Rev Proc 2008-63, 2008-42
The following article is from the 10/2/08 issue of Federal Taxes Weekly Alert.

A NEW revenue procedure concludes that no gain or loss will be recognized under Code Sec. 1058(a) if a lender of securities timely purchases replacement securities after the borrower defaults on the agreement because of the borrower's bankruptcy.

RIA observation: The new revenue procedure appears to be a direct consequence of the bankruptcy filing of Lehman Brothers.

Background. Many financial institutions, including mutual funds and hedge funds routinely lend securities they own to broker dealers. In this type of arrangement, the lender holds collateral from the borrower at least equal to the value of the securities they have lent. When a borrower defaults on the arrangement, the borrower has the right to use the collateral it holds to buy replacement securities for the securities that it lent. As explained in a document submitted to the Treasury and released under the Freedom of Information Act, many such default clauses have been triggered by the bankruptcy filing of Lehman Brothers, a major borrower in the securities markets.

Tax concerns. Under Code Sec. 1058(a), if a taxpayer transfers securities (as defined in Code Sec. 1236(c) under an agreement meeting the requirements of Code Sec. 1058(b)), no gain or loss is recognized on the exchange of such securities by the taxpayer for an obligation under such agreement, or on the exchange of rights under such agreement by that taxpayer for securities identical to the securities transferred by that taxpayer.

Concerns have been raised that a default under a securities lending arrangement would not be covered by Code Sec. 1058 and would instead be treated as a recognition event.

Non-recognition treatment. Rev Proc 2008-63 provides that the purchase of replacement securities will be treated as an exchange of rights under a securities lending agreement for identical securities to which Code Sec. 1058(a) applies if all the following conditions are met:

... The securities loan agreement ("Agreement") satisfies the requirements of Code Sec. 1058(b);

... The Agreement requires the borrower (unrelated to the lender) to transfer collateral to secure the borrower's obligations under the agreement; ... The borrower defaults under the Agreement as a direct or indirect result of its bankruptcy (or the bankruptcy of an affiliate); and

... As soon as is commercially practicable after the default (but in no event more than 30 days following the default), the lender applies collateral provided under the Agreement (or cash generated by the sale of such collateral) to the purchase of identical securities.

IRS says no inference should be drawn about whether similar consequences will obtain if a securities loan falls outside the scope of Rev Proc 2008-63. References: For loans of securities to brokers — non-recognition of gain, see FTC 2d/FIN ¶ I-1311; United States Tax Reporter Income ¶ 10,514; Tax Desk ¶ 221,007; Tax Guide ¶ 12002.  

— Published in the October 2, 2008, issue of the Federal Taxes Weekly Alert available from the Tax & Accounting business of Thomson Reuters. Copyright © October 2008.