ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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II.
BACKGROUND
This chapter provides an overview of the nature, mechanics, and tax and securities
implications of derivatives, options, and basket options. It also reviews key tax principles and
provisions, a 1999 statutory change that attempted to stop option abuses, and the IRS’ decisionmaking
related to basket options.
A. General Description of Derivatives
A financial “derivative” is a broad term covering a variety of different financial
instruments, all of which share the common property that their value is dependent upon an
underlying asset. 4 Derivatives can take numerous forms, including options, swaps, futures,
forwards, structured debt obligations, and others. 5 Derivatives can also be traded in two
different ways: some are traded through standardized instruments over exchanges, while others
are traded privately through individualized contracts, also called “over- the-counter,” “bilateral,”
or “bespoke” derivatives. 6
Derivatives can be used to trade for profit, alter the risk-reward profile of some other
asset, or make risky and sometimes leveraged bets on the future value of equities, options, bonds,
interest rates, companies, or even financial markets as a whole. 7 Also, they are often used by
large banks to hedge or reduce financial risks related to a variety of complex transactions. 8
Derivatives can also be designed to operate in tandem, and combinations of options, forwards,
swaps, or more esoteric transactions can be used to engineer economic returns equivalent to any
single derivative or to ownership of the underlying positions. 9
(1) Taxes, Leverage Limits, and Transparency Problems
A derivative is, in essence, a financial bet. In many cases, it allows the derivative holder
to obtain the same economic effect as if the holder owned the relevant financial instrument, such
as a bond or shares of stock. However, instead of owning the instrument, the derivative holder
can derive value by referencing the instrument and bet that it will go up or down in value.
Economically identical positions may sometimes be treated differently for tax purposes
depending upon the nature of the financial instrument at issue. Derivatives can enable a taxpayer
to elect a form of ownership that defers payment of taxes and characterizes income in the form
4 12/2/2011 “Present Law and Issues Related to the Taxation of Financial Instruments and Products,” prepared by
the Joint Committee on Taxation, JCX-56-11, at 7,
https://www.jct.gov/publications.html?func=startdown&id=4372.
5 1/1/1997 “Risk Management of Financial Derivatives,” Comptroller’s Handbook, at 1,
http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/deriv.pdf.
6 Id.
7 12/2/2011 “Present Law and Issues Related to the Taxation of Financial Instruments and Products,” prepared by
the Joint Committee on Taxation, JCX-56-11, at 7–8,
https://www.jct.gov/publications.html?func=startdown&id=4372.
8 1/1/1997 “Risk Management of Financial Derivatives,” Comptroller’s Handbook, at 1,
http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/deriv.pdf.
9 12/2/2011 “Present Law and Issues Related to the Taxation of Financial Instruments and Products,” prepared by
the Joint Committee on Taxation, JCX-56-11, at 44
https://www.jct.gov/publications.html?func=startdown&id=4372.