In Internal Legal Memorandum 201827011 (the ILM), issued July 9, 2018, the IRS concluded that a taxpayer's short positions in notional principal contracts (Swaps) that tracked the value of a stock index (the Index) were substantially similar or related property within the meaning of Section 246 (SSRP) with respect to shares in an exchange-trade fund (ETF) that tracked the Index's performance. As a result, the IRS determined that the taxpayer was not entitled to claim a dividends received deduction (DRD) under Section 246 for dividends received on the ETF shares.

Background

The ILM addressed transactions executed by certain members of an affiliated group of corporations (Taxpayer) that filed consolidated federal income tax returns. The transactions at issue were executed by X, a market-facing equity-swap dealer and member of Taxpayer's consolidated group. X's business involved using a combination of stocks, futures and exchange-traded funds (ETFs) to enter into long and short positions with respect to the Index.

Before converting into a limited liability company (LLC), X executed Swaps, with varying maturities, to acquire short positions with respect to the Index. Under the terms of the Swaps, X was required to remit or credit to the counterparty any appreciation in the Index and any dividends on the underlying stock, while the counterparty was required to pay amounts equal to any depreciation in value of the Index, plus a financing payment. Additionally, X acquired shares in a unit investment trust (ETF Trust) that provided exposure to the Index's price and yield performance. Specifically, the ETF Trust held a portfolio of the common stock included in the Index, and the weight of each stock in the portfolio closely corresponded to the weight of the stock in the Index. The ETF Trust rebalanced its portfolio to conform to periodic changes in the identity and relative weightings of the securities on the Index.

Holders of the ETF Trust's shares received quarterly dividends in an amount equal to the amount of any cash dividends declared within respect to the common stock held by the ETF Trust (i.e., which were identical to the stock comprising the Index). As a result, the economic returns produced by the ETF Trust and the Index were nearly identical. Further, to manage risk exposure on the ETF Trust shares, X entered into short positions in the Swaps sized to offset risk arising from holding ETF shares purchased on the general market.¹

Taxpayer claimed a 70% dividends received deduction (DRD) under Section 243² with respect to dividends received on its shares in the ETF Trust. The ILM thus considers whether Taxpayer satisfied the technical requirements to properly claim the DRD — specifically, whether the 45-day holding period requirement with respect to the ETF Fund shares was met. To that end, the ILM addressed whether, under Section 246, the short Swap positions were SSRP with respect to the positions in the ETF Fund shares, which would suspend Taxpayer's holding period in the ETF Fund shares for any period that it held a position in the Swaps and thereby prevent Taxpayer from satisfying the holding period requirement of the DRD rules.

Section 246(c)(4)(C) tolls the taxpayer's holding period for any period in which, "a taxpayer had diminished his or her risk of loss by holding one or more other positions with respect to substantially similar or related property." Rules under Treas. Reg. Section 1.246-5 address whether a taxpayer's holding period must be reduced under Section 246(c)(4)(C). Under Treas. Reg. Section 1.246-5(b)(2), certain rules apply to determine whether a taxpayer has diminished its risk of loss on a dividend-paying stock by holding positions with respect to a property interest that constitutes SSRP (rules for positions in property).³ Treas. Reg. Section 1.246-5(c)(1) provides "portfolio rules" to determine whether a position is SSRP to another, where the tested position reflects the value of more than one stock.⁴ Under the portfolio rules, a taxpayer's short position that reflects the value of a portfolio of stocks (e.g., Swaps) is SSRP with respect to the stock held by the taxpayer only if the position and the taxpayer's stock holdings substantially overlap (i.e., an overlap of at least 70%) as of the testing date.

In addition, two anti-abuse rules are provided under Treas. Reg. Section 1.246-5(c)(6) with respect to transactions involving related persons or pass-through entities.⁵ Further an anti-abuse rule under Treas. Reg. Section 1.246-5(c)(1)(vi) specifically applies to treat a position that reflects the value of more than one stock as SSRP as to a taxpayer's stock holdings if it "virtually tracks" changes in the value of the taxpayer stock holdings or any portion thereof.

The ILM

Taxpayer argued that the issue of whether the short positions in the Swaps were SSRP with respect to the ETF Trust shares for purposes of Section 246 had to be determined by applying the "portfolio rules" of Treas. Reg. Section 1.246-5(c)(1). Under these rules, Taxpayer argued, the Swaps were not SSRP with respect to the ETF Trust share because there was no overlap between the stock of the ETF Trust and the stocks represented in the Swaps. Therefore, Taxpayer argued, the Swaps were not SSRP with respect to the ETF Trust shares.

The IRS rejected this contention, concluding that whether the Swaps on an Index were SSRP was a facts-and-circumstances determination and, contrary to Taxpayer's argument, the determination was not limited to application of the portfolio rules of Treas. Reg. Section 1.246-5(c)(1). The IRS provided that individual stocks on the Index, in the aggregate, reflect the performance of the Index and also the performance of a single company's stock — the ETF Trust. The IRS reasoned that the portfolio rules do not prohibit a position referencing a portfolio of stocks from being a position in SSRP with respect to a stock of a single corporation, when the stock and the tested position reflect the performance of the shares of stock on the same Index. Rather, the IRS argued that the portfolio rules are intended to apply when the relevant stock holdings are positions in a portfolio of stocks (as opposed a position in a single share of ETF Trust stock) and the question is whether a position (e.g., the Swaps on an Index) is SSRP with respect to all or a portion of the taxpayer's stock holdings. The IRS thus applied the general rule and, not surprisingly, held that the Swaps were positions in SSRP with respect to the ETF Trust shares. Because Taxpayer acquired the ETF Trust shares and the Swaps positions simultaneously, the holding periods for the ETF Trust shares did not meet the requisite holding period to be eligible for the DRD.

The IRS also noted that the pass-through anti-abuse rule under Treas. Reg. Section 1.246-5(c)(6) may also be applied to deny the DRD with respect to the ETF Trust dividends. The IRS stated that the language of the anti-abuse rule indicates that: (1) a taxpayer "must be motivated to some degree to structure a transaction or series of transactions in a particular manner so as to avoid disallowance of the DRD" and (2) "such a motivation need not be a 'primary' or 'principal' determinant." Therefore, concluding that the Taxpayer's ability to claim the DRD was "one of many factors" in planning the transactions, the IRS advised that the transactions were similarly within the scope of the Treas. Reg. Section 1.246-5(c)(6) anti-abuse rule.

Implications

Although it is unsurprising that the IRS denied the DRD, the IRS's conclusion that the portfolio rules are intended to be triggered only when the taxpayer's relevant stock holdings are with respect to a portfolio of stocks, rather than a single stock, appears to be somewhat strained. In particular, it seems unsound to conclude that the transaction would have achieved its intended result (putting aside the anti-avoidance rules) if the taxpayer had simply owned more stocks in addition to the ETF shares.

In applying the anti-abuse provisions, the IRS did not apply the anti-abuse rule under Treas. Reg. Section 1.246-5(c)(1)(vi), which treats "a position that reflects the value of more than one stock as a position in SSRP with respect to the appropriate portion of the taxpayer's stockholdings if" inter alia, the value of the position virtually tracks (directly or inversely) "changes in the value of the taxpayer's stock holdings, or any portion of the taxpayer's stock holdings." This may have resulted from the fact that the anti-abuse rule is triggered by "a principal purpose" of avoiding the DRD disallowance, rather than if the transaction is undertaken "with a view" to avoiding disallowance of the DRD.

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ENDNOTES

¹ When X converted into an LLC, the other group member (Z) acquired the ETF Trust shares. X continued to enter into Swaps with third-parties and entered into a back-to-back swap with Z, the terms of which mirrored X's external swaps. Thus, Taxpayer continued to hold short positions in Swaps and corresponding long positions in the ETF Trust shares.

² Under Section 243, a corporation generally may claim a 70% DRD on most dividends it receives from a domestic corporation that is subject to income tax. Under Section 246(c)(1), however, no DRD may be claimed for a dividend on a share of stock that the taxpayer holds for 45 days or less during the 91-day period beginning on the date that is 45 days before the date on which the share becomes an ex-dividend with respect to the dividend.

³ Property is generally considered to be SSRP to stock when: (1) the fair market value (FMV) of the stock and property primarily reflects the performance of a single enterprise, the same industry, or the same economic factors (e.g., interest rates, commodity prices, foreign-exchange rates), and (2) changes in the FMV of the stock are reasonably expected to approximate changes in the FMV of the property.

⁴ See Treas. Reg. Section 1.246-5(c)(1)(iii) regarding a three-step procedure used to determine whether a position reflects the value of a portfolio of stocks. The portfolio rules provide that positions reflecting the value of a portfolio of stocks (generally more than 20 stocks) are treated under the rules of that section. Treas. Reg. Section 1.246-5(c)(1)(i).

⁵ Positions held by a related party to the taxpayer (within the meaning of Section 267(b) or Section 707(b)(1)) are treated as positions held by the taxpayer if such positions are held with a view to avoiding the application of Treas. Reg. Section 1.246-5 or 1.1092(d)-2. The second rule provides that a taxpayer is treated as diminishing its risk of loss by holding SSRP if the taxpayer holds an interest in, or is the beneficiary of, a pass-through entity, intermediary, or other arrangement with a view to avoiding the application of Treas. Reg. Section 1.246-5 or 1.1092(d)-2.