The IRS’s Derivative Treatment of Variable Prepaid Forward Sales
Wealthy clients frequently own an appreciated publicly traded stock that comprises a substantial portion of their investment portfolio. This situation often arises through an initial public offering, a corporate acquisition, an inheritance, or through executive compensation. Retention of a concentrated single stock position entails a significant amount of investment risk. Although a client can sell part or all of that stock and reinvest in a diversified portfolio, many clients will not want to pay the resulting capital gains tax. There are, however, a number of techniques that address the inherent risks with a concentrated stock position including puts, equity collars, exchange funds, loans, and charitable remainder trusts. In addition, a variable prepaid forward sale (VPFS) is a popular technique to monetize and diversify a concentrated position in a publicly traded stock.
Variable Prepaid Forward Sales
There is no single uniform structure for a VPFS, but the investor with the concentrated stock position enters into an agreement with a buyer (often referred to as a “counterparty”) that is typically an investment bank or derivatives dealer. The investor agrees to deliver a variable number of shares of the publicly traded stock to the counterparty at the settlement or exchange date, which is generally three to five years after executing the VPFS documents. These documents consist of a stock purchase agreement, stock pledge agreement, and frequently a share lending agreement. When the documents are executed, the investor receives a nonrefundable cash payment equal to approximately 75 to 85 percent of the current fair market value of the stock. The investor is entitled to retain this cash payment in all events.
The investor also retains a share of the upside position if the stock price subsequently increases. This is reflected by a formula that adjusts the number of shares that the investor must deliver on the settlement date. For example, if the stock price subsequently increases, the investor will be required to deliver fewer shares than if the stock price decreases in value, and vice versa. Pursuant to a stock pledge agreement, the investor transfers into a pledge account the maximum number of shares that could be required to close out the VPFS on the settlement date. The investor often retains the right to close out the transaction on the settlement date with cash or other shares of the same issuer in lieu of the pledged shares.
There are a number of significant nontax benefits associated with a VPFS. First, the investor receives downside protection through the up-front cash payment. This nonrefundable payment allows the investor to monetize the concentrated stock position and then utilize that cash to diversify the investor’s investment portfolio. Additionally, the investor retains a share of the upside position if the stock subsequently appreciates in value. Accordingly, the investor receives downside protection, retains a share of the upside position in the stock, and diversifies his or her investment portfolio.
Additionally, if properly structured, the appreciation in the concentrated stock position is not subject to federal income tax until the transaction is closed out years later on the settlement date. This allows immediate reinvestment of the entire cash payment without reduction for federal income taxes. The problem is that a VPFS can take many forms, and it is frequently unclear whether a particular structure qualifies for income tax deferral. There is very little statutory or case law directly addressing the income tax consequences of a VPFS, and all of the recent guidance comes from the Internal Revenue Service (IRS) in the form of rulings and other pronouncements, including a comprehensive coordinated issue paper released in 2008.
Revenue Ruling 2003-7
Based on the uncertainty surrounding the income tax consequences attendant to a VPFS, tax practitioners were relieved when the IRS issued Revenue Ruling 2003-7.1 There, the taxpayer entered into a VPFS. The taxpayer received a cash payment and in exchange agreed to deliver to the counterparty a variable number of shares of the publicly traded stock, calculated by a predetermined formula. The higher the price of the stock on the settlement date, the fewer number of shares the taxpayer would be required to deliver, and vice versa. The minimum number of shares required to close out the transaction was 80 and the maximum was 100.
The taxpayer pledged 100 shares of stock to secure the counterparty’s position. This constitutes the maximum number of shares deliverable under the sale agreement, which is customary in a VPFS. These shares were pledged by transfer to a third-party trustee. The taxpayer retained the right to vote and receive dividends with respect to the pledged shares. The taxpayer also retained the unrestricted legal right to deliver either the pledged shares, cash, or other shares of the same issuer to close out the VPFS on the settlement date. The taxpayer was not legally or economically compelled to deliver the pledged shares to discharge its obligations pursuant to the VPFS. Clearly, however, the taxpayer planned to deliver the pledged shares to the counterparty to close out the VPFS on the settlement date.
The IRS determined that the taxpayer did not sell the pledged shares pursuant to §1001 of the Internal Revenue Code of 1986, as amended when entering into the VPFS and receiving the cash payment.2 This ruling was based on a number of factors. First, the IRS noted that there was no restriction on the cash payment received by the taxpayer, although this is the case with virtually every VPFS. The taxpayer also retained the right to vote and receive dividends with respect to the pledged shares. Additionally, the taxpayer transferred the pledged shares to an unrelated trustee as escrow agent, and the counterparty did not have access to the pledged shares. Another critical factor is that the taxpayer was not required to close out the transaction with the pledged shares, but retained the unrestricted right (legally and economically) to reacquire the pledged shares on the settlement date by delivering cash or other shares of the same issuer.3
The IRS also determined that I.R.C. §1259 did not trigger a constructive sale.4 This was based on the “significant variation” in the number of shares potentially deliverable on the settlement date. The IRS concluded that a minimum of 80 shares and a maximum of 100 shares required to close out the VPFS on the settlement date constituted a “significant variation.” Accordingly, the VPFS did not constitute a forward contract under I.R.C. §1259(d)(1) and, therefore, did not trigger a constructive sale pursuant to I.R.C. §1259(c)(1)(C). Surprisingly, the IRS did not factor the volatility of the underlying securities into its analysis, a seemingly relevant factor.
The VPFS described in Revenue Ruling 2003-7 did not trigger an actual or constructive sale and, therefore, was not taxable at the outset of the VPFS. As a result, the income tax consequences were deferred for years until the settlement date. Clearly, transactions that comport with the specific parameters of the VPFS described in this ruling will qualify for income tax deferral. The problem, however, is that many of the current VPFS transactions do not conform to Revenue Ruling 2003-7, frequently because counterparties are unwilling to enter into a VPFS on those terms.
In Revenue Ruling 2003-7, the IRS indicated that its conclusion might be different if the taxpayer is legally or economically compelled to deliver the pledged shares rather than exercising a right to close out the transaction in cash or other shares of the same issuer.5 The IRS also stated that a VPFS might be subject to tax at the outset if restrictions are placed on the taxpayer’s right to own the pledged stock.6 These statements served as a precursor of future pronouncements, finally materializing in the issuance of TAM 200604033.
Technical Advice Memorandum 200604033
In Technical Advice Memorandum (TAM) 200604033, the IRS ruled that a VPFS was taxable pursuant to I.R.C. §1001 and common law principals when the parties entered into the transaction, not at the future settlement date.7 There, the taxpayer entered into a VPFS that incorporated a share lending arrangement allowing the counterparty to borrow the stock pledged as collateral. The transaction in TAM 200604033 is extremely complicated and, accordingly, its terms have been greatly simplified for illustrative purposes.
In TAM 200604033, the taxpayer entered into a pledge agreement and deposited with the trustee the maximum number of shares that could be required to close out the VPFS. The pledge agreement granted the taxpayer 1) the right to vote the pledged shares; and 2) the right to dividends paid with respect to the pledged shares. The taxpayer also retained the right to cash settle the transaction in lieu of closing out the VPFS with the pledged shares. The trustee, as directed by the stock pledge agreement, entered into a share lending agreement with the counterparty. Pursuant to this agreement, the counterparty acquired the right to borrow the pledged shares. As is customary with share lending arrangements, the counterparty was obligated to replace the borrowed shares with identical shares of the same issuer prior to the settlement date. The counterparty generally desires access to the collateral so that it can enter into delta hedging transactions to minimize its risk or “long” exposure in the transaction. The share lending agreement granted the counterparty all incidents of ownership in the pledged shares.
The counterparty subsequently borrowed and disposed of the pledged shares in a hedging transaction. Even though the taxpayer possessed the right to cash settle the VPFS, since the counterparty disposed of the pledged stock, the taxpayer could not reacquire the pledged shares. The taxpayer’s ability to reacquire the pledged shares was a significant factor supporting the IRS’s conclusion that the VPFS analyzed in Revenue Ruling 2003-7 qualified for tax deferral. In TAM 200604033, the IRS also concluded that an acceleration provision in the stock purchase agreement effectively allowed the counterparty, and not the taxpayer, to determine which shares are ultimately delivered to close out the VPFS.8
Notwithstanding the taxpayer’s retention of the right to vote and receive dividends with respect to the pledged shares, those rights terminated when the counterparty borrowed and disposed of the pledged shares. The IRS determined that although the taxpayer retained those rights through the pledge agreement, the dividend and voting rights were effectively transferred to the counterparty through the share lending agreement, which was an integral part of the overall transaction. The taxpayer’s right to receive dividend equivalency payments did not alter the IRS’s conclusion in that regard.9
In TAM 200604033, the IRS also analyzed the impact of I.R.C. §1058 on a VPFS. I.R.C. §1058(b) provides that a securities lending arrangement qualifies for nonrecognition treatment if the lender retains a significant risk of loss and opportunity for gain along with the ability to regain possession of the securities at any time. The IRS ruled that I.R.C. §1058(b) did not apply because the taxpayer transferred substantial indicia of ownership in the pledged shares, including the risk of loss and a significant portion of the opportunity for gain. The IRS also determined that it was highly unlikely that the taxpayer could regain possession of the pledged shares. Accordingly, the IRS concluded that I.R.C. §1058 did not apply to defer taxation of the VPFS until the settlement date.10
Finally, the IRS concluded that the open transaction doctrine did not apply to the VPFS.11 The open transaction doctrine defers the tax consequences of a transaction only when it is impossible to determine the value of either asset in the exchange. The shares pledged to secure the counterparty’s position constitute publicly traded stock with a readily ascertainable fair market value. Accordingly, the IRS ruled that taxable gain could be reasonably ascertained at the outset of the VPFS.
Generic Legal Advice Memorandum AM-2007-004
To address any remaining doubt about the IRS’s view on VPFS transactions that incorporate share lending arrangements, the Office of Chief Counsel issued Generic Legal Advice Memorandum AM-2007-004 on February 2, 2007. A generic legal advice memorandum is used to resolve audit issues that impact multiple taxpayers in an industry. These memoranda provide internal legal advice to IRS personnel, but do not constitute law.
The memorandum is very interesting because it addresses the same VPFS analyzed in Revenue Ruling 2003-7, with one critical distinction. The distinction is that the VPFS included a share lending agreement, which was not present in Revenue Ruling 2003-7. Pursuant to that agreement, the counterparty acquired the right to borrow the pledged shares from the third-party trustee. When borrowed, the pledged shares were unrestricted with dividend and voting rights attached, notwithstanding that the pledge agreement granted all dividend and voting rights to the taxpayer. The memorandum then assumes that the counterparty borrowed the collateral from the trustee and immediately sold those shares to a third party.
Consistent with TAM 200604033, the memorandum concluded that the VPFS was taxable pursuant to I.R.C. §1001 as a common law sale at the outset of the transaction and not at the settlement date when finalized.12 Interestingly, the IRS determined that all 100 of the pledged shares were sold even though the counterparty might eventually receive as few as 80 shares when the transaction ultimately settles. The memorandum also distinguished Revenue Ruling 2003-7, which determined that a VPFS was not subject to tax until the settlement date. The stock purchase and stock pledge agreements analyzed in the memorandum and in Revenue Ruling 2003-7 were identical in all relevant respects. The existence of the share lending agreement, the sole factual distinction between the memorandum and Revenue Ruling 2003-7, completely altered the IRS’s analysis of these respective VPFS transactions.
Although the stock purchase and stock pledge agreements technically constitute one transaction and the share lending arrangement constitutes another, the IRS integrated these transactions in its analysis. The IRS noted that the stock purchase agreement and the share lending agreement involved the same parties and shares of stock, and those agreements were directly connected by the stock pledge agreement. The stock pledge agreement instructed the trustee to enter into the share lending agreement with the counterparty. Accordingly, the IRS determined that all of the agreements must be considered together as part of a single transaction to determine the objective economic realities of the VPFS.13
A significant factor distinguishing these transactions is that the taxpayer in Revenue Ruling 2003-7 retained the right to vote and receive dividends with respect to the pledged shares. Another critical factor is that the taxpayer in Revenue Ruling 2003-7 retained the right to settle the transaction in cash or other shares of the same issuer and, thereby, reacquire the specific shares transferred to the trustee pursuant to the pledge agreement. Although the taxpayer in the memorandum retained those same rights through the stock purchase and pledge agreements, the share lending agreement effectively vitiated those rights.
The share lending agreement allowed the counterparty to borrow and then sell or otherwise dispose of the pledged shares as the counterparty desired. The borrowed shares were completely unrestricted, with dividend and voting rights attached. According to the IRS, the counterparty’s sale of the pledged shares effectively terminated the taxpayer’s rights to vote and receive dividends with respect to the pledged shares. Additionally, if the counterparty borrowed and sold the pledged shares, it would be virtually impossible for the taxpayer to reacquire the specific shares pledged as collateral.
Interestingly, the IRS’s conclusion that the VPFS is taxable at the outset is predicated solely on the rights conferred upon the counterparty by the share lending agreement. In the IRS’s view, it is completely irrelevant from a tax perspective whether the counterparty ultimately borrows and disposes of the pledged shares. The mere existence of the counterparty’s right to borrow and dispose of the collateral in an unrestricted manner triggers a taxable event.14
The IRS determined that, when considered together, the underlying VPFS documents shift nearly all of the benefits and burdens of owning the pledged shares to the counterparty at the outset of the transaction.15 This included shifting to the counterparty most of the gain from appreciation in the pledged shares (although the taxpayer retained a portion of the upside appreciation) and all of the risk of loss. Interestingly, that was also the case in Revenue Ruling 2003-7, and there the IRS ruled that VPFS was not taxable until the settlement date.
The memorandum’s adverse conclusion is primarily based on the counterparty’s right to the unfettered use of the pledged shares, which effectively terminates the taxpayer’s right to vote and receive dividends and precludes the taxpayer from reacquiring the specific shares pledged by electing to settle the VPFS in cash or other shares of the same issuer. In the IRS’s analysis, these factors shifted the benefits and burdens of ownership of the pledged shares from the taxpayer to the counterparty, thereby triggering a taxable sale at the outset of the transaction. Additionally, consistent with TAM 200604033, the memorandum concluded that neither I.R.C. §1058 nor the open transaction doctrine applied to defer the tax consequences of the VPFS.16
Coordinated Issue Paper
In the event that tax practitioners still weren’t clear on the IRS’s position regarding a VPFS that includes a share lending arrangement, the IRS reiterated effectively the same analysis and conclusion in Coordinated Issue Paper LMSB-04-1207-077, released February 6, 2008, as it did in TAM 200604033 and the memorandum. As a result, the issue paper is derivative of both TAM 200604033 and the memorandum. A coordinated issue paper provides administrative guidance to the IRS’s field examiners to ensure uniform application of the tax law. Although a coordinated issue paper does not represent an official legal position of the IRS, these releases illustrate the IRS’s thoughts on a particular issue.
The issue paper represents the IRS’s most recent and comprehensive analysis of a VPFS that incorporates a share lending arrangement.There, the taxpayer deposited shares into a pledge account for the benefit of the counterparty. The purchase agreement allowed the counterparty to sell, pledge, rehypothecate, invest, use, commingle, otherwise use or dispose of the pledged shares as well as the right to vote the pledged shares.
The IRS makes it clear that the particular form of the transaction does not govern. The issue is whether the counterparty obtains possession and unfettered use of the pledged shares. Accordingly, the IRS determined, consistent with TAM 200604033 and the memorandum, that the transaction was taxable as a current sale of all of the pledged shares under I.R.C. §1001 when the taxpayer entered into the VPFS.17 A critical factor in determining whether a sale has occurred is whether the benefits and burdens of ownership have passed between the parties. This is a question of fact that must be ascertained by the parties’ intentions as evidenced by the written agreements.
The IRS applied a number of factors to determine whether the benefits and burdens of property ownership pass between parties in a transaction: 1) whether legal title passes; 2) whether an equity interest was acquired; 3) whether the right of possession vests in the purchaser; 4) which party bears the risk of loss regarding the property; and 5) which party receives the profits from the property.18 Specifically, when dealing with stock, the IRS also applied the following factors to determine whether a sale has occurred: 1) which party has the right to vote the shares; 2) which party has the right to receive dividends; and 3) which party has the right to sell the shares.19
After analyzing these factors, the IRS concluded that the benefits and burdens of ownership with respect to the pledged shares shifted from the taxpayer to the counterparty when the parties entered into the VPFS. Accordingly, the IRS’s consistently articulated position is that a VPFS that grants the counterparty possession and unfettered use of the pledged shares is taxable at the outset when the counterparty acquires the legal right to borrow and dispose of the collateral.20 Whether the counterparty eventually borrows and disposes of the pledged shares is irrelevant to the tax consequences of the VPFS.
The IRS then distinguishes the conclusion reached in the issue paper from Revenue Ruling 2003-7. The critical distinctions are that, unlike the issue paper, the taxpayer in Revenue Ruling 2003-7 retained the rights to vote and receive dividends regarding the pledged shares and retained the right to reacquire the specific pledged shares from the third-party trustee (which held legal title and possession of the collateral) by electing to settle the transaction in cash or other shares of the same issuer. In all of its pronouncements, the IRS attaches great significance to the taxpayer’s ability to reacquire the specific shares pledged as collateral. This is interesting since share lending arrangements typically require the counterparty to replace the borrowed shares with identical shares of the same issuer prior to the settlement date. Nevertheless, the IRS draws a sharp distinction between the taxpayer’s ability to reacquire the specific shares pledged as opposed to different but identical shares of the same issuer.
The issue paper once again concludes that neither I.R.C. §1058 nor the open transaction doctrine applies to defer the tax consequences of the VPFS.21 The analysis with respect to those issues is consistent with TAM 200604033 and the memorandum. Finally, the IRS substantially ups the ante by advising practitioners that a wide array of civil penalties might apply to taxpayers who adopt a return position contrary to the issue paper.22
Taxpayers can structure a VPFS that achieves the desired tax consequences by following Revenue Ruling 2003-7. Although this seems like a straightforward alternative, many current VPFS transactions do not comply with Revenue Ruling 2003-7 because counterparties frequently require the right to borrow and sell the pledged shares to hedge their transaction risk. While shares other than the pledged shares can be used to hedge this risk, there is an additional cost associated with this alternative. The counterparty’s sale of the collateral would eliminate the taxpayer’s right to vote and receive dividends on the pledged shares and preclude the taxpayer from reacquiring the specific shares pledged by electing to settle the transaction in cash or other shares of the same issuer.
As a result, the IRS currently treats transactions that provide the counterparty with possession and unfettered use of the pledged shares as a current sale under I.R.C. §1001, thereby eliminating a significant tax benefit of a VPFS. Although TAM 200604033, the memorandum, and the issue paper are not law, and accordingly, do not constitute binding authority, taxpayers adopting a contrary return position should be prepared to challenge the IRS, not only regarding the taxation of a VPFS, but also with respect to the numerous penalties outlined in the issue paper. Accordingly, until there is binding authority to the contrary through a court decision or congressional intervention, practitioners would be wise to exercise extreme caution when structuring and advising clients with respect to a VPFS.
1 Rev. Rul. 2003-7, 2003-1 C.B. 363. Prior to the issuance of Revenue Ruling 2003-7, the IRS released a number of field service advisories concluding that a transaction similar to a VPFS was not taxable until the settlement date. See FSAs 200131015, 200130010, and 199940007. But see FSA 200111011 for a contrary result.
2 Rev. Rul. 2003-7, 2003-1 C.B. at 365.
3 See TAM 200341005 for a VPFS that complied with Revenue Ruling 2003-7 when the taxpayer could elect to settle the transaction in cash but not with other shares of the same issuer.
4 Rev. Rul. 2003-7, 2003-1 C.B. at 365.
5 Id. at 364.
6 Id. at 364-365.
7 See also Hope v. Commissioner, 55 T.C. 1020 (1971), aff’d, 471 F.2d 738 (3d Cir. 1973), cert. denied, 414 U.S. 824 (1973). Although Hope did not analyze a VPFS, it addressed similar tax principals.
8 TAM 200604033 at 13.
9 Id. at 12.
10 Id. at 13-14.
11 Id. at 14.
12 Generic Legal Advice Memorandum AM-2007-004 at 4 (February 2, 2007).
13 Id. at 5-6
14 Id. at 4.
16 Id. at 7-8.
17 Coordinated Issue Paper LMSB-04-1207-077 at 2 (February 6, 2008).
18 Id. at 3, citing Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237-1238 (1981).
19 Id. at 5, citing Hall v. Commissioner, 15 T.C. 195, 200 (1950), aff’d, 194 F.2d538 (9th Cir. 1952).
20 Id. at 6.
21 Id. at 7.
William R. Swindle is the national tax director and a senior vice president with Wachovia Wealth Management. He is board certified in taxation and wills, trusts, and estates. Mr. Swindle received his J.D. and LL.M. in taxation from the University of Florida. He frequently publishes and lectures on tax and estate planning matters.
The opinions expressed herein are solely those of the author and do not necessarily reflect those of Wachovia Bank, N.A.
This column is submitted on behalf of the Tax Section, Edward E. Sawyer, chair, and Michael D. Miller and Benjamin A. Jablow, editors.