Basket Option Contracts Now A Listed Transaction
July 14, 2015
They were the subject of a 2014 hearing by the Senate Homeland Security and Government Affairs Permanent Subcommittee on Investigations. They were “red-flagged” in a March 2015 report produced by the Democratic staff of the Senate Finance Committee, which was covered in an EisnerAmper Alert dated March 20, 2015, entitled "Financial Products Changes Recommended by Senate Finance Committee Democrats Worth Attention." And they were targeted in a June 16, 2015 letter from the Senate Finance Committee ranking minority member Ron Wyden to Treasury. So, it should come as no surprise that with Notice 2015-47, issued July 8, 2015, the Treasury and the IRS have identified “basket option contracts” and “substantially similar” transactions as “listed transactions” for transactions in effect on or after January 1, 2011. The Notice also alerts persons involved in these transactions about certain responsibilities that may arise from their involvement with the basket option contracts.
In a typical basket option contract transaction, a taxpayer (“Taxpayer”), generally a hedge fund or high net worth individual, enters into a contract that is denominated as an option with a counterparty (“Counterparty”), typically a bank, to receive a return based on the performance of a notional basket of referenced actively traded personal property (the “reference basket”). Taxpayer or its designee will determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets. While the basket option contract remains open, Taxpayer has the right to request changes in the assets in the reference basket or specified trading algorithm. This is key. While Counterparty can reject certain changes requested by Taxpayer to the assets in the reference basket, Counterparty generally will accept all or nearly all the changes requested by Taxpayer. Counterparty typically acquires substantially all of the assets in the reference basket at the inception of the contract and acquires and disposes of assets during the term of the contract either when Taxpayer changes the assets in the reference basket or the trading algorithm provides for such changes. The amount that Taxpayer receives upon settlement of the basket option contract, which has a stated term of more than one year, is based on the performance of the assets in the reference basket. Consistent with its view of the transaction as an option and that it is not the beneficial ownership of the reference basket, Taxpayer takes the position that short-term gains, and interest, dividend, and other ordinary periodic income from the performance of the reference basket are deferred until the basket option contract terminates, and, if the basket option contract is held for more than one year, that the entire gain is treated as long-term capital gain.
Previous to this Notice, the IRS Chief Counsel’s office had issued a Generic Legal Advice Memorandum (“GLAM”) in 2010 in which it concluded that the basket options were an account of securities owned by the hedge fund and not options. But a GLAM has no precedential legal authority.
We note that while a Notice, like a published revenue ruling, does not have the presumptive force and effect of law, as the official interpretation of the IRS, it is usually accorded significant weight by the courts.
With this Notice, affected taxpayers must now file Form 8886, “Reportable Transaction Disclosure” with respect to the basket option contract transaction. Persons engaged in transactions in effect on or after January 1, 2011 must 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 July 8, 2015; in the case of tax returns (including amended returns) already filed, the disclosure must be filed with the Office of Tax Shelter Analysis (“OTSA”) within 120 calendar days after the date (July 8, 2015) on which the basket option contract became a listed transaction. This obligation to disclose exists regardless of whether the taxpayer participated in the transaction in the year the transaction became a listed transaction.
For each year in which the basket option contract is open, the following are treated as participating, and therefore, have the obligation to disclose: (i) the purchaser of the basket option contract; (ii) if the purchaser of the basket option is a partnership, any general partner of the purchaser; (iii) if the purchaser of the basket option contract is a limited liability company, any managing member of the purchaser; and (iv) the counterparty to the basket option contract.
The failure to file the required forms and provide all necessary information can result in very significant monetary penalties. Generally, the penalty is 75% of the reduction in the tax reported on the income tax return as a result of participation in the transaction or that would result if the transaction were respected for federal tax purposes, subject to a minimum of $5,000 in the case of an individual and $10,000 in any other case. This penalty is assessed for each failure to attach a Form 8886 to the appropriate original or amended return, each failure to file the form with OTSA, if required, or the filing of a form that fails to include all the information required (or includes incorrect information). The annual maximum penalty to disclose a listed transaction is $100,000 in the case of an individual and $200,000 in any other case. This penalty is in addition to any other penalty that may be imposed.
Rules governing “material advisors” with respect to reportable transactions will also apply in connection with this basket option contract transaction.
Basket Contract as “Transaction of Interest”
In addition to the basket option contracts described in Notice 2015-47, the IRS and Treasury in Notice 2015-48 simultaneously identified as a “transaction of interest” a “basket contract” – a type of structured financial transaction in which a taxpayer attempts to defer income recognition and “may” attempt to convert short-term capital gain and ordinary income to long-term capital gain through an option, notional principal contract, forward contract, or other derivative contract. A “transaction of interest” is a transaction that the IRS and Treasury believe has a potential for tax avoidance or evasion, but for which there is not enough information to determine if the transaction should be identified as a tax avoidance transaction.
The description of the basket contract is substantially the same as the basket option contract, except the scope of potential transactions would appear to be 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, and not simply actively traded personal property.
As a transaction of interest, basket contract participants (same as in the basket option contract) are subject to Form 8886 disclosure requirements and applicable penalties (subject to an annual maximum penalty for failure to disclose of $10,000 in the case of an individual and $50,000 in any other case). If a particular transaction fits within the description of both the Notice 2015-47 listed transaction and the Notice 2015-48 transaction of interest, it is to be treated as a listed transaction under Notice 2015-47.