News & Events

In a recently released Chief Counsel Advice Memorandum (the “CCA”), the Internal Revenue Service broadened its scrutiny of so-called ‘barrier option’ transactions, which tax-payers have used to defer recognition of income and to convert ordinary income and short-term capital gain to long-term capital gain.¹ The government had previously announced that it would scrutinise these transactions in guidance released in 2010 and in July of this year.² The CCA is consistent with the previous guidance, and expands upon it in two ways:

• It specifically targets a transaction that is a barrier option on a hedge fund interest. While the previous guidance acknowledged that this type of transaction could come under scrutiny, the previous guidance did not examine the potential for perceived abuse inherent in this kind of transaction; and,
• It develops certain legal doctrines that the government may use to attack these transactions in more detail than the previous guidance.

Because of this, the CCA should be of interest to banks which provide exposure to this kind of option, to hedge funds whose interests are referenced thereby, and to potential investors.

1. Facts

A barrier option is a transaction whereby a party (the long party) pays money to another party (the short party) to gain price exposure to an asset (the underlier, or the referenced asset). Generally, the long party will pay an amount (the premium) to the short party equal to a portion of the referenced asset’s value. Upon maturity, the long party will receive an amount equal to the difference between the fair market value of the underlier at maturity and an amount equal to the underlier’s price at inception, less the premium, plus a financing charge (the strike price). If the fair market value of the underlier approaches the strike price prior to maturity, the contract is terminated. In certain cases, in order to further insulate the short party from risk, the long party is required to pay additional premium to the short party if the value of the referenced asset falls below a certain threshold.

Example: On day one, the value of a referenced asset (say, an interest in a hedge fund) is US$100. Long party pays short party US$10 in order to enter into a contract that the parties call an “option” on the referenced asset. The contract obligates the short party to pay the long party the difference between the fair market value of the referenced asset and a strike price of US$94.56. This number will never be a negative value; the short party will never pay the long party upon termination. However, if the value of the referenced asset falls below US$98, the long party is obligated to pay the short party an amount equal to the difference between US$100 and the value of the referenced asset (with a corresponding decrease in the strike price). These payments may be ‘clawed back’ if the value of the referenced asset subsequently rises above US$100. If the value of the referenced asset decreases below US$95, the contract is terminated. Absent an early termination, the contract has a maturity of two years.

In order to hedge its position under the contract, the short party purchases the referenced assets. To finance this purchase, it uses the US$10 premium received from the long party, and borrows $90 from a bank. Its cost of funds is three-month LIBOR (0.39 percent, at inception).

If the referenced asset is illiquid, payments at maturity are deferred until the short party’s position in the referenced asset can be sold or redeemed. This, along with the early termination provision and the requirement that the short party contribute more cash in the event of a decrease in the value of the referenced asset, insulate the short party from all foreseeable risk due to decreases in the value of the referenced asset. All exposure to potential losses and gains is borne by the long party.

From the long party’s perspective, the transaction is economically identical to a purchase of the referenced asset financed by a nonrecourse loan with an annual interest rate of 2.5 percent, compounded annually. From the short party’s perspective, the transaction is identical to a transaction whereby the short party borrows US$90 at a floating rate equal to three-month LIBOR and provides nonrecourse financing at an annual rate of 2.5 percent compounded annually to the buyer.

So long as a barrier option is respected as an option for federal income tax purposes, it provides two benefits to the long party:

• It defers recognition of gain. Gain or loss from the sale, termination, or lapse of an option is generally recognised in the year of sale, termination or lapse. By contrast, the owner of an actively traded portfolio of securities is required to recognise trading gain currently, and the owner of an interest in a partnership that has trading gain or ordinary income is required to recognise partnership income or gain currently on a ‘pass-through’ basis. Therefore, an option on an actively-traded portfolio, or an option on a partnership interest if respected as an option for tax purposes allows deferral of recognition of taxable gain; and,
• It helps re-characterise ordinary income and short-term capital gain as long-term capital gain. Gain or loss from the disposition, termination or lapse of an option on a capital asset is capital. To the extent that the option has been held for more than a year at the time of sale, termination or lapse, this capital gain or loss is long-term capital gain or loss. Therefore, any capital gain recognised with respect to an option on an actively-traded portfolio, or on a partnership interest, will be long-term capital gain if the option has been held for more than one year, and the option is respected as an option for tax purposes.

In the previous guidance, the Service took the position that income deferral and long-term capital gain treatment were not appropriate for barrier options on actively-traded portfolios, because barrier options are not true options for United States federal income tax purposes. The CCA extended this position to barrier options on hedge fund interests, and further developed the legal support for these conclusions.

2. Previous Guidance

The bulk of the legal analysis in the previous guidance is contained in AM 2010-005. In that notice, the taxpayer was a hedge fund that entered into a transaction that was labelled an option with a bank counterparty. The terms of the contract were materially identical to the facts of the example above, except the referenced asset was an actively traded portfolio of liquid, actively traded securities, instead of a single partnership interest. The taxpayer had the right to request that the portfolio be changed. Although the bank was not contractually obligated to comply with these requests, the requests were made frequently, and were always complied with.

The Service held that the arrangement was, in fact, a custodial arrangement, whereby the bank provided margin financing to the taxpayer, rather than an option. Reasons for this conclusion included the following:

• The transaction was not an option. An option is, generally, a contract that grants a party the right (but not the obligation) to buy or to sell a specified asset at a specified price on or before a specified date. By contrast, a contract that obligates a party to buy or to sell at a specified price is not an option. Because the terms of the contract ensured that the so-called option would always be “in-the-money,” the taxpayer would always be economically compelled to exercise its rights under the contract. This economic compulsion was not consistent with option status; and,
• Under general tax law principles, the taxpayer was the beneficial owner of the underlying portfolio. In determining the owner of illiquid property, courts and the Service generally look to the party that bears economic exposure to the value of the underlier (the ‘burdens and benefits test’). By contrast, in determining the owner of liquid, fungible property such as the securities in the underlying portfolio, courts and the Service look to the party that has the power to dispose of the property (the ‘possession and control test’). Because the taxpayer had the right to vary the portfolio, it had the de facto right to dispose of the assets in the portfolio. Therefore, the taxpayer, rather than the bank, was the owner of the portfolio for United States federal income tax purposes.

Notice 201547 and Notice 201548 (the ’Notices’) stated that certain contracts that resembled the contract described in AM 2010-005 would be treated as reportable transactions.³ The Notices broadened the scope of government scrutiny to cover contracts that referenced baskets of securities, commodities, foreign currency or similar property, as well as interests in entities that trade instruments of this type (i.e., hedge fund interests).

The Notices stated that, in scrutinising relevant contracts, the Service may assert one or more of the following arguments to challenge the taxpayer’s characterisation of a contract, including:

• That the contract is not an option for United States federal income tax purposes;
• That the taxpayer is the tax owner of the referenced portfolio under general federal income tax purposes;
• That a change to the portfolio prior to termination constitutes a modification of the contract that should result in a deemed taxable exchange of the unmodified contract for the modified contract under code section 1001; or,
• That the taxpayer 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.

Significantly, AM 2010-005 and the Notices only applied to contracts that referenced variable portfolios. They did not cover contracts on static baskets, or contracts on single assets that could not be changed. Therefore, at least on its face, the previous guidance did not apply to barrier options on static baskets of hedge fund interests, even if the hedge fund whose interests were referenced were engaged in an active trading business.

3. Current guidance

This appears to have changed with the current guidance.

The taxpayer in the CCA entered into a series of contracts similar to the contract in the example above, each of which referenced a portfolio of hedge fund interests.⁴ The Service held that the contracts should not confer the benefits of deferral and long-term capital gain treatment that would apply if they were respected as options. Reasons for this included, inter alia:

• The contracts were not options. As in AM 2010-005, the Service held that, since the long party was economically compelled to exercise its rights, the contracts did not constitute options.
• The long party was the tax owner of the referenced assets. Although the conclusion here is similar to that in AM 2010-005, the reasoning is slightly different. In discussing tax ownership law, the Service noted that, while courts look to all relevant facts and circumstances to determine tax ownership, the dispositive test regarding illiquid assets tends to be the identity of the party that has the burdens and benefits of ownership, rather than the party that has the right to dispose of the asset. Because the referenced assets in the CCA were illiquid hedge fund interests, the Service held that the party with economic exposure thereto (i.e., the taxpayer), rather than the party that held bare legal title, was the tax owner.⁵ This is noteworthy because some advisors have taken the position that, since hedge fund interests are fungible with each other, the possession and control test, rather than the burdens and benefits test, should apply. The CCA indicates that, in determining tax ownership of hedge fund interests, the Service is more likely to apply the burdens and benefits test, rather than the possession and control test, even though hedge fund interests are, stricto sensu, ‘fungible’ property.⁶
• Even if the bank, rather than the taxpayer, were the tax owner of the referenced assets, the taxpayer should not benefit from income deferral and re-characterisation, because the transaction is a ‘constructive ownership’ transaction, within the meaning of Code section 1260. By way of background — Code section 1260 treats as ordinary income, and imposes an interest charge on, deemed late payment of gain received by holders of certain derivatives on interests in pass-thru entities to the extent that amounts attributable to this gain would have been treated as other than long-term capital gain had the taxpayer owned the interests directly. Derivatives that may constitute a constructive ownership transaction generally include so-called ‘delta one’ derivatives – i.e., derivatives that provide full economic exposure to the risks and benefits of direct ownership of the underlier. Because the taxpayer was the party that bore the full risk of loss due to decreases in the value of the referenced asset, and the full opportunity for profit due to increases in the value of the referenced asset, the Service held that the contract constituted a constructive ownership transaction. Therefore, even if the contracts were respected as derivatives, the Service took the position that the rules of Code section 1260 would remove the benefit of derivative treatment.

The net result of the foregoing is that the Service will scrutinise barrier options on hedge fund interests in the future and has developed the legal doctrines that it may use to do so.

4. Next steps

Per the foregoing, the barrier option business is due for a makeover. Alternative methods for investors to gain exposure to hedge fund interests that are not vulnerable to attack under the CCA include the following. As indicated below, each of the proposed solutions has its merits, but none is perfect:

• True Options. In order for a transaction to withstand scrutiny as a true option, the holder should be under no economic compulsion to exercise its rights thereunder; in order for that to be the case, there should be a reasonable possibility that the option could expire worthless. An option that is issued at or near the money, with no ‘knockout’ provision, and with no requirement that the holder contribute additional premium if it declines in value, would likely be respected as an option for these purposes. While these terms would provide the tax benefits of deferral and long-term capital treatment, they would also incur significant commercial costs, because they would require the short party to assume meaningful risk with respect to the underlier, and they would not allow the long party to obtain "delta one" exposure to the underlier;
• Loans instead of Derivatives. As discussed above, a barrier option is economically equivalent to a nonrecourse purchase-money loan. Instead of issuing a barrier option and holding the underlier as a hedge, the short party could simply lend money to the long party on a nonrecourse basis and hold the underlier as a custodian for the long party. While this would provide the short party with the same profit margin as a barrier option, it would not provide the long party the benefits of income deferral and re-characterisation.
• Offshore Long Parties. Foreign investors that are not engaged in a trade or business within the United States are generally indifferent to income deferral and long-term capital treatment; therefore, if a bank were to offer a barrier option to this type of investor, the Service would have little incentive to challenge the transaction. Note that, to the extent that the barrier option were to reference an interest in a hedge fund that was engaged in a United States trade or business, or that had so-called U.S. source "FDAP" income subject to United States federal withholding tax, the Service would have reason to challenge the transaction.

John Kaufmann is of counsel in the New York office of Greenberg Traurig. He specializes in the taxation of financial instruments. His clients include hedge funds, PE funds, banks and insurance companies. He is reachable at (212) 801-2147, or at kaufmannj@gtlaw.com

For more information, please visit www.gtlaw.com .