Lenders Allowed Nonrecognition Treatment for Certain Securities Loans Terminated Due to Bankruptcy

Rev. Proc. 2008-63 permits securities lenders continued nonrecognition treatment under Sec. 1058(a) for certain securities loans terminated due to the bankruptcy of the securities borrower, provided the lender applies the collateral to the purchase of identical securities within 30 days of the default. Rev. Proc. 2008-63 is effective for tax years ending on or after January 1, 2008.

Sec. 1058(a) provides nonrecognition treatment for the owner of securities exchanged for an obligation under an agreement that meets the requirements of Sec. 1058(b) or on the exchange of the resulting rights for securities identical to the securities transferred. To meet the requirements of Sec. 1058(b), an agreement must:

1. Provide for the return to the transferor of securities that are identical to those transferred;
2. Require payments to the transferor of amounts equivalent to all interest, dividends, and other distributions that the securities owner is entitled to receive during the period beginning with the transfer of the securities and ending with the transfer of identical securities back to the transferor; and
3. Not reduce the risk of loss or opportunity for gain of the transferor of the securities in the securities transferred.

In the current market, a significant number of securities loans have terminated due to borrower default. Often the default is the result of the borrower’s bankruptcy (or the bankruptcy of its affiliate). In that situation, if the agreement meets the Sec. 1058(b) requirements and the lender, as soon as commercially practicable (no more than 30 days after the default), uses collateral provided under the agreement to purchase identical securities, the IRS will treat the purchase as an exchange of rights under the agreement for identical securities to which Sec. 1058(a) applies.

Implications

Prop. Regs. Sec. 1.1058-1(e)(2) will trigger the built-in gain (and built-in loss, subject to deferral under the Sec. 1091 wash sale rules) in securities loaned under a Sec. 1058 agreement if the borrower fails to return the borrowed securities “or otherwise defaults.” A standard-form securities lending agreement treats the bankruptcy filing by the borrower as a default. Thus, the proposed regulations raise the possibility that the bankruptcy of a securities borrower will trigger the built-in gain in securities lent to or through that borrower.

The revenue procedure negated that possibility without analysis. Perhaps the Service viewed the securities lender as the borrower’s agent when it applied collateral to obtain identical replacement securities. In any event, the guidance is both welcome and timely.

One unanswered question is what happens if the posted collateral amount is less than the then full value of the loaned security. Perhaps the guidance can be viewed as splitting the loaned securities into two parts, one adequately secured and the other totally unsecured. The unsecured part cannot meet the requirements for continued nonrecognition, but it seems reasonable to claim the protection of Rev. Proc. 2008-63 for the remainder.

EditorNotes

David Kautter is a partner with Ernst & Young LLP in Washington, DC.

Contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mr. Kautter at (202) 327-8878 or david.kautter@ey.com.