Internal Revenue Service (IRS) recently released Advice
Memorandum 2010-005 (the AM), in which it held that a so-called
barrier option or "knock-out option," as described below,
would not be respected as an option for U.S. federal income tax
purposes and would cause the optionholder to be treated as the
owner of the "optioned" securities.
Generally, when a taxpayer acquires an option, it is not treated as
the owner of the securities underlying the option and is not
required to recognize gain or loss until the option settles or
expires. At the time of settlement, if the asset underlying the
option is a capital asset, the optionholder will generally
recognize long-term capital gain if it held the option for longer
than one year. The IRS's holding in the AM would require a
"barrier" optionholder to accelerate recognition of
income and gain, and may cause the optionholder to recognize
short-term capital gain or ordinary income rather than longterm
capital gain.
Although the AM has limited precedential weight, it reflects the
view, and directive to area counsels, of a senior IRS lawyer, and
its implications should be carefully considered by any taxpayer who
entered into a barrier option or another derivative referencing an
interest in a managed account or a variable basket of securities
(whether held directly or in the form of a private fund, including
a hedge fund).
Facts
In the scenario addressed in the AM, the taxpayer, a hedge fund
(HF), entered into an option with a foreign bank (FB) on a basket
of securities (the Reference Basket). The premium paid by HF for
the option was 10% of the initial value of the Reference
Basket.
The terms of the option provided that upon the settlement date, HF
was entitled to receive the greater of (i) zero, and (ii) the sum
of (a) all gains and income realized on the securities in the
Reference Basket and (b) the option premium less the sum of (x) any
losses or costs incurred in connection with purchasing, holding and
selling the securities in the Reference Basket, and (y) a finance
charge on 90% of the initial value of the Reference Basket.
The option contained a "knock-out" feature whereby it
would immediately settle if the value of the underlying securities
in the Reference Basket decreased by 10% relative to the initial
value of the Reference Fund. FB also had the right to require
certain risk mitigating investment strategies to be implemented if
the value of the securities in the Reference Basket decreased, even
by less than 10%, and certain other conditions were
satisfied.
FB also entered into an agreement with HF's general partner
(GP) to manage the securities that comprised the Reference Basket.
GP, as investment manager of the securities that comprised the
Reference Basket, was required to follow various investment
guidelines. FB had the right to terminate the option if GP violated
these guidelines.
Although not contractually obligated to follow GP's specific
trading instructions, as long as GP's instructions complied
with the investment guidelines, FB in fact always did execute upon
GP's trading instructions. In addition, GP also had the power
to make corporate decisions (i.e., to exercise voting rights)
relating to the securities in the Reference Basket.
FB's rights with respect to the securities in the Reference
Basket were similar to the rights FB had as pledgee with respect to
assets in margin securities accounts of its brokerage
customers.
Finally, GP was paid management fees by FB for its investment
management services to FB. However, such fees were significantly
less than the fees GP ordinarily charged other third parties for
its services.
IRS Holding
The AM concluded that the terms of the "option" caused
HF to have all the upside potential and bear all the downside risk
of the securities in the Reference Basket. Specifically, the
"knock-out" feature of the option effectively ensured
that HF (rather than FB) would bear all the downside risk of the
Reference Basket. In addition, because GP was relying mainly on the
compensation it was receiving from HF and not from FB, the AM
concluded that GP was in essence working for HF. Thus, HF (through
GP) was controlling the securities in the Reference Basket.
Based on the above, the AM advised that the option should not be
respected as such, and that HF should be treated for U.S. federal
income tax purposes as owning the securities in the Reference
Basket throughout the term of the option.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
