Just before New Year’s Eve 2011 the Tenth Circuit affirmed the Tax Court’s ruling against the taxpayer Anschutz Company in a case involving a variable prepaid forward contract. Anschutz Co. v. CIR (10th Cir. 2011). The ruling required the taxpayer to recognize immediately the gain on the stock to be sold under the prepaid forward, rather than postponing gain recognition to the future closing of the sale. The court’s reasoning reflected an unfortunate tendency of courts to default to a “benefits and burdens” analysis of ownership of property rather than grappling with the details of the transactions and the code sections at issue.
Facts: Taxpayer TAC owned appreciated stock of public companies. TAC transferred possession of the stock to a fiduciary and received cash from the counterparty, DLJ. TAC characterized this transaction as involving two simultaneous transactions for tax purposes: (1) as a pledge of the stock to secure its obligation to deliver the stock in the future to DLJ, which had partly prepaid for the future delivery as part of the prepaid forward contract, and (2) as a share lending to DLJ, which would sell the borrowed shares short, purportedly for its own account and not as agent for TAC.
The share lending was facilitated by the fact that the fiduciary, the pledgee of the shares, was authorized to lend the shares to DLJ. In fact, it was DLJ’s sale of the borrowed shares for cash that started the money flow that produced the prepayment on the forward contract.
Law: The IRS ruled in Rev. Rul. 2003-7 that characterization (1) used by TAC could be proper in a transaction that did not also involve share lending. Code section 1058 provides that a share lending will be respected as a loan of shares, and not treated as a sale of shares if, inter alia, the lender receives payments equivalent to the dividends paid on the stock during the term of the lending and the lender’s opportunity for gain and loss is not changed by the lending.
Stock loans normally entail not only the current payments in lieu of dividends described by section 1058, but also a deposit of cash collateral by the stock borrower to secure its obligation to return the shares. Here the documentation of the stock lending evidently did not require cash collateral and did not characterize the cash payment made to TAC as cash collateral (rather, they were part of the prepaid forward contract). In addition, the payments in lieu of dividends to TAC were supposed to occur in a true-up at the closing of the forward sale, and not annually.
Tenth Circuit’s Analysis: The court found section 1058 inapplicable because the payments in lieu of dividends were not paid currently, but more importantly because ATC’s risk of loss was reduced. It found the risk of loss was reduced because of the partial prepayment in the prepaid forward, and the other terms of the prepaid forward, which effectively assured TAC of eventually receiving at least 100% of the initial value of its stock.
Observations: The court refused to integrate the terms of the prepaid forward to make the stock lending appear more similar to a standard stock lending (that is, the prepayment was not the cash collateral for the stock lending), but it integrated the term so that the prepaid forward made the stock lending appear to reduce TAC’s risk of loss.
Because the IRS had effectively waived the power to treat a prepaid forward as a current sale, the IRS had to rely on treating the stock lending as a current sale. The court in effect agreed with this approach, but the opinion did not make clear that it based its ruling on imposing recognition on the stock lending. Rather, it went through a long analysis of ownership of property, referred to above as a “benefits and burdens” test, which can produce results at odds with the standard treatment of both stock lending and prepaid forward contracts. Taxpayer was not eligible for those standard treatments because of the non-standard combination of the two types of transactions that it attempted.
Even though the opinion resorted to supposed first principles for determining ownership of property, the import of the ruling is that a transaction structured as a stock loan will be taxed as a sale if a related transaction eliminates the lender’s risk of loss, even when that related transaction standing alone is not a recognition event (here, the prepaid forward).
TAC might have had a better argument if the parties had found a way economically to have payments in lieu of dividends made annually. Also, characterizing the prepayment on the forward contract as collateral for the stock loan might have helped. However, the problem with that approach would have been that if the stock loan were recalled, ATC would have to return the cash collateral pledged by DLJ, which it did not have to do when it recalled some of the loans and retained the cash because it was received under the prepaid forward contract.
Thus, the very combination of two transactions that TAC relied on to obtain the economic benefits it wanted prevented the tax characterization it wanted, at least in the eyes of the Tenth Circuit.
