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Short sales against the box after the TRA '97.

Prior to the enactment of the Taxpayer Relief Act of 1997 (TRA '97), a taxpayer could hedge against volatility in the value of stock by completing a "short sale against the box," which had no tax consequences until the taxpayer closed the position by returning borrowed shares to the lender. The TRA '97 curtailed use of this technique by deeming the short sale a constructive sale on which gain or loss must be immediately recognized (whether or not the position is sold). This article explains the new law and whether the short sale against the box has survived.

The legislative history and the conference reports for the Taxpayer Relief Act of 1997 (TRA '97) clearly indicate a congressional desire to diminish tax-motivated transactions, such as shorting against the box. In a "short sale against the box," a taxpayer owns a long position and borrows an equal amount of stock from his broker to sell. The taxpayer believes that the stock price will drop in the near future and that the short position can be covered with less expensive shares.

Before the TRA '97, a short sale against the box transaction generally was used to defer capital gains tax on the disposition of a long position. A taxpayer with a significantly appreciated long position would hedge it by selling an equal amount of stock short. The taxpayer would then hold the hedged position until a future tax year, and eventually cover it with the low-basis long position. However, the TRA '97 significantly curtailed the usefulness of this deferral technique; this article discusses these changes and offers planning options.

Background

Prior to the TRA '97, a taxpayer generally did not recognize immediate gain on a short sale against the box. The gain on the borrowed and sold shares was not recognized until the taxpayer closed the sale by returning identical property to the lender. Sec. 1259 was enacted by TRA '97 Section 1001(a). Post-TRA '97 Sec. 1259(a) (1) is relatively straightforward--if a taxpayer makes a "constructive sale" of an "appreciated financial position" (AFP), he recognizes gain as if such position were actually sold, assigned or otherwise terminated at its fair market value (FMV) on the date of such constructive sale. In addition, under Sec. 1259(a)(2), a proper adjustment is made in the amount of any gain or loss subsequently taken into account on that position and a new holding period begins for that position starting on the date of the constructive sale.

Definitions

Sec. 1259(b)(1) defines an AFP generally as any position with respect to stock, a debt instrument or partnership interest if there would be gain on a taxable disposition of the position at its FMV. Other debt instruments, including those identified as part of a hedging or straddle transaction, are also AFPs. Sec. 1259(b)(3) defines a "position" as an interest, including a futures or forward contract, short sale or option. The constructive sale rules are designed to prevent a taxpayer from entering into long-term hedging transactions that would defer gain indefinitely while substantially reducing or eliminating the risk of loss.

Constructive Sale

According to Sec. 1259(c)(1), a taxpayer has made a constructive sale of an AFP when he does any of the following:

* Enters into a short sale of the same or substantially identical property.

* Enters into an offsetting notional principal contract with respect to the same or substantially identical property.

* Enters into a futures or forward contract to deliver the same or substantially identical property.

* In the case of an AFP that is a short sale, offsetting notional principal contract or futures or forward contract as to any property, acquires the same or substantially identical property.

* To the extent provided in regulations, enters into one or more other transactions (or acquires one or more positions) that have substantially the same effect as a transaction described above.

The Senate Committee Report1 noted that, if the standard for a constructive sale is met for only a pro rata portion of the taxpayer's AFP, that portion will be treated as constructively sold. Constructive sale determination for pro rata positions is determined by the actual sales method after adjusting for previous constructive sales.

It is anticipated that Treasury will use the authority granted under Sec. 1259(c)(1)(E) to treat as constructive sales other financial transactions that, like those specified in the provision, have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain on the AFP. It is also anticipated that regulations, when issued, will provide specific standards for determining whether several common transactions will be treated as constructive sales. Sec. 1259(c)(1) specifies certain transactions that Congress will treat as constructive sales and leaves other transactions (most notably, those involving options) for Treasury to address in regulations. Presently, only those transactions enumerated in Sec. 1259(c)(1) are constructive sales until regulations provide otherwise.

Treasury's authority to treat additional transactions as constructive sales is not limited to transactions in substantially identical property. The Conference Committee Report(2) made it clear that Congress expects Treasury to provide specific standards for determining whether several common transactions (e.g., collars and in-the-money options) will result in constructive sales. Treasury is also directed to establish "safe harbor" rules that can be applied without reference to option prices or predictions of future volatility for these and other transactions that do not result in constructive sale treatment. Sec. 1259(f) grants Treasury broad, general authority to issue regulations.

Exceptions

According to Sec. 1259(c)(3), the constructive sale rule does not apply to certain short-term hedges. These include (1) any transaction closed before the end of the 30th day after the close of the tax year (short-term hedge rule), if (2) the taxpayer holds the AFP to which the transaction relates (i.e., securities, if the transaction is a short sale against the box) throughout the 60-day period beginning on the date the transaction is closed and (3) at no time during the 60-day period does the taxpayer reduce his risk of loss on the AFP (i.e., the appreciated stock) or substantially similar property (the 60-day rule).

The restriction against hedging during the 60-day period is an attempt to make that holding period meaningful and to prevent a taxpayer from obtaining a multiple-year deferral by stringing together a series of short-term hedges.

Example: T owns 1,000 shares of ABC stock that he purchased in 1995. On Jan. 1, 1998, T sells short 1,000 shares of ABC. The position was closed on Jan. 15, 1999, with ABC shares purchased on that date. The 1,000 shares of ABC purchased in 1995 are sold on July 1, 1999. No constructive sale of ABC occurs in 1998, because the short-term hedge rule is satisfied. The rule is satisfied because (1) the short position was closed within 30 days after the end of 1998; and (2) the 60-day requirement was not violated, because the long position remained open for 60 days after Jan. 15, 1999 (the date on which the short position was closed) and the long position remained unhedged during that time. The character of the gain or loss realized on the July 1, 1999 sale of the long position would be long-term, because the short sale against the box was not deemed to be a constructive sale and the ABC stock had a long-term holding period when the short sale was entered into.

Had T closed the short position using the 1,000 shares purchased in 1995 rather than the newly purchased shares, or had T established a second short position as to the ABC stock before March 16, 1999, the 60-day requirement would not have been met; a constructive sale would have occurred on Jan. 1, 1998. In addition, a constructive sale of T's 1,000 ABC shares would have occurred on Jan. 1, 1998 if the short position had been closed on Feb. 1, 1999, because the short-term hedge rule would have been violated. Had a constructive sale occurred, the long-position's holding period would have been "clipped" and restarted. Thus, even though the long position was originally purchased in 1995, the constructive sale would treat the long position as being purchased on Jan. 1, 1998.

The constructive sale provision is effective for constructive sales entered into after June 8, 1997. A special rule was provided in TRA '97 Section 1001 (d)(2) for transactions before that date that would have been constructive sales under Sec. 1259. The positions in such a transaction will not be taken into account in determining whether a constructive sale after June 8, 1997 has occurred, provided that the taxpayer identifies the offsetting positions of the earlier transaction within 30 days after Aug. 5, 1997 (the TRA '97 enactment date). The special rule will cease to apply on the date the taxpayer no longer holds any of the offsetting positions so identified.

Planning

It is still possible to do a short sale against the box and avoid constructive sale treatment if the taxpayer meets the clearly enumerated exceptions of closing within 30 days after the end of the tax year and holding the remaining long position unhedged for 60 days. Even though this is still possible, from an economic perspective, short sales against the box designed to avoid constructive sale treatment have now become risky transactions.

To fully recognize the potentially negative impact of a short sale against the box after TRA '97, it is important to understand that the taxpayer can no longer use previously owned shares (i.e., the underlying long position) to close out the short sale against the box position. It is impossible to satisfy one prong of the Sec. 1259(c)(3)(A) exception (closing before the 30th day following the end of the tax year) while satisfying the 60-day holding period if the underlying long position is used to close the short sale.

Further, taxpayers may be surprised by the tax results generated by a short sale against the box designed to avoid constructive sale treatment. For example, if the market price of the stock sold short declines, the taxpayer potentially has a smaller amount of long-term gain in the underlying long position, but he will realize short-term capital gain when the short position is closed. If the stock price rises, the taxpayer potentially has more long-term gain in the long position, and realizes either long-term or short-term capital loss when the short position is closed, depending on how long he owned the long position when the short sale was executed.(3)

Conclusion

As a result of new Sec. 1259, short sales against the box designed to avoid constructive sale treatment have become risky transactions.4 Even though one can still do a short sale against the box after the TRA '97 without triggering a constructive sale, it often will not make economic sense to do so. Because a taxpayer cannot use his underlying long position as replacement shares, and a constructive sale restarts the taxpayer's holding period in the long position, short sales against the box expose the taxpayer to market risk and may subject him to short-term capital gains rates.

EXECUTIVE SUMMARY

* In a short sale against the box, a taxpayer holding a long position borrows and sells shares identical to that position, then subsequently gives the long position shares to the lender to close the transaction.

* Generally under new Sec. 1259, a short sale against the box is a constructive sale on which gain or loss must be immediately recognized, unless strict rules are met.

* Sec. 1259 is designed to prevent a taxpayer from entering into long-term hedging transactions that would defer gain indefinitely while substantially reducing or eliminating the risk of loss.

For more information about this article, contact Mr. Tucker at (202) 467-3875 or letucker @kpmg.com or Mr. Watson at (202) 467-2433 or mwatson@ kpmg.com.

(1) S. Rep't No. 105-33, 105th Cong., 1st Sess. (1997), p. 124.

(2) H. Rep't No. 105-220, 105th Cong., 1st Sess. (1997), p. 513.

(3) See Sec. 1233(d).

(4) However, it is possible to separate the long position into multiple blocks (e.g., blocks A, B and C), short one block (i.e., block A) and use another block (i.e., block B) to close the short position, under Sec. 1259(e)(3); nonetheless, a short sale against the box is no longer a perfect hedge.

Lawrence E. Tucker, J.D., MBA Manager Washington National Tax KPMG LLP Washington, DC

Mark T. Watson, CPA/PFS, CFP Partner Washington National Tax KPMG LLP Washington, DC
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Title Annotation:taxation of hedge stock transactions
Author:Watson, Mark T.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 1999
Words:2103
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