IRS Clarifies Disclosure Requirement for Basket Option Contracts and Basket Contracts
November 09, 2020
On July 8, 2015, the IRS issued Notice 2015-47, which identified certain basket option contract transactions as “listed transactions,” and Notice 2015-48, which identified certain basket contract transactions as “transactions of interest.” (See the EisnerAmper Alert “Basket Option Contracts Now A Listed Transaction.”) These notices required taxpayers to file disclosures for transactions that are the same as, or substantially similar to, transactions described in the notices, with penalties applied for non-filing. Since the release of the notices, taxpayers and their advisors have been concerned that difficulty in identifying those transactions covered by the notices would necessitate the filing of disclosures for transactions that were not intended to be treated as listed transactions, or transactions of interest, as the case may be. In response to that concern (and presumably the realization by the IRS that more clarity was indeed needed), on October 21 the IRS revoked Notices 2015-47 and 2015-48 and substituted Notices 2015-73 and 2015-74, respectively, to provide that greater clarity. The new notices are essentially the old notices with additional detail and discussion included.
Listed Transaction: Basket Option Contract
In describing transactions covered by the basket option contract listed transaction, Notice 2015-73 confirms that the transaction must actually provide a tax benefit, namely, either a deferral of income into a later taxable year or a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss (the “tax benefit”). Specifically, a transaction is the same as, or substantially similar to, the transaction identified in Notice 2015-73 if: (1) taxpayer (“taxpayer”) enters into a transaction with counterparty (“counterparty”) that is denominated as an option contract; (2) taxpayer 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; (4) the contract is not fully settled at intervals of one year or less; (5) taxpayer or taxpayer’s “designee” has exercised “discretion” to change (either directly or through a request to counterparty) the assets in the reference basket or the trading algorithm; and (6) taxpayer’s tax return for a taxable year ending on or after the effective date of the Notice reflects a tax benefit.
Unlike Notice 2015-47, Notice 2015-73 provides in some detail transactions that are explicitly not intended as a listed transaction. Specifically not listed transactions are the following: (1) the contract is traded on (a) a national securities exchange that is regulated by the SEC or a domestic board of trade regulated by the CFTC or (b) a foreign exchange or board of trade that is subject to regulation by a comparable regulator; or (2) the contract is treated under the income tax regulations as a contingent payment debt instrument (including a short-term contingent payment debt instrument) or a variable rate debt instrument. As just noted, with respect to a taxpayer, a transaction is not a listed transaction unless taxpayer’s tax return for a taxable year ending on or after the effective date of the notice reflects a tax benefit with respect to the transaction. From the perspective of the counterparty (and its disclosure obligation), a transaction is not to be treated as a listed transaction if: (1) the taxpayer represents to counterparty in writing under penalties of perjury that taxpayer’s tax return will not reflect a tax benefit in any taxable year ending after the effective date of the notice; or (2) counterparty has established that taxpayer is a nonresident alien who is not engaged in a U.S. trade or business or a foreign corporation that is not engaged in a U.S. 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-BEN, W-NEN-E or W-8EXP), or in the case of payments made outside the U.S. on offshore obligations, by obtaining certain documentary evidence.
Notice 2015-73 provides some further explanation to the terms “designee” and “discretion.” A “designee” is any person who is: (1) taxpayer’s agent under principles of agency law; (2) compensated by taxpayer for suggesting, requesting or determining changes in the assets in the reference basket or the trading algorithm; or (3) selected by taxpayer to suggest, request or determine changes in the assets in the reference basket or trading algorithm. However, a person is not treated as compensated or selected by taxpayer as a result of: (1) the person’s position as an investment advisor, officer or employee of an entity (such as a mutual fund), when the entity’s publicly offered securities are included in the reference basket; or (2) the person’s use of, the person’s payment of a licensing fee for the right to use, or the person’s authority to suggest, request, or determine changes in the assets included in a widely used and publicly quoted index that is based on objective financial information or an index that tracks a broad market or a market segment.
As for “discretion,” taxpayer will not be treated as having discretion to change (either directly or through a request to counterparty) the assets in the reference basket or the trading algorithm if changes are made according to objective instructions, operations or calculations that are disclosed at the inception of the transaction (the “rules”), and taxpayer does not have the right to alter or amend the rules during the term of the transaction or to deviate from the assets in the reference basket or the trading algorithm selected in accordance with the rules. However, the notice further states that taxpayer will not be treated as having authority to alter or amend the rules solely because it has the authority to exercise routine judgment in the administration of the rules (provided that routine judgment does not include deviations or alteration of the rules designed to improve the financial performance of the reference basket), correct errors in the implementation of the rules or calculations made pursuant to the rules, or make an adjustment to respond to an unanticipated event outside of taxpayer’s control (such as a stock split, merger, listing or delisting, nationalization, insolvency of a basket component, disruption in the financial markets for specific assets or in a particular jurisdiction, regulatory compliance requirement, force majeure or any other unanticipated event of similar magnitude and significance).
Effective Date; Time for Disclosure
Affected taxpayers must file Form 8886, “Reportable Transaction Disclosure,” with respect to the basket option contract transaction. Persons engaged in such transactions in effect on or after January 1, 2011 must now disclose the transaction for each taxable year in which the taxpayer “participated” in the transaction, provided that the period of limitations for assessment of tax had not ended on or before October 21, 2015; in the case of tax returns (including amended returns) already filed, the disclosure must be filed with the Office of Tax Shelter Analysis by January 19, 2016. This obligation to disclose exists regardless of whether the taxpayer participated in the transaction in the year the transaction became a listed transaction.
Requests for Change in Accounting Method
New to Notice 2015-73 are procedures for taxpayers to change their method of accounting for transactions within the scope of the notice. According to the notice, the IRS has determined that it is not in the interest of sound tax administration to permit a prospective change in method of accounting. Thus, the IRS will not process applications for any changes in accounting filed under the non-automatic change procedures for a transaction covered by the notice. But, pursuant to Notice 2015-73, consent is granted for any taxpayer that engaged in the basket option contract listed transaction to file amended returns to retroactively change (from an impermissible method of accounting to a permissible method) for the transaction. Consent is granted only if the taxpayer files such amended returns for the first taxable year in which the taxpayer used the impermissible method (or if the period of limitations has expired for that year, then for the first taxable year for which the period of limitations has not expired) and for each subsequent year in which the impermissible method affected the taxpayer’s taxable income. Further, if the period of limitations has expired for the first taxable year in which the taxpayer used the impermissible method for the transaction and the taxpayer files amended returns, the amended return for the first taxable year for which the period of limitations has not expired must include the entire amount of the Section 481(a) adjustment, whether positive or negative, attributable to the change in accounting method as ordinary in character.
Transaction of Interest: Basket Contract
As noted in our earlier Alert, the description of the basket contract in Notice 2015-48 (revoked), and now set forth in Notice 2015-74, is substantially the same as the basket option contract), except the scope of potential transactions is considerably broader in the case of the basket contract – the contract may be denominated as a notional principal contract, forward or other derivative contract, as well as an option – and the reference basket may include interests in entities that trade securities, commodities, foreign currency or similar property (described as “hedge fund interests” in the Notice), securities, commodities, foreign currency or similar property (or positions in such property), and not simply actively traded property.
Notice 2015-74 clarifies the intended scope of the basket contract “transaction of interest” originally set forth in Notice 2015-48, by requiring, for example, that the taxpayer or designee actually exercise discretion to change assets in the reference basket or trading algorithm and that the transaction involve a deferral or conversion. This clarification should materially reduce the number of transaction of interest disclosures resulting from this notice.
As a transaction of interest, basket contracts are subject to Form 8886 disclosure requirements as noted for the basket option contract listed transaction. If a particular transaction fits within the description of both the Notice 2015-73 listed transaction and the Notice 2015-74 transaction of interest, it is treated as a listed transaction under Notice 2015-73.
With respect to requests for a change in accounting method in the case of a transaction of interest, the position of the IRS will depend on whether or not the transaction involves a conversion. In that case, the rules described above in the case of the basket option contract listed transaction generally apply. However, if the only tax benefit is a deferral of income into a later tax year, then the taxpayer may change its method of accounting for the deferral transaction of interest either by filing an amended return (as described for the basket option contract listed transaction) or, if eligible, to request a change in method of accounting under non-automatic change procedures and filing Form 3115. Under these procedures as applied to a deferral transaction, a taxpayer would be required to take into account the entire amount of a positive Section 481(a) adjustment in the taxable year of change.