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

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...