In SIH Partners LLLP v. Commissioner, 167 T.C. No. 8 (2026), the U.S. Tax Court held that a partnership was not entitled to qualified dividend income (QDI) treatment or foreign tax credits (FTCs) arising from a constructed basket swap transaction because the transaction was subject to the anti-abuse rule in Treas. Reg. Section 1.246-5(c)(1)(vi).

Although the court concluded that the taxpayer satisfied the regulations' mechanical substantial overlap test and also rejected the IRS's attempt to recast the transaction under substance-over-form principles, it nevertheless found that some of the stocks held in the swap virtually tracked the taxpayer's long positions, was entered into with a principal purpose of obtaining tax savings, and generated anticipated tax benefits that significantly exceeded its expected pretax economic profits. As a result, the court treated the taxpayer's positions as substantially similar or related property (SSRP) under IRC Section 246(c), causing the taxpayer to fail the holding-period requirements for both QDI treatment and FTC eligibility.

Facts

The taxpayer, through disregarded entities, acquired long positions in four Swiss dividend-paying equities based in Switzerland. The taxpayer entered into a portfolio swap with derivatives dealer that had corresponding short positions in those same Swiss equities as well as a broader "Firm Hedge," consisting primarily of unhedged short positions in one or more indexes or securities. During tax year 2012, the taxpayer reported approximately $170.8 million of QDI and claimed approximately $25.6 million of FTCs associated with Swiss withholding taxes. The IRS challenged both positions.

Law

IRC Section 1(h)(11) generally permits certain dividends received by individuals from domestic corporations and qualified foreign corporations to receive QDI preferential tax treatment. To qualify for this treatment, taxpayers must satisfy holding-period requirements that incorporate the rules contained in IRC Section 246(c). IRC Section 246(c)(4)(C) suspends a taxpayer's holding period during periods in which the taxpayer has diminished its risk of loss through positions in SSRP.

Treas. Reg. Section 1.246-5 establishes rules for determining whether positions constitute SSRP. For positions reflecting the value of a portfolio of stocks, defined generally as positions involving at least 20 unrelated issuers, the regulations provide a mechanical "substantial overlap test." Under that test, a subportfolio is created. The subportfolio "consists of stock in an amount equal to the lesser of the fair market value of each stock represented in the position and the fair market value of the stock in the taxpayer's stock holdings." If the subportfolio's fair market value is 70% or more of the fair market value of the stocks in the position (i.e., taxpayer's portfolio), the position and subportfolio substantially overlap. The regulations also contain a separate anti-abuse rule that can apply even if a taxpayer satisfies the substantial overlap test. Under this anti-abuse rule, a position can still be treated as SSRP if (1) changes in the value of the position or the stocks reflected in the position are reasonably expected to virtually track changes in the value of the taxpayer's stock holdings, and (2) the position is acquired or held as part of a plan with a principal purpose of obtaining tax savings that significantly exceed the plan's expected pretax economic profits.

Holding

Substance-over-form challenge

The IRS argued that the transaction does not match its form, in part because the taxpayer repeatedly changed the composition of the position. As a result, the IRS argued, the transaction should be recharacterized from a swap over a portfolio of stocks to a collection of swaps, each relating to a single stock. If treated in this manner, the swaps would be treated as SSRP, and the taxpayer would fail to satisfy the applicable holding-period requirements.

Rejecting the IRS's argument, the court observed that Treas. Reg. Section 1.246-5 expressly distinguishes portfolio positions from nonportfolio positions and defines a portfolio as a group of stocks of 20 or more unrelated issuers. The court found SIHP created a portfolio of stock in substance and form because the portfolio was made up of 20 or more stocks.

The court further observed that Treasury expressly contemplated dynamically managed portfolios when drafting the regulations. Additionally, the court found the regulations require testing whenever a taxpayer alters the composition of a portfolio, which further suggests that merely making changes to a portfolio swap should not cause the swap to be disaggregated.

Substantial overlap test

After determining that the transaction constituted a portfolio, the court applied the substantial overlap test contained in Treas. Reg. Section 1.246-5(c)(1)(iii). The court found approximately $2.2 billion of a $3.4 billion portfolio overlapped with the taxpayer's stock holdings, resulting in a roughly 64% overlap. Because the overlap did not exceed the 70% threshold established in Treas. Reg. Section 1.246-5(c)(1)(iii), the court concluded that the transaction did not constitute SSRP under the substantial overlap test.

Anti-abuse rule

Although the taxpayer prevailed under the substantial overlap test, the court concluded that the transaction nevertheless ran afoul of the anti-abuse rule contained in Treas. Reg. Section 1.246-5(c)(1)(vi).

Virtual tracking requirement

The first component of the anti-abuse rule requires changes in the value of the position to be reasonably expected to virtually track changes in the taxpayer's stock holdings.

The taxpayer argued that the virtual tracking test should be read differently for portfolio and nonportfolio positions. Specifically, the taxpayer asserted that the regulation's reference to "changes in the value of the position" applied only to portfolio positions, while the phrase "or the stocks reflected in the position" applied only to nonportfolio positions. The taxpayer also relied on its expert's quantitative analysis, which used a percentage-deviation formula to conclude that the taxpayer's Swiss equity holdings did not virtually track the other positions in the transaction.

The court rejected that interpretation. It agreed with the IRS the basket transaction should be disaggregated and the short stock positions in the swap should be tested individually against the long equity holdings to determine whether the short positions "virtually tracked" the long equity positions held. Based on this disaggregation reading, the court held that the short Swiss equity positions embedded in the transaction were reasonably expected to inversely track SIHP's long Swiss equity holdings. The court found SIHP's proposed 5% deviation standard was unsupported by the regulation, which does not prescribe a numerical threshold for virtual tracking. It also found petitioner's reading too narrow because the anti-abuse rule expressly applies "[n]otwithstanding" the special rules for portfolio and nonportfolio positions and does not create separate virtual-tracking tests for each category.

Accordingly, the court read the anti-abuse rule broadly as a catchall provision intended to address potential abuse even when no substantial overlap exists. Because the taxpayer held both long and (through the portfolio swap) short positions in the same Swiss equities, the court held that the positions were reasonably expected to virtually track under Treas. Reg. Section 1.246-5(c)(1)(vi)(A).

Tax-motivation requirement

The second component of the anti-abuse rule examines whether (1) the transaction was undertaken with a principal purpose of generating tax savings and (2) those tax savings were significantly greater than the expected pretax economic profits.

After considering the analyses conducted by the expert witnesses on whether the transaction generated tax savings, the court adopted the conclusion of one of the experts and found the expected tax savings exceeded $25 million. The court observed that the taxpayer did not conduct a comprehensive analysis of the transaction to determine how profitable the transaction would be beyond the potential tax savings. Because a complete pretax analysis was not conducted before the transaction, the court found the pretax profit estimate from the transaction was zero to $2.4 million. Accordingly, the court ruled the anticipated tax benefits were "significantly in excess" of expected pretax economic profits.

Because both the virtual tracking requirement and the tax-motivation requirement were satisfied, the court held that the anti-abuse rule applied notwithstanding the taxpayer's successful reliance on the substantial overlap test. The court therefore treated the Swiss equity positions as SSRP and reduced the applicable holding periods under IRC Section 246(c).

Foreign tax credits

The court also sustained the IRS's disallowance of the taxpayer's FTC claims.

IRC Section 901(k) generally requires taxpayers claiming FTCs for dividend withholding taxes to satisfy specified holding-period requirements and prohibits credits when taxpayers are obligated to make related payments for SSRP positions.

Because the court concluded that the anti-abuse rule applied and that the taxpayer's positions constituted SSRP, it held that the taxpayer failed to satisfy the statutory requirements necessary to claim FTCs attributable to Swiss withholding taxes. Accordingly, the court ruled that the taxpayer was not entitled to claim the FTCs of approximately $25.6 million.

Implications

• Many practitioners were surprised by the court's decision to apply the anti-abuse virtual-tracking test by looking through the basket transaction; they had believed that, as long as the portfolio swap avoided creating a substantial overlap, the anti-abuse rule would apply only if the swap, taken as a whole, virtually tracked one or more stocks in the taxpayer's long portfolio. The decision thus creates uncertainty as to whether a basket swap that does not create a substantial overlap will nevertheless be subject to the anti-abuse rule.
• Interestingly, both the IRS and the court appeared to accept the taxpayer's assertion that, for purposes of counting the number of stocks in the basket, each ETF reflected in the swap should be treated as a direct position in the stocks held by that ETF (rather than as a single stock, consistent with its legal form). However, because the court did not discuss this issue, it is not clear whether other courts would follow it.
• In addition to the FTC and QDI consequences relevant to the decided case, the use of basket swaps can raise issues under the wash sale rules, constructive sale rules, straddle rules, and dividends-received deduction rules. Following this case, taxpayers who are considering entering into basket swaps that implicate any of these rules should consider carefully whether their transaction may be subject to the anti-abuse rule. If so, taxpayers should further consider whether the position is acquired or held as part of a plan that has a principal purpose of obtaining tax savings (including by deferring tax) that significantly exceed the plan's expected pre-tax economic profits.