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GT Alert

Variable Prepaid Forward Contracts Are Subject to Renewed IRS Scrutiny

October 2005

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Many persons, but mostly high net worth individuals, have entered into so-called “variable forward” contracts with respect to stock. Under these arrangements, the client, with a substantially appreciated equity position, enters into a contract that economically resembles a combination of a sold call and purchased put. For example, assume the client’s basis in the stock is 10 and the stock has a current fair market value of 100. The client could buy a put at 90 (which limits her downside risk to 10) and sell a call at 110 (which limits her upside to 10). When the put (with a below-market strike price) and call (with an above-market strike price) are combined and permit share settlement, the resulting contract is referred to as a variable forward. Specifically, using our example, if the share price at maturity was below 90, the client would deliver one share, between 90 and 110, the client would deliver shares with a value of 100 and if the share price was greater than 100, the client would deliver a number of shares to the bank that allowed the client to recognize the value of 10% appreciation. Often, the bank writing these contracts will then make an upfront payment on the contract (usually no greater than 85 on the numbers used in the example). When there is an upfront payment, the transaction is known as a “variable prepaid forward contract.”

“Under these arrangements, the client, with a substantially appreciated equity position, enters into a contract that economically is a combination of a sold call and purchased put.”

In these transactions, the client usually loans the shares to the bank on the other side of the forward contract shortly following the execution of the variable forward. The loan of shares allows the bank to hedge its exposure in an inexpensive manner (and therefore results in better forward contract pricing). For tax purposes, the market had gotten comfortable that the loan should not affect the conclusion that the variable forward transaction should not trigger gain on the hedged stock.

Well, one of these transactions is now under audit. Greenberg Traurig is not involved in this audit. We have heard that the auditing agent has asserted that the loan of shares causes a common law constructive sale of the shares. The matter has been submitted to the IRS National Office for Technical Advice. We have also heard that the initial reaction of the IRS National Office is that the auditing agent is correct. A TAM is expected shortly. Accordingly, clients who have entered into these transactions or are considering them should consider refraining from loaning their stock to the bank until this issue has been resolved. Of course, it is possible that the IRS National offices will agree with the taxpayer that the stock loan has no effect on the constructive sale question.

Shortly following our discovery of this development, an IRS Legal Memorandum (ILM 200542035) was released addressing statute of limitations issues affecting variable prepaid forward contracts. Prior thereto, in Revenue Ruling 2003-7, the IRS favorably ruled that a variable prepaid forward contract did not result in either a statutory or common law constructive sale of the shares that were the subject of the forward contract. Derivatives: Financial Products Report (Vol.4, No. 7) reported in March 2003 that the IRS was then litigating the tax consequences of several prepaid forward contracts. The issuance of the ruling was supposed to end such litigation. In the just-released legal memorandum (ILM 200542035), the IRS has asserted that the extended 6-year statute of limitations (rather than the normal 3-year statute) applies to a forward contract transaction entered into by a partnership on the ground that, because the transaction was only disclosed as a liability, the “LLC failed to disclose in substance” the fact that the forward contract was prepaid. Apparently, the auditing agent and Area Counsel both believed, notwithstanding Revenue Ruling 2003-7, that the forward contract triggered a constructive sale. The ILM does not state whether the concern stems from the fact that the collar band was too narrow, or because the LLC entered into a share lending transaction with the forward counterparty. Accordingly, we cannot tell whether the ILM relates to the audit involving share lending or whether its release at this time is coincidental.


This Alert was written by Mark Leeds in the New York office. Please contact Mr. Leeds at 212.801.6947 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

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