In a rare application of Section 1234A, the Tax Court has held that extending the settlement dates of a set of variable prepaid forward contracts (“VPFCs”) was an exchange for a second set of VPFCs that terminated the taxpayer's underlying obligations under the first set, resulting in short-term capital gain of $71.7 million to the Estate of McKelvey (the “Estate”).
In 2007, Andrew McKelvey entered into multiple VPFCs with two different investment banks. In exchange for substantial cash prepayments, the VPFCs required McKelvey to deliver, at various settlement dates in 2008, a number of shares in Monster Worldwide Inc. (“Monster”) (a company that McKelvey founded) that would vary with Monster's share price at the time of the settlement dates. In 2008, McKelvey and the banks extended the settlement dates of the initial set of VPFCs to 2010. McKelvey died later in 2008. The Estate did not report any gain or loss for that year in relation to the extensions. The IRS claimed that the decedent realized capital gain upon executing the extensions in 2008.
In the initial case, the Tax Court held that the Estate's treatment of the first set of VPFCs as remaining open after the extensions was appropriate and that the extensions did not constitute a sale or exchange of property that resulted in gain. The Second Circuit reversed, determining that the extensions of the VPFCs resulted in the replacement of the first set of VPFCs for a second set of VPFCs. The case was then remanded to the Tax Court to determine whether this replacement was a termination for purposes of Section 1234A, and if so, the amount of gain realized. Section 1234A treats gain or loss attributable to termination of a right or obligation with respect to a capital asset as gain or loss from the sale of a capital asset.
The Tax Court held that the replacement of the first set of VPFCs for the second set was in fact a termination of the first set. The court analogized VPFCs to option contracts and said that the exchange was effectively a repurchase of options held by the investment banks, which repurchase was a closing transaction that terminated the obligations of McKelvey with respect to the first set of VPFCs. Having found the exchange to be a termination, the court undertook a rather straightforward application of Section 1234A to find that the termination resulted in short term capital gain.
The final question was how to calculate the gain. The court applied Section 1001, dealing with the sale or disposition of property, despite admitting that McKelvey's positions with respect to the VPFCs were not property but rather obligations. In doing so, the court reasoned that the nature of the underlying shares as property warranted the application of Section 1001. With that decided, the court calculated the gain by subtracting payments to the investment banks and the outstanding liability as a result of the second set of VPFCs (determined by applying the Black-Sholes option pricing formula) from the prepayment amounts received.
In light of this case, taxpayers should carefully consider the tax consequences of amending their derivatives and other financial contracts.
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