Loans Of Securities, Digital Assets, And Other Fungible Property

• Published date: 03 December 2021
• Subject Matter: Finance and Banking, Corporate/Commercial Law, Technology, Financial Services, Corporate and Company Law, Securities, Fin Tech
• Law Firm: Shearman & Sterling LLP
• Author: Mr Michael Shulman

I. Introduction

Securities loans are financial transactions critical to the operation of efficient trading markets. Although these transactions predate the existence of the federal income tax,¹ there are still many important unanswered questions regarding their tax treatment. Further, loans of fungible property other than securities (for example, digital assets or master limited partnership (MLP) units)² are occurring with greater frequency ' without even the most basic of guidance on their tax treatment. This makes it worthwhile to reexamine the state of the law concerning the appropriate tax treatment of securities loans as well as the extent to which that treatment should extend to loans of non-securities property (which this report refers to as NSP).

One of the conceptual challenges regarding the tax treatment of securities loans stems from the fact that the securities borrower ordinarily transfers the securities to another person, either in a market sale or to repay a prior securities loan. That transferee becomes the tax owner of the borrowed securities. Indeed, the transferee generally is unaware that the securities it acquired were from a securities borrower (as opposed to the original owner of the securities). Because the securities have a new tax owner, the lender can no longer be their tax owner, even though it typically maintains an economic position in the securities that is substantially identical to the position it had before initiating the loan. The fact that tax ownership has been severed while economic exposure continues gives rise to numerous tax issues.

Some of those issues are addressed under current law. Most notably, section 1058 generally provides for nonrecognition treatment when securities are lent to a securities borrower (and when they are returned to the securities lender) if the agreement satisfies specified requirements. As described below, however, the application of section 1058 may be unclear in the context of some types of securities loans (for example, loans with a fixed term). The fact that regulations were proposed under section 1058 over 37 years ago and have yet to be finalized has not helped bring clarity to the treatment of securities loans. Moreover, section 1058 by its terms applies only to the lender of securities, and generally only in determining whether the lender recognizes gain or loss.

As a result, there are several aspects of the tax treatment of securities loans (such as the source of securities lending fees) that have remained stubbornly unclear over the years.³ Further, the existing authorities on the tax treatment of securities loans, including section 1058, do not directly address...