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IRS changes date used in identifying transactions same as or similar to basket transactions

Notice 2015-73, 2015-46 IRB; Notice 2015-74, 2015-46 IRB

IRS has amended and re-issued two recently released Notices on “basket option contracts” and “basket contracts”—two types of structured financial transactions that IRS has respectively determined are, or have the potential to be used as, tax avoidance transactions. Both Notices stated that, to be considered the same as or substantially similar to these “basket transactions,” the taxpayer’s return for a year ending on or after the “effective date of this notice” must reflect a specifically defined tax benefit such as deferral. However, in response to requests for clarification, IRS has removed this effective date phrasing and instead provided a fixed date of Jan. 1, 2011.

Background on reportable, etc. transactions. Under Code Sec. 6011 and its regs, taxpayers must disclose their participation in reportable, tax-shelter-type transactions by, among other things, attaching an information statement to their income tax returns. Under Code Sec. 6111, material advisors must disclose reportable transactions (e.g., identify and describe them and the claimed tax benefits), and, under Code Sec. 6112, material advisors must prepare and maintain lists for reportable transactions. Regs provide that reportable transactions include several categories of transactions including listed transactions and transactions of interest. (Reg. § 1.6011-4(b)(1))

A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that IRS has determined to be a tax avoidance transaction and identified by notice, reg, or other form of published guidance as a listed transaction. (Reg. § 1.6011-4(b)(2)) Several of the disclosure rules described above have stricter provisions for listed transactions than for other reportable transactions.

A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that IRS has determined to be a transaction of interest and identified by notice, reg, or other form of published guidance as a transaction of interest. (Reg. § 1.6011-4(b)(6))

Reg. § 1.6011-4(e) and Reg. § 301.6111-3(e) provide rules on the timing of the disclosures that are required under Code Sec. 6011 and Code Sec. 6111 .

Description of the two contracts at issue. Basket option contracts and basket contracts are types of structured financial transactions that are used by taxpayers in attempts to defer income recognition and convert short-term capital gain and ordinary income into long-term capital gain. IRS stated that it believes that basket option contracts are tax avoidance transactions, and that basket contracts have the potential to be used as such.

Both basket transactions involve taxpayers (typically hedge funds or high net-worth individuals) entering into contracts to receive a return based on the performance of a notional basket of certain property (in general, actively traded personal property for basket option contracts and interests in entities, securities, foreign currency, and other similar property or positions therein for basket contracts). The taxpayer has the option to request or reject basket property changes but seldom does so.

The taxpayer typically makes an upfront payment of between 10% and 40% of the value of the assets and is protected against economic risk by a number of safeguards.

In general, the assets would generate ordinary income if held directly, and short-term gain or loss if sales were carried out, by the taxpayer. However, the taxpayer takes the position that these short-term trading gains and interest, dividend, and other ordinary income from the performance of the “basket” are deferred until the contract terminates—such that if the contract is held for more than one year, the entire gain is treated as long-term capital gain.

For a more detailed explanation of both contracts, see Weekly Alert ¶  1  10/29/2015.

Prior guidance. On July 8, 2015, IRS issued Notice 2015-47, 2015-30 IRB 76 and Notice 2015-48, 2015-30 IRB 77 (the “Original Notices”), in which it described what it considered to be basket option contracts and basket contracts in great detail. It also classified basket option contracts as listed transactions and basket contracts as transactions of interest, both effective July 8, 2015. (See Weekly Alert ¶  30  07/16/2015).

The Original Notices also provided that the Reg. § 1.6011-4(e) and Reg. § 301.6111-3(e) rules for when reportable transaction required disclosures must be made applied to basket option contracts and basket contracts, except that the 90-day period provided in Reg. § 1.6011-4(e)(2)(i) was extended to 120 days.

Less than a month later, IRS amended the Original Notices to provide more time for certain basket option contract and basket contract disclosures. (See Weekly Alert ¶  30  07/30/2015)

Then, in October, in light of commenters’ concerns that difficulty in identifying transactions that are the same as, or substantially similar to, the transactions described in the Original Notices may cause taxpayers to file disclosures for transactions that are not intended to be treated as transactions of interest at this time, IRS revoked the Original Notices and provided new guidance (Notice 2015-73 and Notice 2015-74, the “New Notices”). The New Notices, among other things, changed and expanded the instructions on how to identify basket contracts and basket option contracts and transactions similar to them, including the addition of a condition that the transaction reflect a “tax benefit” (generally, deferral or conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss) on the taxpayer’s return for a tax year ending on or after the “effective date of this notice.” The New Notices also referenced such an effective date in their descriptions of “excluded contracts” that are not considered the same as or substantially similar to basket option contracts and basket contracts with respect to the taxpayer. (See Weekly Alert ¶  1  10/29/2015)

Newest revisions. IRS has now issued amended versions of Notice 2015-73 and Notice 2015-74 that eliminate the “effective date of this notice” language referenced above and revise it as follows.

For a contract to be considered the same as or substantially similar to basket contracts or basket option contracts, in addition to satisfying the other requirements explained at Weekly Alert ¶  1  10/29/2015, the taxpayer’s tax return for a tax year ending on or after Jan. 1, 2011 must reflect a “tax benefit.” Similar changes were made to the sections on “excluded contracts.”

The effective date rules in the New Notices are otherwise unchanged.

References: For tax shelter reporting requirements, see FTC 2d/FIN ¶  S-4400  et seq.; United States Tax Reporter ¶  61,114; TaxDesk ¶  817,000  et seq.; TG ¶  71807  et seq.