rr-04-15.pdf

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Part I

Section 1233.— Gains and Losses from Short Sales
(Also ' 1259; 26 CFR 1.1233–1.)

Rev. Rul. 2004–15

ISSUES

(1) If a taxpayer is obligated to transfer stock to a broker as a result of a short
sale and borrows stock from another broker to satisfy the obligation to the first broker by
having the second broker transfer the borrowed stock to the first broker, does the
transfer close the short sale for purposes of ' 1.1233–1(a) of the Income Tax
Regulations?

(2) If a taxpayer held appreciated stock, entered into a short sale prior to June 9,
1997, of identical stock borrowed from a broker, identified the short sale and the stock
as offsetting positions in accordance with the transition rule in ' 1001(d)(2) of the
Taxpayer Relief Act of 1997, 1997–4 (Vol. 1) C.B. 1, 121, and continues to hold the
appreciated stock, does a transfer of stock borrowed from another broker to satisfy the
obligation to the first broker cause the transition rule to cease to apply?

FACTS

In January 1997, Taxpayer TP owned 100 shares of XYZ stock. In May 1997, at
a time when the value of the XYZ stock exceeded TP’s basis in the stock, TP effected a
short sale (the Short Sale) of 100 shares of XYZ stock. To do this, TP borrowed 100
shares of XYZ stock from Broker A and instructed Broker A to sell those borrowed
shares on TP
’s behalf. Thus, as a result of the Short Sale, TP incurred an obligation to
transfer 100 shares of XYZ
stock to Broker A. Before September 4, 1997, in its books
and records, TP
clearly identified the Short Sale and the XYZ stock (which TP still
owned) as offsetting positions under ' 1001(d)(2) of the Taxpayer Relief Act of 1997.

In January 2004, TP decides to replace its obligation to Broker A with a
substantially identical obligation to Broker B. To do so, TP arranges for Broker B to
deliver 100 shares of XYZ stock to Broker A in satisfaction of TP=s obligation to
Broker A, and TP thus incurs an obligation to transfer 100 shares of XYZ stock to
Broker B
. After Broker B’s transfer of 100 shares of XYZ stock to Broker A, TP
continues to have the obligation to deliver 100 shares of XYZ
stock, but the obligation is
owed to Broker B
rather than to Broker A.

TP continues to hold the XYZ stock, and TP has not satisfied its obligation to
Broker B.

2

LAW AND ANALYSIS

(1) Section 1233

Section 1.1233-1(a)(1) provides, “For income tax purposes, a short sale is not
deemed to be consummated until delivery of property to close the short sale.” Pursuant
to ' 1.1233-1(a)(4), if the short sale is made through a broker and the broker borrows
property to make a delivery, the short sale is not deemed to be consummated until the
obligation of the seller created by the short sale is finally discharged by delivery of
property to the broker to replace the property borrowed by the broker.

In general, a short sale is closed (and thus is consummated) by the transfer of
property that the short seller already owns or property that the short seller purchases for
the purpose of satisfying the obligation from the short sale. If, however, a taxpayer
satisfies its obligation created under a short sale by transferring property borrowed from
another lender, the transfer of the borrowed property does not close the short sale. In
Richardson v. Commissioner
, 42 B.T.A. 830, 840 (1940), aff’d, 121 F. 2d 1 (2d Cir.
1941), the taxpayer borrowed stock to sell short. With respect to a portion of the
borrowed stock, the taxpayer subsequently borrowed other stock from another lender to
satisfy the obligation that resulted from the original borrowing. The taxpayer later
satisfied the obligation under the second borrowing by transferring shares that he
purchased. The Board of Tax Appeals required the taxpayer to recognize the gain or
loss in the year in which the obligation from the second borrowing was satisfied, and the
Board calculated the amount of the gain or loss on the short sale by reference to the
purchase price of the stock used to satisfy the second borrowing. Although the opinion
does not discuss the effect of using borrowed shares to satisfy an obligation to replace
other shares previously borrowed from another lender, it is implicit in the computation of
gain or loss that the satisfaction was not treated as closing the short sale.

Section 1.1233–1(a) does not require a different result. When a taxpayer
transfers borrowed property to satisfy its initial obligation under a short sale, the
taxpayer’s short sale obligation is not “finally discharged.” Here, the obligation of TP
to
deliver 100 shares of XYZ
stock continues to exist, and thus Broker B’s delivery of
borrowed stock to Broker A
on TP’s behalf does not close the Short Sale under
' 1.1233–1(a).

(2) Section 1259 Transition Rule

Section 1259(a)(1) provides that, if there is a constructive sale of an appreciated
financial position, the taxpayer must recognize gain as if the position were sold,
assigned, or otherwise terminated at its fair market value on the date of the constructive
sale. “Appreciated financial position” is defined in ' 1259(b)(1) as including a position
with respect to stock if there would be gain were the position sold, assigned, or
otherwise terminated at its fair market value. Pursuant to ' 1259(c)(1)(A), a taxpayer is
treated as having made a constructive sale of an appreciated financial position if the
taxpayer enters into a short sale of the same or substantially identical property.

3

Under ' 1001(d)(2) of the Taxpayer Relief Act of 1997 (the transition rule), if
Abefore June 9, 1997, the taxpayer entered into any transaction which is a constructive
sale of any appreciated financial position, and . . . before the close of the 30–day period
beginning on the date of the enactment of this Act [August 5, 1997] or before such later
date as may be specified by the Secretary of the Treasury, such transaction and
position are clearly identified in the taxpayer=s records as offsetting, such transaction
and position shall not be taken into account in determining whether any other
constructive sale after June 8, 1997, has occurred. The preceding sentence shall cease
to apply as of the date such transaction is closed or the taxpayer ceases to hold such
position.” Section 1001(d)(2) of the Taxpayer Relief Act of 1997, 1997–4 (Vol. 1)
C.B. 1, 121.

In May 1997, when the value of the XYZ
stock exceeded its basis, TP entered
into the Short Sale. Thus, TP entered into a transaction that is described in
' 1259(c)(1), but, because the Short Sale was entered into before June 9, 1997, no gain
was recognized under ' 1259(a)(1).

Furthermore, before the close of the 30-day period beginning on August 5, 1997,
TP clearly identified the XYZ stock and the Short Sale in its books and records as
offsetting positions. Thus, the XYZ
stock and the Short Sale fall within the transition
rule, and, until either TP ceases to hold the XYZ stock or the Short Sale is closed,
neither the XYZ stock nor the Short Sale is taken into account in determining whether
any constructive sale has occurred after June 8, 1997.

In January 2004, when TP
replaces the obligation to Broker A with the obligation
to Broker B, TP continues to hold the XYZ stock, and the Short Sale has not been
closed for purposes of ' 1.1233-1(a). Accordingly, the transition rule continues to apply
to the Short Sale and the XYZ stock.

HOLDINGS

(1) When, as a result of the Short Sale, TP
is obligated to transfer stock to
Broker A
and TP satisfies the obligation by causing Broker B to transfer stock that TP
borrows from Broker B
, the transfer of the borrowed stock does not close the Short Sale
under ' 1.1233–1(a).

(2) Because replacing the obligation to Broker A
with the obligation to Broker B
does not close the Short Sale under ' 1.1233–1(a), the transfer does not cause the
transition rule to cease to apply to either the Short Sale or the XYZ
stock.

DRAFTING INFORMATION

The principal author of this revenue ruling is Kate Sleeth of the Office of
Associate Chief Counsel (Financial Institutions and Products). For further information
regarding this revenue ruling, contact Ms. Sleeth on (202) 622-3920 (not a toll-free call).