Tax Court Rules the Extension of Variable Prepaid Forward Contracts Is Not a Taxable Event

By:
LD Sergi and Matthew Kaufman
Published Date:
Jul 1, 2017

On Apr. 19, 2017, the United States Tax Court in Estate of Andrew J. McKelvey v. Commissioner held that the extension of certain variable prepaid forward contracts (“VPFC”) did not result in a sale or exchange of property under IRC section 1001 and that the open transaction treatment provided to VPFCs in Revenue Ruling 2003-7 continues until the transactions are closed through the future delivery of the stock underlying the VPFC, or the cash equivalent. The court also held that the extension of the VPFCs did not give rise to a constructive sale under IRC section 1259. 

Background

Andrew J. McKelvey entered into two VPFCs with separate investment banks referencing shares of appreciated stock he held.  Under the terms of each contract, McKelvey received an upfront cash payment in exchange for a legal obligation to deliver a variable number of shares, or cash of equal value, approximately one year later. The number of shares to be delivered under each contract varied depending on the fair market value of the stock on the settlement date. To secure his obligation, McKelvey pledged as collateral the maximum number of shares that could be required to be delivered under each contract. 

Prior to the scheduled maturity of each VPFC, McKelvey made a payment to each investment bank to extend the maturity date of each contract by approximately 16 months. At the time of the extensions, the price of the stock underlying the VPFCs had decreased since the inception of the contracts. Thus, the cash received was greater than the fair market value of McKelvey’s outstanding obligations, and the court considered the effect of such extensions. 

The VPFCs that are the subject of McKelvey are similar to the VPFC addressed in Rev. Rul. 2003-7. In Rev. Rul. 2003-7, the IRS concluded that the VPFC in question (i) was afforded open transaction treatment, in other words, the VPFC did not result in a current sale of the underlying shares, and (ii) did not result in a constructive sale under IRC section 1259.  The analysis in Rev. Rul. 2003-7 relies, in part, on the legislative history to IRC section 1259 which states that a forward contract providing for delivery of property in an amount subject to significant variation, does not result in a constructive sale.  The Commissioner did not dispute that the conclusion reached in Rev. Rul. 2003-7 applied to the original terms of the VPFCs considered in McKelvey

Tax Court Analysis

The Tax Court addressed two issues in McKelvey

  1. Whether the extension of the VPFCs results in an exchange to which IRC section 1001 applies; and
  2. Whether the extension of the VPFCs results in a constructive sale of the underlying shares pursuant to IRC section 1259.

Under IRC section 1001, gain or loss is realized upon a sale or exchange of property differing materially either in kind or in extent. In this regard, the court focused its discussion on whether, at the time of the contract extensions, the VPFCs were “property” in the taxpayer’s hands. The court ruled that at the time of the extensions, McKelvey’s lone right had been satisfied and he had outstanding only obligations. The court thus determined the extensions did not constitute exchanges of property under IRC section 1001 with respect to McKelvey.   

The court further concluded that the extension of the VPFCs did not result in a constructive sale based on its conclusion that there was no exchange under IRC section 1001. Therefore, the court determined there was no need to retest the application of IRC section 1259 to the VPFCs.

Observations

The court did not address the materiality of the modifications of the VPFCs, which has long been an area of uncertainty for non-debt financial instruments. In this regard, the IRS included the modification of non-debt financial instruments under IRC section 1001 in its 2016-2017 priority guidance plan. Further, taxpayers might want to consider what the Tax Court’s conclusion in McKelvey means for the modification of other non-debt obligations, such as written options. 


SERGILD Sergi is a tax principal in the Los Angeles office of Deloitte Tax LLP.  







KaufmanMatthew Kaufman is a tax senior manager in the financial instruments group of Deloitte Tax LLP’s Washington National Tax practice.





 
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