rr-03-7.pdf

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Part I

Section 1001.--Determination of Amount of and Recognition of
Gain or Loss

26 CFR 1.1001-1: Determination and recognition of gain or loss.
(Also § 1259.)

Rev. Rul. 2003-7

ISSUES
Has a shareholder either sold stock currently or caused a
constructive sale of stock under § 1259 of the Internal Revenue
Code if the shareholder (1) receives a fixed amount of cash, (2)
simultaneously enters into an agreement to deliver on a future
date a number of shares of common stock that varies
significantly depending on the value of the shares on the
delivery date, (3) pledges the maximum number of shares for
which delivery could be required under the agreement, (4) has
the unrestricted legal right to deliver the pledged shares or to
substitute cash or other shares for the pledged shares on the
delivery date, and (5) is not economically compelled to deliver
the pledged shares?
FACTS
An individual (“Shareholder”) held shares of common stock
in Y
corporation, which is publicly traded. Shareholder’s basis
in the shares of Y
corporation is less than $20 per share. On

September 15, 2002 (the "Execution Date"), Shareholder entered
into an arm’s length agreement (the "Agreement") with Investment
Bank, at which time a share of common stock in Y corporation had
a fair market value of $20. Shareholder received $z of cash
upon execution of the Agreement. In return, Shareholder became
obligated to deliver to Investment Bank on September 15, 2005
(the “Exchange Date”), a number of shares of common stock of Y

corporation to be determined by a formula. Under the formula,
if the market price of a share of Y
corporation common stock is
less than $20 on the Exchange Date, Investment Bank will receive
100 shares of common stock. If the market price of a share is
at least $20 and no more than $25 on the Exchange Date,
Investment Bank will receive a number of shares having a total
market value equal to $2000. If the market price of a share
exceeds $25 on the Exchange Date, Investment Bank will receive
80 shares of common stock. In addition, Shareholder has the
right to deliver to Investment Bank on the Exchange Date cash
equal to the value of the common stock that Shareholder would
otherwise be required to deliver under the formula.

In order to secure Shareholder’s obligations under the
Agreement, Shareholder pledged to Investment Bank on the
Execution Date 100 shares (that is, the maximum number of shares
that Shareholder could be required to deliver under the
Agreement). Shareholder effected this pledge by transferring
the shares in trust to a third-party trustee, unrelated to

Investment Bank. Under the declaration of trust, Shareholder
retained the right to vote the pledged shares and to receive
dividends.
Under the Agreement, Shareholder had the unrestricted legal
right to deliver the pledged shares, cash, or shares other than
the pledged shares to satisfy its obligation under the
Agreement. Shareholder is not otherwise economically compelled
to deliver the pledged shares. At the time Shareholder and
Investment Bank entered into the Agreement, however, Shareholder
intended to deliver the pledged shares to Investment Bank on the
Exchange Date in order to satisfy Shareholder’s obligations
under the Agreement.
LAW AND ANALYSIS
Section 1001(c) provides that, except as otherwise provided
in subtitle A of the Code, the entire amount of gain or loss,
determined under § 1001, on the sale or exchange of property
shall be recognized. The Code does not define a “sale or
exchange.” The courts have considered many factors significant
in determining whether a sale or other disposition of property
has occurred. The factors that are relevant, and the weight to
be accorded to each factor, must be determined in light of the
nature of the property involved.
See
Torres v. Commissioner, 88
T.C. 702, 721 (1987).
Several cases have addressed the transfer of securities to
a brokerage firm under a subordination agreement intended to

allow the brokerage firm to use the securities to meet its net
capital requirements under stock exchange rules. See
, e.g.,
Cruttenden v. U.S.
, 644 F.2d 1368 (9
th
Cir. 1981); Lorch v.
Commissioner, 70 T.C. 674 (1978), aff’d, 605 F.2d 657 (2d Cir.
1979),
cert. denied
, 444 U.S. 1076 (1980); Miami National Bank
v. Commissioner, 67 T.C. 793 (1977). In these cases, an owner
of marketable securities transferred legal title and actual
possession of the securities to the brokerage firm, which held
the securities in a subordination account under an agreement
that permitted the brokerage firm to sell the securities if
necessary to meet claims of general creditors of the brokerage
firm. The transferor, however, retained the right to receive
dividends and the right to vote any stock. In addition, the
transferor could reacquire the securities in the subordination
account by substituting either cash or other securities of
equivalent value.
In Miami National Bank
, the court held that despite the
right of the brokerage firm to sell stock in a subordination
account to satisfy its creditors, the transferor remained the
owner of the stock. As a result, the court held that the
transferor’s subsequent sale of the stock in the subordination
account was effective to permit the purchaser to be treated as
the direct owner of the stock for purposes of the consolidated
return ownership test. At all times, the transferor had the
right to reacquire the stock in the subordination account by

substituting cash or other readily marketable securities of
equivalent value. The court gave significant weight to this
right in holding that the creation of the subordination account
did not cause the brokerage firm to become the owner of the
stock in the subordination account. The court noted that the
transferor’s right of substitution was not “merely an idle one”
because, at all times, the transferor possessed sufficient
resources to exercise the right. In fact, after the brokerage
firm became insolvent, the transferor substituted cash for the
stock. Thus,
Miami National Bank
and other similar cases
indicate that a transfer of actual possession of stock or
securities and legal title may not itself be sufficient to
constitute a transfer of beneficial ownership when the
transferor retains the unrestricted right and ability to
reacquire the securities.
In cases addressing short sales of stock or securities, the
courts have refused to recognize covering purchases as
triggering a sale because, until actual delivery, the taxpayer
retains the unrestricted right to dispose of the covering
shares.
See
, e.g., Richardson v. Commissioner, 121 F.2d 1 (2d
Cir.), cert. denied, 314 U.S. 684 (1941). In a typical short
sale, the taxpayer borrows stock or securities to effect a short
sale and is under an obligation to return identical stock or
securities to the lender. In
Richardson
, the taxpayer entered
into numerous sales, which were generally short sales effected

with borrowed stock. In one case, the taxpayer purchased 7,100
shares of stock that were intended to be used to close out a
short sale but were in fact delivered to close out a different
sale. Despite the taxpayer’s intent to use the purchased stock
to close his earliest open short sale, and despite a showing
that he followed a consistent practice of applying purchases to
close out his earliest open short sale, the taxpayer was held
not to have closed a short sale because the stock was not
actually delivered to the stock lender. Noting that the
taxpayer had not entered into any agreement or understanding
with the lender of the 7,100 shares and had not otherwise placed
himself in a position in which he was not entitled to treat the
purchased shares as long stock and sell them for his own
account, the court stated:
[The covering shares] remained under control of
the taxpayer and up to the time of actual delivery
could have been sold and replaced by other purchases
in the absence of prior agreement with the lender to
use them to make restitution. Such a shifting intent
to cover a short sale ought not to be the critical
event which would determine gain or loss under a tax
statute. It would leave the whole matter of fixing
the event to the taxpayer’s own will. We hold that
the time of delivery was the time at which the
covering transactions must be regarded as closed.

Richardson
at 4. Accord Klinger v. Commissioner, No. 18315
(T.C.M. 1949). Thus, Richardson
supports the conclusion that
even if the shareholder intends to complete a sale by delivering
identified stock, that intent alone does not cause a transaction

to be deemed a sale, as long as the taxpayer retains the right
to determine whether the identified stock will in fact be
delivered.
By contrast, in Hope v. Commissioner, 55 T.C. 1020 (1971),
aff’d
, 471 F.2d 738 (3d Cir.), cert. denied, 414 U.S. 824
(1973), the Tax Court, in determining that a sale had occurred,
relied on the seller’s receipt of sales proceeds and the
purchaser’s receipt of title and possession of shares without
restriction in use. In that case, the taxpayer was the owner of
approximately 57% of the common stock of a company that had
recently become a publicly traded company, and was having
difficulty in disposing of his remaining large block of stock.
The taxpayer made an arrangement with an investment bank for a
sale at a price that was approximately one half of the price at
which the stock was currently trading. Under the arrangement,
the investment bank earned its fee by reselling 25% of the block
of stock to the general public. The investment bank held the
remainder of the stock subject to options to purchase the stock
at the investment bank’s cost and subject to proxy agreements
that transferred to the optionees the right to vote the shares
for the election of directors. Half of the options and proxy
rights were held by the taxpayer’s brother; the other half were
held by two individuals who were employees of the company.
Subsequent to the closing of the transaction, the taxpayer
became dissatisfied with the sale price and brought a suit for

rescission. The litigation was not concluded in the year of the
transaction. On advice of counsel, the taxpayer held the sales
proceeds in cash and marketable securities pending settlement of
the litigation. On his tax return for the year of the transfer,
the taxpayer disclosed the transfer but did not include in
income his gain on the sale on the ground that the transfer was
not a completed sale on which gain was recognized.
The court concluded that the transaction constituted a sale
of the entire block:
The facts of this case conclusively establish that on July
27, 1960, the petitioner sold 206,400 shares of . . . stock
to [an investment bank] as agent for several purchasers as
well as for its own account. The sale was completed on
that date when title and possession of the certificates
were transferred by the petitioner to [the investment
bank], and the petitioner received $4,000,032 as payment in
full. . . . The petitioner received the money from the sale
without any restrictions on his use or disposition of those
funds.

55 T.C. at 1029.

In the present case, on the Execution Date, Shareholder
received a fixed payment without any restriction on its use and
also transferred in trust the maximum number of shares that
might be required to be delivered under the Agreement. Like the
taxpayers in
Miami National Bank
and Richardson, but unlike the
taxpayer in Hope, Shareholder retained the right to receive
dividends and exercise voting rights with respect to the pledged
shares. Also unlike
Hope
, the legal title to, and actual
possession of, the shares were transferred to an unrelated

trustee rather than to Investment Bank. Moreover, Shareholder
was not required by the terms of the Agreement to surrender the
shares to Investment Bank on the Exchange Date. Rather,
Shareholder had a right, unrestricted by agreement or economic
circumstances, to reacquire the shares on the Exchange Date by
delivering cash or other shares. See Miami National Bank and
Richardson. Accordingly, the execution of the Agreement did not
cause a sale or other disposition of the shares.
A different outcome may be warranted if a shareholder is
under any legal restraint or requirement or under any economic
compulsion to deliver pledged shares rather than to exercise a
right to deliver cash or other shares. For example,
restrictions placed upon a shareholder’s right to own pledged
common stock after the Exchange Date, or an expectation that a
shareholder will lack sufficient resources to exercise the right
to deliver cash or shares other than pledged shares, would be
significant factors to be weighed in determining whether a sale
has occurred.
Section 1259(a)(1) provides that, if there is a
constructive sale of an appreciated financial position, the
taxpayer shall recognize gain as if such position were sold,
assigned, or otherwise terminated at its fair market value on
the date of such constructive sale. Under § 1259(b), the term
“appreciated financial position” means any position with respect
to any stock, debt instrument, or partnership interest if there

would be gain were such position sold, assigned, or otherwise
terminated at its fair market value. Furthermore, for purposes
of § 1259, the term “position” means an interest, including a
futures or forward contract, short sale, or option. Under §
1259(c)(1)(C), a taxpayer is treated as having made a
constructive sale of an appreciated financial position if the
taxpayer (or a related person) enters into a futures or forward
contract to deliver the same or substantially identical
property. The term “forward contract” is defined under §
1259(d)(1) as a contract to deliver a substantially fixed amount
of property (including cash) for a substantially fixed price.
The legislative history indicates that a forward contract that
provides for the delivery of an amount of stock that is subject
to “significant variation” under the terms of the contract is
not within the statutory definition of a forward contract. S.
Rep. No. 33, 105
th
Cong., 1
st
Sess. 125-26 (1997), 1997-4 (Vol. 2)
C.B. 1067, 1205-06.
Under these facts, the Agreement does not cause a
constructive sale of the shares under § 1259(c)(1)(C).
According to the Agreement, delivery of a number of shares,
which may vary between 80 and 100 shares, depends on the fair
market value of the stock on the Exchange Date. Because this
variation in the number of shares that may be delivered under
the Agreement is a significant variation, the Agreement is not a
contract to deliver a substantially fixed amount of property for

purposes of § 1259(d)(1). As a result, the Agreement does not
meet the definition of a forward contract under § 1259(d)(1) and
does not cause a constructive sale under § 1259(c)(1)(C).
HOLDING
Shareholder has neither sold stock currently nor caused a
constructive sale of stock if Shareholder receives a fixed
amount of cash, simultaneously enters into an agreement to
deliver on a future date a number of shares of common stock that
varies significantly depending on the value of the shares on the
delivery date, pledges the maximum number of shares for which
delivery could be required under the agreement, retains an
unrestricted legal right to substitute cash or other shares for
the pledged shares, and is not economically compelled to deliver
the pledged shares.
DRAFTING INFORMATION
The principal authors of this revenue ruling are Christina
Morrison and Mary Truchly of the Office of Associate Chief
Counsel (Financial Institutions and Products). For further
information regarding this revenue ruling contact Ms. Morrison
at (202)622-3950 or Ms.Truchly at (202)622-3960 (nottoll-free
calls).