An investment fund challenged an IRS determination that various contracts entered into between the fund and an investment bank resulted in the fund having effective ownership of the positions that were the subject of the contracts.
In its Petition for Readjustment of Partnership Items filed in the U.S. Tax Court, the fund asserted that its ownership interest was in the contracts themselves and not in the underlying assets. A determination as to whether the fund owned the contracts or the underlying assets will result in significantly different tax consequences. Under the view expressed by the fund, the fund would have long-term gains based on the length of time that it held the contracts without regard to any change in the assets to which the contracts related. Under the view expressed by the IRS, the fund would realize a taxable event essentially each time there was a change in the assets to which the contracts related and, thus, the fund would, in many instances, have short-term gains that would be taxed at a higher rate.
Commentary
The tax treatment of knockout basket options appears to be headed to trial in January 2020. The attached taxpayer's petition and the IRS answer makes for fascinating reading. The Tax Court is faced with the ultimate question of whether the legal form of option carries with it sufficient economic consequences to distinguish it from a prime brokerage account. This case is an exercise in the ultimate line drawing, distinguishing a derivative from tax ownership.
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