United States: Like A Hot Knife Through Butter: The US Congress And Internal Revenue Service Pierce Straight Through Barrier Options

Last Updated: October 9 2014
Article by Mark H. Leeds

Keywords: US Congress, Internal Revenue Service, barrier call options

The author and his reviewer each find themselves raising teenage girls, coincidentally attending the same school. Readers with teenagers of their own may recognize that, sometimes, concerned parents may find themselves with surprisingly little leverage over a particularly important issue on which our young women may have a contrary view: e.g., home before midnight, studying the night before a test or even studying at all. We both have found that when we can't influence the issue that we desire to control, applying pressure on a seemingly unrelated front over which we do have some sway may change behavior on the "big" issue.

The US Congress and the Internal Revenue Service (the "IRS") have been applying a similar technique with hedge funds and their principals who have entered into barrier call options. After finding that a direct attack on the option transactions did not result quickly enough in denying the tax benefits associated with these option transactions, Congress and the IRS have resorted to public shaming and using the accounting method rules to reach the transactions. It is curious that the IRS took this tack instead of designating the barrier option transaction as a listed transaction or a transaction of interest.

AM 2010-005—Dad, That is So 2010

In AM 2010-005, released on November 12, 2010, the IRS considered the following call option contract. HF, a United States partnership entered into a two-year call option contract with a publicly traded United Kingdom bank ("Bank"). HF is described as a hedge fund manager. The property referenced by the call option is a so-called "managed account." A managed account is a brokerage account maintained by the Bank into which a number of stock (and possibly commodities and derivatives) positions are placed. The Advice Memorandum refers to the contents of the managed account as the "Reference Basket." At the inception of the option, the value of the managed account was $10x. HF paid a $1x premium for the option. AM 2010-005 recites that the option premium was not determined barrier option transactions was just the first step in addressing the use of these types of options.

In AM2010-005, the IRS concluded that the option was a disguised leveraged purchase of the positions that were subject to option. As a result, the IRS held that the optionee should be subject to current tax on the income and gains from the securities underlying the option transaction. If option treatment had prevailed, the optionee would have enjoyed deferral and conversion of ordinary income and short-term capital gains into long-term capital gains. We explored the technical basis for the IRS's position in detail in an earlier article.2 Based upon the developments discussed below, the substantive attack on barrier option transactions was just the first step in addressing the use of these types of options.

The Senate Subcommittee Report (Respond with Full Eye Roll & Heavy Sigh)

On July 22, 2014, the US Senate Permanent Subcommittee on Investigations held a hearing on the "Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits." In connection with the hearing, the Committee Staff prepared a report (the "Senate Basket Option Report" or the "Report"). The Senate Basket Option Report begins by naming two international banks that sold option products similar to the one described in AM2010-005 and two hedge funds that purchased such options. The Senate Basket Option Report provided a scathing indictment of the product and the market participants that entered into these transactions.

DAD, CAN I HAVE A LITTLE PRIVACY PLEASE?

Before exploring the Senate Basket Option Report itself, it is worth pausing to consider the extent to which the public shaming of the parties named in the Report constituted a violation of their right to privacy. The Privacy Act3 provides that, subject to enumerated exceptions, no federal agency, including the IRS, may disclose any record which is contained in its system of records, unless the individual to whom the record applies gives the agency consents to make that disclosure. In addition, Section 6103(a) of the Internal Revenue Code of 1986, as amended (the "Code"), provides that the IRS may not disclose taxpayer tax return information except as provided by that Code section. Code § 6103(f)(3) allows the IRS to turn over tax return information to a Congressional Committee4 only if the Senate or the House of Representatives (the "House") by resolution (i) has authorized the Committee to obtain such information and (ii) specified the purpose for which the information is to be furnished. Even if Congress has passed such a resolution, the information may be disclosed only if the Committee is sitting in a closed legislative session.

Congress did not pass a resolution authorizing the Senate Subcommittee on Investigations to obtain taxpayer information. Nonetheless, the Senate Basket Option Report specifically states that the Subcommittee "gathered documents, obtained information and received briefings from a number of federal agencies and related parties." The Senate Basket Option Report states that the agencies "cooperated with the Subcommittee Requests for information." The Subcommittee also obtained documents from the banks involved, the hedge funds and their accountants as well as interviewing individuals associated with each company. There is not enough information provided in the Senate Basket Option Report to determine whether any taxpayer privacy rules were violated.

The Senate Option Basket Report contains a full description of a current audit of a taxpayer. Regardless of whether taxpayer privacy rights were violated, the use of names in the Report is troublesome. The "naming of names" is a public denunciation of a financial product that has not been reviewed by any court and involves taxpayers currently under IRS audit. The Senate Basket Option Report is clearly intended to affect how the IRS should resolve the audits. At best, one can reasonably ask whether this is a fair and impartial administration of the federal income tax laws.

THE OPTION TRANSACTION DESCRIBED IN THE SENATE REPORT (FACT!)

The Senate Basket Option Report addresses three-year American-style call options issued to hedge funds. The option related to unspecified securities held within a designated account. The account was maintained in the name of the bank that wrote the option. The terms of the option contained certain minimal parameters on the securities that could be held in the account. The hedge fund paid an option premium of 10 with reference to options pricing models and economically was reimbursed upon a cash settlement of the option.

In AM2010-005, the IRS concluded that the option was a disguised leveraged purchase of the positions that were subject to option. As a result, the IRS held that the optionee should be subject to current tax on the income and gains from the securities underlying the option transaction. If option treatment had prevailed, the optionee would have enjoyed deferral and conversion of ordinary income and short-term capital gains into long-term capital gains. We explored the technical basis for the IRS's position in detail in an earlier article.2 Based upon the developments discussed below, the substantive attack on percent of the value of the assets held in the account. The bank took that premium and added its own funds (90 percent of the value of the account) to the account. The general partner of the hedge fund was appointed to invest the account proceeds. As a general matter, the trading in the account generated short-term capital gains and other types of ordinary income. In the hands of an individual, these gains and income would have been taxable at ordinary income rates.

Under the terms of the options, if losses in the account came close to 10 percent of the initial value of the account, the option "knocked out." (The knock-out feature is sometimes referred to as a barrier, hence the name of the options as barrier options.) The optionees generally exercised the options shortly after the options had been outstanding for the long-term capital gain holding period, more than one year during the years under investigation. The optionees claimed that the gains from the terminations of the options were long-term capital gains, taxable at a favorable rate.

Based upon the finding of facts described above, coupled with the tax reporting by the hedge funds involved, the Senate Basket Option Report concludes that the option transactions should not be respected as options for federal income tax purposes. The Report concludes that the banks were "aware of the questionable tax status of their basket option structures for many years prior to the issuance of the 2010 IRS advisory memorandum, but continued to sell the product." The Report recommended that the IRS assert the result described in AM2010-005 against the hedge funds that entered into the option transactions.

CCA 201426025—The Accounting Method Issue Is Raised

Following the issuance of AM 2010-005 and the Senate Basket Option Report, one could reasonably have thought that everything that could have gone wrong had happened. But things took a turn for the worse with the issuance of CCA 201426025 (Jan. 17, 2014).5 The most interesting facts underlying CCA 20146025 are not mentioned anywhere in the CCA itself. The actual fight appears to have revolved around a statute of limitations issue, penalties and interest. Specifically, it appears that the year in which a hedge fund entered into a barrier option was closed by reason of the expiration of the statute of limitations on assessment.6 In order to avoid this limitation7 and be able to impose penalties and interest on the deficiency resulting from the change from option treatment to ownership transaction, the IRS argued that a change in accounting method occurred when the hedge fund changed its method of accounting for the barrier options. This would enable the IRS to place the entire adjustment in a single year that was open to assessment.

The IRS may change a taxpayer's method of accounting if the chosen method does not clearly reflect income.8 The IRS's discretion to do so is limited to those items that would constitute a change in accounting method if the change had been initiated by the taxpayer.9 A change in accounting method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.10 Therefore, if the treatment of the options as ownership transactions constitutes a change in accounting method, the taxpayer generally would be required to file a change in accounting method request (Form 3115) with the IRS in order to effectuate such change.

The accounting method for material items involves the proper time for the inclusion of an item in income or the taking of a deduction.11 Thus, the focus of the accounting method change rules is solely on the timing of income and deductions. If the change affects a permanent difference in a taxpayer's "lifetime" income, then it is not a change in accounting method.12 In contrast, if the change involves the year in which an item is reported, it will be treated as an accounting method.13 As described below, even certain changes in the timing of an item, however, are exempted from being considered changes in accounting methods.

As we see below, two of three sets of potentially applicable authorities support the position of the taxpayer that treating the options as ownership transactions did not constitute a change in accounting method. The IRS did not even mention the "change in facts" authorities that favored the taxpayer. Of even more concern, however, is the fact that the IRS found several reasons to simply ignore a body of law (the divergence authorities) that clearly favored the taxpayer's position that no change in accounting method occurred. CCA 201426025 is so results-oriented that it reads like a litigation brief in a highly contested matter. It seems clear to the authors that the CCA has nothing to do with a change in accounting method. It appears to be a blunderbuss attack by the IRS in its quest to avoid statute of limitations issues and impose penalties on the taxpayer for its initial treatment of the barrier option transactions.

Footnotes

1 Mark Leeds is a tax partner in Mayer Brown's New York office and is the editor-in-chief of Derivatives: Financial Products Report, an RIA/Thompson publication. Mark thanks Ed Park for his assistance in developing this article. Ed Park is a managing director with AIG in New York. Mark and Ed will be speaking about the tax issues associated with barrier options at the Wall Street Tax Conference in New York on November 6, 2014. The views expressed herein are solely those of the author and should not be attributed to Mayer Brown.

2 See Leeds, "Dealer's Choice: AM2010-005 Pierces Option Contract to Find Ownership of Referenced Management Account by Optionee," reprinted in Daily Tax Report (December 2, 2010), 230 DTR J-1.

3 5 U.S.C. §§ 552a(b)(5), 552a(b).Many federal circuits limit the right of individual taxpayers to sue the IRS for failures to comply with the Privacy Act. See e.g. Cheek v. IRS, 703 F.2d 701 (7th Cir. 1983).

4 Special rules are provided for disclosures to the congressional tax-writing committees, but the Senate Permanent Subcommittee on Investigations is not encompassed by these rules.

5 It strongly appears that CCA 20140315 (Sep. 10, 2013) also addressed the use of the change in accounting method strategy to circumvent the statute of limitations defense by a hedge fund that entered into barrier option transactions. This CCA addresses whether a change from open transaction accounting to current realization resulting from a change in the characterization of a transaction is a change in accounting method and whether a change in accounting method can take into account closed taxable years.

6 See CCA 201432016 (Apr. 10, 2014).

7 See Suzy's Zoo v. Comm'r, 114 T.C. 1, 12-13 (2000), aff'd 273 F.3d 875, 884 (9th Cir. 2001); Huffman v. Comm'r, 126 T.C. 322, 341-2 (2006), aff'd 518 F.2d 357, 363-4 (6th Cir. 2008); Graff Chevrolet Co. v. Campbell, 343 F.2d at 571-572; Rankin v. Comm'r, 138 F.3d 1286, 1288 (9th Cir. 1998); Superior Coach of Florida v. Comm'r, 80 T.C. 895, 912 (1983); Weiss v. Comm'r, 395 F.2d 500 (10th Cir. 1968); Spang Industries, Inc. v. U.S., 6 Cl. Ct. 38, 46 (1984), rev'd on other grounds 791 F.2d 906 (Fed. Cir. 1986).

8 Code § 446(b); Treas. Reg. § 1.446-1(b)(1).

9 Rev. Proc. 2002-18, 2002-1 C.B. 676.

10 Treas. Reg. § 1.446-1(e)(2)(ii)(a).

11 FPL Group, Inc. v. Comm'r., 115 T.C. 554, 561 (2000) ("The consistent treatment of a recurring, material item, whether that treatment be correct or incorrect, constitutes a method of accounting.").

12 Rev. Proc. 97-27, 1997-1 C.B. 680, 681, § 2.01(1).

13 Id.

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Originally published October 7, 2014

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