On February 6, 2008, the IRS published Coordinated Issue Paper LMSB-04-1207-077 (the “Issue Paper”). The Issue Paper reiterates the position (taken in a prior Technical Advice Memorandum and Generic Legal Advice Memorandum) that a variable prepaid forward contract (“VPFC”) that includes or involves a share lending agreement or other similar arrangement and which allows the counterparty to borrow the pledged shares (“Share Lending VPFCs”) results in a current taxable sale of the underlying shares, and that a taxpayer that fails to pay the resulting tax could be subject to penalties. This position is now binding on all IRS examiners.1 However, the Issue Paper reaffirms that a VPFC that is described in Revenue Ruling 2003-7 (and is not a Share Lending VPFC) does not cause the taxpayer to be treated as selling or engaging in a constructive sale transaction under section 1259.2
Revenue Ruling 2003-7
In Revenue Ruling 2003-7, the IRS described a typical VPFC as a transaction in which a taxpayer that owns appreciated publicly traded stock enters into an agreement with an investment bank (a “counterparty”) under which, in return for an upfront payment the taxpayer agrees to deliver a variable number of the underlying shares on the maturity date. The number of shares delivered is determined by a formula based on the value of the shares at the maturity date. Generally, the taxpayer pledges the maximum number of shares that may be required to be delivered under the VPFC as collateral for its obligations under the VPFC. In the ruling, shares are pledged to a third party trustee as collateral. In the ruling, at maturity, the taxpayer had the option to cash settle the transaction and keep the pledged shares, deliver all or a portion of the pledged shares to the counterparty, or deliver a different lot of identical shares.
TAM 2006-04033 and Generic Legal Advice Memorandum 2007-004
In a 2006 Technical Advice Memorandum (TAM 2006-04033) and in a 2007 Generic Legal Advice Memorandum (AM 2007-004) the IRS held that if the same shares pledged under the VPFC were simultaneously loaned to the same counterparty in a securities lending transaction, the pledged shares would be treated as sold for federal income tax purposes.
The Issue Paper
The Issue Paper addresses Share Lending VPFCs, under which the counterparty has, or acquires the right, to vote, re-hypothecate, and otherwise dispose of the shares during the term of the transaction. The Issue Paper identifies the following seven transactions as Share Lending VPFCs:
- The parties enter a VPFC in which the share pledge agreement gives the counterparty the right to hedge its position under the VPFC by selling, pledging, rehypothecating, investing, using, commingling or otherwise disposing of, or otherwise using in its business, the pledged shares. The counterparty has the right to transfer and to vote the pledged shares but may be required to pay certain distributions received on the shares to the taxpayer.
- After entering a VPFC through a share purchase agreement and a pledge agreement, the parties amend the pledge agreement to allow the counterparty, upon consent of the taxpayer, to sell, lend, pledge, invest, commingle, or otherwise dispose of the pledged shares.
- After entering a VPFC that includes a pledge/security interest provision, the parties (usually within 90 days following the VPFC) execute a separate share lending agreement.
- The parties enter a VPFC through an ISDA Master Agreement and an ISDA Credit Support Annex, which allows the counterparty to rehypothecate, sell, dispose of or use the pledged shares.
- The parties enter a VPFC through a share purchase agreement, execute a Letter and Confirmation Agreement, and then later enter a Rehypothecation Agreement pursuant to the terms of the Letter and Confirmation Agreement.
- The parties enter a VPFC where the shares are placed as security with the counterparty or its subsidiary, subject to a standard margin/broker agreement which grants the counterparty the rights to register the stock in its own name and to rehypothecate, sell, dispose, or use the pledged shares.
- The parties enter a VPFC and the taxpayer contemporaneously deposits a sufficient amount of the same stock used in the VPFC in another account and this stock is borrowed in order to close the counterparty’s short sale.
The Issue Paper provides that in all of these variations, the borrowed stock is treated as sold for federal income tax purposes when the counterparty obtains the legal right to rehypothecate the underlying shares, even if the counterparty does not do so.
The Issue Paper also notes that Share Lending VPFCs could give rise to accuracy-related and other penalties.
Nevertheless, the Issue Paper does not affect the treatment of VPFC transactions that comply with Revenue Ruling 2003-7, under which the taxpayer retains dividend and voting rights, and does not provide the counterparty with any right to borrow, rehypothecate, or otherwise transfer the pledged shares.