United States: Loans Of Securities, Digital Assets, And Other Fungible Property

I. Introduction

Securities loans are financial transactions critical to the operation of efficient trading markets. Although these transactions predate the existence of the federal income tax,¹ there are still many important unanswered questions regarding their tax treatment. Further, loans of fungible property other than securities (for example, digital assets or master limited partnership (MLP) units)² are occurring with greater frequency — without even the most basic of guidance on their tax treatment. This makes it worthwhile to reexamine the state of the law concerning the appropriate tax treatment of securities loans as well as the extent to which that treatment should extend to loans of non-securities property (which this report refers to as NSP).

One of the conceptual challenges regarding the tax treatment of securities loans stems from the fact that the securities borrower ordinarily transfers the securities to another person, either in a market sale or to repay a prior securities loan. That transferee becomes the tax owner of the borrowed securities. Indeed, the transferee generally is unaware that the securities it acquired were from a securities borrower (as opposed to the original owner of the securities). Because the securities have a new tax owner, the lender can no longer be their tax owner, even though it typically maintains an economic position in the securities that is substantially identical to the position it had before initiating the loan. The fact that tax ownership has been severed while economic exposure continues gives rise to numerous tax issues.

Some of those issues are addressed under current law. Most notably, section 1058 generally provides for nonrecognition treatment when securities are lent to a securities borrower (and when they are returned to the securities lender) if the agreement satisfies specified requirements. As described below, however, the application of section 1058 may be unclear in the context of some types of securities loans (for example, loans with a fixed term). The fact that regulations were proposed under section 1058 over 37 years ago and have yet to be finalized has not helped bring clarity to the treatment of securities loans. Moreover, section 1058 by its terms applies only to the lender of securities, and generally only in determining whether the lender recognizes gain or loss.

As a result, there are several aspects of the tax treatment of securities loans (such as the source of securities lending fees) that have remained stubbornly unclear over the years.³ Further, the existing authorities on the tax treatment of securities loans, including section 1058, do not directly address the treatment of NSP loans. Most importantly, section 1058 applies only to "securities" (which are defined to include only debt instruments and corporate stock) and thus does not speak to whether the lender of NSP recognizes gain or loss upon making an NSP loan. As will be discussed, the law as it existed before the enactment of section 1058 generally supports treatment of NSP loans (or at least those that conform to the requirements of section 1058) as not giving rise to realization events, because the lender is treated as receiving property in exchange for NSP that is not materially different (within the meaning of section 1001) from the NSP lent under that agreement.

II. The Pre-Section 1058 Landscape

The government's analysis of the tax treatment of securities lending transactions before the enactment of section 1058 in 1978 reached a consistent result (albeit through inconsistent rationales): Securities lending transactions did not trigger the recognition of gain or loss by the securities lender. Put differently, even without the presence of section 1058, the government maintained in guidance over several decades that the lending of securities was not an event that triggered embedded gain or loss in the securities; it just did not settle on a unified rationale for why nonrecognition treatment applied. Because the tax authorities addressing the treatment of securities loans before the enactment of section 1058 potentially have continuing relevance for property loans not addressed by section 1058 (for example, loans of digital assets, commodities,⁴ and MLP units), an overview of those authorities is set forth below.

The first authority directly addressing the tax treatment of securities lending transactions was a 1925 solicitor's memorandum that considered the appropriate tax treatment of substitute dividends received under a securities loan.⁵ Under the facts considered in the memorandum, C borrowed 100 shares of stock held by A. C then sold those borrowed shares to D. In each case, A, C, and D acted through their own respective brokers. A dividend was declared on the underlying shares before C had repaid his securities loan from A and while D was still the owner of the shares he purchased from C. The memorandum first noted that while A and D are both credited by their brokers with the amount of the dividend, there is only one actual dividend that can be reported. Citing the lower court decision in Provost⁶ (which was later upheld by the Supreme Court, as discussed below), the IRS stated that ownership of the lent securities transferred to D, and therefore D was the only dividend recipient entitled to a dividends received deduction. The dividend equivalent credited to A's account was income to A but was not treated as a dividend⁷.

In 1926 the Supreme Court in Provost addressed whether the lending of stock and its subsequent return were transfers to which a transfer tax applied.⁸ At that time, a 2-cent-pershare transfer tax was imposed on "all sales or agreements to sell . . . or transfers of legal title to shares or certificates of stock." The Court concluded that the securities lender in that case had transferred ownership of the securities, even though it was contractually entitled to receive all the economic benefits and burdens of the securities as if they had not been transferred.⁹ Describing the position of the lender, the Court determined that the lender substituted its ownership of the stock for a personal obligation of the borrower to restore the lender to its prior economic position. However, because the Court was concerned only with determining whether there was a transfer for purposes of the stamp tax, it did not discuss whether the transfers resulted in the recognition of taxable gain or loss to the lender.¹⁰

In a 1948 letter to the New York Stock Exchange,¹¹ the IRS for the first time explicitly concluded that no gain or loss is recognized by a taxpayer upon the lending of its stock. The ruling addressed whether a client's loan of stock to a broker and the broker's return of that stock to the lender constitutes a closed transaction to the lender, such that the lender recognizes gain or loss on the lent stock. The ruling made clear the importance of providing clarity to taxpayers on this issue, noting that "the reluctance of security owners to lend their stock is in some measure traceable to a belief that the loaning of the stock would result in a realization of gain or loss on the Shares loaned." The letter concluded: "It is held that the loan of stock and the return thereof to the lender . . . is not a disposition of property which results in recognized gain or loss for Federal income tax purposes; and that such a transaction does not affect the lender's basis for the purposes of determining gain or loss upon the sale or the disposition of the stock, nor the holding period of the stock in the hands of the lender." However, the letter provides no analysis of why this conclusion is warranted. Further, as discussed below, its conclusion that a securities loan does not effect a disposition of the loaned securities is clearly wrong, in the sense that the securities lender cannot be treated as owning the lent shares once ownership of those shares has been vested in another party.

In Rev. Rul. 57-451, 1957-2 C.B. 295, the IRS considered the tax treatment of a taxpayer who deposits shares with a broker and authorizes the broker to lend those shares to its customers in the ordinary course of its business. However, the ruling was confined to the situation of a brokerage customer who acquired his shares pursuant to the exercise of a qualified stock option under section 421 (the predecessor of section 424). Under that provision, a taxpayer's acquisition of shares pursuant to the exercise of a qualified stock option is not taxable if he does not engage in a "disposition" (within the meaning of prior section 421(d)(4)) of the acquired shares within a prescribed period. Thus, the question faced in the ruling was not whether the lending of securities by their owner generally constitutes a realization event to the lender under section 1001. Rather, the ruling addressed only whether such a loan constitutes a disposition as defined in section 421(d)(4). Because that provision defined disposition in a manner independent of normal realization principles, it is worth examining the language of section 421(d)(4) in some detail before returning to the ruling.

Under section 421(d)(4), the question whether a disposition had occurred melded concepts traditionally associated with realization under section 1001 with other concepts that are not. Specifically, section 421(d)(4) began by stating that generally "the term 'disposition' includes a sale, exchange, gift, or transfer of legal title." However, it excepted from the definition of disposition (1) transfers from a decedent to an estate or by bequest or inheritance; (2) exchanges to which section 354, 255, 256, or 1036 (or so much of section 1031 as relates to section 1036) applies; (3) pledges and hypothecations; and (4) acquisitions of stock by joint tenancy or transfers into the joint ownership (but not terminations of that ownership).

Footnotes

1 Technical Committee of the International Organization of Securities Commissions and Committee on Payment and Settlement Systems, "Securities Lending Transactions: Market Development and Implications" (July 1999) ("Securities lending has existed since at least the 19th century.").

2 This report focuses principally on the tax treatment of loans of securities and digital assets. The tax treatment of loans of MLP units (including the treatment of substitute payments made with respect to those units) generally is not addressed in this report except when that treatment is co-extensive with digital asset loans (e.g., whether a loan of MLP units triggers gain or loss to the lender).

3 Although some issues concerning the borrower in a propertylending transaction are discussed herein, this report is principally focused on the tax consequences to the lender side of a property-lending transaction.

4 The most common manner for commodities to be lent is for a taxpayer that owns a security that is an interest in a grantor trust that owns commodities to lend that security. For example, SPDR Gold Shares (GLD) represent beneficial ownership of gold bullion held by the SPDR Gold Trust. Because the lending of GLD should be treated for tax purposes as a loan of gold bullion, it is ineligible for the benefits of section 1058 because GLD is not treated as a security under section 1236(c).

5 S.M. 4281, IV-2 C.B. 187 (1925).

6 Provost v. United States, 60 Ct. Cl. 49 (1924), aff'd, 269 U.S. 443 (1926).

7 Because securities are fungible with one another, the memorandum observed that it is likely impossible for A to know whether it was his stock specifically, rather than the stock of another client of the same broker, that was lent to C and sold to D. In light of the difficulties of tracing the use of specific shares, the IRS stated that it "would seem expedient" to permit A to treat the amount credited to him as an actual dividend when it is not known that the broker had lent his stock. 8 Provost, 269 U.S. 443.

9 Id. at 455.

10 Interestingly, the subsequent authorities that cite and discuss Provost, including court decisions and the IRS's published guidance, appear to rely on the case more for its description of a standard share loan than for its legal analysis. This is not altogether surprising in that the federal stamp tax was not in pari materia with the federal income tax. Cf. Farid-Es-Sultaneh v. Commissioner, 160 F.2d 812, 814-815 (2d Cir. 1947) ("The income tax provisions are not to be construed as though they were in pari materia with either the estate tax law or the gift tax statutes.").

11 Reprinted in 5 CCH 1948 Stand. Fed. Tax Rep. P6136

Originally Published by Tax Notes

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