In Henry Samueli et al v. Commissioner, 132 T.C. No. 4 (2011), the Tax Court, per Judge Kroupa’s opinion for the majority, in response to the petitioners and respondent (IRS) filing of cross motions for summary judgment in a consolidated proceeding, upheld the Service’s deficiencies in income tax for denying the taxpayers interest deductions claimed on the underlying “margin loans” used to acquire the securities, were disallowed on the basis the purported payments of “interest” were not made with respect to an actual debt. Instead the arrangement was treated as a stock sale and immediate repurchase and the issuance of a forward contract to the taxpayers to later acquire (and sell) the same securities.

Section 1058 In General

Section 1058 provides that where an owner of “securities”, as such term is defined under §1236(c), loans securities to another person, such as a broker or investor engaging in a short sale, the owner is not treated as having engaged in a “sale” in which gain or loss is recognized, either when the securities are transferred to the borrower or when they are later returned to the taxpayer. §1058(a).

In order to qualify for non-recognition treatment, certain agreement provisions must be satisfied in accordance with 1058(b): (i) the agreement provides for the return to the lender of securities that are identical to those transferred; (ii) payments must be made to the transferor of the shares for amounts equivalent to all interest, dividends and other distributions which the owner of the securities is entitled to receive during the period beginning with the transfer of the securities by the transferor and ending with the transfer of identical securities back to the transferor; (iii) the agreement doesn’t reduce the transferor (owner’s) risk of loss or opportunity for gain with respect to the securities transferred; and (iv) the agreement complies with the requirements set forth under the regulations. The third element was of direct consequence in the Samuelis case as discussed below which the Court ruled was not satisfied.

Where the borrower returns to the taxpayer securities which are different from those transferred by the taxpayer, or, if the borrower fails to deliver anything to the taxpayer, gain or loss is recognized at the time of the borrower's default.

According to the proposed regulations, the payments compensating the taxpayer for interest, dividends, and other distributions are treated as “a fee for the temporary use of property,” not as interest or dividend income. Where the equity holder is a tax-exempt organization, such payments are exempt from unrelated business taxable income as if the interest and dividends were received. For purposes of §1058, “securities” includes corporate stock, a “certificate of stock or interest in any corporation,” a bond or other debt instrument, and “any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”

Recent Tax Court Decisions on Section 1058

In a recent decision of the Tax Court, Anshutz Co. v. Comm’r, 135 T.C. No. 5 (2010), the Court characterized “share-lending agreements” as contracts which are frequently entered into by equity holders of stock who have taken a “long” position with respect to such shares and plan on holding the stock for an extended period of time. The equity owner may contract to “lend” the stock to a counterparty, who can use the borrowed shares to increase market liquidity and facilitate stock sales. For example, the equity owner can lend shares to an investment bank, which could then use the loaned shares to execute short sales on behalf of its clients.

In another recent Tax Court decision, Calloway v. Commissioner, 135 T.C. No. 3 (2010), the Court held that a purported securities lending arrangement was in fact a disguised sale. The arrangement involved the equity owner’s transfer of shares of stock to another party in exchange for “”loan payments” for the use of the lender’s funds for an agreed amount. The owner of the stock had retained the right to pay off the loan and require the return of the same stock after 3 years had elapsed. The Tax Court analyzed this agreement as a disguised sale since the purported borrower couldn't repay the “loan” and demand return of his stock before the end of the three year period, he didn't retain the benefit of being able to sell his interest in the stock during that period, and also bore no risk of loss if the stock's value decreased. As such, the transaction failed to meet the requirements under §1058(b)(3) and was not a qualified securities lending agreement.

The Samuelis Case

Two couples were the petitioners in the case, the Samuelis’ (S) and the Rickses’ (R). S and R entered into a structured securities transaction in which they owned a 99.5% interest with S and his wife holding 10% interests indirectly through their operating company, a pass thru entity, and the balance of the same interests in an limited liability company, H&S Ventures, LLC (H&S Ventures) and the balance of the interests in a grantor trust holding interests in H&S Ventures. R owned the remaining .5% along with another individual. Mr. Samuelis, as noted in the Court’s opinion, is a billionaire who co-founded Broadcom Corporation, a publicly traded company listed on the NASDAQ Exchange.

The agreement involved S and R, through H&S Ventures, acquiring securities, i.e., $1.64 billion in value, from their securities broker Refco Securities LLC (RS LLC), on margin and then immediately loaning the securities back to RS LLC in 2001. Under the arrangement, RS LLC promised to transfer identical securities to H&S Ventures on Jan. 15, 2003. The securities consisted of a $1.7 billion principal STRIP of the $5.7 billion principal on an unsecured fixed-income obligation issued by Freddie Mac. The maturity date of the obligation was February 15, 2003, and the yield to maturity on October 17, 2001, at which the securities accrued interest, was fixed at 2.581 percent. The agreement allowed for an earlier transfer of the same or identical between H&S Ventures and RS LLC which permitted the “lender” to require an earlier transfer of the identical securities by termination on July 1, or December 2, 2002. H&S Ventures sold the securities back to RS LLC on January 15, 2003.

H&S Ventures, and therefore S and R to the extent of their proportionate interest in the limited liability company, reported the transaction under §1058 as a securities lending arrangement. H&S Ventures reported approximately $50.6 million in long-term capital gain on the sale in 2003. H&S Ventures also deducted millions of dollars of interest with respect to the transaction which was allocated among its various members. The petitioners also deducted as interest, payments made or accrued with respect to the initial margin loan with RS LLC in acquiring the securities.

The Service challenged the taxpayers’ reporting of the transaction contending that H&S Ventures purchased the securities from RS LLC and immediately sold the securities back to RS LLC in 2001 for no gain or loss and then repurchased from a deemed forward contract the same securities in 2003 realizing an approximate $13.5 million short term capital gain. The transaction was not, in the eyes of the Service, a securities lending transaction or arrangement per §1058. The Service further disallowed all of H&S Ventures’ interest expense reported since there was no true debt obligation present under the facts. Respondent also disallowed all of the petitioners’ interest deductions because the corresponding debt that petitioners claimed was related to the transaction did not exist. Inotherwords, despite the “margin loan” documentation, there was no actual debt to RS LLC as part of the arrangement.

Tax Court Rules in Favor of Respondent-IRS

Acknowledging that the issue presented in the case was one of “first impression”, the Tax Court upheld the Service’s position finding that the agreement under which S and R, through H&S Ventures, transferred the securities was not an agreement described in §1058(b)(3) since the agreement did reduce their opportunity for gain because there were only 3 days during the transaction period where S and R could have the securities transferred back to them to sell for a gain. The taxpayers arguments that their opportunity for gain was not reduced, a requirement under §1058(b)(3), was therefore rejected by the Court.

Responding to the parties filing cross motions for summary judgment in accordance with Tax Court Rule 121 (FRCP 56), the Tax Court, in an opinion issued by Judge Diane Kroupa, noted that not only were the requirements under §1058(b)(3) not established but the arrangement did not coincide with the legislative intent in enacting this provision. Indeed, the Court opined that the legislative history to §1058 provides that a securities loan agreement should result in the lender of the securities being placed in the same economic position the lender would have been in absent the agreement. Since the transaction was a sale, S (and R), through H&S Ventures, were not entitled to their claimed interest deductions made to RS LLC in 2001 and 2003 because an “actual debt” did not exist. The Court upheld the proposed deficiencies in income tax of $2,177,532 deficiency for 2001 and a $171,026 deficiency for 2003 in the Federal income taxes of Henry and Susan F. Samueli and a $6,126 deficiency for 2001 in the Federal income tax of Thomas G. and Patricia W. Ricks.