Okay…Notice 2015-47 and -48 again? Really?


I thought I was done reviewing Notices 2015-47 and -48, but the IRS and Treasury participated in a New York State Bar Association Tax Section panel that offered up some interesting tidbits.  I couldn’t attend the meeting because I’m on fixed income but it was handily summarized in “News Analysis: Hubbard Addresses Basket Contract Notices and Other Developments”, by Lee A. Sheppard, Tax Analysts, Doc 2015-16224.  The article is behind a paywall so I won’t link to it.  I will block quote some of the more interesting parts of the article and make some comments.  Please note that this is a summary by the author of what members of the panel said at the meeting.  I have no idea whether the article is correctly paraphrasing the statements or the opinions of the speakers.  Therefore, I will simply take them at face value.

Michael Farber of Davis Polk insisted that “there are people who do true options on variable baskets.” He argued that these deals should not be covered by Notice 2015-47. [Helen] Hubbard [IRS associate chief counsel] could not see how such a contract could function with no change in the strike price if the investor had the power to vary the basket. She and Farber agreed that such a deal would be economically ill-advised for the counterparty. Farber maintained that these deals have been done. Hubbard wanted more information and suggested that the listing designation could be modified.

Not much to comment on here since I don’t actually know if the highlighted part is true.  I’d love to hear from an actual banker on this point rather than lawyers.  It may well be true, but lawyers have a tendency to talk about the economics of transactions without really understanding what they are talking about.  It’s a thing.

Michael L. Schler of Cravath, Swaine & Moore LLP asked why economic substance was not part of the two notices’ explanation of proposed sanctions….Farber interjected that the customers made a profit on the deals, to which Schler responded that there is no business purpose for the chosen form.The notice also mentions avoidance of withholding taxes.

I personally don’t think economic substance/business purpose is an issue in these transactions and whether the taxpayer makes profit seems irrelevant so long as the taxpayer intended to make profit. Economic substance/business purpose is a difficult issue to deal with and there’s plenty of confusion as to how it should be applied in a specific scenario.  I’ll try to deal with it more in-depth in later posts.  For now, let’s boil it down to this:  in engaging in a transaction, you have to have a non-tax reason for doing it.  If you don’t have a non-tax reason, your transaction lacks substance.

Here, it seems that the underlying motive for the investor/taxpayer is economic exposure to the basket of securities.  There seems to be oodles of substance here.  I doubt if the taxpayer entered into the basket solely for tax reasons. For example, I suspect no one would doubt if someone had a business purpose if they simply bought the stock.  Challenging a purchase of stock on economic substance grounds would be akin to challenging this. Of course, once you get over the economic substance hurdle and conclude that the transaction has  substance, then you can move onto substance over form theories.  This seems to make up the substance of the IRS theories (I’m quite aware of (and happy with) that pun).  Ergo, the IRS proffers the theory that the taxpayer owned the reference security outright rather than through a derivative. It seems to me that one could argue that the form doesn’t reflect the substance of the transaction, but not that the transaction lacked substance.

Practitioners fret that innocent portfolio arrangements would be caught in the reporting maw.

Fret….maw.  Love it.

Investor control is paramount.  The power to vary the components of the basket has to be explicit.  The contract could state that the investor may request changes, and that the counterparty has the right to reject the requested changes, but in fact generally accepts them. A deal in which the investor lacks the power to vary is not within either notice.


What if the investor had the power to change the composition of the basket and did not exercise it?…But Hubbard clearly stated that a lack of exercise would not necessarily remove a contract from the notice’s disclosure obligation.

Huh?  Notice 2015-47 defines a “substantially similar” transaction to include one where “…(4) the purchaser of the option, the purchaser’s designee, or the specified trading algorithm actually changes one or more of the assets in the reference basket during the term of the basket option contract.”  Point (3) of the definition deals with the theoretical possibility of a change in the basket and point (4) deals with an actual exercise of that power.  There’s some disconnect here that I’m not getting.


Sometimes taxpayers treat baskets as a separate derivative on each security in the basket for tax accounting purposes, Maddrey noted.

I would assume this depends on how the taxpayers document their transactions.  It’s not clear to me that taxpayers are always aware of what they are doing. One thing that’s interesting would be to figure out how counterparty/dealer would report something like this for 1099 purposes.  If the dealer felt it was an option, it could be caught up in the basis reporting rules.  If it’s not an option, it might not be reported at all because exchanges of one derivative for another derivative isn’t necessarily something a dealer would report on a 1099.

Would a deal that is treated this way nonetheless constitute a basket for purposes of Notice 2015-48? Hubbard responded that it would be a basket.

I mentioned this in my previous post.  This makes some sense since at least one of the theories proposed by the IRS is that there is a deemed exchange of the entire integrated contract.  This would theoretically have a different tax consequences than a modification of individual contracts or a direct sale of the underlying securities.  Whether that difference would be material in any particular case is a different question.

She said that even if a basket had a single equity in it, the arrangement would be subject to reporting if the investor had the power to change it and exercised it. But if investors were accounting for gains and losses on the securities currently, there would be no problem, she added.

This doesn’t seem right does it?  In substance, a basket contract that references a single stock that gives the taxpayer the “power to vary” the reference has a lot in common with a contract on an individual security that is terminable at will.  At least, it would be a very narrow distinction.  Moreover, I really doubt that taxpayers would take the view that modifying a single reference was not a modification.  It’s possible, but those are crazies…right?

[Lucy] Farr [of Davis Polk] argued that an algorithm that the designers “set and forget” should be outside the notice. The argument is that the investors agreed to a basket controlled by an algorithm and do not themselves have the power to change it…Hubbard would not answer the algorithm hypothetical.

I’m not sure I agree with this sentiment, particularly where the taxpayer (or its agent) designed the algorithm.  I generally think of the algorithm as a surrogate for the taxpayer’s decision-making.  I like to think of this as a “robot” making the decision instead of a “human”.  So instead of a human agent, the taxpayer is using a robot agent.  I don’t think that deprives the taxpayer of their own agency.

Link to Part 1 of Notice 2015-47 and -48 discussion.

Link to Part 2 of Notice 2015-47 and -48 discussion.

Link to Part 3 of Notice 2015-47 and -48 discussion.

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