Chief Counsel Advice Memorandum Released on Options on Basket of Hedge Funds

On November 23, 2015, the IRS released Chief Counsel Advice Memorandum (“CCA”) 201547004, which concerns the federal income tax treatment of a taxpayer entering into an “option” contract on a basket of U.S. and non-U.S. hedge funds.   

In our Alerts of July 14, 2015 and November 3, 2015, we discussed the position of the IRS on certain basket option contract transactions as “listed transactions” and other basket contracts as “transactions of interest,” as reflected in Notices 2015-47 and 2015-48, and updated in Notices 2015-73 and 2015-74. Not surprisingly, this CCA is fully consistent with the general tenor of the notices. It provides a more detailed picture of the Service’s view of these types of transactions, in particular where the referenced assets are hedge fund interests, more specifically an “index” of hedge funds (the “basket”), and cash.  

Summary of Facts. According to the CCA, taxpayer (“taxpayer”), a partnership of an individual (“individual 1”) and his wife, and a corporation, purchased cash-settled barrier “call options” from a bank (“bank”). A “barrier option” is an option contract whose payoff depends on whether or not the price of the underlying asset crosses a certain level during the option’s lifetime. 

In the given case, the contract terms, typical of this type of option, are rather complex. In each contract, the “premium” is K percent of the contract’s initial notional amount. The strike price is (100 - K) percent of the initial notional amount, as adjusted for an annualized LIBOR and spread amount (i.e., interest-like charges and fees imposed by bank) and as modified by the so-called “barrier provisions” (i.e., adjusted upwards to the extent that bank contributes additional capital to re-leverage taxpayer’s position, and adjusted downward to the extent bank withdraws capital to de-leverage taxpayer’s position). The “cash settlement amount” payable to taxpayer at maturity or early termination equals the value of the portfolio minus the strike price, subject to a floor of zero. The barrier provisions, however, are intended to prevent the floor from being reached. Namely, the barrier provisions provide a framework for maintaining bank-provided leverage at or near the initial (100 - K) percent level. If the value of the portfolio increases, taxpayer may request that bank contribute “additional capital.” If the value of the portfolio drops by more than a specified percent from its starting value, taxpayer is required to pay “additional premium” to reset the ratio (i.e., buy down the over-leverage). Otherwise, bank has the right to either “deduct capital” from the portfolio by adjusting the valuation of the portfolio downward, or terminate the contract. Capital may be “deducted” by either withdrawing cash, or by allocating to bank a share in gains from the portfolio. Each of the contracts has a specified term. However, taxpayer is permitted to terminate a contract in whole or in part with specified notice. 

While bank was not required by the contracts to purchase the referenced assets in amounts sufficient to support its obligations, the CCA asserts that the facts indicate that bank held the referenced assets.  

The contracts designated a portfolio manager, a second corporation, to manage the basket while the options remained outstanding. The portfolio manager was formed at the individual’s request and was owned and operated by a second individual (“individual 2”) who was taxpayer’s former employee. The management activities included recommending changes to the basket, requesting the addition of new hedge funds to bank’s platform (enabling them to be added to the basket), and communicating with hedge fund managers to negotiate waivers of redemption fees (which were otherwise borne by taxpayer under the contracts). All changes to the basket were requested by the portfolio manager. While the contracts did not require individual 1 to approve changes to the basket, he in fact approved all changes. The contracts required bank’s consent to changes to the basket and allowed bank to make its own changes for risk management reasons. However, bank rejected less than 1% of the requested changes. The transaction documents stated that the bank “will not recommend any [basket] Component to [taxpayer] that should be included in the [basket],” that bank is not acting as an advisor to taxpayer, and that taxpayer and its advisors are solely responsible for determining the composition of the basket. 

One or more contracts were amended to provide for a portfolio management fee and to reduce the spread payable to bank. In addition, taxpayer made cash withdrawals from the contracts on a number of occasions.  

Although hedge fund interests were held in the name of bank, hedge fund managers were aware of bank’s relationship with taxpayer and knew that the hedge fund interests were held on behalf of taxpayer. Taxpayer was also required to represent in the contracts with bank that the taxpayer met various eligibility requirements to be an investor in the hedge funds.  

Holdings of the CCA. The CCA’s primary holdings are provided in the alternative. 

1. Although the contracts are called options, in the view of Chief Counsel’s Office, the given contracts do not function as options or have the economic characteristics of options. Therefore, they are not options for tax purposes. For example, taxpayer’s ability to alter the basket through the portfolio manager, while the contracts remain open, is inconsistent with the notion that an option on property must reference specific property at a specified strike price. To the extent that bank in fact holds the referenced assets in connection with the contracts, taxpayer is deemed to own the referenced assets for all tax purposes; taxpayer has the economic benefits and bears the economic burdens of ownership of the referenced assets as well as complete dominion and control over the basket.  
2. To the extent taxpayer is not treated as the owner for tax purposes of a referenced asset and the referenced asset is a pass-through entity for tax purposes, taxpayer is then treated as the constructive owner of the referenced asset. See IRC Sec. 1260 (“Gains From Constructive Ownership Transactions”). Specifically, if taxpayer is not deemed to own the contracts’ referenced assets, taxpayer is treated as holding forward contracts with respect to the referenced assets. Forward contracts to purchase interests in hedge funds fall within the IRC Sec. 1260 constructive ownership provisions.
3. To the extent taxpayer is not treated as the owner of the referenced assets for tax purposes, (a) taxpayer’s cash withdrawals from the contracts are taxable, (b) amendments to the contracts to include a portfolio management fee and to reduce bank’s spread are taxable exchanges of taxpayer’s contracts that result in recognition of any net gain or loss on the contracts, and (c) taxpayer’s discretion to make changes to the composition of the basket, combined with the resulting number of changes to the basket based on that discretion, may be economically significant such that, within a given tax year, the changes are cumulatively a “fundamental change” to the contracts, resulting in taxable exchanges of taxpayer’s contracts.

 Observation  

A Chief Counsel Advice Memorandum is guidance generally provided by the IRS, Office of Chief Counsel, to IRS personnel in the National Office or in the field. In the given case, it was made to a senior attorney in the Large Business and International Division, in response to a request for assistance made 4 months prior to the issuance of Notices 2015-47 and 2015-48, which request was supplemented by a further request immediately after the issuance of those notices. CCAs provide guidance on a particular fact pattern, or alternatively may provide guidance more broadly to a group of taxpayers or on a variety of fact patterns. They do not serve as legal precedent, as contrasted to revenue rulings, revenue procedures and notices, which are generally binding on the IRS. Nonetheless, CCAs do provide a strong indication of the IRS view on a particular issue. Here, the author of the CCA is also one of the principal authors of the 4 basket option contract and basket contract notices.