Rev. Rul. 80-135

ISSUE

Is the lender of a municipal bond entitled to exclude from gross income under section 103(a)(1) of the Internal Revenue Code an amount, equal to the interest on the bond, received from a broker who borrowed the bond to cover a short sale?

FACTS

A, an individual, owned a municipal bond (bearer bond) the interest on which was excludable from A's gross income under the provisions of section 103(a)(1) of the Code. A broker asked to borrow A's bond to cover a short sale between two of the broker's clients. A delivered the bond to the broker and the broker subsequently delivered the bond to the purchaser under the short sale. The purchaser, as the new owner, is excluding from gross income the interest received on the bond. Under the agreement with the broker, A is entitled to receive a similar bond from the broker upon demand. In addition, the broker will pay A an amount equal to the interest that would have been received by A on the bond transferred until a similar bond is returned to A.

LAW AND ANALYSIS

Section 103(a)(1) of the Code provides that interest on the obligations of a state or political subdivision of a state is excludable from the gross incomes of the holders of the obligations.

A short sale transaction involves the borrowing by the seller of the securities delivered to the buyer. Subsequently, the seller must deliver similar securities to the lender in order to close the transaction. Short sales are ordinarily made through a broker who borrows the securities for delivery to the purchaser. The character of gain or loss from short sales is determined under the provisions of section 1233 of the Code.

Rev. Rul. 74-482, 1974-2 C.B. 267, holds that interest accrued on tax-exempt municipal bonds after ownership of the bonds had been transferred by a dealer in municipal bonds is not excludable from the gross income of the dealer under the provisions of section 103(a)(1) of the Code because only the owner of obligations described in section 103 may treat the interest accruing on such obligations as excludable from gross income.

Rev. Rul. 60-177, 1960-1 C.B. 9, holds that an amount equal to a cash dividend, paid to a lender of stock by a "short-seller" with respect to the stock borrowed to cover a short sale, is not a dividend within the meaning of section 316(a) of the Code. Section 316(a) provides that the term "dividend" means any distribution of property made by a corporation to its shareholders out of its earnings and profits accumulated after February 28, 1913, or out of its earnings and profits of the taxable year. The phrase in section 316(a) "to its shareholders" means the owners of stock. Rev. Rul. 60-177 states that the purchaser, rather than the lender, is the real owner of the stock because title to the stock passed to the purchaser as a result of the short sale.

In this case the lender delivered the bond to the broker for transfer to the purchaser in the short sale transaction. Because title passed to the purchaser as a result of the short sale, the lender is no longer the owner of the bond. Therefore, the amount received by the lender is not interest on an obligation of a state or political subdivision of a state within the meaning of section 103 of the Code.

HOLDING

The lender of the municipal bond is not entitled to exclude from gross income under section 103(a)(1) of the Code the amount, equal to the interest on the bond, received from the broker who borrowed the bond to cover the short sale.