The Seagram's stock redemption plan may not last long.

Recent articles in The Wall Street Journal and The New York Times have drawn attention to a stock redemption by DuPont of shares owned by Seagram Co. On May 3, 1995, in response to this redemption, Reps. Archer and Gibbons introduced HR 1551, intended to end the perceived abuse by copycat redemptions that may follow the Seagram plan. Although the bill probably is not needed, it will certainly clarify the issue. The controversy centers on the tax effects of the redemption of stock, the simultaneous issue of an equal number of stock warrants, use of the dividends-received deduction (DRD) and the application of Sec. 302(b)(1).

A major shareholder of Seagram Co. Ltd. wanted cash for Seagram to invest in the entertainment conglomerate MCA. Seagram obtained the cash by having DuPont redeem 156 million DuPont shares owned by Seagram. Seagram still retains 8.2 million shares. Seagram's ownership interest in DuPont declined from 24.2% to 1.2%. The shares were exchanged for $8.3 billion in cash and notes, plus approximately $440 million in warrants to purchase DuPont shares, approximately $56 per share in total. Seagram received one warrant for each share redeemed. The warrants issued allow Seagram to purchase 48 million DuPont shares for a 60-day period ending on Oct. 6, 1997, at a price of $89 per share; 54 million shares for a 60-day period ending on Oct. 6, 1998, at a price of $101 per share; and 54 million shares for a 60-day period ending on Oct. 6, 1999, at a price of $114 per share. The warrants are subject to various conditions, including limitations on the sale to parties other than DuPont.

Redemptions under Sec. 302

Sec. 302(a) provides that if a redemption meets one of the requirements in Sec. 302(b)(1), (2), (3) or (4), the redemption will be treated as a sale or exchange. Otherwise, Sec. 302(d) states that the redemption is treated as a distribution of property to which the Sec. 301 dividend rules apply. Usually, the taxpayer wants the distribution to meet one of the Sec. 302(b) requirements, thereby receiving exchange treatment and allowing for recovery of basis before any tax on the gain associated with the redemption. However, Seagram wanted the opposite result, to take advantage of the corporate 80% DRD.

The tax incentive

Since the 80% DRD applies to the redemption, Seagram plans to pay a net tax rate of 7% (20% X 35% maximum tax rate for corporations) on the dividend amount. Seven percent of $8.8 billion is approximately $615 million. Under Sec. 302 sale or exchange treatment, the amount in excess of basis is treated as capital gain and the profit of $6 billion yields a tax of about $2.1 billion when taxed at 35%. This $1.5 billion tax savings certainly motivated Seagram to structure the transaction as a dividend (i.e., by including warrants as part of their consideration received in the redemption).

Sec. 302(b) tests

Sec. 302(b)(1) through (4) identify the circumstances that allow a redemption to qualify for exchange treatment. Sec. 302(b)(4) is applicable only to noncorporate shareholders, and therefore is not available to Seagram. Sec. 302(b)(3) is for the complete termination of a shareholder's interest. Since Seagram retained over eight million shares, this does not apply.

Of the two remaining provisions, Sec. 302(b)(1) is highly subjective and (b)(2) is structured to add certainty by providing a bright-line test. Sec. 302(b)(2) compares the holdings of the shareholder before and after the redemption and has three parts. After the redemption, the shareholder must own less than (1) 50% of the total combined voting power of all classes of stock entitled to vote; (2) 80% of the voting stock owned before the redemption; and (3) 80% of the common stock (voting and nonvoting) owned before the redemption. Since Seagram's ownership percentage in DuPont dropped from about 24% to 1%, the transaction clearly falls within the percentages stated in Sec. 302(b)(2). However, Sec. 318 applies to this transaction (Sec. 302(c)(1)).

Sec. 318(a)(4) provides that if a person has an option to acquire stock, that stock is considered owned by the person who owns the option. If Seagram's options to purchase DuPont stock are considered, the percentage of ownership before and after the redemption is exactly the same. Since the ownership percentage did not change, the transaction fails the two 80% tests of Sec. 302(b)(2) and is treated as a dividend rather than an exchange.

The only possibility for disallowance of the warrants is the time restriction for their exercise. Seagram is relying on Rev. Rul. 89-64 to prevent that interpretation. In Rev. Rul. 89-64, a corporate officer received cash and options in redemption of one-half of his shares. The options provided the officer the right to reacquire the same number of shares that were redeemed, after a fixed period of time elapsed. In the ruling, the Service explained that warrants, convertible debentures and options all are consistent with the intent of Sec. 318, as long as the security is redeemable at the election of the shareholder. In Rev. Rul. 89-64, the executive was denied exchange treatment because considering the options received, the ownership percentage did not change. The required waiting period was not considered as mitigating the taxpayer's right to convert the options at his election. In addition, the IRS noted that the receipt of options was not consistent with the permanent equity contraction envisioned by Congress when enacting Sec. 302(b)(2). Therefore, the distribution was taxed under Sec. 301 as a dividend distribution.

Under Sec. 302(b)(1), a distribution receives exchange treatment if it is not essentially equivalent to a dividend. Sec. 302(b)(5) states that in determining whether or not a redemption meets the requirements of Sec. 302(b)(1), the application of Sec. 302(b)(2), (3) and (4) shall not be taken into account. In other words, even though the redemption does not pass the bright-line test of subparagraph (2), this does not mean that the redemption cannot qualify for exchange treatment.

Davis

The leading case in the Sec. 302(b)(1) area is Davis, 397 US 301 (1970), reh'g denied, 397 US 1071 (1970), from which four important principles resulted. First, the attribution rules of Sec. 318 do apply with reference to Sec. 302(b)(1). Second, redemption of the stock of a sole shareholder is always essentially equivalent to a dividend. Third, the business purpose of the redemption is irrelevant when determining dividend equivalence under Sec. 302(b)(1). Finally, to qualify for exchange treatment, a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.

The nature of a shareholder's "interest" was not explained in Davis, but can be found in Rev. Rul. 75-502. That ruling, citing Himmel, 338 F2d 815 (2d Cir. 1964), defines a shareholder's interest as (1) the right to vote and thereby exercise control; (2) the right to participate in current earnings and accumulated surplus; and (3) the right to share in net assets on liquidation.

The facts of the ruling explain that a trust directly and constructively owned 57% of corporation X. All of the trust's shares were redeemed, but the trust still constructively owned 50% of the outstanding shares. Therefore, the redemption failed the percentage tests of Sec. 302(b)(2). However, applying the principles of Davis, considering the reduction in the trust's share of dividends, rights on liquidation and especially the loss of control due to the reduction of voting rights, the redemption did constitute a meaningful reduction of the estate's interest in X. Therefore, the redemption was not essentially a dividend and qualified for exchange treatment.

In Rev. Rul. 75-512, reduction of an ownership percentage from 30% to 24.3% was deemed a meaningful reduction within the meaning of Davis and the redemption qualified for exchange treatment. In Rev. Rul. 76-385, a redemption that reduced the stockholder's interest from 0.0001118 to 0.0001081 qualified for exchange treatment because the stockholder could no longer exercise control over corporate affairs.

When evaluating the Seagram redemption, one might reasonably assume that a reduction from 24% to 1% is a meaningful reduction within the meaning of Davis. This is especially true when one considers (1) the next largest principal stockholder is Wilmington Trust Corp., which beneficially owns 5.7% of the shares of DuPont's common stock, and (2) that, because of a 1986 agreement, Seagram was committed to a reduction of representation on DuPont's board of directors. After the redemption, four Seagram nominees resigned from the DuPont board. Surely, there can be little doubt that the loss of all four directors is a meaningful reduction of Seagram's interest in DuPont. Therefore, despite the presence of the warrants and the Sec. 318 attribution rule, under Sec. 302(b)(1), Davis and several existing revenue rulings, Seagram should be required to report the redemption as an exchange.

From Leonard G. Weld, Chair, The University of Texas at Tyler, Tyler, Tex., and Charles E. Price, CPA, Ph.D., Auburn University, Auburn, Ala.