In Chief Counsel Advice 201104031 (the “CCA”), the IRS concluded that a variable prepaid forward contract settled with borrowed stock cannot be treated as an open transaction by the seller. Alternatively, the CCA concluded that gain should be recognized under the constructive sale rules of Section 1259.1 The CCA reverses a position that the IRS had taken in 2004 in a similar situation.
The IRS has issued a number of revenue rulings and one private letter ruling (“PLR”) that are of importance in light of the CCA and on which the taxpayer sought to rely. First, the IRS held in Revenue Ruling 2003- 7 that a variable prepaid forward contract does not result in a current common law or constructive sale. Second, in Revenue Ruling 2004-15, the IRS held that where a taxpayer settles a short sale with borrowed stock from a separate short sale, the settlement is not an event that closes the initial short sale, thereby resulting in the continuation of open transaction treatment. Third, in Revenue Ruling 72- 478, the IRS held that a taxpayer’s short position with respect to certain securities in his brokerage account should not be treated as consummated or closed even though the taxpayer maintained a long position in identical securities in a different account with the same broker (provided the broker did not borrow the securities in the taxpayer’s long account for delivery to the purchaser with respect to the short position). Finally, the IRS addressed, in PLR 200440005, a situation in which a taxpayer had entered into certain post-paid variable forward contracts over shares of stock it held. Upon settlement of the forward contracts, the taxpayer, instead of delivering the shares of stock it held, borrowed shares from a third party to settle the contract. In connection with this transaction, the IRS ruled that the forward contracts were not closed out by delivery of the borrowed shares; that the delivery of the borrowed shares did not result in a constructive sale of the forward contracts; and that the delivery of the borrowed shares and retention of the existing shares resulted in a constructive sale. Accordingly, the taxpayer was not required to include the entire gain on its historic stock position, which it had “locked in” through the forward contract, but rather only gain equal to the current (lower) market price of its historic shares position less the taxpayer’s basis.
In simplified form, the facts of the highly redacted CCA are as follows: the taxpayer entered into variable prepaid forward contracts with a bank. The taxpayer received cash in exchange for the forward contracts to deliver a variable number of shares of stock at a specified future time. The taxpayer owned such shares at the time it entered into the forward contracts. The taxpayer treated the forward contracts as open transactions. At the settlement date, rather than settling the forward contracts with the shares the taxpayer already held, the taxpayer settled the forward contracts with newly borrowed shares.
Relying on the authorities mentioned above, the taxpayer argued that, despite delivering the shares to the counterparty, the forward contracts remained open for federal income tax purposes, and that it was permitted to keep the forward contracts open indefinitely until the short sale was closed. The taxpayer acknowledged that the short sale caused a constructive sale under Section 1259 resulting in the taxpayer recognizing gain. Since the amounts in the CCA were redacted, it is not possible to determine what exactly was at stake, but the following is an example of what may have been at issue. At the time the forward contracts were entered into, the taxpayer owned the shares with a basis of $10 and a fair market value of $100. The taxpayer received $80 from the bank pursuant to the forward contracts. On the settlement date of the forward contracts, the fair market value of the shares had decreased to $30. The delivery by the taxpayer of the borrowed shares (causing a constructive sale of the shares owned by the taxpayer) resulted in recognized gain equal to $20 (i.e., the fair market value of the borrowed shares, $30, minus the basis of the shares owned, $10). The taxpayer, however, had received $80 and, under the taxpayer’s theory, could delay recognizing any additional gain until the short sale would be closed out.
The CCA rejected the argument that entering into a short sale and settling the forward contracts with borrowed shares entitled the taxpayer to keep the transaction open. While entering into a variable prepaid forward contract may not result in a taxable event, the CCA reasoned that the settlement of such a forward contract is, in fact, a taxable event under Section 1001. In addition, the IRS argued that the taxpayer’s attempt to defer gain recognition by delivering borrowed shares lacked economic substance. It is not entirely clear from the CCA what the amount of the taxpayer’s recognized gain is under the IRS’s theory. As noted above, in our simplified example, $20 of gain is recognized as a result of the constructive sale. Presumably, the IRS would view the remaining $50 (i.e., the total amount of locked-in gain of $70 minus the gain recognized as part of the constructive sale, $20) as being recognized as a result of the settlement of the forward contract.2
The IRS further argued3 that the taxpayer’s reliance on previous short sale guidance, including Revenue Ruling 72-478 and Revenue Ruling 2004-15, was misplaced on the basis that such guidance is limited to short sales and inapplicable to the closing of forward contracts that terminate all rights and obligations of the parties under such contracts. The CCA also noted that the taxpayer cannot rely on PLR 200440005, as private letter rulings are issued with regards to a particular situation and to a specific taxpayer and are not general advice for all taxpayers. In addition, the CCA noted discontent with the reasoning of PLR 200440005, as conclusions of private letter rulings may change due to various factors, including policy over time. In fact, approximately one month later, the IRS issued a private letter ruling withdrawing PLR 200440005.4
In the alternative, the IRS argued that the constructive sale rules of Section 1259 should cause the taxpayer to recognize gain based on the amount of cash received from the bank (as opposed to the value of the shares based on market prices). In our example, this would mean that the taxpayer would recognize gain equal to $70 (i.e., the $80 cash received less the $10 basis). The IRS based this argument on the theory that the $80 should be treated as the “fair market value” of the shares (despite a lower stock market value at that time) since the fixed price of $80 was determined between a “willing buyer” and a “willing seller.”