United States: Capital Markets Tax Quarterly

Editor's Note

Welcome to Mayer Brown's Capital Markets Tax Quarterly (CMTQ). This is a new publication for Mayer Brown's Tax practice, so let us explain what we're about.

On a daily basis, we here in Mayer Brown's Tax practice come across a lot of interesting and important US capital markets tax developments. As you know, for the really important ones, we put out our Mayer Brown Legal Updates. However, rather than relying solely on these, we thought that sharing current developments with you on a quarterly basis makes a lot of sense. That way, we can remind you of the big developments during the quarter and also throw in smaller, but still important, ones. From time to time, we also want to provide a little color commentary on the state of capital markets tax. The idea for this is to put the technical developments in context based on our decades (too many, some might say!) of experience in the taxation of capital markets transactions. Put it all together, that's CMTQ. Every quarter, we'll bring you a little commentary and a lot of news about capital markets tax. We hope you enjoy it and find it useful.

For our first issue, we couldn't help but reflect on how things have changed in our little corner of the tax world in the last two years! If you went to sleep in October 2016 and woke up today, you wouldn't believe there could be this much change (speaking of tax law, of course).

Almost exactly two years ago, the Obama administration's Treasury Department finalized Treasury regulations under Internal Revenue Code section 385 dealing with the distinction between debt and equity for federal income tax purposes. These were the first section 385 regulations since the early 1980s. The regulations (and the proposed regulations before them) sent the tax adviser community into overdrive with stacks of client alerts and client proposals for assistance with what were sure to be back-breaking compliance obligations with, among other things, the section 385 debt-equity documentation rules.

Now, two years later, the section 385 regulations are on the ropes. As we discuss below, the Treasury Department has announced that it's withdrawing the section 385 documentation rules which were slated to be effective January 1, 2019. Also, as we note below, the Treasury Department has announced that it is studying what changes to make to the other parts of the section 385 regulations.

Of course, it also occurred to us that Code section 385 just can't get a break. Enacted by Congress in 1969, the first set of section 385 regulations was issued, finalized and then withdrawn in 1983. Depending on what happens, the end result of 60-plus years of debt-equity back and forth will be no regulations at all or some very limited regulations at best (or worst, depending on your perspective).

Putting section 385 aside, the biggest news is that tax advisers are still trying to understand what happened in the Tax Cuts and Jobs Act ("TCJA"). New tax benefits and some really ugly potential tax detriments are surfacing all the time. Treasury Department guidance on a host of provisions is starting to emerge. In fact, we raced to complete this edition of CMTQ for fear the government would release regulations under the interest deduction limitation rules of Code section 163(j) and we would have to turn CMTQ into a book!

Also, in this issue of CMTQ:

  • We recount the Second Circuit Court of Appeals decision in McKelvey v. Commissioner dealing with an extension by McKelvey, the founder of Monster.com, of a variable prepaid forward shortly before death. While McKelvey won in the US Tax Court, that decision was overturned by the Second Circuit in late September.
  • We provide an update on mark-to-market ("MTM") taxation; as we recount below, this was not included in TCJA but is still lurking in the wings in Washington DC.
  • We also cover other developments, including:

    • Guidance on what new Code section 451(b) means, or doesn't mean, for accrual of market discount
    • Guidance on the "willfulness" standard in the FBAR rules
    • Guidance on MBS restructurings

* By the way, the ditty "don't tax you, don't tax me, tax that fellow behind the tree" below our masthead has a long history in American tax law. Originally it went "Congress, Congress, don't tax me, tax that fellow behind the tree." More recently it has taken the form on our masthead and has been attributed to Sen Russell Long (D., LA), former long-time chairman of the Senate Finance Committee, among others. So, CMTQ will give you not only current tax developments but a little historical perspective as well.

Second Circuit Overturns Estate V. McKelvey

On September 26, 2018, the Second Circuit Court of Appeals overturned a taxpayer favorable 2017 Tax Court ruling involving an extension of variable prepaid forward contracts ("VPFCs"). In doing so, the Second Circuit made new law; however, its decision also raises new questions about the modification of non-debt derivatives.

In September 2007, Andrew McKelvey, founder of Monster Worldwide, Inc ("Monster"), the popular employment website, entered into two VPFCs with two different banks. Each VPFC provided for an upfront cash payment to McKelvey and settlement in September 2008. McKelvey was required to settle the VPFCs by delivering Monster common stock or (at McKelvey's election) cash. In each case, the number of shares or amount of cash that McKelvey was required to deliver was subject to a cap and a floor. At the time McKelvey entered into the Bank 1 contract, Monster stock was $32.91 per share. When he entered into the Bank 2 contract, Monster stock was $33.47 per share. McKelvey pledged the maximum number of shares under each VPFC as collateral. The IRS and McKelvey agreed that these initial transactions created VPFCs that were subject to open transaction treatment under Revenue Ruling 2003-7.

Here is a summary of the original VPFCs:


Maximum # of Shares

Price on Execution

Floor in Contract

Cap in Contract

Upfront Payment on VPFC

Bank 1 (September 11,2007)






Bank 2 (September 24, 2007)









Ten months later, in July 2008, McKelvey paid roughly $11.7 million to Bank 1 and Bank 2 to extend settlement until early 2010. At the time, Monster stock was at $18.24 (when the Bank 1 contract was extended) and $17.28 (when the Bank 2 contract was amended).

McKelvey died in November 2008 after the VPFCs were extended. His estate settled the contracts in 2009. In the final income tax return, his estate reported no gain or loss on the extensions. The estate received a basis step up in the Monster shares to fair market value at death. Therefore, when the VPFCs were settled, McKelvey recognized no gain or loss. All told, McKelvey received the upfront payments of $193,569,763 and paid no federal income tax.

After an audit, the IRS asserted that when the VPFCs were extended McKelvey realized (i) a short-term capital gain of $88,096,811 on the short VPFC, and (ii) a $112,789,808 long-term capital gain on the constructive sale of the long shares under section 1259.

The first question before the Tax Court was whether the extension was a section 1001 event. Section 1001 provides that gain or loss shall be recognized on the sale or exchange of property. It does not, however, provide a definition of "property," so the Tax Court analyzed the term's definition in Black's Law Dictionary and its use in case law. The Tax Court concluded the original VPFCs did not constitute "property," because the only material property right that the VPFCs provided McKelvey were the initial rights to cash. Accordingly, because McKelvey received the cash prepayments before the extensions, the contracts were "only obligations to deliver the requisite number of shares or the cash equivalent" by the time the extensions occurred.

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