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

As previously reported, 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.21 However, on October 21, 2015, the IRS revoked Notice 2015-47 and Notice 2015-48 and issued Notice 2015-73 and Notice 2015-74 as replacements to cover basket options and basket contract transactions. The prior notices were replaced in response to concerns expressed by practitioners and taxpayers about the difficulty of identifying transactions that are the same as or substantially similar to the transactions described in Notice 2015-47 and Notice 2015-48. The new notices attempt to cure the uncertainty by providing additional details on the types of transactions that are the same as or substantially similar to the transactions described in the prior notices.

Notice 2015-73

Notice 2015-73, which replaced Notice 2015-47, identifies transactions that it references to as "basket option contracts" and any substantially similar transactions as "listed transactions." The general definition of a basket option contract has not changed and is still described as a contract denominated as an option between a taxpayer and its counter party (bank) with a stated term of more than one year. The option entitles the taxpayer to receive a return based on the performance of a notional basket of referenced, actively traded personal property, and the taxpayer or its designee changes the components of the referenced basket or is in control of a trading algorithm that changes those components. What's new in the notice is that it identifies additional features of the transaction that must be present in order for it to be substantially similar to a basket option contract and excludes certain transactions from being substantially similar to a basket option contract.

Under Section 2.01 of the notice, the transaction is the same as or substantially similar to the transaction identified in the notice only if: "(1) T [taxpayer] enters into a transaction with C [counterparty] that is denominated as an option contract; (2) T receives a return based on the performance of the reference basket; (3) substantially all of the assets in the reference basket primarily consist of actively traded personal property as defined under § 1.1092(d)-1(a); (4) the contract is not fully settled at intervals of one year or less; (5) T or t's designee has exercised discretion to change (either directly or through a request to C) the assets in the reference basket or the trading algorithm; and (6) T's tax return for a taxable year ending on or after January 1, 2011 reflects a tax benefit described in Section 2.04 of this notice." A "tax benefit" is defined as a "deferral of income" into a later taxable year or conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss. If for some reason the taxpayer's tax benefit is different, then the transaction is not the same or substantially similar to the basket option transaction.

Sections 2.02 and 2.03 of the notice provide additional guidance about who may be considered the taxpayer's designee and when the taxpayer or its designee will be considered to have discretion to change the referenced basket of assets or the trading algorithm that manages the basket. A designee must be either the taxpayer's agent or compensated or selected by the taxpayer to suggest, request or determine changes in the referenced basket or the trading algorithm. The taxpayer is not considered to compensate or select a person to suggest, request or determine changes in the referenced basket or trading algorithm, however, as a result of (1) the person's position as an investment advisor, officer or employee of an issuer of publicly offered securities included in the basket, (2) the person's use or licensing of an index that is widely used, publicly quoted and based on objective financial information or an index that tracks a broad market or market segment or (3) the person's authority to suggest, request or determine changes in such an index. A taxpayer or its designee are not considered to have discretion to change the basket or trading algorithm if changes are made according to rules that are disclosed at the inception of the transaction and the taxpayer or designee does not have the right to alter, amend or deviate from the rules. There is no alteration, amendment or deviation solely because the taxpayer or designee exercises routine judgment in administering the rules, corrects implementation or calculation errors or makes adjustments to respond to unanticipated, extraordinary events outside of the taxpayer's control.

The notice also excludes certain transactions from being substantially similar to a basket option contract in Section 2.05. A transaction is not treated as a listed transaction by the notice if: (1) the contract is traded on (a) a national securities exchange that is regulated by the Securities and Exchange Commission or a domestic board of trade regulated by the Commodity Futures Trading Commission, or (b) a foreign exchange or board of trade that is subject to regulation by a comparable regulator; or (2) the contract is treated as a contingent payment debt instrument under § 1.1275-4 (including a short-term contingent payment debt instrument) or a variable rate debt instrument under § 1.1275-5. With respect to T, a transaction is not the same as, or substantially similar to, the transaction described in this notice unless T's tax return for a taxable year ending on or after January 2, 2011 reflects a tax benefit of the transaction that is described in Section 2.04 of the notice. With respect to C (counterparty), a transaction is not the same as or substantially similar to the transaction described in this notice if: (1) T represents to C in writing under penalties of perjury that T's tax return will not reflect a tax benefit described in Section 2.04 of this notice in any taxable year ending after January 1, 2011, or (2) C has established that T is a non-resident alien or foreign corporation that is not engaged in a US trade or business by obtaining a valid withholding certificate from the beneficial owner of the payments made or to be made under the basket option contract (W-8BEN, W-8BEN-E OR W3-8EXP), or in the case of payments made outside of the US on offshore obligations, by obtaining documentary evidence as described in Treas. Reg. § 1.1441-1(c)(17).

Notice 2015-74

Notice 2015-74 identifies transactions that it referred to as "basket contracts" and any substantially similar transactions as "transactions of interest." As previously noted in Notice 2015-48, the basket contract transactions bear similarities to the basket options designated as listed transactions in Notice 2015-73, 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. Notice 2015-74 updates Notice 2015-48 by defining when a transaction is considered the same as, or substantially similar to, a basket contract. A transaction will be a reportable transaction of interest under Notice 2015-74 only if: (1) T enters into a contract with C to receive a return based on the performance of the reference basket; (2) the basket contract has a stated term or more than one year or overlaps two of T's taxable years; (3) T or T's designee has exercised discretion to change (either directly or through a request to C) the assets in the reference basket or the trading algorithm; and (4) T's tax return for a taxable year ending on or after January 1, 2011 reflects a tax benefit of the same type described in Notice 2015-73—a "deferral of income into a later taxable year or conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss." Notice 2015-74 contains the same guidance for determining when a person is the taxpayer's designee and when the taxpayer or its designee has discretion over the basket that is included in Notice 2015-73.

In addition, transactions that are excluded from reportable transaction treatment under Notice 2015-73, Section 2.05, are excluded as transactions under Notice 2015-74.

Effective Date

Notice 2015-73 applies to transactions in effect on or after January 1, 2011. Notice 2015-74 applies to transactions entered into on or after November 2, 2006 that were in effect on or after January 1, 2011. Participants in the notice transaction include the purchaser of the contracts, 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 October 21, 2015. Material advisors who made a tax statement on or after January 1, 2011, with respect to transactions in effect on or after January 1, 2011, have disclosure and list maintenance obligations under Sections 6111 and 6112. The penalty under Section 6707A for failure to declare a reportable transaction under Section 6011, and penalties under Section 6707 for failure to register the transaction are both substantial. A reasonable cause defence is applicable to Section 6708, but it is not applicable to Section 6707.

Accounting Method Change

Both notices contain instruction regarding a taxpayer's request to change a method of accounting under Section 446(e) and Treas. Reg. §1.446-1(e). The Service will permit a taxpayer to change the accounting method for a transaction described in the notice for a transaction in which the taxpayer's only tax benefit is a deferral of income into a later taxable year. The change may be made by either (1) filing amended returns in accordance with Section 3.06(3) of the notice, or (2) if eligible, requesting a change in method of accounting under the non-automatic change procedure of Rev. Proc. 2015 13, subject to the rules provided in the notice. However, the IRS will not permit a change in method of accounting filed under Rev. Proc. 2015-13 if the tax benefit involves the conversion of ordinary income or short-term capital gains or loss into long-term capital gains or loss. A taxpayer may, however, change its method of accounting for a conversion transaction within the scope of the notice by filing an amended return in accordance with Section 3.06(3) of the notice.

Footnotes

21 See Shearman & Sterling, Focus on Tax Controversy and Litigation, September 2015 Newsletter, at 6-8.

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.

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