A Tisket A Tasket - Your Hedge Fund's in a Basket

AM 2010-005

This was originally published on PAOO on November 18th, 2010.

So today we get to introduce a new acronym. What is an "AM" you ask. Well it is Legal Advice Issued by Associate Chief Counsel. I suppose that doesn't explain the acronym. I'm going to guess Associate Memo. Regardless, it is one of those things that the IRS would just as soon keep to itself, but that you can get in RIA because of that nasty Freedom of Information Act. This particular one gives us advance notice that there is a very clever plan that the IRS does not like one little bit.

The taxpayer a partnership entered into an option to purchase a basket of securities. Nothing too exciting about that. Here is where it starts getting interesting. The basket is being held offshore. They don't give actual numbers, but for the sake of ease I'm going to say that the partnership put up $1,000,000 and a foreign bank put up $9,000,000. The foreign bank then bought the securities that are supposed to be in the basket. When the contract terminates the partnership is entitled to receive $1,000,000 plus the basket gain or less the basket loss. The gain or loss is inclusive of dividends, appreciation, depreciation, interest, expenses etc. If at any point the basket value goes below $9,000,000 the partnership is "knocked out".

Here is the really clever part. What is in the basket ? Whatever the general partner of the partnership says. So the basket is an actively traded portfolio. I would dearly love it if this thing actually worked because it would be a way to avoid having hedge fund K-1's that run into scores of pages. The portfolio manager decides on the amount of leverage transfers the appropriate amount to the foreign bank, issues trading instructions and nothing need be reported till the contract is settled up.

The associate chief counsel does not think that this thing is really an option :

..... it is clear that the Basket Contract, despite its option terminology, lacks the requisite characteristics of an option. In particular, two elements of the agreements between HF and FB are contrary to the typical functioning of an option: (a) the interplay between the Basket Contract's premium, Cash Settlement Amount, and Knock-Out provision, which imposed upon HF costs similar to an obligated buyer and preclude any possibility of lapse; and (b) HF's ability to alter the Reference Basket, through GP, while the Basket Contract remained open, which is inconsistent with the notion that an option on property must reference specific property at a defined price.

The partnership was deemed to be the owner of the "Reference Basket"

Upon application of the factors set forth by the authorities discussed above to the terms of the agreements between HF and FB, it is clear that HF should be treated as the tax owner of the Reference Basket because HF had: (a) opportunity for full trading gain and current income; (b) substantially all of the risk of loss related to the Reference Basket, and (c) complete dominion and control over the Reference Basket.

A memo from the Associate Chief is a long way from definite authority, but it is a head's up that this structure has a target stenciled on its back.