Forwards: Off the Hot Plate?
A recent Internal
revenue ruling has found that a prepaid variable
forward did not constitute a constructive sale. However, an IRS
official subsequently threw cold water on the party by commenting
that the ruling required a very specific set of facts and
ruling 2003-7 dealt with a taxpayer who
entered into a prepaid variable forward contract on a holding of
low cost-basis stock. Under the terms of the forward agreement,
the number of shares to be delivered on the exchange date
varied depending on the market value of the stock on that date.
The ruling found that because of this variation, the forward
contract agreement did not cause a constructive sale under either
the common law or Internal Revenue Code Section 1259(c)(1)(C).
The finding should ease concerns raised by FSA
suggested that the use of a prepaid variable forward could trigger
immediate taxation of the underlying shares.
focused mainly on Internal Revenue Code Section 1259 legislative
history and case law. Section 1259(d)(1) treats a “forward
contract” as a constructive sale. It defines a forward contract
as a contract to deliver a substantially fixed amount of
property for a substantially fixed priced. The legislative
history of the Code suggested that significant variation in the
number of shares to be delivered would ensure that the contract
would not constitute a constructive sale.
While the ruling
represents general good news for variable forward investors, it
also specifies a combination of conditions that are not commonly
used on Wall Street. First, the ruling emphasized that the shares
were pledged to a third party custodian, with the investor keeping
the right to collect dividends, vote the shares, and substitute
cash or other shares for the pledged shares. The ruling also
specified that the forward contract did not require the
shareholder to deliver the pledged shares upon maturity; the
investor retained the unrestricted legal right to substitute cash
or other securities. Subsequent comments by Service officials
suggested that these conditions were essential to the ruling’s
conclusions. At a January 24 American Bar Association Section
committee meeting in San Antonio, IRS special counsel Matthew
Stevens suggested that if the shares had not been pledged to a
third-party custodian, then the transaction might have triggered a
The basis for
Stevens’ observations is unclear, and it is unlikely that absence
of a third-party custodian alone could turn a prepaid variable
forward into a constructive sale under Section 1259. However, the
comments could serve as a harbinger of future Service attacks on
hedging structures and the lending or pledging of shares. It
seems Mr. Stevens would like only those investors mimicking the
fact pattern in revenue ruling 2003-7 to take comfort from the
|This article and
other articles are provided
for information purposes only.
They are not intended to be an offer to engage in any
securities transactions or to provide specific financial,
legal or tax advice. Articles may have been rendered partly
inaccurate by events that have occurred since publication.
Investors should consult their advisers before acting on any
topics discussed herein.