IRS Affirms Treatment of Short Sales for UBTI Purposes

by Mintz Levin
Contact

Since there are many hedge funds that utilize short selling as part of their investment strategy, it is important for hedge fund investors, including tax exempt organizations, to understand the U.S. tax treatment of these transactions.1 Fortunately for the exempt investors, the IRS has taken a favorable view of short sales, in guidance that was confirmed recently in a private letter ruling. Specifically, the IRS has affirmed a position taken in a 1995 Revenue Ruling to the effect that a short sale does not generally give rise to “unrelated business taxable income” (“UBTI”) with respect to tax-exempt investors. Before considering the ruling itself, it is worthwhile to summarize the key tax issues faced by exempt organizations in hedge fund investments, as well as some of the basics regarding short sale transactions and their treatment for U.S. federal income tax purposes.

It is well known that tax-exempt investors, including universities, foundations, as well as public and private employee pension funds, are among the largest and most influential investors in alternative investment strategies such as private equity and hedge funds. These institutions regularly commit hundreds of millions of dollars to investment funds, and consequently may have significant negotiating power in the structuring of the funds. While there are indications that some of the largest pension funds are slowly allocating some of their capital away from hedge funds,2 the numbers are still astounding. For example, CalPERS, the nation’s largest public employee pension fund, is still reported to have as much as $3 billion invested in hedge funds, even after accounting for a sharp drop this year.3

From a U.S. federal income tax perspective, the key issue impacting hedge fund investment by tax exempt organizations is the UBTI rules imposed under Sections 511 through 514 of the Internal Revenue Code of 1986, as amended (the “Code”).4 Organizations exempt from tax under the Code (e.g., under Section 501) are nevertheless subject to tax on their UBTI, which is defined as the gross income derived from an unrelated trade or business, less related deductions (with certain modifications).5 Tax exempt organizations are subject to tax on UBTI at regular corporate rates, and the incurrence of UBTI also gives rise to a return filing requirement on Form 990-T. 6 Section 512(b) excludes from UBTI numerous categories of passive investment income, such as dividends, interest and gains from the sale of property other than inventory or dealer property. Significantly, however, the use of leverage to acquire property causes even these categories of investment income to constitute UBTI, based on the percentage of the purchase price financed by debt.7 These “unrelated debt financed income” (“UDFI”) rules typically play a prominent role in an exempt organization’s evaluation of a hedge fund investment. The use of leverage in a fund often necessitates the use of tax blockers or other UBTI mitigation strategies.8 Alternatively, an exempt organization may not be UBTI-phobic and may accept the tax costs in light of the investment returns expected (although in the case of a fund that generates only UDFI, as opposed to “active business” UBTI, offshore blocker entities can often preserve the fund’s economics while avoiding any material tax cost to the exempt investors).

The UDFI rules are relatively broad in scope and cover situations in which an incurrence of debt and an investment are less than directly related.9 Furthermore, investments retain a UDFI “taint” for a year following a retirement of the related indebtedness.10 While the IRS has issued rulings (well known to practitioners in the area) to the effect that income from investments funded by certain lines of credit do not give rise to UDFI, these rulings are very narrow in scope and generally address situations in which the borrowings were intended only to cover short-term liquidity constraints resulting from investor redemptions.11

The historical purpose for the enactment of the UDFI rules, although beyond the scope of this article (and not perfectly clear), can best be described as an effort to prevent tax exempt organizations from “trading” on their exempt status by financing investments with debt to improve their economic returns.12 Given the complexity of the financial markets and the vast categories of derivatives and structured financial products traded every day, interesting questions arise relating to the proper characterization of certain transactions for UDFI purposes. One example of such a transaction is a short sale of a security.

In its most basic form, a “short sale” of a security occurs when an investor sells a security he does not currently own (via a borrowing) and later purchases the security (“covering the short”) in order to repay the lender. The stock borrower may also be permitted to repay the lender in the form of cash in an amount equal to the then market value of the loaned securities. The short seller will typically deposit the sale proceeds as collateral with the lender until the short is covered. Most securities loans take place in the context of short selling. In exchange for a borrowing fee, brokers lend stock to speculators who then sell the stock short. In addition to returning the borrowed stock at the maturity of the loan, the stock borrower/short seller also is usually required to make “substitute dividend payments” to the stock lender, representing any dividends paid on the borrowed stock. Subject to certain anti-abuse rules, a short sale is treated as an “open transaction” for U.S. tax purposes until it is closed out.13 The character of the associated income depends on whether the property used to close the short sale is a capital asset in the taxpayer’s hands as well as its holding period.14

In Rev. Rul. 95-8,15 the IRS held that gain from the short sale of publicly traded stock through a broker did not result in UDFI. In the ruling, an exempt organization had its broker borrow 100 shares of stock and sell them short, resulting in $500x of sale proceeds. The broker retained the proceeds as collateral. The organization supplemented the collateral with additional (non-borrowed) cash of its own. Under the collateral arrangement, the organization was credited with a “rebate fee” consisting of a portion of the income earned on the collateral.16 The value of the shorted stock dropped to $400x, at which point the broker closed out the short sale on behalf of the organization. Focusing on the definition of “acquisition indebtedness” under Section 514(c), as well as the Supreme Court’s holding in Deputy v. du Pont,17, the IRS held that “although the short sale created an obligation, it did not create indebtedness” for tax purposes.

The IRS has recently reaffirmed this position regarding short sales under the UDFI rules of Section 514. In PLR 201434024 (8/22/14), the IRS addressed a charitable trust that proposed to invest in a number of hedge funds treated as partnerships for U.S. federal income tax purposes. According to the ruling, the funds’ investment strategy called for neutrality between long and short positions. The short positions were established using customary stock loans from a broker, which charged the funds a lending fee and required collateral equal to the value of the stock loaned. Furthermore, the cash and securities used as collateral were assets owned by the fund and were not borrowed from outside sources.

The key fact in the ruling appears to be that “in no case in which a fund takes a short position will there be any net borrowing by the fund on its own behalf or on behalf of” the trust. Therefore, in the absence of any leverage outside the short sale itself, the only question was whether the short position itself gave rise to “acquisition indebtedness” for UDFI purposes. Citing Rev. Rul. 95-8 and DuPont, the IRS stated that “an indebtedness arises only with respect to the borrowing of money, not the borrowing of property.” Since the income from the short sale did not constitute UDFI, the corresponding long positions purchased with such proceeds were also not UDFI.

Tax-exempt hedge fund investors can continue to be assured that hedge funds that engage in short selling similar to that described in the recent ruling will not implicate the UBTI rules, absent other factors.

Endnotes

1 To be sure, data suggests that due to increasing costs and regulatory limitations, short selling by hedge fund managers has decreased. According to a 2013 Forbes report, “Driving the reduction in hedge fund short trading is the escalating cost of selling stock short in the last few years.” Nathan Vardi, Death of the Hedge Fund Short Seller, Forbes, Jan. 10, 2013. A key contributor to this increased cost is the more onerous terms associated with borrowing the shorted securities, as described more fully below.

2 Dan Fitzpatrick, Calpers Pulls Back from Hedge Funds, The Wall Street Journal, July 23, 2014.

3 Id.

4 All section references herein are to the Code. Importantly, while many state institutions take the position that they are exempt from UBTI as a result of their broad exemption from taxation as state sovereigns under Section 115 of the Code, this article is focused on those organizations that are in fact subject to UBTI.

5 Section 512(a)(1).

6 Sections 511(a)(1); Treas. Reg. Section 1.6012-2(e).

7 Section 514.

8 Section 512(c) provides that exempt organizations are required to look through partnerships of which they are members for purposes of computing their share of UBTI (regardless of distributions). Because many private investment funds, including hedge funds, are structured as partnerships for tax purposes, the presence of active business and/or leverage in these funds implicates UBTI and UDFI issues for exempt investors. See also Treas. Reg. Section 1.514(c)-1(a)(2), Example 4.

9 Section 514(c)(1)(A).

10 Section 514(b)(1).

11 See, e.g., PLR 200233032 (8/16/02); 200235042 (8/30/02). In these rulings, the facts stipulated that “the Line of Credit will be used exclusively to finance redemptions of Units and not for the purpose of making additional investments.”

12 In connection with the 1969 amendments to the UDFI rules (prior to which the rules applied only to certain lease transactions), the House Ways and Means Committee stated that the goal of preventing unfair business competition by tax exempt organizations “can be achieved by imposing the unrelated business income tax on the income received by the exempt organization in proportion to the debt existing on the income-producing property.” See H.R. Rep. No. 91-413 at 44-46 (1969).

13 Treas. Reg. Section 1.1233-1(a).

14 Treas. Reg. Section 1.1233-1(a)(1), (3).

15 1995-1 C.B. 107, 1/03/95.

16 In common securities lending transactions, this rebate fee can be thought of as a payment of interest by the securities lender to the securities borrower in respect of the cash collateral posted by the securities borrower.

17 308 U.S. 488.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Mintz Levin | Attorney Advertising

Written by:

Mintz Levin
Contact
more
less

Mintz Levin on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide

JD Supra Privacy Policy

Updated: May 25, 2018:

JD Supra is a legal publishing service that connects experts and their content with broader audiences of professionals, journalists and associations.

This Privacy Policy describes how JD Supra, LLC ("JD Supra" or "we," "us," or "our") collects, uses and shares personal data collected from visitors to our website (located at www.jdsupra.com) (our "Website") who view only publicly-available content as well as subscribers to our services (such as our email digests or author tools)(our "Services"). By using our Website and registering for one of our Services, you are agreeing to the terms of this Privacy Policy.

Please note that if you subscribe to one of our Services, you can make choices about how we collect, use and share your information through our Privacy Center under the "My Account" dashboard (available if you are logged into your JD Supra account).

Collection of Information

Registration Information. When you register with JD Supra for our Website and Services, either as an author or as a subscriber, you will be asked to provide identifying information to create your JD Supra account ("Registration Data"), such as your:

  • Email
  • First Name
  • Last Name
  • Company Name
  • Company Industry
  • Title
  • Country

Other Information: We also collect other information you may voluntarily provide. This may include content you provide for publication. We may also receive your communications with others through our Website and Services (such as contacting an author through our Website) or communications directly with us (such as through email, feedback or other forms or social media). If you are a subscribed user, we will also collect your user preferences, such as the types of articles you would like to read.

Information from third parties (such as, from your employer or LinkedIn): We may also receive information about you from third party sources. For example, your employer may provide your information to us, such as in connection with an article submitted by your employer for publication. If you choose to use LinkedIn to subscribe to our Website and Services, we also collect information related to your LinkedIn account and profile.

Your interactions with our Website and Services: As is true of most websites, we gather certain information automatically. This information includes IP addresses, browser type, Internet service provider (ISP), referring/exit pages, operating system, date/time stamp and clickstream data. We use this information to analyze trends, to administer the Website and our Services, to improve the content and performance of our Website and Services, and to track users' movements around the site. We may also link this automatically-collected data to personal information, for example, to inform authors about who has read their articles. Some of this data is collected through information sent by your web browser. We also use cookies and other tracking technologies to collect this information. To learn more about cookies and other tracking technologies that JD Supra may use on our Website and Services please see our "Cookies Guide" page.

How do we use this information?

We use the information and data we collect principally in order to provide our Website and Services. More specifically, we may use your personal information to:

  • Operate our Website and Services and publish content;
  • Distribute content to you in accordance with your preferences as well as to provide other notifications to you (for example, updates about our policies and terms);
  • Measure readership and usage of the Website and Services;
  • Communicate with you regarding your questions and requests;
  • Authenticate users and to provide for the safety and security of our Website and Services;
  • Conduct research and similar activities to improve our Website and Services; and
  • Comply with our legal and regulatory responsibilities and to enforce our rights.

How is your information shared?

  • Content and other public information (such as an author profile) is shared on our Website and Services, including via email digests and social media feeds, and is accessible to the general public.
  • If you choose to use our Website and Services to communicate directly with a company or individual, such communication may be shared accordingly.
  • Readership information is provided to publishing law firms and authors of content to give them insight into their readership and to help them to improve their content.
  • Our Website may offer you the opportunity to share information through our Website, such as through Facebook's "Like" or Twitter's "Tweet" button. We offer this functionality to help generate interest in our Website and content and to permit you to recommend content to your contacts. You should be aware that sharing through such functionality may result in information being collected by the applicable social media network and possibly being made publicly available (for example, through a search engine). Any such information collection would be subject to such third party social media network's privacy policy.
  • Your information may also be shared to parties who support our business, such as professional advisors as well as web-hosting providers, analytics providers and other information technology providers.
  • Any court, governmental authority, law enforcement agency or other third party where we believe disclosure is necessary to comply with a legal or regulatory obligation, or otherwise to protect our rights, the rights of any third party or individuals' personal safety, or to detect, prevent, or otherwise address fraud, security or safety issues.
  • To our affiliated entities and in connection with the sale, assignment or other transfer of our company or our business.

How We Protect Your Information

JD Supra takes reasonable and appropriate precautions to insure that user information is protected from loss, misuse and unauthorized access, disclosure, alteration and destruction. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. You should keep in mind that no Internet transmission is ever 100% secure or error-free. Where you use log-in credentials (usernames, passwords) on our Website, please remember that it is your responsibility to safeguard them. If you believe that your log-in credentials have been compromised, please contact us at privacy@jdsupra.com.

Children's Information

Our Website and Services are not directed at children under the age of 16 and we do not knowingly collect personal information from children under the age of 16 through our Website and/or Services. If you have reason to believe that a child under the age of 16 has provided personal information to us, please contact us, and we will endeavor to delete that information from our databases.

Links to Other Websites

Our Website and Services may contain links to other websites. The operators of such other websites may collect information about you, including through cookies or other technologies. If you are using our Website or Services and click a link to another site, you will leave our Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We are not responsible for the data collection and use practices of such other sites. This Policy applies solely to the information collected in connection with your use of our Website and Services and does not apply to any practices conducted offline or in connection with any other websites.

Information for EU and Swiss Residents

JD Supra's principal place of business is in the United States. By subscribing to our website, you expressly consent to your information being processed in the United States.

  • Our Legal Basis for Processing: Generally, we rely on our legitimate interests in order to process your personal information. For example, we rely on this legal ground if we use your personal information to manage your Registration Data and administer our relationship with you; to deliver our Website and Services; understand and improve our Website and Services; report reader analytics to our authors; to personalize your experience on our Website and Services; and where necessary to protect or defend our or another's rights or property, or to detect, prevent, or otherwise address fraud, security, safety or privacy issues. Please see Article 6(1)(f) of the E.U. General Data Protection Regulation ("GDPR") In addition, there may be other situations where other grounds for processing may exist, such as where processing is a result of legal requirements (GDPR Article 6(1)(c)) or for reasons of public interest (GDPR Article 6(1)(e)). Please see the "Your Rights" section of this Privacy Policy immediately below for more information about how you may request that we limit or refrain from processing your personal information.
  • Your Rights
    • Right of Access/Portability: You can ask to review details about the information we hold about you and how that information has been used and disclosed. Note that we may request to verify your identification before fulfilling your request. You can also request that your personal information is provided to you in a commonly used electronic format so that you can share it with other organizations.
    • Right to Correct Information: You may ask that we make corrections to any information we hold, if you believe such correction to be necessary.
    • Right to Restrict Our Processing or Erasure of Information: You also have the right in certain circumstances to ask us to restrict processing of your personal information or to erase your personal information. Where you have consented to our use of your personal information, you can withdraw your consent at any time.

You can make a request to exercise any of these rights by emailing us at privacy@jdsupra.com or by writing to us at:

Privacy Officer
JD Supra, LLC
10 Liberty Ship Way, Suite 300
Sausalito, California 94965

You can also manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard.

We will make all practical efforts to respect your wishes. There may be times, however, where we are not able to fulfill your request, for example, if applicable law prohibits our compliance. Please note that JD Supra does not use "automatic decision making" or "profiling" as those terms are defined in the GDPR.

  • Timeframe for retaining your personal information: We will retain your personal information in a form that identifies you only for as long as it serves the purpose(s) for which it was initially collected as stated in this Privacy Policy, or subsequently authorized. We may continue processing your personal information for longer periods, but only for the time and to the extent such processing reasonably serves the purposes of archiving in the public interest, journalism, literature and art, scientific or historical research and statistical analysis, and subject to the protection of this Privacy Policy. For example, if you are an author, your personal information may continue to be published in connection with your article indefinitely. When we have no ongoing legitimate business need to process your personal information, we will either delete or anonymize it, or, if this is not possible (for example, because your personal information has been stored in backup archives), then we will securely store your personal information and isolate it from any further processing until deletion is possible.
  • Onward Transfer to Third Parties: As noted in the "How We Share Your Data" Section above, JD Supra may share your information with third parties. When JD Supra discloses your personal information to third parties, we have ensured that such third parties have either certified under the EU-U.S. or Swiss Privacy Shield Framework and will process all personal data received from EU member states/Switzerland in reliance on the applicable Privacy Shield Framework or that they have been subjected to strict contractual provisions in their contract with us to guarantee an adequate level of data protection for your data.

California Privacy Rights

Pursuant to Section 1798.83 of the California Civil Code, our customers who are California residents have the right to request certain information regarding our disclosure of personal information to third parties for their direct marketing purposes.

You can make a request for this information by emailing us at privacy@jdsupra.com or by writing to us at:

Privacy Officer
JD Supra, LLC
10 Liberty Ship Way, Suite 300
Sausalito, California 94965

Some browsers have incorporated a Do Not Track (DNT) feature. These features, when turned on, send a signal that you prefer that the website you are visiting not collect and use data regarding your online searching and browsing activities. As there is not yet a common understanding on how to interpret the DNT signal, we currently do not respond to DNT signals on our site.

Access/Correct/Update/Delete Personal Information

For non-EU/Swiss residents, if you would like to know what personal information we have about you, you can send an e-mail to privacy@jdsupra.com. We will be in contact with you (by mail or otherwise) to verify your identity and provide you the information you request. We will respond within 30 days to your request for access to your personal information. In some cases, we may not be able to remove your personal information, in which case we will let you know if we are unable to do so and why. If you would like to correct or update your personal information, you can manage your profile and subscriptions through our Privacy Center under the "My Account" dashboard. If you would like to delete your account or remove your information from our Website and Services, send an e-mail to privacy@jdsupra.com.

Changes in Our Privacy Policy

We reserve the right to change this Privacy Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our Privacy Policy will become effective upon posting of the revised policy on the Website. By continuing to use our Website and Services following such changes, you will be deemed to have agreed to such changes.

Contacting JD Supra

If you have any questions about this Privacy Policy, the practices of this site, your dealings with our Website or Services, or if you would like to change any of the information you have provided to us, please contact us at: privacy@jdsupra.com.

JD Supra Cookie Guide

As with many websites, JD Supra's website (located at www.jdsupra.com) (our "Website") and our services (such as our email article digests)(our "Services") use a standard technology called a "cookie" and other similar technologies (such as, pixels and web beacons), which are small data files that are transferred to your computer when you use our Website and Services. These technologies automatically identify your browser whenever you interact with our Website and Services.

How We Use Cookies and Other Tracking Technologies

We use cookies and other tracking technologies to:

  1. Improve the user experience on our Website and Services;
  2. Store the authorization token that users receive when they login to the private areas of our Website. This token is specific to a user's login session and requires a valid username and password to obtain. It is required to access the user's profile information, subscriptions, and analytics;
  3. Track anonymous site usage; and
  4. Permit connectivity with social media networks to permit content sharing.

There are different types of cookies and other technologies used our Website, notably:

  • "Session cookies" - These cookies only last as long as your online session, and disappear from your computer or device when you close your browser (like Internet Explorer, Google Chrome or Safari).
  • "Persistent cookies" - These cookies stay on your computer or device after your browser has been closed and last for a time specified in the cookie. We use persistent cookies when we need to know who you are for more than one browsing session. For example, we use them to remember your preferences for the next time you visit.
  • "Web Beacons/Pixels" - Some of our web pages and emails may also contain small electronic images known as web beacons, clear GIFs or single-pixel GIFs. These images are placed on a web page or email and typically work in conjunction with cookies to collect data. We use these images to identify our users and user behavior, such as counting the number of users who have visited a web page or acted upon one of our email digests.

JD Supra Cookies. We place our own cookies on your computer to track certain information about you while you are using our Website and Services. For example, we place a session cookie on your computer each time you visit our Website. We use these cookies to allow you to log-in to your subscriber account. In addition, through these cookies we are able to collect information about how you use the Website, including what browser you may be using, your IP address, and the URL address you came from upon visiting our Website and the URL you next visit (even if those URLs are not on our Website). We also utilize email web beacons to monitor whether our emails are being delivered and read. We also use these tools to help deliver reader analytics to our authors to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

Analytics/Performance Cookies. JD Supra also uses the following analytic tools to help us analyze the performance of our Website and Services as well as how visitors use our Website and Services:

  • HubSpot - For more information about HubSpot cookies, please visit legal.hubspot.com/privacy-policy.
  • New Relic - For more information on New Relic cookies, please visit www.newrelic.com/privacy.
  • Google Analytics - For more information on Google Analytics cookies, visit www.google.com/policies. To opt-out of being tracked by Google Analytics across all websites visit http://tools.google.com/dlpage/gaoptout. This will allow you to download and install a Google Analytics cookie-free web browser.

Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit http://www.aboutcookies.org which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at: privacy@jdsupra.com.

- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.