United States: MoFo Tax Talk, Volume 8, No. 2 August 2015


It was only a matter of time before "transactions of interest" ("TOIs") found their way to Wall Street. Way back in 2006, the IRS added a new category of "reportable transaction" (reported on IRS Form 8886): a "transaction of interest." Unlike the other reportables, e.g., "listed" transactions, conditions of confidentiality, etc., a TOI wasn't per se bad. It was just something the IRS suspected might be bad but needed more information. Since 2006, the IRS has announced four relatively narrow TOIs involving charitable contributions of real estate, termination and re-creation of grantor trust status, sale of interests in charitable remainder trusts, and use of domestic partnerships to prevent inclusion of subpart F income. None of them had much to do with financial instruments.

That all changed right after the end of 2015 Q2 when the IRS announced that "basket contracts," e.g., certain derivatives based on a basket of stocks, were TOIs. This, coupled with a July weekend NYSBA Tax Section panel featuring the IRS's Associate Chief Counsel (Financial Institutions and Products), has led to much confusion about what a "basket contract" is. Unfortunately, tax lawyers have a quaint notion that stock "indices" are static—they never change. Put aside the fact that even the DJIA is administered by a three-person committee. Are they money managers? Are they journalists? What are they? And should this affect the tax treatment of someone who buys a DJIA derivative? Probably not, however, this month's Tax Talk explains the IRS notice in question and the resulting market confusion.

In other news, Tax Talk reports on proposed regulations on publicly traded partnerships and final and temporary regulations on nonperiodic payments under notional principal contracts. We also discuss two tax cases—a circuit court case regarding the applicability of an excise tax to retrocessions and a tax court case regarding "investor control" of separate accounts for variable life insurance contracts—and review a (heavily redacted) field service advice memorandum regarding consent payments to noteholders. Finally, Tax Talk checks in with our elected officials in Washington, where tax reform remains a topic. Bipartisan working groups on the Senate Finance Committee published five separate reports on tax reform, and Sen. Rand Paul filed a lawsuit challenging FATCA. Enjoy!


On Wednesday, July 8, the IRS released two notices addressing "basket contracts," which are generally derivative instruments linked to a basket of reference assets that, among other things, allow the holder to vary the basket over the instrument's life. According to the IRS, these types of contracts have the potential for tax avoidance because taxpayers account for gain or loss on the contract once the contract terminates instead of when changes to the underlying assets are made. This may result in deferral and conversion of short-term capital gain into long-term capital gain and other tax discontinuities. Basket contracts were first scrutinized in AM 2015-005, where the IRS recharacterized option contracts as direct ownership in the underlying assets.1

The two notices denominate certain basket contract transactions as "listed transactions," and others as "transactions of interest." Both listed transactions and transactions of interest are "reportable transactions," requiring the taxpayer and the taxpayer's material advisors to disclose the transaction on their tax returns. Among other things, penalties for failing to disclose a listed transaction are more severe than penalties for failing to disclose other types of reportable transactions.

Under Notice 2015-47, transactions are listed transactions if (1) the transaction is denominated as an option contract, (2) the underlying assets are publicly traded, (3) the purchaser of the option (or the purchaser's designee) has the right to determine (or select or use a controlled algorithm to determine) the assets in the reference basket both at inception and periodically over the term of the transaction, and (4) the purchaser (or the purchaser's designee) actually exercises such control.

Notice 2015-48, which describes transactions that are transactions of interest, does not specifically enumerate factors that cause a transaction to be a transaction of interest. However, the transactions described in Notice 2015-48 are similar to those described in Notice 2015- 47 in that they are contracts that allow the holder to vary the assets in the reference basket over the life of the contract. Notably, however, contracts do not have to be denominated as options in order to be transactions of interest under Notice 2015-48.

Notice 2015-48 thus describes a basket contract as an option, notional principal contract, forward contract, or other derivative contract through which a taxpayer "attempts to defer income recognition and may attempt to convert short-term capital gain and ordinary income into long-term capital gain." The underlying assets may include securities, commodities, foreign currencies, or similar properties, as well as interests in entities that trade these properties. The taxpayer or its designee has the right to determine (or select or use a controlled algorithm to determine) the assets in the reference basket and to request changes to the assets in the reference basket (or to the algorithm). Notice 2015-48 also includes characteristics typical of a basket contract. For example, the taxpayer typically pays upfront between 10% and 40% of the value of the underlying assets, and the basket contract typically terminates if the value of underlying assets decreases by the amount of the upfront payment.

Both notices require that either the taxpayer or the taxpayer's designee be able to control the contract's underlying assets. However, it is not clear from the notices what it means for one to be a taxpayer's designee. Notably, at an NYSBA Tax Section panel on July 12, IRS Associate Chief Counsel (Financial Institutions and Products) Helen Hubbard said that, in her personal view, an unrelated investment advisor managing a basket might be an investor's "designee."2 The meaning of "designee" may be crucial for determining the scope of the notices, given that, in the case of index-linked contracts, there may always be someone that controls the composition of the underlying assets (e.g., the index sponsor).



A notional principal contract ("NPC") is a financial instrument under which one party pays amounts to another at certain intervals by looking to a specified index on a notional principal amount. In return, the counterparty agrees to pay a certain amount of consideration or promises to pay similar amounts. Any payments in addition to those prescribed in the intervals, like upfront payments, are nonperiodic payments. Under rules found in Treasury Regulation Section 1.446-3, when an NPC includes a "significant" nonperiodic payment, the contract is bifurcated into two separate transactions: an on-market, level payment swap and a loan. This is referred to as the embedded loan rule. The loan must be accounted for separately from the swap, and the timevalue component of the loan is treated as interest for all purposes of the Code.

The Dodd-Frank Act of 2010 changed some requirements for NPCs. Specifically, the Act imposes clearing and trade execution requirements, creates rigorous recordkeeping and real-time reporting regimes, and enhances rulemaking abilities of the federal regulators. In response, the Commodity Futures Trading Commission mandated that certain swap contracts (cleared contracts), which include NPCs under Section 1.446-3, be cleared through U.S.-registered clearing organizations. The issue that these regulations aim to correct is that clearing NPCs through clearinghouses often gives rise to upfront payments because of clearinghouse requirements to post collateral, and the regulations required those payments to be bifurcated. These rules lead to additional administrative complexity for parties entering NPCs.

Temporary Regulations

On May 8, 2015, the Treasury issued final and proposed regulations changing the treatment of nonperiodic payments with respect to NPCs. The new temporary regulations simplify the embedded loan rule by removing the requirement that nonperiodic payments be significant, and narrowing the rule by adding two exceptions under Section 1.446-3T. Under the first exception, a nonperiodic payment made under an NPC with a term of one year or less does not have to be bifurcated (the "short-term exception"). The anti-abuse rule for the short-term exception provides that the IRS may treat two or more contracts as a single contract if a principal purpose of entering into separate contracts is to qualify for the exception. The second exception applies to NPCs cleared by a derivatives clearing organization or certain other clearing agencies, as well as swaps that have a collateralization arrangement ensuring a full cash margin for the duration of the swap. To qualify for the margin exception, all collateral must be paid in cash. If the collateral posted is less than a full 100%, the exception will not apply.

Additionally, the Treasury issued temporary regulations in conjunction with the new rules described above under Section 956. Under those regulations, certain obligations of U.S. persons arising from upfront payments on NPCs that qualify for the margin exception to the embedded loan rule are exempted from the definition of U.S. property. Only an upfront payment made by a controlled foreign corporation that is either a dealer in securities under Section 475(c)(1) or a dealer in commodities will qualify for the exception.

Practitioner Concerns

While practitioners are relieved to have the exceptions to the rule, the Regulations have also caused some concern. First, since the regulations remove "significant" from the description of nonperiodic payments subject to the embedded loan rule, there is no longer a de minimis exception. If an NPC has a small upfront payment and no collateral, the NPC is still subject to the embedded loan rule, while under the old rules it would not be. Second, the margin exception's requirement that all collateral be posted in cash limits the scope of that exception.


In Validus Reinsurance, Ltd. v. U.S., No. 14-5081, the D.C. Circuit held that the excise tax imposed under Section 4371 does not apply to retrocessions between foreign reinsurers.

Validus Reinsurance, Ltd. is a corporation organized in Bermuda that sells reinsurance to insurance companies that sell policies in the United States. Validus also purchases retrocessions (i.e., insurance on reinsurance) from foreign retrocessionaires. The IRS determined that Validus owed Section 4371 excise tax on the premiums paid on the retrocessions.3 Validus paid the tax and filed a claim for refund in the federal district court challenging the tax. Validus argued that the tax does not apply to retrocessions and, in the alternative, that Congress did not intend for the tax to apply to retrocessions between foreign parties. The federal district court granted summary judgment for Validus, holding that the excise tax did not apply to retrocessions.

On appeal, the D.C. Circuit found that each party presented a plausible argument based on a plain reading of the statute, and that the statute was therefore ambiguous. The D.C. Circuit resolved this ambiguity by relying on the presumption against an extraterritoriality application of the statute. The presumption assumes a statute does not apply outside the U.S. unless clearly intended by Congress. After reviewing the statute and the legislative history, the D.C. Circuit found no clear evidence that Congress intended the statute to reach outside the U.S., and so decided in favor of Validus. By concluding that Section 4371 does not apply to retrocessions between foreign parties, the D.C. Circuit narrowed the federal district court's ruling.


In Webber v. Commissioner, 144 T.C. No. 17, the U.S. Tax Court invoked the "investor control" doctrine in finding that a taxpayer was the true owner of the assets held in segregated accounts for variable life insurance policies.

Taxpayer, a venture capital investor, established a grantor trust to purchase "private placement" variable life insurance contracts on two elderly relatives. The premiums paid on these investments were placed in separate accounts, segregated from the assets of the insurance company. Taxpayer intended for the investment strategy to defer income and capital gains on the investments in the separate accounts, and ultimately to pass the funds to beneficiaries without incurring income and estate tax.

The money in the separate accounts was used to purchase investments in start-up companies in which Taxpayer had financial interests. The record showed that Taxpayer effectively directed the investment manager of the separate accounts to invest in these companies.

The Tax Court applied the "investor control" doctrine, first set forth in Rev. Rul. 77-85. Under the investor control doctrine, an investor that has sufficient "incidents of ownership" is deemed the true owner of the assets despite the fact that the assets are nominally owned in a separate account. The Tax Court held that Taxpayer had sufficient "incidents of ownership" because Taxpayer had the unfettered ability to select investments by directing the investment manager to buy, sell, and exchange assets. The Tax Court looked beyond the written policies of the separate accounts which gave the investment manager complete discretion to select investments. In reality, the investment manager complied with Taxpayer's investment directives. In addition to directing investments in the separate accounts, Taxpayer, through his agents, directed what actions the investment manager should take in its capacity as shareholder. Taxpayer also had various methods of extracting cash from the separate accounts, including by selling assets to the separate accounts.

Because Taxpayer was held to be the owner of the investments in the separate account for federal income tax purposes, Taxpayer was liable for the taxable income earned on those investments during the taxable years at issue. However, the Tax Court find did not hold Taxpayer liable for the accuracy-related penalty under Section 6662(a) because the Tax Court found that Taxpayer relied in good faith on professional advice from a competent tax professional.

Notably, the Tax Court rejected Petitioner's argument that Congress eliminated the "investor control" doctrine when Congress added Section 817(h) to the Code in 1984. Section 817(h) provides that a variable contract based on a separate account shall not be treated as an annuity, endowment or life insurance contract for any period for which the investments in the separate account are not adequately diversified in accordance with treasury regulations. Legislative history shows Congress directed that the new diversification standards apply where investments are made "in effect, at the direction of the investor." The Tax Court noted that this language refers to situations where investments are actually selected by an insurance company, but are so narrowly focused and undiversified as to be a proxy for investments that are publicly available to investors. In contrast, the "investor control" doctrine applies to situations where investment decisions are made at the actual direction of an investor. Furthermore, the Tax Court noted that the preamble to the final regulations regarding Section 817(h) states that the diversification standards do not provide guidance regarding the "investor control" doctrine. Thus, the Tax Court concluded that Section 817(h) does not displace the "investor control" doctrine.

To read this Newsletter in full, please click here.


1. For our client alert addressing AM 2015-005, please see http://media.mofo.com/files/Uploads/Images/101115-Knock-Out-Option.pdf; for prior Tax Talk coverage of basket contracts, please see Tax Talk 7.2, available at http://www.mofo.com/~/media/Files/Newsletter/2014/07/140729TaxTalk.pdf.

2. For a report on that meeting, please see Lee A. Sheppard, News Analysis: Hubbard Addresses Basket Contract Notices and Other Developments, Tax Notes, 148 Tax Notes 255 (July 20, 2015).

3. In Rev. Rul. 2008-15, the IRS took the position that Section 4371 applies to retrocessions between foreign parties where the underlying risk resides in the United States.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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