On February 2, 2007, the IRS Office of Associate Chief Counsel (Financial Instruments and Products) issued Generic Legal Advice memorandum AM 2007-004 (“Legal Advice”) addressing variable prepaid forward (“VPF”) contracts. These contracts are typically used by investors who seek to diversify a concentrated position in a single stock (e.g., a shareholder-owner with substantial stock holdings in his or her company) by investing the cash prepayment in other securities and/or financial instruments. Taxpayers were encouraged to enter into these arrangements after the IRS issued Revenue Ruling 2003-7, 2003-1 C.B. 363, which held that a VPF and pledge of the underlying shares to a third-party trustee did not result in current sale treatment to the forward seller. Unlike the 2003 ruling, the VPF in the Legal Advice also includes a share lending arrangement whereby the forward contract counterparty borrows and on-lends the pledged shares. The IRS concluded in the Legal Advice that the share lending arrangement gave the counterparty unrestricted use and control of the forward-sold shares. Because the IRS viewed the counterparty as receiving all the “benefits and burdens” of ownership in exchange for its cash prepayment, the forward seller was held to recognize gain or loss currently – rather than determining gain or loss, if any, at settlement as under the 2003 ruling.
Given the retroactive reach of the Legal Advice and the size and growth of the VPF market – the value of registered VPF transactions grew from $392 million in 2000 to $9 billion in 2005 – the Legal Advice potentially will have a significant detrimental impact on investors and financial institutions. Generic Legal Advice memoranda are intended as “an authoritative opinion on industry-wide issues.” Chief Counsel Notice CC-2006-013.
In addition, the large size of the cash prepayment in a typical VPF transaction may cause some taxpayers to face an increase in the statute of limitations from three to six years. Recent guidance by the IRS Office of Associate Chief Counsel (Procedure and Administration) applied the six-year statute of limitations in the VPF context because the taxpayer’s failure to include the cash prepayment in income on receipt was treated as a “substantial omission of gross income.” Chief Counsel Advice 200542035.
In a forward sale of stock, the shareholder (forward seller) agrees to deliver in the future a specific number of shares at a price agreed upon at the transaction date but paid on delivery. When the forward contract matures, the forward seller has the option of (i) completing the sale with the shares identified in the contract (“the identified shares” or, if the identified shares are pledged, “the pledged shares”), (ii) completing the sale with a different lot of identical shares (e.g., higher or lower basis shares owned by the forward seller), or (iii) cash settling the contract and keeping the identified or pledged shares.
In a VPF, the number of shares potentially required to be delivered on the contract’s maturity date varies depending on the stock’s value at settlement. The variability in the number of shares typically signifies that the shareholder participates in a portion of the upside and is protected from downside risk. The forward seller in a VPF also (i) receives a cash prepayment, and (ii) collateralizes its forward obligation by pledging to the forward purchaser (counterparty) the identified shares, which are transferred to a third-party trustee.
To combat constructive sales of appreciated financial positions using forward contracts, Congress enacted Section 1259, which requires sale treatment for forward sales of appreciated stock if the forward contract requires delivery of “a substantially fixed amount of property for a substantially fixed price.” Section 1259(d)(1). Because the number of shares to be delivered at settlement of the VPF varies depending on the stock’s value, the constructive sale rules of Section 1259 do not apply.
In Revenue Ruling 2003-7, the IRS confirmed that current sale treatment did not apply to the forward seller in a VPF involving a pledge of the shares. The IRS based its conclusion on Section 1259 and its analysis of the “benefits and burdens” of ownership. Persuasive to the IRS was that the forward seller (i) had the unrestricted right to deliver the pledged shares, other identical shares, or cash; and (ii) was not economically compelled to deliver the pledged shares, even if the forward seller “intended to deliver the pledged shares” at settlement.
The 2007 Legal Advice
The Legal Advice addressed facts similar to those in the 2003 ruling with the addition of a share lending arrangement between the forward seller and its VPF counterparty. A share lending agreement allows the counterparty (e.g., an investment bank) to hedge its long position in the forward-sold securities. The counterparty typically hedges its position in the VPF by borrowing identical shares on the open market or, at a lower cost to the counterparty, by borrowing the pledged shares in the VPF. The counterparty uses the borrowed shares for short sales or other transactions to efficiently manage its risks in the VPF and passes on a portion of its cost savings from borrowing the pledged shares to the forward seller in the form of a reduced fee.
In the IRS’s view, the lending arrangement transferred “unfettered use of the shares” to the counterparty. This “dominion and control” over the shares, coupled with the counterparty’s ability to resell the forward-sold shares to a third party without restriction and with all dividend and voting rights attached, was viewed by the IRS as indicating that all the “benefits and burdens” of ownership in the pledged shares had been transferred to the counterparty. Thus, the IRS treated the forward seller’s entry into the VPF as a current sale of the pledged stock.
In its analysis, however, the IRS ignores the forward sale mechanics that allow the forward seller to choose the property it will deliver to settle the forward contract. Under the authorities cited in the 2003 ruling (i.e., Section 1259 and the “benefits and burdens” case law), these delivery options must be taken into account when the forward seller has the economic ability to use these options. Assuming the VPF seller has the economic ability to make delivery under the three different forward sale scenarios – the pledged shares in the trust, another lot of identical shares, or cash – the VPF transaction is not a completed sale until the forward seller decides which property it will use to settle the contract – i.e., not until maturity of the forward contract.
The Legal Advice also concluded that the exclusion from sale treatment contained in Section 1058 – the safe harbor for securities lending arrangements – did not apply. The Section 1058 exclusion applies only if the loan does not reduce the lender’s risk of loss and opportunity for gain from the transferred securities. In order to ignore Section 1058’s safe harbor, the Legal Advice treated the VPF, pledge, and share lending arrangement as a single “integrated” document and then concluded that the “economic realities” of the overall arrangement did reduce the forward seller’s risk of loss and opportunity for gain.
Given that the IRS did not cite any authority for its “integration” theory, its conclusion is suspect. More importantly, Section 1058 is not necessary for a taxpayer to reach the no-sale result. Based on the mechanics of forward sales and the “benefits and burdens” analysis applied in the 2003 ruling, current sale treatment applies only at maturity of the forward contract when the forward seller decides which property it will use to settle the contract. The 2007 Legal Advice fails to appreciate this critical point.