IRS Characterizes Unique “Knock-Out” Option Contract as Direct Ownership of Underlying Property


On November 12, 2010, the Internal Revenue Service (“IRS”) released an advice memorandum – AM 2010-005, dated October 15, 2010 – in which it concluded that a contract styled as an option should in substance be characterized for federal income tax purposes as direct ownership of the underlying property.


Taxpayer, a hedge fund (“HF”) without any employees, was organized as a Delaware limited partnership and managed by its general partner (“GP”). HF entered into a call option contract (“Contract”) with a foreign bank (“FB”) on a basket of securities (“Reference Basket”) held in an account administered by FB. The Reference Basket was funded with $1x, the premium paid by HF to FB, and $9x paid by FB.1 Pursuant to the terms of the Contract, HF had the right to terminate the Contract at any time during its two-year term upon which it would receive the “Cash Settlement Amount.” This amount equaled the greater of (i) zero, or (ii) the reimbursement of the $1x premium, plus “Basket Gain” or less “Basket Loss.” Basket Gain or Loss equaled (i) trading gains, unrealized gains, interest, dividends, or other current income, less (ii) trading losses, unrealized losses, interest, dividend, or other current expenses, less (iii) commissions and other trading costs incurred in acquiring or disposing of the securities and positions, and less (iv) financing charges on the $9x provided by FB. The terms of the Contract included a “knock-out” provision, pursuant to which the Contract would automatically terminate at any time the Basket Loss reached 10%, and gave FB the right to require HF to enter into risk-reducing trades.

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