A stock loan is not very different conceptually from a money loan. In a money loan, the borrower borrows money from a lender (which the borrower must later return) and the borrower uses that money to buy things, maybe even stock. In a stock loan, the borrower borrows stock from a lender (which the borrower must later return) and the borrower uses that stock to buy things, likely money. In the money loan, the borrower pays interest; in a stock loan, the borrower pays a fee. In a money loan, the borrower may have to collateralize the loan with property (like stock); in the stock loan, the borrower may have to collateralize the loan with property (like money).
The derivative that is typically created by a money loan is referred to as debt. The derivative that is typically created by a stock loan is, rather boringly, referred to as a stock loan.* The one big difference between the two is that virtually everyone is familiar with the lending of money where only a smaller subset of people is familiar with a stock loan. But, if you are familiar with money loans, the analysis of the tax ownership issue in stock loan is pretty much the same.
For this analysis, let’s start with a money loan. In this case, I want you to think of the specific dollar that the lender is transferring to the borrower. In other words, mark that dollar with a specific symbol that is near-and-dear to you (it’s, of course, quaint to still think of money in physical terms, but bear with me). For example: I will mark mine with something from Buffy the Vampire Slayer:
Now if you, or any lender for that matter, transfers that bill as part of a loan to the borrower, do you consider yourself the owner of that specific dollar bill? Do you expect to ever see it again? No way. You gave the borrower complete dominion over that dollar bill and, in all likelihood, that borrower will quickly transfer ownership of that specific dollar to someone else. Moreover, you have no claim over any other specific dollar bill in the borrower’s possession. Therefore, the lender would not view themselves as the owner of that dollar bill with the original markings and there’s no replacement bill that the lender could lay claim on over the term of the contract..
That’s pretty much typical of a stock loan as well. In a typical stock loan, the stock lender will grant the borrower the right to use the stock borrowed at the borrower’s own discretion. A borrower would likely be using that stock to close a short sale. That is, the borrower likely sold stock that it did not own to some third party purchaser and therefore needed to borrow the stock in order to complete the sale. Analogous to the money loan, the lender does not expect to see the exact same certificate delivered back at the conclusion of the loan, particularly since the lender gave the borrower the right to dispose of that stock. Moreover, the stock lender does not have any claim over any other specific stock during the term of the loan (i.e., they cannot prevent the borrower from using any other stock in any particular way). They expect only to receive shares back that are, in all other respects, identical to the shares that were loaned. Therefore, the lender should not view themselves as the owner of the specific stock that was loaned or any other particular stock in the borrower’s possession..
The thesis here is: the giving of property to another along with complete dominion and the control of disposition over that property constitutes the transfer of ownership to the other party. The fact that one does not expect the return of specifically identified property supports the notion that control over disposition of the property has been transferred. Note that the fact that the property is not specifically identified (that it’s fungible) does not establish that control was transferred. It just makes it easier to believe.
This was essentially the decision in the Supreme Court case Provost v. United States, 269 U.S. 443 (1926) This case fits well into my original thesis (discussed here) that it’s control over the disposition of property that determines ownership. Once the lender, in either the case of money or stock, cedes control over the disposition of the property, the property is owned by another. The Supreme Court decision summed it up as follows:
But the borrower of stock holds nothing for account of the lender….The seller [the stock borrower], having contracted to sell securities which he does not own, is under the necessity of acquiring dominion over stock of the kind and amount which he has sold, with unrestricted power of disposition of it in order that he may fulfill his contract. Whether his broker acquires the stock by purchase or by giving to the lender of it the market value of the stock plus his personal obligation to acquire and return to the lender, on demand, a like kind and amount of stock, the legal effect of the transfer is the same. Upon the physical delivery of the certificates of stock by the lender, with the full recognition of the right and authority of the borrower to appropriate them to his short sale contract, and their receipt by the purchaser, all the incidents of ownership in the stock pass to him.
The Court basically held that the lender was considered to transfer the shares for stamp tax purposes. That is, the lender was no longer considered the owner of the shares.
The import of a stock loan where a transfer has occurred is that it could result in, among other things, (a) a transfer of the shares in a transaction in which gain/loss is recognized, or (b) the lender not being entitled to a dividend-received deduction or the qualifying dividend rate because they don’t own stock on which dividends are received (See, Rev. Rul. 60-177). In the case of (a), even if such an exchange takes place, it should be noted that IRC Sec. 1058 might prescribe that no gain or loss is recognized so long as certain conditions are met even if there is a deemed exchange.**
Since I want to leave this at the “easy case”, I’m not going to go much deeper into certain stock loan twists and turns. But consider these two questions. First, what happens if the stock borrower doesn’t actually dispose of the borrowed stock. They just hold it in an account because they can’t figure out what to do with it or it has some nice design on the certificates that they like to look at. Under those circumstances, can the lender view themselves as the owner of the shares because the borrower has not “re-hypothecated” them? Spoiler alert: I think the answer is that the lender is still not the owner of the shares because it’s the power to dispose that counts, not the actual disposition. Second, and building on that, what if the borrower has not disposed of the shares but the lender also has the power to repossess the shares. Which one wins—the borrower’s right to dispossess or the lender’s right to repossess? That’s a toughie. The last situation, of course, comes close to describing the client-broker relationship when the client has purchased stock on margin.
*As mentioned in my previous post, I’m using the broad meaning of the term derivative; that is, the stock loan derives its value from stock.
** Some recent cases (Anschutz, Samueli, and Calloway) addressed this provision and we might look at those cases in the future.
Update/Addendum: One thing to keep in mind here as well. The ownership has transferred even though, between the lender and the seller, the lender has virtually 100% of the economic equivalent of owning the stock and the borrower does not and the stock was transferred directly to the borrower (well, sort of). This will become relevant when we discuss swaps.