In addition to providing analysis and updates on pending tax appeals, this blog is intended to serve as a resource where readers can easily access the briefs and relevant opinions in those cases. Because of the press of business and other reasons, the posting of a couple of the opinions in cases we have discussed has slipped through the cracks. So we are providing links to those opinions here, even though the opinions are long past the point of “breaking news”:
The Second Circuit’s decision in TIFD (“Castle Harbour”), once again reversing the district court and holding that the banks did not qualify as partners under § 704(e)(1), and that the government could impose a penalty on the taxpayer for substantial understatement of income.
The Eleventh Circuit’s decision in Calloway, affirming the Tax Court and holding that the transaction in question was properly treated as a sale, not a loan, and upholding the penalties. The decision approves the multi-factor approach employed by the Tax Court majority, and notes infirmities in the alternative analytical approaches suggested by Judges Halpern and Holmes in their respective concurring opinions.
The Supreme Court’s decision upholding the Affordable Care Act (linked below). The opinion was eventually entitled NFIB v. Sebelius, although we had covered it using the caption of one of the companion cases, HHS v. Florida. The discussion of the Anti-Injunction Act, the issue that was covered in the blog, is found at pages 11-15 of the Court’s slip opinion. Our prior coverage (linked here only so that I can show off my against-the-mainstream prediction that the legislation would survive) can be found here and here. The majority’s key holding that the individual mandate could be upheld as an exercise of the Taxing Power is found at pp. 33-44.
As we have previously reported (see here, here, and here), in Anschutz the Tax Court collapsed two transactions and held that they amounted to a taxable sale of stock. The Tenth Circuit was unmoved by the taxpayer’s appeal and has now affirmed, barely five weeks after hearing oral argument. In its decision, the court of appeals analyzes the transaction through the lens of the eight factors for determining a sale listed in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981). With respect to the factor that assesses whether an equity interest was acquired in the property, the court quotes at length from the IRS’s Feb. 6, 2008, Coordinated Issues Paper on the topic, finding its analysis “compelling and applicable to the case before us.”
The court also rejects the taxpayer’s efforts to analogize its transactions to other approved transactions. The court explains that the transaction addressed in Rev. Rul. 2003-7 is distinguishable, in part because there was no borrowing of pledged shares. And the court holds that the taxpayers’ transactions in this case did not fall within the “safe harbor” of Code section 1058 because they “effectively eliminated [the] risk of loss and substantially reduced [the] opportunity for gain.”
On November 16, the Tenth Circuit heard oral argument in the Anschutz case, involving the taxpayers’ appeal from the Tax Court’s decision to collapse two transactions involving the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”), and treat them as a taxable sale of stock. A fuller description of the case and the parties’ briefs can be found in our prior reports here and here.
The panel hearing oral argument was Chief Judge Briscoe (a Clinton appointee and former Kansas state court judge and Assistant U.S. Attorney), Senior Judge McKay (a Carter appointee who was previously in private practice), and Judge O’Brien (a Bush II appointee who served for many years as a Wyoming state judge).
There is no specific date by which the court must decide the case, but a decision is most likely in the spring of 2012.
The government filed its response brief in Anschutz Co., et al. v. Commissioner, Nos. 11-9001 & 11-9002 (10th Cir.), on June 22, 2011 (linked below). See our prior coverage here. Not surprisingly, the government argues that the Tax Court got it right in viewing the putatively separate variable prepaid forward contracts and stock loans as two parts of one overall arrangement, designed to monetize the value of the taxpayer’s low-basis stock at the outset of the deal. The Tax Court held that, in substance, the overall arrangement was a sale for tax purposes because the benefits and burdens of owning the stock had been passed to Anschutz’s counterparty. Based on the briefing, it appears that the key question in the case will be whether the IRS and the Tax Court were correct in viewing the transactions as an integrated whole, or whether they must be analyzed separately under the technical provisions applicable to stock loans and variable prepaid forwards.
As we’ve reported in the last few months, several securities lending cases are percolating in the appellate courts (see here and here). On April 29, 2011, Anschutz Company filed the opening brief in its appeal of the Tax Court’s decision for the government (opinion and brief linked below).
At issue in Anschutz is the appropriate tax treatment of a set of transactions between the taxpayer and Donaldson, Lufkin & Jenrette Securities Corp. (“DLJ”). The taxpayer sought to leverage long-held shares in publicly-traded railroad companies to obtain financing for other endeavors. In the taxpayer’s hands, the shares had a low basis relative to their fair market value at the time of the transactions in question. The transactions involved the use of prepaid variable forward contracts (“PVFCs”) and concurrent share lending agreements (“SLAs”). Under the PVFCs, DLJ paid the taxpayer a percentage of the current market value of the shares in exchange for the right to receive a number of shares or their cash equivalent at a point in the future. The number of shares to be delivered (or their cash equivalent) was to be determined by a formula agreed upon at the outset. In order to secure its obligation, the taxpayer pledged a number of shares sufficient to ensure consummation of the deal at maturity. In parallel, DLJ entered into an SLA with the taxpayer under which DLJ would take possession of the pledged shares to use them in short sale transactions. Although each of the two transactions, viewed in isolation, would have passed muster under relevant authorities as non-taxable open transactions, the government challenged the arrangement as constituting in substance a taxable sale of the shares at the inception of the deal. After a two-day trial, the Tax Court agreed.
On appeal, Anschutz argues that the Tax Court’s decision to view the transactions as two legs of one overall arrangement was error. Rather, the taxpayer contends that the two transactions should be respected as stand-alone occurrences to be analyzed separately. Under the taxpayer’s view, the PVFCs are non-taxable open transactions under Rev. Rul. 2003-7, and the SLAs fall within the ambit of I.R.C. section 1058 (stock loans not taxable provided certain conditions are met). For the Tax Court, the crux of the case was that the PVFCs had the effect of shifting to DLJ all risk of loss and most of the opportunity for gain on the shares. Under section 1058, a stock lending arrangement cannot reduce the risk of loss or opportunity for gain if it is to be considered non-taxable. The taxpayer contends, however, that in spite of a master agreement governing both legs of the arrangement, the facts properly construed require the two transactions to be analyzed separately as independent deals, each with their own tax consequences.
The government’s response is now due on June 24, 2011. We’ll keep you posted on this and other developments in the securities lending cases.
A while ago we reported on a spate of IRS successes in cases involving purported securities loans (here). The Samueli case is fully briefed in the Ninth Circuit and is expected to be argued in the next couple of months. As we anticipated, two more of those cases, Anschutz and Calloway, have been appealed to the Tenth and Eleventh Circuits, respectively. The taxpayer in Calloway filed his opening brief on March 15, 2011 (linked below). Briefing has not yet begun in Anschutz.
In Calloway, the taxpayer was an IBM employee of many years who had acquired IBM stock during his employment. By the time of the transaction in question, the stock’s value was five times the taxpayer’s basis. Desiring to monetize the stock, and by his own admission, seeking to maximize his after-tax return, the taxpayer entered into an arrangement whereby he transferred his stock to a counterparty in return for a loan equal to 90% of the stock’s fair market value. This resulted in a 10% higher return than a straight sale subject to long-term capital gains tax. Under the arrangement, the taxpayer had no right to any dividends, no ability to reap any gains from appreciation of the stock, and no right to recall the stock during the loan period. The counterparty had the right to sell or otherwise dispose of the stock it purportedly held as collateral. At the close of the three-year loan period, the taxpayer had the option of repaying the principal with interest to redeem his collateral, refinancing the transaction for an additional term, or surrendering his collateral in exchange for extinguishment of the debt. As the stock had depreciated significantly, the taxpayer chose to surrender his collateral. Notably, not only did the taxpayer not report the transaction as a sale, he also did not report any cancellation of indebtedness income upon extinguishing the purported debt.
The IRS challenged the taxpayer’s treatment of the transaction as a loan, asserting that in substance the arrangement was a sale of the taxpayer’s securities. In a reviewed decision, the Tax Court agreed with the IRS that the transaction was indeed a sale, primarily because the benefits and burdens of ownership of the stock had in fact passed to the counterparty (under an application of the test articulated in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)). Of course, it didn’t help the taxpayer that the counterparty had been sued successfully for promoter penalties and for an injunction to cease all further shelter promotion activities.
On appeal, the taxpayer’s position centers around the arguments that (1) the Tax Court’s finding that the counterparty had the right to sell the stock immediately was clear error, and (2) the finding that the taxpayer could not demand the return of his stock during the three-year period was also clear error. These arguments apparently are based on the position that the counterparty did not have the right to sell the stock until a “legitimate” loan was already in place, and because the counterparty used the stock sale to finance the purported loan, no such right ever accrued. Thus, according to the taxpayer, he remained in control of the stock under the terms of the arrangement, and therefore the transaction is subject to the safe harbors under I.R.C. § 1058 and Rev. Rul. 57-451, and furthermore should not be deemed a sale under the applicable common law securities-loan authorities.
We’ll provide an update when the government files its response, and we’ll post on Anschutz when the briefing gets under way (the opening brief is due May 2). On a related note, the Tax Court recently held for the government in a case involving a transaction materially identical to the one in Calloway. See Kurata v. Commissioner, T.C. Memo 2011-64 (March 16, 2011).
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.).