Monetization Strategy (Short Sale against the Box)

Why is there no tax liability in short sale against the box?

Say for instance in own 100 units of Company A which sells for $1 and this $100 constitute 70% of my total asset. I am also an executive of the company and company policy prohibits me from selling. To monetize the position, I approached a broker to borrow 99% of my holdings (99 units) in Company A and sold it in the market for $1 each, thereby generating $99 which I can invest in order asset classes to diversify my portfolio.

The question is: Why is there no tax liability for the sale?

Either i own the stock or not, as long as an asset has been sold, there should some form of tax liability accompnying the sale. So how come Short Sale against the Box manages to evade this tax liability?

In the real world there are tax liabilities. Keep in mind however that you haven’t actually sold the shares you own - you’ve sold borrowed shares and retained yours with the original cost base.

The IRS has constructive sale rules which are similar to Canada’s synthetic sale. These rules effectively consider the position sold for tax purposes if you eliminate a substantial portion of your risk.

The actual rules are ambiguous and do not clearly define what is meant by a “substantial portion”, although it is generally believed to be > than 80% or 90%. You need serious tax advice before implementing this is the real world.

The text ignores this because I’m sure there are some countries that do not have such tax policies in place. For the purpose of the exam assume that the transaction is tax free.

Saw this in the curriculum:

Historically, the concept of capital gain realization has been tied to the “sale or disposition” of appreciated securities. In the case of monetization transactions, there has been no actual transaction in the appreciated securities themselves. That is, there is no formal legal “connection” between the monetization transaction and the appreciated securities. The investor still owns the securities and, if the securities are viewed in isolation, remains fully exposed to the risk of loss and opportunity for profit associated with the securities. The investor can assert that entering into a monetization arrangement does not, as a matter of legal form, constitute a sale or disposition of the appreciated securities.

I have the following question:
Richards: “My broker says he can arrange a cashless collar against CTAS or a short sale against the box. I understand that both methods will avoid incurring an immediate capital gain and both will expose me to the same level of market risk. I can borrow against the position in both cases and offset the cost of borrowing with the CTAS dividends.”

Richards’ understanding about monetizing CTAS is most accurate with respect to:

  1. using the CTAS dividends to offset borrowing costs.
  2. avoiding immediate capital gains under both strategies.
  3. the risk exposure of both strategies.

*** COrrect option is 2**

In my opinion, there is a tax even becasue since you sell the option, , you earn money that sould pay taxes (even if is a 0 cash collar, becase the expense does not imply a tax earning). On the other hand, option 1 is true since the lender of the stock has the economic right of the dividend. What i am getting wrong??

thanks in advance.