For years, many fund managers and tax advisers viewed the 70/30 basket swap, a derivative that references a basket of securities rather than a single position, as a reliable way to manage investment risk while preserving the intended tax treatment of the underlying positions. The premise was straightforward: if a basket derivative was constructed to reference at least 20 unrelated issuers and the taxpayer’s physical holdings represented less than 70% of the basket, the position generally would not be treated as substantially similar or related property (SSRP) under the mechanical substantial-overlap test in Treasury Regulation Section 1.246-5.
That assumption deserves a fresh look after the U.S. Tax Court’s decision in SIH Partners LLLP v. Commissioner, 167 T.C. No. 8, filed August 6, 2026.
In SIH Partners, the taxpayer acquired Swiss equities and simultaneously added short exposure to those same securities through a larger portfolio swap. The taxpayer designed the structure to pass the regulation’s mechanical, substantial-overlap test. The court respected the portfolio swap as a single instrument and declined to disaggregate it into individual short positions. Even so, the taxpayer lost its desired tax treatment (i.e., qualified dividend income treatment and foreign tax credits) because the court applied the regulation’s separate anti-abuse rule.
The anti-abuse rule asks two questions: whether the derivative is reasonably expected to virtually track the relevant stock holdings, directly or inversely, and whether the position is part of a plan whose principal purpose is to generate tax benefits that significantly exceed the expected pre-tax economic profit. The court concluded that both requirements were met. Most notably, it found the virtual tracking requirement satisfied because the basket contained short positions in the same Swiss securities held by the taxpayer. Rather than comparing the performance of the basket swap as a whole to the taxpayer’s individual long stock positions, the court focused on the overlapping securities within the basket. This aspect of the opinion has generated significant discussion among practitioners, some of whom view the court’s approach as effectively disaggregating the basket for purposes of the anti-abuse rule after having earlier respected the basket as a single financial position. The court concluded that the estimated tax savings of approximately $25 million significantly exceeded the expected pre-tax profit, which the court placed between zero and $2.4 million.
The decision does not mean that every portfolio hedge fails. It does, however, make it harder to pass the 70% portfolio overlap test and anti-abuse rules. Mechanical compliance is still relevant, but it may not protect a transaction when a portfolio hedge closely offsets the fund’s actual holdings and the tax savings significantly outweigh the expected pretax economic profit. Funds using basket swaps or similar portfolio derivatives to hedge individual stock positions should revisit both the composition and intention of their hedges.
Funds with potentially affected positions should coordinate with their tax and legal advisers to evaluate the specific facts, refresh the economic analysis and determine whether any reporting, documentation or year-end planning action is appropriate.
Important notice: This article is for general informational purposes only and is not intended as tax or legal advice. The application of the decision depends on the facts and circumstances of each transaction.
For more information on this topic, please contact a member of our team.
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