Opinion ID: 613690
Heading Depth: 4
Heading Rank: 1

Heading: Whether the Transaction Was Factually a Securities Loan

Text: As an initial matter, the parties dispute the baseline question of whether a transaction may qualify as a securities loan eligible for nonrecognition if it does not fulfill the requirements of § 1058(b). Taxpayers argue that the requirements of § 1058(b) merely create a safe harbor and do not delineate the limits of what is considered a securities loan for tax purposes. However, we need not decide today whether § 1058(b) is a safe harbor or the only route to nonrecognition, because the facts of this case clearly indicate that this particular transaction does not fall within the category of transactions that Congress sought to cover with § 1058. The Tax Court, in characterizing the transaction as in substance two separate sales of the Securities, cited the wellestablished principle that [f]or Federal tax purposes, the characterization of a transaction depends on economic reality and not just on the form employed by the parties to the transaction. Samueli, 132 T.C. at 52. See, e.g., Teruya Bros., Ltd., 580 F.3d at 1043 ([T]ax classifications turn on the objective economic realities of a transaction rather than the particular form the parties employed.) (internal quotation marks and punctuation omitted). We are cognizant of the reality that the tax laws affect the shape of nearly every business transaction and therefore will not recharacterize a transaction merely because tax considerations were one motivation for its particular structure. Frank Lyon Co. v. United States, 435 U.S. 561, 580, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978). However, we may recharacterize a transaction that had no business or corporate purpose when what was done, apart from the tax motive, was [not] the thing which the [relevant tax] statute intended. Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 79 L.Ed. 596 (1935). Taxpayers' purchase of the Securities, and the funding of that purchase by the Margin Loan, did have a non-tax business or corporate purchase. That step of the transaction was motivated by Taxpayers' belief that interest rates would fall. If interest rates were to fall (and they did), holding a security that produced a return based on the interest rate at the time of purchase, and financing that purchase with a loan charging a variable rate, would result in a profit based on the difference between the fixed rate and the variable rate. If this were Taxpayers' only goal, however, there would have been no need for them to lend the Securities to Refco. Had they not transferred the Securities to Refco, Taxpayers clearly would have been able to secure the tax treatment for the transaction that they are arguing for here: they would have held the Securities for more than one year and been able to claim long-term capital gains upon their sale, and the interest under the Margin Loan would have been deductible. The sole motivation for adding the purported securities loan to the transaction was tax avoidance. As is explained in marketing materials for the transaction produced by Twenty-First Securities, [10] if Taxpayers had simply bought and sold the Securities, they would have been forced to report the yield on the Securities as interest income (taxed at the highest rate) even though they did not actually receive any payment until the Securities matured. See § 1272(a)(1) (providing that the original issue discount on debt instruments like the Securities shall be included in the gross income of the holder). As the marketing materials explain, however, when a taxpayer loans a security to a borrower (such as a bond dealer) and certain criteria are met, then the taxpayer lending the security will no longer be treated as the owner of the security for federal tax purposes and will not be required to report such interest income. The loan was thus conceived as a way for Taxpayers to avoid interest income and generate, as the marketing materials put it, income taxed at favorable rates and expenses deductible at the highest rate. Unlike a typical securities lending arrangement, this transaction was designed around minimizing Taxpayers' tax bill rather than around Refco's need to have the Securities available to deliver to its customers. Taxpayers received no compensation from Refco for the loan of the securities. They did receive the cash collateral, but that was economically meaningless, because the cash collateral was used to repay the Margin Loan, so that Taxpayers never held it for their own account or earned interest on it. The Cash Collateral Fee was identical to the interest rate under the Margin Loan, the deposit required under the Addendum was the same as that required for the Margin Loan, and Taxpayers used the cash collateral to pay off the Margin Loan. Because of this, their economic position vis-a-vis Refco was identical to what it would have been absent the Loan Agreement and Addendum except in one key respect: as discussed above, their ability to profit from the sale of the Securities during the term of the loan was severely compromised. Congress' explicit goal in enacting § 1058 was to encourage loans for the benefit of brokers who needed large supplies of securities on hand to deliver to purchasers, because such loans can have a favorable impact on the liquidity of securities markets. Senate Report at 6, 1978 U.S.C.C.A.N. at 1292. It may be possible that nonrecognition treatment should be given to a transaction that fails to meet all of the specific requirements of § 1058(b), but that nonetheless is motivated by the goals that Congress had in mind when it enacted § 1058. But this loan, a tax shelter marketed as such for which the borrowing broker (Refco) did not pay the lender any consideration, clearly was not the thing which the statute intended. Gregory, 293 U.S. at 469, 55 S.Ct. 266. Indeed, even the ABA Report favored the position that a loan transaction must share the motivations indicated by Congress to receive nonrecognition treatment: the ABA Committee suggested that Treasury issue a regulation requir[ing] that a Section 1058 securities loan be entered by the borrower for the purposes which Congress intended. ABA Report, Section IV.2. Exceptions to the general rule requiring the recognition of all gains and losses on property dispositions are to be `strictly construed and do not extend either beyond the words or the underlying assumptions and purposes of the exception.' Teruya Bros., Ltd., 580 F.3d at 1043 (quoting 26 C.F.R. § 1.1002-1(b)). The purported loan at issue here does not fit within the underlying assumptions and purposes of § 1058 and should not be afforded nonrecognition treatment as a securities loan.