Internal Revenue Code Section 1259: A Legitimate Foundation for Taxing Short Sales against the Box or a Mere Makeover?
Ulcickas, Simon D., William and Mary Law Review
"[B]ulls make money, bears make money, and hogs get slaughtered."(1) That is the Wall Street gospel on investors who are motivated by greed. Gluttonous investors should heed its advice because Congress, through its enactment of the Taxpayer Relief Act of 1997,(2) has taken aim at the tax benefits once reaped by engaging in short sale against the box transactions.(3) Investors no longer will be able to enter into absolute hedges without recognition of capital gain; rather, they will be forced to recognize capital gain on appreciated financial positions even if those positions are not sold. This latest attack on a specialized application of short selling(4) is merely an extension of a long running disdain for this financial practice.
For centuries, governments have treated short sales with varying degrees of contempt.(5) In the United States, government scrutiny of short selling dates back to World War I,(6) but politicians did not voice their disapproval of short selling until the stock market crashed in 1929. Consider Illinois Representative Adolph Sabath's assessment of short selling activity: "`short selling' ... is the greatest evil that has been permitted or sanctioned by the Government that I know of."(7) Fifty-eight years later, in the wake of the 1987 stock market crash, this critical attitude resurfaced.(8) Joseph Grundfest, then Commissioner of the Securities and Exchange Commission, commented on the possibility of heightened government regulation of short sales: "`When you sell short, you are in a sense betting against the team.'"(9) After the 1929 and 1987 crashes, investors attacked short sales on the grounds that they facilitated the manipulation of securities prices and aggravated market declines.(10)
Recently, critics have renewed calls for intensified regulation of short sales in reaction to the November 16, 1995 initial public offering (IPO) of the Estee Lauder Companies, Inc.(11) Rather than picking at the wound left by years of criticism regarding short selling's alleged "demoralizing" effect, government regulators now are attacking short sales from a different angle. The focus of regulatory watchdogs has shifted to the tax advantages enjoyed by investors using one version of these transactions: short selling against the box.(12)
Although many investors sell short against the box,(13) a variant of short selling that can defer or reduce tax liability, Estee Lauder Companies' 1995 IPO served as the impetus for the restructured assault on short sales.(14) Congress responded to the manner and degree to which the Lauders used short selling to effectuate their stock offering by passing tax legislation that treats certain financial transactions as "constructive sales" so long as those transactions function to lock in capital gain or loss with respect to the security involved.(15) The new law, codified as Internal Revenue Code section 1259, treats certain appreciated financial positions as constructive sales and taxes the capital gains on those positions.(16) This Note contends that section 1259 is flawed. Fundamentally, section 1259 does not address directly the true abusive practices involved in the Lauder transaction--the ability to sell short against the box indefinitely without any possibility of being squeezed;(17) the opportunity to obtain the proceeds from the short sale against the box before the transaction is closed;(18) and, finally, the combination of Revenue Ruling 72-478(19) and section 1014 of the Internal Revenue Code ("the Code").(20) Rather, section 1259 creates an inequitable standard that is both contrary to longstanding tax doctrine and detrimental to legitimate investment decisions.
This Note is divided into six parts. The first part explains the principal financial instruments affected by section 1259: short sales against the box and total return equity swaps. The second part traces Estee Lauder Companies' November 16, 1995 IPO and uses that transaction as a case study to flesh out the abuses with which section 1259 should be concerned. …