By Matthew Stevens and Clay Littlefield
Alston & Bird, Washington, DC and Charlotte NC
Section 1058 of the Internal Revenue Code provides that no gain or loss is recognized when an owner of securities transfers ("loans") them to another party who is obligated to return identical securities. There are other various requirements including that the stock loaned cannot reduce the stock lender's risk of loss or opportunity for gain on the loaned shares.
Section 1259 of the Code mandates gain if a taxpayer has an "appreciated financial position" and enters into a "constructive sale transaction."
A recent case Anschutz Co. v. Comr.,1 highlights the interplay between the two sections.
In 2000, the Anschutz Company (the "Taxpayer") held appreciated publicly traded stock (through a qualified subchapter S subsidiary) that it wanted to monetize without triggering taxable gain, while simultaneously protecting itself from any future declines in the price of such stock. To accomplish this, the Taxpayer entered into an arrangement (comprised of many separate agreements, but each with substantially similar terms) with an investment bank (the "Bank") in which: (1) the Taxpayer agreed to deliver, at the end of 10 years, a variable number of shares of the stock; (2) the Bank paid Taxpayer a fixed price equal to 75% of the fair market value of the shares on the date the contract was executed; and (3) the number of shares due at the end of the arrangement was tied to the price of the stock at the scheduled time of their delivery (i.e., a variable prepaid forward contract arrangement). Under the contractual formula, the Taxpayer would not suffer any loss upon a depreciation in the value of the shares over the term of the contract term; however, the Taxpayer would enjoy the first 50% of any appreciation in the forward-sold shares during the term of the arrangement. To secure its obligation to deliver the shares due under the contract, the Taxpayer pledged them to the Bank.
Upon entering the stock sale agreement, the Bank was economically long the shares. To hedge this long position, the Bank needed to short the stock, and initially borrowed the necessary shares in the market. However, this borrowing of shares from the market would cost the Bank money to maintain over the term of the contract. To avoid incurring this cost, the Taxpayer authorized the lending of its pledged shares to the Bank for the 10-year term of the transaction. In return, the Bank paid the Taxpayer 5% of the value of the lent stock, with a rebate owed by the Taxpayer to the extent the shares were returned to the Taxpayer during the 10-year term.
The IRS contended that the Taxpayer should be required to recognize gain on the appreciated shares in 2000 when the above arrangement was entered into, either because the Taxpayer had completed a sale of the appreciated shares, or because the arrangement constituted a constructive sale under §1259. In either case, the Taxpayer would be required to recognize gain, although the amount of such gain could vary depending on which theory the court adopted. Not surprisingly, the Taxpayer contended that it had neither sold the stock under common law principles nor entered into a constructive sale of the shares. The Tax Court agreed with the IRS that the Taxpayer had completed a common law sale of the appreciated stock when it entered into the arrangement, but rejected the IRS's argument that the arrangement constituted a constructive sale transaction.
The Tax Court held that the Taxpayer entered into an integrated transaction composed of two legs — an agreement to sell shares in the future, and an agreement to lend those shares immediately (or almost immediately) upon entry into the contract. Thus, the court held, "[i]f we analyze [the Taxpayer's] transactions as a whole, it is clear that [the Taxpayer] transferred the benefits and burdens of ownership, including (1) legal title to the shares; (2) all risk of loss; (3) a major portion of the opportunity for gain; (4) the right to vote the stock; and (5) possession of the stock." While the Taxpayer did retain, and did exercise on two occasions, the right to recall the pledged shares, the court treated these as borrowings of shares that had previously been sold (done solely for tax purposes), rather than as indications that the shares had, in fact, not been sold.
Of course, it was hard for the Taxpayer to contend that it still owned the loaned stock under general common law principles — the Bank had sold the loaned stock into the market, where the buyer (or his transferee) was presumably claiming ownership. Even a discipline as abstruse as tax law requires that each share of stock have only a single owner. The new record owner of the loaned shares will have all of the burdens and benefits of ownership and the right to convey title, and must be seen as the owner of the stock under common law tax principles. The Taxpayer contended, however, that §1058 applied to the transaction. That section generally allows a taxpayer to lend out its stock without recognizing any gain, even though the Taxpayer ceases to be the owner of the loaned shares for tax purposes. In order to qualify for the protection of §1058, however, the stock loan cannot reduce the stock lender's risk of loss or opportunity for gain on the loaned shares. In Anschutz, the court viewed the share loan agreement and the variable prepaid forward agreement as a single integrated agreement. Because the variable prepaid forward contract protected the taxpayer from any downside risk with respect to the forward-sold stock, the integration of the two agreements made it impossible to conclude that the taxpayer retained any of the risk of loss on the loaned shares. Thus, the court concluded that Section 1058 did not protect the Taxpayer from recognizing gain upon its entry into the stock loan agreement.
On the §1259 issue, however, the Taxpayer won. Section 1259 provides that if a taxpayer has an "appreciated financial position" with respect to which it enters into a "constructive sale transaction," the taxpayer recognizes gain as though it had sold the appreciated financial position for its fair market value (even if, as was the case in Anschutz, the taxpayer actually receives cash less than the fair market value of the stock). The IRS had argued that either the Taxpayer had executed a short sale (i.e., that the Bank was acting on behalf of the Taxpayer when it shorted the stock at the inception of the transaction) or the Taxpayer had executed a forward contract. The Tax Court rejected both of these contentions, holding that the Bank had sold the shares short into the market, for its own account, not the Taxpayer's. The Tax Court also held that the variability provided by the variable prepaid forward contract was sufficient to fall outside the legislative history's definition of a "forward contract."
For many years, financial products tax practitioners have posited that the ownership test for publicly traded stock should emphasize the power to transfer title, rather than the more general "benefits and burdens of ownership" test used to determine tax ownership of other types of property. While the result reached by the Tax Court in Anschutzis consistent with this theory, the Tax Court's reliance on a traditional common law-based burdens and benefits of ownership test leaves practitioners uncertain as to what the result will be in other fact patterns.
Once the court determined that a sale was deemed to have occurred on the Taxpayer's entry into the contract, it then had to determine how much consideration the Taxpayer should be treated as receiving. The court held that the Taxpayer should be treated as having received only the cash it received for entering into the variable prepaid forward contract, plus the cash that was denominated as a stock lending fee, but not as having received any property right pertaining to the shares it would have been entitled to receive in the future if the stock appreciated. Could this be treated as an installment sale of the sold shares, in which case the taxpayer would have been subject to an interest charge on the deferred tax liability? If not, then is there a continuing opportunity for some deferral in these types of arrangements?
Finally, the court's holding on §1259 is interesting because it focuses on the potential variation in the number of shares, rather than in the total percentage of value retained as a percentage of their potential future upside. Does this suggest that a taxpayer could plan around §1259 by including a very small possibility of retaining a very substantial number of shares?
For more information, in the Tax Management Portfolios, see Schizer, 186 T.M., Financial Instruments: Special Rules, and in Tax Practice Series, see ¶1810, Transactions in Stock, Securities, and Other Financial Instruments.
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