Prepaid Variable Forward - Explained
What is a Prepaid Variable Forward?
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Table of ContentsWhat is a Prepaid-Variable Forward?How Does a Prepaid Variable Forward Work?Prepaid Variable Forward ExampleCollar Strategy with Prepaid Variable Forward Purpose of Prepaid Variable Forwards Drawbacks
What is a Prepaid-Variable Forward?
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.
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How Does a Prepaid Variable Forward Work?
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, its a contract, usually between an investor and a financial institution or a brokerage firm. Secondly, its 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, its 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 lets 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 its 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 institutions 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 courts 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 Este 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 doesnt 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 ones 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.