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IRS reissues guidance identifying basket options and contracts as reportable transactions

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Tax Hot Topics: Basket options and contractsThe IRS issued Notices 2015-73 and 2015-74, which replaced previous guidance that identified certain “basket option contracts” and “basket contracts” as reportable transactions under Treas. Reg. Sec. 1.6011-4(b) and Sections 6111 and 6112.

Specifically, Notice 2015-47, issued in July 2015, previously identified certain basket option contracts and substantially similar transactions as listed transactions under Treas. Reg. Sec. 1.6011-4(b)(2), and Notice 2015-48 previously identified certain basket contracts and substantially similar transactions as transactions of interest under Treas. Reg. Sec. 1.6011-4(b)(6). Both transactions of interest and listed transactions require disclosure to the IRS.

Notices 2015-73 and 2015-74 both indicate that commenters had expressed concern that the prior notices may cause disclosures for transactions that were not intended to be treated as reportable transactions. Thus, the new notices revoke the prior notices and provide additional details on the types of transactions that are the same as, or substantially similar to, the transactions described as reportable transactions.

Notice 2015-73 -- Basket option contracts
Notice 2015-73 generally describes a basket option contract (a basket option) as a contract denominated as an option under the same terms and circumstances described in Notice 2015-47.

As an overview, the basket option is entered into by a taxpayer, typically a hedge fund or high-net-worth individual, and a counterparty, which is 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. Additional terms are specified in Notice 2015-73.

Section 2.01 of Notice 2015-73 provides revised requirements for when a transaction is the same as, or substantially similar to, a transaction identified as a reportable transaction. Such revised requirements include:
Taxpayer enters into a transaction with the counterparty that is denominated as an option contract.
  • Taxpayer receives a return based on the performance of the reference basket.
  • Substantially all the assets in the reference basket consist of actively traded personal property defined under Treas. Reg. Sec. 1.1092(d)-1(a).
  • The basket option is not fully settled at intervals of one year or less.
  • The taxpayer or its designee has exercised discretion to change the assets in the reference basket or trading algorithm.
  • The taxpayer’s tax return for the taxable year ending on or after the effective date of Notice 2015-73 reflects a tax benefit.
For purposes of Notice 2015-73, a tax benefit is: (i) a deferral of income into a later taxable year; or (ii) a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

The new notice also provides certain exceptions that a basket option under Notice 2015-73 does not include: (i) a contract that is traded on a national securities exchange regulated by the SEC, a domestic board of trade regulated by the Commodity Futures Trading Commission, or a foreign exchange or board of trade that is subject to regulation by a comparable regulator; or (ii) a contract that is treated as a contingent payment debt instrument under Treas. Reg. Sec. 1.1275-4 or a variable rate debt instrument under Treas. Reg. Sec. 1.1275-5.

In addition, the notice provides guidance on determining whether another person is the taxpayer’s designee and whether the taxpayer or the taxpayer’s designee has discretion to change the reference basket.

Furthermore, Notice 2015-73 states that the IRS determined that it is not appropriate to permit a prospective change in method of accounting for a transaction within the scope of Notice 2015-73. Accordingly, the IRS will not process applications for changes in method of accounting under the non-automatic procedures provided in Rev. Proc. 2015-13. However, a taxpayer may get consent granted for an accounting method change related to a transaction under Notice 2015-73, if the taxpayer files amended tax returns for appropriate taxable years as stipulated under the notice.

Notice 2015-74 -- Basket contracts
Notice 2015-74 generally describes a basket contract as a contract denominated as an option, notional principal contract, forward contract or other derivative contract, under the same terms and circumstances described in Notice 2015-48.

As an overview, the basket contract is 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). Additional terms are specified in Notice 2015-74.

Section 2.01 of Notice 2015-74 provides additional requirements that a transaction is the same as, or substantially similar to, the transaction identified in Notice 2015-74 only if:

  • The taxpayer receives a return based on the performance of the reference basket.
  • The basket contract has a stated term of more than one year or overlaps two of the taxpayer’s taxable years.
  • The taxpayer or its designee has exercised discretion to change the assets in the reference basket or trading algorithm.
  • The taxpayer’s tax return for a taxable year ending on or after the effective date of Notice 2015-74 reflects a tax benefit.

For purposes of Notice 2015-74, a tax benefit is: (i) a deferral of income into a later taxable year; or (ii) a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

Notice 2015-74 provides similar exceptions as Notice 2015-73 and guidance in determining whether another person is the taxpayer’s designee and whether the taxpayer or the taxpayer’s designee has discretion to change the reference basket.  

Pursuant to Notice 2015-74, a taxpayer may change its method of accounting for a “deferral transaction” described under Notice 2015-74 by either: (i) filing appropriate amended returns stipulated under the notice or (ii) requesting a change in method of accounting under the non-automatic procedures in Rev. Proc. 2015-13. A “deferral transaction” is defined as a transaction in which the taxpayer’s only tax benefit is a deferral of income into a later taxable year.

However, Notice 2015-74 states that the IRS determined that it is not appropriate to permit a prospective change in method of accounting for a “conversion transaction” described under Notice 2015-74. A conversion transaction is defined as a transaction that involves the conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.  

Accordingly, the IRS will not process applications for changes in method of accounting under the non-automatic procedures for such conversion transactions. However, a taxpayer may get consent granted for an accounting method change related to a conversion transaction under Notice 2015-74, if the taxpayer files amended tax returns for appropriate taxable years as stipulated under the notice.

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