Tax Court warns 70/30 basket swaps may not protect tax benefits

A basket swap is a derivative tied to a group of stocks rather than a single stock. Under the section 246 regulations, a position tied to a portfolio of at least 20 unrelated issuers generally is treated as substantially similar or related property (SSRP) when it substantially overlaps the investor’s own holdings. The overlap is substantial when it reaches 70% or more. That threshold gives the strategy its name; the basket swap is structured so that less than 70% overlaps the investor’s stocks and more than 30% reflects other stocks or market indices.

The intended result is that the investor keeps the stock but uses the swap to reduce downside risk. Tax benefits related to stock ownership are intended to remain unimpeded by the swap.

To qualify for tax benefits related to stock ownership, several tax rules require the investor to retain meaningful market risk. The principal benefits at issue in SIH Partners were:

• Qualified dividend income (QDI): Non-corporate taxpayers may pay tax on qualified dividends at lower capital gain rates, but only if the applicable holding period requirement is met.
• Foreign tax credits (FTCs): Foreign withholding tax on dividends may generate a credit, but the recipient must satisfy a holding-period requirement.

The applicable holding period rules generally disregard days on which the taxpayer’s risk of loss is reduced by a position in SSRP.

Therefore, the appeal of a 70/30 basket is that it appears to reduce risk without crossing a bright-line threshold. However, the Tax Court’s decision makes clear that a strategy designed around the threshold may still fail if the overall economics trigger the anti-abuse rule.

For a qualifying portfolio, the mechanical test generally looks to whether 70% or more of the position overlaps the taxpayer’s stockholdings. A basket below that threshold generally is tested as one instrument rather than as a collection of single-stock hedges, and therefore is not SSRP. But the regulations also contain an anti-abuse rule that can treat the position as SSRP even when the mechanical threshold is not met. See Reg. section 1.246-5(c)(1)(iii), (vi).

The anti-abuse rule focuses on the substance of the position and the purpose of the plan. It can apply when:

• Changes in the position, or in the stocks it reflects, are reasonably expected to track—directly or inversely—all or part of the taxpayer’s stockholdings.
• The position is part of a plan whose principal purpose is to obtain tax savings that significantly exceed the expected pretax economic profit.

SIH Partners purchased stock in four Swiss companies—Nestlé, Novartis, Roche and Swisscom—and entered into a portfolio swap with Morgan Stanley. The swap created identical short exposure to those four stocks, plus short exposure to market indices intended to provide broader downside protection. SIH Partners received dividends on the Swiss stocks and made substitute-dividend payments to Morgan Stanley under the swap.

For 2012, SIH Partners reported more than $170 million of dividend income as QDI and claimed FTCs exceeding $25 million. The IRS challenged both benefits.

The taxpayer won on the first issue, the mathematical 70% test. On the relevant 2012 testing date, the overlap was about 64%, so the swap passed the regulation’s mechanical 70% substantial-overlap test.

The court also refused to split the basket into separate swaps under substance-over-form principles as the IRS had requested, ruling that the nonoverlapping portion had a real business purpose because it provided protection against a broader market decline.

But the taxpayer lost under the anti-abuse rule. Rather than compare the swap as a whole with the stocks generating dividends, the court focused on the short positions tied to the four Swiss stocks. Those positions were an exact inverse of the taxpayer’s long positions—a “100 percent hedge,” in the court’s words—and were reasonably expected to track them.

The court also found that the expected tax savings significantly exceeded the expected pretax economic profit.

After considering pre- and post-transaction analyses of the transaction's expected returns and costs, the court concluded that the expected pretax result ranged from a loss to a profit of about $2.4 million, compared with anticipated tax savings of roughly $25 million.