Are Repos Really Loans

ARE REPOS REALLY LOANS?

By William W. Chip

A “repo” is the sale of a security accompanied bythe seller’s agreement to repurchase the security at alater time for the original purchase price plus a differ-ential that equates to interest between the dates of thesale and repurchase. If the security itself pays interestor dividends between the dates of the sale and repur-chase, the purchaser pays them over to the seller.

For federal income tax purposes, the Internal Reve-nue Service has long held that the sales proceeds froma repo are really a loan from the purchaser to the seller(so that the repurchase price differential is interest in-come to the purchaser and interest expense to theseller) and the transferred security is really collateral(so that the seller remains the owner of the security andof any interest or dividends paid on the security). Fewtax advisers would dispute these longstanding hold-

ings. Indeed, the ability to explain how a repo works,and the knowledge that it is taxed as a loan rather thana sale, demonstrates the adviser’s tax sophistication.

Yet, are repos really loans? The consensus that reposare collateralized loans is based on court decisions andrevenue rulings that dealt with transactions essentiallydifferent from those that constitute the vast repo busi-ness that is nowadays conducted in New York, London,and other financial centers. In the traditional repotransaction, the purchaser was a bank that purchaseda security from a customer and held onto that securityuntil the customer repurchased it. Only two partieswere involved, and the courts readily concluded thatthe bank was really a lender in the transaction and thatthe customer retained ownership of the security for taxpurposes. In contrast, the purchaser in a modern repotransaction may have the power to dispose of the se-curity that was purchased, so that the repurchased se-curity is not the same security that was purchased fromthe customer, although it may be identical in everyrespect. The longstanding notion that a repo sellerremains the owner of the security may be untenableonce tax ownership of that security has passed to athird party.

In this respect the modern repo is like a securitiesloan. A securities “lender” transfers a security in ex-change for cash or other collateral. The securities “bor-rower” commits to return an equivalent security plusa “rebate” that equates to interest on the collateral. Likea repo purchaser, a securities borrower pays over anyinterest or dividends that are paid on the security be-tween the two legs of the transaction. A securities bor-rower typically delivers the borrowed security to athird party that has purchased the security from theborrower or from one of the borrower’s customers. Foreven longer than the Service and courts have held thata repo seller remains the tax owner of the security thatit sold, the Service and courts have held that a securi-ties lender has given up tax ownership of the securitythat it lent, primarily on the grounds that a third partyhad become the owner.

If a securities lender cannot remain the owner of aloaned security once tax ownership has passed to athird party, how can a repo seller remain the owner ofa sold security that has likewise been transferred to athird party? As the economics of repos and securitiesloans converge, the disparity in tax treatment becomesmore difficult to sustain. Should a taxpayer or the Ser-

William W. Chip is a principal with Deloitte &Touche, Washington and New York City.

A repo is the sale of a security accompanied bythe seller ’s agreement to repurchase it. Repos aretraditionally treated as secured loans. A modernrepo permits the buyer to resell the security andsubstitute an identical security in the repurchasetransaction. In this respect, the author explains, amodern repo is similar to a stock loan, which hastraditionally been treated as an exchange of secu-rities. This raises a question whether modernrepos should continue to be treated as loans.

© Copyright Deloitte & Touche 2002. All rights reserved.

Table of Contents

International Tax Consequences . . . . . . . . . . . . . . . . . 1058

Tax Authorities on Repos . . . . . . . . . . . . . . . . . . . . . . . . 1058

The Modern Repo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1059

Tax Authorities on Securities Lending . . . . . . . . . . . 1061

Sale vs. Exchange? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1062

Tax Consequences of Netting . . . . . . . . . . . . . . . . . . . . 1063

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1063

TAX NOTES, May 13, 2002 1057

vice mount a court challenge to the current consensuson the tax treatment of repos, the challenge might beupheld. That would have important consequences formultinational financial institutions.

International Tax Consequences

Even a purely domestic repo business has importantinternational tax consequences for a multinationalbank or securities firm. If a repo is a loan for tax pur-poses, then the price differential paid by the repo sellerwhen it repurchases the security is interest expense.Under the section 861 regulations, a U.S. financial in-stitution with foreign operations must apportion theinterest expense between foreign and worldwide in-come in proportion to the ratio of foreign to worldwideassets, even if all of the income generated from thetransaction is from U.S. sources. This may impair theinstitution’s ability to use foreign tax credits undersection 904. Under the section 882 regulations, a foreignfinancial institution with a U.S. branch suffers an equi-ty “haircut” on the interest expense, even if all of theincome generated from the transaction is taxable aseffectively connected income.

Even a purely domestic repo businesshas important international taxconsequences for a multinational bankor securities firm.

The starkest example of the negative arbitrage thatresults from treating repo price differentials as interestoccurs in a “matched book” repo business. A dealerrunning a matched book purchases securities from acustomer or dealer that owns securities but needsmoney (the reverse repo) and sells them to a customeror dealer that has money but needs securities (therepo). The dealer agrees to repurchase the securityfrom the repo purchaser, and the reverse repo selleragrees to repurchase the security from the dealer. Thedealer profits from any “spread” in the price differ-entials.

Very recently, in Technical Advice Memorandum200207003, Doc 2002-3903 (4 original pages), 2002 TNT33-26, the Service ruled that the repo transactions in adealer ’s “matched book” generated interest expensethat had to be allocated between income from U.S. andforeign sources, notwithstanding that the repos were“matched” with reverse repos that generated incomeonly from U.S. sources. The taxpayer had instead beennetting the income and expense and reporting the netamount as a service fee, which had the effect of directlyallocating 100 percent of the repo interest expense tothe reverse repo interest income. To refute the tax-payer ’s netting approach, the Service cited courtdecisions and revenue rulings that held repos are col-lateralized loans. According to the memorandum, the“Service is not aware of any legal authority . . . thatdoes not treat repos as collateralized loans for federaltax purposes.”

The assertion that a dealer running a matched bookis really an intermediary providing a service is a

reasonable characterization of the economics of thebusiness.1 Nevertheless, because is it always difficultfor a taxpayer to argue against the form in which itchose to frame a transaction, the Service would havethe upper hand were it to contend that matched bookrepos involved sales and repurchases, not the perfor-mance of services. However, in TAM 200207003, theService did not argue in favor of the form of the trans-actions. Had the transactions been characterized inaccordance with their form, as sales and repurchases,losses on the repos would have been netted againstgains on the reverse repos, producing the same resultas was reported by the taxpayer, albeit on differentgrounds. To avoid netting, the Service had to agreewith the taxpayer that the substance of the matchedbook repo business differed from its form but thendisagree as to the substance. In so doing, the Service ison less solid ground because participants in the finan-cial services industry probably have a better notion ofthe substance of modern financial transactions thandoes the government.

As noted above and explained below, all of the legalauthorities that characterize repos or reverse repos fortax purposes dealt with sales and repurchases of thesame security. TAM 200207003 is the first official con-sideration of a repo in which the purchaser was per-mitted to dispose of the purchased security androutinely did so. By relying on authorities that dealtwith essentially different transactions, rather thananalyze the matched book transaction as a matter offirst impression, the Service arguably erred in itsanalysis, although not necessarily in its conclusion.

Tax Authorities on Repos

Repos have been around for a long time, and thecase law on repos begins with early decisions of theBoard of Tax Appeals. In both the earlier and latercases, the issue has always been whether the repo pur-chaser is entitled to treat a portion of its profit as tax-exempt interest on the security. In First Nat’l Bank ofWichita v. Commissioner,2 the taxpayer was a bank thatpurchased municipal bonds from a bond dealer underan agreement that entitled, but did not require, thedealer to repurchase them. The court found that thetransaction was structured as a sale only to circumventa restriction on how much the bank could lend to asingle customer. Although the dealer was not legallybound to repurchase the bonds, the board found: “Atno time were any bonds placed by this company withthe bank under repurchase agreements ever sold toanyone other than the company; and in no case did thecompany ever fail to repurchase such bonds for theamount advanced with interest.”3 Based on those facts,the board held that the “true relationship” between thedealer and the bank was that of borrower and lender,

1Saul Rosen, “Securities Industry Seeks Regulatory Ex-clusion From PFIC and Excess Passive Assets Rules,” TaxNotes, Dec. 5, 1994, p. 1192.

219 B.T.A. 744 (1930), aff’d 57 F.2d 7 (10th Cir. 1932).319 B.T.A. at 747.

COMMENTARY / SPECIAL REPORT

1058 TAX NOTES, May 13, 2002

that the bank held the bonds only for security, and thatthe bank was therefore not entitled to exclude anyamount as tax-exempt bond interest.

In General Counsel Memorandum 12355,4 the Gen-eral Counsel of the Internal Revenue Service citedWichita in opining that an agreement to sell and repur-chase securities was really a loan collateralized by thesecurities. In arriving at his opinion, the General Coun-sel stated that it appeared from the agreement that “theidentical securities which are ‘sold’ to the bank arerequired to be held by it for repurchase by the cus-tomer, and that the customer is entitled to demand andreceive such identical securities when he performs hisagreement to repurchase.”

The board’s decision in Wichita was discussed andanalyzed in American Nat’l Bank of Austin v. U.S.,5

which held that a bank that “took up” state bond issueson behalf of dealers and held them until the dealerssold them to their customers was a lender of moneyrather than a purchaser of securities for tax purposes.The rationale of American Nat’l Bank of Austin was fol-lowed in First American Nat’l Bank of Nashville v. U.S.,6

which involved similar facts, and also in Union PlantersNat’l Bank v. U.S.,7 which involved facts similar to thosein Wichita.

In Revenue Ruling 74-27,8 the Internal Revenue Ser-vice cited American Nat’l Bank of Austin and FirstAmerican Bank of Nashville as authorities for updatingand restating its 1933 holding in General CounselMemorandum 12355. The reverse repo agreements atissue provided that “the identical securities which are‘sold’ to the bank are required to be held by it forrepurchase by the customer.”

Revenue Ruling 74-27 was cited in Revenue Ruling77-59 and Revenue Ruling 79-1089 in arriving at thesame conclusion with respect to reverse repos enteredinto by, respectively, a real estate investment trust anda municipality. In Revenue Ruling 77-59, no specificsecurity was credited to the real estate investmenttrust’s account and possession of the securities wasnormally not transferred to the trust. In RevenueRuling 79-108, there was an understanding that thesecurities transferred to the municipality would be“retransferred” to the dealer from which they werepurchased.

In Nebraska Dep’t of Revenue v. Loewenstein,10 theSupreme Court upheld a State of Nebraska ruling thatincome from reverse repos of federal securities was noteligible for the state tax exemption of income fromthese securities. The Loewenstein decision is important,not only because it came down from the SupremeCourt, but also because of the Court’s unique analysis.

All of the prior cases took for granted that the tax-payer ’s entitlement to the tax benefit associated withinterest on the securities depended on whether the tax-payer had purchased the securities or merely taken asecurity interest. The Loewenstein decision stated incontrast that it did not matter whether the taxpayer“owned” the securities and it therefore did not matterwhether the securities had been “sold.”11 What mat-tered was that the taxpayer’s profit from the transac-tion was “in economic reality” tied to the cash that hadbeen transferred to the seller rather than to the couponson the securities.12 While the Loewenstein analysis wasunique, the conclusion was not — the purchaser ’sreturn on the transaction could not be characterized asincome from the security.

The Modern Repo

In all of the court decisions and revenue rulingsholding that repos were collateralized loans, it wasexpressly stated or apparent from the statement of factsthat the purchaser of the securities was going to holdonto the securities until they were repurchased by theoriginal seller.13 Yet, in a modern repo the security thatis “repurchased” by the repo seller is frequently notthe same security that was sold in the first leg of thetransaction.

The master repo agreement endorsed by the PublicSecurities Association and the International SecuritiesMarket Association does not require the repo purchaserto return to the repo seller the same securities that werepurchased. The repo purchaser is obliged only toreturn securities “equivalent” to the securities thatwere purchased. “Equivalent” securities are defined assecurities that are part of the same issue and are iden-tical as to amount, type, description, and nominalvalue.

The repo purchaser ’s ability to sell the purchasedsecurities and satisfy its repurchase obligation withequivalent securities does not change the proper ac-counting of the transaction, which must be reported asa secured loan under Generally Accepted AccountingPrinciples (GAAP). According to Paragraph 9 of Finan-cial Accounting Standard 140, the critical question indetermining whether securities have been sold ratherthan posted as collateral is whether the transferor hassurrendered control of the securities, and a transferoris considered to have retained effective control if thereis an “agreement that both entitles and obligates thetransferor to repurchase or redeem them before theirmaturity.” Paragraph 100 provides that “contractsunder which the securities to be repurchased need notbe the same as the securities sold, qualify as borrow-ings if the return of substantially the same . . . securities

4XII-2 C.B. 100 (1933).5421 F.2d 442 (5th Cir. 1970).6467 F.2d 1098 (6th Cir. 1972).7426 F. 2d 115 (6th Cir. 1970), cert. denied 400 U.S. 827

(1970).81974-1 C.B. 24.91977-1 C.B. 196 and 1979-1 C.B. 75, respectively.10513 U.S. 123 (1994).

11513 U.S. at 133-34.12513 U.S. at 134.13Although the matter was not discussed in Loewenstein,

the parties had stipulated to a form of agreement that pro-hibited reselling the securities to third parties. Brief of AmicusCuriae Investment Company Institute, 1993 U.S. Briefs 823,Nebraska Dept. of Revenue v. Loewenstein, 513 U.S. 123 (1944).


TAX NOTES, May 13, 2002 1059

as those concurrently transferred is assured.” In otherwords, financial institutions must account for repos assecured lending transactions whether or not the secu-rities purchaser must return the same security, as longas the security is “substantially the same.”

Notwithstanding that modern GAAP accounting ofrepo transactions follows the traditional tax treatment,the traditional tax treatment is premised on assump-tions that often no longer apply. In the repo rulings andcases, the parties had entered into a complex financialtransaction that took the form of a sale but had theeconomics and other indicia of a loan. Under thosecircumstances, the courts and the Service could ex-amine both the formal agreement of the parties andtheir course of behavior to discover the real agreementbetween the parties and the “real owner” of the secu-rity. Many facts could have a bearing on that deter-mination, and the courts found that a sale rather thana loan had occurred in cases with facts only slightlydifferent from those in cases in which a loan wasfound.14 However, when the security in question hasbeen transferred by the repo purchaser to a third party,there is no need to scrutinize the arrangement betweenthe repo seller and repo purchaser to discern the “realowner” of the security. Unequivocally, neither the reposeller nor the repo purchaser is the owner.

Notwithstanding that modern GAAPaccounting of repo transactionsfollows the traditional tax treatment,the traditional tax treatment ispremised on assumptions that oftenno longer apply.

Because all of the repo authorities were premised onthe repo seller ’s continuing ownership of the security,it may be that none of them controls the tax treatmentof modern repos in which the repo purchaser may anddoes transfer ownership of the security to a third party.If the repo seller no longer owns the security, the trans-fer to the repo purchaser is difficult to characterize asa mere transfer of collateral, and the tax consequencesmay have to be determined under section 1001, whichprovides for the recognition of gain or loss from the“sale or other disposition of property.” Treasury reg.section 1.1001-1(a) provides that “the gain or loss real-ized from the conversion of property into cash, or fromthe exchange of property for other property differingmaterially either in kind or in extent, is treated as in-come or as loss sustained.”

A repo seller receives cash from the repo purchaserplus the repo purchaser ’s commitment to return anequivalent security. The tax result will depend on howthe transaction is analyzed. If the transaction is bifur-cated into a sale and repurchase, in accordance with its

form, then the repo is a taxable sale followed by apurchase of equivalent property in which the reposeller acquires a basis equal to the repurchase price.There would be no interest income or expense for pur-poses of the interest allocation rules of section 861 or882. If the transaction is bifurcated into a cash transac-tion and a securities transaction, then the cash transac-tion is likely treated as a loan, the securities transactionis likely treated as an exchange, and sections 861 and882 would apply to the interest expense arising fromthe loan.

If the security that is sold is treated as exchanged, aquestion arises whether it is exchanged for the securitythat is repurchased or exchanged for the repopurchaser ’s obligation to deliver that security. If thereis an exchange of securities, the exchange is likely tobe a nonevent for tax purposes because a security thatis “equivalent” under current repo arrangements is notlikely to differ “materially either in kind or scope” fromthe originally purchased security. However, if the se-curity that is sold is treated as exchanged for thepurchaser ’s obligation to deliver equivalent securities,then there may have been a taxable disposition. InCottage Savings Ass’n v. Commissioner,15 the SupremeCourt held that an exchange of interests in eco-nomically equivalent mortgage pools was a taxabledisposition because the obligors on the mortgages weredifferent. In a repo transaction, the repo purchaser ’sobligation to deliver equivalent securities (and to payover interest or dividends on the securities in the mean-time) is economically equivalent to holding the secu-rity, but the repo purchaser and the issuing entity areclearly not the same obligor.

Were one to rely only on the traditional repo author-ities, one might conclude that the default classificationfor a repo that is not a collateralized loan is a sale ratherthan an exchange. All of the cases that did not charac-terize repos as secured loans characterized them in-stead in accordance with their form, that is, as sales.However, part of the rationale of those cases was thatthe repo seller was not really obligated to repurchasethe security.16 Consequently, they may not govern thetax character of a modern repo, in which the purchasermay dispose of the purchased stock but in which theseller is genuinely obligated to “repurchase” anequivalent security.

As a general rule, when a taxpayer sells property toanother person and purchases property from the sameperson in “reciprocal and mutually dependent transac-tions,” the taxpayer is treated as exchanging theproperty sold for the property purchased.17 This rulewas applied by the Tax Court to the simultaneous saleand purchase of mortgage pool interests in the Cottage

14See, e.g., Bank of California v. Commissioner, 30 B.T.A. 556(1934), aff’d 80 F.2d 389 (9th Cir. 1935); Citizens Nat’l Bank ofWaco v. U.S., 551 F.2d 832 (Ct. Cl. 1977); American Nat’l Bankof Austin v. U.S., 573 F.2d 1201 (Ct. Cl. 1978).

15499 U.S. 554 (1991).16See, e.g., Bank of California v. Commissioner, 30 B.T.A. at

561; Citizens Nat’l Bank of Waco v. United States, 551 F.2d at842; American Nat’l Bank of Austin v. United States, 573 F.2d at1207.

17Revenue Ruling 61-119, 1961-1 C.B. 395.


1060 TAX NOTES, May 13, 2002

Savings case.18 The Supreme Court’s upholding of theTax Court’s decision did not amount to an endorsementof this rule because the parties agreed in that venuethat there had been an exchange rather than a sale.19

Although all of these issues remain to be addressedfor the modern repo, they have already been raised andaddressed with respect to securities lending. Becausea modern repo is in some respects more akin to a se-curities loan than to a traditional repo, the securitieslending authorities may have more bearing on the taxcharacter of modern repos than the cases and rulingscited in TAM 200207003.

Tax Authorities on Securities Lending

According to American Institute of Certified PublicAccountants, Brokers and Dealers in Securities, paras.1.100, 1.102 (2001):

A stock loan is an arrangement in which securitiesare loaned from one broker-dealer to another inexchange for collateral. Broker-dealers may lendsecurities to enable a borrowing broker-dealer tomake delivery of securities sold that the borrow-ing broker-dealer does not have available todeliver on the settlement date. . . . Securities lend-ing is generally collateralized by cash, althoughsecurities or letters of credit may also be used ascollateral. . . . When a stock loan is terminated,the securities are returned to the lender and thecollateral or cash to the borrower. Fees (oftenreferred to as rebates) are paid to the cash lenderbased on the principal amounts outstanding.

In Provost Bros. & Co. v. U.S.,20 the Supreme Courtfound that the lender of securities in a securities lend-ing transaction had passed title to the borrower forpurposes of a federal stamp tax on sales and transfersof title to securities. Because the purpose of the trans-action was to provide stock for delivery to a third party,the Court held specifically that the loaned stock couldnot be treated as collateral:

When the transaction is thus completed, neitherthe lender nor the borrower retains any interestin the stock which is the subject matter of thetransaction and which has passed to and becomethe property of the purchaser. . . . Unlike thepledgee of stock, who must have specific stockavailable for the pledgor on payment of his loan,the borrower of stock has no interest in the stocknor the right to demand it from any other. Forthat reason he can be neither a pledgee, trustee,nor bailee for the lender, and he is not one “withwhom stock has been deposited as collateral se-curity for money loaned.” For the incidents ofownership the lender has substituted the per-sonal obligation, wholly contractual, of the bor-

rower to restore him, on demand, to the economicposition in which he would have been, as ownerof the stock, had the loan transaction not beenentered into.21

In describing the procedure and consequences of astock loan, the Supreme Court might as well have beendescribing a modern repo, in which the purchaser hasgiven its “personal obligation” to restore the seller tothe economic position of owning the security ratherthan having “specific stock available” to meet thatobligation.

In Solicitor Memorandum 428122 the Service fol-lowed Provost Bros. in holding that when a borrowerof stock sells the stock to a customer, the dividendbelongs to the customer, not the borrower or the lender.In Revenue Ruling 60-177,23 the Service addressed thetax consequences of loaning stock to a broker thatdelivered the stock to a customer to close a short sale.As is customary in stock lending transactions, the stockborrower had paid over to the stock lender an amountequal to the dividends on the borrowed stock. TheService ruled that the lender was not eligible to claima dividends-received deduction because the customerwho had purchased the stock from the broker, not thelender, was the “real owner” of the stock. In RevenueRuling 80-135,24 the Service concluded that the lenderof a municipal bond to a broker to cover a short salewas not entitled to exclude as municipal bond interestamounts received from the broker in substitution forinterest. The Service reasoned: “Because title passed tothe purchaser as a result of the short sale, the lender isno longer the owner of the bond.”

Provost was concerned only with a transfer tax andthe subsequent revenue rulings only with determiningwhich taxpayer should be treated as receiving divi-dends on the loaned securities. The income tax conse-quences of the transfer itself were addressed only inRevenue Ruling 57-451,25 which ruled that a lender ofstock is regarded as having exchanged its stock for thestock returned by the borrower and that the exchangeis tax-free if section 1036 applies. The Service con-cluded explicitly that an exchange could occur eventhough the stock borrower did not yet possess the se-curity to be returned in exchange:

That the delivery of shares of stock by the op-tionee to his broker and the satisfaction by thelatter of the resulting obligation to replace themmay constitute an exchange is supported by au-thority. A simultaneous delivery of property isnot essential to an exchange. If the parties so in-tend, title to property delivered on one side maypass even though the contract remains executoryon the other side.26

18Cottage Savings Ass’n v. Commissioner, 90 T.C. 372, 386-87(1988), rev’d 890 F.2d 848 (6th Cir. 1989), rev’d and remanded 499U.S. 554 (1991).

19Cottage Savings v. Commissioner, 499 U.S. at 599.20IV-1 C.B. 352 (1924).

21VI-1 C.B. at 420.22IV-2 C.B. 187 (1925).231961-1 C.B. 9.241980-1 C.B. 18.251957-2 C.B. 295.261957-2 C.B. at 298.


TAX NOTES, May 13, 2002 1061

In General Counsel Memorandum 36948 (Dec. 10,1976), the General Counsel of the Internal RevenueService considered the stock lending transaction inRevenue Ruling 57-451 and affirmed that the passageof time between the loan of the stock and the return ofequivalent securities did not preclude treating thestock that was loaned as having been exchanged forthe stock that was returned. Citing Revenue Ruling61-119, supra, the General Counsel reasoned that theloan and return of stock, as “reciprocal and mutuallydependent transactions,” should be treated as an ex-change rather than “a sale and a subsequent purchase.”The General Counsel also noted that if the securitieslent and returned were not materially different, thenno gain or loss would be realized under reg. section1.1001-1(a), making resort to section 1036 unnecessary.

In 1978, Congress enacted section 1058 of the Inter-nal Revenue Code, which provides that when a tax-payer transfers securities pursuant to an agreementproviding for the return of “identical securities” meetscertain conditions, “no gain or loss shall be recognizedon the exchange of such securities by the taxpayer foran obligation under such agreement, or on the ex-change of rights under such agreement by that tax-payer for securities identical to the securities trans-ferred by that taxpayer.” Proposed Treasury reg.section 1.1058-1(b) defines “identical securities” as se-curities “of the same class and issue” as the securitieslent to the borrower.

According to the legislative history of section 1058,Congress intended to endorse the holding in RevenueRuling 57-451 and was acting in response to a recentsuspension in the issuance of letter rulings on securi-ties loans.27 However, the main benefit to taxpayers ofRevenue Ruling 57-451 was that it treated the securitiesloan as an exchange of one security for another, eventhough the borrower did not own the security at thetime it committed to return an identical security. Thatmade it possible to qualify the exchange as tax-exemptunder either section 1036 or Treasury reg. section1.1001-1(a). Section 1058 presupposes instead that thesecurity is being exchanged for an obligation of theborrower, in which case sections 1.1001-1(a) and 1036do not necessarily apply, and the taxpayer ’s onlysecure defense against a taxable transaction may besection 1058 itself. That troubling consequence ofCongress’s action seems to be confirmed by proposedTreasury reg. section 1.1058-1(e), which provides thata stock lender that does not satisfy all the requirementsof section 1058 is engaged in a taxable sale or exchangeof the loaned securities.

Sale vs. Exchange?

The principal question presented by this article ishow to analyze a repo if it is not a secured loan. Whilethe case law and revenue rulings on securities lendingclearly support the conclusion that a modern repo isnot a secured loan, they do not clearly point to analternative characterization, in part because of the

lesser significance assigned to collateral in securitieslending transactions. While securities lending often en-tails the transfer of cash collateral in exchange for thetransferred securities, the posting of collateral is not aninevitable incident of securities lending, and the col-lateral may be, and often is, securities rather than cash.The case law and revenue rulings either omit referenceto the posting of collateral or say nothing about its taxtreatment.

Section 1058 may provide more guidance on the taxcharacterization of repos that are not secured loans. Ifwe are to infer from enactment of section 1058 that amodern repo cannot be viewed as a security-for-security exchange, we are left with treating it asa s ale for cash or as an exchange for the buyer ’sobligation to sell back an equivalent security. If therepo is characterized as a sale and repurchase, then anygain or loss will be recognized to the original seller inthe first leg of the transaction and to the original pur-chaser in the second leg, and there will be no interestexpense for purposes of sections 861 and 882. If therepo sale is characterized as an exchange of the securityfor the buyer ’s obligation to sell back an equivalentsecurity, then the repo might be covered by section1058, which never uses the words securities loan andwould apply to any transaction that met its require-ments.

Section 1058 would be a futility if thetax risk in securities lending was thatcash collateral would be treated assales proceeds.

Can we also infer from section 1058, which neverrefers to a sale, that exchange classification trumpssales classification for any transaction that meets itsrequirements? Possibly, because Congress clearlyunderstood that securities loans usually involved col-lateral, and section 1058 itself does not exempt a secu-rities sale from taxation. Section 1058 would be afutility if the tax risk in securities lending was that cashcollateral would be treated as sales proceeds.

Because section 1058 and the prior authorities onsecurities lending implicitly segregate the transactionin collateral from the transaction in securities, it isinevitable that the return to the securities borrowerattributable to cash collateral is treated as interest. Thisimplicit segregation of the securities transaction fromthe cash transaction in the securities lending author-ities calls to mind the Supreme Court’s analysis inLoewenstein, wherein the Court fixed on the fact thatthe stock purchaser ’s return was ultimately deter-mined by reference to the cash transaction, not thestock transaction. However, the Loewenstein Court em-phasized that its decision on the ownership of incomefrom the securities was not a decision on how to char-acterize the securities transaction itself. Because theCourt refrained from characterizing the repo before itin Loewenstein, it would be pointless to speculate howit might have characterized a different version of thesame transaction. The Loewenstein analysis and

27See S. Rep. No. 762, 95th Cong., 2d Sess. 1, 4 (1978).


1062 TAX NOTES, May 13, 2002

decision is arguably confined to its facts and not bind-ing on a lower court faced with a repo of securities thatwill be sold to third parties.

Absent definitive guidance from either the repo orsecurities lending authorities on how to characterize amodern repo transaction, at least four alternativespresent themselves as reasonable:

(1) Secured Loan. Treat the sale and repurchase as asingle, integrated transaction in which the securitiesare collateral for a cash loan. This characterization hasthe merit of being endorsed by the Service in TAM200207003, but it flies in the face of the Supreme Court’sdecision in Provost and every subsequent authority onsecurities lending.

(2) Loan Plus Exchange. Segregate the cash transac-tion from the securities transaction, treating the formeras a loan and the latter as an exchange subject to section1058. This yields the same result as the analysis in TAM200207003, except for the risk of a taxable exchange ifone of the section 1058 requirements is not satisfied.

(3) Sale Plus Repurchase. Segregate the sale transac-tion from the repurchase transaction and treat each asa taxable sale. This characterization has the merit offollowing the form of the transaction, a conservativeapproach whenever the law is unclear on what alter-native characterization might apply. This yields thesame netting as advocated by the taxpayer in TAM200207003, albeit on different grounds.

(4) Service Plus Service. If the repo is executed pur-suant to a matched book strategy, treat the repo andthe matching reverse repo as a single integrated trans-action in which the dealer performs a matching servicefor both the repo buyer and the reverse repo seller. Thisis the characterization advanced by the taxpayer inTAM 200207003.

Under both (1) and (2), the repo seller treats the pricedifferential on the repurchase as interest expense forpurposes of sections 861 and 882. Under both (3) and(4), the repo seller nets the results of its transactions,eliminating interest expense for purposes of sections861 and 882.

Tax Consequences of Netting

The taxpayer in TAM 200207003 assumed that net-ting would leave no repo interest expense to allocateagainst foreign-source income under section 861. Thatwould be the case, provided that the price differentialson the repos were not characterized as “interestequivalents” under reg. section 1.861-9T(b)(1)(i), whichprovides as follows:

Any expense or loss (to the extent deductible)incurred in a transaction or series of integratedor related transactions in which the taxpayersecures the use of funds for a period of time shallbe subject to allocation and apportionment underthe rules of this section if such expense or loss issubstantially incurred in consideration of thetime value of money.

At first glance this rule might seem to reach charac-terization (3), a sale plus a repurchase, because therepurch ase pr ice di fferential i s unequivocal ly

measured by the time value of money. However, if theanalysis in (3) applies, and the repo is characterized inaccordance with its terms, there is arguably no “inter-est equivalent.” The repo seller would have gain or losson the sale, but the amount of the gain or loss wouldnot represent the time value of money. There is nodeductible “expense or loss” incurred on the repur-chase: The repurchase price simply becomes the basisin the repurchased security. While the taxpayer mayrealize a loss on a subsequent disposition of the repur-chased security, a gain might be realized instead, anda loss would be driven by changes in market value andnot the time value of money.

TAM 200207003 puts financialinstitutions on notice that at least oneof their competitors does notsubscribe to the supposed consensuson the tax character of repos andreverse repos.

Assuming that characterizat ions (3) and (4)eliminate repo interest expense from the section 904calculation, that does not necessarily mean an increasein the section 904 limitation. If the reverse repos do notcreate loans, then the would-be loans are disregardedin the denominator of the fraction used to allocate otherinterest. Because repo financing is usually low-costfinancing, the benefit of allocating repo interest to in-terest income from U.S. sources could theoretically beoutweighed by the detriment of eliminating a domesticasset to which higher-rate interest expense would havebeen apportioned.

While the service-fee analogy is limited to reposthat are part of a matched book, the reasons fortreating a repo as a sale followed by a repurchasewould apply equally to any repo in which the repobuyer is free to dispose of the security. If charac-terization (3) is applied to repos and reverse reposthat are not part of a matched book, gain or losswill be recognized by the repo seller on the originalsale and by the repo buyer on the subsequentrepurchase. This may not matter for securit iesdealers, who must mark their securities holdingsto market under section 475 in any event, but itmight matter for their customers.

There would also be state and local tax consequencesif repos and reverse repos were no longer characterizedas loans, although some states, including New York,have their own criteria for characterizing repos, leav-ing open the theoretical possibility of treating them assales for purposes of section 904 and loans for purposesof state franchise tax.

Conclusion

TAM 200207003 puts financial institutions on noticethat at least one of their competitors does not subscribeto the supposed consensus on the tax character of reposand reverse repos. TAM 200207003 is not binding onother taxpayers and, for all most of us know, is not


TAX NOTES, May 13, 2002 1063

even the final word on that case. Until the proper taxcharacter of the modern repo is sorted out, taxpayersmay be motivated to adopt the characterization thatresults in the most section 904 limitation or thelowest section 882 haircut. What will drive taxpayersto disparate positions is the negative arbitrage in-herent in the consensus classification of repos as

secured loans. The Service has it in its power toeliminate the negative arbitrage by permitting thedirect allocation of repo interest expense againstreverse repo interest income for purposes of sections861 and 882. It could mitigate the incentive to disparatereporting by exercising that power as promptly as pos-sible.


1064 TAX NOTES, May 13, 2002

Documents

Are Repos Really Loans