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

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Anna Pinedo
In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions