Variable Prepaid Forward Contracts Incorporating Share Lending Arrancements
Effective Date: February 6, 2008
COORDINATED ISSUE PAPER
VARIABLE PREPAID FORWARD CONTRACTS
INCORPORATING SHARE LENDING ARRANGEMENTS
On August 24, 2006, the Service identified certain Variable Prepaid Forward Contract (“VPFC”) transactions in an emerging issue alert describing certain VPFC transactions that include a share lending agreement or other similar arrangement permitting the counterparty to borrow the pledged shares that would result in a current sale of such shares, and I.R.C. § 1058 will not apply to prevent recognition of gain in such shares. The issue was addressed most recently in a generic legal advice memorandum AM 2007-004 in January 2007.
The taxpayer owns appreciated stock in a publicly traded corporation. To monetize its position the taxpayer enters into a VPFC through a stock purchase agreement (“SPA”) with an investment bank (hereinafter the counterparty). In exchange for an up-front cash payment, which generally represents 75 percent to 85 percent of the current fair market value of the stock, the taxpayer agrees to deliver a variable number of shares at maturity (typically three to five years). The VPFC usually has a cash settlement option in lieu of delivering the underlying shares at maturity. The purported economic benefits of the VPFC structure are as follows: (1) downside protection represented by the amount of the unrestricted payment to the taxpayer, (2) limited upside growth participation as reflected by the maximum share value price, (3) the potential for diversification by reinvesting the up-front cash advance, and (4) tax deferral of the gain to the maturity date of the VPFC.
Under the terms of the SPA, the taxpayer is required to deposit the maximum number of shares that may be delivered under the VPFC into a pledge account and to grant the counterparty a security interest in the pledged securities. The parties to the pledge agreement are the taxpayer (as pledgor) and the counterparty (as pledgee). In most instances, the SPA will contain a provision that allows the counterparty to hedge its position under the VPFC by giving it the right to sell, pledge, rehypothecate, invest, use, commingle or otherwise dispose of, or otherwise use in its business the pledged securities. During the life of the SPA, the counterparty has the right to transfer and to vote the pledged shares but may be required to pay certain distributions received on the pledged shares to the taxpayer.
In addition to the fact pattern described above, the Service has also identified similar transactions with the following variations (“collectively, the “VPFC transactions”):
- The taxpayer enters into a VPFC through a SPA and executes a separate pledge agreement.After these agreements are finalized, the original pledge agreement is amended.The Amended & Restated Pledge Agreement includes a rehypothecation clause, which allows the secured party, upon consent of taxpayer, to sell, lend, pledge, invest, commingle or otherwise dispose of the pledged shares.
- The taxpayer enters into a SPA that includes a pledge/security interest provision and at a later date (usually within 90 days following the VPFC) executes a separate share lending agreement.
- The taxpayer enters into a VPFC through an International Swaps and Derivatives Association (“ISDA”) Master Agreement and an ISDA Credit Support Annex, which allows the counterparty the right to rehypothecate, sell, dispose of or use the pledged shares.
- The taxpayer enters into a VPFC through a SPA, executes a Letter and Confirmation (“L&C”) Agreement and then later a Rehypothecation Agreement pursuant to the terms of the L&C Agreement.
- The stock is placed, as security, with the counterparty or its subsidiary, but with a standard margin/broker agreement which confers upon the counterparty the rights to register the stock in its own name and to rehypothecate, sell, dispose, or use the pledged shares.
- The taxpayer contemporaneously deposits a sufficient amount of the same stock in another account and this stock is borrowed to close the counterparty’s short sale.
Regardless of the variation, all of these VPFC variations share the following common characteristic: the counterparty, via a share lending agreement or through some other contractual arrangement, obtains the unfettered use of the pledged shares. Because the determination of whether a sale occurred for federal income tax purposes is based upon the facts and circumstances of a particular case, it is possible that a transaction will result in a sale even though it does not have all the facts set forth in this coordinated issue paper. For deviations, consult with the Financial Products Technical Advisor and local Counsel.
- Whether VPFC transactions that incorporate a share lending agreement or other similar arrangement permitting the counterparty to borrow or otherwise dispose of the pledged shares result in a current taxable disposition of the underlying shares.
- Whether certain VPFC transactions are actual sales pursuant to I.R.C. § 1001 under common law “benefits and burdens” principles.
- Whether VPFC transactions described herein are factually distinguishable from those governed under Rev. Rul. 2003-7, 2003-1 C.B. 363.
- Whether the open transaction doctrine applies in VPFC transactions.
- Whether the nonrecognition treatment under I.R.C. § 1058 is applicable to VPFC transactions.
- Whether the Service should assert the I.R.C. § 6662 accuracy-related penalty on underpayments and the accuracy-related penalty on reportable transaction understatements under I.R.C. § 6662A in examinations of taxpayers who have entered into VPFC transactions.
SUMMARY OF CONCLUSIONS
- There is a current sale for federal tax purposes of the underlying stock when a taxpayer enters into a VPFC transaction that includes a share lending arrangement with the counterparty.
- These VPFC transactions result in a current sale under common law principles, i.e. transfer of ownership because the taxpayer does not retain, and the counterparty acquires, substantial indicia of ownership (including most of the risk of loss and opportunity for gain).
- Rev. Rul. 2003-7 is not controlling as the VPFC transactions that are the subject of this paper are distinguishable from the facts described in that ruling. Most significantly, the counterparty in VPFC transactions acquires possession and unfettered use of the pledged shares.
- The open transaction doctrine is inapplicable since the pledged shares are publicly traded and their value is easily ascertainable.
- Nonrecognition treatment under I.R.C. § 1058 is not appropriate since the VPFC transaction and share lending arrangement effectively eliminates the risk of loss with respect to the pledged shares.
- Depending on the facts of each VPFC transaction and the year in question, the Service should consider asserting (a) the accuracy-related penalty on underpayments attributable to a substantial understatement of income tax under I.R.C. § 6662, and (b) the accuracy-related penalty on reportable transaction understatements under I.R.C. § 6662A, in accordance with the guidance herein.
1a. CURRENT SALE UNDER COMMON LAW BENEFITS AND BURDENS TEST
Section 1001(c)provides that, except as otherwise provided, the entire amount of gain or loss, determined under I.R.C. § 1001, on the sale or exchange of property shall be recognized. The Code, however, does not define the term "sale or exchange.” A “sale or exchange” is generally defined as a transfer of property for money or a promise to pay money. Grodt & McKay Realty v. Commissioner, 77 T.C. 1221, 1237 (1981); Torres v. Commissioner, 88 T.C. 702, 720 (1987). The key to deciding whether a transaction is a sale is to determine whether the benefits and burdens of ownership have passed. Grodt & McKay Realty, 77 T.C. at 1237; Torres, 88 T.C. at 720. This is a question of fact, which must be ascertained from the intention of the parties as evidenced by the written agreements read in light of the attending facts and circumstances. Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955), aff’d 241 F.2d 288 (9th Cir. 1956); Torres, 88 T.C. at 720; Grodt & McKay Realty, Inc., 77 T.C. at 1236.
In Grodt & McKay Realty, Inc., the Court found that any transactional analysis must consider various agreements relating to the purchase, including the sales agreements, registration certificates, and warranties and guaranties relating to the subject property. Thus, when considering whether a sale occurred for tax purposes, the Service is not limited by the four corners of any particular agreement, but instead must consider all surrounding circumstances, including the terms of any side agreements or related contracts. The Tax Court listed the following factors that should be considered in determining whether there has been a sale: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property. Grodt & McKay Realty, Inc., 77 T.C. at 1237-38. When the property at issue is stock, the following factors are also relevant: (1) who has the right to vote the shares, (2) who has the right to receive dividends, and (3) who has the right to sell or rehypothecate the shares. See Miami Nat’l Bank v. Commissioner, 67 T.C. 793 (1977). Accordingly, for purposes of determining ownership with respect to the pledged shares, it is appropriate to consider all agreements between the taxpayer and counterparty affecting the rights and obligations of such shares when applying the relevant factors.
Grodt & McKay Factors
(1) Legal Title to Pledged Shares
The taxpayer is obliged to deliver the maximum number of shares that it may be required to deliver under the contract. Delivery required transfer of unencumbered title and shares are generally required to be reregistered in the name of the counterparty or nominee. Under the share lending arrangement, the pledged shares are delivered to the counterparty and are not subject to any transfer restrictions. Therefore, the counterparty was given all incidents of ownership in the “pledged” shares, including the right to transfer these shares. This factor favors treatment as a current sale.
(2) Treatment of VPFC Transaction by Parties
The transaction is structured in form to be a purported executory contract of sale with the parties reporting the VPFC transactions as such for tax purposes. The agreements often refer to the transaction as sale to take place in the future. The agreements when read together, however, indicate, in substance, the parties’ treatment of the transaction is otherwise. The parties clearly contemplate that (1) the counterparty would have clear title to the pledged shares during the life of the agreements, (2) the counterparty would be able to dispose of the pledged shares, (3) the taxpayer would have given up the right to keep the same shares, (4) the economics of the transaction are such that the taxpayer bears no risk of loss with respect to any decline in value of the pledged shares and (5) the taxpayer would be entitled to capture only a circumscribed amount of any future appreciation in the pledged shares. The substance of the transaction, therefore, is consistent with an understanding that counterparty was in fact the owner of the shares notwithstanding the form. Accordingly, this factor is neutral.
(3) Equity Interest Acquired in Underlying Property
This test has its primary application in the area of nonrecourse financing - whether the purported purchaser of property has an interest in the property that he cannot prudently abandon. See Estate of Franklin v. Commissioner 544 F.2d 1045, 1047 (9th Cir 1976). Where property is ostensibly purchased with a nonrecourse note that greatly exceeds the actual value of the property, the titular purchaser does not acquire an equity in that property because payments on the principal of the purchase price yield no equity so long as the unpaid balance of the purchase price exceeds the then existing fair market value. In this transaction, however, the counterparty clearly has an equity interest in the pledged shares. The counterparty has paid between 75 percent and 85 percent of the purchase price up front and is economically entitled to 100 percent of the initial value of the stock with no obligation to make additional payments. In contrast, the taxpayer has effectively cashed out its equity in the property in exchange for the upfront cash payment and a contingent contract right to acquire a certain number of shares based on the stock price on the settlement date. This factor favors treatment as a current sale.
(4) Present Obligations of Parties
The standard VPFC transaction creates certain contractual obligations on both parties. The taxpayer has a present obligation to transfer legal title in the stock under the pledge agreement to the counterparty or its designee when the parties enter into the VPFC. The counterparty has a present obligation to transfer cash equal to 75 percent to 85 percent of the fair market value of the pledged shares on the date of transfer. This factor favors the treatment as a current sale.
(5) Possession of Stock
The property at issue in a VPFC transaction is stock, which is an intangible asset. As such, it cannot be “possessed” in the same sense that tangible property can be. In fact, it is unusual for stock investors to have actual possession of share certificates associated with their equity interest. If a taxpayer’s stock is in certificate form, it is usually transferred to the counterparty with a stock power that allows counterparty to transfer the shares or convert them to electronic form in the name of a nominee, usually Cede & Co. Regardless of its form, Cede & Co.’s records will show the counterparty as owner. At such point it is readily transferable. Due to the type of asset involved, this factor is of limited utility but to this limited extent, it favors a current sale.
(6) Payment of Property Taxes Associated with Asset
No property or similar taxes are assessable with respect to publicly traded stock. Accordingly, this factor is not applicable.
(7) Risk of Loss
The taxpayer receives an upfront cash payment at the inception of the contract that it is not required to repay regardless of the value of the stock at maturity. The taxpayer has substantially eliminated all its downside risk and the counterparty bears any remaining economic risk of loss with respect to the pledged shares. This factor favors treatment as a current sale.
(8) Opportunity For Gain
Under the VPFC transaction, the taxpayer acquired a separate contract right, which entitles the taxpayer to receive additional payments that are keyed off of the value of the pledged shares. Under this provision, the taxpayer will receive payments equal to a limited amount of future appreciation, if any, on the stock position, which usually is capped at 20 to 25 percent of the fair market value of the shares at the VPFC execution date. If the stock is trading above that cap, the counterparty will capture this additional upside profit potential. The current value of any payment that the taxpayer is entitled to receive upon termination will likely approximate the difference between (1) the prepayment received by the taxpayer at execution and (2) the fair market value of the stock at time of execution. This rough equivalence further supports the economic similarity between the VPFC transaction and a current sale at fair market value.
Supplemental Factors Specific to Stock Transactions
In order to apply the benefits and burdens test in any given case, the various rights and obligations associated with the specific type of property must be identified. In addition to who has the opportunity for gain from an increase in value of the stock and who bears the risk of loss from a decrease in value with respect to the stock, the court in Hall v. Commissioner, 15 T.C. 195, 200 (1950), aff’d 194 F.2d 538 (9th Cir. 1952) also focused on (1) who has the right to vote the shares, (2) who has the right to receive dividends, and (3) who has the right to dominion or control over the stock, especially the right to sell the stock.
(1) Voting Rights
Although the taxpayer, as pledgor, nominally retains the right to vote shares that are deposited in the pledge account, once the pledged shares are loaned, the counterparty expressly acquired all of the incidents of ownership in the shares. The taxpayer does not have the right to prevent the counterparty from “borrowing” the shares. Accordingly, even though it may retain voting rights under certain circumstances, it cannot keep the counterparty from acquiring the right to vote such shares. This factor will slightly favor current sale treatment in those situations where a borrowing or subsequent sale of the pledged shares by the counterparty can be established.
(2) Dividend Rights
The treatment of dividend rights varies among VPFC transactions. In some cases, there are restrictions on the payments in lieu of dividends to the taxpayer. For instance, the contract may require that the amount of any distribution be added to the pledge account. Alternatively, the payment of dividends may affect the cap and floor values in the formula for determining the additional payment that is due to the taxpayer at the end of the contract. Treatment of “ordinary” and “extraordinary” dividends may also vary; ordinary dividends are generally those dividends that are expected while extraordinary dividends may only be paid in particular types of corporate transactions, as defined under the transactional documents. This factor may be neutral under certain circumstances but may favor sale treatment to the extent that the counterparty receives the economic benefit of the dividends.
In addition, it must be noted that the fact that a taxpayer may have a right to a dividend equivalent payment should not result in avoidance of sale treatment. Such payment merely represents a sum of money measured by the amount of the dividend rather than an ownership interest in the shares. See Rev. Rul. 60-177, 1960-1 C.B. 9.
(3) Right to Sell or Rehypothecate Shares
The counterparty has all of the indicia of ownership in the “pledged” shares including the right to transfer them. In a number of cases developed so far, it appears that the counterparty does in fact sell the pledged shares in order to close out its initial position under the VPFC transaction. This factor favors the Service.
Most of the relevant factors outlined above support the Service with the remaining factors neutral or not applicable. In the typical VPFC transaction, the taxpayer (1) receives its prepayment upon execution of the stock agreement and has the immediate and unrestricted use of the money; (2) transfers control and unfettered use of the pledged shares to the counterparty at the same time as or shortly after the execution of the stock agreement; (3) eliminates its entire risk of loss; and (4) retains a relatively limited opportunity for gain in any future appreciation of the stock. Therefore, the counterparty acquires and holds nearly all of the benefits and burdens of ownership in the pledged shares resulting in an actual sale by the taxpayer under I.R.C. § 1001.
Moreover, VPFC transactions, in which the seller receives an upfront payment and the counterparty obtains title and possession of underlying shares without restriction in use, are directly analogous to the facts in Hope v. Commissioner, 55 T.C. 1020 (1971), aff'd, 471 F.2d 738 (3d Cir. 1973), cert. denied, 414 U.S. 824, 94 S.Ct. 126, 38 L.Ed. 57 (1973). In Hope, the taxpayer was the owner of approximately 57 percent of the common stock of a company that had recently become a publicly traded company, and was having difficulty in disposing of his remaining large block of stock. The taxpayer transferred the shares to an investment bank for a sale at a price that was approximately one half of the price at which the stock was currently trading. Under the arrangement, the investment bank was free to resell 25 percent of the block of stock to the general public. The investment bank held the remainder of the stock subject to options to purchase the stock at the investment bank's cost and subject to proxy agreements that transferred to the optionees the right to vote the shares for the election of directors. Half of the options and proxy rights were held by the taxpayer's brother; the other half were held by two individuals who were employees of the company. Subsequent to the closing of the transaction, the taxpayer became dissatisfied with the sale price and brought a suit for rescission. The litigation was not concluded in the year of the transaction. On the tax return for the year of the transfer, the taxpayer disclosed the transfer but did not include in income gain on the sale on the ground that the transfer was not a completed sale on which gain was recognized. The Tax Court concluded that the transaction constituted a sale of the entire block and the sale was completed on that date when title and possession of the certificates were transferred by the taxpayer to the investment bank. Like the VPFC cases, the taxpayer received its proceeds from the sale without any restrictions on his use or disposition of those funds. Hope, 55 T.C. at 1029; see also Greenfield v. Commissioner, T.C. Memo. 1982-617 (1982).
Consistent with these common law principles and the holding in Hope, taxpayers who have entered into VPFC transactions the same or substantially similar to the transactions described herein have transferred ownership of the pledged shares when the counterparty obtains the legal right to lend such shares out of the collateral account (i.e., a subsequent transfer by the borrower is not necessary to divest the taxpayer of ownership). The taxpayers did not retain sufficient indicia of ownership to avoid an actual sale for federal income tax purposes and the conditional ability to substitute cash or other shares on the settlement date, without more, does not represent sufficient control over the pledged shares to treat the taxpayers as the owner of the shares for tax purposes.
This determination is also the most logically consistent with facts developed. Intuitively, a taxpayer cannot be considered the owner of stock which has been loaned pursuant to an agreement that legally and practically deprives it of both title and the right to receive back the specific stock transferred and where the borrower can transfer legal title and all beneficial interest in those specific shares to a third-party. Furthermore, the conclusion reached under the benefits and burdens of ownership analysis comports with the economic substance of the transaction. As a practical matter, if a taxpayer does not directly own an asset and has no right to obtain such asset, the taxpayer is not the owner even if that asset is fungible with other assets that the taxpayer does have the right to acquire.
1b. DISTINGISHING REV. RUL. 2003-7
In Rev. Rul. 2003-7, the Service held that a taxpayer neither sold stock currently nor caused a constructive sale of stock when it (1) receives a fixed amount of cash; (2) simultaneously enters into an agreement to deliver on a future date a number of shares that varies significantly based on the value of the shares on the exchange date; (3) pledges the maximum number of shares that could be delivered under the agreement; (4) retains an unrestricted legal right to substitute cash or other shares for the pledged shares; and (5) is not economically compelled to deliver the pledged shares on the contract’s maturity date. The ruling’s conclusion that the taxpayer had not sold the shares at the time the forward contract was entered into is primarily based on the following three factual determinations: (1) the seller retains all dividend and voting rights; (2) legal title and possession of the pledged shares are not transferred to the counterparty, but instead to an unrelated third-party trustee; and (3) the taxpayer is not required to deliver the pledged shares to the counterparty. The ruling, however, cautions its holding is limited to the specific facts of the ruling that a “different outcome may be warranted if a shareholder is under any legal restraint or requirement or under any economic compulsion to deliver pledged shares rather than to exercise a right to deliver cash or other shares.”
The Service also ruled that no constructive sale occurred under I.R.C. § 1259 because the variation in the number of shares that ultimately would be required to be delivered under the contract was a significant variation. I.R.C. § 1259(d)(1) defines a “forward contract” that results in a constructive sale under that section as a contract to deliver a substantially fixed amount of property for a substantially fixed price. Under the legislative history, a forward contract under I.R.C. § 1259(d)(1) does not include a contract with a “significant variation” in the number of deliverable shares.
In contrast, the determinative facts underpinning the rationale for the holding in Rev. Rul. 2003-7 are simply not present in any of these VPFC transactions. Moreover, the critical facts established in VPFC transactions are distinguishable and in significant ways inapposite to the ruling. Most importantly, the pledged shares do not remain in an account with a third-party trustee but are transferred to the counterparty who is afforded all incidents of ownership in the shares. Similarly, once the shares are borrowed by the counterparty and there is a subsequent transfer of such shares by the borrower, the taxpayer could not regain possession of those shares. In addition, the taxpayer has relinquished its dividend and voting rights once the pledged shares were delivered to the counterparty under the share lending arrangement. Therefore, these transactions are clearly distinguishable from the facts contained in Rev. Rul. 2003-7 and the conclusion reached in that ruling is not controlling.
1c. OPEN TRANSACTION DOCTRINE
Having concluded that the transfer constitutes a taxable event for purposes of I.R.C. § 1001, an ancillary issue is whether taxable gain may be "reasonably ascertained," and therefore realized by the taxpayer. I.R.C. § 1001(b) defines the "amount realized" upon a sale or other disposition as "the sum of any money received plus the fair market value of the property (other than money) received." In the VPFC transaction, the money and property received consists of an upfront cash payment and a contingent contractual right entitling the taxpayer to the later receipt of some lesser number of shares (or cash equivalent) based on a formula related to the appreciation, if any, in the fair market value of the pledged shares at settlement. Some taxpayers will likely argue that there is no way to compute the fair market value of the contingent contract right, and therefore, it is not possible to determine with reasonable certainty the taxable gain realized. As a result, these taxpayers will assert that the transfer is not a "closed and completed" transaction for federal income tax purposes.
The purpose of the open transaction doctrine is to relieve a taxpayer from having to report income that may never be received. For example, in Burnet v. Logan, 283 U.S. 404, 413, 51 S.Ct. 550, 75 L.Ed. 1143 (1931), the Court concluded that the transaction was not "closed" because taxpayer might never recoup capital investment. The open transaction doctrine is a "rule of fairness designed to ascertain with reasonable accuracy the amount of gain or loss realized upon an exchange, and, if appropriate, defer recognition thereof until the correct amounts can be accurately determined." Dennis v. Commissioner, 473 F.2d 274, 285 (5th Cir.1973). The open transaction treatment applies only in "rare and extraordinary circumstances." McShain v. Commissioner, 71 T.C. 998, 1004 (1979); Parrish v. Commissioner, T.C. Memo. 1997-474 (1997), aff'd, 168 F.2d 1098 (8th Cir. 1999). The open transaction doctrine is only applicable, however, when it is not possible to determine the value of either of the assets exchanged. Davis v. Commissioner, 210 F.3d 1346, 1348 (11th Cir. 2000). In an arm's length transaction, where only one of the assets has an unascertainable value, it is presumed equal to the property for which it was exchanged. United States v. Davis, 370 U.S. 65, 82 S.Ct. 65, 8 L.Ed. 2d 335, 1962-2 C.B. 15 (1962). See also Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184, 189, 130 Ct.Cl. 166 (1954) (value of two properties exchanged in an arms-length transaction are presumed to be equal).
In VPFC transactions, the pledged shares are publicly-traded stock, and therefore, have a readily ascertainable value. As a result, the value of the property received is presumed to be equal to the value of the stock transferred. The contingent contract right is additional consideration received by the taxpayer that has a value equal to the stock transferred less the cash received and taxable gain may be "reasonably ascertained" for tax purposes.
1d. Section 1058
Section 1058 contains an exception to the general recognition requirement of I.R.C. § 1001(c). Pursuant to I.R.C. § 1058(a), no gain or loss will be recognized by a taxpayer who transfers securities pursuant to a share lending agreement that satisfies the conditions set forth in I.R.C. § 1058(b). One of those conditions is that the securities lending agreement must not reduce the taxpayer’s risk of loss or opportunity for gain with respect to the securities transferred. I.R.C. § 1058(b)(3). In these transactions, the taxpayer transfers its risk of loss and most of its opportunity for gain. Therefore, the taxpayer does not qualify for nonrecognition under the narrow I.R.C. § 1058 statutory safe harbor provisions applicable to certain security lending transactions.
2. CONSIDERATION OF ACCURACY-RELATED PENALTIES
The purpose of this section is to discuss the Service’s position with respect to the application of the negligence and substantial understatement portions of the accuracy-related penalty under I.R.C. § 6662, the reasonable cause and good faith exception under I.R.C. § 6664, and the reportable transaction understatement penalty of I.R.C. § 6662A to VPFC transactions. In order to assist examiners and other Service personnel, this section will also discuss the reduction in an understatement due to a position supported by substantial authority in I.R.C. § 6662(d)(2)(B) before and after the American Jobs Creation Act of 2004 (“AJCA”) and highlight factual issues under I.R.C. §§ 6662, 6662A and 6664(c) that examiners should develop and discuss in their reports.
APPLICABLE LAW AND REGULATIONS
Section 6662 imposes an accuracy-related penalty on any portion of an underpayment required to be shown on a return. Two of the components of this penalty are potentially applicable to VPFC transactions: (1) negligence or disregard of the rules or regulations and (2) any substantial understatement of income tax. Stacking of the accuracy-related penalties is not permitted. Accordingly, the maximum amount of the accuracy-related penalty that can be imposed on a VPFC transaction is 20 percent even if the underpayment is attributable to both negligence and substantial understatement. Treas. Reg. § 1.6662-2(c).
For taxable years after October 22, 2004, I.R.C. § 6662A imposes a minimum 20 percent penalty (30 percent if no adequate disclosure under the I.R.C. § 6011 regulations) for a “reportable transaction understatement.” I.R.C. § 6662A(a) and (c). Such an understatement occurs when there is an understatement due to an item which is a reportable transaction (other than a listed transaction) if a significant purpose of such transaction is tax avoidance or evasion. I.R.C. § 6662A(b)(2). The 20 percent I.R.C. § 6662 penalty may not apply to the extent that the I.R.C. § 6662A penalty applies. If an I.R.C. § 6662A penalty is asserted, however, and the I.R.C. § 6662 penalty is also appropriate, examiners should raise both penalties (I.R.C. §§ 6662 and 6662A) in the alternative. This will ensure that the Service’s position with regard to penalties is protected.
When tax shelters are involved, special provisions apply in determining the amount of the understatement for the purpose of calculating the penalty for substantial understatements. I.R.C. § 6662(d)(2)(C). In addition, under I.R.C. § 6664, an I.R.C. § 6662 or an I.R.C. § 6662A penalty is not imposed if there is reasonable cause and good faith. However, there are provisions which apply to tax shelters and reportable transaction understatements which, in general, make it more difficult for the taxpayer to qualify for the reasonable cause and good faith exception.
Negligence and Reasonable Basis under I.R.C. § 6662
Section 6662 imposes a penalty of 20 percent of the underpayment of tax attributable to negligence. Negligence is a failure to make a reasonable attempt to comply with the provisions of the tax law, exercise ordinary and reasonable care in tax return preparation, or keep adequate books and records. The penalty for negligence does not apply if the taxpayer's position has a reasonable basis. Negligence is determined as of the filing date of the return. Taibo v. Commissioner, T.C. Memo. 2004-196 (2004).
A reasonable basis is “a relatively high standard of reporting, that is, significantly higher than frivolous or not patently improper.” Treas. Reg. § 1.6662-3(b)(3). The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. Id. If a return position is reasonably based on one or more of the authorities in Treas. Reg. § 1.6662-4(d)(3)(iii), the position will satisfy the reasonable basis standard even though it does not rise to the level of substantial authority. Id.
Substantial Understatement and Substantial Authority under I.R.C. § 6662
Taxable Years Beginning Before October 22, 2004 (Pre-AJCA)
Section 6662 imposes a penalty of 20 percent of the underpayment of tax attributable to a substantial understatement. A substantial understatement is reduced by the amount that is due to an item that is supported by either substantial authority or a proper disclosure coupled with a reasonable basis for the position. I.R.C. § 6662(d)(2)(B). However, special rules apply to tax shelter items.
A “tax shelter” is any partnership or other entity, investment plan or arrangement, or any other plan or arrangement “if a significant purpose … is the avoidance or evasion of federal income tax.” I.R.C. § 6662(d)(2)(C)(iii). In 1997, I.R.C. § 6662(d)(2)(C)(iii) was amended by the Taxpayer Relief Act of 1997, Pub. L. 105-34, § 1028(c)(2) which replaced “primary purpose” with “significant purpose.” Thus, tax avoidance need not be the sole purpose for entering into a VPFC or even of first importance, as long as it is an important purpose. A VPFC is an “investment plan or arrangement or other plan or arrangement” and will likely have such a tax avoidance purpose for application of the penalty and the reasonable cause determination because deferral or elimination of tax is almost always an important goal of the VPFC.
For a tax-shelter item of a non-corporate taxpayer, prior to the amendments to I.R.C. § 6662(d)(2) by AJCA (effective for tax years beginning after October 22, 2004), the substantial understatement penalty applied unless there was (1) substantial authority for the item’s tax treatment and (2) a reasonable belief that the tax treatment was more likely than not proper. I.R.C. § 6662(d)(2)(C)(i). No reduction in the understatement under I.R.C § 6662(d)(2)(B) is allowed for any item of a corporation attributable to a tax shelter item. I.R.C. § 6662(d)(2)(C)(ii).
Since non-corporate taxpayers may qualify for the reduction in an understatement for years beginning before October 22, 2004, if they have, inter alia, substantial authority for their position, this paper includes a discussion of this standard. The substantial authority standard is an “objective test” involving the analysis of law and application of law to relevant facts. It is less stringent than the “more likely than not“ standard but more stringent than the reasonable basis standard. Treas. Reg. § 1.6662-4(d)(2). It requires an evaluation of the weight of authorities in light of the facts and relevance, persuasiveness, finality, reasoning, precedential value, and age, both pro and con. The existence of substantial authority is determined as of the time the return is filed or on the last day of the taxable year to which the return relates. Treas. Reg. § 1.6662-4(d)(3)(iv)(C). There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. Treas. Reg. § 1.6662-4(d)(3)(i). In addition, substantial authority may exist despite the absence of any of the listed types of authority. Accordingly, a taxpayer may have substantial authority for a position that is "supported only by a well-reasoned construction of the applicable statutory provision." Treas. Reg. § 1.6662-4(d)(3)(ii).
The types of authority that may be taken into account are listed in the regulations. Treas. Reg. § 1.6662-4(d)(3)(iii). Treatises, articles, tax opinions and the like are not themselves authority for this purpose, although they may discuss or cite sources that do give rise to substantial authority. Id.
Taxable Years Beginning after October 22, 2004 (Post-AJCA)
Effective with taxable years beginning after October 22, 2004, AJCA amended I.R.C. § 6662(d)(2) by making the test for non-corporate taxpayers the same as for corporate taxpayers. Thus, there is no reduction of the understatement permitted with respect to items attributable to tax shelters for the purpose of calculating the penalty for substantial underpayments. Substantial authority, adequate disclosure, and reasonable basis for the tax treatment are irrelevant for this purpose.
Section 6662A/6707A – Reportable Transaction Penalties
The AJCA added I.R.C. § 6662A, which generally imposes a 20 percent penalty on an item due to a reportable transaction (if a significant purpose is tax avoidance or evasion) or a listed transaction. The section is effective for tax years ending after October 22, 2004. The 20 percent I.R.C. § 6662 penalty is not imposed on any amount to which an I.R.C. § 6662A penalty is imposed. I.R.C. § 6662A(e)(1)(B). The penalty is increased to 30 percent for the portion of a reportable transaction understatement that is not adequately disclosed under the I.R.C. § 6011 regulations.
The AJCA also added I.R.C. § 6707A, which imposes a penalty on any person who fails to disclose a reportable transaction in accordance with the rules in Treas. Reg. § 1.6011-4. The amount of the I.R.C. § 6707A penalty with respect to a reportable transaction other than a listed transaction is $10,000 in the case of an individual and $50,000 in any other case. If the failure is with respect to a listed transaction, the penalty is increased to $100,000 in the case of an individual, and $200,000 in any other case. I.R.C. § 6707A(b). The penalty applies to returns and statements the due date for which is after October 22, 2004, and which were not filed before that date. See Rev. Proc. 2007-21; 2007-9 I.R.B. 613 and Notice 2005-11, 2005-1 C.B. 493 for further guidance on the I.R.C § 6707A penalty.
Treas. Reg. § 1.6011-4 defines a reportable transaction. See also I.R.C. §§ 6662A(d) and 6707A(a). There are other categories of reportable transactions besides listed transactions. VPFCs have not been identified as listed transactions as of the date of this Coordinated Issue Paper (CIP). A VPFC may be within one or more of the other categories. See Treas. Reg. § 1.6011-4(b). Examiners should consult the specific requirements of Treas. Reg. § 1.6011-4, as well as local Counsel, to determine if the VPFC transaction they are auditing is a reportable transaction and if the transaction would be subject to a penalty under I. R.C. §§ 6662A or 6707A.
Section 6664(c): The Reasonable Cause Exception to the Penalty under I.R.C. § 6662
Taxable Years Beginning Before October 22, 2004 (Pre-AJCA)
A taxpayer (both corporate and non-corporate) is not liable for the accuracy-related penalty if it had reasonable cause and acted in good faith. I.R.C. § 6664(c). This is a case-by-case, facts and circumstances test. Treas. Reg. § 1.6664-4(b). “Reliance on an information return or on the advice of a professional tax advisor or an appraiser does not necessarily demonstrate reasonable cause and good faith. …Reliance on … professional advice …, however, constitutes reasonable cause and good faith if, under all the circumstances such reliance was reasonable and the taxpayer acted in good faith.” Treas. Reg. § 1.6664-4(b)(1). See also Treas. Reg. § 1.6664-4(c) for particular rules governing reliance on an opinion or advice.
For tax years beginning before October 22, 2004, different rules apply to a corporation with respect to its treatment of a tax shelter item. Treas. Reg. § 1.6664-4(f). The reasonable-cause determination is based on all the facts and circumstances. Treas. Reg. § 1.6664-4(f)(1). If a corporate taxpayer relies upon a “legal justification,” i.e. a position justified by a legal opinion or argument, the regulation sets forth requirements for such justification. Id.
A corporate taxpayer’s legal justification may be taken into account in establishing that the taxpayer acted with reasonable cause and in good faith in its treatment of a tax shelter item, but only if there is substantial authority within the meaning of Treas. Reg. § 1.6662-4(d) for the treatment of the item and the taxpayer reasonably believed, when the return was filed, that the treatment was more likely than not the proper treatment. Treas. Reg. § 1.6664-4(f)(2)(i). The reasonable belief standard is met if: (1) the taxpayer analyzed pertinent facts and relevant authorities to conclude in good faith that there would be a greater than 50 percent likelihood (“more likely than not”) that the tax treatment of the item would be upheld if challenged by the Service; or (2) the taxpayer reasonably relied in good faith on the opinion of a professional tax advisor who analyzed all the pertinent facts and authorities, and who unambiguously states that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by the Service. Treas. Reg. § 1.6664-4(f)(2)(i)(B).
Many cases confronting the issue of whether the taxpayer reasonably relied in good faith on advice have found that reliance on an advisor is not reasonable where the advisor is not an independent party, such as a tax shelter promoter or his agent. Where the advisor holds a financial interest or stake in the outcome of a transaction, a potential conflict exists, and taxpayers should not blindly trust such self-interested persons. Addington v. Commissioner, 205 F.3d 54, 59 (2d Cir. 2000)(finding it unreasonable for taxpayer to rely on an attorney who drafted offering materials, prepared an opinion, and invested in the partnership, because this created a conflict of interest); Goldman v. Commissioner, 39 F.3d 402, 408 (2d Cir. 1994), aff’g T.C. Memo 1993-480 (reliance on accountant unreasonable where he was a salesperson for the investment and thus burdened with an “inherent conflict of interest”).
Satisfaction of the minimum requirements for legal justification is an important factor in determining whether a corporate taxpayer acted with reasonable cause and in good faith, but not necessarily dispositive. Treas. Reg. § 1.6664-4(f)(3). For example, the taxpayer’s participation in a tax shelter lacking a significant business purpose, the taxpayer’s claim of benefits that are unreasonable in comparison to the taxpayer’s investment, and the taxpayer’s entering into a confidentiality agreement with the promoter are additional factors that should be considered. Id.
Failure to satisfy the minimum standards will, however, preclude a finding of reasonable cause and good faith based on a taxpayer’s legal justification. Treas. Reg. § 1.6664-4(f)(2)(i). Additional facts and circumstances other than a taxpayer’s legal justification also may be taken into account regardless of whether the minimum requirements for legal justification are met. Treas. Reg. § 1.6664-4(f)(4).
Taxable Years Beginning after October 22, 2004 (Post-AJCA)
For tax years beginning after October 22, 2004, the regulatory provision applicable to corporate and non-corporate taxpayers for the purpose of determining reasonable cause and good faith is unchanged. Thus, the more stringent rules applicable to corporations discussed above still apply with respect to a corporation’s tax shelter items.
However, given that AJCA extended stringent penalty standards applicable to corporate taxpayers to non-corporate taxpayers in other similar contexts (see AJCA amendment to I.R.C. § 6662(d)(2)(C)), it is the Service’s position that non-corporate taxpayers must also satisfy the more demanding standards for the reasonable cause and good faith exception in Treas. Reg. § 1.6664-4(f) with respect to tax shelter items. As of the date of this CIP, the regulations under I.R.C. § 6664 have not been amended to reflect the changes made by AJCA.
Section 6664(d): The Reasonable Cause Exception to the Penalty under I.R.C. § 6662A
Section 6664(d) also establishes a reasonable cause and good faith exception for an accuracy-related penalty attributable to a reportable transaction understatement under I.R.C. § 6662A. However, this exception is more stringent than the reasonable cause exception for the accuracy-related penalty on underpayments under I.R.C. § 6662. Although the rules are complex, this exception does not apply if the taxpayer failed to adequately disclose (in compliance with I.R.C. § 6011 and the regulations thereunder). The taxpayer must also show substantial authority for the tax treatment and a reasonable belief that such treatment was more likely than not the proper treatment in order for the reasonable cause exception to apply. As of the date of this CIP, the regulations under I.R.C. § 6664 have not been amended to reflect the changes made by the AJCA. Examiners auditing returns to which this penalty is applicable should consult with local Counsel in developing their cases.
A thorough examination and analysis must be conducted in order to determine whether the various accuracy-related penalties discussed above apply to a specific VPFC transaction. The negligence, substantial understatement, the reportable transaction understatement penalty, and the reasonable cause and good faith exceptions to these penalties contain specific factual and legal elements that revolve around concepts such as reasonable basis, substantial authority, reasonable reliance, reasonableness and good faith. These elements must be developed by the examiner in consultation with local Counsel in order to assert and sustain the accuracy-related penalty. Examiners must investigate and collect evidence of the facts and circumstances of the VPFC and the taxpayer’s background, experience, involvement in the transaction, the timing, source, fee payment, contents of and reliance on any opinion(s), the depth of analysis in any internal research, whether it was written or oral, who performed any internal research and to whom were the conclusions communicated, when it was communicated, the extent to which it was relied upon, the circumstances under which any opinion or research was obtained or conducted, the reasons or purpose for the transaction, the degree of transparency or confidentiality of the transaction, and any other facts that bear on the taxpayer’s “honesty in fact.”
Rev. Rul. 2003-7 is a safe harbor for certain VPFC transactions that do not involve stock loans. Therefore, Rev. Rul. 2003-7 generally will not serve as substantial authority for the VPFC transactions described herein, subject to additional administrative guidance. For deviations, consult with local Counsel.
Examiners who propose a penalty should request a written “reasonable cause” statement from the taxpayer before closing an examination and consider any grounds discussed. In addition, examiners should strongly consider conducting in-person interviews of the taxpayer, its officers, return preparer, and other employees involved with the VPFC as part of their development of the penalty and reasonable cause portions of their examinations. Reports should also discuss these elements of the penalty.
After conducting this thorough penalty analysis, examiners should consult with local Counsel in determining whether assertion of an accuracy-related penalty is appropriate. Further administrative guidance may be provided with respect to the assertion of penalties in VPFC cases.
 The change from “primary” to “significant” purpose is effective for transactions entered into after August 5, 1997. Treas. Reg. § 1.6662-4(g)(2), however, has not been updated to take into account the 1997 change. Despite the unchanged Regulation, the “significant purpose” test is applicable to transactions to which the 1997 amendment applies. See, Umbach v. Commissioner, 357 F.3d 1108 (10th Cir. 2003); Farrell v. United States, 313 F.3d 1214, (9th Cir. 2002).
 If examiners need to determine whether an S corporation or a partnership with corporate partners should be treated as a corporate taxpayer for this purpose, they should consult with local Counsel.
 The types of authorities listed by the Regulation are (1) the applicable provisions of the Internal Revenue Code and other statutory provisions; (2) proposed, temporary and final regulations construing such statutes; (3) revenue rulings and revenue procedures; (4) tax treaties and regulations there under, and Treasury Department and other official explanations of such treaties; (5) court cases; (6) congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; (7) General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); (8) private letter rulings and technical advice memoranda issued after October 31, 1976, (but only for the taxpayer for whom the ruling or technical advice was issued); (9)Actions on Decisions and General Counsel Memoranda issued after March 12, 1981, (as well as General Counsel Memoranda published in pre-1955 volumes of the Cumulative Bulletin); (10) Internal Revenue Service information or press releases; and (11) Notices, Announcements and other administrative guidance published by the Service in the Internal Revenue Bulletin. Treas. Reg. § 1.6662-4(d)(3)(iii).
Index for Coordinated Issue Paper - LMSB