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Prepaid-variable forward (PVF) Definition
A prepaid variable forward contract (PVFC) is a strategy employed by investors who have large stocks and want to generate liquidity. Under a PVFC, an investors agrees to sell certain amount of shares at a discount, usually between 75-90% of the prevailing market value, but the buyer doesn’t take ownership of the shares immediately but at a future date , mostly after 2 – 5 years. However, the number of shares owed at maturity is variable and not necessarily the earlier fixed amount.
A Little More on What is a Prepaid Variable Forward
A prepaid variable forward contract is an open transaction more like a stock option since both relate to a future commitment. To understand a PVFC better we can explain it by breaking it down to individual words;
Firstly, it’s a “contract”, usually between an investor and a financial institution or a brokerage firm. Secondly, it’s a “forward” contract since the agreement stipulates that the shares will be delivered by the investor at a future date. Also, there is an option of cash settlement instead of stock.
In addition, it’s a “prepaid” forward contract since the investor typically receives all the cash up front without relinquishing the share ownership. The prepayment does not attract capital gain tax, this is because the transaction is not completed and the payment is treated like a loan/ debt and the underlying security as the contingency. Further, the payment is at a discount which can be said to be a form of interest expense for the debt.
Lastly, the prepaid forward contract is “variable” since the number of shares to be delivered by the investor depends on the subsisting share value at the material time of expiration/ maturity. Generally, at execution of the contract a floor or lower strike price and a threshold or upper strike price are usually set. These strike prices are what guides computation on a sliding scale to determine the number of shares due.
Prepaid Variable Forward Example
For instance, an investor owns shares in company “A” whose shares are trading at $5 per share and the investor pledges 100,000 shares in a PVFC and sells the same at $3.50 per share($350,000 total) with a maturity of let’s say two years. The lower strike price is then set to $4 per share and the upper strike price is set to $6 per share.
Now, at the end of two year if the share price is trading below $4, the investor will simply deliver all the pledged shares. There is no obligation to make up for the loss by additional shares or financial consideration by the investor. However, if the share is trading within the threshold set, that is, either at $4, $5, or $6 the shares due is calculated by dividing the principal($350,000) and the prevailing share value (either at $4, $5, or $6)
- If the share price is $4/share, the investor delivers; $350,000/ $4 = 87, 500 shares.
- If the share price is $6/share, the investor delivers; $350,000/ $6 = 58, 333 shares.
On the other hand, if share price is above the upper strike price, the investor will deliver the principal ($350,000) plus the excess of the share price above the upper strike price ($6).
- If the share price is $8/share, the investor delivers the principal ($350,000) plus ($8 − $6) (100,000) = $550,000. This is if it’s a cash settlement.
- Or; $550,000/ $8 = 68,550 shares.
- If the share price is $10/share, the investor delivers the principal ($350,000) plus ($10 − $6) (100,000) = $750,000 or 75,000 shares.
The moment the shares are delivered, the transaction is completed and therefore the deferred capital gain tax becomes due from the initial proceeds. The gain or loss realized by a party to a prepaid forward contract is governed by the general rules applicable to the sale or disposition of the underlying security.
Collar Strategy with Prepaid Variable Forward
A prepaid variable forward contract (PVFC) is a Wall Street invented technique for wealthy investors to delay or entirely avoid taxes on their investment gains – thanks to advanced financial engineering. A PVFC is technically a hedge wrapper or collar that involves buying a long put option and selling a short call option on a security, and marrying the same with a third element which is basically loaning money; the monetization of the transaction.
The put is slightly below the prevailing market value and the call is slightly above Fair market value. This effectively places a ‘collar’ around the potential upside or downside of the security. This structure enables the investor to loan certain amount of appreciated shares to a financial institution which then limits the institution’s exposure and results in substantially lower interest fees to the investor.
The put option protects the investor against a decline in the stock price while the premium received from selling the call option is used to fully or partially fund the cost of the put. In addition, an investor choosing to sell a call option in a PVFC means one is giving up their stock appreciation potential beyond the call.
A PVFC differs slightly from a standard forward contract, in that the payment for the forward contract and the transfer of the ownership of the underlying security take place simultaneously at a predetermined future date. Also, the price in a standard forward contract is determined at the contract date and is not variable but fixed.
Purpose of Prepaid Variable Forwards
There are different motivations that attract investors to take up prepaid variable forward contracts (PVFCs) including;
- To hedge against the risk of a bear run that could lead to substantial loss especially to executive holding substantial chunks of shares and are prohibited from selling due to public relations.
- To gain liquidity from large amount of unrealized gain in the stock position.
- To defer taxes that would otherwise be paid as a result of gains from sale of security, that is, capital gain taxes.
- It is an easier way to get a loan at a reduced interest expense.
Going forward more sophistication and spread of the use of financial products such as a PVFC to produce as many benefits of a security is expected to witness an increased uptake by investors.
PVFCs still faces some level of uncertainty regarding their tax treatment. For instance; in 2010 billionaire Philip Anschutz made headlines after he lost a high-profile case involving the use of PVFCs to defer over one hundred million dollars in capital gains taxes. The Tax court held that a prepaid forward sale of a security, coupled with a loan of that security to the forward purchaser, triggered a taxable sale of the underlying security upon receipt of the up-front payments.
Philip Anschutz appealed the decision, but in late December the U.S. 10th Circuit Court of Appeals in Denver upheld the tax court’s 2010 ruling that Mr. Anschutz had transferred the benefits and burdens of ownership to the forward purchaser. The treatment of the PFC as an open transaction was inappropriate and consequently he owed at least seventeen million dollars in capital gain taxes to the IRS.
However, that was just the beginning of PVFCs making the headlines as financial journalist started to dig deeper and IRS sent its agent after PVFCs. Later, in 2011 Ronald Lauder, the heir to Estée Lauder cosmetic company, was the subject of a front page feature in the New York Times on the ways in which he and the family has over the years artfully avoided taxes since 1995 when the company went public.
According to the article, Mr. Lauder used a prepaid variable forward to acquire $72 million in cash to from an investment bank but the contract was artfully schemed to avoid taxes. Further, the PVFC sheltered his executive compensation that was extremely high in comparison to the average employee compensation level.
Nevertheless, this doesn’t mean that the use of prepaid variable forward contract will always land the investor in hot waters with IRS. There are just some caveats that should be considered. For instance, the contract should be well drafted in line with the stock lending provision, also known as Section 1058, so that the PVFC does not constitute a sale till maturity.
In addition,Investors should avoid situations where the shares that were pledged under the contract are construed to be an actual loan to a financial institution as the IRS views the prepayment taxable at the time of receipt. Also, the IRS requires a PVFC transaction to reflect the principle of time value of money, which would mean a higher amount of gain recognized by the investor and consequently liable to a corresponding interest expense amount.
Lastly,It is advisable to get wealth management advisory on hedging and monetization of PVFC in order to exploit this “perfectly legal” way to get money out of one’s held security and not pay the taxes due. A word of caution to investors who bought stocks before 1984 is to avoid a PVFC altogether. A prepaid variable forward contract automatically builds interest costs into its price. This means such an investor is throwing away a potential current interest expense deduction when they use a PVFC.
References for Prepaid Variable Forward
Academic Research on Prepaid-variable forward (PVF)
An analysis of insiders’ use of prepaid variable forward transactions, Jagolinzer, A. D., Matsunaga, S. R., & Yeung, P. E. (2007). Journal of Accounting Research, 45(5), 1055-1079. The study looks at how Insiders use PVF that are typically traded over the counter to hedge downside risk, share performance gains, and obtain immediate large‐sum cash payments for investment or consumption. The paper examines the performance of such companies to suggests PVF are part of insider trading schemes to diversify risk portfolio in anticipation of performance declines consequently passing the risk to a third party.
Taxing exchange-traded notes and the future of variable prepaid forward contracts, Pahl, J. (2012). [Re-written]The paper tries to provide an overview in regards to Taxing exchange-traded notes (ETNs) based on a qualitative and a quantitative analysis in comparison with mutual funds. The article further discusses the future of ETNs as a prepaid forward contract and suggests that enhanced spotlight on tax deferral can be achieved through structured taxation approaches.
The Impact of Recent Court Decisions on the Tax Treatment of Prepaid Variable Forward Contracts, Shaheen, N. A., & Chambers, V. (2011). The ATA Journal of Legal Tax Research, 9(1), 1-13.
[Re-written]The paper examines recent high profile court ruling in regard to tax treatment of prepaid variable forward contracts and their impacts the overall use of such contracts in the securities market. The paper further provides an overview of how a PVFC typically works and the implication on tax planning following the Tax court ruling inferring a PVFC is taxable at execution rather than at maturity.
Anschutz v. Commissioner: Integration of Prepaid Variable Forward Contracts and Share Lending Agreements under Internal Revenue Code Section 1058, Barazi, W. (2011). The paper analyses the court ruling in 2010 touching on case involving Anschutz v. Commissioner and the tax treatment of PVFCs executed by billionaire Philip Anschutz. The paper looks at whether the decision might have unnecessarily placed constraints on securities lending by use of section 1058 of the Internal Revenue Code to strike down the tax deferral scheme.
IRS National Office Rules Adversely on Variable Prepaid Forward Contracts with Securities Loan, Barnet, H. J. (2006). Journal of Taxation and Regulation of Financial Institutions, 19(6), 31-35. The paper looks at the IRS National Office Rules and how it adversely affects Variable Prepaid Forward Contracts coupled with Securities Loan in terms of tax treatment.
Pledge (and hedge) allegiance to the company, Larcker, D. F., & Tayan, B. (2010). The article looks at how companies include equity as a compensation package to managers as a way of winning allegiance to the company so that the executive interest are in line with those of shareholders. However, interestingly the board does not allow such executives who have accumulated substantial amount of stock over the year to hedge the stock due to certain Issues and Controversies in Corporate Governance and Leadership. The paper examine the issues in detail.
Are Incentive Contract Settlements Nonevents?, Gagnon, M. H., & Philippot, A. (2018). International Review of Finance. The paper examines whether Incentive Contract Settlements such prepaid variable forward can be interpreted as nonevents. The paper notes that the execution and future settlement date have minimal effect on the volatility of the company taking up such contracts and are therefore nonevents.
Investor Applications of Equity Options, Schofield, N. C. (2017). In Equity Derivatives (pp. 315-346). Palgrave Macmillan, London. The paper covers Investor Applications of Equity Options in relation to yield enhancement, portfolio downside protection, anticipated market performance, benefits as well as strategies employed to increase performance.
Does a CEO’s hedging ability affect the firm’s capital structure?, Dunham, L. M. (2018). Journal of Economics and Finance, 42(3), 615-630. The paper examines whether the amount of stock held by the company’s CEO has any impact on the amount of leverage that a company carries in the wake of a highly volatile market.
Optimal compensation contracts when managers can hedge, Gao, H. (2010). Journal of Financial Economics, 97(2), 218-238. The paper looks at how the ability by listed firms Chief Executive Officer’s (CEO’s) to hedge risk and hold more exercisable in-the-money options, have weaker incentives to cut dividends, and pursue fewer corporate diversification initiatives. The paper suggests that the CEOs pay-performance sensitivity is influenced by the executive-hedging costs involved.