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US Court Strikes Down Stock Option Scheme,
by Mike Godfrey, Tax-News.com, Washington
Thursday, July 29, 2010
A recent United States Tax Court ruling has attacked the basis of a scheme
whereby many US company executives have, in the past, deferred the capital gains
tax due on share options.
The scheme was based upon prepaid forward sale contracts, usually with a share
lending transaction executed at the same time. The Internal Revenue Service
has now challenged the whole arrangement, contending that it constitutes an
immediate sale of the shares in question and that, therefore, capital gains
accrued on the shares are subject to tax in the usual way. That view has now
been upheld by the court.
Under the forward sale agreement, the taxpayer would normally receive up to
80% of the market value of shares sold to a bank, with completion of the transaction
and physical transfer of the shares to be made at a future date, for example
ten years later.
Taxpayers would treat the forward sales as remaining ‘open’, rather
than ‘closed’, and therefore not declarable in their tax returns.
It was believed that any tax due on capital gains on the shares would be deferred
to that later date. This was of great value during the previous bull market
when share options were usually of significant mark-to-market value.
Usually, the forward sale contract is accompanied by a simultaneous share lending
agreement by which the taxpayer also lends the stock to the bank. The taxpayer
thereby receives an additional return, while the bank is able to sell the shares
short, or otherwise hedge its risk, over the period of the forward sale.
The case brought before the court involved the well-known US businessman, Philip
Anschutz who, it was said, had previously invested in oil exploration and railroad
companies, in which he had accrued substantial shareholdings. When he wished
to invest in the real estate and entertainment sectors, he used a forward sale
and share lending agreements to obtain the necessary funds on a non-taxable
basis.
Although Anschutz had used an S corporation to hold the shares in his previous
companies, this did not alter the fact that any tax liability would have been
for his account. For federal tax purposes, such a corporation acts in a similar
fashion to a partnership, in that its income is taxed at shareholder rather
than corporate level. A shareholder reports his portion of the corporation’s
income or loss on his individual tax return.
In analysing the agreements, the tax court found that the S corporation, and
Anschutz, had effectively transferred the benefits and responsibilities of share
ownership, including legal title to the shares; all risk of loss from falls
in market value; a major portion of the opportunity to take advantage of future
capital gains; the right to vote the shares; and their physical possession.
The court therefore decided that the two transactions taken together represented
a closed sale of shares, and that the consequent capital gains should have been
declared in Anschutz’s 2000 and 2001 tax returns.
While it is believed that Anschutz intends to make an appeal against the tax
court’s ruling, the extent of the capital gains at risk from the ruling
is currently unquantifiable. It is, however, known that the use of this scheme
has been widespread, and the capital gains in question could run into billions
of dollars.
There also remains some doubt whether a forward sale of shares, but without
the share lending arrangement, would produce a similar court decision. It would
appear to be the latter arrangement that triggered the court’s opinion
that the scheme constituted a complete disposal of the shares, and there have
been comments that a forward sale of shares by itself could remain, under the
federal tax laws, an open transaction.
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