Since the enactment of the constructive sale rules¹ in 1997, a strategy known as a prepaid variable forward (PVF) has emerged in the United States as the tool most commonly used by taxable investors to hedge, monetize, and defer the capital gains tax on the highly appreciated, publicly traded securities they own. Although common, PVFs are being challenged by U.S. tax authorities. Concern about PVFs has given rise to an alternative, the options-based collar combined with a margin loan, which achieves economically equivalent results to a PVF with less tax and audit risk.

A PVF is economically a collar and loan combined into a single financial instrument. The optionality of the collar is achieved by requiring the investor to deliver a variable number of shares (or cash in lieu thereof) to the dealer counterparty on expiration of the PVF.

The PVF is popular with investors holding concentrated stock positions because a PVF does not limit the use of the proceeds released to the investor. For instance, if an investor owns appreciated stock now worth $100 per share and enters into a three-year PVF containing an embedded put strike price of $100 and an embedded call strike price of $115, the dealer counterparty might release $88 per share in cash to the investor. The investor can do anything desired with the cash, including investing it in publicly traded equity securities.

If the same investor were to hedge the stock position with options, buying puts with a strike price of $100 and selling calls with a strike price of $115, the most the investor could borrow against the hedged position would be $50 because of margin rules.² This is referred to in the parlance of Wall Street as a “purpose” loan, the purpose being to buy publicly traded equity securities.

If the investor does not wish to use the loan proceeds to buy publicly traded equity securities, the 50 percent initial margin requirement does not apply. In this case, most broker/dealers will lend up to 90 percent of the put strike price (in our example, the loan could be up to $90). The proceeds of this “nonpurpose” loan cannot be used to purchase publicly traded equity securities, which is what most investors and their advisers would choose to do to diversify the investor’s portfolio.

It is the aforementioned 50 percent initial margin requirement under Regulation T and Regulation U that is the primary reason most investors and their advisers have favored the PVF over options-based collars combined with margin loans.

IRS Repeatedly Attacks PVFs
The IRS has made it crystal clear to the investment and tax communities over the past several years that it views PVF contracts with a suspect eye. Specifically, in 2006, 2007, and 2008, the IRS issued memorandums concluding that appreciated stock hedged and monetized through a PVF triggers a taxable event immediately on entering into the contract.³

In each case, the IRS based its analysis on the common law “benefits and burdens” test and concluded that investors who entered into PVF contracts were left with insufficient “incidents of ownership” in their shares and thus triggered an immediate taxable event.

The IRS memorandums do not rely on just one particular concern but mentioned a number of factors that collectively led to their holding that a taxable event had occurred, including the following:

• The investor either lent its shares to the dealer counterparty or, alternatively, made its shares available for the dealer to borrow should the stock become difficult to borrow. The dealer executing a PVF will typically establish a short position in the stock to hedge the synthetic long exposure acquired through the PVF. This action by the investor potentially reduces the dealer’s cost and risk in managing the PVF position.
• The investor passed through to the dealer some or all of the dividends received on the stock, plus any dividend increases.
• The investor forfeited its voting rights (because it lent out its shares).
• The investor was obligated to settle its obligations under the PVF by delivering shares of stock. That is, the investor did not have the right to cash settle its obligations under the PVF.
• The amount of cash released to the investor (i.e., the monetization or release percentage) was tied to the short sale price the dealer was able to achieve when establishing its hedge, and this was explicitly stated in the PVF contract.

Although it certainly should be possible to structure a PVF to satisfy these concerns raised by the IRS, many tax practitioners are very concerned about two other points the IRS made in the memorandums.

First, in the 2007 memorandum, the IRS strongly urged field agents to search for and audit taxpayers who have executed PVF contracts. Therefore, no matter how carefully investors and their advisers structure PVFs, such investors are clearly subject to a heightened risk of audit by the IRS.

Second, in the 2008 memorandum, the IRS further upped the ante against PVF contracts by informing agents that a PVF might very well constitute a tax shelter that the investor should have previously registered with the IRS and specifically identified numerous penalties associated with these possible “tax shelters.” Again, the 2008 memorandum urged field agents to search for and audit taxpayers who executed PVF contracts.

Given these recent and repetitive attacks by the IRS against PVF contracts, cautious investors, especially those with fiduciary responsibilities, have become reluctant to enter into even the most conservatively structured PVF contracts.

Put–Call Parity Offers an Attractive Solution
Enter the concept of put–call parity. This financial theorem claims that different combinations of financial tools can be used to deliver economically equivalent results. Put another way, financial equivalency exists among various combinations of financial tools. Can this basic principle of financial engineering be applied to replicate the economics of a PVF while eliminating the concerns the IRS has raised with respect to PVF contracts? The answer is a resounding yes.

Broker/dealers that meet certain stringent requirements are allowed to regulate the extension of credit to their customers pursuant to a separate regime, the “alternative rules.” The alternative rules allow an investor who enters into an options-based collar to borrow much more against the hedged position than would be possible under traditional rules or through a PVF.

In addition, the alternative rules do not limit the use of the loan proceeds. Therefore, the investor can enter into a collar using exchange-traded options and use the loan proceeds to buy publicly traded equity securities with impunity. In our previous example, the investor could borrow approximately 98 percent under the alternative rules versus about 88 percent for a PVF.

Therefore, under the alternative rules, an options-based collar combined with a margin loan achieves results economically equivalent to a PVF in that the investor’s stock position is hedged; a loan with a very high loan-to-value ratio is possible (e.g., up to 98 percent of the value of the hedged position); and there are absolutely no limitations on the use of the loan proceeds.

Reduced Tax and Audit Risk
This strategy will also reduce the tax and audit risk currently associated with a PVF because all the concerns the IRS has expressed with respect to PVF contracts simply do not exist under this strategy if exchange-traded options are used. Specifically:

• If exchange-traded options are used, the Options Clearing Corporation (OCC) will necessarily be the investor’s counterparty, making it impossible for the investor to lend its shares to the OCC or make its shares available for the OCC to borrow.
• Under the rules of the exchanges, an investor who collars a stock position with options gets to keep all the dividends received on the stock and any normal increases to the dividend.
• Because the investor cannot lend its shares to the counterparty (the OCC), the investor retains full voting rights.
• Because exchange-traded options, including those comprising a collar, can be closed out at any time by acquiring exactly offsetting positions, the investor is not required to deliver its shares to satisfy its obligations under the collar, thus eliminating the IRS concern.
• Finally, the amount of cash the investor receives pursuant to the margin loan depends solely on the alternative rules. Because the amount of the margin loan has nothing to do with the short sale price the dealer achieves when establishing its hedge, the IRS concern is eliminated.

Moreover, although the IRS has strongly encouraged field agents to specifically search for and audit PVF contracts in recent memorandums, it did not mention any other equity monetization strategies. Therefore, the use of exchange-traded options and a margin loan under the alternative rules, instead of a PVF, should significantly reduce the risk of the transaction being audited by the IRS.

Other possible benefits of the collar and loan strategy using listed options include:

• Greater tax efficiency than a PVF, depending on the characteristics of the shares of stock being hedged.
• Less counterparty risk because the OCC is the counterparty, is backed by each member of the OCC, and is rated AAA by the credit-rating agencies.
• The ability to structure the loan as a revolving line of credit that can be drawn down as investment opportunities or the need for liquidity arises.
• Inherent price discovery and transparency not present in the OTC market.
• Possibility of unwinding the position early without having to negotiate a costly exit.
• Periodic marks to market by the OCC upon request.

Conclusion
The collar and margin loan strategy is economically equivalent to a PVF contract. This strategy can put more cash in the investor’s pocket and, as with the PVF, does not limit the use of the proceeds. This strategy should completely eliminate the tax risk and lessen the audit risk currently associated with PVF contracts. In addition, a host of nontax advantages are associated with the collar and loan strategy versus a PVF, including a reduction in credit risk, inherent price discovery and transparency, and the ability to unwind the hedge at any time.

This and other cutting-edge strategies and developments will be covered in detail during the CFA Institute Concentrated Stock Management Workshop to be held on 4–5 September 2008 in New York City.

Thomas J. Boczar, CFA, is managing partner of Hallmark Capital, an investment banking firm based in New York City that focuses on the tax-efficient monetization of highly appreciated assets.