On September 15, 2011, the United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) held that the securities loan transaction at issue did not qualify for nonrecognition treatment as a securities loan under section 1058, affirming the March 16, 2009 Tax Court ruling,13 in Samueli v. Commissioner.14

Under a securities loan agreement, a borrower typically borrows securities from a lender and posts collateral to secure its obligation to return identical securities. Even though the securities are loaned, for federal income tax purposes, there is a transfer of ownership from the lender to the borrower resulting in an exchange upon entering into the agreement and upon termination. However, no gain or loss is recognized by the lender for federal income tax purposes upon the initial transfer of securities to the borrower and the return of identical securities to the lender upon termination of the securities lending agreement, provided the securities loan agreement meets certain requirements specified by section 1058. In Samueli v. Commissioner, the taxpayer had purchased stripped Freddie Mac bonds (i.e., zero-coupon bonds) from his broker on margin. The taxpayer subsequently loaned the stripped bonds back to the broker and the broker posted cash collateral with the taxpayer. The taxpayer used the cash collateral to repay the margin loan. The taxpayer took the position that he was not required to accrue income on the stripped bonds because he was not the owner for tax purposes. Under federal income tax law, there is no accrual of interest or original issue discount on a securities loan. The taxpayer took the position that his holding period in the stripped bonds, once returned to him, included his holding period in the securities loan agreement. As such, the taxpayer argued he had converted original issue discount, generally taxed at ordinary tax rates, into long-term capital gain generally taxed at lower preferential rates.

One of the requirements a securities loan agreement must meet in order to qualify for favorable treatment is that it must not reduce the lender’s risk of loss or opportunity for gain in the securities loaned. Treasury regulations that were proposed more than two decades ago, but which have never been finalized, clarify that the securities loan agreement must provide that the lender may terminate the loan upon notice of not more than five business days in order to meet the aforementioned requirement. The notion is that if the securities rise in value, the lender can terminate the loan and sell the securities in the market. The securities loan agreement entered into between the taxpayer and his broker had a term of approximately 15 months and prevented the taxpayer on all but three days during that period from causing the broker to transfer the stripped bonds, or identical securities, back to the taxpayer.

The Tax Court held that the transaction between the taxpayer and his broker was not a securities loan agreement that qualified for favorable treatment under the Internal Revenue Code because the taxpayer’s ability to cause his broker to transfer the stripped bonds, or identical securities, back on only three days of the entire 15-month term of the agreement reduced the taxpayer’s opportunity for gain in the stripped bonds. This was the case, according to the court, because the taxpayer could only realize any inherent gain in the securities if the gain continued to be present on one of the days the taxpayer was able to cause his broker to transfer the stripped bonds, or identical securities, back. The Ninth Circuit affirmed the Tax Court’s decision that the transaction failed to meet the section 1058(b)(3) requirement for these same reasons. The Ninth Circuit noted “[the taxpayer] relinquished all control over the [s]ecurities… for all but two days in a term of approximately 450 days. During this period, [the taxpayer] could not have taken advantage of a short-lived spike in the market value of the [s]ecurities, because they had no right to call the [s] ecurities… and sell them at that increased price until several months later. Common sense compels the conclusion that this reduced the opportunity for gain that a normal owner of the [s]ecurities would have enjoyed.”

The Ninth Circuit, in disagreement with the Tax Court, held the interest deductions claimed by the taxpayer should have been allowed, although such error was harmless and did not make a difference in the ultimate determination of the tax deficiency since allowing the interest expense deduction resulted in offsetting additional short-term capital gain.