Paul L. Caron

Friday, July 23, 2010

Tax Court Rejects Billionaire Anschutz's Use of Variable Prepaid Forward Contracts to Avoid $144m Capital Gain

The Tax Court yesterday disallowed billionaire Philip Anschutz's use of variable prepaid forward contracts with Donaldson, Lufkin & Jenrette to avoid $144 million in capital gains taxes. Anschutz Co. v. Commissioner, 135 T.C. No. 5 (July 22, 2010).

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As the CEO of Intelligent Edge Advisors, an investment banking and brokerage boutique focusing exclusively on the tax-efficient monetization of concentrated wealth, including concentrated positions in publicly-traded stock, I’m keenly aware of current events in this very complex discipline and what the potential impacts could be for investors.

Anschutz was decided by the Tax Court on July 22nd and McCombs was filed in Tax Court in May. In addition, the IRS has previously challenged the tax treatment of PVFs in four other separate cases dating back to 2001, 2006, 2007 and 2008. In each of these cases the IRS released an accompanying memorandum concluding that the PVF was a “common law sale” triggering an immediate taxable event because the investor did not retain sufficient “incidents of ownership” with respect to the hedged shares. In addition, the IRS directed its agents to audit investors who executed PVFs (which has occurred), suggested that PVFs might constitute “tax shelters”, and identified a litany of potential penalties that would apply if a PVF was deemed a tax shelter. So the PVF has been under steady attack since 2006.

While it’s certainly not good news for investors that a PVF was successfully challenged, the “good news”, I suppose, is that collectively these “case studies” can give investors and their advisors some guidance as to what it might take to structure PVFs in the future that will pass muster with the IRS. For instance, it is absolutely clear the investor should not enter into an arrangement to make its shares available for the dealer to borrow (to enable the dealer to facilitate its hedge).

However, even if a PVF is structured conservatively from a tax perspective, because of its very nature - and by that I mean it’s legal form - some degree of tax uncertainty will remain, and many advisors seem to be completely missing this point.

The PVF is a classic case of “regulatory arbitrage” and that gives it a “shaky foundation” to begin with. That is, for margin rule (Reg T) purposes a PVF is intentionally structured to trigger an immediate sale - this is why the margin rules do not apply to PVFs and there are no limitations on the use of the cash proceeds that are released to the investor. In direct contrast, for tax purposes a PVF is not supposed to be an immediate sale. Can you feel that tension?

The IRS and government regulators typically bristle when they are aware such regulatory arbitrage is occurring and often take action to eliminate it. For instance, the recently passed Dodd/Frank Act severely limits the use of “trust preferred securities” by bank holding companies - those securities were a form of regulatory arbitrage as they were simultaneously treated by the bank holding company as debt for tax purposes (with interest payments being tax deductible) and Tier 1 capital for regulatory purposes.

One of the basic tenants of U.S. tax law is that form controls over substance, and a PVF has the legal form of a sale. The documentation clearly labels and refers to the transaction as a sale and a PVF is in fact treated as a sale for regulatory (margin rule) purposes.

It is certainly not outside the realm of possibility that this line of reasoning might form the basis for future challenges. Therefore, it would seem advisable to use a strategy that does not have the legal form of a “sale” in order to eliminate this inherent risk.

Having said this, and given the steady and repeated attacks by the IRS, it is perlexing why Wall Street continues to tout PVFs as the "preferred" hedging & monetization tool for investors desirous of hedging, monetizing and deferring taxes on their concentrated positions, while there are other tools and techniques that can be used to achieve these objectives that don’t have nearly the same degree of tax risk posed by PVFs.

Feedback from tax practitioners on this point is welcomed and appreciated.

Posted by: Thomas J. Boczar, Esq., LL.M., CFA, CEO of Intelligent Edge Advisors | Aug 1, 2010 10:48:25 AM