Even though this is still possible, from an economic perspective, short sales against the box designed to avoid constructive sale treatment have now become risky transactions.
1259, short sales against the box designed to avoid constructive sale treatment have become risky transactions.4 Even though one can still do a short sale against the box after the TRA '97 without triggering a constructive sale, it often will not make economic sense to do so.
The first part explains the principal financial instruments affected by section 1259: short sales against the box and total return equity swaps.
To understand short sales against the box, familiarity with the practice of short selling is necessary.(21) "The term short sale means any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller."(22) At some point in the future, the short seller returns the borrowed security to the lender with an identical security purchased in the market.(23) A short sale, therefore, involves three brokers: the selling broker who represents the customer selling short, the buying broker who represents the investor purchasing the security sold short, and the lending broker who represents the account lending the securities to the selling broker.(24)
Although referred to as short sales against the box legislation,(47) section 1259 reaches beyond this one financial instrument and also affects certain derivative instruments.
to exchange a series of cash flows over time."(51) The various types of swaps are distinguished by looking at the definitions of periodic cash flows, i.e., whether the payments consist of different rates of return within one currency or different currencies.(52) Items that may be swapped include returns on equity, interest rates, and currencies.(53) Similar to short sales against the box, the motivations to enter into swap arrangements include speculation, hedging, and tax advantages.(54) The swap arrangements affected most by section 1259 are total return equity swaps.(55)
Prior tax law did not recognize capital gain or loss until realization occurred.(87) Additionally, a taxpayer did not realize capital gain or loss until a capital asset was sold or exchanged.(88) With respect to open transactions such as short sales against the box, a taxpayer did not realize capital gain or loss until the taxpayer returned the borrowed stock and closed the short position.(89) As a result, taxpayers could lock in capital gain or loss by entering into certain positions while deferring recognition until some future date(90) or, in some instances, avoid recognition altogether.
Short sales against the box have long been used by sophisticated investors to hedge security positions without negative income tax consequences.
To prevent taxpayers from eliminating the economic risk of loss and the opportunity for gain in appreciated property without recognizing taxable gain, and in order to more clearly reflect income from the sale of stock or other securities, President Clinton's proposed fiscal 1997 budget includes two revenue provisions addressing short sales against the box.
Consequently, this proposal would eliminate taxpayers' ability to avoid immediate recognition of gain through short sales against the box.
Although it is impossible to predict at this time whether either proposal will be enacted and, if enacted, in what form, the attention being focused on short sales against the box (and other similar hedging techniques) as an income tax deferral or avoidance device may eventually result in legislation eliminating the tax benefits currently associated with short sales against the box.