Basket contracts as listed transactions and transactions of interest.

• Author: Jones, Gordon M.

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

Background

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

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

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

Notice 2015-73

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

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