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A reportable transaction is any of the following. Listed transaction. A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax-avoidance transaction. These transactions have been identified in notices, regulations, and other published guidance issued by the IRS. For a list of existing guidance, see the instructions for Form Confidential transaction. A confidential transaction is one that is offered to you under conditions of confidentiality and for which you have paid an advisor a minimum fee.
The transaction is treated as confidential even if the conditions of confidentiality are not legally binding on you. Transaction with contractual protection.
Generally, a transaction with contractual protection is a transaction in which you or a related party has the right to a full or partial refund of fees if all or part of the intended tax consequences of the transaction are not sustained, or a transaction for which the fees are contingent on your realizing the tax benefits from the transaction. Certain losses such as losses from casualties, thefts, and condemnations are excepted from this category and do not have to be reported on Form see Form instructions. For information on other exceptions, see Revenue Procedure in Internal Revenue Bulletin This Internal Revenue Bulletin is available at www.
Transactions with a significant book-tax difference. The book-tax difference is the amount by which the amount of any income, gain, expense, or loss item from the transaction for federal income tax purposes differs on a gross basis from the amount of the item for book purposes for any tax year.
On December 4, , the Service issued Notice , C. The transaction is designed to create an overall net loss either ordinary or capital when a taxpayer transfers two foreign currency contracts to a charity where only one such contract is subject to the mark-to-market rules contained in I. Taxpayers deployed Notice transactions in order to offset substantial taxable income either capital or ordinary. Taxpayers initiated the transactions by entering into an investment management agreement and opening a trading account managed by the promoter, who is also a registered investment advisor.
Generally, the initial capital investment is determined by the anticipated loss needed. The taxpayer agrees to leave the funds in the account for a five-year period, although funds can be withdrawn at any time subject to significant monetary penalties. A small portion, approximately 1.
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The remaining balance is invested in a hedge fund of funds that in turn invests in a variety of investment vehicles including other hedge funds, stock funds, commodity funds and currency funds. These positions are in a foreign currency traded through regulated futures contracts, and thus the taxpayer takes the position that such positions are I.
The European currency is one in which positions are not traded on a qualified board or exchange and are not I. Therefore, the initial cash outlay to enter into the foreign currency positions is limited to the net premium among the offsetting contracts. In a more complex variation of the transaction, the taxpayer enters into a series of day European-style digital options on the same day.
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Usually, the taxpayer buys two put options and sells two call options pegged to fluctuations in the exchange rate between the U. In some deals, the taxpayer will enter into a second series of day European-style options on the following day. The values of the respective currencies underlying the foreign currency transactions historically have demonstrated a very high positive correlation with one another.
Therefore, the major options will move inversely to the minor options such that any gain in a major foreign currency position will be largely offset by a corresponding, though not always identical, loss in a minor foreign currency position. The bank, which serves as counterparty for these deals, generally makes representations to the taxpayer and trader concerning the statistical probabilities of the potential rate of return from the option positions indicating a profit is possible but unlikely.
Prior to the exercise date, that taxpayer assigns two of its open foreign currency contracts to a charity. The first contract is a major currency option contract that is in a loss position at the time of assignment. The taxpayer also assigns the obligation that is associated with a minor currency option contract that is in a gain position at the time of assignment of the obligation.
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The taxpayer takes the position that 1 the assignment of the major contract i. The loss claimed is a direct result from the disparate reporting of the donated major and minor contracts. The major contract in a loss position and the remaining option contracts that are not assigned to the charity are accounted for on Form The remaining option contract positions when closed effectively offset one another. The reporting exclusion of the gain from the donated minor contract, which closely mirrors the loss reported from the donated major contract, creates the artificial loss claimed by the taxpayer.
In these instances, the taxpayer makes an election pursuant to I. The taxpayer is required to attach a verification statement to its filed return for a valid capital treatment election. Gain and loss on options is accounted for on an open transaction basis.
As explained in Notice , the justification for open transaction treatment is that the gain or loss on an option cannot be finally accounted for until such time as the option is terminated. Thus, premium income is not recognized until an option is sold or terminated.
Commissioner , 67 T. However, in other cases where a novation does not occur, the writer of the minor foreign currency option writer may well have a continuing obligation because the writer may be called upon to perform if the charity fails to perform or to reimburse the charity for any losses or expenses it may incur if called upon to perform. Notice It is generally understood that charities that received these options may have terminated them either contemporaneous with or shortly after the assignments.
Even if a novation did not occur to cause premium income to be recognized, there is still no support for the apparent contention that responsibility for recognizing premium income shifts to the charity as a result of the assignment of the obligation on the written option.
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At least some of the tax promotional materials associated with this shelter transaction suggest that the gain or premium income received by the taxpayer on the written option must be recognized by the charity but goes untaxed because of its taxexempt status. Rather, the taxpayers and their advisors seem to simply assume that a taxpayer can receive premium income, pass off the obligation associated with having received that premium and not be taxed on the premium. Nor is there any explanation as to how a charity could be taxed on this premium that the charity does not receive.
See Rev. In these challenged transactions, however, property rights were not transferred — only the obligation associated with the out-of-the money losing purchased option was transferred. The assumption of an obligation is not a donation of property to which I. Rather it is a disposition event governed by I. Crane v. Commissioner , U. If the assumption of the obligation by the charity also involves the donation of associated property, I. Commissioner , F. Thus, to the extent there was a transfer of property along with an associated obligation, the taxpayers were, in general, properly advised in this scheme that their charitable deduction for the donated purchased option rights would be reduced by the amount of liability relief provided by the charity that assumed the obligation on the written minor option.
In short, contrary to the advice apparently received by the taxpayers, there is no factual or legal basis for the contention that taxpayers in these shelters shifted the responsibility for recognizing the premium income or gain on the written minor option position to a charity. Rather, the taxpayers only transferred an obligation and must be taxed on the premium that they retain. A taxpayer did not obtain a timing benefit because section does not permit a taxpayer to recognize loss in advance of gain on the offsetting foreign currency contracts.
For several reasons, this foreign currency shelter transaction did not provide a timing benefit to participating taxpayers.
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As also indicated, a taxpayer will be required to pick up premium income on the minor option at the same time as loss is allowed on the major option under I. That may have occurred in the same tax year as the assignment because the options were short term and are understood to have been closed out by the charities either contemporaneous with or shortly after assignment. However, even if a charity kept open the written option obligation beyond the year of assignment, a taxpayer still would not have obtained an overall timing advantage. As indicated in Notice , the purchased major foreign currency option and the written minor foreign currency option are substantially offsetting positions.
Consequently, such positions were parts of a straddle subject to I. Thus, under I. Under I. See also ACM Partnership v. In this case, the taxpayer has suffered no real economic loss because the acquisition and disposition of the offsetting option contracts constitute an economically inconsequential investment, with the taxpayer effectively in the same economic position as prior to the purported investment strategy less fees paid to the promoter.
See ACM Partnership v. Accordingly, the loss is not allowable under I. Therefore, a loss in this transaction is only allowable for an individual if it is incurred in a transaction undertaken for profit. Commissioner , 82 T. Commissioner , 78 T. Fox v. National Grocery Co. Moreover, any profit generated would likely be derived from the capital that was invested in the hedge fund of funds rather than the small amount of capital used to acquire the major and minor contracts.
Therefore, it is unlikely that a taxpayer can demonstrate a reasonable expectation to earn more than minimal profit solely from the foreign currency investment strategy described above, apart from tax savings. See Knetsch v. United States , F. Therefore, the loss is disallowed under I. In the case of an individual taxpayer, I. Commissioner , 92 T. This interpretation is supported by the legislative history of I.
In this case, I. Amounts protected against loss by nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements, however, are not at-risk. The Senate report promulgated in connection with I. I at 49, 94th Cong. The at-risk rules in I.
I at 48, 94th Cong. The legislative history also provides that in evaluating the amount at-risk, it should be assumed that a loss-protection guarantee, repurchase agreement or other loss limiting mechanism will be fully paid to the taxpayer. Although the foregoing assumption regarding loss-limiting arrangements does not explicitly claim to interpret I. See e. A theoretical possibility of economic loss is insufficient to avoid the suspension of losses. See Levien v. Commissioner , T. The case law, however, is not in complete accord on this issue. In Emershaw v. Commissioner , 91 T.
In contrast, the Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of the arrangements under I. Waters v. The view, as adopted by these circuits, is that, in determining who has the ultimate liability for an obligation, the economic substance and the commercial realities of the transaction control. See Waters v. Commissioner , 94 T. Commissioner , 89 T. Thornock v. To avoid the application of I.
The transaction is carefully structured so that any gain in one option position is largely offset by a loss in another contract. See Knestch v. United States , U. Accordingly, this doctrine is applicable to the typical Notice transaction where the purported tax benefits are unintended by Congress and accomplished by a prearranged deal that serves no economic purpose apart from tax savings.
Tax Terminology
In determining whether a transaction is to be respected for tax purposes, both the objective economic substance of the transaction and the subjective business motivation are considered. ACM Partnership v. Some courts apply a conjunctive analysis that requires a taxpayer to establish the presence of both economic substance i.
See Pasternak v. Other courts apply a less stringent test that either a subjective business purpose or actual economic substance is sufficient. See also Casebeer v.
IRS Tax Laws Regarding Foreign Currency
Commissioner , 69 F. In addition, several courts have applied the economic substance doctrine where a taxpayer was exposed to limited risk and the transaction had a theoretical potential for profit but the profit potential was nominal and insignificant when compared to the tax benefit derived. Gregory v. Helvering , U. See also Compaq Computer Corp v. The doctrine of economic substance should be raised in cases where the facts show that the transaction at issue was primarily designed to generate the tax losses, with little if any possibility for profit, and that such was the expectation of all the parties to the transaction.
The wide variety of facts required to support its application should be developed at examination.