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California's FTB Targets Derivium Loan Transactions
Introduction   The California Franchise Tax Board (FTB) has targeted Calfornia taxpayers who have engaged in loan transactions through Derivium Capital between 1997 and 2002 by sending them letters stating the Derivium loan transaction may be considered an abusive tax shelter. In essence, FTB believes the Derivium loan transaction is really a taxable sale of securities, coupled with an option to purchase, rather than a bona fide loan.



How It Works   In general, Derivium arranged loans for 90% of the value of a stock for an initial 3-year period at a compounded interest rate of approximately 10%. The loan is non-recourse, which means that at the end of the loan term, if the borrower cannot repay both principal and interest, the lender forecloses on the stock in full payment for the loan. The borrower does have the option of rolling over the loan at maturity for an additional fee.



Tax Consequences   When the loan matures and if the borrower does not repay it, the lender forecloses on the security (the stock) and the borrower has a taxable event at that time. The stock is treated as sold for the full amount of principal and interest outstanding. Thus, the borrower has a gain equal to the difference between the sales price (the full amount outstanding on the loan) and the borrower's basis in the security. The gain will usually meet long-term capital gain requirements under federal law and be taxed at 15%. Unfortunately, California does not have a special rate for capital gains, so that the gain is taxed at ordinary income rates.



Borrower's Arguments   FTB's position is questionable on several fronts:

1. Derivium documents treat the transaction as a loan secured by a pledge of stock. The borrower retains the beneficial economic interest in the stock and dividends are credited to the borrower.

2. The constructive stock sales rules of IRC Sec. 1259 address and control the analysis of whether a stock transaction is considered a sale and the Derivium loan transaction is not covered by IRC Sec. 1259. IRS has not addressed the Derivium loan structure specifically. California tax law is governed by IRC Sec. 1259 with respect to constructive sales since California incorporates federal tax law.

3. California's Department of Corporations filed a lawsuit against Derivium claiming that it was illegally engaged in the purchase and sale of securities. Derivium claimed the transactions in question were loans secured by a pledge of securities which fell within an exception under California's securities laws. On a summary judgment motion, the court ruled in favor of Derivium on this issue.



FTB's Concern   Apparently, FTB's concern is two-fold: (1) the loan foreclosure is not reported to FTB so taxpayers may never report it; and (2) the loan may be renewed indefinitely, so that a taxable event of foreclosure is never triggered - or is activated many years in the future. These concerns, however, do not exist if taxpayer correctly reports the transaction as a foreclosure when it occurs and pays the taxes due.



Conclusion   Based on the present state of the law, the loans arranged by Derivium Capital should be considered bona fide loans and not the sale of securities. Thus, California's Franchise Tax Board's position that some Derivium loans may be considered sales is incorrect, until IRS or the courts take a position to the contrary.

However, taxpayers should be concerned with the potential federal tax consequences if FTB successfully challenges the Derivium transaction. A sale at the time the transaction was entered into could convert a potential long-term capital gain into ordinary income, especially if the stock involved an employee incentive stock option under IRC Sec. 422, or if the stock was held for less than one year.

Since California has an information-sharing arrangement with IRS, taxpayers who amend their California returns to report the Derivium transaction as a sale can expect a notice from IRS requesting an amended return on the federal side as well.

Those who have received a notice from FTB with regard to their loans obtained through Derivium Capital need to consult an experienced tax professional and thoroughly understand the ramifications of amending their returns to report the transaction as a sale, as advocated by FTB.