SECTION 1. BACKGROUND

In a basket option contract, a taxpayer (“T”), typically a hedge fund or a high net-worth individual, enters into a contract that is denominated as an option with a counterparty (“C”), typically a bank, to receive a return based on the performance of a notional basket of referenced actively traded personal property (the “reference basket”). T, or a designee named by T, will either determine the assets that comprise the reference basket or design or select a trading algorithm that determines the assets. While the basket option contract remains open, T ¹ has the right to change the assets in the reference basket, request that C change the assets in the reference basket, change the trading algorithm, or request that C change the trading algorithm (collectively, discretion). ² The terms of the basket option contract may permit C to reject certain changes requested by T to the assets in the reference basket or the trading algorithm. C, however, generally accepts all or nearly all of the changes requested by T.

When the basket option contract is entered into, T typically makes an upfront cash payment to C of between 10 and 40 percent of the value of the assets in the reference basket. To manage its risk under the basket option contract, C typically acquires substantially all of the assets in the reference basket at the inception of the contract and acquires and disposes of assets during the term of the contract either when T changes the assets in the reference basket or the trading algorithm provides for such changes. C generally supplies the

additional cash required to purchase the assets in the reference basket. The assets in the reference basket would typically generate ordinary income if held directly by T, and short-term gains and losses if purchases and sales of the assets were carried out directly by T.

The basket option contract has a stated term of more than one year but contains provisions that in effect allow either party to terminate the contract at any time during the stated contract term with proper notice. The amount that T receives upon settlement of the basket option contract is based on the performance of the assets in the reference basket. A common payout formula on the basket option contract entitles T to a return equal to the upfront payment, plus net basket gain or minus net basket loss. The net basket gain or net basket loss includes net changes in the values of the assets in the reference basket, together with interest, dividend, and other periodic income on the assets, reduced by C’s fee for its role in the transaction. The basket option contract typically includes a provision automatically terminating the contract if the amount of the net basket loss reaches the amount of the upfront payment, giving T a cash settlement amount of zero. The basket option contract also may permit or require T to provide additional collateral or otherwise reduce risk in the reference basket if a specified level of risk is reached.

The basket option contract typically contains other safeguards to minimize the economic risk to C. For example, C may terminate the basket option contract if T violates investment guidelines that are part of the contract. C typically holds the rights associated with legal title to the assets and positions in the reference basket, including voting rights and the right to commingle, lend, pledge, transfer, or otherwise use the assets in the basket without notice to T.

T takes the position that T’s short-term trading gains and interest, dividend, and other ordinary periodic income from the performance of the reference basket are deferred until the basket option contract

1When used in this sentence and subsequently with respect to changing or requesting changes to the assets in the reference basket or the trading algorithm, references to “T” include T’s designee as defined in section 2.02 of this notice.

2See also section 2.03 of this notice.

November 16, 2015 660 Bulletin No. 2015–46

terminates and, if the basket option contract is held for more than one year, that the entire gain is treated as long-term capital gain.

The Treasury Department and the IRS are concerned that taxpayers are using a basket option contract to inappropriately defer income recognition or convert ordinary income or short-term capital gain into long-term capital gain. In some cases, taxpayers are also mischaracterizing a transaction as an option to avoid application of § 1260. Therefore, the Treasury Department and the IRS are identifying transactions described in section 2 of this notice as listed transactions.

The IRS may assert one or more arguments to challenge the parties’ tax characterization of a basket option contract, including: (1) that C, in substance, holds the assets in the reference basket as an agent of T and that T is the beneficial owner of the assets for tax purposes; (2) that the basket option contract is not an option for tax purposes; (3) that changes to the assets in the reference basket during the year materially modify the basket option contract and result in taxable dispositions of the contract under § 1001 throughout the term of the contract; and (4) that T actually owns separate contractual rights with respect to each asset in the reference basket such that each change to the assets in the basket results in a taxable disposition of a contractual right under § 1001 with respect to the asset affected by the change. The IRS may assert other arguments supporting the conclusion that T is the beneficial owner of the assets in the reference basket for tax purposes.