Barrier contracts create ownership and current tax events
Apply this to your situation
This page covers one taxpayer's ruling from 2015, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.
Plain-English summary
A taxpayer used bank contracts labeled cash-settled barrier call options to obtain leveraged exposure to baskets of hedge-fund interests that its chosen manager could change. Chief Counsel advised that the contracts were not options because their fixed premiums, settlement mechanics, and barriers made lapse economically unrealistic and shifted the referenced assets' gains, losses, costs, and control to the taxpayer. To the extent the bank actually held the referenced assets, the taxpayer was their tax owner; otherwise, section 1260 treated the taxpayer as constructive owner of pass-through assets. Cash withdrawals were taxable, fee and spread amendments were taxable exchanges, and cumulative basket changes could be fundamental changes producing additional exchanges. The taxpayer's deferral accounting method therefore did not clearly reflect income, allowing the IRS to impose a permissible method and a section 481(a) adjustment for non-PFIC assets.
Ruling snapshot
- Question: How should cash-settled barrier contracts referencing taxpayer-controlled hedge-fund baskets be characterized, taxed, and corrected for accounting-method purposes?
- Outcome: Advice given
- Key authorities: IRC §§ 446, 481, 1001, 1234, 1260
Full text (IRS public release)
Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 201547004
Release Date: 11/20/2015
CC:FIP:B01:FIP:OJO’Connor
POSTF-120543-14
UILC: 446.01-00, 481.00-00, 1234.00-00, 1234.03-00, 1260.00-00, 9300.00-00
date: August 11, 2015
to: Michael Kramarz
Senior Attorney - LB&I
(Large Business & International)
from: Associate Chief Counsel (Financial Institutions & Products)
subject: Cash-Settled Barrier "Call Options"
This Chief Counsel Advice responds to your request for assistance dated March 18,
2015, as supplemented by your request for assistance dated July 10, 2015. This advice
may not be used or cited as precedent.
LEGEND
Taxpayer = --------------------------
Bank = -------------------------------
Individual 1 = -----------------------------
Individual 2 = ------------------------
Corporation 1 = ---------------------------------
Corporation 2 = ------------------------------------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Year 6 = -------
Year 7 = -------
Year 8 = -------
Date 1 = --------------
Contract 1 = ------------------------------------------
Contract 2 = ------------------------------------------
POSTF-120543-14
State A = --------------
A = -----------------
B = ------
C = ------
D = -------
E = -----
F = -----
G = -----
H = -----
I = -----
J = -----
K = -----------------------------------
L = ----------
M = -------------
N = ------
O = -----
P = ------
Q = ----------------
R = -------------
S = ------
T = -------
Basket = ---------------
ISSUES
To obtain exposure to hedge funds (both U.S. and non-U.S. entities1, the “referenced
assets”) Taxpayer, a U.S. person, entered into contracts with a counterparty bank
(“Bank”) referencing an index specific to the transactions in issue, composed of the
referenced assets (the “Basket”).2 You have asked for advice on the following:
(1) Whether the contracts should be treated as options held by Taxpayer to
purchase the referenced assets or, if not, whether Taxpayer should be treated as
the owner of the referenced assets for tax purposes;
(2) If Bank (and not Taxpayer) is treated as the owner of the referenced assets for
tax purposes, whether Taxpayer should be treated as the constructive owner of
the referenced assets under section 1260;
1
The “passive foreign investment company” (“PFIC”) rules are set forth at sections 1291 through 1298 of
the Internal Revenue Code (the “Code”). Some or all of the non-U.S. hedge funds may meet the
definition of PFIC under section 1297. This memorandum does not address the application of the PFIC
rules.
2
The contract refers to the Basket as an “index”.
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(3) Whether, to the extent the contracts are not treated as transferring ownership of
the referenced assets for tax purposes, (a) withdrawals from the contracts are
income of Taxpayer to the extent of any gain on the contracts as of the date cash
was received, and (b) changes to the Basket or amendments to the contracts are
taxable exchanges of Taxpayer’s contracts under section 1001; and
(4) Whether Taxpayer’s deferral of gains, losses, income or deductions arising from
the contracts under its current accounting method (a “deferral accounting
method”) clearly reflects Taxpayer’s income under section 446(b) and, if not,
whether the Internal Revenue Service (the “Service”) may change Taxpayer’s
deferral accounting method to a method that does clearly reflect Taxpayer’s
income and make an adjustment under section 481(a), in both cases only as
relates to the non-PFIC referenced assets.3
CONCLUSIONS
(1) Although the contracts are labeled as options, the contracts do not function as
options, or have the economic characteristics of options, and therefore we
conclude they are not options for tax purposes. To the extent that Bank in fact
held the referenced assets in connection with the contracts, we conclude that
Taxpayer owns the referenced assets for all purposes of the Code.
(2) To the extent Taxpayer is not treated as the owner for tax purposes of a
referenced asset and the referenced asset is a “pass-thru” entity, we conclude
that under section 1260 Taxpayer is the constructive owner of the referenced
asset.
(3) To the extent Taxpayer is not treated as the owner of the referenced assets for
tax purposes, (a) Taxpayer’s cash withdrawals from the contracts are taxable, (b)
amendments to the contracts to include a portfolio management fee and to
reduce Bank’s spread are taxable exchanges of Taxpayer’s contracts that result
in recognition of any net gain or loss on the contracts, and (c) Taxpayer’s
discretion to make changes to the composition of the Basket, combined with the
resulting number of changes to the Basket based on that discretion, may be
economically significant such that, within a given tax year, the changes are
cumulatively a “fundamental change” to the contracts resulting in taxable
exchanges of Taxpayer’s contracts.
(4) To the extent Taxpayer is treated as the owner of any referenced asset for tax
purposes or if there is a taxable cash withdrawal or taxable exchange of
3
This memorandum does not address whether an adjustment under section 481(a) is required related to
Taxpayer’s deferral of gains, losses, income or deductions arising from any non-U.S. referenced assets
that are PFICs.
3
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Taxpayer’s contracts, then the deferral accounting method does not clearly
reflect Taxpayer’s income and therefore the Service may change Taxpayer’s
deferral accounting method to a method that does clearly reflect its income and
may compute the necessary adjustment under section 481(a), in both cases only
as relates to the non-PFIC referenced assets.
FACTS
Bank marketed various products to investors seeking hedge fund exposure.
Taxpayer, a U.S. person, purchased several contracts styled as “call options” from
Bank, including the two contracts that are the subject of this advice.4 The contracts
designate a portfolio manager, Corporation 2, to manage the Basket while the “options”
remain open. As described below under “Corporation 2’s Management of the Portfolio,”
Corporation 2 is a company formed at Individual 1’s request and operated by Individual
2, who was Taxpayer’s former employee. The transaction documents state that Bank
“will not recommend any [Basket] Component to [Taxpayer] that should be included in
the [Basket],” that Bank is not acting as an advisor to Taxpayer, and that Taxpayer and
its advisors are solely responsible for determining the composition of the Basket.
The tax years under examination are Years 4 and 5. Several of Taxpayer’s call
option contracts were terminated in prior years; the two that have not been terminated
(Contract 1 and Contract 2 and collectively, the “contracts”) are the subject of this
memorandum.
Taxpayer is a State A partnership. During the years in issue, Individual 1 and his
wife owned A percent of Taxpayer and Corporation 1 owned B percent.5 Taxpayer is on
the cash receipts and disbursements accounting method but has not included any gains
or losses from Contract 1 and Contract 2 in its taxable income through Year 5.
Contract Terms. In each contract the “premium” is K percent of the contract’s
initial notional amount.6 The “strike price” is (100 - K) percent of the initial notional
amount, as adjusted for an annualized LIBOR and spread amount (i.e., interest-like
charges and fees imposed by Bank), and as modified by the “barrier provisions” (i.e.,
adjusted upward to the extent Bank contributes additional capital to re-leverage
4
Although each contract bears the title “Cash-Settled Equity Barrier Call Option,” the general terms of
each contract specify a “Number of Options” of T.
5
Corporation 1 is the general partner of Taxpayer and the legal entity referenced in the contracts.
Corporation 1 is owned by Individual 1 and relatives of Individual 1. Individual 1 is also the president of
Corporation 1.
6
We note that the premium is a fixed percentage of the initial notional amount, and therefore not priced
using the Black-Scholes, or any other accepted methodology for determining the fair market value of an
option.
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Taxpayer’s position, and adjusted downward to the extent Bank withdraws capital to de-
leverage Taxpayer’s position, as described further below). The “cash settlement
amount” payable to Taxpayer at maturity or early termination equals the value of the
portfolio7 minus the strike price, subject to a floor of zero.8 The barrier provisions,
however, are intended to prevent the floor from being reached.
The barrier provisions provide a framework for maintaining Bank-provided
leverage at or near the initial (100 - K) percent level. If the value of the portfolio
increases, Taxpayer may request that Bank contribute “additional capital.” The barrier
provisions also provide for termination of the contract if the value of the portfolio
decreases more than a specified percentage. Specifically, if the value of the portfolio
drops by more than approximately L percent from its starting value (representing less
than half of Taxpayer’s “premium”), Taxpayer is required to pay “additional premium” to
reset the ratio (i.e., buy down the over-leverage). Otherwise, Bank has the right to
either “deduct capital” from the portfolio by adjusting the valuation of the portfolio
downward, or terminate the contract. Capital may be “deducted” either by withdrawing
cash, or by allocating to Bank a share in gains from the portfolio.
The contracts do not explicitly permit Taxpayer to withdraw cash from the
contracts while the contracts remain open, except for partial terminations as discussed
below.
Each of the contracts has an L-year term. However, Taxpayer is permitted to
terminate a contract in whole or in part on D days’ notice.
Amendments to Contracts. Contract 1 was amended in Year 2 to provide for a
portfolio management fee and both Contract 1 and Contract 2 were amended in Year 5
to reduce to the spread payable to Bank. There were other less relevant amendments
to the contracts as well, which we have not discussed in this advice.
Cash Withdrawals. In Year 4, Taxpayer began to make cash withdrawals from
the contracts. Between Years 4 and 8, Taxpayer withdrew cash on Q separate
occasions for Contract 1 and R separate occasions for Contract 2. Although the
contracts provide for partial terminations at Taxpayer’s election, Taxpayer’s cash
withdrawals were not treated by either party as a partial termination event.9
7
As described further below in the discussion of “The Portfolio” and “Corporation 2’s Management of the
Portfolio,” the “portfolio” is defined by the contracts as the Basket.
8
Accordingly, each contract, at the outset, was in-the-money by an amount equal to Taxpayer’s
“premium” payment. The value of the portfolio under the contract is the “aggregate USD value of the net
asset values of the components which comprise the [Basket]. . . less any fees and expenses associated
with the maintenance of the [Basket]. . .” Bank’s fees and expenses in the form of the LIBOR and spread
amounts, alternatively, affect the strike price.
9
In particular, the amounts withdrawn do not correspond to the fixed number of options referenced by
5
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The Portfolio. The contracts define the “portfolio” as the Basket referenced in the
contract, and then, in a section called “Portfolio Description,” provide that the portfolio
“shall consist of notional interests in (1) investment vehicles, managed accounts, and
indices thereof, (2) cash, and (3) other assets or securities.” The Basket in fact
referenced hedge fund interests and cash. Although Bank was not required by the
contracts to purchase the referenced assets in amounts sufficient to support its
obligations to Taxpayer, the following facts (as described further below) indicate that
Bank held the referenced assets: (a) the type of referenced assets, (b) the focus of the
parties on the management of liquidity risk, and (c) Bank’s “division of the Basket” in
Years 3 and 4.
First, the referenced assets, hedge fund interests, are not publicly traded and,
unlike publicly traded securities, such interests do not have a readily ascertainable
value. Because the value of a particular hedge fund is not available to the public, Bank
would have needed to own some interest in each of the underlying hedge funds in order
to determine the value of a contract’s referenced assets.
Second, the contracts treated failure to maintain sufficient “liquidity” in the Basket
as a “market disruption event.” Absent such a “market disruption event,” the contracts
require C percent of the cash settlement amount to be paid within D days of termination
or maturity, with the remainder payable within E days. However, Bank did not meet this
timeline on Taxpayer’s terminated contracts on account of illiquid “side pocket”
investments made by the referenced hedge funds.10 This fact indicates that Bank
needed to redeem its investment in the referenced hedge funds before paying a cash
settlement to Taxpayer and, because of the “side pocket” investments that may have
delayed Bank’s ability to redeem its investment, the payment to Taxpayer was delayed.
Moreover, Bank’s “basket reports” provided to Taxpayer show transfers to “side
pockets,” which is indicative of the fact that Bank owned an interest in the underlying
hedge fund and needed to track the illiquid “side pocket” investments of the hedge fund.
In other words, the tracking of these “side pockets” would not typically be of concern for
those with merely notional interests in a hedge fund.
Third, the same Basket referenced by Contract 1 and Contract 2 was initially
each contract (for example, cash withdrawn in an amount corresponding to the cash settlement value of
one or more out of the T total options).
10
A hedge fund “side pocket” is an account that separates a hedge fund’s illiquid investments from its
more liquid investments. Although the creation of a side pocket generally does not affect the fund’s net
asset value, “once an investment is made in a side pocket . . . funds associated with the investment may
not be withdrawn from the partnership until the particular investment is sold, even if an investor redeems
out of the hedge fund before the side pocket investment has been liquidated . . . .” David S. Miller & Jean
Bertrand, “Federal Income Tax Treatment of Hedge Funds, Their Investors, and Their Managers,” 65 Tax
Lawyer 309, 322 (2012).
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referenced by other contracts held by Individual 1’s friends and family.11 However, in
Years 3 and 4, Bank “divided the Basket” as between its various counterparties. Bank
would not have had to do this if Bank did not need to rely on redeeming the referenced
assets it held to respond to a cash settlement request.
Bank “divided the Basket” because the performance of the Basket had been
affected by a relatively high cash balance in the Basket created by the requests of
certain counterparties for cash settlements of their contracts. In response to a
counterparty’s request that Bank cash settle the counterparty’s contract, Bank would
redeem interests in hedge funds (which would not have been required if Bank did not in
fact hold the referenced assets). Redemption of such interests could only take place at
certain pre-specified times when the hedge funds processed redemption requests, and
could take a number of months to complete. While hedge fund interests were being
redeemed, the Basket would consequently include a relatively high proportion of cash,
resulting in lower yields on all contracts referencing the Basket. To prevent this result,
Bank “divided the Basket.” After the Basket was divided, Bank maintained a separate
Basket for each contract.
Corporation 2’s Management of the Portfolio. As explained above, the Basket
was managed by Corporation 2, a company owned by Individual 2. Individuals 1 and 2
had an existing working relationship that predated the contracts in issue in this case.
Individual 2 was a former Taxpayer employee; several years prior to Year 1, Individual 1
hired Individual 2 to work for Individual 1 at Taxpayer. Individual 2 worked out of an
office in Individual 1’s home, and lived there for several years while he worked for
Taxpayer. Individual 1 requested that Individual 2 form Corporation 2 for the purpose of
managing Taxpayer’s contracts with Bank, such as Contracts 1 and 2.
Corporation 2 was selected by, compensated by, and acted on behalf of
Taxpayer. Corporation 2 did not earn any fees or other compensation under the
contracts for performing advisory functions until Contract 1 was amended in Year 2.
Corporation 2’s portfolio management activities included recommending changes to the
Basket, requesting the addition of new hedge funds to Bank’s platform (enabling them
to be added to the Basket), and communicating with hedge fund managers to negotiate
waivers of redemption fees (which were otherwise borne by Taxpayer under the
contracts).
All changes to the Basket were requested by Corporation 2. The contracts do
not require Individual 1 to approve changes to the Basket, but Individual 1 in fact
approved all changes. The contracts require Bank’s consent to changes to the Basket,
and allow Bank to make its own changes for “risk management” reasons. Bank in fact
rejected, at most, only P requests to change the Basket, yet there were F, G, H, I, and J
11
Individual 2 stated that two contracts referencing the Basket were held by “friends” of Individual 1.
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changes to the Basket in Years 1 through 5, respectively.12 The transaction documents
include multiple statements that Bank “will not recommend any [Basket] Component to
[Taxpayer] that should be included in the [Basket],” that Bank is not acting as an advisor
to Taxpayer, and that Taxpayer and its advisors are solely responsible for determining
the composition of the Basket.
Expenses Associated with Bank’s Holdings of Referenced Assets. Although the
contracts refer to Bank’s potential positions in the referenced assets as “hedges,” the
contracts’ valuation of the portfolio ensured that Taxpayer bore any expenses
associated with maintaining these positions to the extent Corporation 2 was unable to
negotiate fee reductions with hedge fund managers. These expenses were generally
created when hedge fund interests were acquired and redeemed and as described
above in “Corporation 2’s Management of the Portfolio,” Taxpayer, through Corporation
2, controlled these decisions.
Taxpayer’s Relationship with Hedge Fund Managers. Although hedge fund
interests were held in the name of Bank, hedge fund managers were generally aware of
Bank’s relationship with Taxpayer (as described in more detail above under
“Corporation 2’s Management of the Portfolio”), and knew that interests were held on
behalf of Taxpayer. Additionally, Taxpayer consented in the contracts to the “disclosure
to any [h]edge fund . . . the identity of [Taxpayer], the amount of exposure [Taxpayer]
has, or is proposed to have, to such [h]edge fund, the amount of any change in
exposure [Taxpayer] has to such [h]edge fund or any other information requested by
such [h]edge fund . . . with respect to [Taxpayer].” Taxpayer was also required to
represent in the contracts with Bank that it met various eligibility requirements to be an
investor in the hedge funds, including its status as a “qualified purchaser” under the
Investment Company Act of 1940, and that it is not a “benefit plan investor” for purposes
of the ERISA rules.
Bank’s Contractual Protections. In addition to the barrier provisions, the
contracts include the following provisions, which may have the effect of protecting Bank
from loss by indirectly requiring the portfolio to meet certain diversification and liquidity
requirements.
The contracts treat the following as “market disruption events,” which result in a
delay of up to S years of a cash settlement upon termination or maturity of a contract:
(1) “the [portfolio] contains an insufficient amount of liquidity to meet [Bank’s] hedging
requirements”; and (2) “the portfolio is insufficiently diversified, or the portfolio would be
insufficiently diversified as a result of [Bank] altering its hedge, if any, to effect a
termination of any portion of the options.” Bank’s “hedging” requirements are not set
out in the contracts, nor is the diversification standard for the portfolio. However,
12
Thus, Bank rejected, at most, 0.N percent of the requested changes.
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according to Bank’s marketing materials, portfolios typically include the following
attributes: “a minimum of M different hedge funds; a minimum of N different strategies;
annualized historical volatility less than N percent (standard deviation); and all funds
must have annual liquidity or better.” The portfolio in fact included over O different
hedge funds at one point.
Taxpayer in fact sought the most favorable liquidity terms possible for the
referenced assets, directing that positions be taken in non-U.S. hedge funds when
available. According to Individual 2, this liquidity was the primary reason why
Individuals 1 and 2 selected non-U.S. hedge funds for the Basket. Onshore hedge
funds (typically structured as State A partnerships) limit investors’ ability to redeem to
certain timeframes, typically upon opinion of counsel, to avoid “publicly traded
partnership” status, which would result in entity level taxation.13 Offshore hedge funds
(typically structured as non-U.S. corporations) are not subject to these restrictions, and
therefore are able to offer more frequent redemptions.
Taxpayer’s Position. An entity related to Taxpayer (specifically, a partnership for
which Corporation 1 was also a general partner) initially entered into the contracts in
Year 1. At the end of Year 1, Taxpayer obtained limited scope tax opinions for the
contracts. On Date 1, Year 2, Taxpayer purchased the contracts from the related party.
As explained above, Taxpayer has deferred reporting for federal income tax purposes
all income, gain, loss and deduction from the contracts through Year 5.
The tax opinion, which was provided to Corporation 1 (in its capacity as
Taxpayer’s general partner) concluded as follows: (1) the contracts are options; (2) the
ownership of the referenced assets for tax purposes is not transferred by the contracts;
(3) the options are not constructive ownership transactions under section 1260; and (4)
upon sale or exchange of the options, capital gain will be realized, except for the portion
of any gain or loss attributable to “unrealized receivables” of hedge funds “to the extent
required by [section 751 of the Code].”14 To reach these conclusions the opinion
assumes that there is a reasonable possibility that the final option value will be less than
the strike price, in which case the opinion concludes the options will expire “out of the
money.” The opinion appears to give weight to the L-year term of the contracts, and in
particular the accretion of interest and spread payable to the Bank over this term. The
opinion erroneously assumes that the contracts’ premiums were set using the Black-
Scholes option pricing methodology. The opinion also relies on a representation from
13
See Miller & Bertrand, supra, note 10, at 327 (explaining that hedge funds typically avoid treatment as
publicly traded partnerships).
14
The opinion implicitly assumes that the referenced assets are partnerships and does not address any
PFIC-related issues. The opinion advises that market discount bonds and short-term obligations of
hedge funds could be considered “unrealized receivables” and that gain on the options could be treated
as ordinary income to the extent of any ordinary income Taxpayer would have realized if it held the hedge
funds directly.
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Bank that “several other investors unrelated to [Taxpayer]” held contracts using the
Basket.15
LAW AND ANALYSIS
Taxpayer entered into contracts labeled “cash-settled equity barrier call options”
to purchase components of the Basket cross-referenced by the contracts. The Basket
is made up of a diversified pool of domestic and foreign hedge fund interests and
varying amounts of cash. As described above in Contract Terms, if the value of the
portfolio decreases by more than a specified percentage, the contracts require
Taxpayer to contribute additional “premiums” and permit the Bank to withdraw capital or
terminate the contract, effectively limiting both parties’ risk of loss (Bank’s to zero,
Taxpayer’s to its “premium”). The effect of the contracts is to transfer the economic
gain or loss associated with ownership of the referenced assets to Taxpayer.
1. We conclude the contracts are not options and, to the extent Bank holds
the referenced assets on Taxpayer’s behalf, the contracts transfer
ownership of the referenced assets for tax purposes.
a. Although labeled “options,” the contracts lack the essential
economic and legal characteristics of options.
Case law defines an option as having two characteristics: (1) a continuing offer to
do an act, or to forebear from doing an act, which does not ripen into a contract until it is
accepted; and (2) an agreement to leave the offer open for a specified period of time.
Saviano v. Commissioner, 80 T.C. 955, 970 (1983), aff’d, 765 F.2d 643 (7th Cir. 1985).
The purpose of an option that references property is to provide a party the opportunity
to buy or sell specified property in the future at a defined price without the potential
liability inherent in being obligated to buy or sell. See United States Freight Co. v.
United States, 422 F.2d 887, 894-95 (Ct.Cl. 1970). Thus, an option only makes sense
economically if the option holder’s cost of failing to exercise is lower than the holder’s
potential liability had he or she instead entered into and breached a contract to buy or
sell the underlying property. See Halle v. Commissioner, 83 F.3d 649, 655-56 (4th Cir.
1996) (comparing potential buyer’s liquidated damages with seller’s expected damages
in event of buyer’s default to determine whether an “option” is likely to be exercised and
therefore treated as a sale).16 A contract that imposes a high cost upon an offeree for
15
The opinion does not specify the meaning of “unrelated” in this context. Corporation 2 only managed
contracts for Taxpayer and Individual 1’s friends and family. Thus, we assume that the opinion’s
reference to “unrelated” investors is referring to friends of Individual 1.
16
In terms of pricing and risk, call options generally allocate risk of loss between option writers and
holders such that the option writers/sellers bear the risk of price decreases in the underlying asset while
the option holders/buyers enjoy the benefits of price increases while also bearing the risk that they may
lose their premium. See Halle, 83 F.3d at 657.
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failing to accept an offer will not be deemed an option if the cost effectively compels the
offeree to exercise. See Progressive Corp. v. United States, 970 F.2d 188, 193 (6th Cir.
1992) (explaining that certain “options” may be disguised sales because “the exercise of
such options may be virtually guaranteed”); Commissioner v. Baertschi, 412 F.2d 494,
498 (6th Cir. 1969) (noting buyer’s high cost of breach equal to 29% of property value is
indication of sale rather than option).
Upon applying these principles to the contracts between Taxpayer and Bank, it is
clear that the contracts, despite their use of option terminology, lack the requisite
characteristics of options. In particular, two elements of the contracts between Taxpayer
and Bank are contrary to the typical functioning of an option: (a) the interplay between
the contracts’ premiums, cash settlement amounts, and the barrier provisions, which
imposed upon Taxpayer costs similar to an obligated buyer and preclude any possibility
of lapse; and (b) Taxpayer’s ability to alter the Basket, through Corporation 2, while the
contracts remained open, which is inconsistent with the notion that an option on
property must reference specific property at a specified strike price.
i. The contracts imposed costs upon Taxpayer similar to an
obligated buyer, and did not allow for any possibility of lapse,
which is inconsistent with treatment of the contracts as
options.
The contracts did not function as options because the terms of the contracts
imposed costs upon Taxpayer similar to the costs that would be borne by an obligated
buyer and the imposition of these costs would compel Taxpayer to exercise rather than
allow the options to lapse. As noted by the courts in United States Freight and Halle, a
call option should function so that the holder has a real choice to allow the option to
lapse; if the contract imposes a cost for failure to exercise that places the holder in a
similar economic position to a party obligated to buy, then the holder lacks the choice
not to buy and the contract is not an option. In the instant case, the cash settlement
provisions ensured that Taxpayer would lose its premiums investment-dollar-for-
investment-dollar until the Basket fell in value by an amount sufficient to terminate the
contracts under the barrier provisions, with Taxpayer losing its entire investment.
Accordingly, the terms of the contracts ensured one of two outcomes: (1) if the Basket
increased in value or decreased by less than the requisite amount under the barrier
provisions, Taxpayer would exercise to reap its profits or to recoup at least a portion of
its investment; or (2) the Basket would fall in value by the requisite amount under the
barrier provisions and the barrier provisions would permit Bank to terminate the option.
Thus, the cash settlement provisions placed Taxpayer in the same economic position as
a party obligated to buy each component of the Basket and the barrier provisions
ensured that the contracts would never lapse unexercised. In this manner, the
contracts did not function as options.
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Moreover, there is no indication that Taxpayer and Bank employed recognized
option pricing methodologies to determine the premium. Rather, the premiums that
Taxpayer paid were merely a fixed percentage of the contracts’ notional value. Thus,
the premiums under the contracts are more akin to collateral for a nonrecourse loan
than to option premiums. The similarity between Taxpayer’s premium and loan
collateral is consistent with the other terms of the contracts, which, again, imposed
potential costs upon Taxpayer that were more like those imposed upon an owner or a
party obligated to buy than upon a party with the mere option to buy.
ii. Taxpayer’s ability (through Corporation 2) to alter the Basket
undermines option treatment.
The contracts did not function like options insofar as they referenced the Basket,
which Taxpayer (through Corporation 2) could and did alter by changing the Basket’s
components. Corporation 2 acted on Taxpayer’s behalf. Individual 2’s relationship with
Taxpayer, the contracts’ failure until the amendment in Year 2 to provide for payment of
a fee to Corporation 2 for its services, Corporation 2’s management of similar contracts
with Bank only for Taxpayer’s friends and family (and not Bank’s other clients), and, as
discussed above in “Corporation 2’s Management of the Portfolio,” the fact that
Corporation 2 did not make a single recommendation to Bank without first obtaining
Individual 1’s consent all indicate that Corporation 2 has acted on behalf of Taxpayer.
Taxpayer’s control over the Basket caused the contracts to operate unlike an
option. As explained by the court in Saviano, an option provides one party with the
choice of accepting an offer, while the other party is obligated to keep the offer open for
a specified period of time. Options on property allow the holder to accept an offer to buy
or sell specified property at a defined price. In this case, the contracts purport to identify
the Basket as specific property subject to an option, yet the contracts contradict that
characterization by allowing Taxpayer (through Corporation 2) to alter the Basket while
the contracts remained open.
It was feasible for Bank to permit Taxpayer to have this control because the
terms of the contracts ensured that Bank was protected from Taxpayer’s investment
decisions; as noted above in Section 1.a.i., the contracts imposed potential costs upon
Taxpayer that were more consistent with a party that had an obligation to buy than upon
a party with a mere option to buy. The contracts were neither priced like options nor did
the contracts apportion costs like a typical option because Taxpayer’s power to control
and alter the Basket was contrary to the essential function and nature of an option.17
17
The Treasury Regulations governing notional principal contracts also recognize this principle by
prohibiting parties to a contract from controlling indexes that are used as referenced assets. Treas. Reg.
§ 1.446-3(c)(4)(ii).
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For all of the reasons discussed above, we conclude that the contracts are not
options for Federal income tax purposes.
b. To the extent Bank held the referenced assets on behalf of
Taxpayer, we conclude that the contracts transfer ownership of the
referenced assets for tax purposes to Taxpayer.
We now turn to the question of whether Taxpayer, in substance, owns the
referenced assets.18 Although the contracts function economically as if Taxpayer owns
the referenced assets, to treat the contracts as transferring ownership for tax purposes
of a particular referenced asset, Bank must in fact hold the referenced asset in
connection with the contracts.19
To determine whether a taxpayer holds the beneficial ownership of assets for tax
purposes, courts have considered numerous factors indicative of the benefits and
burdens of ownership. No one factor is determinative; courts accord varying weight to
each factor, depending on the type of property and transaction at issue. See Pac. Coast
Music Jobbers v. Commissioner, 55 T.C. 866, 874 (1971) (employing multi-factor test to
determine ownership of stock and according less weight to attributes that are formalistic
and “not useful”), aff’d, 457 F.2d 1165 (5th Cir. 1972).
Ownership for tax purposes of property that is not freely transferrable, such as
hedge fund interests, has generally been evaluated by courts using an analysis of the
economic benefits and burdens of ownership. For example, in Frank Lyon Co. v. United
States, 435 U.S. 561 (1978), the Supreme Court set out the “general and established
principles” for evaluating the substance of a transaction, and also determined that a
lessor was the owner of property. In reaching its conclusion, the Court considered
twenty-seven factors largely looking at the economics of the real property transaction.
For example, the Court considered the substantiality of the purchase price, the lack of
certainty as to whether a purchase option would be exercised, and the lessor’s risks
with respect to depreciation of the property. Courts have generally determined that
18
We have already concluded that the contracts are not options. A remaining question is whether
Taxpayer owned each of the referenced assets during its holding period, or whether Taxpayer was
merely obligated to purchase the assets in the future, i.e., through a forward contract. Forward contracts
are typically treated as open transactions, and parties obligated to buy under forward contracts are not
taxed as though they are current owners of the asset for tax purposes. See Lucas v. N. Texas Lumber
Co., 281 U.S. 11, 13 (1930) (agreement to sell land in 1916 was not a closed sale for tax purposes until
price paid and title transferred in 1917). As discussed below in Section 2, in certain circumstances,
however, taxpayers holding forward contracts may be treated as constructively owning the underlying
asset. See section 1260(d)(1)(B) (treating taxpayers as constructively owning financial assets referenced
by certain forward contracts).
19
It is unclear if Bank in fact owned each referenced asset in an amount sufficient to support its
obligations to Taxpayer under the contracts; these facts require further development.
13
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ownership for tax purposes of property that is not freely transferrable, like hedge fund
interests, is transferred when the economic benefits and burdens of ownership are
transferred, regardless of when legal title is transferred. See Commissioner v. Union
Pac. Railroad Co., 86 F2d 637 (2d Cir. 1936) (holding that a sale happened even
though the deed and title to real property, respectively, did not transfer until a later
date); Baird v. Commissioner, 68 T.C. 115 (1997) (same).
As discussed below in Sections 1.b.i.-iii., it is clear that Taxpayer should be
treated as the owner for tax purposes of the referenced assets because Taxpayer had
(i) the opportunity for full gain and current income from the referenced assets (i.e., the
economic benefits), (ii) substantially all of the risk of loss and the burden associated
with the referenced assets’ lack of liquidity (i.e., the economic burdens), and (iii) the
effective power to direct Bank to acquire and redeem the referenced assets. Moreover,
as discussed below in Section 1.b.iv., courts and the Service have treated certain
options that are “in-the-money” at the contract’s outset as transferring ownership for tax
purposes.
That Taxpayer was exposed to Bank’s credit risk under the contracts is not a
significant countervailing factor. Persons using custodians are exposed to real credit
risk of the custodian yet such persons are the owners of deposited assets.20 We do not
find Taxpayer’s exposure to Bank’s credit risk a compelling reason to treat Bank (the
custodian) as the owner for tax purposes of the securities or other investments that
Bank holds on behalf of another party, including Taxpayer. Nor is the contracts’ failure
to require Bank to own the referenced assets sufficient reason to retain ownership of the
assets with Bank for tax purposes. As explained below in Section 1.b.i-iv., to the extent
Bank “hedged” its portfolio by holding the referenced assets, Taxpayer was the owner of
the referenced assets for tax purposes.
i. The economic benefits of owning the referenced assets were
Taxpayer’s.
Taxpayer had full opportunity for gain and income from the performance of the
referenced assets. Cash settlement amounts include a refund of Taxpayer’s premium
and the positive or negative total return in the value of the portfolio, as adjusted for
expenses, including interest and spread payable to Bank. Because Taxpayer could
exercise its right to receive a cash settlement at any time, Taxpayer was at all times free
to take full advantage of its opportunity for gain and income. Moreover, while the
contracts remained open, Taxpayer could lock in gain in any single position within the
Basket by instructing that the interest in the referenced asset be redeemed and that the
referenced asset be deleted from the Basket.
20
See Office of the Comptroller of the Currency, Dept. of the Treasury, OCC Bull. No. 2002-39,
Investment Portfolio Credit Risks (2002) (cautioning banks that they may lose “investment portfolio
assets” deposited with third party “deposit brokers” who subsequently fail).
14
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ii. The economic burdens of owning the referenced assets
were Taxpayer’s.
Taxpayer had substantially all of the risk of loss of the referenced assets. As
explained in Section 1.a.i., the contracts’ cash settlement provisions reduced
Taxpayer’s ability to recoup its investment to the extent of any losses on the referenced
assets. Taxpayer had the risk of loss, dollar-for-dollar, up to any point at which Bank
might terminate the contracts under the barrier provisions. Moreover, due to the barrier
provisions, the full risk of loss inherent in the contracts was the initial premium paid by
Taxpayer. Bank did indeed bear a theoretical risk; Bank could possibly suffer a loss if
the diversified pool of the referenced assets decreased in value so quickly that Bank
was unable to redeem hedge fund interests quickly enough to prevent losses beyond
the threshold created by the barrier provisions, and such losses were sustained beyond
the two-year delay in payment of any cash settlement amount triggered by a “market
event.” That possibility was remote, however.21 Thus, the barrier provisions merely
reflected the typical arrangement between a broker and an investor who purchases
securities through margin loans in a prime brokerage account, i.e., the investor’s risk of
loss is limited to the amount of the purchase price the investor itself funded, while the
broker has rights to liquidate the securities or take other actions to ensure that losses
will not exceed the amount funded by the investor.
In addition to the barrier provisions, the contracts protected Bank from loss
through provisions designed to require the portfolio to meet certain diversification and
liquidity requirements. As noted above in the Facts Section, the contracts treat the
following as “market disruption events,” which result in a delay of up to two years of a
cash settlement upon termination or maturity: (1) “the [portfolio] contains an insufficient
amount of liquidity to meet [Bank’s] hedging requirements”; and (2) “the portfolio is
insufficiently diversified, or the portfolio would be insufficiently diversified as a result of
[Bank] altering its hedge, if any, to effect a termination of any portion of the options.”
Taxpayer also bore the economic burdens associated with ownership of the
referenced assets by bearing all fees and liquidity risk associated with their ownership.
Although interests in hedge funds generally cannot be transferred, a holder may redeem
hedge fund interests at specified intervals for then “net asset value” (subject to certain
fees, for example, if the owner’s holding period is considered short-term or otherwise).
Absent a “market disruption event,” the contracts require C percent of the cash
settlement amount to be paid within D days of termination or maturity, with the
remainder payable within E days; Bank did not meet this timeline on Taxpayer’s
terminated contracts on account of illiquid “side pocket” investments made by the
21
Likewise, we do not view as a “reasonable possibility” the risk that Taxpayer’s cash settlement at
maturity (but for the barrier provisions) would be less than zero through accretion of interest and the
spread, as assumed by Taxpayer’s counsel in rendering its opinion of the transaction.
15
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referenced hedge funds, demonstrating that it was Taxpayer and not Bank that bore
liquidity risks associated with the ownership of the referenced assets. Furthermore,
under the contracts Taxpayer bore any and all fees associated with the subscription for
and redemption of the referenced assets.22
iii. Taxpayer’s control over the Basket indicates its ownership of
the referenced assets for tax purposes.
Taxpayer, through Corporation 2, had complete dominion and control over the
Basket. Acting at Taxpayer’s direction, Corporation 2 instructed a large number of
changes to the Basket, which Bank executed with only very few exceptions. Bank
initiated no changes to the Basket on its own.
The Tax Court recently addressed whether a taxpayer owned investments in
start-up companies that were nominally owned by an insurance company that used the
investments to fund variable life insurance policies owned by grantor trusts that the
taxpayer established. See Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015).
In determining whether the taxpayer owned the assets underlying the policies, the court
explained that “[t]he core ‘incident of ownership’ is the power to select investment
assets by directing the purchase, sale, and exchange of particular securities.” Webber,
slip op. at 61 (emphasis added) (citing Griffiths v. Helvering, 308 U.S. 355, 357-58
(1939)).23 The court then noted that the taxpayer “enjoyed the unfettered ability to select
investments” for the account by directing the investment manager (who nominally had
independent discretion) to buy, sell, and exchange assets in which the taxpayer wanted
to invest, and that “such facts support a finding that [the taxpayer] retained significant
incidents of ownership over those assets.” Webber, slip op. at 62, 67 (citing Helvering
v. Clifford, 309 U.S. 331 (1940)).24 The court concluded that the taxpayer was the
owner of the assets, despite the formalities, because the taxpayer maintained
essentially the same rights of ownership over the assets that he would have retained
had he chosen to title the assets in his own name. Webber, slip op. at 73.
iv. Courts and the Service have held that “in-the-money”
options transfer ownership for tax purposes.
22
Individual 2’s level of communication with hedge fund managers (on behalf of Taxpayer) in seeking
waivers of redemption fees is an indication of Taxpayer’s ownership of referenced assets for tax
purposes.
23
The court also noted that other “incidents of ownership” include the power to vote securities and
exercise other rights with respect to the investments and the power to obtain “effective benefit” from the
assets by extracting money from the account. Webber, slip op. at 61-62.
24
The court explained that the investment manager merely acted as a “rubber stamp” for the taxpayer’s
“recommendations,” which the court deemed as equivalent to “directives.” Webber, slip op. at 62.
16
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As noted above in Section 1.a., courts have treated options that are likely to be
exercised as sales. See Halle, 83 F.3d at 655-56 (comparing potential buyer’s
liquidated damages with seller’s expected damages in event of buyer’s default to
determine whether an “option” is likely to be exercised and therefore treated as a sale).
A contract that imposes a high cost upon an offeree for failing to accept an offer will be
deemed a sale if the cost effectively compels the offeree to exercise. See Progressive
Corp., 970 F.2d at 193; Baertschi, 412 F.2d at 498.
The court in Progressive adopted language from Rev. Rul. 80-238, 1980-2 C.B.
96, which held that that writing a call option on a stock does not generally diminish a
stockholder’s risk of loss for purposes of claiming the dividends received deduction
under section 246 of the Code, but distinguished an in-the-money call option. In
distinguishing in-the-money options, the court in Progressive explained:
. . .[S]uch considerations, however, are not applicable to "in-the-money" call
options, that is, call options that are sold with a [strike] price below the market
price of the underlying stock on the date that the option is written, since in such a
situation the exercise of such options may be virtually guaranteed and the
element of risk is either greatly reduced or eliminated.
Progressive, 970 F.2d at 193-94. Likewise, the Service in Rev. Rul. 82-150, 1982-2
C.B. 110, held that a sale of a deep-in-the-money option was, in substance, not an
option but a completed sale of the referenced stock for purposes of the foreign personal
holding company rules. Rev. Rul. 82-150 cited Commissioner v. Court Holding
Company, 324 U.S. 331 (1945) (for “substance over form” principles), John Kelley Co.
v. Commissioner, 326 U.S. 521, 530 (1946) (for, in characterizing an instrument for tax
purposes, the relevance of whether it is a “risk investment” in corporate stock), Zilkha
and Sons, Inc. v. Commissioner, 52 T.C. 607, 613 (1969) (same), and Tenn. Natural
Gas Lines v. Comm'r, 71 T.C. 74, 84 (1978) (for factors to be weighed in determining
ownership for tax purposes, weighting payment of property taxes heavily in determining
the earlier of two possible sale dates).
As noted above, each of Taxpayer’s “options” was “in-the-money” not only at the
outset of the contract but, under the contract’s terms, on every day of the contract. This
is because, as described in the Facts Section above in “Contract Terms,” the cash
settlement amount equals the fair market value of the portfolio minus the “strike price,”
and the “strike price” equals Bank’s upfront contribution25 plus the interest paid to the
Bank and the spread paid to the Bank to compensate it for its participation in the
contracts.
This factor, along with the factors discussed in Section 1.b.i.-iii. indicates that the
contracts transfer ownership of the reference assets for tax purposes. We therefore
25
(100 - K) percent of the initial notional amount.
17
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conclude that, to the extent Bank held a particular referenced asset on behalf of
Taxpayer in connection with the contracts, Taxpayer was the owner of the referenced
asset for tax purposes. To the extent Taxpayer is treated as the owner of the
referenced assets for tax purposes, Taxpayer must also accrue gross items of income
and loss for the referenced assets that are partnerships as reported annually on
Schedules K-1 by the U.S. partnerships to their partners.26 Additionally, Taxpayer may
be entitled to claim deductions annually for interest and other expenses incurred,
subject to applicable limitations under the Code.
2. If Taxpayer is not the owner of any referenced asset for tax purposes, and
the referenced asset is a “pass-thru” entity, we conclude that Taxpayer is
the constructive owner of the referenced asset under section 1260.
We concluded above that the contracts are not options. Particularly, in Section
1.a.i, we concluded that the contracts imposed costs upon Taxpayer similar to those
imposed upon an obligated buyer. Consequently, if Taxpayer is not deemed to own the
contracts’ referenced assets, Taxpayer will be treated as holding forward contracts with
respect to the referenced assets that Taxpayer is not deemed to own.27 Forward
contracts to purchase interests in hedge funds raise the “constructive ownership”
provisions of section 1260.
a. Section 1260 applies to the contracts.
Section 1260 was enacted in response to taxpayers’ use of derivatives to avoid
tax consequences associated with owning certain property, in particular, ordinary
income and short-term capital gains passed through to holders by hedge funds
structured as partnerships.28 Section 1260 limits the amount of long-term capital gain
realized by taxpayers entering into certain derivative contracts, called “constructive
ownership transactions,” over certain “financial assets.” Section 1260 also increases
the tax on the amount of ordinary income that a taxpayer is treated as having deferred
by an interest charge calculated on a constant yield basis.
A “constructive ownership transaction” includes a forward or futures contract to
acquire a “financial asset.” The definition of “forward” in section 1260 is broad, including
“any contract to acquire in the future (or provide or receive credit for the future value of)
26
We note that the K-1 items are realized by Taxpayer in addition to any gains or losses Taxpayer
realizes from Taxpayer’s disposition of any referenced assets; similarly, Taxpayer must accrue flow-
through gross items of income or loss in respect of any referenced assets that are non-U.S. partnerships.
27
Whereas the holder of a call option has the option, but not the obligation, to purchase the contract’s
referenced assets, the holder of a forward contract has the obligation to purchase the referenced assets
th
at a certain future time. See John C. Hull, Options, Futures, and Other Derivatives, at 3 (7 ed. 2009).
28
S. Rep. No. 106-201, at 32 (1999).
18
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any financial asset.” Section 1260(d)(4). A “financial asset” includes “any equity
interest in any pass-thru entity.” Section 1260(c)(1)(A). A “pass-thru entity” includes a
partnership.29 Section 1260(c)(2)(D), (G). The Senate Report, explaining the provision,
states as follows:
The Committee is concerned with the use of derivative contracts by
taxpayers in arrangements that are primarily designed to convert what
otherwise would be ordinary income and short-term capital gain into long-
term capital gain. Of particular concern are derivative contracts with
respect to partnerships and other pass-thru entities. The use of such
derivative contracts results in the taxpayer being taxed in a more favorable
manner than had the taxpayer actually acquired an ownership interest in
the entity. [Text omitted].
One example of a conversion transaction involving a derivative contract is
where a taxpayer enters into an arrangement with a securities dealer
whereby the dealer agrees to pay the taxpayer any appreciation with
respect to a notional investment in a hedge fund. In return, the taxpayer
agrees to pay the securities dealer any depreciation in the value of the
notional investment. The arrangement lasts for more than one year. The
taxpayer is substantially in the same economic position as if he or she
owned the interest in the hedge fund. However, the taxpayer may treat
any appreciation resulting from the contractual arrangement as long-term
capital gain. Moreover, any tax attributable to such gain is deferred until
the arrangement is terminated.
S. Rep. No. 106-201, at 32-33 (1999) (footnote omitted).
If the contracts in the present case do not transfer ownership of particular
referenced assets for tax purposes to Taxpayer, as discussed above in Section 1.b., the
contracts are forward contracts to purchase pass-thru entities, and are therefore
constructive ownership transactions under section 1260. The deferral and character
conversion inherent in the contracts is precisely the type of avoidance that Congress
sought to address when it enacted section 1260. We further note that the Service, in
Rev. Rul. 85-87, 1985-1 C.B. 268, held that a “put option” in form was a forward
contract; the Service disregarded the form of the option because at the time written
there was “no substantial likelihood that the put would not be exercised.”30
29
Pass-thru entities also include PFICs, which are not addressed in this memorandum.
30
We note that this ruling deals with a classic put option (the strike price was determined at the outset
with respect to a future exercise date) and the difference between treating the contract as a transfer of
ownership for tax purposes as opposed to a forward contract was not relevant to the wash sale
conclusion.
19
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b. The mechanics of applying section 1260 to the contracts.
Section 1260(d)(1) provides that a taxpayer “shall be treated as having entered
into a constructive ownership transaction with respect to any financial asset if the
taxpayer [holds the relevant derivative with respect to the] financial asset.” The
determination as to whether a transaction is a “constructive ownership transaction” is
therefore made on a “financial asset” by “financial asset” basis. Taxpayer may directly
own some of the contracts’ referenced assets as discussed above in Section 1.b. and
constructively own other referenced assets under section 1260.
When realized, any gains from Taxpayer’s constructive ownership transactions
must be analyzed to determine whether, absent section 1260, those gains would be
treated as long-term capital gains. For example, if Taxpayer recognized ordinary
income prior to termination or maturity of the contracts on account of cash withdrawals
(as discussed below in Section 3), that income would not be taxed using the principles
of section 1260 because that income would not otherwise treated as long-term capital
gains. However, any gains realized by Taxpayer upon termination or maturity of the
contracts may be gains that, absent section 1260, would be treated as long-term capital
gains and would therefore require further analysis under section 1260. 31
Next, Taxpayer determines the amount of any “net underlying long-term capital
gain.” Gain that is not attributable to net underlying long-term capital gain will be treated
as ordinary income by section 1260(a)(1) and will be subject to an interest charge,
determined on a constant yield basis, by section 1260(b). Section 1260(e) defines “net
underlying long-term capital gain” as the aggregate net capital gain Taxpayer would
have had if it had acquired the “financial asset” for fair market value on the date the
constructive ownership transaction was opened and sold the “financial asset” for fair
market value on the date the constructive ownership transaction was closed. To
perform this calculation, Taxpayer must disaggregate the Basket and consider gains it
would have realized upon its redemption of, and throughout its holding period for, each
referenced asset (including any gains reported to holders by the referenced assets that
are partnerships).
Section 1260(e) requires Taxpayer to demonstrate by “clear and convincing
evidence” the amount of any net underlying long-term capital gain. This subsection
defaults the characterization of constructive gains under section 1260 to ordinary for
taxpayers who may not have access to information regarding the tax characteristics of
31
In addition to any maturity or termination event under the contracts, gain from Taxpayer’s constructive
ownership of the referenced assets may be recognized under section 1001 upon any taxable exchange of
the contracts, or of a particular referenced asset. Additionally, if Taxpayer argues that its withdrawals
from the contracts, as discussed further in Section 3, would (absent section 1260) result in Taxpayer
recognizing long-term capital gains, then section 1260 would likewise apply to Taxpayer’s gains from
withdrawals at the time they are realized.
20
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the underlying referenced assets (e.g., Schedules K-1 or, to the extent relevant,
information regarding the underlying assets held by any pass-thru entities).32 Evidence
submitted by Taxpayer to substantiate the amount of any net underlying long-term
capital gains must also substantiate the tax year or years to which the gains are
allocable so that tax may be calculated using the rates in effect for those years, as
required by section 1260(a)(2).
3. Taxpayer may have other taxable events in respect of the contracts.
An option holder generally does not realize gain or loss until the option is
exercised, terminated, or lapses unexercised. Rev. Rul. 78-182, 1978-1 C.B. 265. You
have asked whether, to the extent the contracts are not treated as transferring
ownership of the referenced assets for tax purposes, (a) withdrawals from the contracts
are income of Taxpayer to the extent of any gain on the contracts as of the date cash
was received, and (b) changes to the Basket or amendments to the contracts are
taxable exchanges of Taxpayer’s contracts under section 1001.
a. Taxpayer’s cash withdrawals from the contracts are realization
events.
First, we consider Taxpayer’s cash “withdrawals.” As noted in the Facts Section
above under “Cash Withdrawals,” the cash withdrawals have been treated by Taxpayer
as extra-contractual withdrawals of cash from the contracts, and not partial
terminations.33 However, if the contracts are not treated as transferring ownership of
the referenced assets for tax purposes, then Taxpayer would realize gain from the
contracts to the extent of any cash received “under a claim of right and without
restriction as to disposition.” See section 61 (including as gross income “all income
from whatever source derived”); Boyce v. United States, 186 Ct. Cl. 420 (1968) (holding
that where taxpayer withdrew amounts awarded to it for seizure of land from an escrow
account, and which were subject to contest proceedings, the withdrawn amounts were
taxable to taxpayer in the year withdrawn, and not later). Taxpayer has offered no
explanation as to how it could withdraw cash from its appreciated positions in the
contracts without realizing taxable income. Any income Taxpayer realizes on account
of its cash withdrawals would be ordinary income, because Taxpayer has not sold or
exchanged a capital asset.
32
The legislative history contemplates that Taxpayers may have difficulty establishing the amount of net
underlying long-term capital gain, particularly “[t]o the extent that the economic positions of the taxpayer
and the counterparty do not equally offset each other. . . .” S. Rep. No. 106-201, at 34 n.20.
33
If the cash withdrawals had been partial terminations gain or loss would have been realized on the
proportionate number of options deemed terminated.
21
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b. The contracts may be deemed exchanged in each year of
Taxpayer’s holding period because of material amendments to the
contracts and changes to the Basket.
Section 1001 provides rules for the computation of gain or loss from the sale or
other disposition of property. Treas. Reg. §1.1001-1(a) provides, as relevant here, that
gain or loss is realized upon an exchange of property for other property differing
materially in kind or in extent. See Cottage Savings Ass’n v. Commissioner, 499 U.S.
554, 566 (1991) ("Under [the Court's] interpretation of [section] 1001(a), an exchange of
property gives rise to a realization event so long as the exchanged properties are
'materially different' -- that is, so long as they embody legally distinct entitlements.").
Treas. Reg. § 1.1001-3 provides specific guidance addressing when the exchange or
amendment of a debt instrument will be considered a significant modification that results
in an exchange of the original debt instrument for a modified instrument that differs
materially in kind or in extent. With respect to financial instruments other than debt
instruments, the “fundamental change” doctrine described in Rev. Rul. 90-109, 1990-2
C.B. 191, continues to apply. See Rev. Rev. 90-109 (concluding that the substitution of
one employee for another as the party insured by a life insurance contract held by an
employer was a “fundamental change” that resulted in the recognition by the employer
of gain or loss on its contract); see also T.D. 8675 (Treas. Reg. §1.1001-3 debt
modification regulation preamble stating that the final regulations do not limit or
otherwise affect the application of the “fundamental change” concept articulated in Rev.
Rul. 90-109).34
There were two amendments to the terms of the contracts: (1) a provision for
portfolio management fees for Contract 1 in Year 2, and (2) a reduction of the spreads
payable to Bank under both contracts in Year 5. The first change is “fundamental” (and
therefore material) if the contracts are respected as options because it reduces
Taxpayer’s return on the contracts by a fixed amount regardless of whether there is gain
on the contracts (and recovery of Taxpayer’s “premiums” beyond that). Likewise, the
modification to reduce Bank’s spread also fundamentally changes Taxpayer’s return on
the contracts and should be considered material.
We now turn to the question of whether changes to the referenced Basket
constitute taxable exchanges of Taxpayer’s contracts. No fewer than J and up to H
changes to the referenced Basket have been made in each year of the contracts’
holding period, per request of Taxpayer or Corporation 2. A derivative contract where
one or both of the parties have the discretion to change the referenced assets and one
or both of the parties use that discretion to change the referenced assets raises the
question of whether the parties have terminated the derivative and entered into a new
34
The Service in Rev. Rul. 78-408, 1978-2 C.B. 203, held that the substitution of “X corporation” stock for
“Y corporation” stock in warrants issued pursuant to X corporation’s acquisition of Y corporation resulted
in taxable gain or loss under section 1001 even though the warrants’ terms and conditions otherwise
remained identical (including the number of shares and price per share).
22
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one. In the present case, Taxpayer’s discretion to make changes to the composition of
the Basket, combined with the resulting number of changes to the Basket based on that
discretion, may have been economically significant such that, within a given tax year,
the changes are cumulatively a “fundamental change” to the contracts resulting in
taxable exchanges of Taxpayer’s contracts. That the changes to the Basket were made
pursuant to the terms of the contracts does not alter this result. See, e.g., Rev. Rul. 90-
-
Given the factual nature of this determination, we discuss this issue further in the
“Case Development, Hazards, and Other Considerations” Section.- To the extent Taxpayer is treated as the owner for tax purposes of any
referenced asset, or there is a taxable cash withdrawal or exchange of
Taxpayer’s contracts, Taxpayer’s deferral accounting method for the
gains, losses, income, or deductions arising from the contracts fails to
clearly reflect income. The Service may change Taxpayer’s deferral
accounting method to a method that does clearly reflect its income and
may compute the necessary adjustment under section 481(a) only as
relates to the non-PFIC referenced assets.
An accounting practice that involves the timing of when an item is included in
income or when it is deducted is considered an accounting method. General Motors
Corp. v. Commissioner, 112 T.C. 270, 296 (1999); Color Arts, Inc. v. Commissioner,
T.C. Memo. 2003-95.
An “item” is any recurring element of income or expense. For example, the Court
of Appeals for the Second Circuit determined that a local tax is an “item,” and that the
treatment it is given qualifies as an accounting method. American Can Co. v.
Commissioner, 317 F.2d 604 (2d Cir. 1963). Likewise, the Court of Appeals for the
Fourth Circuit determined that a vacation pay accrual is an “item,” and the treatment it is
given qualifies as an accounting method. Capital One Fin. Corp. v. Commissioner, 130
T.C. 147, 159-61 (2008), aff’d, 659 F.3d 316 (4th Cir. 2011). See also Color Arts, Inc. v.
Commissioner, T.C. Memo. 2003-95.Treas. Reg. § 1.446-1(e)(2)(ii)(a) provides that a change in accounting methodincludes a change in the overall plan of accounting for gross income or deductions, or a
change in the treatment of any material item used in such overall plan. A ''material
item'' includes ''any item that involves the proper time for the inclusion of the item in
income or the taking of a deduction.”In determining whether timing is involved, generally the pertinent inquiry is
whether the accounting practice permanently affects the taxpayer's lifetime taxable
income or merely changes the tax year in which taxable income is reported. See
Section 2.01 of Rev. Proc. 2002-18, 2002-1 C.B. 678, 681; Rev. Proc. 91-31, 1991-1
C.B. 566; Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 798 (11th Cir.
1984); Peoples Bank & Trust Co. v. Commissioner, 415 F.2d 1341, 1344 (7th Cir. 1969);23POSTF-120543-14
- To the extent Taxpayer is treated as the owner for tax purposes of any
Huffman v. Commissioner, 126 T.C. 322, 343 (2006); Primo Pants Co. v.
Commissioner, 78 T.C. 705, 723-4 (1982).
Taxpayer’s current deferral of gains, losses, income, or deductions arising from
the contracts qualifies as an accounting method. For the reasons discussed above in
Sections 1 and 3, we conclude that this accounting method is impermissible. Thus, as
Taxpayer’s accounting method is not permissible, the Service has broad discretion in
selecting a new accounting method that properly reflects the income of Taxpayer. The
selected method must be a permissible accounting method. A taxpayer may challenge
the selected method only upon showing an abuse of discretion. See Wilkinson-Beane,
Inc. v. Commissioner, 420 F.2d 352, 353 (1st Cir. 1970); Stephens Marine, Inc. v.
Commissioner, 430 F.2d 679, 686 (9th Cir. 1970); Standard Paving Co. v.
Commissioner, 190 F.2d 330, 332 (10th Cir. 1951).
Changing from Taxpayer’s current deferral accounting method to the accounting
method that has been selected by the Service is an accounting method change. This
change does not permanently affect Taxpayer’s lifetime taxable income.
Section 481(a) provides that in computing the taxpayer's taxable income for any
tax year (the year of change), if such computation is under an accounting method
different from the method under which the taxpayer's taxable income for the preceding
tax year was computed, then there shall be taken into account those adjustments which
are determined to be necessary solely by reason of the change in order to prevent
amounts from being duplicated or omitted. See also Treas. Reg. § 1.448-1(a).
Once the Commissioner has imposed a change in accounting method, the
application of section 481(a) to such change is mandatory. Primo Pants Co. v.
Commissioner, 78 T.C. 705, 723-4 (1982). An adjustment under section 481(a) can
include amounts attributable to tax years that are closed by the statute of limitations.
Rankin v. Commissioner, 138 F.3d 1286 (9th Cir. 1998); Weiss v. Commissioner, 395
F.2d 500 (10th Cir. 1968); Spang Indus., Inc. v. United States, 6 Ct. Cl. 38, 46 (1984),
rev’d on other grounds, 791 F.2d 906 (Fed. Cir. 1986); Suzy’s Zoo v. Commissioner,
114 T.C. 1, 13 (2000), aff’d, 273 F.3d 875, 884 (9th Cir. 2001). See also Earthquake
Sound Corp. v. Commissioner, T.C. Memo. 2000-112 (section 481(a) adjustment to
eliminate duplicated deductions resulting from accounting method change could be
imposed even though related years in which duplicate deductions were taken have
been closed by the statute of limitations).
The section 481(a) adjustment in this case should reflect relevant amounts from
any tax years preceding the year of change, even if such years are closed by the statute
of limitations. Thus, if, under Taxpayer’s current deferral accounting method, Taxpayer
earned amounts in Year 1 but did not report any income on the Year 1 tax return, then
positive amounts (increases to taxable income) will be recognized under section 481(a)
to eliminate the omission that would otherwise result, despite Year 1 now being closed
under the statute of limitations. Since the adjustment proposed by the Service is for
24
POSTF-120543-14
income earned in Year 4, the section 481(a) adjustment will ensure that all gains,
losses, income, or deductions arising from the contracts in all years prior to Year 4,
including Year 1, are accounted for.
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
The conclusions that we reach in the memorandum are subject to change if facts
come to light that are inconsistent with the facts described herein. We recommend
further development of the following facts:
1.
2.
3.
4.
5.
25
POSTF-120543-14
This writing may contain privileged information. Any unauthorized disclosure of
this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.
Please call Orla J. O’Connor at (202) 317-6367 if you have any further questions.
_____________________________
Robert A. Martin
Senior Technician Reviewer, Branch 1
Office of Associate Chief Counsel
(Financial Institutions and Products)
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