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Dividends received deduction denied for forward conversions.

For a corporate taxpayer to enjoy a dividends received deduction (DRD), the stock on which the dividend is paid must be held for more than 45 days. This holding period is reduced for any period during which the taxpayer has an option to sell the stock or substantially identical stock.

In Progressive Corp. v. United States, the district court ruled a taxpayer that entered into a "forward conversion" (that is, the purchase of stock, purchase of a put and sale of a call ) was nevertheless eligible for a DRD. The court's view was based on its interpretation of a regulation that seemingly required a taxpayer to be short the underlying stock (that is, sell borrowed stock) in order for the holding period to be tolled.

Predictably, the Sixth Circuit Court of Appeals reversed the lower court's holding (in a July 22, 1992 decision). It said the statute requiring a reduction in the holding period for days on which the investor owns a put is unambiguous, and the district court's construction of the regulations ignored the plain language of the statute, which does not require (or even use the phrase) a short position.

Moreover, the lower court's interpretation of the regulation was internally inconsistent, viewing the holding period as reduced only if the taxpayer is short the stock. If, however, the taxpayer does not own the stock, it will not, by definition, receive any dividends to which the DRD might apply.

Progressive also executed trades in which it bought stock and sold a call with an exercise price substantially below the value of the stock (a "deep-in-the-money" call). In accordance with revenue ruling 80238, the Internal Revenue Service claimed Progressive earned no holding period for this stock because, in substance, such a call is the equivalent of an obligation to sell the underlying stock.

Observation: The Sixth Circuit seemed sympathetic to the IRS but ultimately remanded the case to the lower court to restore the question of whether Progressive was entitled to a dividends received deduction. The lower court is expected to side with the IRS.
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Publication:Journal of Accountancy
Article Type:Brief Article
Date:Oct 1, 1992
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