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.

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.”

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.


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