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Extension of a Derivative as a Taxable Exchange

In September, the Second Circuit held in Estate of McKelvey v. Commissioner that the extension of a variable prepaid forward contract in exchange for an extension fee constituted a taxable exchange of the contract for tax purposes.  This decision, which reversed an earlier Tax Court decision, should serve as a cautionary tale to taxpayers taking the position that the extension of a derivative is not a "material modification" of the derivative.

Material Modifications

A material modification of an investment generally is treated for tax purposes as a taxable exchange of the investment for a new investment.  There are no bright-line rules for what constitutes a material modification of a derivative.  Accordingly, some taxpayers have historically taken the position that the extension of the tenor of a derivative is not a material modification.

The absence of a material modification confers two significant tax advantages to a holder of a derivative:

  • Taxpayers generally can continue to defer gain or loss recognition until the (extended) maturity date. 
  • Under Section 871(m) of the tax code, certain non-delta-one U.S. equity-linked derivatives that were "issued" after 2020 and are held by a non-U.S. person may be subject to 30% withholding tax if, at issuance, they have a delta of at least 0.80 with respect to the underlying stock or certain other conditions are satisfied.  A material modification may be treated as a new issuance for this purpose.  Thus, so long as a non-delta-one derivative is entered into before 2021 and is not materially modified after 2020, it generally is "grandfathered" out of Section 871(m) withholding tax.

McKelvey Fallout

The Second Circuit concluded in McKelvey that a "sufficiently fundamental or material change to an original contract that results in a change in the fundamental substance of the original contract will be considered an exchange of the original contract for the amended contract."  Although the Second Circuit's decision does not require all extensions of a derivative to be treated as material modifications, it should serve as a reminder to taxpayers to be cautious when considering such an extension.


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Linda Z. Swartz
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Jon Brose
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Andrew Carlon
T. +1 212 504 6378

Mark P. Howe
T. +1 202 862 2236

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