to disclose a reportable transaction under  Section 6011 is 75 percent of the decrease in tax as a result of the transaction, subject to a  maximum cap of $200,000 in the case of a listed transaction for an entity, or $100,000  for an individual. The basket option contracts are considered to be listed transactions.  The penalty under Section 6707 for failure to register the transaction is the greater of  $200,000 or 50 percent of the gross income derived by such person. The penalty under  Section 6708 related to maintaining an investor list is $10,000 for each day a material  advisor fails to furnish a reportable transaction advisee list to the Service starting the day  after the 20th day from which such list was requested in writing from the Service. A  reasonable cause defense is applicable to Section 6708, but is not applicable to  Section 6707.

Footnotes

17   The basket option contracts identified as listed transactions in the Notice are similar in many respects to the basket contract options addressed in GLAM 2010-005, which was issued by the IRS in 2010. The GLAM concluded that a basket option contract was not an option and that the hedge fund that purchased the "option" instead owned the reference basket of assets.

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