Caution Flag for Forward Contracts Coupled with Securities Loans
Client Advisory
Earlier this week the Internal Revenue Service released a much-anticipated Technical Advice Memorandum taking the position on audit that a taxpayer who entered into a variable pre-paid forward contract (VPFC) with respect to shares of a publicly traded company had engaged in a taxable sale of such shares because, as part of “one whole, continuous transaction,” the taxpayer not only pledged but also loaned the underlying shares to its counterparty under the VPFC, and the counterparty sold the shares in the market.
Since the enactment in 1997 of the Section 1259 constructive sale rules (rendering “short against the box” transactions taxable), “variable pre-paid forward contracts” have become a heavily utilized technique, allowing a taxpayer who holds a large position in low-basis securities of one issuer to hedge against a significant decline in the value of the shares, and also raise funds to be used for diversification, without paying capital gains tax. In exchange, the taxpayer gives up most of the up-side potential of the same shares. In Revenue Ruling 2003-7, the IRS blessed the basic VPFC transaction as not causing a taxable disposition.
Assume a taxpayer, T, is long 100,000 shares of XYZ corporation, which trade at $100 per share, but for which T has a very low basis. T enters into a VPFC with a counterparty, often an investment bank or brokerage firm. Details of the agreements vary from one financial institution to another, and even from transaction to transaction. Generally, however, T agrees to sell to the counterparty, on a specified future date, a variable number of XYZ shares. The counterparty pays for the shares today, at a discount to reflect the time value of money. The number of shares to be delivered by T to the counterparty at the future date depends on the price of the XYZ shares on such future date. The more they are worth, the fewer shares T must deliver, and the less they are worth, the more shares T must deliver, but within limits, so that under no circumstances will T be required to deliver more than 100,000 shares or fewer than, say, 80,000 shares. T pledges its 100,000 XYZ shares to secure its obligation to perform at settlement. (Most VPFCs can also be settled by the delivery to the counterparty of the cash equivalent of the shares otherwise deliverable.) The IRS confirmed in Rev. Rul. 2003-7 that, given sufficient variability in the number of shares (or the amount of cash) deliverable, the transaction does not result in a constructive sale under Code Section 1259. Equally important, the IRS ruled on the facts of the published ruling that T remained the owner of the XYZ shares under general tax principles. This latter ruling was based to some extent upon the premise that T had the legal right and the practical ability at settlement to retrieve the pledged XYZ shares which it had historically owned, and to deliver either cash or other XYZ shares, as well as T’s right to vote the shares and receive dividends.
In the new Technical Advice Memorandum (200604033), the IRS argues that a loan, coupled with a sale of those shares by the counterparty, dictates a different result. The taxpayer had lost the right to vote and receive dividends on the loaned XYZ shares, and there was no practical way that the taxpayer could retrieve the “same” old XYZ shares. The fact that a securities loan by itself does not constitute a disposition of securities under Section 1058 did not avail the taxpayer.
The TAM actually reviews a number of VPFCs, each tranche occurring under essentially the same documentation, with the same counterparty. The IRS and the taxpayer in the TAM seem to differ on just how close a connection there was between the VPFC and the securities loan in each case. In general, the bank or other financial institution will naturally hedge its exposure under the VPFC, which is essentially a long position in the shares in question, by selling short in the market. To do that, the counterparty has to borrow shares. At best, it will cost the counterparty some money to borrow the shares in the market, and of course the counterparty’s cost will be passed along to T. At worst, it may be difficult to borrow the shares at all. In either case, T and the counterparty may agree that T may or must lend the shares to the counterparty, either immediately or later. In the TAM, the IRS concludes that the taxpayer was contractually required to make the loan, and that it occurred “promptly” upon the execution of the VPFC. Other details of the transactions appear to have been unfavorable, as well. For example, the taxpayer’s right to settle in cash was apparently absent in at least some of the tranches.
As news of the TAM has leaked out, practitioners have expressed disappointment that the IRS had not previously indicated that a securities loan, which in some form or another is part of many VPFC transactions, might make the transaction taxable. Rev. Rul. 2003-7 contains no mention of a securities loan. This silence was interpreted by some as indicating that a securities loan would not be a relevant factor; recently, however, an IRS spokesman suggested that the omission from the 2003 ruling rather may have reflected ignorance on the part of the drafters that such loans were common. The IRS’s position in the TAM is likely to lead to litigation. Clearly, however, it would be prudent at this juncture to exercise caution before entering into VPFCs that involve a loan of the underlying shares.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
© 2008 Carter Ledyard & Milburn LLP.
© Copyright 2006