Internal Revenue Code section 1259: a legitimate foundation for taxing short sales against the box or a mere makeover?

• Author: Ulcickas, Simon D.

"[B]ulls make money, bears make money, and hogs get slaughtered."(1) That is the Wall Street gospel on investors who are motivated by greed. Gluttonous investors should heed its advice because Congress, through its enactment of the Taxpayer Relief Act of 1997,(2) has taken aim at the tax benefits once reaped by engaging in short sale against the box transactions.(3) Investors no longer will be able to enter into absolute hedges without recognition of capital gain; rather, they will be forced to recognize capital gain on appreciated financial positions even if those positions are not sold. This latest attack on a specialized application of short selling(4) is merely an extension of a long running disdain for this financial practice.

For centuries, governments have treated short sales with varying degrees of contempt.(5) In the United States, government scrutiny of short selling dates back to World War I,(6) but politicians did not voice their disapproval of short selling until the stock market crashed in 1929. Consider Illinois Representative Adolph Sabath's assessment of short selling activity: "`short selling' ... is the greatest evil that has been permitted or sanctioned by the Government that I know of."(7) Fifty-eight years later, in the wake of the 1987 stock market crash, this critical attitude resurfaced.(8) Joseph Grundfest, then Commissioner of the Securities and Exchange Commission, commented on the possibility of heightened government regulation of short sales: "`When you sell short, you are in a sense betting against the team.'"(9) After the 1929 and 1987 crashes, investors attacked short sales on the grounds that they facilitated the manipulation of securities prices and aggravated market declines.(10)

Recently, critics have renewed calls for intensified regulation of short sales in reaction to the November 16, 1995 initial public offering (IPO) of the Estee Lauder Companies, Inc.(11) Rather than picking at the wound left by years of criticism regarding short selling's alleged "demoralizing" effect, government regulators now are attacking short sales from a different angle. The focus of regulatory watchdogs has shifted to the tax advantages enjoyed by investors using one version of these transactions: short selling against the box.(12)

Although many investors sell short against the box,(13) a variant of short selling that can defer or reduce tax liability, Estee Lauder Companies' 1995 IPO served as the impetus for the restructured assault on short sales.(14) Congress responded to the manner and degree to which the Lauders used short selling to effectuate their stock offering by passing tax legislation that treats certain financial transactions as "constructive sales" so long as those transactions function to lock in capital gain or loss with respect to the security involved.(15) The new law, codified as Internal Revenue Code section 1259, treats certain appreciated financial positions as constructive sales and taxes the capital gains on those positions.(16) This Note contends that section 1259 is flawed. Fundamentally, section 1259 does not address directly the true abusive practices involved in the Lauder transaction--the ability to sell short against the box indefinitely without any possibility of being squeezed;(17) the opportunity to obtain the proceeds from the short sale against the box before the transaction is closed;(18) and, finally, the combination of Revenue Ruling 72-478(19) and section 1014 of the Internal Revenue Code ("the Code").(20) Rather, section 1259 creates an inequitable standard that is both contrary to longstanding tax doctrine and detrimental to legitimate investment decisions.

This Note is divided into six parts. The first part explains the principal financial instruments affected by section 1259: short sales against the box and total return equity swaps. The second part traces Estee Lauder Companies' November 16, 1995 IPO and uses that transaction as a case study to flesh out the abuses with which section 1259 should be concerned. The third part outlines the prior tax law as it applied to short sales against the box, highlights the pertinent requirements of section 1259, and discusses section 1259's purpose. The fourth part documents the shortcomings of section 1259. The fifth part suggests alternative proposals that Congress might have considered. Finally, the sixth part offers a paradigm, the Related Individual--Income With Respect to a Decedent Rule, that more appropriately addresses and alleviates the abuses that can occur when particular investors sell short against the box.

THE AFFECTED FINANCIAL INSTRUMENTS

Short Sales Against the Box

To understand short sales against the box, familiarity with the practice of short selling is necessary.(21) "The term short sale means any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller."(22) At some point in the future, the short seller returns the borrowed security to the lender with an identical security purchased in the market.(23) A short sale, therefore, involves three brokers: the selling broker who represents the customer selling short, the buying broker who represents the investor purchasing the security sold short, and the lending broker who represents the account lending the securities to the selling broker.(24)

Mechanically, the selling broker borrows the security from the lending broker and then sells the same security to the buying broker.(25) In exchange for the loan of the security, the lending broker receives full protection from the selling broker in the form of a check equal to the fair market value of the loaned security.(26) The short seller, furthermore, must "mark to the market" whenever the price of the shorted security rises.(27) In other words, the loan of the security must be protected at 100% of its fair market value, meaning that the short seller must make cash deposits with the lending broker to the degree that cash reserves are equal to the market value of the borrowed security.(28) A collateralization system is necessary to ensure that the security will be returned to the accounts from which the security was borrowed when the owners of those accounts demand delivery.(29) A more salient point with respect to this Note is the fact that the proceeds from short sales against the box cannot be used by the average short seller.(30) Rather, the proceeds are transferred to the lending broker who holds the proceeds in an interest bearing account as collateral for the borrowed shares.(31) Wealthy short sellers with large accounts, however, may obtain the proceeds by taking out a loan from the selling broker(32) for up to ninety-five percent of the value of the security sold short.(33)

In addition to transaction costs and a premium paid to the lender for the right to borrow the security, the short seller must reimburse the lender for all dividends declared to the stockholders of record while the short sale remains open.(34) Such payment is required because the lender transfers only the physical certificate to the short seller, thereby retaining all of his shareholder rights.(35) The short seller does not collect the dividend paid out to the borrowed shares but instead adjusts his financial position to reflect the dividend payment.(36)

A short sale against the box is mechanically identical to a plain short sale with one important exception. When an investor sells short against the box, he owns the security or a similar marginable security being sold short but elects to borrow the identical security from a third party rather than deliver the security he already owns (i.e., the security in "the box").(37) As a result, the investor creates both a long and a short position in the same security, thereby hedging against any price fluctuations.(38) The investor has removed all of the risk of loss and opportunity for gain associated with the fluctuation in the security's market price.(39) Short selling is motivated by speculation, hedging, and tax planning.(40) The primary incentives to short selling against the box, though, are hedging and tax planning.(41)

For example, assume an investor owns 100 shares of XYZ stock with a cost basis of $100 per share and a current market value of $150 per share. Instead of selling the XYZ stock in the market, perhaps motivated by a desire not to create a taxable event, the investor can instruct his broker, the selling broker, to borrow 100 shares of XYZ from a third party, the lending broker, and then sell the borrowed shares short in the market.(42) The $15,000 in proceeds would then be deposited with the lending broker who, in turn, would place the proceeds in an interest bearing account.(43) Next, the investor, perhaps because he or she wishes to become more liquid, could take out a loan from the selling broker that is valued at no more than $14,250.(44) At some future date, the short seller will return the borrowed stock, repay the loan, and receive $5,000 in capital gain, the difference between the value of the shorted stock ($15,000) and the cost basis of the investor's original shares ($10,000).(45) Under prior tax law, recognition of the $5,000 capital gain occurred at this time.(46)

Total Return Equity Swaps

Although referred to as short sales against the box legislation,(47) section 1259 reaches beyond this one financial instrument and also affects certain derivative instruments. Derivatives are financial products that derive their value from the value of some underlying asset.(48) The value of derivatives fluctuates in reaction to changes in the underlying asset's value.(49) As a result, derivatives are attractive instruments to investors who wish to hedge their risk and to others who want to speculate in the financial markets.(50) The principal type of derivative instrument affected by section 1259 is called a notional principal contract or swap.

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