Case Study: Tax Ownership and Stock Held in Prime Brokerage Accounts

In my last post on tax ownership, I discussed AM 2010-005 and basket options and left you with a cliffhanger…

ive been expecting you

In the memorandum, it appears that the IRS analogizes the arrangement between the taxpayer and the bank to stock held in a prime brokerage account.  While there are some differences, the analogy does appear appropriate in some respects:  (1) the taxpayer (at least per the IRS’ argument) has full control over the stock in an account, (2) the bank provides financing to the taxpayer for a financing charge, (3) the bank appears to have the ability to re-hypothecate stock in the account, and (4) the taxpayer appears to substantively have full opportunity for gain and risk of loss.  While there are some notable differences, these are some of the things you’d see in a margin account.  Of course, the IRS uses this analogy to bring home the point that, just like a customer who owns stock in a margin account, the customer must be considered the owner of the underlying reference.  Here, we examine whether that’s true.

One caveat before I start this:  I’m not a master of how brokerage accounts work, but I have a working knowledge (and the ability to google things).  

Stock held in cash accounts.  Before we slide into a discussion of margin accounts, however, we should make a brief stop in cash accounts.  This is probably the type of account that most people are quite familiar with.

Unconfusingly enough, it’s simply an account where you buy stock for cash.  From a tax ownership perspective, the important thing to remember about this account is that the broker typically cannot borrow shares in this account and cannot otherwise rehypothecate those shares.  In this, the broker is acting as a custodian.

Because the broker does not have the power to dispose of the shares (and the beneficial owner of the account does), I think it’s fairly easy to declare the beneficial owner the tax owner of the shares.  Therefore, the beneficial owner is not deemed to sell the shares by holding them in this account and when dividends are paid, the beneficial owner of the account would receive a “real” dividend and not a substitute dividend.  Easy.

Stock held in margin accounts.  While it’s possible to have securities purchased for cash in a margin account, for purposes of this discussion we’ll assume that stock held in a margin account was bought on margin; that is, it was purchased, in part, with a loan from the broker.

Unlike stock held in a cash account, stock held in a margin account can typically be rehypothecated by the broker.  Here are links to two margin account applications I could find online:  Margin Account Application 1 and Margin Account Application 2.   They both have provisions that deal with rehypothecation.  For example, one of the agreements provides, in part, as follows:

Note that property in a margin account may be pledged or repledged, hypothecated (loaned) or rehypothecated, either separately or in common with any other property, for as much as your obligation to us or more, without our having to retain a like amount of similar property in our control for delivery.

Generally, pledgees of stock can only dispose of collateral in the event of default.  However, the right to rehypothecation is generally the right of a prime broker to re-use client assets for its own purposes.   When assets are rehypothecated, title to those assets transfers to the prime broker and the prime broker’s only obligation is to return ‘equivalent assets’. If the prime broker becomes insolvent in the meantime, the customer will likely become a mere unsecured creditor of the broker.

A broker who is given a right of re-hypothecation can exercise this right and dispose of the stock, typically by means of sale, repo, or loan to another third party.  While there are certain legal limitations on the ability of the broker to rehypothecate stock in margin accounts, this regulatory landscape is too vast to describe here (and I’m not the one to do it)..

But what does all of the above mean for tax ownership?  Well, to the extent that the broker actually rehypothecates a security, it’s pretty much a done deal.  The prime brokerage customer could not possibly be considered the owner of the stock.  The arrangement now looks almost exactly like a stock loan arrangement whereby the stock lender loaned shares to the borrower who used the shares to close out an unrelated short sale.  Like the stock lender, a prime brokerage customer in such case should generally not be considered the owner of shares that have been rehypothecated.

But the more interesting case arises when shares have been purchased on margin but haven’t been rehypothecated.  Is the prime brokerage customer the owner of those shares?  This can be important because brokers may themselves borrow shares from other parties over dividend dates to place in a margin customer’s account.  This presumably allows the customer to receive a “real” dividend and not a substitute dividend.  This may be important for tax sensitive margin loan account holders who want to obtain the preferential tax rate that applies to so-called “qualifying dividend income”.  This lower rate only applies to dividends paid on shares actually held, not to “in lieu of” dividend payments  Therefore, it’s important that the prime brokerage customer (and not the broker) be treated as the owner of the shares for tax purposes.

However, there is a slight problem here.  For shares purchased on margin, the broker has the right to dispose of the shares, even if the shares are just sitting there.  It’s simply a right that the broker hasn’t exercised.  This strikes me as problematic from a theoretical perspective because I believe the power to dispose is the relevant inquiry for tax ownership.  In my mind, an actual disposition simply proves that the right to dispose existed; that is, it removes any doubt that the right existed in the first place.  It’s evidence of, but not a requisite for, transfer of ownership.  Think of it this way, if you give someone your car and tell them they can do whatever they want with it, do you still own the car even if they leave it on the curb overnight?  Or, using my “go to” analogy, if you lend someone $1,000, and they keep the money you loaned on their nightstand for a week, are those specific dollar bills still yours?   Is the broker having the right to dispose of the shares and simply not exercising it different from these examples?

There is one other aspect of this arrangement I’d like to consider though.  The prime brokerage customer does retain the ability to “de-margin” and, in doing so, restrict the ability of the broker to rehypothecate the shares.  Basically, the customer turns the margin shares into cash shares.  Now, the question before us is whether the power of the customer to “re-possess” is enough for the customer to claim actual ownership over shares that the broker has the power to dispose of.  I tend to think not.

The problem with this customer’s “power” is that it has the feel of a condition subsequent and not a condition precedent.  Recall in my discussion about conditions as it relates to options, where there is a condition precedent to the power to dispose, it is natural to conclude that the person whose power is subject the condition is not the owner because they can’t exercise that power until the condition has been satisfied.  A condition subsequent turns off a power that one possesses.  In this case, the broker’s power to dispose is in the “on” position and the customer can flip it to the off position.

In a way, the exercise of the customer’s power here (from the customer’s perspective) seems like it’s subject to a similar condition that would apply to the purchase of a house.  The purchaser of a house can’t get the house until the settlement/closing date (ie., the date they actually pay the cash), and the customer cannot take away the broker’s power until they pay cash for the shares.  Some might argue that the customer is exercising power over the shares when they sell stock A and buy stock B.  However, it’s easy enough to counter that they simply terminated stock loan on A and entered into new stock loan on B.

Given the above, I think there are some very problematic theoretical issues in treating customers as owners of stock in margin accounts.  Does this mean everyone who holds stock on margin is at real risk that they will not earn a “real” dividend?

Probably not I’d be surprised if the IRS actually pursued this angle.  I’d guess they would take the opposite view.

While you may not take a lot of comfort in my guesses, there is some comfort one could take from Treas. Reg. Sec. 1.6045-2 which sets forth rules as to how broker’s may allocate “in lieu of” dividend payments to the specific owners known to have had their shares loaned out based on the broker’s records.  These rules are written in such a way that they apply to allocations of shares actually transferred by the broker.  In other words, Treasury did not require “in lieu of” dividend payments to be associated with shares that were held in margin accounts but had not yet been rehypothecated.

Therefore, there’s probably very little to worry about from a practical perspective.

Circling back to AM 2010-005.

Well, what does this mean for AM 2010-005 and the IRS claim the hedge fund was really the owner of the shares?  Does the taxpayer have an opening because the Bank in AM 2010-005 had the power to re-hypothecate?

Actually, no.  It really doesn’t mean a heck of a lot.  The taxpayer would still not be a in a good position.  Whether the taxpayer is viewed as buying and selling shares or terminating and opening stock loans, the tax result will be similar in that the taxpayer will not be able to get long-term gain.  So yeah, I tricked you into thinking there was a cliffhanger.  How does that feel?

charlie chaplin

Sorry.

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