Modifications to VPFCs Did Not Constitute Sales or Exchanges; Open Transaction Rule Applied

CCH Tax Day Report

Modifications to variable prepaid forward contracts (VPFC) did not constitute sales or exchanges pursuant to Code Sec. 1001 ; the open transaction treatment afforded to the original VPFCs under Rev. Rul. 2003-7, 2003-1 CB 363, continued until the transactions were closed by the future delivery of the stock. Further, the individual did not engage in constructive sales of stock under Code Sec. 1259 in the tax year at issue because there was no exchange of the extended VPFCs for the originals under Code Sec. 1001.

Comment. A VPFC is a variation of a standard forward contract, requiring the forward buyer (usually a bank) to pay a forward price (discounted to present value) to the forward seller on the date of contract execution, rather than on the date of contract maturity. In exchange for the cash prepayment, the forward seller becomes obligated to deliver to the forward buyer: (1) shares of stock that have been pledged as collateral at the inception of the contract; (2) identical shares of the stock which have not been pledged as collateral; or (3) an equivalent cash amount. The actual number of shares (or cash equivalent) to be delivered by the forward seller is determined by a formula which takes into account changes in the market price of the underlying stock over the duration of the contract.

Under Rev. Rul. 2003-7, VPFCs are open transactions when executed and do not result in the recognition of gain or loss until future delivery. The IRS agreed that the original contracts satisfied the requirements of Rev. Rul. 2003-7. However, the IRS argued that the extensions to the original contracts resulted in taxable exchanges of the original VPFC under Code Sec. 1001. The IRS also argued that the extensions to the original VPFCs resulted in constructive sales of the underlying shares of stock under Code Sec. 1259.

Contrary to the IRS’s argument, the individual contracted for the right to receive cash prepayments in exchange for his obligation to deliver shares of stock (or cash) on specified future dates. After the individual received his cash prepayments, all he had left was the obligation to deliver the stock or the cash equivalent. He did not retain any further property rights with respect to the contracts. Thus, when the individual extended the settlement and averaging dates, he had no right to receive anything more; all he had were obligations that might increase or decrease in amount.

Moreover, the contractual provisions allowing the individual to choose settlement with stock or in cash and to substitute collateral did not equate to property rights. Those provisions did not have any value that the individual could dispose of in an arm’s length transaction. Further, the ability to substitute collateral was not absolute; it was subject to the approval of the counterparties. Thus, the contractual provisions were not property rights but rather procedural mechanisms designed to facilitate his delivery obligations. Therefore, the extensions did not constitute exchanges of “property” under Code Sec. 1001.

Finally, the extensions to the original VPFCs did not constitute constructive sales under Code Sec. 1259, because the original VPFCs were the only contracts subject to evaluation. Since the IRS conceded that the original VPFCs were properly afforded open transaction treatment under Code Sec. 1001 and the open transaction treatment continued when the individual executed the extensions, there was no merit to the IRS’s argument that the extended VPFCs should be viewed as separate and comprehensive financial instruments under Code Sec. 1259. Thus, the extensions to the original VPFCs were not constructive sales under Code Sec. 1259 because there was no exchange of the extended VPFCs for the originals under Code Sec. 1001.

A.J. McKelvey Est., 148 TC —, No. 13, Dec. 60,879

Other References:

Code Sec. 1001

CCH Reference – 2017FED ¶29,226.25

Code Sec. 1259

CCH Reference – 2017FED ¶31,130G.021

CCH Reference – 2017FED ¶31,130G.10

Tax Research Consultant

CCH Reference – TRC SALES: 45,456.05



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