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Variable prepaid forwards: are stock loans possible in light of TAM 200604033?

For years, taxpayers have been using a variety of strategies designed to get cash out of their appreciated stock positions without recognizing tax gain. One such strategy is the so-called variable prepaid forward contract (VPF), under which a taxpayer agrees to deliver to a counterparty, in exchange for an upfront cash payment, an amount of stock in the future that varies based on the stock price.

In Rev. Rul. 2003-7, the IRS ruled, based on commercially reasonable facts, that a VPF was neither a common law sale nor a constructive sale of an appreciated stock position. This ruling may have offered some comfort to taxpayers seeking to use VPFs to get cash currently without triggering gain. However, based on a recently issued technical advice memorandum (TAM), it appears that Rev. Rul. 2003-7 may have given taxpayers a false sense of security. In TAM 200604033, the IRS concluded that a VPF was a common law sale at (or near) inception, because the taxpayer (among other things) permitted the counterparty to borrow the shares the taxpayer pledged as collateral. Giving the counterparty the right to borrow shares is fairly common in VPFs. The apparent rejection of this feature by the TAM raises significant questions about how to treat existing and future VPFs.

Standard VPF Transactions

In a typical VPF, a taxpayer agrees to sell to a counterparty (usually an investment bank) a variable number of shares on a fixed future date in exchange for an upfront cash payment. The number of shares to be delivered on the settlement date varies, depending on the stock's value on the settlement date. Under the share-delivery formula, the taxpayer usually transfers to the counterparty a significant portion of its risk of loss (e.g., all loss below 95% of the current price) and opportunity for gain (e.g., all appreciation beyond 120% of the current price) on the shares. To secure its future obligation under the VPF, the taxpayer will typically pledge to the counterparty (either directly or with a third-party custodian) the maximum number of shares that it may be required to deliver under the VPF. In some cases, the taxpayer will have the right to substitute cash or other collateral for the pledged shares. Generally, the VPF may be physically settled (with either the pledged shares or different shares of the subject stock) or, at the taxpayer's option, settled in cash.

The counterparty to a VPF typically hedges its position. The easiest and most cost-effective way to do this is to borrow the pledged shares from the taxpayer and sell them short. The counterparty can obtain the right to borrow the shares either by agreeing to make the right a feature of the original pledge agreement or by entering into a separate agreement, either contemporaneously or at some later date. In either case, the counterparty will generally obtain the right to sell, use, transfer or otherwise re-pledge the shares. If the shares are borrowed, the counterparty typically will agree to return identical shares to the taxpayer on demand and will make payments to the taxpayer equal to any dividends or other distributions the taxpayer would have received on the stock. The counterparty will generally offer to pay the taxpayer for this right--either by increasing the amount of cash advanced or paying a periodic lending fee. If the taxpayer does not give the counterparty the right to borrow the shares, the counterparty will generally pass its cost of hedging the long position to the taxpayer (to the extent it exceeds the cost that would have resulted from entering into a securities loan with the taxpayer).

Tax Consequences of VPFs: Rev. Rul. 2003-7

Rev. Rul. 2003-7 involved a VPF with standard commercial terms similar to the VPF described above, with one notable exception: the counterparty in the ruling did not have the right to borrow the underlying shares pledged by the counterparty.

The IRS concluded that the taxpayer's transfer of legal title to, and actual possession of, the stock to the counterparty pursuant to the pledge agreement was not sufficient to trigger a common law or constructive sale (under Sec. 1259) of the pledged stock to the investment bank, because the taxpayer (1) retained the right to vote the stock and receive dividends and (2) had the right to reacquire the shares on the settlement date by delivering cash or other shares to settle the VPF. The IRS noted that the taxpayer's right to reacquire the shares was unrestricted by agreement or economic circumstances and that it might reach a different conclusion if there was a legal or economic restraint on the taxpayer settling the contract with cash or other shares.

Although Rev. Rul. 2003-7 did not involve a stock loan, some taxpayers may have relied on its holding when entering into VPFs with stock loans. The fact that the counterparty had the use of the shares during the VPF's term may not have seemed relevant, because the securities loan did not affect the right to reacquire the shares at maturity. If a stock loan would have altered the IRS's conclusion in the ruling, it may have been reasonable to assume that the IRS would have specifically addressed that fact in the ruling or in separate guidance.

Even if a stock loan resulted in a common law sale, the agreement would be structured to qualify for nonrecognition treatment under Sec. 1058. Under Sec. 1058(a), if a taxpayer transfers securities to a transferee pursuant to an agreement to return identical securities, the transferor recognizes no gain or loss on the exchange of the actual securities for the rights under the securities loan contract or on the later exchange of the rights under the securities loan contract for the actual securities. For a stock loan to qualify for nonrecognition treatment under Sec. 1058(a), the requirements set forth in Sec. 1058(b) and Prop. Regs. Sec. 1.1058-1(b) must be satisfied. One of these requirements is that the stock loan does not reduce the transferor's risk of loss or opportunity for gain with respect to the stock.

TAM 200604033

In TAM 200604033, the taxpayer entered into numerous VPFs on publicly traded stock. Under the VPFs, the taxpayer had to deliver a variable number of shares to the counterparty on a future date in exchange for receiving an upfront cash payment. The number of shares to be delivered was determined by a formula based on the stock's fair market value (FMV) as of the settlement date. In accordance with the share-delivery formula, the taxpayer transferred all of its risk of loss on the stock but retained the right to benefit from an unspecified portion of any future stock appreciation. Only one of the taxpayer's VPFs contained a cash settlement option; the other contracts could only be settled by the taxpayer delivering the pledged shares.

In connection with entering into the VPFs, the taxpayer pledged with the counterparty the maximum number of shares of stock to be delivered on the settlement date, by transferring the stock to a collateral account to be held by a trustee for the counterparty's benefit. The pledge agreements obligated the taxpayer to enter into share-lending agreements with the counterparty with respect to the pledged stock. Absent a loan of the shares, the taxpayer generally retained the right to vote the shares held in the collateral account.

As contemplated under the pledge agreements, the trustee, acting as an agent of the taxpayer, entered into share-lending agreements with the counterparty with respect to the pledged stock. The pledge agreements provided instructions to the trustee to begin lending the pledged shares "promptly" after the pledge agreements were executed. The counterparty was required to pay a fee to the taxpayer for borrowing the pledged stock and was required to make in-lieu-of payments to the trustee equal to any dividends or other distributions received with respect to the borrowed shares. On borrowing the shares, the counterparty obtained the right to vote and dispose of the shares. On notice to the counterparty, the taxpayer had the unconditional option to terminate a loan of the shares.

In the event of a default, the counterparty was entitled to accelerate the VPFs and request the trustee deliver to the counterparty all of the stock in the collateral account to satisfy the taxpayer's share-delivery obligation. The counterparty's inability to establish a hedge of its position on reasonable terms constituted an event of default. In that case, the taxpayer's obligations under the VPF to deliver the shares could be offset with the counterparty's obligations to return the shares under a share-lending agreement.

Common Law Sale

Based on these facts, the IRS concluded that the cumulative effects of the VPFs, pledge agreements and share-lending agreements resulted in a common law sale of the pledged shares when the counterparty borrowed the shares. The IRS concluded, in effect, that the taxpayer (1) transferred the shares, through the securities loan, for cash at or near inception, (2) had no meaningful right to call back the shares (because of the event-of-default provisions) and (3) was obligated in all but one case to deliver the pledged shares at maturity. Unlike Rev. Rul. 2003-7, the counterparty in the TANI acquired possession and unfettered use of the pledged shares at inception and never had to return them. Under those facts, the IRS concluded that the common law sale occurred when the shares were loaned.

Significant to this analysis was the position that the VPFs, pledge agreements and share-lending agreements should be viewed as part of one overall transaction, rather than distinct component parts. To justify its position, the IRS noted that (1) the VPFs, pledge agreements and share-lending agreements all involved the same taxpayer and the same stock, (2) the VPFs and pledge agreements obligated the taxpayer to enter into the share-lending agreements and (3) no independent collateral was required to be posted by the counterparty pursuant to the sharelending agreement. The INS also asserted that the parties did not strictly observe the purported separateness of the VPFs and share-lending agreements. Specifically, the trustee allowed the counterparty to borrow the pledged shares without first securing the taxpayer's consent. According to the IRS, the agreements entered into by the parties required the taxpayer to consent to each stock loan.

Sec. 1058

After concluding that the taxpayer sold the pledged shares to the counterparty, the Service addressed whether the taxpayer qualified for nonrecognition treatment under Sec. 1058. In a very short discussion, the IRS concluded that the stock loan at issue did not meet the requirements of Sec. 1058. Specifically, by entering in to the VPF "nearly simultaneously" with the share-lending transaction, the taxpayer gave up nearly all indicia of ownership in the pledged shams, including its risk of loss and most of its opportunity for gain. Accordingly, while the various contractual requirements for Sec. 1058 to apply may have been met, the substantive requirement that the contract not reduce the taxpayer's risk of loss and opportunity for gain was not. Additionally, the IRS concluded that it was doubtful whether the taxpayer would reacquire possession of the loaned stock because of the counterparty's ability to accelerate the VPF in certain cases, leading to an offset of the securities loan with the VPF.

Open Transaction

The IRS ruled that the taxpayer should be treated as selling the stock for the upfront cash payment and a contingent right to receive back a variable number of shares on settlement. The IRS concluded that, even though the contingent right may be difficult to value, the open transaction doctrine should not apply to defer the taxpayer recognizing gain on the sale because the open transaction doctrine is available only when the value of the consideration received is unascertainable. In the context of an arm's-length transaction, the value of each side of the transaction is presumed to be equal. Thus, if only one side can be valued, the side that cannot be valued is presumed to be equal to the side that can. Accordingly, the IRS ruled that the taxpayer's amount realized on disposition of its shares was the FMV of the publicly traded pledged shares.

Can Stock Loans and VPFs Exist Together?

At its core, this TAM is a reminder that whether a transaction is a common law sale is based on the specific facts and circumstances of the taxpayer's transaction, and is a caution that Rev. Rul. 2003-7 is not a blanket approval of VPFs. Thus, any taxpayer that enters into a VPF should reflect on all aspects of its arrangement with the counterparty, including the pledge arrangement and other existing agreements (e.g., margin account terms), to structure an effective VPF.

In particular, TAM 200604033 raises significant questions about whether a taxpayer that enters into a VPF can ever enter into a stock loan of the underlying shares without running afoul of Sec. 1058. Critical to the IRS's Sec. 1058 conclusion was that the VPF, pledge agreement and stock loan were viewed as one transaction. If the taxpayer were to enter into the stock loan separately from the VPF and pledge agreement, would the same conclusion be reached? For example, if (1) the taxpayer did not loan the pledged shares to the counterparty until six months after the VPF was entered into, (2) there was no pre-existing agreement that such a loan would ever take place and (3) the counterparty paid an arm's-length fee for borrowing the shares, would the stock loan and the VPF be viewed as part of one agreement? Surely it would be more difficult to reach the TAM's one-agreement conclusion under those circumstances. On the other hand, it will always be hard to disprove any relationship between the two transactions if the same parties are involved, regardless of how the steps are documented.

Given the uncertainty created by TAM 200604033, taxpayers with VPFs and stock loans in place may be advised to take steps geared toward establishing that their VPF and stock loan are indeed separate transactions. This might involve calling in any shares that have been lent to the counterparty and/or settling the VPF with cash or shares different from those lent to the counterparty. These steps may help establish the taxpayer retained control over the subject shares throughout the VPF's life.

Until the government issues guidance that addresses some of the issues raised by TAM 200604033, taxpayers will be left wondering whether their existingVPFs and stock loans "work" and whether stock loans should be avoided altogether when entering into future VPFs.

FROM ELIZABETH R. DYOR, J.D., LL.M., CPA, WASHINGTON, DC
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Title Annotation:technical advice memorandum
Author:Dyor, Elizabeth R.
Publication:The Tax Adviser
Date:Jun 1, 2006
Words:2422
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