The characterization of a transaction as a sale has significant tax implications, and there is an abundance of case law and IRS guidance that interprets if and when a sale occurs in numerous contexts. One recent case, Calloway, 135 T.C. No. 3 (2010), rules on if and when a taxpayer sold his stock upon entering into an agreement, which purported to be a nonrecourse loan. While the result of the case may appear acceptable due to the facts and circumstances, the rationales in reaching the result significantly differed among the court’s judges. This item summarizes the facts and holding in Calloway and the differences among the judges’ opinions.
The Facts of Calloway
In this case, Calloway purchased 990 common shares of IBM while employed at IBM. The shares appreciated in value after Calloway acquired them. In early August 2001, Calloway entered into an agreement with Derivium Capital LLC, which provided that Derivium would lend an amount of cash to Calloway that was equal to 90% of the market value of the shares (the loan). The terms provided that the loan accrued interest equal to 10.5% (which compounded annually), was nonrecourse, and had a three-year maturity term.
On August 16, 2001, Calloway transferred the shares to Derivium as collateral for the loan and agreed that Derivium had the right to sell some or all of the shares without providing notice to him. Calloway did not have to maintain margin requirements other than transferring the shares. Dividends that Derivium received from the shares would be applied against the interest due from Calloway.
On August 17, 2001, Derivium sold the shares on the open market and subsequently transferred the loan to Calloway based on the amount that it received from the sale (i.e., 90% of the market value of the shares). Thus, the amount of the loan was not determined until after Derivium sold the shares. Calloway could not prepay the loan, and Derivium could not require Calloway to repay the loan prior to maturity.
Upon the end of the loan’s three-year maturity term, Calloway had the option to:
- Pay cash equal to the outstanding principal and interest related to the loan and receive the shares;
- Extend the term of the loan in exchange for a fee that would be equal to a percentage of the balance due; or
- Surrender the shares with no additional obligation.
On July 27, 2004, immediately prior to the loan’s maturity, Calloway stated that he relinquished his right to the shares in satisfaction of the loan and never made any payments of principal or interest on the loan.
The primary issue in Calloway was whether the loan constituted a sale of the shares in 2001 or a nonrecourse debt that Calloway owed to Derivium. If the loan constituted a nonrecourse debt, Calloway would have had dividends from the shares after he transferred the shares to Derivium and gain from relinquishing the shares in retirement of the loan in 2004. However, Calloway failed to report such dividends and gain on his tax returns.
The Court’s Opinions
Notwithstanding the fact that the loan was purported to constitute a nonrecourse debt, the court sought to characterize the loan according to the economic substance of the transaction (citing Heller, 866 F.2d 1336 (11th Cir. 1989)). Thus, the court held that the loan constituted a sale of the shares by Calloway in 2001 rather than a nonrecourse debt that Calloway owed to Derivium. While the judges agreed on the conclusion, the court provided three different opinions for treating the loan as Calloway’s sale of the shares in 2001, as discussed below.
The opinion from the majority of the court’s judges analyzed the loan under the factors provided in Grodt & McKay Realty, Inc., 77 T.C. 1221 (1981). In Grodt, the corporation Grodt & McKay entered into an agreement to purchase a herd of cattle from an unrelated seller. The primary issue facing the court was whether Grodt & McKay purchased the cattle in a bona fide sale or whether that transaction was a sham. While determining that there was not a bona fide sale in Grodt, the court held that the key was whether the benefits and burdens of ownership in the cattle had shifted to Grodt & McKay. In its decision, the court established the following list of factors to determine where the benefits and burdens of ownership resided:
- Whether the legal title passed;
- How the parties treated the transaction;
- Whether an equity interest was acquired in the property;
- Whether the contract created a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments;
- Whether the right of possession was vested in the purchaser;
- Which party had to pay the property taxes;
- Which party would bear the risk of loss or damage to the property; and
- Which party would receive the profits from the operation and sale of the property.
Based on the Grodt factors, the majority held that the loan constituted a sale of the shares in 2001 because:
- Legal title of the shares had passed to Derivium in 2001 because Derivium held the shares and was authorized to sell the shares without notice to Calloway;
- Calloway failed to report the transaction on his tax returns consistent with treating the loan of the shares as a nonrecourse debt;
- Calloway retained no property interest in the shares;
- There was an obligation for Derivium to pay 90% of the market value of the shares after Derivium sold the shares;
- Derivium obtained title, possession, and complete control of the shares;
- Calloway bore no risk of loss in the event that the value of the shares decreased (i.e., he was entitled to keep the proceeds from the loan and surrender the shares rather than repaying the loan and receiving the shares from Derivium); and
- Calloway was not entitled to any gains from Derivium’s disposition of the shares.
However, Judge Halpern asserted in his concurring opinion that the Grodt factors were inappropriate to determine whether the loan constituted a sale of the shares. As the judge stated:
The traditional, multifactor, economic risk-reward analysis, as argued by the parties, is appropriate for determining tax ownership of nonfungible assets, such as cattle. [Citing Grodt.] For fungible securities, however, a more focused inquiry—whether legal title to the assets and the power to dispose of them are joined in the supposed owner—has been determinative for more than 100 years. [135 T.C. No. 3 at 40–41]
To support his assertion, Judge Halpern cited two ancient cases, Richardson v. Shaw, 209 U.S. 365 (1908), and Provost, 269 U.S. 443 (1926).
In Richardson, the Supreme Court held that a stockbroker was not the owner of fungible securities that it held in a customer’s margin account merely because the stockbroker had the ability to pledge such securities to secure a loan. The Court in Richardson viewed that the stockbroker’s limited authority to pledge securities (and not to sell them except in limited circumstances) was not enough for the stockbroker to be the owner of such securities.
Contrary to Richardson, the Court in Provost held that a borrower in a securities lending transaction was the owner of such securities because the borrower could dispose of the securities. In Provost, the Court held that the borrower was the owner despite the fact that the lender retained the economic benefits and burdens related to securities, and the borrower was obligated to return equivalent stock to the lender.
Similar to Provost, Judge Halpern thought that Derivium’s possession of the shares coupled with its ability to sell the shares was most relevant in determining that the loan constituted a sale of the shares. He stated, “It is enough for me that petitioner [Calloway] gave Derivium the right and authority to sell the IBM common stock in question for its own account” (135 T.C. No. 3 at 43).
Judge Holmes, in his concurring opinion, agreed with Judge Halpern that the Grodt factors were inappropriate. However, he disagreed with Judge Halpern’s assertion that Derivium’s possession of the shares, coupled with its ability to sell the shares, should trigger a sale. Judge Holmes asserted that Calloway sold the shares to Derivium no sooner than when Derivium sold the shares on the open market (i.e., August 17, 2001) rather than the date that Calloway transferred the shares (i.e., August 16, 2001). Differentiating his view from Judge Halpern’s, Judge Holmes stated that the ability to sell the shares “does not adequately distinguish . . . between secured interests in stock and outright transfers of ownership” (135 T.C. No. 3 at 50, n.1).
Judge Holmes cited Regs. Sec. 1.1001-2(a)(4)(i) and Tufts, 461 U.S. 300 (1983), to support the idea that Calloway sold the shares (to Derivium) upon Derivium’s sale of the shares on the open market. Regs. Sec. 1.1001-2(a)(4)(i) provides that the sale of property that secures a nonrecourse liability discharges the transferor from the liability. The Supreme Court in Tufts held that when a borrower transfers collateral to retire a nonrecourse debt, the amount realized on the transfer of collateral includes the amount of the debt (see also Sec. 7701(g)). Thus, under Judge Holmes’s rationale, Derivium’s sale of the shares triggered Calloway’s sale of the shares under Regs. Sec. 1.1001-2(a)(4)(i), and Calloway was treated as selling the shares for an amount equal to the loan pursuant to Tufts.
The result in Calloway may not be surprising to practitioners; however, the different opinions among the judges create questions in determining if and when Calloway sold the shares.
First, should the Grodt factors be used in determining the owner of the shares? The benefits and burdens related to ownership of a cow are certainly different than the ownership of a share of stock. In addition, commentators and prior case law have recognized different thresholds to determine the ownership of fungible intangible property (i.e., shares of publicly traded stock) and nonfungible tangible property (i.e., cattle) (see Kleinbard, “Risky and Riskless Positions in Securities,” 71 Taxes 783 (1993), and Raskolnikov, “Contextual Analysis of Tax Ownership,” 85 B.U.L. Rev. 431 (2005)).
Second, if the Grodt factors are inappropriate in determining who owned the shares, should the combination of possession and the right to sell the shares be the triggering factor as suggested by Judge Halpern? If so, this rationale could possibly conflict with other common transactions that are not characterized as sales (e.g., certain “repo” transactions, which may be characterized as loans similar to the transaction in Nebraska Dep’t of Rev. v. Loewenstein, 513 U.S. 123 (1994)).
Third, while Judge Holmes’s rationale is straightforward in applying specific current tax law, is it practical to administer? His rationale would appear to require Calloway to know precisely when Derivium sold the shares in order for Calloway to have appropriately reported the gain on his tax return. Thus, it may not be practical for Calloway to report a taxable transaction based on information from Derivium to which he may not have been privy.
Even though the court in Calloway may have reached the appropriate conclusion, taxpayers and their advisers may be challenged in applying the court’s opinions in other circumstances. As Judge Holmes noted, “[u]nless future courts treat our analysis today as a limited-time ticket good only on Derivium cases, we may be creating more problems than we’re solving” (135 T.C. No. 3 at 75).
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.