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IRS identifies certain financial transactions as reportable transactions

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Tax Hot Topics: IRS identifies certain financial transactions as reportable transactionsThe IRS issued two pieces of related guidance on July 8 identifying certain financial transactions as reportable transactions under Treas. Reg. Sec. 1.6011-4(b) and Sections 6111 and 6112.

Specifically, Notice 2015-47 identified certain “basket option contracts” and substantially similar transactions as “listed transactions” for purposes of Treas. Reg. Sec. 1.6011-4(b)(2) and Sections 6111 and 6112. Notice 2015-48 identified certain “basket contracts” and substantially similar transactions as “transactions of interest” for purposes of Treas. Reg. Sec. 1.6011-4(b)(6) and Sections 6111 and 6112.

Listed transactions and transactions of interest are each reportable transactions subject to disclosure rules, list maintenance requirements and potential penalties. A listed transaction is a transaction the IRS has determined to be a tax avoidance transaction. A transaction of interest is a transaction the IRS believes has potential for tax avoidance but for which it lacks sufficient information to determine if the transaction should be identified as a tax avoidance transaction.

The following summarizes the transactions described in Notices 2015-47 and 2015-48. However, taxpayers and their advisers should carefully review the notices to determine if their transactions fall under the notices’ reporting requirements.

Basket option contracts
Notice 2015-47 describes a basket option contract (a basket option) as a contract denominated as an option. The basket option is entered into by a taxpayer, typically a hedge fund or high net-worth individual, and a counterparty, typically a bank, to receive a return based on the performance of a notional group of investments (the reference basket). The reference basket consists of actively traded personal property.

The taxpayer (or a designee) will either determine the reference basket or design or select a trading algorithm that determines the reference basket. While the basket option remains open, the taxpayer has the right to request changes in the reference basket or the specified trading algorithm. The counterparty may be permitted to reject certain changes but generally accepts all or nearly all of the changes requested by the taxpayer.

The taxpayer generally makes an upfront payment of between 10% and 40% of the value of the reference basket when the basket option is entered into. The counterparty typically acquires substantially all of the reference basket to manage its risk, and acquires and disposes of the components of the reference basket to correspond with the changes provided by the taxpayer or the trading algorithm. The counterparty generally supplies additional cash to purchase the reference basket.

The basket option has a stated term of more than one year, but contains provisions that allow either party to terminate at any time. The basket option typically includes a provision automatically terminating the contract if the value of the reference basket approaches the amount of the upfront payment. The basket option typically includes other safeguards to reduce economic risk to the counterparty.

The amount the taxpayer receives when the basket option is settled is based on the reference basket’s performance including net changes in its value, interest, dividends and other periodic income on the assets, reduced by a fee paid to the counterparty.

Notice 2015-47 states that the Treasury Department and the IRS identified basket options and substantially similar transactions as listed transactions. A transaction is the same as or substantially similar to the basket option transaction in Notice 2015-47 if all of the following apply:

  • The transaction is denominated as an option contract.
  • Substantially all of the assets in the reference basket consist of actively traded personal property defined under Treas. Reg. Sec. 1.1092(d)-1(a).
  • The purchaser of the option (or a designee) has the right to either (a) determine the reference basket at the inception of the transaction and periodically over the term of the transaction, or (b) select or use a specified trading algorithm to determine the reference basket.
  • The purchaser of the option, the purchaser’s designee or the specified trading algorithm actually changes one or more of the assets in the reference basket during the term of the transaction.

Notice 2015-47 states that the Treasury Department and the IRS believe that the basket option is a tax avoidance transaction and accordingly identified those basket options as listed transactions.
 
The reporting requirements of the notice apply to transactions in effect on or after Jan. 1, 2011, that are the same as or substantially similar to the basket option described in Notice 2015-47, which became effective on July 8.

Basket contracts
Notice 2015-48 describes a basket contract as a contract denominated as an option, notional principal contract, forward contract or other derivative contract.  The basket contract is also entered into by a taxpayer and a counterparty to receive a return based on the performance of a reference basket.  

The reference basket may 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).  

The taxpayer (or a designee) will either determine the reference basket or design or select a trading algorithm that determines the reference basket. While the basket contract remains open, the taxpayer has the right to request changes in the reference basket or the specified trading algorithm. The counterparty may be permitted to reject certain changes but generally accepts all or nearly all of the changes requested by the taxpayer.

The taxpayer generally makes an upfront payment of between 10% and 40% of the value of the reference basket when the basket contract is entered into. The counterparty typically acquires substantially all of the reference basket to manage its risk, and acquires and disposes of the components of the reference basket to correspond with the taxpayer’s changes or changes provided by the trading algorithm. The counterparty generally supplies additional cash to purchase the reference basket.

The basket contract has a stated term of more than one year, but contains provisions that allow either party to terminate at any time. The basket contract typically includes a provision automatically terminating the basket contract if the value of the reference basket approaches the amount of the upfront payment. The basket contract usually contains other safeguards to reduce economic risk to the counterparty.

The amount the taxpayer receives when the basket contract is settled is based on the reference basket’s performance including net changes in its value, interest, dividends and other periodic income on the assets, reduced by a fee paid to the counterparty.

Notice 2015-48 states that the Treasury Department and the IRS believe that the basket contract has a potential for tax avoidance or evasion, and accordingly identified basket contracts and substantially similar transactions as transactions of interest.

The notice’s reporting requirements apply to transactions entered into on or after Nov. 2, 2006, that are the same as or substantially similar to the basket contracts described in Notice 2015-48, which became effective on July 8.

Contacts
Andy Cordonnier
+1 202 521 1502
andy.cordonnier@us.gt.com

Jeff Borghino
+1 202 521 1532
jeff.borghino@us.gt.com

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