The Tax Court held that a leveraged securities agreement was not a securities lending arrangement under IRC § 1058 since its economic substance indicated the taxpayers’ opportunity for gain had been reduced. Thus the arrangement was treated as two separate sales transactions; the first resulted in no gain or loss, and the second resulted in the recognition of short-term capital gain. Also, the court found the agreement had no debt component. Since no debt existed, the taxpayers’ interest deductions were also disallowed.
Under section 1058, no gain or loss is recognized by an owner of securities when those securities are transferred to a borrower under a securities lending arrangement. The agreement must require the return of identical securities to the transferor, and the transferor must receive payments equal to the amount of any interest, dividends or other distributions related to the securities during the period beginning with the transfer and ending with their return. The agreement may not reduce the transferor’s risk of loss or opportunity for gain related to the transferred securities, and the agreement must conform to any other requirements prescribed in Treasury regulations. Property acquired under such an agreement will have the same basis as the property transferred.
In a marketed arrangement, in October 2001, Henry and Susan Samueli entered into a leveraged securities agreement with Refco Securities, a securities broker. Henry Samueli is the co-founder of Broadcom Corp. and in 2008 ranked No. 262 among the Forbes 400 richest Americans. The Samuelis, using a margin loan, purchased roughly $1.64 billion of securities from Refco. As soon as the purchase was settled, the Samuelis transferred the securities back to Refco, which was obligated to return identical securities to them on Jan. 15, 2003, or if the Samuelis exercised their option to terminate the agreement early, on July 1, 2002, or Dec. 2, 2002.
After it received the securities, Refco immediately transferred cash collateral of about $1.64 billion to the Samuelis, who used those proceeds to repay their margin loan with Refco. During the transaction period, the Samuelis were required to pay a variable rate of interest on the cash collateral to Refco but were entitled to receive any interest, dividends or other distributions related to the securities. The early termination option was not exercised, and rather than returning the securities on Jan. 15, 2003, Refco purchased them from the Samuelis for $1.69 billion, their market value on that date. The Samuelis used the proceeds to repay the cash collateral plus the accrued interest, totaling $1.68 billion.
The Samuelis, believing the arrangement satisfied section 1058, reported a $50.7 million long-term capital gain on their 2003 federal income tax return. Also, on their 2001 and 2003 tax returns, they deducted interest of approximately $7.8 million and $33 million, respectively. The IRS determined the arrangement did not satisfy section 1058, and instead determined the Samuelis had purchased and immediately resold securities in 2001 with no gain or loss, purchased and immediately resold securities in 2003 with a short-term capital gain of about $13.5 million and that no debt existed, therefore disallowing their interest deductions.
The Samuelis petitioned the Tax Court. The court reasoned that the Samuelis’ opportunity for gain was reduced if it was less with the agreement than it would have been without it. That was in fact the case, the court said, since the Samuelis could have realized gain only on the three days—July 1, 2002; Dec. 2, 2002; and Jan. 15, 2003—that they could demand the return of the securities from Refco.
The Samuelis argued that they could have locked in a gain on any day by purchasing a sell option related to the securities, but the court also rejected that argument, stating such a transaction was not part of the agreement related to the transferred securities. The court also stated that, although section 1058 does not explicitly require that the loaned securities be returned to the transferor on demand, the legislative history of section 1058 indicates that Congress intended that the transferor retain all risks and benefits of ownership during the loan period. The court also ruled that the cash transferred in 2001 was the proceeds of a stock sale, not cash collateral for a loan. Since the Samuelis were not holding Refco’s cash as loan collateral, they incurred no interest expense for holding that collateral; thus the court disallowed their interest deductions as well.
In a separate opinion, the Tax Court also granted the government’s motion to dismiss the Samuelis’ argument that their amended return for 2003 qualified as an administrative adjustment request (AAR) under section 6627. If the amended return did constitute an AAR, certain adjustments would no longer be considered partnership items and would result in an overpayment, the Samuelis argued. In dismissing that portion of the case, the court noted that the amended return did not meet the administrative requirements for an AAR under Treas. Reg. § 301.6227(d)-1(a).
Henry and Susan F. Samueli v. Commissioner , 132 TC no. 4 and 132 TC no. 16
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.