September 12, 2010
Lately, the IRS has had a successful run of attacking transactions involving purported securities loans. See Anschutz Co. v. Commissioner, 135 T.C. 5 (July 2010); Calloway v. Commissioner, 135 T.C. 3 (July 2010); Samueli v. Commissioner, 132 T.C. 4 (March 2009). Two of the cases, Samueli and Anschutz, involve the construction of I.R.C. section 1058, which provides for non-recognition treatment of a loan of securities that meets the following criteria: (1) the loan agreement provides for the return of securities identical to the securities transferred; (2) the agreement provides for payments to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive during the period of the loan; and (3) the agreement does not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred.
In Samueli, the Tax Court held that a series of transactions between a taxpayer and a broker/dealer did not qualify for section 1058 treatment because the purported securities loan reduced the taxpayer’s opportunity for gain (the taxpayer was the lender of securities under the form of the transactions). The transactions consisted of: (1) taxpayer’s purchase of $1.7 billion in mortgage-backed interest strips on margin (the broker/dealer allowed the taxpayer to purchase the securities on credit); (2) a securities loan of the interest strips back to the broker/dealer, with a transfer of $1.7 billion in cash collateral to the taxpayer; and (3) the taxpayer paying interest on the cash collateral at a variable rate (with the broker/dealer paying a relatively small amount of interest on taxpayer’s funds deposited in its margin account). The arrangement further provided that taxpayer could recall the securities only on two specified dates during the term of the loan, or at maturity. Ordinarily, securities loans are callable at any time. The Tax Court determined that the limited ability of the taxpayer to retrieve its securities reduced the taxpayer’s opportunity for gain, because taxpayer did not have the right to take advantage of favorable swings in the price of the securities if they occurred at a time when taxpayer did not have the right to call the loan.
Interestingly, the Tax Court went a step further than merely holding that non-recognition treatment was improper under section 1058. Cursorily invoking the substance-over-form doctrine, the court also held that as a matter of economic reality there was no securities loan at all; rather, in the court’s view there was a wash sale at the outset (purchase of the securities by taxpayer immediately followed by a resale to the broker/dealer for no gain), and a subsequent purchase under a constructive forward contract followed by a resale to the broker/dealer, resulting in a modest short-term capital gain. Because there was no true indebtedness, the court held, taxpayer’s interest deductions were not allowable.
The taxpayer has appealed the Tax Court’s decision to the Ninth Circuit, and the case has been fully briefed. The Tax Court’s opinion and the appellate briefs are linked below. In the opening brief, the taxpayer argues that the Tax Court: (1) misinterpreted section 1058 by adding a “loan terminable upon demand” requirement, (2) erroneously construed the section 1058 requirements as the sine qua non of securities loans for federal tax purposes (cf. Provost v. United States, 269 U.S. 443 (1926) (for purposes of the stamp tax, the borrowing of stock and the return of identical stock to the lender are taxable exchanges)), (3) recharacterized the transactions in a manner inconsistent with their economic reality, and (4) even if the recharacterization stands, improperly treated the deemed disposition of the forward contract shares as short-term capital gain.
In its response, the government contends that the Tax Court correctly determined that the arrangement was not eligible for non-recognition treatment under section 1058 because it reduced the taxpayer’s opportunity for gain in the securities, contrary to section 1058(b)(3). Furthermore, the government argues, the court correctly held that the overall arrangement was not a loan in substance, and therefore the purported interest paid on the collateral is not deductible.
In the reply, the taxpayer changes tack somewhat and argues that the focus on section 1058 heretofore has been a mistake by all involved. The taxpayer contends that the tax treatment of the transactions should be the same regardless of the application of section 1058—long-term capital gain and deductible interest, based on the notion that taxpayer received basis in a contractual right at the outset, which was later disposed of at a gain, and that taxpayer’s payment of interest on the collateral was consideration for the broker/dealer’s forbearance of the use of the collateral.
We will continue to follow the case as it develops. According to news reports, the taxpayer in Anschutz intends to appeal the Tax Court’s decision as well, and we will post on that case as soon as the appeal is filed (which will likely be in the 10th Cir.).