Proposed rules identify basket contracts as listed transactions

The IRS has issued proposed regulations under Section 6011 that identify certain “basket contract” transactions as “listed transactions.” The proposed regulations identify as a listed transaction each of the basket option contracts previously identified as a “listed transaction” in Notice 2015-73 and basket contracts previously identified as a “transactions of interest” in 2015-74. The proposed regulations also identify the parties treated as participating in such transactions that are subject to the disclosure requirements related to a reportable transaction.

Background

Regulations under Treas. Reg. Sec. 1.6011-4 require a disclosure statement for every taxpayer that has participated in a “reportable transaction.” A reportable transaction includes a “listed transaction” and a “transaction of interest” as identified by the IRS by notice, regulations, or other published guidance. A “listed transaction” is a transaction determined by the IRS to be a tax avoidance transaction.

Taxpayers that have participated in a reportable transaction and are required to file a tax return must file a disclosure statement within the time period prescribed in Treas. Reg. Sec. 1.6011-4(e). The disclosure statement is Form 8886 and must be attached to the taxpayer’s tax return for each year for which the taxpayer participates in a reportable transaction.

Notices 2015-73 and 2015-74

In 2015, the IRS first addressed concerns around basket contract transactions in Notices 2015-47 and 2015-48.  These notices were later replaced by Notices 2015-73 and 2015-74 after comments.

The transaction described in Notice 2015-73 generally consists of:

• A taxpayer entering into a contract denominated as an option with a counterparty to receive a return based on the performance of a notional basket of referenced actively traded personal property (the “reference basket”)
• Substantially all of the assets in the reference basket consisting of actively traded personal property defined under Treas. Reg. Sec. 1.1092(d)-1(a)
• The option is not fully settled at intervals of one year or less
• The taxpayer or the taxpayer’s designee exercising discretion to change the assets in the reference basket or trading algorithm
• The taxpayer’s tax return for a taxable year reflected a tax benefit

The primary concern for abuse by the IRS was taxpayers attempting to convert to defer income recognition and convert short-term capital gain and ordinary income to long-term capital gain, taxed at a lower rate.

Notice 2015-74 described a “transaction of interest,” which was similar to the transactions described in Notice 2015-73. However, Notice 2015-74 described transactions that could be denominated as an option, notional principal contract, forward contract, or other derivative contract with a Reference Basket that could include: (i) interest in entities that trade securities, commodities, foreign currency, or similar property (i.e., hedge fund interests); (ii) securities; (iii) commodities; (iv) foreign currency; or (v) similar property (or positions in such property). Notice 2015-74 also covered contracts that are more than one year and contracts that overlap two taxable years for the taxpayer.

Based on examinations since Notices 2015-73 and 2015-74, the IRS stated that there was sufficient information to conclude that one or both abuses related to their concerns existed. 

Prop. Reg. Sec. 1.6011-16

The proposed regulations identify transactions that are the same as, or substantially similar to, the transactions described in both Notices 2015-73 and 2015-74 as listed transactions. The transaction described in the proposed regulations has the following characteristics:

• A taxpayer enters into a contract with a counterparty denominated as an option, notional principal contract, forward contract, or other derivative, to receive a return based on the performance of a basket of referenced actively traded personal property (the reference basket)
• The contract has a stated term of more than one year, or overlaps two or more of taxpayer’s taxable years
• The taxpayer has exercised discretion to change (either directly or through a request to the counterparty) the assets in the reference basket or the trading algorithm
• The taxpayer’s tax return for a taxable year ending on or after Jan. 1, 2011, reflects a tax benefit with respect to the transaction
• The transaction is not described as an exception in Prop. Reg. Sec. 1.6011-16(d)

This list does not include a requirement that substantially all assets in the reference basket be actively traded personal property or that a basket option is not fully settled at intervals of one year or less.

The types of assets that may be included in the reference basket include:

• Actively traded personal property as defined under Treas. Reg. Sec. 1.1092(d)-1(a);
• Interests in entities that trade securities, commodities, foreign currency, digital assets as defined in Section 6045(g)(3)(D) or similar property
• Securities
• Commodities
• Foreign currency
• Digital assets as defined in § 6045(g)(3)(D) or
• Similar property (or positions in such property)

The proposed regulations provide a list of exceptions including the following:

• A contract that is traded on a national securities exchange that is regulated by the SEC or similar governing body
• A contract treated as a contingent payment debt instrument under Treas. Reg. Sec. 1.1275-4 (including a short-term contingent payment debt instrument) or a variable rate debt instrument under Treas. Reg. Sec. 1.1275-5
• If a taxpayer represents to the counterparty in writing that none of taxpayer’s tax returns for taxable years ending on or after Jan. 1, 2011, has reflected or will reflect a tax benefit described in Prop. Reg. Sec. 1.6011-16(b)(5) with respect to the transaction
• The counterparty has established that the taxpayer is a nonresident alien that 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 upon which it may rely under the requirements of Treas. Reg. Sec. 1.1441-1 from the taxpayer as the beneficial owner of the payments made or to be made under the basket contract