By Jeff Callender and Steven Kaplan

In Revenue Ruling 2003-7 [2003-5 IRB 1 (January 16, 2003)], the IRS held that a shareholder who entered into a variable prepaid forward transaction secured by a pledge of appreciated shares neither caused a sale of stock under general tax principles nor triggered a constructive sale under IRC section 1259. The IRS had previously released a field service advice (FSA 200111011) that reached a different conclusion on a somewhat different set of facts. Additionally, the Denver office of the IRS has been challenging several variable prepaid forward transactions, most notably that of Ciber, Inc., chief executive Bobby G. Stevenson, arguing that the taxpayers should be considered to have sold their stock upon execution of the transaction. Revenue Ruling 2003-7 appears to be good news for investment banks that have seen declines in many areas of their business. The IRS’ position may embolden those hesitant to move forward with variable prepaid forward transactions.

Revenue Ruling 2003-7

In the facts of the ruling, an individual held appreciated shares of a publicly traded corporation. The shareholder entered into a variable prepaid forward transaction with an investment bank, wherein the shareholder agreed to deliver to the investment bank upon expiration of the contract (exchange date) a variable number of shares of such stock (determined by a formula) in exchange for an upfront cash payment upon execution of the agreement. The term of the transaction was three years. Under the formula, if the market price of a share of the common stock was less than $20 on the exchange date, the shareholder would have to deliver 100 shares of the common stock to the investment bank. If the market price of a share of stock was between $20 and $25 on the exchange date, the shareholder would have to deliver a number of shares having a total market value equal to $2,000. If the market price of a share exceeded $25 on the exchange date, the shareholder would be required to deliver 80 shares of common stock. This is the equivalent of an embedded collar band equal to 100–125% of the fair market value of the shares upon execution of the transaction.

In order to secure the obligation under the variable prepaid forward, the shareholder pledged to the investment bank on the execution date the maximum number of shares that would be required under the agreement (i.e., 100). This pledge was effected by transferring the shares in a trust to an unrelated third-party trustee. The shareholder retained the right to vote the pledged shares and to receive dividends from the stock.

Under the terms of the variable prepaid forward, the shareholder had the unrestricted legal right to, upon settlement, deliver the pledged shares, cash, or shares other than the pledged shares to satisfy its obligation under the agreement. The ruling indicates that at the time the parties entered into the variable prepaid forward, the shareholder intended to deliver the pledged shares to the investment bank on the exchange date in order to satisfy his obligations under the variable prepaid forward. The shareholder, however, was not otherwise economically compelled to deliver the pledged shares and could have, in fact, delivered either cash or different shares.

The IRS first addressed whether entering into the variable prepaid forward transaction resulted in a sale of the shares under general tax principles by examining the attributes of tax ownership (the “benefits and burdens” of ownership). In this case, on the date the transaction was executed, the shareholder received a fixed payment without any restriction on its use and also pledged in trust the maximum number of shares to be delivered under the variable prepaid forward. The shareholder retained the right to receive dividends and exercise voting rights for the pledged shares. The IRS concluded that the execution of the variable prepaid forward did not result in a sale or other disposition of the shares, focusing on the fact that the shareholder retained dividend and voting rights and was not required by the terms of the agreement to deliver the pledged shares to the investment bank on the exchange date. However, the IRS stated that a different outcome might be warranted if the shareholder were under any legal restraint or economic compulsion to deliver the pledged shares rather than to deliver either cash or other shares. The IRS cited restrictions placed upon a shareholder’s right to own pledged shares after the exchange date and an expectation that a shareholder will lack sufficient resources to exercise the right to deliver cash or other shares as examples of significant factors to weigh in determining whether a sale has occurred.

The IRS next addressed whether the variable prepaid forward transaction resulted in a constructive sale of the shares under IRC section 1259. Under section 1259(d)(1), the term forward contract is defined as a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price. The IRS examined the legislative history, which indicated that a forward contract that provides for the delivery of an amount of stock that is subject to “significant variation” under the terms of the contract is not within the statutory definition of a forward contract. The IRS concluded that under these facts, the variable prepaid forward transaction did not result in a constructive sale under section 1259(c)(1)(C). Accordingly, the IRS found that the variable prepaid forward was not a contract to deliver a substantially fixed amount of property. As a result, the IRS concluded that the variable prepaid forward did not meet the definition of a forward contract under section 1259(d)(1) and did not cause a constructive sale under section 1259(c)(1)(C).

Analysis

The facts of Revenue Ruling 2003-7 are similar in many respects to those at issue in Stevenson v. Comm’r, a case that had been pending in the Tax Court. In Stevenson, an IRS auditor had asserted that the taxpayer’s STRYPES transaction (essentially a DECS-like transaction or variable prepaid forward) resulted in an immediate sale of his shares under general tax principles. Stevenson secured his obligation by transferring the maximum number of shares deliverable under the variable prepaid forward to a third-party trustee, under a pledge agreement giving Stevenson the right to vote the shares and receive dividends. (Interestingly, in Stevenson, absent default by the trust, the shares held under the pledge agreement could not be “sold, assigned, exchanged or otherwise disposed of” by the investment bank.) It appears that Revenue Ruling 2003-7 was issued as an IRS national office response to the challenge of several transactions by the Denver office of the IRS, and possibly the Stevenson transaction in particular. Accordingly, it is anticipated that the IRS will back off these and other similar cases.

Pledging of shares. Revenue Ruling 2003-7 does not address what happens if shares have been pledged directly with the investment bank (or an affiliate) and not an independent third-party trustee. Accordingly, it is not clear how much weight, if any, should be given to this factor. Given that the final holding focuses on the economic compulsion to deliver the pledged shares, this may not be a critically important factor. The IRS did not address the issue of sale or rehypothecation of the pledged shares.

Economic compulsion. The economic compulsion argument to deliver shares raises several questions. The IRS cited Miami National Bank v. Comm’r [67 T.C. 793 (1977)], in which the court held that the transferor remained the owner of the stock, despite the transferee’s right to sell stock in a subordination account to satisfy its creditors. The court noted that the transferor’s right to substitution was not “merely an idle one” because, at all times, the transferor had the right to reacquire the stock in the subordination account by substituting cash or other readily marketable securities of equivalent value.

The crux of the IRS’ economic compulsion argument is whether a shareholder is economically compelled to deliver the pledged shares should be determined at the time the variable prepaid forward is entered into. Because the IRS believes that this is a factor to be considered when performing a common law sale analysis, it would make sense to evaluate a taxpayer’s ability to deliver other property at the time the transaction is entered into. It seems inappropriate to conclude that a taxpayer who had the right and ability to deliver either cash or other shares at the time a transaction was executed but whose other assets have subsequently deteriorated in value, has had a sale at this later date when no event fixes this determining date. Accordingly, the authors think that the sale analysis under general tax principles must be measured on the date a transaction is executed.

In executing future equity monetization and hedging transactions, it is prudent to ensure that a taxpayer’s cash settlement option is more than an idle one and that that he has the ability to deliver other shares or cash in settling the transaction. Additionally, it will be helpful for a taxpayer to have a genuine right to substitute collateral. An open issue is how to structure transactions where a taxpayer enters into a variable prepaid forward and uses the proceeds to buy nonliquid assets such as real estate. It is also interesting to note that short-against-the-box transactions have been around since the 1930s and the IRS had never argued that they should result in a sale under general tax principles, even where the taxpayer may not have had the ability to deliver shares other than those in the “box.” Not until the constructive sales rules were enacted in 1997 were these transactions no longer an effective tax planning strategy.

Embedded collar band. In determining whether the transaction described in Revenue Ruling 2003-7 resulted in a constructive sale, the IRS focused only on IRC section 1259(c)(1)(C), which provides that a taxpayer will be treated as having made a constructive sale transaction when the taxpayer (or a related person) enters into a futures or forward contract to deliver the same or substantially identical property. As previously discussed, the IRS concluded that the variable prepaid forward was not a forward contract for purposes of IRC section 1259 because it was not a contract to deliver a substantially fixed amount of property for a substantially fixed price. The IRS did not analyze section 1259(c)(1)(E), which covers other transactions that have substantially the same effect as a transaction described elsewhere in section 1259(c)(1). The fact that regulations have not yet been issued under IRC section 1259 probably explains why the IRS did not focus on the size of the embedded collar band.

The facts of the ruling indicate an embedded collar band of 25%, which is slightly larger than the embedded collar band proposed by the New York State Bar Association as a “safe-harbor.” This suggested safe-harbor has been followed by most practitioners in structuring transactions. While it is not clear why the IRS chose to illustrate a 25% embedded collar band for a three-year transaction, many practitioners and investment banks think that a 20% embedded collar band for a three-year transaction should continue to be sufficient.

Benefits and burdens. In order to not have a sale under general tax principles, it is important that a shareholder retain the benefits and burdens of ownership of the underlying shares. This includes dividends and voting rights. In some variable prepaid forward transactions, the terms of the transaction often call for an extraordinary dividend amount (above the current divided rate) to be paid to the investment bank. While it can be argued that the shareholder receives the actual dividend and the payment of the extraordinary dividend amount is merely a pricing adjustment, it is not clear how the IRS would view this fact.

Bifurcation and time value of money. It is also worth noting that the IRS, in Revenue Ruling 2003-7, did not attempt to bifurcate the transaction into its components (e.g., a forward contract and a deposit, or perhaps a collar and a zero coupon loan). Additionally, the IRS did not argue that the time value of the money element inherent in the variable prepaid forward contract should be recognized.

While Revenue Ruling 2003-7 appears to be good news for taxpayers, care must be taken in structuring transactions that fall outside the fact pattern. Accordingly, it is important to make sure that a taxpayer who enters into a variable prepaid forward has an unrestricted legal right to deliver cash or shares other than those originally pledged. Additionally, advisors should make sure that a taxpayer is not economically compelled to deliver the originally pledged shares to settle the transaction.