In the Notices discussed in a prior post, the IRS indicated that it may assert one or more arguments to deny taxpayers deferral and/or long-term capital gain which include: (1) that the taxpayer directly owned the assets in the reference basket rather than owning a derivative, (2) that the basket option (in the case of something designed as an options) is not an option for tax purposes, (3) that changes to the assets in the reference basket materially modify the basket option contract result in a disposition of the entire contract under Section 1001, and (4) that the taxpayer has a separate contractual right for each reference asset.
I’ll discuss each of these briefly below. For most of the above points, there is a fairly long discussion to be had and want to save that discussion for later posts.
It’s difficult to fully determine the consequences of (2) because declaring something is not an option doesn’t really tell us what it is. However, given the position the taxpayers had taken in previous iterations of this transaction, I suspect that the IRS must poke a hole in the taxpayer theory before they can move on to characterizing the transaction appropriately. The conclusion that the basket contracts in AM 2010-005 were not options rested on two facts: (1) the interplay of the various provisions of the contract precluded lapse, and (2) the ability of the taxpayer to change the references was inconsistent with the idea of an option referencing a specific property at a defined price.
As to (1), if the IRS succeeds in arguing that the taxpayer is the owner of the property, then the taxpayer should be taxed similar to what it would look like if they held the referenced assets in a prime brokerage account. Effectively, the taxpayer would be deemed to have receive dividends (or other current payments directly) which would ultimately reduce the amount of capital gain (if any) that they experience on unwinding the contract. In addition, each time the taxpayer changes a reference asset, the taxpayer will be deemed to dispose of that specific asset and would recognize gain or loss at that time.
Whether the IRS can succeed on this point will be depend on the facts and circumstances. While tax ownership is a complicated issue which I will discuss in a later post, the issue should turn on who had control over disposition of the reference assets. Keep in mind that I’m distinguishing (x) control over what is referenced in the contract from (y) control over the referenced asset. Only in the latter case do I believe that tax ownership transfers to the taxpayer. The former would be more relevant to issues (3) and (4).
As to (3) (each change is a modification of the contract), I would think that the IRS would have a fairly strong argument assuming the contract is viewed as an integrated whole. Where the taxpayer has the right to arbitrarily (or, more correctly, somewhat arbitrarily) to change the referenced assets from time-to-time, it would seem that this would result in a material modification of the contract. In this context, you might hear some of the more aggressive tax advisors push a theory that this is not a material modification because it is a unilateral option inherent in the contract, akin to the carve-out for significant modifications under Treas. Reg. Sec. 1.1001-3(c)(3). However, these rules specifically only apply to debt instruments. The standard in Rev. Rul. 90-109, 1990-2 C.B. 191 seems more appropriate. In that ruling, the exercise of the option to change the insured under a key man life insurance contract constituted a “fundamental or material change”. The change of the reference asset would seem analogous to that ruling. The only question remaining would be what quantum of change would constitute a fundamental or material change.
Under this theory, unlike (2), the taxpayer would be deemed to recognize gain or loss with respect to all of the net gains and losses in the entire basket at the time of the modification because the entire contract would be deemed modified. It is not clear whether this would require the taxpayer to accrue dividends prior to the termination of the contract but theoretically it should not. Of course, if the taxpayer had sufficiently high turnover in the referenced assets in a given year, this may have very little impact on the final result.
The final theory of the IRS is that the taxpayer entered into separate contracts over each individual reference. This would seem to rest on a fairly technical reading of the specific provisions of the contract. If drafted with care, there are likely several provisions of the contract that rely on treating the contract as an indivisible whole—e.g., termination rights, increased cost provisions, etc. I would think it would be difficult to ignore the reality of such provisions and declare what is an otherwise indivisible contract as several independent contracts. I would think this would require some kind of substance over form attack, but that would seem inappropriate when there is an underlying economic reality to the contracts entered into by the taxpayer. Moreover, it may well be that the economics of certain basket trades can only work if you treat them as indivisible. For example, let’s say you have a basket of X and Y that for an investment of $100 will pay you $110 if both X and Y reach a value of $105. It would seem impossible to treat the taxpayer as having two contracts relating to X and Y, respectively. In any event, this last theory is very dependent on the terms of the contracts and how carefully they were drafted to ensure that they would be treated as an integrated contract.