In proposed regulations (REG-102161-23), the IRS and Treasury Department identified transactions that are the same as, or substantially similar to, certain basket contract transactions as listed transactions under Treas. Reg. Section 1.6011-4(b)(2). Participants and material advisors involved in these transactions would be required to file disclosures with the IRS or face penalties.

According to the IRS, taxpayers use these transactions to defer income recognition and convert short-term capital gains and ordinary income to long-term capital gains. The deferral of recognition and conversion is achieved by using a contract denominated as an option, notional principal contract, forward contract, or other derivative contract.

The IRS is holding a public hearing on the regulations on September 26, 2024.

Background

On October 21, 2015, the IRS released Notice 2015-74, which identified certain transactions as transactions of interest. At the same time, the IRS released Notice 2015-73 which identified a narrower set of basket transactions as listed transactions. See Tax Alert 2015–2084. The scope of that Notice is unaffected by the proposed regulations.

The IRS in Notice 2015-74 identified certain required elements of a transaction that would make it a reportable transaction, but not a listed transaction.

1. A taxpayer enters into a transaction with a counterparty to receive a return based on the performance of a reference basket.
2. The contract has a term of more than one year or overlaps two of the taxpayer's tax years.
3. The taxpayer or taxpayer's designee has exercised discretion to change (either directly or through a request to the counterparty) the assets in the reference basket or the trading algorithm.
4. The taxpayer's tax return for a tax year ending on or after January 1, 2011, reflects a tax benefit consisting of a deferral of income into a later tax year or a conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss.

IRS concerns

For transactions identified in Notice 2015-74, taxpayers take the position that short-term trading gains and interest, dividends, and other ordinary income from the performance of the reference basket are deferred until the basket contract terminates. If the contract is held for more than one year, taxpayers treat the entire gain as long-term capital gain.

Treasury and the IRS said they are concerned taxpayers may be using basket contracts to inappropriately defer income recognition or convert ordinary income or short-term capital gains into long-term capitals gains.

Treasury and the IRS are also concerned taxpayers may also be mischaracterizing transactions as options or other derivatives to avoid rules on constructive ownership transaction and passive foreign investment companies in IRC Sections 1260 and 1291, respectively.

The proposed regulations

The proposed regulations would (i) obsolete Notice 2015-74 and (ii) treat the transactions described in Notice 2015-74, with some modifications as described later, as listed transactions, rather than as transactions of interest. The proposed regulations would consider a transaction to be a listed transaction if it were the same as, or substantially similar to, a transaction that contains the five elements described in Prop. Treas. Reg. Section 1.6011-16(c)(1) through (5):

1. A taxpayer enters into a contract with a counterparty, including a contract denominated as an option, 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 of the taxpayer's tax years.
3. The taxpayer or the taxpayer's designee has exercised its discretion to change the assets in the reference basket or the trading algorithm.
4. A taxpayer's return for a tax year ending on or after January 1, 2011, reflects a tax benefit from the transaction (i.e., the deferral of income into a later tax year or the conversion of ordinary income or short-term capital gain or loss into long-term capital gain or loss).
5. The transaction does not meet one of the exceptions described in Prop. Treas. Reg. Section 1.6011-16(d) discussed later.

The proposed regulations would also expand the definition of the types of assets included in the reference basket from those provided in Notice 2015-73 and Notice 2015-74, specifically to include digital assets.

Exceptions

The proposed regulations provide two exceptions that apply to all parties to a transaction.

1. The contract is traded on an exchange regulated by the Securities and Exchange Commission, a domestic board of trade regulated by the Commodity Futures Trading Commission, or a foreign exchange or board of trade that is subject to regulation by a comparable regulator (Prop. Treas. Reg. Sections 1.6011-16(d)(1).)
2. The contract is treated as a contingent payment debt instrument under Treas. Reg. Section 1.1275-4 (including a short-term contingent payment debt instrument) or a variable-rate debt instrument under Treas. Reg. Section 1.1275-5.

Additionally, the proposed regulations provide two other exceptions that apply only to the counterparty to the contract. Specifically, the proposed regulations provide an exception if (1) the taxpayer represents to the counterparty under penalty of perjury that none of the taxpayer's returns for tax years ending on or after January 1, 2011, reflect, or will reflect, a tax benefit from the transactions described, or (2) the counterparty has established that the taxpayer is a nonresident alien or foreign corporation not engaged in a US trade or business by obtaining certain types of withholding certificates.

Implications

The proposed regulations would clarify the scope of Notice 2015-74 by explicitly including otherwise-includible transactions where the underlying asset is a digital asset. More importantly, all transactions that were reportable transactions of interest under Notice 2015-74 would be listed transactions under the proposed regulations, which may require those transactions to be re-disclosed as listed transactions, even if they had previously been disclosed as reportable transactions. Thus, the Treasury Department and the IRS are proposing to identify both the transactions in Notice 2015-73 (which were previously identified as a listed transaction) and the transactions in Notice 2015-74 as listed transactions. Reportable transactions include listed transactions, confidential transactions, transactions with contractual protection, loss transactions, and transactions of interest (TOIs). A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction.

The proposed regulations also expand the scope of the term "substantially similar." Under Notice 2015-74, a transaction was defined as the same as, or substantially similar to, the transaction of interest identified in that Notice only if it possessed the four enumerated factors described in that Notice. By contrast, under the proposed regulations, a transaction will be a listed transaction if it is the same as or "substantially similar to" a transaction that satisfies the enumerated factors. This implies that, even if a transaction does not satisfy all of the factors listed in the proposed regulations, it may still be a listed transaction. If this same wording is used in the final regulations, the definition of a "listed transaction" under the final regulations could be substantially broader than the definition of a "transaction of interest" was under Notice 2015-74.

If these proposed regulations are finalized, taxpayers must file a disclosure statement with the IRS on Form 8886, Reportable Transaction Disclosure Statement (or successor form) if they (i) have 'participated' in the basket contract transactions identified as a listed transaction, and (ii) must file a tax return. The disclosure statement must be attached to the tax return for each tax year in which the taxpayer participates in a reportable transaction. Taxpayers must also send an exact duplicate copy of the disclosure statement to the IRS's Office of Tax Shelter Analysis (OTSA) in the initial year in which they are required to first file a disclosure statement for a particular reportable transaction. Persons acting as a material advisor may also have a disclosure obligation in accordance with the final regulations and the regulations issued under IRC Sections 6011 and 6111, as well as have list-maintenance requirements under the final regulations and the regulations issued under IRC Section 6112.

More importantly, taxpayers participating in transactions described in Notice 2015-73 and Notice 2015-74 before the date the final regulations are published in the Federal Register, may have a disclosure requirement, even if the transaction was previously disclosed. For example, a taxpayer that previously disclosed a transaction under Notice 2015-74 as a transaction of interest may be required to re-disclose the same transaction as a listed transaction.

Generally, taxpayers must disclose their participation within 90 calendar days after the final regulations are published in the Federal Register if the period of limitations for assessment for any taxable year in which the taxpayer participated in the transaction remains open.

Taxpayers that participate in a reportable transaction and fail to disclose may be subject to penalties under IRC Section 6707A. Those taxpayers may also be subject to additional accuracy related penalties under IRC Sections 6662 or 6662A and 6694.

The proposed regulations will become effective on the date Treasury and the IRS publish the final regulations in the Federal Register.

The prior discussion is intended to be for educational purposes. Taxpayers should consult with their tax advisor as to the applicability of the proposed regulations and any disclosure requirement that may arise when the proposed regulations are published as final in the Federal Register.