After a recent Tax Court ruling (the Anschutz decision) involving a Donaldson, Lufkin & Jenrette product, structured product departments at investment banks who were selling to high net worth individuals (HNWs) a tax-advantaged monetization strategy involving a prepaid forward structure coupled with a counterparty’s hedging of its position through a stock lending agreement with the forward seller, may want to revisit their structure.
In a typical prepaid forward structure, a forward seller (a long party) holds shares of a publicly traded stock appreciated in value. A forward seller and the counterparty would enter into a forward sale and purchase agreement and, contemporaneously, the forward seller would borrow an amount equal to a percentage of the current market value of shares of stock from the counterparty (the “prepaid” element of the structure). The forward seller would also pledge the stock to secure the loan. The forward contract can be settled in cash or in-kind (by delivering shares) and is typically net settled (i.e., payments due by the counterparty, such as dividend or interest payments, are netted against the forward seller’s obligation to deliver shares at maturity. In a variable forward structure, at the conclusion of the loan term, the forward seller would generally to deliver a number of shares to the counterparty or an equivalent amount of cash, which may be different than the amount pledged, depending on whether the stock appreciated or depreciated over the term of the loan. Typically, the long party would have an upside limit and may also have a downside protection. Usual loan terms would be: a mid term maturity, interest bearing, and non-recourse except with respect to the pledged stock. If the stock falls in value by more than a stated amount during the loan term, the forward seller would be required to pledge additional collateral.
In order for the counterparty to hedge its risk, it would have to borrow the pledged shares in almost every instance so it can enter a short position on the pledged shares.
When it comes to tax consequences, the structure makes sense for the forward selling party, as long as it is able to monetize its position and not pay taxes at the time it pledges stock. The long party would have to pay tax if the Internal Revenue Service (NYSE:IRS
) considered it to have sold shares pursuant to the forward prepaid sale.
Borrowers are not required to pay tax when they secure a non-recourse loan secured by property (including shares of stock), because, typically, pledging property to secure a loan is not considered a taxable sale. Moreover, the variable element in the structure, allowed taxpayers to argue that because the number of shares and the identity of certificates would be unknown until near the settlement date, the transaction should be considered an “open” transaction. Under long standing tax principles, open transactions are not considered taxable.
However, if the property (shares) pledge is coupled with another transaction in which the forward seller/borrower is considered to have sold shares to the counterparty, the pledge may be considered a taxable sale even where the value of the pledge property exceeds the loan amount. For instance, the IRS may assert that the long party sold shares in an installment sale where the pledged shares exceed the loan amount in value.
In a 2003 ruling, the IRS ruled that a pledge of stock in a plain vanilla forward prepaid variable structure coupled with a contemporaneous stock lending agreement did not result in a taxable sale by the forward seller, as long as the forward seller had legal rights and means to reacquire shares identical to the shares pledged as collateral and was not economically compelled to deliver to the counterparty the pledged shares. In a subsequent 2006 ruling, the IRS dealt with a variable forward structure and interpreted the 2003 ruling restrictively to treat as a taxable sale the transaction where the counterparty had a “put” option with the long party in case the counterparty was unable to hedge the pledged stock (the long party also may have relinquished its voting rights upon pledging). The IRS considered the forward purchase sale and the stock lending transactions stapled and ruled that the forward seller sold its stock at the time the shares of stock were pledged.
After the 2006 ruling, practitioners went to great lengths to decouple the forward sale and purchase from the stock lending leg of the transaction, most often requiring a 30-90 day time lag between the two legs of the transaction and even that the forward seller be allowed to withhold consent to the counterparty’s borrowing to sell the stock short or pledge additional collateral. Once decoupled, the practitioners argued that the stock lending leg of the transactions would otherwise qualify as a tax-free transaction under the Tax Code stock lending provision (Section 1058). Generally, under the Tax Code’s stock lending provision, a stock lender is not considered to have sold the stock lent to the stock borrower and will not pay tax on the stock lending transfer, if the borrower returns identical securities, makes dividend payments the stock lender would otherwise receive, and the stock lender does not reduce the risk of loss or opportunity for gain as a result of the transfer. Based on legislative history regarding the constructive sales Tax Code provision and the facts of the 2003 ruling, some practitioners considered a twenty-five point spread between the put and the call price sufficient indicia of residual risk.
Despite the taxpayer’s loss, the Anschutz decision comes as good news to structured products desks and practitioners as it flushed out what works and what does not in terms of decoupling the two legs of the above transaction as well as the requisite variance to avoid the application of the constructive sales rules.
In light of the Anschutz decision, investors engaged in these types of transactions should consult with their tax advisors to assess whether they need to restructure the transaction.
This letter is not intended to provide any tax advice and its contents may not be used to avoid penalties under the Internal Revenue Code. Disclosure: