Tax News
VPF with a Short Sale on the Backend is a No Go, Service Says
February 01, 2011
Administrative Actions
Few days ago Chief Counsel (Financial Institutions & Products) released Written Determination Number: 201104031 (UILC: 9300.99-11).  Basically, the IRS said that you can't unwind a variable prepaid forward (VPF) by delivering borrowed shares and not recognize gain.  A VPF is a prepaid forward with an embedded collar where an owner of the shares pledges the shares to a financial institution in exchange for cash. Because of the collar, and because of the variable delivery of shares when the deal is unwound, the transaction is not treated as a sale from the outset.  In other words, the title and benefits of tax ownership remain with the owner of the shares, tax practitioners would argue. Now, this in itself is a sufficiently controversial issue and the Government recently had few successful cases against taxpayers on the tax ownership issue (e.g. Anschutz v. Commissioner, 135 T.C. No. 5 (July 22, 2010)).

Tax ownership in this ruling was not an issue, however. The taxpayer had, what appears to be a good VPF.  On the backend, however, when the parties were going to unwind the VPF, the taxpayer elected physical settlement (i.e. to actually deliver the shares) but instead of delivering the pledged shares, it borrowed shares from another institution and delivered those shares.  Then the taxpayer took the position that it is entering into a short sale and that the VPF remains an open transaction.  In other words, in large part, on the unwind, no gain or loss was recognized.  This strategy appears clever enough and I for one have not seen it. It seems logical too.  When you engage in a short sale you sell borrowed shares and you get cash. The transaction remains open until you buy back the shares. So here, one could argue that the VPF prepayment is associated with the newly borrowed shares (i.e. the short sale leg).  The taxpayer relied on various authorities, such as PLR 200440005, section 1.1233-1, section 1259, Rev. Rul. 2004-15, and Rev. Rul. 72-478, 1972-2 C.B. 487.  Admittedly, I am not familiar with some of these authorities.  What is important here is that Chief Counsel thought that this approach does not work. Counsel had a lot of issues with the taxpayer’s arguments. Gain should have been recognized either under Section 1001 or 1259.  Also, none of the rulings and guidance the taxpayer relied upon were applicable.  In few words, Christina A. Morrison, the drafting attorney, did not like any of this.

Investment funds enter in VPFs. The transaction is much more common for hedge funds than private equity funds, but it is not unheard of that a PE fund enters into a VPF after a company is taken public. This ruling seems to state patently enough the Service’s view in respect of VPFs with an embedded short sale on the backend. I have not analyzed this ruling enough, or had this situation in practice before, so I can’t say who is right or wrong here, but the more important thing, at least to me, is the IRS’ position taken, than the merits or logic of the position.  The ruling can be found on IRS’s website (under “IRS Written Determinations”) and is also copied below.

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Tags: short sale, variable prepaid forward, VPF