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Nonqualified preferred stock.

On September 23, 1998, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the tax treatment of transactions involving "nonqualified preferred stock." TEI's comments, which took the form of a letter from TEI President Lester D. Ezrati of Hewlett-Packard Company to Commissioner of Internal Revenue Charles O. Rossotti, were prepared under the aegis of the Institute's Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc.

In order to eliminate tax deferral on receipt of certain preferred stock received in connection with specified corporate transactions, the Taxpayer Relief Act of 1997 amended a number of provisions of the Internal Revenue Code. Specifically, taxpayers receiving "nonqualified preferred stock" (NQPS) in connection with specified transactions are to treat such stock as property other than stock, i.e, generally treat such stock as taxable "boot." The changes were made in respect of selected transactions that Congress believed improperly benefitted from deferral because the "taxpayer receive[d] relatively secure instruments in exchange for relatively risky instruments."(1)(*) Congress also authorized the Secretary of the Treasury to promulgate regulations to effect the specific purposes of the statutory changes.

Tax Executives Institute believes that the statutory changes have engendered significant confusion and recommends that the IRS use its authority to issue proposed regulations to clarify the definition of NQPS and the manner in which the definitions apply under the rules governing the specified transactions. In addition, the extent to which NQPS will be treated as property other than stock under the Code should be clarified. As a result, I am pleased to submit the following comments and recommendations on issues raised by the NQPS provisions of the 1997 Act.

Background

TEI is the principal association of corporate tax executives in North America. Our 5,000 members represent the largest 2,800 companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to the uniform and equitable enforcement of the tax laws, and to reducing the cost and administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to addressing the issues raised by the NQPS provisions.

Overview of Statutory Changes

The Taxpayer Relief Act of 1997 amended sections 351, 354, 355, 356 and 1036 of the Internal Revenue Code to, in general, treat certain preferred stock as "property other than stock" for purposes of the specified sections. More specifically, sections 351(g)(2) and (g)(3) define the terms and conditions under which preferred stock instruments are to be considered "nonqualified." Sections 351(g)(1), 354(a)(2)(C), 355(a)(3)(D), 356(e), and 1036(b) apply the NQPS definition and prescribe the tax treatment under the specified transactions. As "property other than stock," the NQPS will be treated as "boot" and, hence, the recipients will be taxed on the value of NQPS. Unless regulations provide otherwise, NQPS continues to be treated as stock for all other purposes of the Code, including determining the tax consequences to other participants to the same transaction. For example, a person transferring property to a corporation that receives stock and securities, including NQPS, in an exchange transaction described under section 351(a) is not accorded nonrecognition treatment in respect of NQPS.(2) In determining whether the transaction qualifies under section 351(a) -- in determining, for example, whether transferors of property meet the "control" requirement -- NQPS is counted as stock.(3) The treatment of NQPS as boot does not, moreover, enable the issuer to reclassify the stock as debt for which an interest expense deduction is permitted on payment of dividends.

Under section 351(g)(2)(A), "preferred stock," which is defined under section 351(g)(3) as "stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent," is treated as NQPS if any of the following criteria is satisfied:

(i) the holder has the right to require the issuer or a related person to redeem or purchase the stock,

(ii) the issuer or a related person is required to redeem or purchase such stock,

(iii) the issuer or a related person has the right but not obligation to redeem or purchase the stock, and, as of the issue date, it is more likely than not that such right will be exercised, or

(iv) the dividend rate on such stock varies in whole or in part with reference to interest rates, commodity prices, or similar indices.

Section 351(g)(2)(B), however, circumscribes the application of the criteria in clauses (i) to (iii). Specifically, where rights or obligations of redemption or purchase may be exercised only following a 20-year period beginning on the issue date, the stock will not be treated as NQPS. In addition, where the right or obligation of purchase or redemption is subject to a contingency that, as of the issue date, "makes remote the likelihood of redemption or purchase," the stock will not be NQPS.

Section 351(g)(2)(C) sets forth additional exceptions for disregarding certain rights or obligations of purchase or redemption in determining whether preferred stock is considered NQPS. Under that section, the preferred stock is not treated as NQPS by virtue of clauses (i) to (iii) if the right or obligation may be exercised only upon the death, disability, or mental incompetency of the holder, but only if neither the stock surrendered nor the stock received in the exchange is stock of a corporation any class of which is readily tradable on an established securities exchange or otherwise. Finally, the rights and obligations set forth in clauses (i) to (iii) are disregarded (i.e., the preferred stock is not treated as NQPS) if the rights or obligations (a) relate to preferred stock received as reasonable compensation for services for the issuer or a related person and (b) are contingent upon the holder's separation from service from the issuer or a related person.

Finally, since Congress intended to require gain recognition only where a taxpayer is exchanging risky instruments for more secure instruments, gain recognition is not required under section 354, 355, or 356 under the following circumstances: (1) certain exchanges of preferred stock for comparable preferred stock of the same or lesser value;(4) (2) an exchange of preferred stock for common stock; and (3) certain exchanges of debt securities for preferred stock of same or lesser value. An exception to gain recognition is also provided for certain recapitalizations of family owned corporations.

Discussion

Section 351(g)(4) authorizes the Treasury and IRS to prescribe "such regulations as may be necessary or appropriate" to carry out the purposes of sections 351(g), 354(a)(2)(C), 355(a)(3)(D), and 356(e). In addition, regulations consistent with the treatment of NQPS under these sections may also be issued under other provisions of the Code. TEI has four principal recommendations concerning the manner in which issues arising under the NQPS provisions should be addressed under regulations. We urge the IRS and Treasury to issue proposed regulations incorporating TEI's recommendations as soon as possible.

(1.) To determine whether preferred stock "does not participate in corporate growth to any significant extent," the regulations should (a) generally adopt the facts and circumstances approach provided under Treas. Reg. [sections] 1.305-5(a) and (b) exclude from NQPS treatment instruments that contain meaningful rights to convert the preferred stock into the issuer's common stock.

For an instrument to be classified as NQPS, it must first be considered preferred stock that is "limited and preferred as to dividends and does not participate in corporate growth to any significant extent."(5) In determining what rights constitute "participation in corporate growth to any significant extent," TEI recommends that the regulations generally adopt a facts-and-circumstances approach. We believe the factors listed in Treas. Reg. [sections] 1.305-5(a) and the examples provided in Treas. Reg. [sections] 1.305-5(d) (examples 8 and 9) are helpful in determining whether an instrument has indicia of "significant participation" in corporate growth? We submit, however, that a comparison of fair market value of the corporation's net assets to the liquidation preference of the preferred stock is more economically meaningful than a comparison of book value with the corporation's net assets (which Treas. Reg. [sections] 1.305-5(a) contemplates). The book value of self-developed intangibles, for example, may not reflect the true value.

TEI submits that a meaningful right to convert preferred stock into the issuer's common should constitute sufficient evidence of a right to "participate in corporate growth to a significant extent" and, hence, prevent the application of the NQPS provisions. Indeed, most convertible preferred stock is issued with the view that the instrument will convert into the issuer's common. Hence, most such instruments should not be viewed as NQPS. In the legislative history to the NQPS provisions, however, Congress evinced concern that the NQPS provisions should not necessarily be avoided by the inclusion of conversion rights per se: "In no event will a conversion privilege into stock of the issuer automatically be considered to constitute participation in corporate growth to any significant extent."(7) The statute includes no specific prohibition against considering conversion rights, and it is likely Congress concluded that many conversion rights are in fact indicative of an opportunity to "participate in corporate growth to [a] significant extent." In other words, Congress was concerned only about illusory conversion rights that were unlikely, if ever, to be exercised. TEI believes that a "meaningful" conversion right granting the holder, for example, real upside potential in the growth of anticipated earnings, etc., should serve to remove the stock from the ambit of NQPS.(8) In our view, a conversion right should be deemed to be "meaningful" unless at the time of the exchange there was little or no likelihood that the holder would exercise its conversion rights.

(2.) Instruments containing put rights for holders that are exercisable only upon a change in control should be excluded from NQPS treatment, unless, at the time of the exchange, the probability of a change in control is not remote. In addition, the test to determine whether it is more likely than not that a right to redeem or purchase by the issuer (or a related person) will be exercised should include a safe harbor similar to that contained in Treas. Reg. [sections] 1.3055(b)(3).

Preferred stock containing holder put rights is excluded from NQPS treatment under section 351(g)(2)(B) if the put rights are "subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase." Put rights are often included in financial instruments in order to protect investors in the event that the ownership and management of the company changes significantly. TEI submits that a holder's right to put the shares to the issuer upon change of control should automatically be treated as falling outside the ambit of NQPS, unless, at the time of the exchange, the probability of a change in control is significant enough to warrant disclosure in offering materials governing the preferred stock. Offering materials describing the risks of the preferred stock that are developed in connection with the exchange transaction should afford taxpayers a presumption concerning either the likelihood or remoteness of a change of control.

Under sections 351(g)(2)(A)(ii) and (iii), preferred stock is NQPS if the issuer or a related person is either required or has the right but not the obligation to redeem or purchase the stock, and, as of the issue date, it is more likely than not that such right will be exercised. The regulations under section 305 include rules governing the treatment of redemption premiums and, more important, set forth a specific standard for determining whether it is more likely than not that a right to redeem or purchase in the issuer (or a related person) will be exercised. Since the standard is the same for both the section 305 regulations and section 351(g) -- whether it is more likely than not the rights of redemption or purchase will be exercised -- TEI recommends that the NQPS regulations adopt the standards, including the safe harbor, set forth in Treas. Reg. [sections] 1.305-5(b)(3) for determining whether the rights of redemption or purchase will be exercised.(9)

(3.) The regulations governing section 351(g)(2)(A)(iv) should clarify that instruments will be treated as NQPS only if the dividend return is substantially tied to indices unconnected with the profitability of the issuer.

Section 351(g)(2)(A)(iv) includes within the definition of NQPS preferred stock where "the dividend rate on such stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices or other similar indices." The provision is seemingly intended to classify preferred stock as NQPS where the return does not reflect traditional risks associated with an equity investment in the issuer. Thus, as explained by one court differentiating debt from equity, tax-free treatment upon receipt of preferred stock should be limited to someone "embark[ing] upon the corporate adventure, taking the risks of loss attendant upon it, so that he may enjoy the chances of profit."(10)

The legislative history illustrates the provision with an example involving "auction rate" preferred stock that "has a mechanism to reset the dividend rate...so that it tracks changes in interest rates over the term of the instrument...."(11) TEI recommends that the regulations governing section 351(g)(2)(A)(iv) clarify that this provision only applies to instruments where the dividend return is substantially tied to indices unconnected with the profitability of the issuer. In other words, the clause should only encompass preferred stock where the holder's rate of return and risk of loss is akin to that of a lender rather than a shareholder. While there may be sound tax policy reasons for Congress to deny tax-free treatment where debt-like instruments disguised as equity are used as consideration for exchanges under section 351, 355, or 368, the reach of the disqualification must hew to the statutory provision and in our view should be circumscribed. Where the holder's dividend return on an instrument remains tied substantially to the underlying profitability of the issuer, there is no policy or administrative reason to deny tax-flee treatment to the recipient of the preferred stock.

(4.) The IRS and Treasury should be chary in treating NQPS as an instrument other than stock, limiting the application of such rules to prevent taxpayers from obtaining tax-free treatment where the instrument received is subject to substantially less risk than the one exchanged.

The statute states that until regulations are issued, NQPS is to be treated as stock for all other provisions of the Code.(12) There are countless provisions in the Code where the characterization of an instrument as "stock" is important. Hence, the question arises whether NQPS should be treated as "other than stock" under, for example, section 267, section 1504, or even under the passive foreign investment company provisions. Concededly, arguments may be made to the contrary under any particular Code provision, but TEI believes that generally the recharacterization of NQPS as "other than stock" under any Code provision other than those targeted in the 1997 Act is rife with risks for creating confusion, complexity, and unintended consequences to the detriment of the government as well as taxpayers. Indeed, the laserlike targeting of the 1997 Act's statutory amendments implies that the scope and number of instances where NQPS is to be treated as an instrument other than stock should be quite narrow. We believe that the problems that may arise from the legislative changes can be mitigated only by limiting the scope and number of instances where NQPS is treated as something "other than stock" under any provision of the Code other than the sections in the 1997 legislation. For example, voting NQPS should be treated as stock for purposes of section 368(c). Consequently, in crafting the regulations, we recommend that the IRS and Treasury avoid characterizing NQPS as an instrument other than stock except in very limited circumstances.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the treatment of nonqualified preferred stock under 1997 Taxpayer Relief Act. If you should have any questions about the Institute's position or if we can be of any assistance, please do not hesitate to contact either Philip G. Cohen, chair of TEI's Federal Tax Committee, at (201) 871-5504 or Jeffery P. Rasmussen of the Institute's legal staff at (202) 638-5601.

(*) Notes appear on page 383.

Notes

(1) Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, at 209 (1997) (hereinafter "1997 General Explanation").

(2) Section 6010 of The Internal Revenue Service Restructuring and Reform Act of 1998 includes a technical correction clarifying that section 351(b) applies to a transferor who transfers property in a section 351 exchange and receives NQPS in addition to stock that is not treated as "other property" under that section. In other words, if the transferor receives only NQPS but the transaction in the aggregate qualifies as a section 351 exchange, the transferor would recognize loss and the basis of NQPS and the property in the hands of the transferee corporation would reflect the transaction in the same manner as if that transferor had received solely "other property." As under the 1997 Act, NQPS continues to be treated as stock received by a transferor to qualify a transaction under section 351(a) unless regulations provide otherwise.

(3) H. R. Rep. No. 105-220, 105th Cong., 1st Sess. 544 (1997); 1997 General Explanation 209, 213.

(4) Where there is an exchange of NQPS for NQPS meeting the requirements of both sections 351 and 354, section 354 will apply for purposes of the NQPS provisions and thus the exchange would be tax-free. H. R. Rep. No. 105-220, 105th Cong., 1st Sess. 544 (1997); 1997 General Explanation 209, 212.

(5) I.R.C. [sections] 351(g)(3)(A).

(6) Treas. Reg. [sections] 1.305-5(a) provides the following description of preferred stock.

The term "preferred stock" generally

refers to stock which, in relation to

other classes of stock outstanding, en

joys certain limited rights and privileges

(generally associated with specified

dividend and liquidation priorities)

but does not participate in corporate

growth to any significant extent.

The distinguishing feature of "preferred

stock" for the purposes of section

305(b)(4) is not its privileged position

as such, but that such privileged

position is limited and that such

stock does not participate in corporate

growth to any significant extent.

However, a right to participate which

lacks substance will not prevent a

class of stock from being treated as

preferred stock. Thus, stock which enjoys

a priority as to dividends and on

liquidation but which is entitled to

participate, over and above such priority,

with another less privileged

class of stock in earnings and profits

and upon liquidation, may nevertheless

be treated as preferred stock for

purposes of section 305 if, taking into

account all the facts and circumstances,

it is reasonable to anticipate at the

time a distribution is made (or is

deemed to have been made) with respect

to such stock that there is little

or no likelihood of such stock actually

participating in current and anticipated

earnings and upon liquidation beyond

its preferred interest. Among the

facts and circumstances to be considered

are the prior and anticipated

earnings per share, the book value per

share, the extent of preference and of

participation of each class, both absolutely

and relative to each other, and

any other facts and which indicate

whether or not the stock has a real

and meaningful probability of actually

participating in the earnings and

growth of the corporation. The

determination of whether stock is preferred

shall be determined without regard to

any right to convert such stock into

another class of stock of the corporation.

The term "preferred stock," however,

does not include convertible debentures.

(7) H. R. Rep. No. 105-220, 105th Cong., 1st Sess. 544 (1997); 1997 General Explanation 209, 211 (emphasis supplied).

(8) In determining whether stock is considered preferred stock for purposes of section 305(b)(4), the regulations generally disregard conversion rights. See Treas. Reg. [sections] 1.305-5(b)(1). Regardless of the merits of excluding conversion rights for purposes of section 305(b)(4), conversion rights should not be ignored for purposes of the NQPS provisions. Indeed, for NQPS purposes the view should be the opposite -- convertible stock should not be NQPS unless there is something unusual about the conversion terms that make the likelihood of exercise (at the time of issuance of the stock) so remote or contingent that conversion is unlikely.

(9) A redemption pursuant to an issuer's right to redeem is not treated as more likely than not to occur if (1) the issuer and holder are unrelated; (2) there are no plans or arrangements that effectively require or are intended to compel the issuer to redeem; and (3) the exercise of the right to redeem would not reduce the yield of the stock.

(10) United States v. Title Guarantee & Trust Co., 133 F.2d. 990, 993 (6th Cir. 1943).

(11) 1997 General Explanation 209.

(12) H. R. Rep. No. 105-220, 105th Cong., 1st Sess. 544 (1997); 1997 General Explanation 209, 213.
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