Extension of Variable Prepaid Forward Contracts Results in Taxable Capital Gain, Tax Court Holds

The Tax Court on November 2 held, on remand from the Second Circuit, that a taxpayer’s amendments to extend the settlement dates for a set of variable prepaid forward contracts (VPFCs) terminated the taxpayer’s original obligations with respect to this set of VPFCs, resulting in more than $70 million in short-term capital gain for the taxpayer (Estate of McKelvey v. Commissioner, 161 T.C. No. 9). The Tax Court determined that by extending the settlement dates on these VPFCs, the taxpayer had effectively exchanged one set of VPFCs for another. 

The U.S. Court of Appeals for the Second Circuit in 2018 had reversed a 2017 decision by the Tax Court with respect to whether the taxpayer realized gain on the VPFC exchange in the year it occurred. While the Second Circuit agreed that the VPFC exchange was not an exchange of “property” triggering gain under Internal Revenue Code Section 1001, it considered an alternative argument from the government that the exchange triggered short-term capital gain under Section 1234A by terminating the taxpayer’s obligations under the original VPFCs.

The Second Circuit remanded to the Tax Court to determine if what the court had concluded was an exchange of contracts constituted a termination of obligations that would give rise to taxable capital gain and, if so, the amount of that gain. 

Modification of VPFCs

The taxpayer – the founder of job search site Monster.com – entered into VPFCs with two banks in 2007. In exchange for cash prepayments in 2007 of approximately $50 million and $142 million, the taxpayer agreed to deliver to the banks on set dates in 2008 approximately 1.8 million and 4.8 million (respectively) Monster shares or their cash equivalent. The actual amount of shares or cash delivered on each settlement date was set to vary based on the Monster stock price on given dates.

In 2008, the taxpayer paid the two banks approximately $3.5 million and $8.1 million in consideration to extend the settlement dates of the VPFCs until 2010. The taxpayer subsequently died in November 2008, and the taxpayer’s estate settled the VPFCs in 2009. 

The taxpayer’s 2008 tax return reported no gain on the 2008 extension/exchange of the VPFCs. The IRS in 2014 issued a notice of deficiency asserting the taxpayer realized capital gain of approximately $200 million. 

Termination of Obligations

The Second Circuit held that the extension of the VPFCs resulted in a replacement of the original contracts. It remanded to the Tax Court on whether this exchange of contracts resulted in a termination of obligations resulting in taxable short-term capital gain under Section 1234A. 

In considering whether there was a taxable termination of obligations on the VPFC exchange, the Tax Court reviewed guidance and case law addressing options – which, the court reasoned, are analogous to VPFCs. The court concluded that treating the extension of the VPFCs as an exchange of one contract for another makes the transactions similar to an option repurchase. As with an option repurchase, the court determined that the exchange of contracts resulted in a termination of the taxpayer’s obligations under the first set of contracts. 

Taxable Gain on Exchange

Section 1234A provides, in general, that gain or loss on the termination of a right or obligation with respect to a capital asset is treated as a gain or loss on the sale of a capital asset. The Tax Court noted that the Monster shares – with respect to which the taxpayer had an obligation – are capital assets. Because the exchanges of the VPFCs terminated these obligations, the court held that Section 1234A applies to the exchanges. As the taxpayer held the first set of VPFCs for less than a year, the resulting gain is short-term capital gain.

The court dismissed the argument of the taxpayer’s estate that the open transaction doctrine applies. The court noted that the open transaction doctrine applies only when it is impossible to determine the value of either of the exchanged assets. The court stated the doctrine does not apply in taxpayer’s case because it is possible to determine the value of the property and obligations exchanged and thereby the gain on the exchange of the first set of VPFCs; it does not matter that at the time of the exchange it would not have been possible to calculate the gain on the second set of VPFCs.

Having determined that any gain would be short-term capital gain and that the open transaction doctrine does not apply, the court turned to Section 1001 to calculate the gain. The court noted that although Section 1001 generally applies to the sale or exchange of property, Section 1234A provides that gain or loss from the termination of an obligation with respect to property which is a capital asset in the hands of a taxpayer is treated as gain or loss from the sale of a capital asset – despite the nonproperty nature of the obligation. Taking the prepayment amount that the taxpayer received and subtracting the taxpayer’s basis in the transactions (calculated as payments to the VPFC holders and the taxpayer’s outstanding liability related to the second set of VPFCs), the court held that taxpayer realized approximately $72 million in short-term taxable gain in 2008 when the VPFCs were exchanged. 

BDO Insights

Although clear guidance exists with respect to modification of debt instruments, the same is not true for modifications of non-debt financial transactions. Modifications of such instruments – in particular, interest rate swaps – have become increasingly common due to recent changes in interest rates. For that reason, the analyses in the McKelvey decisions (both the Tax Court’s and the Second Circuit’s prior to remand) are noteworthy and portend how the IRS may approach modifications to other derivatives in the future, including interest rate swaps.