Background: A financial institution or business corporation that is engaged exclusively in buying, selling, dealing in, or holding securities on its own behalf and not as a broker may be classified as a security corporation. G.L. c. 63, § 38B. Security corporations are not subject to the corporate excise in the same manner as other business corporations. Rather, they are subject only to a single income measure excise determination and are taxed on their gross income, generally at a 1.32% rate. G.L. c. 63, § 38B(a), (c). However, “[a] corporation that is engaged in any business activity other than securities investment activity during any portion of its tax year is not entitled to classification as a security corporation.” 830 CMR 63.38B.1(3)(b). Further, if a security corporation which has been so classified engages in an impermissible activity, the Commissioner may revoke the classification and assess the corporation for any amounts due under the corporate excise. 830 CMR 63.38B.1(9).
Issue 1: Whether a corporation whose stock is pledged as security or collateral for a loan made by a third party to a shareholder of the corporation may be classified as a security corporation under G.L. c. 63, § 38B?
Directive 1: The pledge by a shareholder of shares of stock of a corporation as security or collateral for a loan to the shareholder, in and of itself, will not preclude classification of the corporation as a security corporation or result in revocation of a corporation’s existing security corporation classification. Moreover, restrictive covenants or similar provisions that directly or indirectly accompany any such pledge generally will not preclude or result in revocation of such classification as long as they merely limit the security corporation to investment activities that are permissible under G.L. c. 63, § 38B. Thus, a covenant that places a limitation on the debt levels of the security corporation would not result in denial or revocation of security corporation status. Likewise, a covenant that limits a security corporation to investments in a certain general class of securities or assets would not result in denial or revocation of security corporation status. However, a covenant that specifically pertains to the security corporation’s relationship with or holdings in the securities of the shareholder or pledgee or one or more affiliates of such shareholder or pledgee is impermissible. For example, the following types of restrictive covenants will result in denial or revocation of security corporation classification:
- A covenant which provides that a stock pledgee could, in the event of a financial deterioration of the borrower (but prior to an actual event of default) become (i) a direct creditor of the security corporation or (ii) a pledgee of assets of the security corporation;
- A covenant which requires the shareholder/pledgor to withdraw securities from the security corporation through a direct or indirect distribution and to provide a pledge of (or other form of security in) those securities to the lender;
- A covenant which directs the investments of the security corporation in any manner to the securities of the shareholder or the pledgee or any affiliate of either the shareholder or the pledgee, or of any other party in whom the shareholder or the pledgee or an affiliate has a material business interest, such as customers or business partners.
These examples are not exhaustive of fact patterns that may give rise to denial or revocation of security corporation status. A taxpayer may request a letter ruling from the Department with respect to particular covenants, issues, or fact patterns not addressed in this Directive. See 830 CMR 62C.3.2(4).
The rules contained in this Directive 1 shall apply as of the date of issuance of this Directive. No inference is intended as to the status of a corporation claiming security corporation classification for any period prior to the issuance of this Directive.
Discussion: A corporation that is engaged in any business other than securities investment activity during any portion of its tax year is not entitled to classification as a security corporation. 830 CMR 63.38B.1(3)(b). Furthermore, assets must be held for investment purposes and not as an accommodation to shareholders or other related entities. Thus, for example, a security corporation may not act as guarantor of a loan to a shareholder. Nor may the assets (as opposed to the stock) of a security corporation be pledged as security for a loan to a shareholder. Where the assets and, in certain circumstances, the shares of stock of a corporation are pledged to secure an obligation of a shareholder of the corporation, the corporation whose assets or stock is pledged is effectively performing a business function on behalf of the shareholder, something that is impermissible as to a corporation that either is, or seeks to be, classified as a security corporation pursuant to G.L. c. 63, § 38B. In particular, if a stock pledge contains restrictive covenants or comparable provisions allowing a stock pledgee to become a direct creditor of the security corporation, or requiring the pledgor to withdraw securities from the security corporation through a distribution and pledge of those securities to the lender, or directing the security corporation’s investments to securities of the shareholder or the pledgee (or affiliates or other parties having a business relationship with the shareholder or pledgee), the Commissioner will view the corporation as performing a business function on behalf of the shareholder and thereby engaged in a business activity other than securities investment. In such a case, the corporation will not qualify to be classified as a security corporation or, if previously classified, its § 38B classification will be revoked. See 830 CMR 63.38B.1(5)(a)(1) (a corporation that holds securities, such as cash equivalent instruments, in circumstances where the funds invested in an instrument are used directly or by an affiliate for operational purposes….does not qualify as a security corporation).
Issue 2: To what extent is it permissible for a security corporation to acquire appreciated securities from an affiliate and subsequently sell such securities to a third party?
Directive 2. A security corporation may acquire appreciated securities from an affiliate and subsequently sell such securities to a third party in cases where (1) the transfer of the appreciated securities from an affiliate to the security corporation comports with the general requirements of § 38B, including the requirements of 830 CMR 63.38B.1(4)(d) (i.e., that securities acquired from the affiliate were initially acquired by the affiliate through a public exchange or other arm’s-length secondary market), and (2) the security corporation can demonstrate that (a) the security corporation’s acquisition and ownership of the stock is for investment purposes, (b) is consistent with all other requirements for security corporation classification under the applicable statutes, regulations and administrative pronouncements, and case law, and (c) is not part of a plan for disposition of the asset to minimize tax on any built-in gain. As to requirement (2), in any case where the security corporation cannot meet this burden, such acquisition and ownership is not permissible and shall result in the revocation of the security corporation’s classification. This Directive shall apply to all open tax years.
Discussion: In order to qualify for security corporation classification under G.L. c. 63, § 38B, a corporation must acquire and hold the securities in question for investment purposes. 830 CMR 63.38B.1(3)(a). A corporation that is engaged in any business activity other than securities investment activity during any portion of its tax year is not entitled to classification as a security corporation. 830 CMR 63.38B.1(3)(b). Security corporation classification is not intended to be a means for an owner of an appreciated security to shelter the gain realized from the sale of that security from the general corporate excise rate by using a security corporation as a conduit for such sale. Such activity does not comport with the requirement that a security corporation be engaged exclusively in buying, selling, dealing in, or holding securities for investment purposes. See State Tax Commission v. The PoGM Co., 369 Mass. 611, 612 (1976); Letter Ruling 94-2 (April 1, 1994).
Apart from examining compliance with the statutory requirements of G.L. c. 63, § 38B, in cases where appreciated assets are transferred to a security corporation and are subsequently sold by the security corporation, the Commissioner may, in appropriate circumstances, apply the sham transaction doctrine, step transaction doctrine, or other applicable anti-abuse principles. See e.g. Syms Corp. v. Commissioner of Revenue, 436 Mass. 505, 509-510 (2002); MASSPCSCO v. Board of Assessors of Woburn, Appeals Court Docket No. 10-P-1286 (September 15, 2011); G.L. c. 62C, § 3A (sham transaction codification that applies for tax years beginning on or after January 1, 2002). In applying the sham transaction or related doctrines, the Commissioner will take into consideration all the facts and circumstances surrounding the transfer of the securities to a security corporation and the subsequent sale thereof, including the securities’ holding periods of both the affiliate transferor and the security corporation transferee, and the amount of any built-in gain in such securities at the time of the transfer of the securities to the security corporation.
The rules contained in this Directive 2 shall apply to all open tax years. For taxable years beginning on or after January 1, 2002, the provisions of G.L. c. 62C, § 3A are also applicable.
Commissioner of Revenue
May 24, 2012