Investors holding a concentrated position can (1) hedge against a decline in the price of a stock, (2) defer the capital gains tax, and (3) generate liquidity (cash), which can be used to diversify, by implementing an equity monetization strategy.
In addition to avoiding an immediate tax liability associated with an outright sale, there are other factors that might make the use of an equity monetization strategy attractive to a holder of a concentrated position, such as the following:
- The investor may be subject to a diverse array of securities law restrictions that are applicable to a sale of stock.
- The investor might own a large percentage of outstanding shares of the company and may not wish to cede control of the company or give the opportunity to another investor to acquire a large block of company shares.
- The investor may be subject to contractual provisions, such as an IPO lockup or an employment agreement or policy, that prohibit the sale of shares.
Equity monetization entails a two-step process:
- The first step is for the investor to remove a large portion of the risk inherent in the concentrated position. The process of hedging the concentrated stock position could be fraught with complex tax regulations.Care should be taken in structuring the hedge such that the economic incentives of holding the concentrated stock position are not, for practical purposes, eliminated.
- The second step is for the investor to borrow against the hedged position. In most instances, a high loan-to-value (LTV) ratio can be achieved because the stock position is hedged; the loan proceeds are then invested in a diversified portfolio of other investments.
The four basic tools an investor can use to establish a short position in a stock are:
- a short sale against the box, which involves shorting a security that is held long
- a total return equity swap, which is a contract for a series of exchanges of the total return on a specified asset in return for specified fixed or floating payments
- options (forward conversion), which is involves the construction of a synthetic short forward position against the asset held long
- this strategy is based on the fact that the payoff of a short forward position is identical to the payoff of a long put and a short call on the same underlying asset
- a forward sale contract or single-stock futures contract
by using any of these four techniques, an owner of a concentrated position accomplishes the following:
- A riskless position is created by establishing a direct or synthetic short position covering the same amount of shares that she is long.
- A money market rate of return is generated on the full value of the long position.
- Borrowing against the hedged position with a very high LTV ratio is possible (it is similar to borrowing against a government bond).
- Borrowing is quite inexpensive because the income generated on the hedged position greatly offsets cost of borrowing.
- The borrowed proceeds can be invested in a diversified portfolio.
Tax Treatment of Equity Monetization Strategies
Equity monetization strategies allow an investor to transfer the economic risk and reward of a stock position without transferring the legal and beneficial ownership of that asset.
Historically, the concept of capital gain realization has been tied to the sale or disposition of appreciated securities. In the case of monetization transactions, there has been no actual transaction in the appreciated securities themselves.
The critical question is whether an equity monetization strategy will be treated as a taxable event for tax purposes in a particular country. If the tax regime treats the long and short (or synthetically short) position separately for tax purposes, tax on the appreciation of the long position will be deferred.
It is important that advisers, irrespective of the country where their client is domiciled, know how to appropriately appraise equity monetization strategies. No matter which tax regime is being examined, certain questions should be asked and a certain process followed as investors and their advisers seek to ensure that the strategy that is used is the most tax efficient. Along these lines, working with the client’s tax adviser to answer the following questions should help in selecting the tool that minimizes the tax cost to the client.
- When unwinding or cash settling the hedge, if there is a gain generated by the hedge, is it short term or long term in nature? Long-term gain is generally preferred in many jurisdictions.
- When unwinding or cash settling the hedge, are potential losses generated by the hedge short term or long term in nature, and is it currently deductible or instead added to the tax cost basis of the shares being hedged? Short-term loss and currently deductible are generally preferred.
- If the contract is physically settled by delivering shares, is the gain short term or long term in nature? Long-term gain is usually better.
- Are the carrying costs associated with monetization (i.e., interest expense or the equivalent) currently deductible or instead added to the tax cost basis of the shares being hedged? Current deductibility is preferred.
- Does the hedge in any way affect the taxation of dividends or distributions received on the shares? No impact is preferred.
Classification of Income Tax Regimes
| Income Tax Regime | 1. Common Progressive | 2. Heavy Dividend Tax | 3. Heavy Capital Gains Tax | 4. Heavy Interest Tax | 5. Light Capital Gains Tax | 6. Flat and Light | 7. Flat and Heavy |
|---|---|---|---|---|---|---|---|
| Ordinary Tax Rate Structure | Progressive | Progressive | Progressive | Progressive | Progressive | Flat | Flat |
| Interest Income | Some interest taxed at favorable rates or exempt | Some interest taxed at favorable rates or exempt | Some interest taxed at favorable rates or exempt | Taxed at ordinary rates | Taxed at ordinary rates | Some interest taxed at favorable rates or exempt | Some interest taxed at favorable rates or exempt |
| Dividends | Some dividends taxed at favorable rates or exempt | Taxed at ordinary rates | Some dividends taxed at favorable rates or exempt | Some dividends taxed at favorable rates or exempt | Taxed at ordinary rates | Some dividends taxed at favorable rates or exempt | Taxed at ordinary rates |
| Capital Gains | Some capital gains taxed favorably or exempt | Some capital gains taxed favorably or exempt | Taxed at ordinary rates | Some capital gains taxed favorably or exempt | Some capital gains taxed favorably or exempt | Some capital gains taxed favorably or exempt | Taxed at ordinary rates |
| Examples | Austria, Brazil, China, Thailand, United Kingdom, United States, Vietnam | Argentina, Indonesia, Israel, Venezuela | Colombia | Canada, Denmark, Germany, Luxembourg, Pakistan | Australia, Belgium, India, Kenya, Mexico, New Zealand, Norway, Spain, Switzerland, Turkey | Kazakhstan, Russia, Saudi Arabia (Zakat) | Ukraine |