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Derivium Loan Update: IRS Targets Derivium
Loan Transactions

Introduction   IRS has targeted taxpayers who have engaged in loan transactions through Derivium Capital by sending them Preliminary Notices, in late January, 2007, stating that the Derivium loan transaction may be a "tax avoidance" device.

In essence, IRS claims the Derivium loan transaction is really a taxable sale of securities at the time taxpayers received the proceeds, rather than a bona fide loan. IRS has an audit project underway in Sacramento, California, involving Derivium-type loans.

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 has the option of rolling over the loan at maturity for an additional fee.

Note: Derivium has filed for bankruptcy and its client list has become public, thereby providing IRS with a road map of taxpayers who engaged in the loan transactions. Derivium is no longer in business.

Tax Consequences   IRS challenges the transaction and maintains a sale occurred in the initial year of the transaction on the following grounds:

1. The taxpayer was obligated to transfer the stock to Derivium, but repayment was optional because the purported loan was non-recourse to the taxpayer.

2. Taxpayers eliminated the risk of loss.

3. Principal payments are prohibited during the entire term of the transaction.

4. Legal title to the stock was transferred to Derivium.

5. The stock was treated as belonging to Derivium.

6. Derivium sold the stock to fund the transaction.

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%.

Borrower's Arguments   IRS'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. There is nothing nefarious about non-recourse loans. They are a staple of the real estate industry and the mere fact that the lender may only satisfy the amount owed from the collateral does not convert the loan into a sale.

    Indeed, there is a U.S. Supreme Court case, Tufts v. Commissioner, 461 U.S. 300 (1983) which analyzed the tax consequences of foreclosure on a non-recourse loan and the court treated the transaction as a bona fide loan.

    3. The constructive stock sales rules of IRC Sec. 1259 address and control the analysis of whether a stock transaction is considered a sale. IRS has not addressed the Derivium loan structure specifically in any published rulings.

    4. While the lender took possession of the stock as part of the transaction, the lender had no greater rights than other lenders who take stock as collateral for a loan, such as a margin loan. The rules with respect to a secured party in stock require the lender to have many of the rights granted to Derivium.

    5. IRS's allegation that Derivium sold the stock and then funded the loan with the sales proceeds is troublesome, but such actions, if true, occurred outside the parameters of the of the transaction as presented to the borrowers. The documentation and loan balance statements provided by Derivium always indicated the transaction was a loan.

Settlement   After representing at least a dozen taxpayers concerning Derivium loan transactions, it turns out that accepting the IRS position, in many instances, results in either a small increase or decrease in tax.

Thus far, I have not seen the situation where it was economically justifiable to challenge IRS's position, because of how the interest calculations work. Taxpayers who incurred capital losses in the years after they entered into the transaction may find themselves with unused capital loss carryforwards.

Penalties   Also, as part of any settlement, penalties should be waived since there is no justification for penalties under these circumstances, especially when the transaction was clearly structured to be a loan and IRS has not published any warnings or guidance regarding these transactions.

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. However, once a taxpayer understands how to analyze the transaction and how to crunch the numbers, filing an amended return to report the transaction in the year of sale may be the least costly alternative. For some taxpayers, they may wind up owing less tax under the IRS's theory.

Those who have received a Preliminary Notice from IRS regarding Derivium-type loans need to consult with an experienced tax professional and thoroughly understand the ramifications of amending their returns to report the transaction as a sale, as advocated by IRS.