Calloway v. Comm’r, decided on July 8, 2010, in the Tax Court, held (i) that a purported non-recourse loan equal to 90% of the value of stock held by a taxpayer was, in substance, a sale for U.S. federal income tax purposes, and (ii) that the transaction was not a securities lending arrangement under Section 1058 of the Code. The lender was Derivium Capital, LLC (“Derivium”), which operated a 90%-stock-loan program and seems to have entered into approximately 1,700 similar transactions over the course of a 5-year period. It filed for bankruptcy a few years ago. A number of cases are docketed in the Tax Court. It is hard to imagine, however, that their facts could be worse than Calloway’s.
Those facts can be briefly summarized as follows: (i) the taxpayer entered into an agreement with Derivium whereby the taxpayer transferred 990 shares of IBM common stock in exchange for a cash payment equal to 90% of the fair market value of the stock at that time; (ii) the terms of the agreement, including supporting documentation, characterized the transaction as a 3-year nonrecourse bullet loan accruing interest at 10.5% compounded annually; (iii) at maturity, the taxpayer had the option of (a) paying the balance due and having the stock returned to the taxpayer, (b) renewing or refinancing the transaction, or (c) surrendering the stock and walking away without paying any balance due; (iv) upon the initial transfer of the stock, Derivium had the right to sell, and did in fact sell, the stock (although the taxpayer claimed he didn’t know about the sale); (v) at maturity, taxpayer surrendered the stock extinguishing the loan; and (vi) upon initial transfer of the stock, the taxpayer did not treat the transaction as a sale of the stock for tax reporting purposes. Interestingly, the taxpayer did not report the transaction on his tax return when the transaction was terminated.
In determining whether the purported loan was, in substance, a sale for U.S. federal income tax purposes, the Tax Court analyzed whether the benefits and burdens of ownership of the stock passed to Derivium. Upon applying a multi-factor test (including, e.g., whether legal title passes, how the parties treat the transaction, whether an equity interest in the property is acquired, whether the right of possession is vested in the purchaser, who bears risk of loss on the transferred property, who receives the profits from the operation and sale of the property), the Tax Court concluded that the benefits and burdens of ownership did, in fact, pass to Derivium. For example, according to the Court, Derivium had the right, and did sell, the stock immediately upon transfer; the parties treated the transaction as a sale (e.g., the taxpayer did not report dividends throughout the term of the transaction, and did not report any discharge of indebtedness upon termination of the transaction); and the taxpayer did not bear any risk of loss with respect to the stock following the transfer to Derivium but only retained the option for gain if the stock appreciated beyond what was due at maturity.
The Court also concluded that the arrangement was not a securities lending arrangement under Section 1058 of the Code. If a securities lending agreement meets several requirements under Section 1058, then a taxpayer does not recognize any gain or loss upon a transfer of securities pursuant to the agreement. One of the requirements a securities lending agreement must meet in order to so qualify is that it must not reduce the lender’s risk of loss or opportunity for gain in the securities loaned. In this case, since the taxpayer did not have the right to reacquire the stock on demand, but only upon maturity, the Tax Court held that this requirement was not met (i.e., the taxpayer did not retain all of the benefits and burdens of ownership of the stock and the right to terminate the lending agreement upon demand).
Calloway reminds us that we are still awaiting the Tax Court’s decision in Anschutz v. Comm’r, a case that involves a variable prepaid forward coupled with a stock loan. There were three sets of Tax Court judges that wrote opinions in Calloway and it appears that the Tax Court is somewhat split about the correct legal standard for determining whether a taxpayer has sold publicly traded stock. This issue is at the heart of the dispute in Anschutz. Eleven of the Calloway judges adopted an eight factor “benefits and burdens” test derived from a 1981 case (Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221) involving a sale of cattle. Judge Halpern concurred in the result but said the multifactor, economic risk-reward analysis used by the eleven was only appropriate for determining ownership of non-fungible assets (such as cattle). Judge Halpern would only ask two questions: whether legal title and the power to dispose are joined in the supposed owner, if so that person owns the stock. Judge Holmes’s opinion decides the case on narrow grounds: Regs. Section 1.1001-2(a)(4)(i) which provides that the sale of property that secures a non-recourse loan discharges the loan.