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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