Last week, the Internal Revenue Service (“IRS”) proposed regulations (the “Proposed Regulations”) to treat certain basket contracts as listed transactions. Basket contracts were previously identified as transactions of interest in IRS Notice 2015-73 and IRS Notice 2015-74 (the “TOI Notices”). For additional background, please refer to our memorandum on the TOI Notices. The Proposed Regulations would classify these structured financial contracts as listed transactions.
Listed transactions are tax avoidance transactions which are specifically designated as such by the IRS, and are a type of “reportable transaction.” Every taxpayer that has participated in a reportable transaction must file a disclosure statement with the IRS.
A basket contract must satisfy four criteria to be within the scope of the Proposed Regulations:
(1) The taxpayer must enter into a financial contract (including an option contract, notional principal contract, forward contract, or other derivative contract) to receive a return based on the performance of a reference basket of certain financial assets;
(2) The contract must have a stated term of more than one year, or the term must overlap two or more of the taxpayer’s taxable years;
(3) The taxpayer must have exercised discretion to change (either directly or through a request to the counterparty) the assets in the reference basket or the trading algorithm;
(4) The taxpayer’s tax return for a taxable year ending on or after January 1, 2011, must reflect a tax benefit with respect to the transaction.
The IRS has sought to crack down on basket contracts because they allow taxpayers to defer income recognition and convert short-term capital gains and ordinary income to long-term capital gains. The Proposed Regulations refer to such deferral and improved tax character as a “tax benefit.” The Proposed Regulations define a “basket” as a notional basket of assets, including stocks, securities, commodities, foreign currency, digital assets, other actively traded personal property (as defined within the meaning of the straddle rules under Code Section 1092) and interests in entities that trade the foregoing assets or similar property. The Proposed Regulations expand the TOI Notices’ list of assets that may be included in a basket contract.
The Proposed Regulations provide three exceptions to the designation of a basket contract as a listed transaction. The first exception applies to contracts traded on a national securities exchange regulated by the SEC or the CFTC. The second exception applies to financial instruments that are treated as “contingent payment debt obligations” for U.S. federal income tax purposes. The third exception applies to the counterparty when either:
(a) the taxpayer certifies to the counterparty under penalties of perjury that none of the taxpayer’s U.S. federal income tax returns since 2011 have reflected or will reflect a tax benefit from a basket contract; or
(b) the counterparty has received a valid Form W-8 that the taxpayer is a non-resident alien or a foreign corporation and is not engaged in a trade or business within the United States.
If the Proposed Regulations are finalized, taxpayers that participate in basket contracts and persons who act as material advisors with respect to such activity would be required to disclose these transactions to the IRS. Failure to disclose may result in significant U.S. federal income tax penalties. Note that there are still disclosure obligations under the TOI Notices.
As with the TOI Notices, we expect the Proposed Regulations to continue to have a chilling effect on the use of these types of financial instruments. Nonetheless, there may be normal investment transactions that are inadvertently covered by the broadness of the Proposed Regulations. Taxpayers with basket transactions in their strategies should carefully review this activity to ensure the transactions do not fall within the Proposed Regulations.
Seward & Kissel LLP actively monitors tax changes and their impact on the investment management industry. For additional information on recent income tax changes, please contact a member of Seward & Kissel’s Tax Group.
