Not What You Bargained For: Equity Forward Contracts

Companies that buy back stock using equity forward contracts may not get the tax result they had hoped for following a merger.
Robert WillensSeptember 2, 2008

Many companies have chosen to repurchase their shares by means of “equity forward” contracts, but some confusion remains regarding how the Internal Revenue Service views these transactions. In April, the IRS tried to clear things up with guidance laid out in a chief counsel advisory letter (CCA 200832002, April 23, 2008.)

In the letter, the IRS used a generic example to explain its position, noting that Alpha Corporation decided to repurchase shares using equity forward contracts. In other words, Alpha agreed to buy back a certain number of its shares for a set price on various scheduled termination dates, known as settlement dates.

Each contract entered into by Alpha could be settled in one of three ways. Alpha could deliver the forward price and the counterparty would deliver the agreed amount of Alpha shares. This method of settlement is known as “physical settlement.” Alternatively, one party could deliver to the other party the amount of “net equity” in the contract, which could be settled in one of two ways. If the payment is made in cash, the contract is said to “cash settled” and if the payment is made in the form of shares, the contract is regarded as “stock settled.”

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

The example goes to say that over the course of two years, Alpha physically settled seven of the nine forward contracts it had previously entered into, relying on Section 1032 to report neither gain nor loss with respect to these contracts. However, with two contracts still unsettled, Alpha merges with Sigma Inc., a controlled subsidiary of Pi Corporation.

The merger qualified as an ‘Alpha’ reorganization under the tax code — specifically Section 368(a)(2)(D). Under the terms of the two remaining forward contracts, the shares Alpha agreed to buy back are changed to shares of PiCorp using a conversion ratio. The conversion ratio pinpointed the number of PiCorp shares that would equal the value of one Alpha share on the merger date. So, the value of Alpha’s stock on the merger date was used to establish the number of shares of “substitute stock” that would be measured against the original forward price.

A few months later, Sigma “cash settled” the two remaining contracts, and was forced to make a payment to the counterparty. The payment was necessary because the market price of the “reference stock” at the time of settlement was below the forward price. As a result, Sigma reported a capital loss in the amount of the payment.

Sigma’s parent, PiCorp based its action on the argument that Section 1032 did not apply so a loss could be realized with respect to stock, which was not Sigma’s own stock.The IRS, nonetheless, disallowed the loss. Here’s why.

Successor stock

Section 1032, the section in dispute, provides that a corporations shall not recognize a gain or loss on the receipt of money or other property in exchange for stock of such corporation. In the chief counsel advisory, PiCorp refers to a 1970 IRS ruling (Revenue Ruling 70-305, 1970-1 C.B. 169) to support recognizing the loss. To be sure, the ruling notes that a subsidiary purchased shares of its parent on the open market and later sold the purchased shares to “outside interests” at a gain. The ruling holds that the stock of the parent held by the subsidiary is not “treasury stock” and therefore, (1) the sale of such stock is not a sale by a corporation of its own stock for purposes of Section 1032, and (2) the transaction results in a gain or loss recognized by the subsidiary.

Despite the surface similarity, however, the advisory concludes that Revenue Rule 70-305 does not apply to the loss in the PiCorp case. The loss to the subsidiary in the ruling was based on the value of a different corporation’s stock. By contrast, the loss to Sigma was based on the value of “Sigma’s Section 381 predecessor’s stock” (in effect, Sigma’s own stock) up to the point of the merger.1

As a result, the loss on the Alpha stock that was embedded in the amended contract did not change or disappear just because the parties agreed to deliver a new underlying stock.2 In short, the loss did not lose its “origin” when the parties changed the underlying stock to be delivered. Accordingly, the IRS advisory concludes that Sigma’s loss on the forward contract should have been treated as a non-recognized loss under Section 1032.

According to the advisory, the IRS believes that Congress did not intend Section 1032 to be elective — or to be avoided by economically equivalent transactions — and that it should be applied broadly. Indeed, if taxpayers enter into transactions that result in a gain or loss based on the value of their own stock Section 1032 mandates non-recognition.3

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1 Would it have made a difference if Sigma was not Alpha’s successor under Section 381? What if the merger had been structured as a “two party” merger of Alpha with and into PiCorp, and as part of the plan, PiCorp transferred a substantial amount, but less than all, of Alpha’s assets to Sigma under Section 368(a)(2)(C). In that event, PiCorp, not Alpha, would be treated as the “acquiring” corporation for purposes of Section 381. See in this regard, Regulation Section 1.381(a)-1(a)(2); in a transaction to which Section 381(a)(2) applies. In that case, the acquiring corporation is that corporation which, pursuant to the plan of reorganization, ultimately acquires directly or indirectly, all of the assets transferred by the transferor. If in a transaction qualifying under Section 381(a)(2) no one corporation ultimately acquires all of the assets transferred by the transferor corporation, the business that directly acquires the transferred assets (PiCorp) is deemed the acquiring corporation for purposes of Section 381 — even though the corporation ultimately retains none of the assets. It seems unlikely that the IRS would be moved by such an insignificant change in the manner in which the transaction was carried out and that, even if Sigma was not technically the “Section 381 successor” to Alpha, its loss on settling the forward contracts would be governed by the provisions of Section 1032.

2See in this regard IRS Letter 9838007, June 16, 1998, in which the stock of T Corporation (T) was acquired by FA Corporation (FA) in a transaction qualifying as an ‘A’ reorganization by reason of Section 368(a)(2)(E). A portion of the FA voting stock to be delivered to the T shareholders was contingently issuable. This “contingent stock” was to be delivered to the former T shareholders after a certain period of time following the merger had elapsed. At the time of the merger no future union or reorganization of FA was “contemplated.” Later, however, FA entered into a plan and agreement in which its shareholders would exchange their FA stock for a percentage of the stock of FN in a transaction intended to qualify as a reorganization. FN will succeed to all of the rights, assets, obligations, and liabilities of FA including FA’s obligation to issue stock, in connection with the T/FA merger to the former T shareholders. The ruling concludes that the FN stock received by the former T shareholders would be governed by Section 354(a)(1)’s non-recognition provisions even though, clearly, FN was not a “party” to the T/FA merger. The ruling provides that “…the issuance by FN, as a successor to FA, of its stock on Date 1 and Date 2, instead of FA stock, will not result in the T shareholders being treated as receiving stock of a corporation other than the controlling corporation, a party to the reorganization…”

3See LTR 200450016, August 17, 2004 in which X Corporation (X) issued contracts for the purchase of its stock for “$c” on Date 4. The value of X’s stock declined. X, in response to this decline, cancelled the stock purchase contracts. X was paid “$i” in settlement of the contracts. The ruling concludes that Section 1032 applies to this receipt by X of property in cash settlement of a contract to sell its stock.