This article is written by Vaibhavi S U and pursuing a Certificate Course in Advanced Commercial Contract Drafting, Negotiation & Dispute Resolution. This article has been edited by Zigishu (Associate, Lawsikho).
This article has been published by Sneha Mahawar.
Table of Contents
Introduction
If your best friend loans you money, is it taxable? Nope. How about a sale? If you receive money for selling your stock, it is income. Can you get money upfront that is not a loan, but that also isn’t income when you receive it? The answer to this riddle is “yes,” – with a variable prepaid forward contract. A Prepaid Variable Forward Contract is a mechanism used by stockholders in market equity transactions to cash in portions of their stock and defer the tax on capital gains.
It’s a method used by investors who desire to generate liquidity from their huge stock holdings. A PVFC is a contract in which an investor promises to sell a specific number of shares at a discount, typically between 75 and 90 percent of the current market value, but the buyer does not take possession of the shares immediately but rather at a later date. The amount of shares owed at maturity is not always the same as the fixed sum and is variable.
How does PVFC work
A variable prepaid forward isn’t really a loan; it’s a sale of a variable number of shares that will be delivered at a later date in exchange for a cash advance today. However, the number of shares—and consequently their exact cash value—isn’t known until the stock’s price reaches maturity. It’s because of this uncertainty that these transactions don’t trigger the constructive-sale regulations, which allow you to postpone paying taxes while hedging your equity position. The downside protection comes from the fact that even if the stock price falls, the investor only loses the shares pledged. Variable prepaid forwards can be constructed in a variety of ways since they are individually negotiated.
This method works well for a client who is already planning to sell the stock. He generates more money upfront than he would in after-tax proceeds from an outright sale, defers capital-gains tax for at least the life of the contract, and doesn’t lock himself into a sell decision because, at maturity, he can create a cash settlement and retain his shares or roll them into a new trade.
A prepaid variable forward contract is an open transaction similar to a stock option. because both involve a future commitment. To better comprehend a PVFC, we’ll break it down into component phrases. First and foremost, it’s a contract, normally between an investor and a financial institution or brokerage firm. Second, the agreement specifies that the shares will be given by the investor at a later period, making it a forward contract. There’s also the option of paying cash instead of stock. Furthermore, it’s a prepaid forward contract because the investor often receives all of the money upfronts without giving up ownership of the stock. Because the transaction is not completed, the prepayment is handled as a loan or debt, with the underlying security acting as a contingency. Furthermore, the payment is made at a discount, which might be considered a sort of loan interest expense. Finally, the prepaid forward contract is variable since the number of shares that the investor must provide is determined by the current share value at the time of expiration or maturity. A floor, or lower strike price, and a threshold, or upper strike price, are normally set at the time of contract execution. These strike prices serve as a guide for calculating the number of shares due on a sliding scale.
The goals and benefits of Prepaid Variable Forward Contracts (PVFC)
Prepaid variable forward contracts (PVFCs) are popular among investors for a variety of reasons, including:
- Hedging against the risk of a bear run, could result in significant losses, particularly for executives who own large amounts of stock and are unable to sell due to public relations.
- To obtain liquidity from a high unrealized gain in a stock position.
- To delay capital gain taxes, which would otherwise be paid as a result of gains from the sale of securities.
- It is a simpler way to secure a loan with a lower interest rate.
Disadvantages of Prepaid Variable Forward Contracts (PVFC)
The usage of variable prepaid forward contracts is divisive, eliciting opposing views from many sectors. Arguments against it centre on corporate ethics violations, such as investors’ desire to delay capital gains taxes, protect voting rights, keep a limited upside gain, and decrease litigation risk.
However, in some situations, the strategy is useful. For example, in some cases, CEOs are prohibited from trading their shares for a set length of time. Insiders can also unwind company-specific risks by selling a big chunk of a company’s assets through hedged transactions.
The technique also provides a share or cash settlement option, meaning that the transaction is either a zero-coupon loan with a zero-cost collar or the sale of an underwater call option with a deferred and prepaid stock sale. Similarly, a trading strategy can shield a corporation from expected future performance declines while also hedging against future uncertainty.
A variable prepaid forward contract is likely to reflect private information in any instance. It is due to the fact that the transaction involves a significant amount of company-owned stock. In comparison to the Center for Research in Security Prices value-weighted index, the CSRP’s equally-weighted index, an industry average, and a matched sample on size and industry, the method is associated with a relatively average drop in excess returns.
Technically, it’s a zero-cost collar transaction, with the stock represented by a short call option and a long put option.
The third feature is a prepaid variable forward contract that is monetized by taking out a loan against the underlying stock. Financial engineering advances are reducing the complexity of off-market transactions. The complex current elements are inserted to make it easier to incorporate insiders’ sensitive information into the transaction.
For example, in 2010, billionaire Philip Anschutz made headlines after losing a high-profile case concerning the use of PVFCs to avoid paying capital gains taxes on over a hundred million dollars. The Tax Court held that a prepaid forward sale of a security, combined with a loan of that security to the forward purchaser, triggered a taxable sale of the underlying security upon receipt of the up-front payments. Philip Anschutz challenged the finding, but the United States 10th Circuit Court of Appeals in Denver affirmed the tax court’s 2010 decision that Mr. Anschutz had transferred the benefits and burdens of ownership to the forward purchaser in late December. Because the PFC was improperly treated as an open transaction, he owes the IRS at least seventeen million dollars in capital gains taxes.
Later, in 2011, Ronald Lauder, the heir to the Este Lauder cosmetics company, was the subject of a front-page article in the New York Times about how he and his family had evaded taxes since the company went public in 1995. According to the paper, Mr. Lauder obtained $72 million in cash from an investment bank via a prepaid variable advance, but the contract was cleverly structured to evade taxes. Furthermore, the PVFC protected his extraordinarily high executive salary in relation to the typical employee compensation level.
This isn’t to say that using a prepaid variable forward contract will always get you in trouble with the IRS. There are a few things to keep in mind before proceeding. The contract, for example, should be well-drafted in accordance with the stock lending provision.
Let us consider a hypothetical situation where an investor owns a relatively large number of shares in Company X. The shares are priced at $9 each, and the investor commits $100,000 in a variable prepaid forward contract and trades them at $9.5 per share with a maturity of three years. The cap floor and upper floor prices are set at $8 and $10, respectively. The total sale, including the principal, would amount to $950,000.
At the end of the third year, the investor will deliver all the pledged shares if they sell below $8. In such a case, the investor is under no obligation to compensate for the loss through financial consideration or additional shares.
Nevertheless, if the shares are trading at the preset values of $8, $9.50, or $10, one can obtain the due share by dividing the principal ($950,000) and the current market value of the stock (either $8, $9.5, or $10).
If the share price is $8, the investor pays $118,750 ($950,000 / $8).
If the price per share is $9.50, the investor will deliver $100,000 ($950,000 x $9.50).
If the price per share is $10, the investor will deliver $95,000 ($950,000 x $10).
At the other end of the spectrum, the investor will deliver a sum of the principal ($950,000) plus the excess of the share above $10 if the shares are traded at a value that exceeds the preset upper strike.
It then follows that:
If the price per share is $12, the investor will deliver $1,150,000 ($950,000 + 100,000) ($12 – $10).
Alternatively, the investor can deliver approximately 95,833 shares ($1,150,000/12).
The deferred capital gain tax only becomes due relative to the previous gains after the shareholder delivers the shares and settles the transaction.
Conclusion
Prepaid forward contracts will very certainly always be considered exotic. At the same time, they can be a legal way to generate money in a tax-efficient and financially prudent manner. A forward contract is an agreement to sell something in the future. The upfront cash acts as a tax-free deposit between the signing and closing of the deal. A prepaid forward contract, like a loan, offers cash to the seller without immediate taxation if specific conditions are met. Obtaining the proper documentation, on the other hand, is crucial.
References
- https://www.investopedia.com/terms/v/variable-prepaid-forward-contracts.asp
- https://www.investment-and-finance.net/derivatives/p/prepaid-forward-contract.html
- https://www.thetaxadviser.com/issues/2018/feb/no-gain-extension-prepaid-forward-contract.html
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join:
Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.
