How Short Sales Circumvent the Capital Gains Tax System

TL;DR

The paper explains how short sales can be used to defer taxes by offsetting gains and losses, highlighting a loophole in the Philippine tax system that allows such abuse.

Contribution

It reveals a novel tax avoidance strategy involving short sales and owned stocks, exposing unregulated loopholes in the Philippine tax system.

Findings

Short sales can offset gains and losses to defer taxes.

Tax loophole allows abuse in the Philippine system.

Potential for regulatory reform identified.

Abstract

Through a short sale, a person borrows a share of stock from a lender, sells the borrowed share to a third person at the current price, and purchases an identical share in the market at a future date and at a future price to replace the borrowed share of stock. This only makes sense if the short seller anticipates a downward trend in share price. The short seller incurs a gain if share price decreases because the cost of replacing the borrowed share falls below the selling price. The reverse is true in an ordinary sale, where a person owning a share of stock incurs a loss if price decreases because the selling price falls below the basis or acquisition cost. Therefore, when a taxpayer simultaneously owns a share of stock and short sells an identical stock, any gain in an ordinary sale of the owned stock is offset by a corresponding loss in the short sale of the borrowed identical stock, vice versa. This offsetting effect, in turn, creates an unexpected tax deferral opportunity abused in other jurisdictions and which remains unregulated in the Philippine tax system.