ESTATE OF ANDREW J. McKELVEY, Deceased.
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent - Appellant. Bradford G. Peters, Executor, Petitioner - Appellee,
Argued: June 5, 2018
Appeal
from the May 22, 2017, decision of the United States Tax
Court rejecting the claim of the Commissioner of Internal
Revenue that the Estate of Andrew J. McKelvey owed $41
million in taxes with respect to McKelvey's 2008 income
tax return for omitting what the Commissioner alleged were
short- and long-term capital gains arising from the execution
of new contracts extending the valuation dates of two
variable prepaid forward contracts.
Decision
reversed, and case remanded for (1) determination, in light
of this opinion, of whether the termination of obligations
that occurred when the new contracts were executed resulted
in taxable short-term capital gains, and (2) calculation of
the amount of long-term capital gains that resulted from the
constructive sales of the collaterized shares. Judge Cabranes
concurs with a separate opinion.
Clint
A. Carpenter, (David A. Hubbert, Deputy Asst. Atty. General,
Gilbert S. Rothenberg, Joan I. Oppenheimer, on the brief),
Tax Division, Appellate Section, U.S. Dep't. of Justice,
Washington, D.C., for Respondent- Appellant Commissioner of
Internal Revenue.
Mark
D. Lanpher, (Robert A. Rudnick, Kristen M. Garry, on the
brief), Shearman & Sterling LLP, Washington, D.C., for
Petitioner- Appellee Estate of Andrew J. McKelvey.
Before: NEWMAN, CABRANES, and CARNEY, Circuit Judges.
Jon O.
Newman, Circuit Judge
This
appeal concerns somewhat unusual financial instruments known
as variable prepaid forward contracts ("VPFCs"). A
VPFC is an agreement between a short party (typically, the
shareholder of a large quantity of low-basis, appreciated
stock) and a long party (typically an investment bank). The
long party agrees to pay the shareholder a substantial sum of
money equal to the value of the stock discounted to present
value. In exchange, the shareholder agrees to deliver to the
long party on a specified settlement date up to a maximum
number of shares of stock (or their cash equivalent), the
exact number to be determined by the price of the shares on a
specified valuation date. The short party also agrees to
secure its delivery obligation with the maximum number of
shares to be delivered at settlement. A VPFC usually sets a
floor price and a cap price that limit the number of shares
to be delivered in the event that the share price on the
valuation date is below the floor price, above the cap price,
or between them. The issues on this appeal arise because a
shareholder, after executing two similar VPFCs with two
financial institutions, paid substantial sums of money to
each institution to obtain an extension of the settlement
date and, more significantly, the valuation date.
There
are two precise issues. The first is whether, with respect to
each contract, the extensions resulted in a short-term
capital gain. The Commissioner of Internal Revenue
("Commissioner") contends that a short-term capital
gain occurred because either (1) the extension of the
valuation date resulted in an exchange of property with a
more valuable new contract replacing the original contract or
(2) a termination of the delivery obligation occurred because
the obligation in the first contract to deliver shares on the
original settlement date was extinguished.
The
second issue is whether, with respect to each contract, the
extension of the valuation date also resulted in a long-term
capital gain. The Commissioner contends that the execution of
each new contract resulted in a constructive sale of the
shares pledged as collateral to secure the obligation of the
new contract. His reason for this claim is that, on the date
of the new contract, the share price of the stock pledged as
collateral was so far below the floor price that there was no
more than a fifteen and thirteen percent probability,
respectively, for each contract that the share price would
reach that floor price and therefore, under each contract,
the shareholder would almost certainly be required to deliver
the maximum number of collateralized shares. As a result, the
Commissioner contends, the number of shares to be delivered
at settlement was "substantially fixed" within the
meaning of 26 U.S.C. § 1259(d)(1) on the date of each
new contract, resulting in a long-term capital gain on shares
constructively sold.
These
rather esoteric issues arise on an appeal by the Commissioner
from the May 22, 2017, decision of the United States Tax
Court (Robert P. Ruwe, Judge) rejecting the
Commissioner's claims to collect $41, 257, 103 from the
estate of Andrew J. McKelvey ("Estate") for both
short- and long-term capital gain taxes alleged to have been
incurred by the decedent in 2008.
Background
McKelvey,
who died on November 27, 2008, was the founder and principal
shareholder of Monster Worldwide, Inc. ("Monster"),
a publicly traded company that maintains a website,
monster.com, which helps job-seekers find jobs. In 2007,
McKelvey executed two VPFCs, one with Bank of America, N.A.
("Bof A") as long party and another with Morgan
Stanley & Co. International plc ("MSI") as long
party.
The
Bof A VPFC. Under the Bof A contract, which became
effective September 11, 2007, Bof A agreed to pay McKelvey
$50, 943, 578.31 on September 14, 2007; he agreed to pledge
1, 765, 188 shares of Monster stock to secure his obligation
to Bof A; and he agreed to deliver to Bof A up to 1,
765, 188 shares of Monster stock (or the cash equivalent) at
settlement. Settlement was to be made by delivering to Bof A
up to ten percent of the 1, 765, 188 shares on each of ten
consecutive weekdays between September 11 and 24, 2008. At
the close of trading on the NASDAQ on September 11, 2007, the
price of Monster stock was $32.91.
The
contract provided that the actual number of shares to be
delivered on each of the ten settlement dates would be
determined in one of three ways, depending on the closing
price of Monster stock on each of the ten dates. If the
closing price on a settlement date was less than (or
equal to) $30.4610 ("Bof A floor price"), the
number of shares to be delivered on each of the ten dates
would be 176, 519 (ten percent of 1, 765, 188).[1] If the closing price on a
settlement date was more than the Bof A floor price
but less than (or equal to) $40.5809 ("Bof A
cap price"), the number of shares to be delivered on
each of the ten dates would be a fraction of 176, 519: the
numerator of the fraction would be the Bof A floor price and
the denominator would be the Monster stock closing price. If
the closing price on a settlement date was more than
the Bof A cap price, the number of shares to be delivered
would be a more complicated fraction of 176, 519: the
numerator of the fraction would be the closing price minus
the difference between the Bof A cap price and the Bof A
floor price, and the denominator would be the closing price.
These
three methods of determining the number of shares to be
delivered at settlement would yield curious results. To
illustrate these results, it will be convenient to ignore the
fact that ten percent of the total number of the 1, 765, 188
shares would be delivered on each of ten consecutive weekdays
and consider the collateralized shares as a bloc. If the
closing price was equal to, or any price below, the floor
price, the number of shares to be delivered would always be
the total number of shares pledged as collateral, which would
be the maximum number of shares required to be delivered at
settlement. If the closing price was between the floor price
and the cap price, the number of shares to be delivered would
decline from 1, 765, 188 the closer the closing
price was to the cap price. The decline would end when the
closing price equaled the cap price, at which point the
number of shares to be delivered would be 1, 324, 993 (1,
765, 188 times 30.4610/40.5809).[2] If the closing price was any price
above the cap price, the number of shares to be delivered
would increase from 1, 324, 993 and continue to
increase the more the closing exceeded the cap price. The
increase would be continuous as the closing price increased
and the number of shares to be delivered approached the total
number of the collateralized shares, but the number of shares
to be delivered would never exceed that maximum total number.
These effects are illustrated in the following table, showing
an example of how many shares of a 1, 000-share bloc would be
delivered at various closing prices: some below or equal to
the floor price of 30.5 (rounded), some between the floor
price and the cap price of 40.6 (rounded), and some above the
cap price. The table also shows the fraction used to
determine the number of shares to be delivered.
closing price:
|
20
|
25
|
30.5
|
35
|
40
|
40.6
|
45
|
50
|
60
|
fraction:
|
|
|
30.5/35
|
30.5/40
|
30.5/40.6
|
34.9/45
|
39.9/50
|
49.1/60
|
|
shares delivered:
|
1000
|
1000
|
1000
|
850
|
763
|
751
|
776
|
798
|
818
|
Under
the Bof A contract, McKelvey had the option to settle the
contract with the "cash equivalent" no matter which
of the three methods for determining the number of shares to
be delivered was applicable. The cash equivalent for each
share to be delivered was 105 percent of the closing share
price three trading days prior to the valuation date for the
first portion of the collaterized shares to be delivered,
which was September 11, 2008.[3] Of course, had McKelvey used the cash
equivalent option (for both the Bof A and MSI contracts), he
would have had to pay a substantial sum of money.
On July
24, 2008, two months before the ten settlement dates,
McKelvey paid Bof A $3, 477, 949.92 to amend the Bof A
contract by extending the original settlement dates, which
also served as valuation dates, from ten consecutive weekdays
in September 2008 to ten consecutive weekdays in February
2010 ("amended contract"). No other terms of the
2007 Bof A contract were changed. On the date of the Bof A
extension, the closing price of Monster stock was $18.24.
The
MSI VPFC. Under the MSI contract, effective September
24, 2007, MSI agreed to pay McKelvey $142, 626, 185.80 on
September 27, 2007; he agreed to pledge 4, 762, 000 Monster
shares to secure his obligation to MSI; and he agreed to
deliver to MSI up to 4, 762, 000 Monster shares (or
the cash equivalent) on September 24, 2008. At the close of
trading on the NASDAQ on September 24, 2007, the price of
Monster stock was $33.47.
The
contract provided that the actual number of shares to be
delivered on the settlement date would be determined in one
of three ways depending on the average of the closing prices
of Monster stock on ten valuation dates ("average
price"). If the average price was less than (or
equal to) $30.894 ("MSI floor price"), the number
of shares to be delivered would be 4, 762, 000. If the
average price was more than the MSI floor price but
less than (or equal to) $35.772 ("MSI cap
price"), the number of shares to be delivered would be a
fraction of 4, 762, 000, the numerator of the fraction to be
the MSI floor price and the denominator to be the average
price. If the average price was more than the MSI
cap price, the number of shares to be delivered would be a
more complicated fraction of 4, 762, 000: the numerator of
the fraction would be the average price minus the difference
between the MSI cap price and the MSI floor price, and the
denominator would be the average price. These three methods
of calculation yielded precisely the same curious results
described above with respect to the Bof A contract when the
closing price was equal to or below the MSI floor price,
above the MSI cap price, or between them.
Under
the MSI contract, like the Bof A contract, McKelvey had the
option to settle the contract with the "cash
equivalent" no matter which of the three methods for
determining the number of shares to be delivered was
applicable, but the calculation of the cash equivalent
differed from the Bof A contract. Under the MSI contract, the
cash equivalent was the number of shares to be delivered
multiplied by the closing price of Monster stock on the last
of the ten averaging dates.[4] That date was September 24, 2008.
On July
15, 2008, two months before the settlement date, McKelvey
paid MSI $8, 190, 640 to amend the MSI contract by extending
the original settlement date from September 24, 2007, to
January 15, 2010, and to extend the dates on which the
average price would be determined from ten consecutive
weekdays in September 2008 to ten consecutive weekdays in
January 2010 ("amended contract"). No other terms
of the 2007 MSI contract were changed. On the date of the MSI
extension, the closing price of Monster stock was $17.28.
On the
dates of the extensions of both the Bof A and MSI contracts,
the value of McKelvey's Monster shares was about $114
million. If McKelvey had delivered his Monster shares on
those dates instead of extending the settlement and valuation
dates of the VPFCs, he would have realized a substantial
capital gain.
Settlement
of amended contracts.
After
McKelvey's death, the Estate settled the amended Bof A
contract by delivering 1, 757, 016 Monster shares to Bof A on
May 8, 2009, [5]
and settled the amended MSI contract by delivering 4, 762,
000 Monster shares to MSI on August 5, 2009. Both the
original VPFCs and the amended contracts provided for
expedited settlement in the event of various occurrences
including McKelvey's death. The parties make no claim
that the expedited settlements have any significance to the
issues on appeal. The Estate obtained a stepped-up basis for
the Monster shares. See 26 U.S.C. § 1014(a)(1).
To
recapitulate: by executing both VPFCs in September 2007,
McKelvey received about $194 million, [6] pledged about 6.5 million
Monster shares, [7] then worth about $218 million,
[8] and agreed
to deliver one year later between about 5.4
million[9] and
6.5 million Monster shares (then worth between about $181
million[10]and
$218 million). Ten months later, McKelvey paid $11, 668, 590
to execute amended contracts, which extended the settlement
dates and the valuation dates that would determine the number
of shares to be delivered at settlement. The Estate settled
the amended contracts by delivering 6, 519, 016 Monster
shares, which the Commissioner states were worth about $88
million, to Bof A and MSI. Neither McKelvey nor the Estate
paid any income taxes with respect to the Monster shares.
McKelvey's
2008 income tax return.
McKelvey's
2008 federal income tax return, filed by the executor of his
Estate, reported no income attributable to the execution of
the amended contracts. The Estate's reason for not
reporting any short-term capital gain was its view that the
extensions of the settlement and valuation dates did not
result in a taxable exchange of the original VPFCs for the
amended contracts. The Estate's reason for not reporting
any long-term capital gain was its view that such a gain
could not have occurred until the amended contracts were
settled by delivery of Monster shares to Bof A and MSI, and,
by that time, the shares had ...