Resources

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

IRS, revoking two prior rulings, has issued two Notices that (i) identify basket contracts and basket option contracts (types of structured financial transactions) as “transactions of interest” and “listed transactions,” respectively; and (ii) provide a more extensive framework for how to identify transactions that are the same as or substantially similar to those transactions.

Background. 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 . For example, under Reg. § 1.6011-4(e)(1), a disclosure statement must be attached to the taxpayer’s tax return for each tax year for which a taxpayer participates in a reportable transaction. And, a copy of the disclosure statement must be sent to the Office of Tax Shelter Analysis (OTSA) at the same time that any disclosure statement is first filed by the taxpayer pertaining to a particular reportable transaction. And, Reg. § 1.6011-4(e)(2)(i) provides that, under certain circumstances under which a transaction becomes a listed transaction or a transaction of interest after the taxpayer files his tax return for the year of that transaction, he has 90 days after the transaction became a listed transaction or transaction of interest to report it to OTSA.

Description of the two contracts. Here are descriptions of the basket option contract and the basket contract (collectively, the two contracts).

Basket option contracts. In a basket option contract, a taxpayer (“T”), typically a hedge fund or a high net-worth individual, enters into a contract that is denominated as an option with a counterparty (“C”), typically a bank, to receive a return based on the performance of a notional basket of referenced actively traded personal property (the “reference basket”). T or a designee named by T will either determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets. While the basket option contract remains open, T has the right to request changes in the assets in the reference basket or the specified trading algorithm. The terms of the basket option contract also permit C to reject certain changes requested by T to the assets in the reference basket. C, however, generally accepts all or nearly all of the changes requested by T.

When the basket option contract is entered into, T typically makes an upfront cash payment to C of between 10% and 40% of the value of the assets in the reference basket. To manage its risk under the basket option contract, C typically acquires substantially all of the assets in the reference basket at the inception of the contract and acquires and disposes of assets during the term of the contract either when T changes the assets in the reference basket or the trading algorithm provides for such changes. C generally supplies the additional cash required to purchase the assets in the reference basket. The assets in the reference basket would typically generate ordinary income if held directly by T, and short-term trading gains and losses if purchases and sales of the assets were carried out directly by T.

The basket option contract typically contains safeguards to minimize the economic risk to C. For example, C may terminate the basket option contract if T violates investment guidelines that are part of the contract. C typically holds rights associated with the legal title to the assets and positions in the reference basket, including voting rights and the rights to commingle, lend, or otherwise use those assets without notice to T.

T takes the position that short-term gains and interest, dividend, and other ordinary periodic income from the performance of the reference basket are deferred until the basket option contract terminates and, if the basket option contract is held for more than one year, that the entire gain is treated as long-term capital gain.

Basket contracts. In a basket contract, T enters into a contract with C to receive a return based on the performance of a notional basket of referenced assets (the “reference basket”). The assets that comprise the reference basket may include (1) interests in entities that trade securities, commodities, foreign currency, or similar property (“hedge fund interests”), (2) securities, (3) commodities, (4) foreign currency, or (5) similar property (or positions in such property). T or a designee named by T will either determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets. While the basket contract remains open, T has the right to request changes in the assets in the reference basket or the specified trading algorithm. The terms of the basket contract also permit C to reject certain changes requested by T to the assets in the reference basket. C, however, generally accepts all or nearly all of the changes requested by T.

When the basket contract is entered into, T typically makes an upfront cash payment to C of between 10% and 40% of the value of the assets in the reference basket. To manage its risk under the basket contract, C typically acquires all or substantially all of the assets in the reference basket at the inception of the contract and acquires and disposes of assets during the term of the contract either when T changes the assets in the reference basket or the trading algorithm provides for such changes. C generally supplies the additional cash required to purchase the assets in the reference basket. The assets in the reference basket would typically generate ordinary income if held directly by T, and short-term gains and losses if purchases and sales of the assets were carried out directly by T.

The basket contract typically contains safeguards to minimize the economic risk to C. For example, C may terminate the basket contract if T violates investment guidelines that are part of the contract. C typically holds the rights associated with the legal title to the assets and positions in the basket, including voting rights and the rights to commingle, lend, or otherwise use the assets in the basket without notice to T.

T takes the position that T’s short-term trading gains and interest, dividend, and other ordinary periodic income from the performance of the basket are deferred until the basket contract terminates and, if the basket contract is held for more than one year, that the entire gain is treated as long-term capital gain.

Notices 2015-47 and 2015-48, as originally issued. On July 8, 2015, IRS issued Notice 2015-47 and Notice 2015-48 (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) is extended to 120 days.

Original Notices amended to provide more time to make disclosures. Less than a month later, IRS amended the Original Notices to provide more time for certain basket option contract and basket contract disclosures by adding the following to the Original Notices’ rules for when disclosures must be made: If Reg. § 1.6011-4(e) would require the filing of a disclosure statement with respect to a basket option contract or a basket contract after July 8, 2015 and before Nov. 5, 2015, that disclosure statement will be considered to be timely filed if it is filed with OTSA by Nov. 5, 2015 (i.e., 120 days after the Original Notices’ July 8, 2015 issuance). (See Weekly Alert ¶  30  07/30/2015)

New Notices. 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 has revoked the Original Notices and provided new guidance (Notice 2015-73 and Notice 2015-75, the “New Notices”). The New Notices also provide procedures for taxpayers to change their accounting method for transactions that fall within the New Notices’ scope.

The descriptions of the basket option contracts and basket contracts are the same as those in the Original Notices, but the instructions on how to identify transactions that are substantially similar to them, and thus are listed transactions or transactions of interest, have been changed.

A transaction is the same as, or substantially similar to, a basket option contract if: (1) T enters into a transaction with C that is denominated as an option contract; (2) T receives a return based on the performance of the reference basket; (3) substantially all of the assets in the reference basket primarily consist of actively traded personal property as defined under Reg. § 1.1092(d)-1(a); (4) the contract is not fully settled at intervals of one year or less; (5) T or T’s designee has exercised discretion (as these terms are defined in Notice 2015-73) to change (either directly or through a request to C) the assets in the reference basket or the trading algorithm; and (6) T’s tax return for a tax year ending on or after the effective date reflects a tax “benefit” (below). There is also a list of specifically excluded transactions, such as contracts traded on a national securities exchange regulated by the SEC. (Notice 2015-73)

A transaction is the same as, or substantially similar to, a basket contract only if: (1) T enters into a contract with C to receive a return based on the performance of the reference basket; (2) the basket contract has a stated term of more than one year or overlaps two of T’s tax years; (3) T or T’s designee has exercised discretion to change (either directly or through a request to C) the assets in the reference basket or the trading algorithm; and (4) T’s tax return for a taxable year ending on or after the effective date of Notice 2015-74 reflects a tax benefit described in section 2.04 of this notice. (Notice 2015-74) A similar list of excluded contracts applies.

A “tax benefit,” for purposes of the New Notices, is defined as “a deferral of income into a later taxable year or a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

Accounting method changes. The New Notices also provide guidance on accounting method changes related to transactions covered by the Notices.

For transactions covered by Notice 2015-73 (i.e., basket options contracts and similar transactions), IRS will not process applications for any changes in method of accounting filed under the non-automatic change procedures, but a taxpayer may change its method of accounting by filing an amended return in the manner specified. Consent is granted for any taxpayer that has engaged in such a transaction to file amended returns to retroactively change from an impermissible method of accounting to a permissible method of accounting.

For transactions covered by Notice 2015-74 (i.e., basket contracts and similar transactions), a taxpayer that wants to change a method of accounting for such a transaction from which the taxpayer’s only tax benefit is a deferral of income into a later tax year, may change its method of accounting by either: (1) filing amended returns in the manner specified, or (2) if eligible, requesting a change in method of accounting under the non-automatic change procedures. However, for a transaction that involves the conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss, IRS will not process applications for any changes in method of accounting filed under the non-automatic change procedures, but a taxpayer can change its method of accounting for such a transaction by filing an amended return in the manner specified.

Effective dates. The New Notices provide the following effective dates:

Basket option contracts. Transactions in effect on or after Jan. 1, 2011, that are the same as, or substantially similar to, the transaction described in Notice 2015-47 are identified as “listed transactions” effective Oct. 21, 2015.

Persons engaged in transactions in effect on or after Jan. 1, 2011 must disclose the transactions for each tax year in which the taxpayer participated in the transactions, provided that the period of limitations for assessment had not ended on or before Oct. 21, 2015.

Basket contracts. Transactions entered into on or after Nov. 2, 2006, that are the same as, or substantially similar to, the transactions described in Notice 2015-48, and in effect on or after Jan. 1, 2011, are identified as transactions of interest effective Oct. 21, 2015.

Persons engaged in transactions entered into on or after Nov. 2, 2006, and in effect on or after Jan. 1, 2011, must disclose the transactions for each tax year in which the taxpayer participated in the transactions, provided that the period of limitations for assessment had not ended on or before Oct. 21, 2015.

For both types of contracts, material advisors who make a tax statement on or after Jan. 1, 2011, with respect to transactions in effect on or after Jan. 1, 2011, have disclosure and list maintenance obligations under Code Sec. 6111 and Code Sec. 6112 . (Notice 2015-74)

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.