Proposed regulations add certain basket contracts to list of listed transactions

On July 17, 2024, the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (Proposed Regulations) identifying certain “basket contract” transactions, and transactions that are the same as, or substantially similar to such transactions, as listed transactions, which generally require specific disclosure of the transaction to the IRS subject to enhanced penalties relating to the failure to provide such disclosure. The Proposed Regulations expand upon Notice 2015-73 and Notice 2015-74 (collectively, Notices), which identified “basket option contracts”¹ as listed transactions and previously identified “basket contract”² transactions as a transaction of interest.

The Notices generally describe tax avoidance transactions in which a taxpayer enters into an arrangement with a counterparty to receive a return based on the performance of a “notional basket” of assets. The taxpayer chooses the assets held in the basket and is permitted to request that the counterparty modifies the composition of the basket. The counterparty is not obligated to honor requests to modify the composition of the basket, but, in practice, such requests are rarely denied. The assets that comprise the basket would typically produce ordinary income if held directly by the taxpayer, or if such assets were purchased and sold by the taxpayer, short-term gain or loss. However, by entering into a derivative arrangement with the counterparty that terminates after one year (or which spans two tax years), the taxpayer seeks to take the position that any short-term trading gains or interest income derived by the counterparty will be deferred until the contract terminates and, upon settlement, all amounts paid to the taxpayer are treated as long-term capital gain.³ The IRS’s principal concerns with these transactions were that they enabled taxpayers to inappropriately defer income recognition and convert ordinary income or short-term capital gain into long-term capital gain.

While the Notices explicitly identify certain transactions that are considered the same or substantially similar to a basket option contract or a basket contract, the Proposed Regulations take a broad approach that extends beyond the transactions identified within the Notices. Under Proposed Regulation § 1.6011-16(c), any transaction that meets the following requirements will be considered a listed transaction:

1. The taxpayer enters into a contract with a counterparty, including a contract denominated as an option contract, notional principal contract, forward contract, or other derivative contract, to receive a return based on the performance of a reference basket;
2. The contract has a stated term of more than one year, or overlaps two or more of taxpayer’s taxable years;
3. The taxpayer has exercised discretion to change the assets in the reference basket or trading algorithm;
4. The taxpayer’s tax return reflects a tax benefit with respect to the transaction; and
5. The transaction is not described in one of three specific exceptions, described below.

Due to the fairly broad definition of basket option and basket contracts contained in the Proposed Regulations, certain arrangements are excluded from being treated as a listed transaction. Notably, the presence of any of the following features of a transaction that would otherwise be treated as a listed transaction pursuant to the Proposed Regulations are sufficient to conclude that an arrangements is not a listed transaction:

1. The contract is traded on a national securities exchange regulated by the SEC or a domestic board of trade regulated by the CFTC, or by a similarly regulated foreign exchange or board of trade;
2. The contract is treated as a contingent payment debt instrument under Treas. Reg. § 1.1275-4 or a variable rate debt instrument under § 1.1275-5;
3. With respect to the counterparty, if the taxpayer represents under penalties of perjury that the taxpayer’s tax returns will not reflect a tax benefit of the transaction, or the counterparty established the taxpayer is a non-US person, not engaged in a US trade or business.

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1. A basket option contract is a structured transaction in the form of an option agreement whereby the taxpayer seeks to receive a return based on the performance of a notional basket of actively-traded securities that are selected by the taxpayer directly or using a trading algorithm. Taxpayer has the right to directly, or indirectly via the counterparty, modify the composition of the basket of securities or the algorithm that selects such securities. The intended goal of the strategy is obtain long term capital gain treatment in lieu of deriving ordinary income and short-term capital gain.
2. A basket contract is similar to a basket option contract but instead of taking the form of an option agreement, the taxpayer and the counterparty enter into a derivative instrument such as a notional principal contract relating to securities, commodities, foreign currency, interests in entities that trade the forgoing property, or similar property or interests.
3. The three differences between basket option contracts and basket contracts are: (1) the form of the contract; (2) the type of assets in the reference basket; and (3) the term of the contract. The contract in a basket option contract must be an option, while a contract in a basket contract transaction is more broadly defined as any derivative contract. The reference assets in a basket option contract will generally only include assets consisting of actively traded personal property, while the reference assets in a basket contract may include interests in entities that trade securities, commodities, as well as actively traded personal property. Finally, the contract term for basket option contracts is over one year, while it is more than one year that overlaps two taxable years for a basket contract.

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