Read it here: How short sales circumvent the capital gains tax system [pdf]
Six months ago, u/jackofspades123 and I had a wonderful conversation where we tried to sleuth out how Short Sales avoid taxes.
Tonight, we found the smoking gun, and it was right in front of us all the entire time.
I give credit and thanks to Jack for co-piloting this 6 month long rollercoaster and for not giving up.
TLDR?
- US Tax Law is both precise and absurd.
- Our definition of a Short Sale is wrong.
- We found the smoking gun.
Normally, I like the meat and potatoes style DD, but tonight, we’re making beef wellington.
Example
- You borrow the stock. You put a liability on your books for the total market value of the stock at the time of the borrow. You sell the shares for market value. Your trade’s assets and liabilities are even, so your books are neutral.
- A Realized Gain occurs when you sell something for a profit, like a stock. You pay Capital Gains Taxes on Realized Gains. The formula for capital gains tax is: ($ Sell – $ Cost ) * Tax Rate.
- Short-selling does not incur a Realized Gain, therefore there is no Capital Gains Tax.
Jack, we were so fucking close.
The clue is in #2. Readers, see if you can figure out why #3 is correct before scrolling down.
Solution
I expected the short sale to trigger a taxable event of Realized Gains and incur Capital Gains Tax. I expected ~100% profit now, less any fees for the borrow, and then get a tax break later for the business expense of buying back the shares. You’d have these incredibly fun rolling windows of taxable events now and tax breaks later, but computers and accounting software can already do all that. You’d net profits on the difference in price, minus the fun rolling taxes.
Except that’s not quite how it works, and this paper, “How short sales circumvent the capital gains tax system,” by Russell Stanley Q. Geronimo (PDF) explains how.
The Meat
Pages 10-11: In an ordinary sale, the taxable realization event is the sale, pursuant to Section 40(C) of the NIRC, which states, “[…] upon the sale or exchange of property, the entire amount of the gain or loss, as the case may be, shall be recognized.” Accordingly, the date of realization in an ordinary sale is the date of the sale.[57] This is pursuant to the longstanding income tax principle that capital gains are recognized when they are realized, and they are realized when capital assets are sold, transferred, exchanged or disposed.[58]The situation is different in a short sale. Here, the traditional buy-and-sell sequence is reversed, and then he subsequently purchased identical shares.[59] Of course, at the time that he sold the shares at time 2, he did not yet know the basis of the shares. It was only at time 3, when he bought shares to replace the borrowed shares, did X determine the cost of replacing the borrowed shares, and therefore the basis of the stock.[60][58]: This requirement was adopted from the U.S. income tax system and which originated from the Supreme Court ruling in Eisner vs. Macomber (252 U.S. 189, 1920), where it was held that a taxable gain must be derived and severed from capital. The Eisner doctrine was applied domestically in CIR vs. A. Soriano Corp., G.R. No. 108576 January 20, 1999.
The part, “[…] upon the sale or exchange of property, the entire amount of the gain or loss, as the case may be, shall be recognized,” is why I expected Realized Gains to occur at the time of selling the borrowed stock.
The bolded portion, “at the time that he sold the shares at time 2, he did not yet know the basis of the shares,” explains the key issue in my point 2 above about Realized Gains and Capital Gains Taxes.
#2. Capital Gains Taxes occurs when you sell an asset for a profit (Realized Gains). The formula is not Capital Gains Tax = Profit * Tax Rate. The formula for Capital Gains Tax = ($ Sell – $ Cost ) * Tax Rate.
The taxes are determined upon completion of the short sale, because you cannot establish your cost basis until you close the position. If you never cover OR close your position, you get the revenue now without cost basis in exchange for an outstanding liability.
In reality, you can send the shorted company into a death spiral and then a years-long bankruptcy process.
The Crust
We keep looking at a Short Sale as the borrow & sell. But the IRS’s definition of a completed Short Sale is the borrow, sell, & return of the shares.
Page 11: This special realization rule was upheld in Doyle v. Commissioner, which states that a “short sale is completed on the date the sale is covered, not at the time the order for the sale was entered into.” … By “covered”, we mean that the obligation to return the borrowed stock has been complied with.
It doesn’t matter if the SHF covered or closed the transaction, only that they returned shares. The case was in 1961.
The Seasonings
Did I say the same thing two ways? Yes. We confirmed with the formula. We confirmed with case law. Even if we exclude the paper (whose conclusions I agree with), we still have two independent sources that agree.
Dessert
Pages 6-7: Section 2(r) of the Rules on Securities Borrowing and Lending (SEC Memorandum Circular No. 7 series of 2006) defines a securities borrowing and lending agreement, as follows:Securities Borrowing and Lending (SBL) means the lending of securities from a lender’s portfolio on a given date to a borrower’s portfolio to support the borrower’s trading activities with the commitment of the borrower to return or deliver said securities or equivalent to the lender on a determined future date. This is also referred to as a Securities Lending Transaction (SLT).
I don’t even know where Naked Shorts fall in this mess, but they don’t fit this definition because the bolded portion doesn’t fit, and that’s how law works.
Sprinkles
This whole paper is fantastic and worth a read. I especially recommend Page 28, Paragraph 1.
In Ocier vs. Commissioner of Internal Revenue[125], Jerry Ocier transferred 4.9 million shares of Best World Resources Corporation (hereinafter referred to as BW shares) to Dante Tan. The transfer was allegedly made pursuant to a stock lending agreement, denominated as a trust declaration, with Ocier as lender and Tan as borrower. The BIR construed the transfer as a sale and assessed a deficiency capital gains tax of P17.86 million to be paid by Ocier. Disregarding the claim of Ocier that the transfer was made pursuant to a stock lending agreement, the Court of Tax Appeals (CTA) states that a securities borrowing and lending agreement is a non-taxable transaction, but only if it complies with the formalities required by regulation. In this case, the trust declaration between Ocier and Tan was not prepared in accordance with the BIR guidelines on securities borrowing and lending agreements. Accordingly, Ocier was liable for deficiency capital gains tax.
Commissioner of IRS.