Service Denies Tax Deferral and Long-Term Capital Gains Through Basket Option Transaction

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Advice Memorandum 2010-005, released on November 12, 2010, sets out the Internal Revenue Service’s position on whether the purchased call option described therein should be respected as an option; treated as another form of a derivative transaction; or recast as, in substance, tax ownership of the underlying basket of securities.

In a recent Chief Counsel’s Advice Memorandum, the Internal Revenue Service (Service) challenged the availability of tax deferral and long-term capital gains pursuant to a basket option transaction by disregarding the form of the transaction and treating the option purchaser as having made a leveraged investment directly in the underlying securities.

Advice Memorandum 2010-005, released on November 12, 2010, sets out the Service’s position on whether the purchased call option described therein should be respected as an option; treated as another form of a derivative transaction; or recast as, in substance, tax ownership of the underlying basket of securities (Reference Basket). The Service noted that the option purchaser “sought two tax advantages in characterizing the Basket Contract as an option,” namely, (1) deferral of taxable income with respect to gains, interest and dividends earned within the Reference Basket until the option either was exercised or was earlier terminated and cash-settled, and (2) conversion of short-term capital gains and ordinary income (interest and dividends) with respect to the Reference Basket into long-term capital gains if the option remained open for more than one year before termination and cash settlement.

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