Tax Relief Blog
IRS gets tougher on variable prepaid forward contracts with share lending arrangements Variable Prepaid Forward Contracts Incorporating Share Lending Arrangements
An IRS coordinated issue paper for all industries concludes that variable prepaid forward contract (VPFC) transactions that incorporate a share lending or similar agreement permitting the counterparty to borrow or dispose of the pledged shares results in a current taxable sale of the underlying stock.
Observation: VPFCs are sophisticated tools used by wealthy individuals with large stock gains who want to cash out some of their shares but defer the tax until a later year.
Observation: In Rev Rul 2003-7, 2003-5 IRB, IRS OK’d deferral for a “plain vanilla” VPFC. When taxpayers and their advisers tried to push the envelope with hedging and borrowing add-ons, IRS countered with PLR 200604033. Then, in EMISC 2007-004, IRS gave its personnel the legal ammunition to stop a variation with a share lending agreement it considered over-the-line. Now IRS has continued its crackdown on VPFCs coupled with share lending agreements, instructing agents to consider whether such transactions are subject to hefty accuracy related penalties.
Facts. The taxpayer owns appreciated stock in a publicly traded corporation. To monetize its position the taxpayer enters into a VPFC through a stock purchase agreement (SPA) with an investment bank (the counterparty). In exchange for an up-front cash payment, which generally represents 75% to 85% of the current fair market value of the stock, the taxpayer agrees to deliver a variable number of shares at maturity (typically three to five years). The VPFC usually has a cash settlement option in lieu of delivering the underlying shares at maturity. The purported economic benefits of the VPFC structure are:
(1) downside protection represented by the amount of the unrestricted payment to the taxpayer,
(2) limited upside growth participation as reflected by the maximum share value price,
(3) the potential for diversification by reinvesting the up-front cash advance, and
(4) tax deferral of the gain to the maturity date of the VPFC.
Under the terms of the SPA, the taxpayer must deposit the maximum number of shares that may be delivered under the VPFC into a pledge account and grant the counterparty a security interest in the pledged securities. The parties to the pledge agreement are the taxpayer (as pledgor) and the counterparty (as pledgee). In most instances, the SPA will contain a provision that allows the counterparty to hedge its position under the VPFC by giving it the right to sell, pledge, rehypothecate, invest, use, commingle or otherwise dispose of, or otherwise use in its business the pledged securities. During the life of the SPA, the counterparty has the right to transfer and to vote the pledged shares but may be required to pay certain distributions received on the pledged shares to the taxpayer.
Variations. IRS has also identified similar transactions with the following variations (VPFC transactions):
(1) The taxpayer enters into a VPFC through a SPA and executes a separate pledge agreement. After these agreements are finalized, the original pledge agreement is amended. The Amended & Restated Pledge Agreement includes a rehypothecation clause, which allows the secured party, upon consent of taxpayer, to sell, lend, pledge, invest, commingle or otherwise dispose of the pledged shares.
(2) The taxpayer enters into a SPA that includes a pledge/security interest provision and at a later date (usually within 90 days following the VPFC) executes a separate share lending agreement.
(3) The taxpayer enters into a VPFC through an International Swaps and Derivatives Association (ISDA) Master Agreement and an ISDA Credit Support Annex, which allows the counterparty the right to rehypothecate, sell, dispose of or use the pledged shares.
(4) The taxpayer enters into a VPFC through a SPA, executes a Letter and Confirmation (L&C) Agreement and then later a Rehypothecation Agreement pursuant to the terms of the L&C Agreement.
(5) The stock is placed, as security, with the counterparty or its subsidiary, but with a standard margin/broker agreement which confers upon the counterparty the rights to register the stock in its own name and to rehypothecate, sell, dispose, or use the pledged shares.
(6) The taxpayer contemporaneously deposits a sufficient amount of the same stock in another account and this stock is borrowed to close the counterparty’s short sale.
IRS notes that, regardless of the particular version, all of these VPFC variations share the following common characteristic: the counterparty, via a share lending agreement or through some other contractual arrangement, obtains the unfettered use of the pledged shares. IRS says that because the determination of whether a sale occurred for federal income tax purposes is based upon the facts and circumstances of a particular case, it is possible that a transaction will result in a sale even though it does not have all the facts set forth in the new coordinated issue paper.
Transactions result in sale. The coordinated issue paper reaches the following conclusions with respect to these transactions:
(1) There is a current sale for federal tax purposes of the underlying stock when a taxpayer enters into a VPFC transaction that includes a share lending arrangement with the counterparty.
+ These VPFC transactions result in a current sale under common law principles, i.e. transfer of ownership because the taxpayer does not retain, and the counterparty acquires, substantial indicia of ownership (including most of the risk of loss and opportunity for gain).
+ Rev Rul 2003-7 is not controlling as the VPFC transactions identified above are distinguishable from the facts described in that ruling. Most significantly, the counterparty in VPFC transactions acquires possession and unfettered use of the pledged shares.
+ The open transaction doctrine is inapplicable since the pledged shares are publicly traded and their value is easily ascertainable.
+ Nonrecognition treatment under Code Sec. 1058 is not appropriate since the VPFC transaction and share lending arrangement effectively eliminates the risk of loss with respect to the pledged shares. Under Code Sec. 1058 , no gain or loss is recognized when an owner transfers securities for the contractual obligation of the borrower to return identical securities. The securities must be lent under an agreement that: provides for the return to the lender of identical securities; requires that payments be made to the lender in amounts equal to the interest, dividends, and other distributions that the owner of the securities is entitled to receive because of ownership during the period that the loan is outstanding; doesn’t reduce the lender’s risk of loss or opportunity for gain as to the transferred securities; and meets any other requirements specified by regs.
(2) Depending on the facts of each VPFC transaction and the year in question, IRS agents are instructed to consider asserting (a) the accuracy-related penalty on underpayments attributable to a substantial understatement of income tax under Code Sec. 6662 , and (b) the accuracy-related penalty on reportable transaction understatements under Code Sec. 6662A .
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