ASSUMPTION OF OBLIGATION TO DELIVER SECURITIES TO CLOSE OUT SHORT SALE IS ASSUMPTION OF LIABILITY, IRS RULES.

Rev. Rul. 95-45

ISSUE

Is a corporation's assumption of its shareholder's obligation to provide replacement securities to a broker-dealer pursuant to a short sale the assumption of a liability for purposes of sections 357 and 358 of the Internal Revenue Code, and if so, what is the amount of the liability?

FACTS

Corporation P owns all the outstanding shares of corporation S. P enters into a short sale of XYZ securities on a national securities exchange. P's broker-dealer takes securities on hand and sells them on P's behalf for a total sum of $1000x. P leaves the $1000x of cash proceeds from the sale with the broker-dealer as collateral and deposits additional cash as further collateral with the broker- dealer. P is obligated to deliver identical XYZ securities on some future date to close out the short sale.

Prior to that date, in a transaction described in section 351, P contributes its interest in the $1000x of sale proceeds on deposit with the broker-dealer, though not in the additional deposited cash, to the capital of S. P's transfer to S is part of the transfer to S of an entire ongoing business. S assumes the obligation of P to deliver identical XYZ securities to close out the short sale. At the time of S's assumption of the obligation, the market price of XYZ securities has fallen, and replacement securities would cost only $800x. P is not required to mark the short-sale position to market upon disposition.

LAW AND ANALYSIS

Section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation solely in exchange for stock and immediately after the exchange the transferor is in control of the corporation.

Section 357(a) provides a general rule that a corporation's assumption of a shareholder's liability in a section 351 exchange will not be treated as money or other property received by the shareholder. Section 357(b) provides an exception to the general rule of section 357(a) when it appears that the principal purpose of the shareholder in having the liability assumed was avoidance of Federal income tax on the exchange or, if not such purpose, was not a bona fide business purpose.

Section 357(c)(1) contains a second exception to the general rule of section 357(a). Section 357(c)(1) provides that if the sum of the liabilities the corporation assumes and takes property subject to exceeds the total of the adjusted basis of the property the shareholder transfers to the corporation pursuant to the exchange, then the excess shall be considered as gain from the sale or exchange of the property.

Section 358(a)(1) provides that in a section 351 exchange the basis of the property permitted to be received under section 351 without the recognition of gain or loss shall be the same as that of the property exchanged, decreased by (i) the fair market value of any other property (except money) received by the taxpayer, (ii) the amount of any money received by the taxpayer, and (iii) the amount of loss to the taxpayer which was recognized on such exchange, and increased by (i) the amount which was treated as a dividend and (ii) the amount of gain to the taxpayer which was recognized on such exchange (not including any portion of such gain which was treated as a dividend).

Section 358(d)(1) provides that where, as part of the consideration to the taxpayer, another party to the exchange assumed a liability of the taxpayer, such assumption (in the amount of the liability) shall, for purposes of section 358, be treated as money received by the taxpayer on the exchange.

A short sale creates an obligation on the part of the seller to return the borrowed securities. See, e.g., Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118, 122 (a short sale creates an obligation although not an indebtedness). The initial proceeds of an open short sale are not currently taxed to the short seller, but nonetheless are an asset of the short seller, increasing the aggregate adjusted basis of its total assets by the amount of the proceeds. Because the obligation on the part of the seller to return the borrowed securities resulted in an increase in the adjusted basis of its assets, the obligation is treated as a liability. See S. Rep. No. 1263, 95th Cong., 2d Sess. 183-185 (1978), 1978-3 C.B. 481-483 (an obligation that creates basis is treated as a liability); Rev. Rul. 95-26, 1995-14 I.R.B. 6; and Rev. Rul. 88-77, 1988-2 C.B. 128. Therefore, for purposes of sections 357 and 358, the assumption by S of the obligation to deliver replacement securities constitutes the assumption of a liability, and the amount of the short-sale liability is the amount of basis to which the short sale gave rise.

HOLDING

For purposes of sections 357 and 358, S's assumption of the obligation of P to deliver XYZ securities to close out the short sale constitutes an assumption of a liability, and the amount of the liability assumed is $1000x, the amount of the proceeds of the short sale of the XYZ securities. Pursuant to section 358, P's basis in its S stock is first increased by the amount of the proceeds contributed to S, or $1000x, and then decreased by the amount of the liability assumed, also $1000x, for a net change of zero.

For an analysis relating to whether a partnership's obligation to deliver replacement securities to close out a short sale constitutes a partnership liability under section 752, see Rev. Rul. 95-26, supra.

For an analysis relating to whether short-sale transactions give rise to unrelated business taxable income under section 512, see Rev. Rul. 95-8, 1995-4 I.R.B. 29.

DRAFTING INFORMATION

The principal author of this revenue ruling is Richard Starke of the Office of the Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling contact Mr. Starke on (202) 622-7750 (not a toll-free call).