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IRS concludes that contracts are not options

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IRS concludes that contracts are not optionsThe IRS concluded in an internal legal memorandum (ILM 201547004) released Nov. 20 that certain contracts purchased by a partnership were not options for federal income tax purposes.

In ILM 201547004, the taxpayer, a partnership, entered into two contracts that were styled as call options with a counterparty bank. The contracts referenced hedge fund interests and cash (the basket).

In each contract, the taxpayer paid a premium to the bank equal to a fixed portion of an initial notional amount. The initial exercise price of the contract (the strike price) was equal to the notional amount less the premium.  

The strike price was adjusted for: (i) interest-like charges and fees imposed by the bank; (ii) upward adjustments if the bank contributed additional capital to “re-leverage” the taxpayer’s position; and (iii) downward adjustments if the bank withdrew capital to “de-leverage” the taxpayer’s position. The contracts were settled in cash upon maturity or termination of the contracts for an amount equal to the value of the basket less the strike price, subject to a floor of $0.

The contract terms provided for certain “barrier provisions,” which were intended to prevent the floor from being reached. The barrier provisions provided that the bank provided leverage initially equal to the notional amount less the premium. However, if the value of the basket increased, the taxpayer could request that the bank contribute additional capital to re-leverage. If the value of the basket decreased by more than a specified percentage, the taxpayer was required to pay an additional premium to reset the ratio. In addition, the bank had the right to deduct capital from the basket by withdrawing cash or by allocating a share of gains from the basket to the bank.

The composition of the baskets was allowed to change during the term of the contracts, and the baskets were managed by a corporation. The corporation was selected by, compensated by and acted on behalf of, the taxpayer. Any changes to the basket required the bank’s consent, and the corporation requested all changes to the basket. The contracts provided that the bank was not acting as an advisor to the taxpayer, and that the taxpayer was solely responsible for determining the composition of the basket.  

Although the contracts did not require the bank to hold the baskets, certain facts stipulated in the ILM indicated that the bank in fact held the components of the baskets. For example, the bank would have needed to own some interest in each hedge fund in the basket in order to determine the value of the contracts’ baskets because the hedge fund interests were not publicly traded and did not have a readily ascertainable value.

In addition, notwithstanding that the hedge fund interests in the baskets were held in the name of the bank, the hedge fund managers understood the bank’s relationship with the taxpayer and that interests were held on behalf of the taxpayer. The taxpayer was required to represent in the contracts that it was eligible to be an investor in the hedge funds under the Investment Company Act of 1940.

The taxpayer’s position in ILM 201547004 was that: (i) the contracts were options for tax purposes; (ii) the ownership of the basket components was not transferred by the contracts; (iii) the contracts were not constructive ownership transactions under Section 1260; and (iv) capital gain will be realized upon the sale or exchange of the contracts except to the extent such gain is characterized as ordinary under Section 751.

The IRS concluded that the contracts were not options for tax purposes, and that the taxpayer was the owner of the basket components to the extent that the bank actually held the components of the baskets. The IRS noted that two particular elements of the contracts were contrary to a typical option: (i) the interplay of the premium, cash settlement and the barrier provisions; and (ii) the taxpayer’s ability to alter the basket through the corporation.  

In addition, the IRS reasoned that the taxpayer should be treated as the owner of the basket components for tax purposes because the taxpayer had the substantial benefits and burdens of ownership including: (i) the opportunity for full gain and income from the basket; (ii) substantially all the risk of loss of the basket; and (iii) the ability to direct the bank to acquire and redeem basket components.

The IRS also concluded that Section 1260 was applicable to the contracts to the extent that the taxpayer was not the owner of a pass-through entity in the baskets. Section 1260 limits the amount of long-term capital gain realized by taxpayers from certain derivative contracts meeting the definition of a “constructive ownership transaction.” A constructive ownership transaction is defined in Section 1260 to include a forward contract to acquire an equity interest in a partnership.  

The IRS also concluded that if the contracts did not transfer ownership of the basket components to the taxpayer, the contracts were forward contracts to purchase partnerships (i.e., the hedge fund interests in the basket), and therefore constituted constructive ownership transactions under Section 1260. In addition, under such a scenario, the IRS further concluded that withdrawals from the contracts would have been taxable income to the extent of gains on the contracts, and changes in the basket would have been taxable exchanges under Section 1001 because the contracts were effectively modified.

Last, the IRS concluded that the taxpayer’s “deferral accounting method,” which presumably treated the contracts as options for tax purposes, did not clearly reflect the taxpayer’s income related to the contracts.  Thus, the IRS could change the taxpayer’s accounting method to an appropriate method with a necessary adjustment under Section 481(a).

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