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IRS starting to challenge popular tax deferral technique.

A recent article in Forbes magazine refers to it as a "tax trick" and a "kinky forward" contract. (1) In particular, the article describes a transaction entered into in January 1998 by Bobby Stevenson, CEO of Ciber, Inc., in which he received $82 million in cash up front from Merrill Lynch in exchange for his agreement to deliver a certain number of his Ciber shares by Feb. 1, 2001. It was supposed to be a great deal for Stevenson, whose stock has fallen more than 80 percent since he received the cash, as he locked in the gain in his Ciber shares before the stock market crashed in March 2000, but would not be subject to tax on this gain until he delivered the shares in 2001. The IRS, however, is now claiming that Stevenson owes taxes on the $82 million gain dating back to the 1998 taxable year. (2) The transaction described in the article is commonly referred to as a variable prepaid forward contract (VPFC).

In general, a VPFC is a privately negotiated agreement between an individual taxpayer who owns shares of appreciated stock and a counterparty (i.e., a commercial or investment bank). The individual receives an up-front cash payment from the bank equal to the present value of the forward delivery price in exchange for the obligation to deliver to the bank a variable number of shares of the underlying stock on the contract's maturity date. Typically, these contracts are entered into by individuals who have a concentrated stock position in their own company and are still bullish on the company, but want to generate liquidity so they can diversify their portfolio without triggering a current income tax liability on the appreciation in the shares.

Given that the number of shares ultimately required to be delivered on the maturity of the VPFC will depend upon the value of the underlying stock at that time, it is generally thought a VPFC does not constitute a "forward contract" under [section] 1259(d)(1) (3) (i.e., a contract to deliver a substantially fixed amount of property for a substantially fixed price), and thus, does not give rise to a constructive sale of the underlying shares of stock under [section] 1259. Recently, however, as indicated by several field service advisories (4) (FSAs) (and the Stevenson case), the IRS is starting to challenge these types of transactions. (5) For example, in FSA 200111011, the IRS determined under common law principles that taxpayers sold shares of appreciated stock when' they entered into a derivative product that is similar economically to a VPFC because, among other things, the taxpayers did not have the option to cash-settle the contract. Similarly, in both FSA 200131015 and FSA 200150012, the IRS stated that a derivative product that is also similar economically to a VPFC could be analyzed as a cash-settled collar in addition to a prepaid forward contract. As such, it may not be sufficient, in order to avoid constructive sale treatment, to simply rely on the fact that a VPFC does not satisfy the specific definition of a forward contract.

Economics of a VPFC

The economics of a VPFC can best be illustrated by way of an example. Assume individual taxpayer Aidan is the chief executive officer of Oliver, Inc., a company that went public a little more than one year ago. Aidan currently owns 400,000 shares of Oliver, Inc. stock with a cost basis of $5 per share. The shares of Oliver, Inc. are presently trading at $100 a share. Consequently, the market value of Aidan's interest in Oliver, Inc. is worth $40 million, an amount which represents approximately 25 percent of his net worth.

While Aidan still believes in Oliver, Inc. and, therefore, does not want to sell his shares, he recognizes this position represents too high a percentage of his net worth. Moreover, Aidan wants to generate liquidity so he can invest in other stocks and diversify his portfolio, but he does not want to currently pay tax on the $38 million of built-in gain in the Oliver, Inc. shares.

Accordingly, Aidan enters into a five-year VPFC with Big Bank, a large commercial bank, involving 200,000 of his 400,000 shares of Oliver, Inc. (6) The contract is structured with a minimum share value of $100 per share (i.e., 100 percent of the current market value of the Oliver, Inc. shares) and a maximum share value of $120 per share (i.e., 120 percent of the current market value of the Oliver, Inc. shares). Aidan will keep 25 percent of any appreciation beyond the $120 per share. At the inception of the contract, Big Bank will pay to Aidan 75 percent of the current market value of the Oliver, Inc. shares involved in the transaction (i.e., $15 million), an amount which represents the present value of $20 million discounted back five years from the contract's maturity date. (7) The difference between the $20 million current market value of the Oliver, Inc. shares involved in the transaction and the $15 million up-front payment from Big Bank represents the cost of entering into the transaction (i.e., the implied financing cost).

As security for his obligation to deliver a certain number of his Oliver, Inc. shares to Big Bank on the contract's maturity date, Aidan is required to pledge his shares of Oliver, Inc. stock to Big Bank as collateral. When the contract matures, Aidan has the option to either "physically settle" the contract (i.e., deliver a certain number of the Oliver, Inc. shares to Big Bank) or "cash settle" the contract (i.e., deliver the cash equivalent of a certain number of Oliver, Inc. shares to Big Bank).

By entering into the VPFC, Aidan has in effect agreed to sell a certain number of his Oliver, Inc. shares to Big Bank, the exact number of which will depend upon the value of the stock's trading value when the contract matures. In exchange for agreeing to deliver a certain number of Oliver, Inc. shares, Big Bank will pay to Aidan $15 million today and will ask for $20 million (or more) on the contract's maturity. As a result of the up-front cash payment, Aidan essentially is protected against any decline in the stock's $100 current trading value (less the implied financing cost of entering into the transaction) over the term of the contract. Moreover, he will participate fully in any growth in the stock up to $120 (i.e., 20 percent) a share and 25 percent in any growth thereafter.

At the end of the five-year period, if the Oliver, Inc. shares are trading below $100 per share, Aidan can satisfy its contractual obligation by delivering all 200,000 shares of Oliver, Inc. stock, or the cash equivalent, to Big Bank, notwithstanding that the shares of Oliver, Inc. stock may be worth less than $20 million. If at the end of five years, Oliver, Inc. is trading somewhere between $100 and $120, Aidan can settle the contract by delivering the number of shares necessary to generate $20 million, or the cash equivalent, and thus participate fully in any appreciation up to $120 per share. For example, if the stock is trading at $110 a share, Aidan could settle the contract by delivering 181,818 of the 200,000 shares (i.e., 181,818 shares times $110 per share equals $20 million). (8) If, however, Oliver, Inc. is trading at $120 or more at the end of five years, given that Aidan participates in 25 percent of any growth in the value of the Oliver, Inc. stock above $120 a share, Aidan can settle the contract by delivering only 75 percent of the shares. Therefore, if at the end of five years Oliver, Inc. is trading at $130 a share, Aidan can settle the contract by delivering 150,000 shares of Oliver, Inc. stock, or the cash equivalent (i.e., $19.5 million), and keep 25 percent, or 50,000 of his shares.

Is There a Sale of the Underlying Shares of Stock?

Clearly, the most significant perceived income tax benefit of entering into a VPFC is the ability to defer the payment of taxes on the appreciation in the underlying shares of stock and at the same time receive an up-front cash payment that should not be subject to current U.S. federal income tax. In order for this goal to be achieved, the taxpayer must not be treated as constructively selling the underlying shares when it enters into the VPFC.

In 1997, [section] 1259 was enacted to prevent taxpayers from entering into transactions that allowed them to substantially reduce or eliminate their risk of loss (and opportunity for gain) without causing a taxable disposition for U.S. federal income tax purposes. Under [section] 1259, a taxpayer who holds an appreciated financial position will be deemed to sell such position if the taxpayer: 1) enters into a "short sale" of the same or substantially identical property; 2) enters into an offsetting notional principal contract with respect to the same or substantially identical property; 3) enters into a futures or forward contract to deliver the same or substantially identical property; or 4) enters into a transaction having "substantially the same effect" as the three previously mentioned transactions. If [section] 1259 applies, the taxpayer will be treated as if he or she sold the underlying shares and then immediately reacquired them with a new holding period.

As stated above, since the enactment of [section] 1259, it has been thought that a VPFC does not give rise to a constructive sale of the underlying shares of stock because it does not meet the definition of a forward con' tract under that section (i.e., a contract to deliver a substantially fixed amount of property for a substantially fixed price). (9) This is based on the fact that the number of shares required to be delivered on the maturity of the contract will depend upon the value of the underlying stock at that time. Further support for this position is grounded on the legislative history of [section] 1259, which provides "a forward contract providing for delivery of an amount of property, such as shares of stock, the amount of which is subject to significant variation under the contract terms does not result in a constructive sale." (10) As to what constitutes a "significant variation" is not clear.

As also stated above, however, several recent FSAs indicate that a number of other factors may need to be taken into account when a taxpayer enters into a contract similar to a VPFC to ensure a sale of the underlying shares does not arise.

FSA 200111011

In FSA 200111011, two shareholders owned the majority of stock in a privately held. corporation. The shareholders also owned, through separate flow-through conduit entities, a controlling interest in a publicly traded corporation ("Public Corp."). The shareholders sought to raise capital for the privately held corporation by selling a minority interest in Public Corp., but did so by selling derivative securities tied to the market performance of Public Corp. Neither shareholder reported gain in connection with this transaction on their respective U.S. federal income tax returns in the year of issuance.

The derivatives were registered on an exchange and issued by an independent trust that was characterized as a grantor trust for U.S federal income tax purposes. The trust's assets consisted of zero coupon Treasuries with staggered maturities and agreements from the conduit entities to provide a specified number of Public Corp. shares on or shortly after the exchange date.

On the exchange date, each holder of a derivative was entitled to receive a specified number of Public Corp. shares, the exact number of which was based on the market price of the Public Corp. shares on the exchange date. Under the terms of a collateral agreement also entered into on the date of issuance of the derivative securities, the conduit entities agreed to pledge the maximum deliverable number of shares and gave to the trust a perfected security interest in the shares as security for their obligations to provide the number of shares on the exchange date. If they elected, however, the conduits could provide substitute collateral consisting of U.S government obligations equal to a certain percentage of the value of the maximum deliverable shares.

The shareholders, through their conduits, retained the right to vote the shares and the right to receive dividends with respect to the pledged shares. Upon termination of the trust, the derivative holders were to receive either the pledged shares or the equivalent of Public Corp. shares. The derivative holders did not, however, have the option to receive cash (except in exchange for fractional shares).

IRS analysis. The IRS concluded the conduits constructively sold the underlying Public Corp. shares in the year of issuance of the derivative securities, and therefore, the shareholders should have recognized their pro rata share of the gain inherent in these shares. The IRS based its analysis on common law principles rather than on the constructive sale provisions of [section] 1259. Specifically, the IRS determined the shareholders effectively transferred the shares in Public Corp. because, in the IRS's view, the conduits were "fairly limited in surrendering anything but the shares" as collateral. The IRS thought it was unlikely the conduits would actually post substitute collateral consisting of U.S. government securities, given that it was more economical to pledge the shares on hand. The IRS also determined that all of the "benefits and burdens" of ownership over the underlying Public Corp. shares were transferred, and therefore, a sale occurred. (11)

The FSA is significant in that the IRS relied on common law principles to find a constructive sale where one would likely not exist under [section] 1259. (12) The FSA's conclusion, however, is somewhat questionable in light of the fact the IRS ignored several factors that usually are indicative of a sale not taking place for U.S. federal income tax purposes, including the shareholders retaining formal title to the shares, the right to vote the shares, the right to receive dividends on the shares, and the right, whether economical or not, to post substitute collateral. Nevertheless, the FSA is noteworthy in that it sets forth the key factors the IRS considers when analyzing whether a sale is deemed to occur with a contract such as a VPFC. As such, when structuring the terms of a VPFC, the factors discussed in the FSA should be adhered to, if possible. (13)

In particular, the terms of a VPFC should always provide the taxpayer with the option to cash settle the contract (as opposed to merely having the option to physically settle the contract). Moreover, if the taxpayer is required to pledge the underlying shares of stock as collateral for his obligation to deliver the shares at maturity, the taxpayer should be given the right to substitute other collateral. Finally, as is typically the case, the taxpayer should retain the right to vote the underlying shares and the right to receive dividends on the underlying shares. If these requirements are satisfied, it is unlikely that the IRS will argue that a sale of the underlying shares is deemed to occur when a VPFC is entered into. (14)

Another issue that commonly arises with certain financial instruments is how they should be characterized for U.S. federal income tax purposes. (15) Specifically, given that the economics of many financial instruments are similar to one another, it is possible the IRS may argue a constructive sale results under [section] 1259 by testing a VFPC as something other than a forward contract under that section. In FSAs 200131015 and 200150012, while not discussing [section] 1259, the IRS does consider how a financial instrument that is similar economically to a VPFC should be characterized for U.S. federal income tax purposes.

FSAs 200131015 and 200150012

The facts of the FSAs are almost identical In both, a corporation (the "issuer") issued a certain number of instruments (the "instruments") to investors for a stated dollar amount. At the time of the issuance, the issuer owned a fixed percentage of stock in another company (the "underlying"). The instruments were issued for an amount equal to what the fair market value of shares of the underlying common stock were a few days prior to the issue date (the "issue price").

At maturity, the instruments were exchangeable for a certain number of shares of the underlying common stock, the number of which was based on the value of the underlying common stock on the date of maturity (the "maturity date"). Specifically, 1) if the value of a share of the underlying common stock on the maturity date was equal to or less than the issue price, each instrument would be exchanged for one share of the underlying common stock; 2) if the value of a share of the underlying common stock on the maturity date was greater than the issue price but less than a certain percentage amount above the issue price (e.g., 20 percent) (the "cap amount"), the instruments would be exchanged for a fractional share of the underlying common stock equal to the fair market value of the issue price; and 3) if the value of a share of the underlying common stock was equal to or greater than the cap amount, the instruments would be exchanged for a fraction (e.g., 5/6) of a share of the underlying common stock. (16) Importantly, in the FSAs the issuer had the sole discretion to decide whether to deliver cash equal to the fair market value of the amount of underlying shares to be delivered rather than the shares themselves.

IRS Analysis. In analyzing the instruments, the IRS stated, among other things, (17) that the instruments could be analyzed as cash-settled collars (i.e., a combination of holding a put option and selling a call option) in addition to a prepaid forward contract. Specifically, the issuer of the instruments is in a situation analogous to the holder of a put option with a strike price equal to the issue price (i.e., if the value of the underlying stock falls below the issue price, the issuer is required to give each investor only a share of the underlying common stock or cash equal to the fair market value of the underlying stock). Similarly, the issuer is in a situation analogous to the grantor of a call option with a strike price equal to a percentage of the cap amount (i.e., only if the value of the underlying stock equals or exceeds the cap amount will the investors participate in any further appreciation in the value of the underlying stock).

Accordingly, the issue arises whether the IRS will attempt to characterize a VPFC as something other than a forward contract (i.e., a collar) under [section] 1259. Because a specific definition of a forward contract exists under [section] 1259(d)(1), the better view is the IRS generally would be prevented from characterizing a VPFC as something other than a forward contract as a matter of statutory interpretation (i.e., the more specific controls the general). Whether the IRS agrees with this interpretation remains to be seen.

In any event, even if the IRS does attempt to characterize a VPFC as a collar, so long as the terms of the VFPC contain terms similar to those that are typically seen in such arrangements, [section] 1259 likely will not apply. In particular, although [section] 1259 currently does not apply to purchases and sales of options or collars, the Treasury is granted regulatory authority to reach these transactions. (18) The House Ways and Means Committee report states it is anticipated Treasury will issue regulations that provide standards that take into account various factors with respect to the collared stock, including the stock's volatility, the spread between the put and call prices, the term of the transaction, and the extent to which the taxpayer retains the right to receive dividends on the collared stock. (19) It is also anticipated Treasury will establish "safe harbor" rules for common financial transactions, such as collars, that do not result in constructive sale treatment. (20) One Treasury official has stated the government is considering a safe harbor provision in which collars would not be deemed to be equivalent to a sale if there is at least a 20 percent spread, the collar lasts no longer than three to five years, and the current strike price is enveloped by the collar. (21) Most practitioners seem to be comfortable with this standard. (22)

Assuming the regulations under [section] 1259 adopt this 20 percent, three-to-five-year collar as a safe harbor, the typical VPFC, where the taxpayer retains 100 percent of the first 20 to 25 percent of any appreciation, should not result in a constructive sale. On the other hand, if the terms of the VPFC are such that the taxpayer only participates in the first five percent, for example, of the stock's appreciation and the underlying stock is one that is very volatile, it is more likely a constructive sale will result (assuming the IRS can successfully argue a VPFC can be characterized as something other than a forward contract under [section] 1259). (23)

Conclusion

With the continued decline in the stock market, it is likely that more and more taxpayers holding concentrated stock positions will enter into transactions such as VPFCs. Accordingly, notwithstanding that [section] 1259 on its face seems to exempt these contracts from constructive sale treatment, based on recent guidance from the IRS, it may be prudent to take into account a number of factors (e.g., whether the taxpayer has the option to cash-settle the contract or whether there is a sufficient spread between the minimum and maximum share values) when advising taxpayers who are considered entering into these types of trans actions.

(1) Janet Novack, Kinky Tax Tricks, FORBES, September 30, 2002, at 50.

(2) See United States Tax Court Petition Bobby G. Stevenson, et ux. v. Commissioner, U.S. Tax Court Docket No. 1344902, reproduced at 2002 TNT 199-96 (Oct. 15, 2002).

(3) All references to "section" refer to sections of the Internal Revenue Code of 1986, as amended (the "Code").

(4) It should be noted that FSAs are not binding on either the Internal Revenue Service or on taxpayers. They do, however, provide guidance on the IRS's current position of certain issues.

(5) See also Lee A. Sheppard, News Analysis--IRS Pursues Individual Constructive Sales Using Equity-Linked Securities, 96 TAX NOTES 1797 (September 30, 2002).

(6) The terms of a VPFC can range from anywhere from two to 10 years, with three to five years typically being the most common.

(7) The up-front cash payment received with respect to a VPFC can be as high as 90 percent of the value of the underlying shares.

(8) For purposes of this article, the number of shares have been rounded to the nearest whole share.

(9) Section 1259(d)(1).

(10) Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), Dec. 17, at 176 (the "Blue Book").

(11) Specifically, the IRS looked to the following factors in making this determination: 1) the sales price was fixed, 2) the conduits received cash for the entire amount with no restriction on the use of the funds, 3) the prospectus and purchase and collateral agreements used "sale/purchase" terminology, 4) the prospectus and the agreements specified the date on which money changed hands, and another date on which the derivative securities holders would receive the shares free and clear of any restrictions, 5) the holders of the derivative securities bore the greater risk of loss and opportunity for gain to the extent the share prices on the exchange date were, for example, less than $80 or greater than $120 per share, and 6) although formal title did not pass to the holders on issuance of the derivative securities, the holders did receive a first priority perfected security interest and a first lien on the maximum deliverable shares.

(12) While the transaction at issue in FSA 200111011 apparently occurred prior to the effective date of [section] 1259, given that the Treasury is granted regulatory authority "to treat as constructive sales other financial transactions that ... have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain," until regulations are issued that implement these standards, the factors discussed in the FSA may have continuing relevance. Blue Book, supra note 10, at 177.

(13) To the extent the factors discussed in FSA 200111011 are not included in the terms of a VPFC, until regulations are issued under [section] 1259, a taxpayer may want to consider requesting a private letter ruling from the IRS on the issue whether entering into a VPFC results in a sale of the underlying shares of stock.

(14) See FSA 199940007 (June 15, 1999) (IRS determined under common law principles that a taxpayer did not sell shares of stock when it issued instruments to the public which entitled the holders to receive an amount of cash equal to the market value of a share of the underlying stock where 1) the instruments could only be cash-settled, 2) the taxpayer retained all voting rights and dividends on the underlying stock, and 3) the taxpayer retained legal title to the underlying stock).

(15) See David F. Levy, Towards Equal Tax Treatment of Economically Equivalent Financial Instruments: Proposals for Taxing Prepaid Forward Contracts, Equity Swaps, and Certain Contingent Debt Instruments," 3 FLA. TAX REV. 471 (1997).

(16) The heavy redaction of the FSAs makes it impossible to know the actual number of shares that are required to be delivered.

(17) The IRS also stated that holding the underlying shares of common stock and entering into a variable forward contract constitutes a straddle, and therefore, subject to the rules of [subsection] 1092 and 263(g).

(18) Code [section] 1259(c)(1)(E).

(19) Blue Book, supra note 10, at 178.

(20) Id.

(21) See Darren Allen, IRS Looking for 20 Percent Safe Harbor for Collars Under Constructive Sales Rules, BNA DALLY TAX RETORT, July 1, 1998, discussing comments made by Paul Crispino, an attorney in Treasury's Office of Tax Policy.

(22) NYSBA Report on Short-Against-The-Box Proposal, (May 21, 1997) reprinted at 97 TNT 103-11.

(23) To the extent that the spread between the minimum and maximum share prices is less than 15 percent and the underlying stock is volatile, until regulations are issued under [section] 1259, a taxpayer may want to consider requesting a private letter ruling from the IRS on the issue whether entering into a VPFC results in a sale of the underlying shares of stock.

Jeffrey L. Rubinger is an associate in Baker & McKenzie's Miami office. He received his J.D. from the University of Florida and an LL.M. in taxation from New York University. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.

This column is submitted on behalf of the Tax Section, Richard A. Josepher, chair, and Michael D. Miller, Benjamin A. Jablow, and Normaria Segurola, editors.
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Title Annotation:variable prepaid forward contracts
Author:Rubinger, Jeffrey L.
Publication:Florida Bar Journal
Date:Jan 1, 2003
Words:4534
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