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October 1, 2018

Second Circuit holds modification of variable prepaid forward contracts triggers gain realization, reverses Tax Court

In Estate of McKelvey v. Commissioner, No. 17-2554 (2d Cir. September 26, 2018), the US Court of Appeals for the Second Circuit reversed the Tax Court and held that the extensions of settlement dates of variable prepaid forward contacts (VPFCs) resulted in the replacement of the original contracts with new contracts. The Second Circuit then remanded the case to the Tax Court on the issue of whether the corresponding termination of obligations under the old contracts resulted in income or gain (presumably, short-term capital gain). The Second Circuit further held that the amended contracts resulted in constructive sales of the stock under Section 1259, and remanded to the Tax Court to calculate the resulting long-term capital gains.


In September 2007, Andrew McKelvey entered into VPFCs with two investment banks (the Banks). Under the VPFCs, McKelvey received around $193 million cash upfront from the Banks. In return, McKelvey was required to deliver shares, or the cash equivalent, to the Banks on specified dates in September 2008. The actual number of shares to be delivered would vary under a formula based on the value of the stock at the time of delivery.

In July 2008, McKelvey paid approximately $11 million to the Banks to extend the VPFC's settlement dates until early 2010. McKelvey died in November 2008 and his estate subsequently settled the VPFCs in 2009.

McKelvey did not recognize gain in 2007 upon execution of the VPFCs, and his 2008 federal income tax return, similarly, did not report any income as a result of the extension of the VPFCs.

The IRS issued a notice of deficiency of more than $41 million for McKelvey's 2008 tax year, asserting that McKelvey realized a capital gain of more than $200 million from extending the respective settlement dates of the VPFC in 2008. McKelvey's estate challenged the IRS's determinations in Tax Court.

The Tax Court held for McKelvey, concluding that the extensions of the settlement dates of the VPFCs did not (1) result in taxable exchanges under Section 1001, (2) affect the open transaction treatment afforded to the VPFCs under Revenue Ruling 2003-7, or (3) result in constructive sales under Section 1259. For a discussion of the Tax Court decision, see Tax Alert 2017-0676.

Second Circuit opinion

The Second Circuit decided two issues and remanded to the Tax Court on two others. First, as to whether the modification of the VPFCs created new contracts, the Second Circuit concluded that it did. Although the Second Circuit agreed with the Tax Court that McKelvey did not incur short-term capital gain on the basis of the IRS's primary claim that the modification of the VPFCs was an "exchange of property" under Section 1001(c), it considered the IRS's alternative argument that McKelvey realized a short-term gain under Section 1234A(1). In this regard, the Second Circuit reasoned that, if a sufficiently important change (described as "fundamental") occurred to a contract, then that change results in a replacement of the original contract with a new contract.

In part, the Court analogized the extension of the valuation dates for the amended VPFCs to the extension of expiration dates with respect to options, and, similar to changes in expiration dates for options, the Court concluded that the new valuation dates were fundamental changes that resulted in new contracts.

With respect to the issue of whether this VPFC modification satisfied the criteria for a termination of obligations that gives rise to taxable income (presumably, the court said, capital gain), and with respect to the amount of any such income, the Second Circuit remanded for determination by the Tax Court.

In light of its conclusion that the modification resulted in the replacement of the original contracts with amended contracts, the Second Circuit then considered whether the extension of the VPFCs resulted in a constructive sale of the underlying shares under Section 1259. For purposes of Section 1259, the issue before the court was whether the number of shares to be delivered at settlement of each amended contract was "substantially fixed" on the date when each amended contract was executed.

The IRS argued that, when the VPFC extensions were executed, the share price had fallen so low that there was only a remote chance that the price would recover and exceed the floor price under the terms of the VPFC by the valuation date. Thus, the IRS concluded that McKelvey would be required to deliver the maximum number of shares specified by the contracts. The IRS relied on a valuation expert's conclusion that, as of the execution date, the shares under the two VPFCs had approximately a 15% and 13% chance of exceeding the floor price at expiration. The Court declined to define a bright-line test but stated that it considered the percentage liabilities sufficiently low for this purpose. Therefore, it determined that the amount of property to be delivered at settlement was "substantially fixed" under Section 1259 — thereby resulting in a constructive sale of the shares. The Second Circuit remanded to the Tax Court for the calculation of the amount of long-term gain that resulted from the constructive sales of the shares.


The Second Circuit's decision is odd in several respects. First, while most practitioners tended to agree that a sufficiently important modification of a contract could produce income of some sort, many believed that Section 1234A only treated certain gains or losses as capital rather than ordinary, and could not by itself be applied to determine when income was to be realized. Second, most practitioners had believed that the fundamental change doctrine, which appears to contemplate a deemed reissuance only if the changes to the derivative are quite important (e.g., the change in the named insured on a life insurance policy), applied only to a change made under the terms of the derivative itself, not one that was separately negotiated by the parties. That is, in the context of a separately negotiated change to the terms of a contract, many believed that a much lower standard of materiality (e.g., a "significant modification") was the relevant standard to determine whether a deemed reissuance had occurred. The Court did not discuss these standards, but simply concluded that the change was fundamental. Third, whatever the threshold, although there is a small amount of authority to the effect that extending the exercise date of an option can cause a deemed exchange, it is not self-evident that this authority applies to VPFCs; in addition, other authorities cited by the taxpayer reached a contrary result. Fourth, the Court surprisingly concluded that, although the modification created a new contract, it was not clear whether the replacement of the original contract with the new contract was an appropriate time for the recognition of income.

More broadly, the Second Circuit's decision may affect the analysis of whether the modification of a derivative (e.g., the extension of the term of a total return swap) triggers gain or loss. Many advisors have concluded that such changes could, if economically important enough, require the recognition of gain, or permit the recognition of loss, and McKelvey appears to have lowered the bar for triggering gain (and, subject to the potential application of the wash sale rules, loss). Moreover, in the area of Section 1259 planning, the Court appears to have established an upper boundary on taxpayers' ability to pass along upside on the stock to their counterparties. Taxpayers contemplating the modification of any derivative, or entering into an equity derivative transaction implicating the constructive sale rules of Section 1259, should proceed with increased caution.


Contact Information
For additional information concerning this Alert, please contact:
International Tax Services — Capital Markets Tax Practice
Matthew Stevens(202) 327-6846;
Michael Yaghmour(202) 327-6072;
Lena Y. Hines(213) 977-1532;
Richard Larkins(202) 327-7808;
Lee Holt(212) 773-9636;
David Golden(202) 327-6526;
Menna Eltaki(312) 879-5340;
Robert Contreras(202) 327-7496;
Tyler Arbogast(202) 327-6867;
International Tax Services/Financial Services Office
Matthew S. Blum(617) 585-0340;
Private Client Services
David H. Kirk(202) 327-7189;
Justin Ransome(202) 327-7043;



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