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Tax Court: Variable Prepaid Forward Contract + Stock Loan = Sale

Client Advisory

July 30, 2010

In a much-anticipated decision, the Tax Court has held that a taxpayer who entered into a variable prepaid forward contract and a related stock loan with the same counterparty had in substance sold the underlying securities as a matter of tax common law.[1]   The taxpayer has already signaled that he will appeal. 

Like many investors and executives a decade ago, Philip Anschutz[2] was holding some very highly appreciated securities, which he wished to monetize on a tax-free basis. One popular method was a prepaid variable forward contract (or "PVFC," in the Tax Court's discussion), in which the investor agreed to the future sale of shares, in return for an upfront cash payment from the counterparty (generally an investment bank or other financial institution). The investor was permitted to satisfy its obligation by the future delivery of shares or cash. Under well-established case law and rulings, a taxpayer has not sold (for tax purposes) fungible securities until he delivers shares from his long position. So a forward contract, even a prepaid forward contract, of securities is not a "sale" under IRC Section 1001. 

The "variability" was necessary, however, to avoid a "constructive sale" under Section 1259, enacted in 1997. The number of shares actually deliverable (or the amount of cash) varied, within a range, depending upon the future performance of the stock in question. In Revenue Ruling 2003-7 the IRS blessed this type of transaction. The ruling stated that a variable prepaid forward contract would not be considered a current sale under Section 1001 or a constructive sale under Section 1259, provided the taxpayer retained a sufficient degree of exposure to future fluctuations in the value of the underlying shares. It also permitted a pledge of the taxpayer's long position (to the extent of the maximum number of shares deliverable) to its counterparty, as long as the taxpayer had the legal ability and financial wherewithal to substitute other collateral and ultimately to satisfy its obligations under the contract with cash or other property.  

The IRS ruling did not discuss the possibility of a stock loan from the taxpayer to the counterparty. In fact, such loans were quite common, as they reduced the effective cost of the transaction.[3] In late 2005, the IRS first indicated that it would challenge transactions that included a stock loan element. Anschutz is the first court case to decide this issue. The IRS appears to have been clever in choosing to litigate this case first, as there are a number of peculiarities that make it a more difficult one for the taxpayer.

In a securities loan, the lender delivers title to securities to the borrower, which gains the right to sell the shares to third parties. The borrower is obligated, however, to return identical securities upon the demand of the lender, and to make dividend equivalent payments in the interim. It is clear that a lender of securities is no longer the tax owner of such securities, even though he retains full economic exposure. Section 1058 provides that a securities loan will nevertheless NOT be treated as a taxable event if four conditions are satisfied. One such condition is that the agreement must "not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred."[4] 

The core question faced by the Tax Court in Anschutz was whether the PVFC and the stock loan should be "integrated," as maintained by the IRS. The taxpayer argued that its obligations under the PVFC and the stock loan were "substantively independent and separable." Judge Goeke agreed with the IRS, however, that the two elements should be integrated, with the result that (i) the securities loan failed Section 1058 because the lender's risk of loss was diminished by the PVFC,[5] and (ii) the transaction viewed as a whole constituted a sale for tax purposes. 

Without belaboring the technical tax issues, we believe that the standard applied by the Tax Court to integrate the two elements was insufficiently articulated and in effect too low. The opinion states, for example, that the share lending was "contemplated" and a "vital part" of the transaction. In contrast, in Rev. Rul. 2003-7 itself, and again in Rev. Rul. 2003-97 (the "Feline PRIDES" ruling), the IRS applied an "economic compulsion" standard. Even though the taxpayer in Anschutz was required to and did deliver shares pursuant to the stock loan agreement, he was able (both legally and economically) to recall such shares.[6] According to the Tax Court, the PVFC and stock loan were "related. One could not occur without the other." But this does not appear to be true, even in the decided case; the terms may have differed somewhat, but they could have occurred without each other. Indeed, PVFCs and stock loans often do occur without each other. For this and other reasons, the Tax Court's decision in Anschutz is unlikely to be the final word.


Questions regarding this advisory should be addressed to Howard J. Barnet, Jr.  (212-238-8606, barnet@clm.com) or Dan Pittman (212-238-8854, pittman@clm.com).


Endnotes


[1] Anschutz Co. v. Comm'r, 135 T.C. No. 5 (July 22, 2010).  

[2] The appreciated securities were actually held by an S corporation wholly owned by Mr. Anschutz.

[3]   In general, the counterparty hedges its exposure under the variable prepaid forward, and raises cash, in large part by entering into a short sale of the underlying stock.  For this it needs to borrow shares, which carries a cost.

[4] Section 1058(b)(3).

[5] Proposed regulations seemingly interpret Section 1058(b)(3) to be satisfied if the lender has the right to terminate the loan on five days' notice, and the same Tax Court in Samueli v. Comm'r, 132 T.C. No. 4 (2009) held that the absence of such right meant that the loan failed to qualify, but that is not how it has now been interpreted by Judge Goeke (without discussion).

[6]   It is more customary for the investor to have the option to lend shares to his counterparty. The IRS has made clear its view that these distinctions are not material (see Coordinated Issue Paper LMSB-04-1207-077 (February 6, 2008)), but it is not at all clear that Judge Goeke would agree.



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. © 2017 Carter Ledyard & Milburn LLP.
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