Last week, in McKelvey v. Commissioner¸[1] the U.S. Tax Court held that the extension of a typical variable prepaid forward contract (“VPFC”) did not give rise to a taxable exchange to the obligor because a VPFC is solely an obligation, and not property, within the meaning of section 1001 of the Internal Revenue Code. The Tax Court also noted this result is consistent with the usual treatment of a VPFC as an “open transaction”. This decision is very good news for an obligor under a VPFC (that is, the party required under the contract to deliver cash or stock at the end of the term of the VPFC), that wishes to extend a VPFC without tax consequences. If the decision is upheld on appeal under the Tax Court’s reasoning, the case would seem to apply equally an obligor that extends a conventional option, and could even provide a basis for debtors to argue that a modification of their debt does not give rise to an exchange (and thus, does not give rise to cancellation of indebtedness income) notwithstanding Treasury regulations section 1.1001-3. However, the Tax Court’s reasoning in McKelvey is in some tension with other authorities and, if taken at face value, could create opportunities for significant tax deferral on a wide variety of financial products.

In September 2007, Andrew McKelvey, the founder of job search website, entered into two VPFCs with respect to his appreciated Monster Worldwide, Inc. (“Monster”) shares. Under the VPFCs, McKelvey received an upfront cash payment of over $190 million in exchange for the obligation to deliver up to 6,527,188 Monster shares over several days in September 2008. The actual number of Monster shares was determined as of each settlement date, subject to a cap and a floor, based on the fair market value of the Monster shares as of the settlement date. McKelvey pledged Monster shares as collateral, but was entitled to settle the contract with cash or other property instead. The Internal Revenue Service (IRS) conceded that the VPFCs did not cause McKelvey’s appreciated Monster shares to be treated as sold under section 1001, or constructively sold under section 1259, consistent with Revenue Ruling 2003-7.

In July 2008, McKelvey paid $11.7 million to extend the VPFCs through early 2010. McKelvey died after extending the VPFCs, and his estate (the taxpayer) continued to treat the contracts as subject to the open transaction doctrine and did not report any gain or loss in 2008 related to the extensions.

The IRS asserted that the extensions resulted in a taxable disposition of the VPFCs (i.e., that McKelvey should be treated as if he had exchanged the original VPFCs for the extended VPFCs in a taxable transaction that resulted in short-term capital gain for his estate. The Tax Court disagreed.

First, the Tax Court held that section 1001 applies only to sales or exchanges of “property”. Because McKelvey had received cash upon executing the VPFCs, had no future payment rights, and had only the obligation to deliver the Monster shares or cash, the Tax Court held that the VPFCs represented “obligations” and not “property” within the meaning of section 1001. As a result, section 1001 did not apply. The Tax Court further concluded that its holding was consistent with the open transaction doctrine with respect to McKelvey’s Monster shares. By extending the VPFCs, McKelvey had not resolved the uncertainty as to the amount and character of gain or loss to be recognized with respect to his Monster stock. This amount and character of any gain or loss would vary depending on whether the contracts were settled with cash, shares, or other property, just as they did when the VPFCs were initially entered into.

Because the Tax Court held that extensions of VPFCs do not implicate section 1001 at all, it did not consider whether the extension of the VPFCs was significant enough to trigger a “sale or exchange” of the VPFCs. The McKelvey court’s reasoning is particularly surprising because a whole set of regulations – Treasury regulations section 1.1001-3 – address the application of section 1001 to debt instruments. As to the debtor, a debt instrument is purely an “obligation”, just like McKelvey’s short position under the VPFCs.

Further, it is far from clear that treating an extension of the VPFCs as a taxable event with respect to the VPFCs is inconsistent with open transaction treatment with respect to McKelvey’s Monster shares. The continuing open treatment of McKelvey’s shares could be maintained even if the VPFCs (a bundle of contract rights and obligations separate and apart from the collateral posted in respect of that contract) were treated as exchanged for new VPFCs, and would be generally consistent with authorities dealing with option extensions, which are frequently treated as deemed taxable exchanges.[2]

If the McKelvey decision survives appeal with the reasoning preserved, pure obligors under forward contracts and options would appear to be able to extend their contracts without a taxable event, effectively allowing potentially indefinite deferral of tax liability. Indeed, obligors could effectively achieve indefinite deferral by continued extension. In theory, notwithstanding regulations section 1.1001-3, debtors could possibly even argue that an extension of a debt instrument does not give rise to a taxable event under the theory that their debt instrument are merely obligations (just like McKelvey’s VPFCs) and thus are not subject to section 1001. With these concerns in mind, a future court could very well seek to limit McKelvey to its facts.

The IRS has not yet announced whether it intends to appeal the decision.

[1] 148 T.C. No. 13 (Apr. 19, 2017).

[2]  See PLR 9129002 (Mar. 26, 1991) (purported extension of option was treated as new option, with writer of option required to recognize ordinary income in aggregate amount of option payments received under the unexercised original option).  Cf. Rev. Rul. 80-134, 1980-1 C.B. 187 (extension of worthless warrants did not allow holder to defer taking option premium into income because options had in substance lapsed) (obsoleted by Rev. Rul. 86-9, 1986-1 C.B. 290, after enactment of section 1032(a)).