The Internal Revenue Service (the “IRS”) recently released two notices designating “Basket Option Contracts” as listed transactions (Notice 2015-73) and “Basket Contracts” as transactions of interest (Notice 2015-74). Participants engaged in transactions in effect on or after January 1, 2011 that are the same as, or substantially similar to, the transaction described in Notice 2015-73 must disclose such transactions for each taxable year of participation, provided that the period of limitations for assessment of tax for such taxable year had not ended on or before October 21, 2015. Participants engaged in transactions that were entered into on or after November 2, 2006 and in effect on or after January 1, 2011 that are the same as, or substantially similar to, the transactions described in Notice 2015-74 must disclose such transactions for each taxable year of participation, provided that the period of limitations for assessment of tax for such taxable year had not ended on or before October 21, 2015.¹

These notices withdraw and replace two notices released during the summer of 2015 addressing the same subject matter, Notice 2015-47 and Notice 2015-48. The withdrawn notices were subjected to heavy criticism by the financial industry for being overly broad and containing a number of technical deficiencies. The main criticism was that these notices could apply to normal commercial transactions that lacked any tax avoidance motive. To its credit, the government responded to these criticisms in a prompt manner.

Under the new notices, we believe that most of our investment fund clients would be unlikely to enter into one of these transactions without consciously attempting to achieve the prohibited tax benefits. Nonetheless, there could be situations where normal investment transactions are inadvertently covered by the notices, and you may want to examine any basket derivatives contracts to ensure that they do not fall within the notices.

TRANSACTIONS COVERED: GENERALLY

The release of the notices was prompted by the awareness on the part of the IRS of certain financial transactions being used by taxpayers to defer income recognition and to convert short-term capital gains and ordinary income to long-term capital gains. These types of transactions were the focus of a Senate Subcommittee investigation which focused on basket options used by, among others, Renaissance Technology Corp. LLC.

These transactions are typically cast in the form of options, notional principal contracts, forward contracts, or other derivative instruments. The financial contracts typically reference a pool of underlying securities which the taxpayer can request the counterparty to alter from time to time. The taxpayer takes the position that these alterations do not cause a current taxable event, and that gain or loss is only recognized on settlement of the contract, which would normally take place at least one year after the commencement of the contract so that the taxpayer can claim long-term capital gains treatment and thus be taxed at a favorable rate.

BACKGROUND OF LISTED TRANSACTIONS AND TRANSACTIONS OF INTEREST

A listed transaction is one that the IRS has determined to be a tax avoidance transaction. The IRS identifies these types of transactions in notices from time to time. Participants in a listed transaction have disclosure obligations. The failure to disclose such a transaction may result in penalties. Material advisors to a listed transaction have additional list maintenance requirements.

A transaction of interest is a transaction that the IRS believes has the potential for tax avoidance or evasion but lacks enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction. As with listed transactions, participants have disclosure obligations and material advisors may have additional list maintenance requirements.

BASKET OPTION CONTRACT: NOTICE 2015-73

A transaction is the same as, or substantially similar to, the transaction identified in this notice only if:

1. Taxpayer (T) enters into a transaction with Counterparty (C) 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;
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 the effective date of the notice reflects a tax benefit.

Tax benefit for this purpose is 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.

For example, by using these options, a fund could trade a high-turnover portfolio, which would have generated current, short-term capital gains, and convert such gains into long-term capital gains in the year in which the option was ultimately settled. This would achieve both deferral and character conversion for the taxpayer.

BASKET CONTRACT: NOTICE 2015-74

A transaction is the same as, or substantially similar to, the transaction identified in this notice only if:

1. T enters into a contract with C to receive a return based on the performance of the reference basket (which basket may include hedge fund interests, securities, commodities, foreign currency, or similar property);
2. the basket contract has a stated term of 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 the effective date of the notice reflects a tax benefit.

Tax benefit for this purpose has the same meaning as in Notice 2015-73.

EXCLUDED CONTRACTS

A transaction is not the same as, or substantially similar to, the transactions described in the notices 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 or a variable rate debt instrument.

IRS CHALLENGES

The IRS may assert one or more arguments to challenge the parties’ tax characterization of a basket option contract, including: (1) that C, in substance, holds the assets in the reference based as an agent of T and that T is the beneficial owner of the assets for tax purposes; (2) that the basket option is not an option for tax purposes; (3) that changes to the assets in the reference basket during the year materially modify the basket option contract and result in taxable dispositions of the contract throughout the term of the contract; and (4) that T actually owns separate contractual rights with respect to each asset in the reference basket such that each change to the assets in the basket results in a taxable disposition of a contractual right with respect to the asset affected by the change.

QUESTIONS

This alert sets forth only a general summary of the notices. The notices contain various nuances that may affect the applicability of the notices to transactions not explicitly described therein. The Seward & Kissel Tax Department would be happy to assist our clients in any review or to answer any questions regarding the notices.

If you have any questions regarding the issues discussed herein, please contact Jonathan P. Brose (212-574-1615; brose@sewkis.com), Ronald P. Cima (212-574-1471; cima@sewkis.com), James C. Cofer (212-574-1688; cofer@sewkis.com), Daniel C. Murphy (212-574-1210; murphyd@sewkis.com) or Peter E. Pront (212-574-1221; pront@sewkis.com).

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¹ Material advisors who make a tax statement on or after January 1, 2011 with respect to transactions described in these notices have disclosure and list maintenance obligations.