Court of Appeals reverses Tax Court holding on derivative extensions
The IRS scored a multi-million dollar victory against the estate of Monster Worldwide, Inc. founder Andrew McKelvey in the Second Circuit Court of Appeals. Estate of Andrew J. McKelvey v. Commissioner, No. 17-2554 (2d Cir. 2018). The IRS sought $41 million of tax based on treating extensions of two variable prepaid forward contracts (VPFCs) as taxable transactions.
The 2017 Tax Court decision in this case held the VPFC extensions nontaxable (see our prior alert), but the Second Circuit reversed that decision on appeal in 2018. The Second Circuit held that the extensions were taxable as long-term capital gain from a constructive sale of the Monster stock. In an even worse development for the taxpayer, the Second Circuit stated that the extended VPFCs represented new contracts for federal income tax purposes, which may give rise to short-term capital gain on the original VPFCs. This second issue was remanded for further consideration by the Tax Court.
Variable prepaid forward contracts
In regular forward contract, the parties exchange both the subject property and the agreed-upon price when the forward expires. A VPFC (or other prepaid forward) requires the buying party to make payment to the selling party at the inception of the contract. The variable nature of VPFCs comes from the fact that the quantity of property (often corporate stock) to be delivered varies with its market value; terms are generally set so that the buyer receives an interest-like return on its initial payment, with the seller retaining some economic upside or downside. Such The upside and downside generally are capped by a ceiling and floor on the number of shares to be delivered, a distinction which ultimately factored into the court of Appeals’ analysis. Some contracts, including the ones in this case, also allow the seller to make a cash payment in lieu of actual delivery of shares, with that payment equal to the market value of the shares that would otherwise be deliverable.
VPFCs structured like the one described in Rev. Rul. 2003-7 generally receive open transaction treatment—the seller recognizes no gain or loss until the seller delivers shares (or cash) to close the contract. This ruling means that VPFCs may be an attractive way to monetize appreciated assets while deferring tax related to that appreciation.
The Second Circuit’s ruling
The Second Circuit first considered the Tax Court’s holding that the taxpayer did not recognize gain upon modification of the original contracts because the taxpayer held only obligations, rather than property rights that could be exchanged. The Appeals Court agreed that the taxpayer had only obligations, not property. However, it noted that section 1234A requires capital gain to be recognized on the termination of an obligation with respect to property that is a capital asset in the hands of the taxpayer (which the Monster shares were). The Second Circuit held that the extension of the VPFCs represented entry into new contracts for federal tax purposes. The Court agreed with the IRS contention that, “by extending the valuation dates, the parties fundamentally changed the bets that the VPFCs represented, from bets on the value of Monster stock in September 2008 to bets on the value of Monster stock in January and February 2010.” The Second Circuit adopted the fundamental change principle set out in Rev. Rul. 90-95, and held that because the extension constituted an exchange of old contracts for new contracts because the extensions represented a fundamental change to each contract.
The Second Circuit also remanded this issue to the Tax Court to determine whether capital gain resulted from this exchange of contracts. The gain in question could be short-term capital gain, based on the as the amount of time the contracts had been outstanding.
The Court next explained why it held the VPFC extensions resulted in constructive sales of the underlying Monster stock. As mentioned above, the VPFCs were subject to both a cap and a floor on the number of shares that eventually would be delivered. At the time the contract extensions were effected, the underlying Monster shares had declined greatly in value. Because of that decline in value, the cap would very likely be in effect at settlement of each contract. An expert witness for the government testified that the probability of the cap applying was 85 and 87 percent for each of the two contracts.
In view of this analysis, the Second Circuit held that the extended contracts amounted to obligations to deliver a fixed number of shares, triggering the constructive sale rules of section 1259. The constructive sale’s result was that the taxpayer recognized long-term capital gain on the appreciated Monster shares – those shares were treated as sold at the time of the extension.
Notwithstanding the turn of events against the taxpayer in the instant case, the general principle that original entry into a properly effected VPFC does not cause gain recognition is still valid under Rev. Rul. 2003-7. As such, VPFCs remain a valuable planning tool, even if their flexibility has been somewhat curtailed.
More broadly speaking, the case has importance for taxpayers who modify derivative contracts. The Second Circuit’s application of the fundamental change principle to modifications of the derivative VPFCs at issue and its acceptance of probability analysis in applying the constructive sale rule should both prove relevant to the analysis of other derivative contract modifications. Taxpayers considering modifying their derivative contracts should consult with their tax advisors regarding the expected consequences.