Share Loans Under IRS Microscope
[ILLUSTRATION OMITTED] In a recently released Coordinated Issue Paper (LMSB-04-1207-077), the IRS underscored how its examinations will home in on a once-favored strategy for monetizing stock gains while deferring capital gains taxes. In doing so, the Service reiterated its legal basis for why a variable prepaid forward contract (VPFC) that includes a share lending agreement (SLA) results in a currently taxable sale. Technical Advice Memo 200604033 drew widespread consternation when issued in January 2006 because of the popularity of VPFCs as, it was believed, a viable strategy to obtain cash from a highly appreciated stock position without triggering gain. Taxpayers had taken this position based on a 2003 revenue ruling holding that VPFCs under certain circumstances were not sales. COLLARING RISK, SKIRTING GAIN Generally, in a VPFC, a shareholder pledges highly appreciated stock to an investment bank (counterparty) in return for an options collar. In the spread between the collar's put and call exercise prices, the shareholder enjoys protection from stock price declines while still participating in limited further appreciation. In exchange for an upfront cash payment (generally 75% to 85% of the stock's current fair market value), the shamholder agrees to deliver a variable number of shares at maturity, typically in three to five years, or alternately to settle with cash or other property In most cases, the counterparty can hedge its position by selling, re-pledging or investing the pledged securities. Most counterparties borrow the pledged shares and sell them short. The counterparty may be given the right to transfer and to vote the pledged shares. In the earlier revenue ruling, 2003-7 (2003-1 CB 363), the Service said VPFCs per se were not sales, actual or constructive, under either IRC [section] 1001 or 1259, provided specific requirements were satisfied. Most importantly, the shareholder must be under no legal restraint or requirement or under any economic compulsion to deliver the pledged shares to the counterparty and must have the fight to deliver cash, property or other shares. The Service also noted that restrictions on a shareholder's right to own pledged common stock after the exchange date, or an expectation that a shareholder will lack sufficient resources to exercise the right to deliver cash or shares other than pledged shares, would be significant factors in determining whether a sale has occurred. "UNFETTERED USE"A TOUCHSTONE Then, in TAM 200604033, followed by Chief Counsel legal advice memorandum AM-2007-004 (January 2007) and now the coordinated issue paper, the Service said that a VPFC that includes an SLA or other similar arrangement that allows the counterparty to use the pledged shares results in a current tax able sale of the underlying shares. …