Spring 2003, Volume VI, Issue 2    

Prepaid Variable Forwards: Off the Hot Plate?

December 20, 2005: Troublesome Variable Forward Ruling Now "Public".  

A recent Internal Revenue Service 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 circumstances.

IRS revenue 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 200111011, which suggested that the use of a prepaid variable forward could trigger immediate taxation of the underlying shares.

Ruling 2003-7 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 capital gain.

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 ruling’s conclusions.


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. 

 


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