Case Study: Tax Ownership and “Basket Options” – AM 2010-005

In this post, I’ll be taking a closer look at Office of Chief Counsel IRS Memorandum AM 2010-005See also, CCA 200941015(which outlines some precedent the IRS was relying on).

This memorandum contains the IRS analysis of the so-called “basket options” that eventually lead to the Senate Permanent Subcommittee of Investigations Report and Notices 2005-47 and Notices 2005-48.

Some of the relevant facts of the memorandum are as follows:

  1. The taxpayer was a hedge fund (“HF”) which had general partner (“GP”) that also managed other related funds.
  2. HF entered into a contract (“Basket Contract”) with Foreign Bank (“FB”) which was nominally structured as a call option on a basket of securities (“Reference Basket”) held in a specified prime brokerage account administered by FB.
  3. The value of the securities in the Reference Basket was $10x (which was the strike price of the “option”) when the parties entered into the Basket Contract, and the Reference Basket was funded with $1x in “premium” paid by HF and $9x paid by FB.
  4. While FB put up $9x of funding, FB had protection from losses to the extent the Basket Contract exceeded HF’s $1x.premium
    1. The Basket Contract contained a “Knock-Out” provision that automatically terminated the contract at any time that Basket Losses reached 10% (i.e., whenever the losses exceeded the $1x of HF’s investment).
    2. FB also had the right to require HF to enter into risk reducing trades even before losses in the Reference Basket reached the 10% barrier.
  5. HF and FB entered into an Investment Management Agreement related to the Basket Contract which provided that GP managed the securities in the Reference Basket, subject to certain guidelines. The memorandum doesn’t go into these guidelines but I imagine that they are restrictions that dealt with FB’s regulatory requirements.
  6. GP would generally issue instructions to the FB which executed all of the trading instructions, though it was not contractually obligated to do so. GP also had power to make corporate action decisions over the securities, addressing tender offers, mergers, and other decisions that offer a choice of consideration of cash or shares.
  7. Nothing contractually prohibited FB from commingling, lending or otherwise using the securities in the Reference Basket without notice to HF.

Based on the facts above, the economics of the Basket Contract were such that the taxpayer, HF, effectively had full economic exposure to the Reference Basket.  One potential risk of loss to FB was that Basket Contract would have losses that blew past the Knock-Out and FB would end up covering that loss.  But this seemed very unlikely given the parameters of the contract.

The first part of the IRS analysis concluded that the Basket Contract was not an option, arguing that the terms of the Basket Contract precluded lapse and that the Basket Contract did not relate to any specific property.  A different way of saying this is that the option holder didn’t really have any choice.  I mean, it’s not called an “option” for nothing, right?

The only provision that seemed to act like an option was the “knock-out” provision, but this seemed to act more like a condition subsequent than a condition precedent.  That is, it terminated the duties of the parties to the contract rather than initiated them.  Therefore, it’s hard to find the sorts of condition precedents you’d expect to see which would normally preclude the option holder from being treated as the owner of the property.

Next, the IRS addressed the ownership issue more directly.  Here, the IRS indicated that a factor-test should be implied but then they went on to discuss the IRS went to a factor test but limited their discussion to three factors:

  1. HF had full opportunity for gain.
  2. HF had full risk of loss.
  3. HF, through GP, had complete dominion and control over the Reference Basket.

This is the kind of a joke, right?  They basically suggest that they are going to use the factor test and the first two factors seem almost entirely pointless.  In a “plain vanilla” stock loan, I had concluded that the stock lender, who has full opportunity for gain and risk of loss related to the reference is generally not the owner of the stock loaned and presume that the IRS would agree with me (again, the generic case).   But they came up with a different answer here.  Therefore, the issue would seem to almost entirely turn on the resolution in point 3.

Of course, it’s arguable I’m seeing it this way because, based on everything I’ve said in previous posts, I obviously think that this is the right, if not only, factor to focus on. In any event, giving an agent of the taxpayer (i.e., GP) complete control over the Reference Basket is ultimately the problematic point. The IRS does point out that FB did not have the contractual obligation to execute the GP trades but it did, in fact, execute all such trades, and, therefore, it does appear that the taxpayer had control over disposition of the securities.

Notwithstanding this, there is an opening for the taxpayer here at least theoretically if not practically.  The IRS does concede that the FB has some control over the Reference Basket as they could lend or re-hypothecate securities in the account without HF’s knowledge or consent.  Here, the IRS rightly analogized this to the customary powers that a broker would have over assets under custodial arrangement with prime brokerage customers.

Of course, the IRS asserts this as a way of drilling home that HF is the owner of the Reference Basket because everyone knows that the prime brokerage customer who buys stock on margin loan is the owner of the stock in that account.  Right?…

…this is a cliffhanger.

3 thoughts on “Case Study: Tax Ownership and “Basket Options” – AM 2010-005

  1. “giving an agent of the taxpayer (i.e., GP) complete control over the Reference Basket”. is this fair, or are you arguing for X by assuming X is the case?

    • First, I should say that my argument wasn’t attempting to establish that the HF had complete control. Only that it is the dispositive factor given the other factors the IRS was using. In this case, I’m taking HF’s control is a “given” since it’s stated rather positively by the IRS. In fact, a direct quote from the memorandum (the first quote under the heading “c. HF’s Control over the Reference Basket” is …”HF, through GP, had complete dominion and control over the Reference Basket. As HF’s agent…” etc.

      But, to your point, the IRS might be pushing it by saying “complete control”. There are a few facts that go to the control point: (1) the bank executed all of the GP’s trading instructions (although not contractually obligated to do so), (2) the trading was subject to investment guidelines, (3) GP had the power to make corporate action decisions over the securities, addressing tender offers, mergers, and other decisions that offer a choice of consideration of cash or shares, and (4) the bank had the power to rehypothecate.

      I’m going to address (4) in a later post when I talk about rehypothecation rights and margin accounts. Short answer before I get to that post: I DON’T think the taxpayer had complete control over the shares in the reference basket and that they shouldn’t be treated as the owner (at least theoretically–there may be a different story from a practical perspective).

      The power given to (3) would normally be fairly unusual in a derivative arrangement, at least insofar as the way the memorandum poses this. It seems to suggest that the GP had the actual direct power to address corporate actions. While it’s likely a customer in a derivative contract would make elections that apply to the derivative, this wouldn’t necessarily mean that the dealer is bound to that election with respect to the underlying reference. The way the IRS discusses (3) suggests that the power of the GP related to the shares directly. Point (1) is likely the IRS strongest argument and while the taxpayer could argue that the bank was not contractually obligated to follow any instructions, the argument is undermined by the fact that the bank always followed the instructions. I would think that this would likely fail on substance over form grounds.

      Lastly, with respect to (2) and the investment guidelines, there may be something to argue there, but without having enough information about the investment guidelines, it’s difficult to say. However, my suspicion is that they are there for regulatory purposes; that is the bank is, at least for regulatory purposes, treating themselves as the owner of the security. If this is true, someone could push that argument forward, depending on what the regulatory rules of ownership are and whether they would be analogous to tax ownership rules I don’t have enough information on this though.

  2. Pingback: Case Study: Tax Ownership and Stock Held in Prime Brokerage Accounts | Tax Pro Super Happy Fun Time - A Tax Blog

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