Appeals from a Decision of the Tax Court Tax Ct. No. 13953-06, Tax Ct. No. 14147-06
The opinion of the court was delivered by: Tashima, Circuit Judge
Argued and Submitted July 21, 2011-San Francisco, California
Before: A. Wallace Tashima and Johnnie B. Rawlinson, Circuit Judges, and Jed S. Rakoff, Senior District Judge.*fn1
Opinion by Judge Tashima; Concurrence by Judge Rawlinson
This case requires us to decide whether a purported securities loan with a fixed term of at least 250 days and possibly as long as 450 days, entered into not for the purpose of providing the borrower with access to the lent securities, but instead for the purpose of avoiding taxable income for the lender, qualifies for non-recognition treatment as a securities loan pursuant to § 1058 of the Internal Revenue Code (the "Code"), 26 U.S.C. § 1058.*fn2 We hold that it does not.
As a general rule, any sale or other disposition of property is a taxable event. § 1001(c). Prior to 1978, there was some uncertainty regarding the application of this general rule to so-called securities lending transactions. These transactions were developed in response to the needs of securities brokers, who frequently faced delays in obtaining securities to deliver to purchasers and therefore were forced to borrow the required securities from organizations and individuals who held such securities in their investment portfolios. See S. Rep. 95-762 ("Senate Report"), at 3-4 (1978), reprinted in 1978 U.S.C.C.A.N. 1286, 1289. In 1926, the Supreme Court had held that the passage of securities from lender to borrower pursuant to a securities lending agreement, and then back again from borrower to lender at the end of the loan term, were taxable events. Provost v. United States, 269 U.S. 443, 459 (1926). Subsequent rulings by the Internal Revenue Service (the "IRS"), however, had taken the opposite position and declared that these transactions were not taxable events. E.g., Rev. Rul. 57-451, 1957-2 C.B. 295, 1957 WL 11085.
In 1978, Congress sought to clear up this confusion by enacting § 1058, which provides that securities lending transactions will not be treated as taxable dispositions. The Senate Finance Committee recognized that such transactions are "desirable" because they reduce the chances that brokers will fail to deliver securities to purchasers within the time required by the relevant market rules. Senate Report at 5, 1978 U.S.C.C.A.N. at 1291. Under § 1058, when a taxpayer transfers securities under an agreement that meets certain enumerated requirements, "no gain or loss shall be recognized on the exchange of such securities by the taxpayer for an obligation under such agreement, or on the exchange of rights under such agreement by that taxpayer for securities identical to the securities transferred by that taxpayer." § 1058(a).
In order to qualify for non-recognition under § 1058(a), an agreement must:
"(1) provide for the return to the transferor of securities identical to the securities transferred;
(2) require that payments shall be made to the transferor of amounts equivalent to all interest, dividends, and other distributions which the owner of the securities is entitled to receive during the period beginning with the transfer of the securities by the transferor 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."*fn3
B. Factual Background*fn4
Petitioners in this case are Henry and Susan Samueli and Thomas and Patricia Ricks (collectively, "Taxpayers"). Both the Samuelis and the Rickses are married couples who filed joint income tax returns for 2001 and 2003. Henry Samueli is the billionaire co-founder of Broadcom Corporation, and Thomas Ricks is an investment advisor to the Samuelis.*fn5
In 2000 and 2001, the Samuelis' accountant and tax consultant, Arthur Andersen LLP, and Twenty First Securities, a brokerage and financial firm, jointly designed and marketed to the Samuelis a transaction that was predicated on the expectation that short-term interest rates were going to fall from their then-current levels. After evaluating memoranda prepared by Twenty-First Securities, Thomas Ricks recommended to the Samuelis that they invest in the proposed transaction, and they elected to do so. Thomas Ricks later became a participant in the transaction as well when he acquired a 0.2% stake in it from another pass-through entity affiliated with the Samuelis.
In its economic essence, the transaction consisted of Taxpayers purchasing a security with a fixed rate of return deter- mined by interest rates at the time of purchase, and paying for that purchase at a price derived from a variable interest rate. However, the transaction as executed was considerably more complex than that description and is best understood as a series of discrete steps.
1. Step One: Purchase of the Securities; Margin Loan
On October 17, 2001, Taxpayers purchased a $1.7 billion principal "strip"*fn6 (the "Securities") issued by the Federal Home Loan Mortgage Corporation ("Freddie Mac") from Refco Securities LLC ("Refco"), a securities broker. By purchasing a strip, Taxpayers were purchasing the right to receive the principal on a Freddie Mac bond at the date of maturity but not the right to receive interest payments on that bond prior to maturity. The Securities had a maturity date of February 18, 2003, on which date their holder had the right to receive $1.7 billion. Taxpayers purchased the Securities for $1.643 billion, which meant that cashing in the Securities for their par value on the maturity date would provide them with an annual yield of 2.5810% on the purchase price.
Taxpayers funded the purchase of the Securities with a margin loan (the "Margin Loan") from Refco. The interest rate of the Margin Loan was set at the variable London Inter-bank Offering Rate ("LIBOR") plus 10 basis points.*fn7 The Margin Loan was secured by the Securities, and Taxpayers also deposited $21,250,000 with Refco as a condition of obtaining the Margin Loan.
2. Step Two: Loan of the Securities
The plan all along had been for Taxpayers to lend the Securities back to Refco after purchasing them. On or about October 11, 2001, six days before Taxpayers' purchase of the Securities, Taxpayers and Refco had entered into a Master Securities Loan Agreement and an Amendment to the Master Securities Loan Agreement (together, the "Loan Agreement"). The Loan Agreement was on a standard form for securities loan agreements. Taxpayers and Refco then entered into an Addendum to the Loan Agreement (the "Addendum") on October 17, the same day that Taxpayers purchased the Securities.
The Loan Agreement required Taxpayers, as lender, to transfer the Securities to Refco, as borrower. In return, Refco would transfer to Taxpayers collateral with a market value at least equal to that of the Securities. Taxpayers were required to pay Refco a fee (the "Cash Collateral Fee") equal to an agreed-upon percentage of the amount of any such collateral in cash. Refco also was required to "mark to market" the collateral on a daily basis, meaning that if the market value of the Securities went up on any given day, Refco was required to transfer additional collateral to Taxpayers no later than the close of the next business day, so that the market value of the collateral remained equal to the market value of the Securities. The Loan Agreement also provided that Taxpayers could terminate the loan of the Securities at any time, in which event Refco would be required to return the Securities no later than the third business day following notice of termination. All of these terms are standard features of securities lending agreements. See Senate Report at 5-6, 1978 U.S.C.C.A.N. at 1291.
The Addendum, however, was a customized document and overrode several of the terms in the Loan Agreement. The provision in the Loan Agreement permitting Taxpayers to terminate the loan and demand return of the Securities on three business days' notice was superseded by a section of the Addendum entitled "Term of Specified Loan." This section provided that the loan would terminate on January 15, 2003 (approximately one month before the maturity date of the Securities), unless Taxpayers elected to terminate it on either July 1, 2002, or December 2, 2002. The Addendum also specified that, beginning on November 5, 2001, the Cash Collateral Fee would be set at one-month LIBOR plus ten basis points (the same rate as the interest rate under the Margin Loan) and would be re-calculated on the first Monday of each month. The Cash Collateral Fee would "be deemed to be added to the Collateral held by" Taxpayers and would be paid by Taxpayers to Refco when they returned the collateral to Refco at the end of the loan term, unless Taxpayers elected to pay the Cash Collateral Fee, "in whole or in part, prior to termination" of the loan. ...