Basket Contracts as Listed Transactions and Transactions of Interest

Editor: Anthony S. Bakale, CPA, M.Tax.

On Oct. 21, 2015, the IRS issued Notices 2015-73 and 2015-74, regarding basket contracts. These notices, which revoke and replace Notices 2015-47 and 2015-48, identified certain basket contracts as listed transactions and as transactions of interest. The new notices provide greater detail and discussion than the previous notices on the types of transactions intended to be covered under these rules.

Background

In a basket contract, a taxpayer enters into an agreement with a counterparty, typically a bank, by which the taxpayer receives a return based upon the performance of a notional basket of actively traded securities. The taxpayer typically makes upfront payments to the counterparty, which serve as collateral on the contract, and determines a basket of securities or selects a trading algorithm that determines the basket of securities that will dictate the notional value of the contract. While the contract remains open, the taxpayer generally has the right to change the assets in the basket.

Basket contracts typically have a stated term of more than one year but may contain provisions allowing for early termination. The payment on settlement is based upon the performance of the assets in the basket. Most commonly, the payout is calculated as the upfront payments made by the taxpayer plus or minus the investment performance of the basket of underlying securities (including dividends, interest, etc.), minus fees charged by the counterparty for entering into the contract.

The IRS was concerned that taxpayers were entering into these derivative agreements to claim tax deferral or convert the character of what would be ordinary income (dividends, short-term capital gains, interest income, etc.) if the taxpayer had directly invested in the assets in the basket into long-term capital gain.

Notice 2015-73

Notice 2015-73 revokes Notice 2015-47 and specifically identifies basket option contracts and substantially similar transactions as listed transactions. The notice conveys the IRS’s concern that taxpayers are using basket option contracts to “inappropriately defer income recognition or convert ordinary income or short-term capital gain into long-term capital gain.” The notice further states that taxpayers are treating these transactions as outside of the scope of Sec. 1260, which generally would cause recognition of income of assets constructively owned to be treated as if the taxpayer directly owned the underlying assets.

Under Section 2.01 of Notice 2015-73, a transaction is the same as, or substantially similar to, a transaction identified in the notice only if (1) the taxpayer enters into a contract with a counterparty that is denominated as an option contract; (2) the taxpayer receives a rate of return based upon the performance of the basket; (3) substantially all of the assets in the basket primarily consist of actively traded personal property under Regs. Sec. 1.1092(d)-1(a); (4) the contract is not fully settled in intervals of one year or less; (5) the taxpayer (or the taxpayer’s designee) has exercised discretion to change the assets in the basket; and (6) the taxpayer’s tax return for a tax year ending on or after Jan. 1, 2011, reflects a tax benefit of deferral of income into a later tax year or a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

Section 2.05 of Notice 2015-73 excludes certain contracts and does not treat a contract as the same, or substantially similar to, the basket option contracts described in the notice if (1) the contract is traded on a national securities exchange regulated by the SEC or a domestic board of trade regulated by the Commodity Futures Trading Commission or is traded on a foreign exchange subject to regulation by a comparable regulator; or (2) the contract is treated as a contingent payment debt instrument under Regs. Sec. 1.1275-4 or a variable-rate debt instrument under Regs. Sec. 1.1275-5. Different exclusions may apply to counterparties.

Transactions in effect on or after Jan. 1, 2011, that are the same as, or substantially similar to, the transactions described in the notice are identified as listed transactions as of Oct. 21, 2015. Persons engaged in transactions in effect on or after Jan. 1, 2011, must disclose the transactions as described in Regs. Sec. 1.6011-4 on Form 8886, Reportable Transaction Disclosure Statement, for each tax year in which the taxpayer participated in the transactions, provided that the period of limitation for assessment of tax had not ended on or before Oct. 21, 2015.

The notice also provides procedures for taxpayers related to accounting method changes. Specifically, the IRS will not process nonautomatic accounting method changes on the treatment of basket option contracts. Instead, consent is granted to file amended returns to retroactively change from an impermissible method of accounting to a permissible method of accounting for the transaction if the taxpayer amends the earlier of the first year the taxpayer entered into the transaction or the first year for which the statute of limitation has not expired and each subsequent tax year. If the statute of limitation for the first year has expired, the taxpayer must include a Sec. 481(a) adjustment (either positive or negative) attributable to the change of accounting method in the first tax year for which the statute of limitation has not expired. These amended returns must indicate they are being filed under Notice 2015-73.

Notice 2015-74

Notice 2015-74 revokes Notice 2015-48 and identifies basket contracts and any similarly structured transactions as transactions of interest, as the IRS believes the transactions have the potential for tax avoidance or evasion but lacks enough information to determine whether they should be specifically identified as tax-avoidance transactions.

The purpose of Notice 2015-74 is fundamentally the same as that of Notice 2015-73. The two notices’ requirements for disclosure, procedure for accounting method changes, and timing are the same. However the scope of the potentially covered transactions is broader under Notice 2015-74 as including any basket contract, not just basket option contracts. Transactions covered under Notice 2015-74 may include notional principal contracts, forwards, or any other derivative, and are not limited exclusively to those structured as options. Furthermore, referenced baskets under Notice 2015-73 are limited to those containing actively traded property, while basket contracts covered by Notice 2015-74 can include those with other referenced assets.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.