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In Revenue Ruling 2003-7 [2003-5 IRB 1 (January 16, 2003)], the 1RS held that a shareholder who entered into a variable prepaid forward transaction secured by a pledge of appreciated shares neither caused a sale of stock under general tax principles nor triggered a constructive sale under IRC section 1259. The 1RS had previously released a field service advice (FSA 200111011) that reached a different conclusion on a somewhat different set of facts. Additionally, the Denver office of the 1RS has been challenging several variable prepaid forward transactions, most notably that of Giber, Inc., chief executive Bobby G. Stevenson, arguing that the taxpayers should be considered to have sold their stock upon execution of the transaction. Revenue Ruling 2003-7 appears to be good news for investment banks that have seen declines in many areas of their business. The 1RS' position may embolden those hesitant to move forward with variable prepaid forward transactions.
Revenue Ruling 2003-7
In the facts of the ruling, an individual held appreciated shares of a publicly traded corporation. The shareholder entered into a variable prepaid forward transaction with an investment bank, wherein the shareholder agreed to deliver to the investment bank upon expiration of the contract (exchange date) a variable number of shares of such stock (determined by a formula) in exchange for an upfront cash payment upon execution of the agreement. The term of the transaction was three years. Under the formula, if the market price of a share of the common stock was less than $20 on the exchange date, the shareholder would have to deliver 100 shares of the common stock to the investment bank. If the market price of a share of stock was between $20 and $25 on the exchange date, the shareholder would have to deliver a number of shares having a total market value equal to $2,000. If the market price of a share exceeded $25 on the exchange date, the shareholder would be required to deliver 80 shares of common stock. This is the equivalent of an embedded collar band equal to 100-125% of the fair market value of the shares upon execution of the transaction.
In order to secure the obligation under the variable prepaid forward, the shareholder pledged to the investment bank...