SHORT SALES DO NOT CREATE UBTI, ATTORNEYS ASSERT.

The authors point out that the preamble to the proposed regulations under section 512 invited comments on the types of income to be treated in a revenue ruling as "substantially similar income from ordinary and routine investments in connection with a securities portfolio." And they note that one commentator suggested that income from short sales should be identified as a type of substantially similar income excluded from UBTI. In their letter, Grala and Quinn explain why "current law is clear that short sale proceeds are not UBTI," and they state that the Service should "promptly confirm" that result.

On behalf of Fidelity Management Trust Company, we are writing concerning the proposed regulation modifying Treas. Reg. section 1.512(b)-1(a), published by the Internal Revenue Service (the "Service") on September 3, 1991. The preamble to the proposed regulation invited comments regarding the types of income to be treated in a revenue ruling as "substantially similar income from ordinary and routine investments in connection with a securities portfolio" under the proposed regulation. One recent commentator suggested that income produced by short sales should be identified in a revenue ruling as a type of substantially similar income excluded from unrelated business taxable income ("UBTI").

While we urge the Service to confirm that short sales do not create UBTI, the recently proposed regulation relating to UBTI and notional principal contracts is not an appropriate vehicle. All gain or income from short sales is currently exempt under section 512(b), for the reasons stated below, without regard to the proposed regulation.

Section 512(b)(5) excludes from UBTI all gains or losses from the sale, exchange or other disposition of property that is not inventory-type property. ¹ Section 1233(a) provides that "[f]or purposes of this subtitle, gain or loss from the short sale of property shall be considered as gain or loss from the SALE OR EXCHANGE of a capital asset to the extent that the property . . . used to close the short sale constitutes a capital asset" (emphasis added). Upon enactment of the predecessor to section 1233 in 1934, the House report stated that the statutory amendment would "preclude the contention that gains or losses from short sales of property are not capital gains and losses." ² In addition, the regulations under section 1233 provide that "[f]or income tax purposes a short sale is not deemed to be consummated until delivery of property to close the short sale." ³ It is unequivocal under the express language of the statute, the legislative history and the regulation that a section 1233 transaction is deemed to produce gain or loss from the sale or exchange of property. Such gain or loss would necessarily be excluded from UBTI under section 512(b)(5).

In GCM 39615 (March 12, 1987), the Service analyzed purchases and sales of stock index futures and the underlying stock pursuant to a stock arbitrage investment program. The Service stated that the futures contracts, some of which constituted short sales, were "themselves property, albeit intangible." The Service concluded that the trading gains and losses from the stock index futures would be excluded from UBTI under section 512(b)(5) if they were not derived from inventory-type property and were not debt-financed. ⁴

In addition to the potential for gain from short sales, institutional short sellers are often entitled to interest income earned on the investment of short sale proceeds. This interest income, however, is explicitly excluded from UBTI under section 512(b)(1).

Finally, income or gain connected with short sales does not become subject to tax by virtue of the "acquisition indebtedness" rules contained in section 514. ⁵ The borrowing of securities by the short seller does not create an indebtedness for federal income tax purposes. ⁶ Similarly, the cash sale proceeds arising from the short sale are treated as sales proceeds, for the reasons described above, and do not arise from an indebtedness. Thus, the short seller has borrowed securities and engaged in a property transaction and has not created an indebtedness for Federal income tax purposes. ⁷

For the reasons above, current law is clear that short sale proceeds are not UBTI. The Service should promptly confirm this result. If you have any questions regarding this matter, please call Bronislaw Grala at (212) 504-6466 or Jeffrey Quinn at (213) 955-4628.

Very truly yours,

² H.R. Rep. No. 1385, 73rd Cong., 2d Sess. (1934), reprinted in 1939-1 (Part 2) C.B. 627,633.

³ Treas. Reg. section 1.1233-1(a)(1).

⁴ See also PLR 8708031 (November 25, 1986) and PLR 8338138 (June 24, 1983).

⁵ In GCM 39620 (April 3, 1987), the Service stated that in determining the meaning of indebtedness under section 514, it would look to the interpretation of the same term in section 163.

⁶ Deputy v. DuPont, 308 U.S. 488 (1940). See also Ansley v. Comm'r, 217 F.2d 252 (3rd Cir. 1954) (securities lender is not entitled to a bad debt deduction under section 166); Stahl v. United States, 441 F.2d 999 (D.C. Cir. 1970) (same); Rev. Rul. 72-521, 1972- 2 C.B. 178 (equivalent payments made pursuant to a securities lending transaction were deductible under section 212; the ruling did not refer to section 163); GCM 36948 (December 10, 1976) (equivalent payments received by a tax-exempt entity lending securities were not interest under section 512(b)(1)); sections 163(d)(3), 263(g)(2), 265(a)(5)(A) and 1277(c) (sections specifically providing that short sale expenses be treated as interest, demonstrating Congressional understanding that, in the absence of such specific language, short sale expenses would not be treated as interest).

⁷ The Service has explicitly assumed that a short futures contract, as a short sale, cannot give rise to acquisition indebtedness. GCM 39615 at n. 6. See also GCM 39620; PLR 8832052 (May 18, 1988).