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Variable rate preferred stock: current status and prospects for a continuing favorable tax climate in the 1980s and 1990s.

Variable Rate Preferred Stock: Current Status and Prospects for a Continuing Favorable Tax Climate in the 1980s and 1990s

I. OVERVIEW

Until this decade, aggressive investors and chief financial officers showed little interest in inventing in preferred stock. The basic drawback to preferred stock investments has historically been their erratic price swings in reaction to fluctuations in interest rates and their inability to preserve principal value. The investment climate changed in 1981 with the entry of certain financial products called variable interest rate preferred stock (VRP), resulting in a virtual flood of such offerings. The attraction of traditional preferred stock among corporate investors has always been the availability of the section 243(a)(1) (1) dividends received deduction (DRD). (2) The continued availability of the full DRD for VRPs may be in doubt considering proposals to limit the deduction introduced in recent sessions of Congress. The most recent attack occurred in the Revenue Act of 1987, though the proposal was stricken in Conference. (3) More recently, a Treasury official, reflecting the Treasury's concern over perceived abuses of "junk food" financing in leveraged buyouts, stated that the issue of distinguishing debt from equity is "an active area of discussion" in the Treasury Department. This official further stated that the Treasury may include the matter in a proposal for changes of the debt-equity rules in the Subchapter C study that may be issued in late 1988. (4)

Although VRPs provide a very competitive after-tax rate of return on investment by adjusting their prices for changes in market rates and, thereby, preserving principal value, several critical issues face investors who intend to commit funds in VRPs:

* Are VRPs debt or equity for the purpose of determining whether payments are dividends or interest income?

* Does the convertibility feature of certain VRPs (e.g., Convertible Adjustable Preferred Stock--so-called CAPs) constitute a "put option" under section 246(c)(4)(A) and, therefore, toll the 46-day and the 6-month holding periods?

* What is the effect, if any, on VRPs of the sections 246A and 7701(f) amendments introduced by recent tax reform legislation?

* As a policy matter, what are the implications of eliminating or severely limiting the DRD for VRPs?

* Should increases in a VRP's dividend rate (e.g., where an investor's proportionate share in the issuer's earnings increase) be considered an additional, extraordinary dividend to the extent of the fair market value of the increase under section 305(c)?

To overcome the drawbacks of traditional preferred stock, ingenious Wall Street minds created VRPs. The first version of these instruments were Adjustable Variable Preferred Stock (ARP) which experienced an immediate and astonishing degree of investor acceptance. (5) Once the market's initial appetite for ARPs was stated, (6) ARPs were replaced by "Convertible Adjustable Preferred" Stock (CAP), (7) whose dividend rate was set at a level where it would trade as close to par as possible. This mechanism protected principal and theoretically discouraged investors from converting CAPs into the related common stock. CAPs soon lost their appeal, however, when investors became concerned that the IRS would disallow the DRD by ruling that CAPs were "put options" (that is, options to sell). (8) This concern and the search for new investment alternatives accelerated the rise of auction rate-determined preferred stock. (9) "Money market preferred" (MMP) stock became the best known of these instruments, (10) representing a significant departure from other forms of VRPs. The difference was that, whereas the dividend rate on standard VRPs fluctuates in a range pre-determined by formula, MMP dividend rates were set at a "Dutch auction" of investors. (11) Under the auction mechanism, rates were set directly as investors bid prices up or down as market conditions warranted and allowed MMPs to trade at par value, providing exceptional stability and liquidity.

II. VRPs AND EQUITY STATUS

A. Debt or Equity?--The Threshold

Question

Establishing that VRPs are equity instruments is absolutely essential for obtaining the 70-percent or 80-percent DRD. Historically, debt-equity classification determinations have been muddled by inconsistent and often-conflicting judicial decisions. (12) These inconsistencies have proven particularly confounding in respect of exotic equity-flavored securities. To address the problem, Congress in 1969 enacted section 385 and directed the IRS to issue guidelines for classifying interests as debt or equity.

After a lapse of about 11 years, the Treasury first issued and then withdrew the proposed regulations under section 385, forcing taxpayers to rely again on the much-maligned case law for guidance. (13) There are no cases or rulings directly on point determining the debt-equity status of VRPs. A recent private letter ruling, (14) however, does support, by implication, the equity status of CAPs. (The ruling made no reference to the status of mMPs and ARPs.). (15)

B. Traditional Criteria for

Determining Debt-Equity Status

Without regulatory guidance, the courts again became the arbiters of debt-equity controversies. (15) In Texas Farm Bureau v. United States, (16) the Fifth Circuit identified several factors that should be analyzed in distinguishing debt from equity. The court's analysis, which was directed at whether advances of funds by shareholders to a subsidiary were debt or contributions of capital, are equally applicable in ascertaining the equity status of publicly-traded securities. At bottom, the Fifth Circuit employed a balancing test--did the financing instrument exhibit more of the indicia of equity than debt? This "laundry list" of commonly accepted, relevant factors cited in Texas Farm Bureau (17) were originally enumerated by the same court in the Mixon Estate case. (18) The following discussion examines these criteria and then compares and contrasts them to the characteristics exhibited by VRPs.

1. Intent of the Issuer. Generally, classifying a corporate advance of funds ultimately presents a question of law. (19) An exception arises when a court must depend on the subjective intent of the issuer, which presents a question of fact, (20) because as soon as a court's analysis of other, objective factors fails to provide a clear indication, the determination of intent then becomes a question of fact. (21) In Mixon, the court explained that, where "the objective facts of the case are ambiguous and do not result in a clear manifestation of objective intent, then subjective intent is relevant to the issue." (22) Following the withdrawal of the section 385 regulations, the determination of intent will once again prove to be difficult to deal with because taxpayers will have to rely on earlier conflicting case law and IRS rulings. For example, in Zilkha & Sons, Inc. v. Commissioner, (23) the Tax Court held that a party's debt-equity intent can be inferred from the way that the instrument has been labelled. Although this ruling would seem to dispose of the issue once and for all, the holding in Rev. Rul. 83-98 (24) may cast some doubt on the resolution of the issue. That revenue ruling involved the classification of hybrid securities and concluded that merely labelling an instrument did not conclusively establish the issuer's intent. In Texas Farm Bureau, the court stated that intent will not be relevant unless the court's analysis of the objective factors fail to clarify the status of the corporate instrument. (25) In the context of VRPs, certain proxy statements and prospectuses (26) show that some issuers have carefully documented that their intent was to offer equity not debt.

2. Absence of a Fixed Maturity Date. The absence of a fixed maturity date on an instrument has historically implied equity status. For example, even if an issuer has coupled a preferred stock offering with a redemption date, many courts have held that the instrument was equity. (27) There are, however, some exceptions. (28) Such a provision convinced at least one court that a preferred stock issue was actually debt--a decision so dated that it may no longer be valid law. (29)

Nevertheless, the wise inventor should avoid acquiring VRPs with fixed redemption dates in which holders can compel a redemption on a fixed date. (30) Such a right could ma the equity flavor of the instrument. Therefore, unless there is an overriding reason for doing so, VRPs should not be issued with a fixed redemption date. Even where there is such a "flaw," the perpetual nature of VRPs (particularly where the holders do not have a put option on them) should still make VRPs resemble equity more than debt because there is no guarantee of a return when they are issued.

3. The Term of the Instrumemt. Placing funds at risk indefinitely in the issuer's trade or business has been historically considered to be an indicium of equity. (31) the risk is measured by the length of time that funds are invested in abusiness. Since funds to purchase VRPs are considered to be invested indefinitely, this attribute should support equity status for VRPs. (32) Despite this implication, the Tax Court in Ragland (33) ruled that equity has been issued even though the security was theoretically redeemable within four years of issuance.

Although investors should not place excessive reliance in this interpretation, additional support for this theory can be found in a 1940 case, Schmoll Fils Association, (34) which held that the mere discretionary right of the issuer to redeem its corporate security will not, by itself, jeopardize the equity status of the security. Although some VRPs (e.g., ARPs) may be callable after five years, this attribute is not necessarily inconsistent with the long-term nature of equity instruments. Inasmuch as ARPs are perpetual and have no explicitly fixed maturity date, the call feature is probably sufficiently indefinite and speculative (e.g., inknown market conditions at a future time when the issuer must exercise the call provisions) that it should not negate an ARP's long-term investment characteristics. (35)

4. Voting Power and Stockholder Remedies onDefault. The Ragland case demonstrates that equity is distinguishable from debt because it participates in managing the business and has voting rights. (36) Absent shareholder control over operations, however, voting rights by themselves carry little weight in determining equity status. (37) In the case of VRPs, this feature should be neutral because they rarely carry voting rights. The important equity characteristics of VRPs is not so much the existence of voting rights, but rather that VRP holders have a slightly higher priority than a common shareholders yet a slightly lower one than creditors have on default. On default, VRP holders share with common stockholders the standard right to vote for members of the board of directors. Thus, to enhance the equity flavor of these securities, issuers may wish to attach voting rights to their VRPs. In this context, certain VRP prospectuses (38) provide that the holder of shares of VRPs are entitled to receive the standard "liquidation preference" in case of inslovency--that is, a specified amount per share plus accrued and unpaid dividends. This remedy, coupled with voting rights upon dafault, may confer equity status on VRPs so long as creditor remedies (e.g., acceleration upon default) (39) are not simultaneously granted to the VRP investor. (40) It is unclear, however, what the effect of the "Standby Obligation" on the classification of securities will be. It seems likely that the guarantee on default may not be sufficient to force the reclassification of these MMPs as debt. (41)

5. Source of Payment and Fixed Dividends. A preferred shareholder's right to a dividend is conditioned on corporate earnings and the discretionary declaration of dividends by the board of directors. (42) Therefore, earnings as the sole recourse to income for VRPs is similar to the contribution of capital cases where the shareholders' only recourse to income is the issuer's earnings. Similarly, preferred issues are typically not supported by the establishment of a sinking fund to retire or repay principal and dividends. The courts have typically viewed the absence of a sinking fund in the capital contribution cases as evidence that advances were not debt. (43) the same reasoning should apply, by analogy, to VRP investments that rely solely on the issuer's earnings for their dividends. The trigger mechanism for payments on VRPs (i.e., earnings and the action of the board of directors) are in marked contrast to that which causes repayment on debt. A creditor-decbtor relationship imposes on an issuer of securities an unqualified duty to repay certain fixed amounts at a reasonably pre-established maturity date coupled with a fixed interest perecentage that is due and payable at fixed intervals independent of the debtor's income and ability to repay. Even where a creditor's right to receive interest on an advance is contingent, creditors have an absolute right to enforce payment as soon as the contingency materializes. Accordingly, since a VRP holder's rights differ significantly from those of creditors, VRPs must be classified as equity.

With respect to planning opportunities, investors should only buy VRPs that carry an assurance that purported dividends will be paid only from earnings and that payments are contingent solely on the discretion of the board of directors. (44) Meeting this dual requirement may further support equity classification for VRPs. As a practical matter, investors assume the "risk" that in an unprofitable year, the issuer's board may not declare a dividend. Nevertheless, a skeptic may justifiably argue against this point of view, pointing out that a financially viable issuer will as likely meet its dividend commitments as it would its debt service obligations, thereby blurring any distinction between debt and equity. On the other hand, a competing inference is that there is a major difference between the legal protections that a creditor enjoys upon default and those that VRP holders have when the issuer passes up a dividend payment. A failure to pay a dividend is not a "default" on the stock. VRP holders cannot sue or foreclose on the stock as a creditor could but must wait (short of outright liquidation in bankruptcy) until the board of directors reinstates the dividend. Finally, where there is a default, VRP holders must always stand behind creditors in sharing the issuer's assets if it should later go bankrupt.

6. Subordination to Creditors. Subordination to creditors is a major risk that distinguishes equity from debt and seems to be an essential characteristic of VRPs. (45) Clearly, where an issue of VRPs is called or labelled "stock," it is legally subordinated to creditors of the issuer. Therefore, VRPs invariably share this characteristic of equity.

7. Thin Capitalization. Generally, the courts have viewed the issuance of securities by a thinly capitalized corporation as a sign that the instrument was debt rather than equity because thinly capitalized companies cannot normally borrow funds from lending institutions. (46) Consequently, in such cases, a shareholder "loan" may, in fact, be equity. In light of this judicial attitude, it is not surprising that in Gilbert v. Commissioner, (47) the Second Circuit treated an excessive debt structure as equity. This test has arisen primarily in the context of closely held companies where a corporate shareholder advances funds to that wholly owned subsidiary. (48) Because of the factual ambiguity that surrounds "thin" capitalization issues, the application of this criterion to VRPs of large, publicly traded companies does little to resolve the debt-equity controversy and is, consequently, largely a neutral factor in determining whether VRPs are equity.

8. Name Given to the Instrument. Closely tied to the intent test is the question of what the instrument is called. In certain capital contribution cases, the courts have been willing to overlook discrepancies by taxpayers when they recorded equity as loans on their books. In these cases, the courts have viewed them as equity because no debt instruments were ever drawn up. (49) Thus, the absence of any evidence of indebtedness has been more conclusive that the advances were equity than a mistaken entry of an item as a loan on the books. (50)

As a practical matter, preferred stock issues are rarely recorded as loans. Nevertheless, it appears that VRPs will be viewed as equity regardless of what they were called unless they are in fact evidenced by a note or other instrument of indebtedness. On balance, it can only be included that VRPs are equity. this conclusion is particularly compelling if issuers attach voting rights to VRPs and provide them with an unlimited term (i.e., omit fixed redemption dates) so they can be convincingly distinguished from debt.

III. CAPs: ARE THEY OPTIONS

TO SELL?

After the passage of the Tax Reform Act of 1984, many investors feared that CAPs might be classified as "puts" (51) by the IRS and thereby lose the benefits of the section 243(b) DRD. This concern was dissipated somewhat when the irs privately ruled (52) that CAPs were not options to sell within the meaning of section 246(c)(4)(A). The IRS distinguished options to sell from exchange transactions (e.g., conversions of CAPs into the issuer's common), relying on Commissioner v. Brown, (53) which dealt with the definition of a salse as "a transfer of property for a fixed price in money or its equivalent." The private ruling also emphasized that later cases (e.g., Guest v. Commissioner (54) ), had construed Brown (55) to mean that there has been a transfer of property for money or a promise to pay money as dictinct from a reciprocal conveyance as property that characterizes exchanges such as a CAP into common stock. The ruling stressed that the CAP was not a put because holders of the CAp stock were not guaranteed receirt of the common on conversion at a set price. The reason for reaching this conclusion was that the number of common shares into which the CAP stock could be converted was limited. the ruling also noted that if the value of the common stock received in the exchange had a specific fair market value, it was not a cash equivalent because it first had to be sold subject to market risk before the holder could "cash out" of the investment. the IRS concluded that a CAP conversion option into common was not an option to sell within the meaning of section 246(c)(4)(A).

IV. EFFECT OF SECTION 246A

ON THE DIVIDENDS-RECEIVED

DEDUCTION

A. Federal Tax Implications

The section 243 DRD is a historically recent development of public policy because, until 1984, there were no Code restrictions on full deductibility. Spurred by abuses presumably perpetrated by some corporations involved in leveraged equity investments, Congress restricted the deduction to ,/ percent (or 100 percent in a consolidated tax return context) of a distribution. Its most recent area of concern has been the use of portfolio debt in leveraged buyouts.

One of the perceived abuses was the purchased of adjustable rate preferred stock (55) which both limited the risk of the loss of principal and sheltered income. Congress responded by enacting section 246a, a key provision of the Tax Reform Act of 1984, (57) that disallowed a part of the DRD on dividends financed with portfolio debt. Section 246A does not apply, however, to dividends recieved from an affiliated corporation which is eligible for the 100-percent DRD. (58)

Section 246A concerns portfolio stock investors (59) because equity purchases may become tainted through their own inadvertence. consider, for example, the simple act of borrowing funds that later are discovered to be directly traceable and, therefore, attributable to the purchase of portfolio stock. the most obvious violation would be to pledge portfolio stock as collateral where the borrower could reasonably be expected to sell the stock. apart from these unambiguous situations, the "directly attributable" standars stands as a major obstacle for the IRS in disallowing a part of the DRD. the scope of section 246A appears to be narrow, and careful planning will minimize the harmful potential of this provision on most corporate financing arrangements. To the extent this "trap" is overlooked, a portion of the DRD will be disallowed. the reduction is geared to a formula that reduces the percentage of the dividend to a percentage equal to 100 percent minus the average indebtedness percentage. (60)

Congress apparently felt that a specific mandate (i.e., the addition of section 7701(f)) was needed where there was a potential for abuse, such as borrowing funds through a related affiliate, a controlled corporation, or a pass through entity linked to the acquisition of tax-favored securities. (61) Although section 7701(f) operates in conjunction with other Code provisions (62) such as section 246A, sectiom 246A has a narrower focus: before its sanctions can apply, the IRS must established that borrowings are directly attributable to the purchase of stock to cause the proportional disallowance of the DRD. Section 7701(f), on the other hand disallows the DRD proprtionally if there is (a) merely a link between borrowings and investments or (b) a diminution of risk. for unstated reasons, the Conference Report on the 1984 Act adopts a tougher stance about the restrictions on financing tax-exempt securities with debt than those set forth in the Senate Report, (63) since the conferees expanded the related-party prohibitions to section 246A and other Code sections by moving the restriction to section 7701(f) from section 265 (a)(2). The shift creates a tension between section 246A and 7701(f) that may further confuse taxpayers until the Treasury issues regulations under both provisions.

B. State Tax Implications

With respect to the states, restrictions on the DRD vary depending on the state in question. Certain jurisdictions follow the federal rules, (64) other provide for no exclusion at all, (65) and still others allow the DRD but on a sliding scale of disallowance based on a variety of significant factors. (66) the effect of state tax consequences cannot be ignored because, to the extent they are overlooked, investors may not truly receive the returns that they originally intended to make on VRPs.

V. FUTURE LEGISLATION--A

CLOUDY PROSPECT

Near the end of 1987, the House of Representatives passed legislation that unnerved many investors. section 10132 of H.R. 3545 (as apporved by the House) was intended to eliminate prospectively the DRD on new offerings of variable-rate equity securities. The provision faced strong opposition in the Senate and was ultimately dropped from the final legislation. Nevertheless, the proposal curtailed new offerings of VRPs. (67)

The deletion of the measure from the final 1987 bill, moreover, did not render the question moot, for there is much support for the introduction of a similar provision in the future. As a result, the repeal of the DRD is still a viable possibility, requiring considerations of such action's implications. The House appropriated the DRD proposal from the Administration's 1984 and 1985 tax reform proposals. Certain legislators now perceive the DRD for VRPs and their kin as a form of tax shelter abuse--a "loophole" that ought to be closed. The rationale is that under current law, VRP investors which have the virtual assurance of preserving capital and maintaining a under current law, VRP investors, set level of dividend cash flow, will unfairly receive the economic benefit of equity from an investment that has "non-stock" characteristics. (68) Thus, Congress was concerned over a VRPs presumed resemblance to debt and that the DRD allowed related entities to pass through net operating losses in consolidation with inordinate and unjustifiable frequency.

One disadvantage of the proposal was that it would have deprived corporation of yet another relatively inexpensive source of equity funding and force issuers to market debt securities, thereby weakening corporate balace sheets and increasing the cost of financing their working capital and long-term capital information needs. The proposal may well have been defeated because of the concern over its affect on U.S. competitiveness. As previously stated, however, taxpayers remain concerned that the DRD repeal proposal may resurface in future legislation and that, if enacted, will deprived investors and corporations of an efficient and inexpensive corporate financing vehicle.

VI. INCREASE IN VALUE OF

PREFERRED HOLDER'S

INTEREST--SHOULD ADJUSTMENTS

BE TAXABLE UNDER

SECTION 305(b) and (c)?

A. General Tax Treatment of

Dividends

In addition to the availability of the section 243 DRD, amounts paid on preferred are taxable under section 301 if they (a) are quantifiable and subject to the holder's demand (69) and (b) are eligible for the stock for a minimum investor has held the stock for a minimum of 46 days. (70) The resulting current net tax cost of a dividend to a corporate taxpayer will be either 10.2 percent (30 percent X 34 percent) or 6.8 percent (20 percent C 34 percent). (71) Although these considerations are straightforward, an important collateral question is whether the incremental fluctuations in the price of VRPs are themselves dividends subject to taxation under sections 305(b)(2), 305(b)(4), and 305(c) or whether they are excluded from dividend threatment under the general rule of section 305(a).

B. The General Rule of Section 305(a)

Under the general rule of section 305(a), gross income does not include the amount of any stock dividend received by a stockholder with respect to its stock. Two exceptions to this rule take into account shifts in ownership interest in the issuer. the first is section 305(b), which enumerates five examples of a taxable stock dividend. In each case, certain shareholders are tread differently from others. for example, if a shareholder receives additional equity, increasing its proportionate share of a corporation, it must include the value of the stock dividend in income if other shareholders received cash instead. (72) Under the second exception, certain events (that in themselves would not trigger a tax) will be treated as taxable "deemed" distributions even though they would ordinarily be taxfree transactions under section 305(a). (73)

A "deemed" distribution may be taxable under section 305(c) if it meets the following conditions: (a) the transaction is an event listed in section 305(c) (for example, where there is a change in the redemption price or the conversion ratio) or is equivalent to a transaction "having a similar effect" to a change in price or ratio; (b) the transaction causes an increase in a shareholder's proportionate interest in the assets and earnings and profits (E&P) of the corporation; and (c) the transaction is one of the events discribed in subsections 305 (b)(2) through 305(b)(5). (74) If these criteria are met, the income recipient will have a deemed section 305(c) distribution, taxable as an event described in section 305(b).

C. Should Section 305 Apply Due to a

Dividend Rate Adjustment?

VRPs pay taxable cash dividends that are not subject to the tax-free stock dividend rules. But it is not entirely clear whether a rate adjustment may be a taxable section 305(c) deemed distribution. (75) A deemed distribution could arise when an adjustment occurs before the regular dividend is declared. Although the investor may be entitled to an increased or decreased amount, it should not be immediately taxable under section 301 until it is actually or constructively received by the shareholder. Here, the issue is whether the section 305(b) increase itself makes the "distribution" taxable at the auction, long before the actual or constructive receipt of the cash.

There are three criteria under the section 305 regulations (76) that normally determine the taxability of a "deemed" distribution. First, the increase must be one of the events listed in section 305(c)--a change in conversion ratios, a change in redemption price, a difference between redemption price and issue price, a redemption which is treated as a distribution to which section 301 applies, or any transaction (including a recapitalization) having a similar effect on the proportionate interest of any shareholder. (77) These events focus on changes in a shareholder's respective interest in the assets (as opposed to the earnings) of the issuer. Because VRPs did not exist when section 305 was last amended, fluctuations in dividend rates are not expressly included as a taxable event triggering income under section 301. However, there is no reasonable inference from the legislative history of the statute that the failure to include rate changes (i.e., principally shifts in a shareholder's share of earnings) would otherwise preclude the sanctions of the statute.

Second, a taxable event will occur if there is an increase in another shareholder's pro rata share of the issuer's earnings or assets. (78) Assuming that a rate increase occurs at auction or under a prescribed formula, a VRP holder's pro rata share of the earnings will increase in relation to other equity holders.

Finally, the regulations further require that a distribution end up with one of the results described in section 305(b)(2), (3), (4), or (5) in order to have a section 301 distribution. (79) With respect to VRPs, there may be two applications of this rule. Section 305(b)(2) makes an actual distribution taxable if it would result in (a) an increase to certain shareholders' proportionate interest in the issuer's earnings and assets, and (b) the receipt of "property" by other shareholders. In this regard, the adjustment itself will cause an increase in proportionate equity interests. Moreover, a cash dividend will probably satisfy the second condition for taxability. Section 305(b)(4) makes a distribution taxable if it is made with respect to preferred stock; where the redemption price of the preferred has increased, the increase is taxable as an additional distribution of preferred on the existing preferred. (80) This result may also follow in the case of auction rate-determined increases where the holder's share of the issuer's profits has also increased. Consequently, it could be argued that a taxable transaction under section 305(c) occurs every time the dividend rate increases. (81)

D. The Rationale of Section 305(c)

Section 305(c) is intended to prevent issuers from making tax-free distributions on equity that would permanently escape taxation under section 301 merely because of the form of the transaction. The problem with applying section 305(c) to a rate adjustment is that the shareholder may be subject to double taxation of income. An adjustment (where interest rates are rising) will provide the investor with a higher dividend amount based on a constant value of principal. The higher distribution is eventually captured under section 301 as current income in any event. Moreover, the investor will be unable to benefit from having the incremental value taxed at the capital gains rate because (a) the differential between capital and ordinary rates has been eliminated by TRA 1986 and (b) the adjustment mechanism, in theory, helps keep the fair market value of preferred unchanged so that there is no capital gain to be realized in any event. Of course, section 305 might technically reach a rate adjustment where, after an upward adjustment is made, the issuer omits the dividend for several quarters. In such a case, section 305 (c) could be asserted to tax the value of the increase caused by the rate change.

Such a scenario, however, seems implausible because it depends on the occurrence of a couple of unlikely events occurring simultaneously. First, an investor would have to continue to hold a security that is not yielding an adequate return on investment rather than move the funds to a more lucrative alternative. Second, even if the investor retained the investment after the omission of a dividend, it would have to include in income currently the discounted present value of future dividend increases. This approach would yield speculative results considering that there is no assurance that the rate will remain constant, let alone increase over future adjustments. The dynamics of such a scenario reduce themselves to conjecture, where the shareholder embarks on an unrealistic, losing strategy of holding a non-performing security indefinitely. Consequently, even though such a strategy is conceivable, it is a highly unlikely scenario because the economics of the transaction simply do not justify such investment practices.

E. A Questionable Basis for Applying

Section 305(c) to VRPs

Applying section 305(c) to VRPs can lead to some interesting yet irreconcilable logical inconsistencies. Typically, the taxability of VRPs will be premised on rate increases. It ignores the fact that the rate may also decline from auction to auction in response to lackluster bidding or to other market factors. This peculiarity highlights the unique nature of VRPs and supports a reconsideration of any attempt to apply section 305(c) to VRPs. For example, if the rate decreases, the section 305(c) regulations do not impose a tax on the common stockholders because of a pro rata reduction of their interest in the issuer's capital structure. If the three tests described previously were to be applied to a hypothetical decline in the dividend rate, obvious and inappropriate results would occur. (82)

Under the first test, a drop in the rate might be viewed as a "similar transaction" proscribed in section 305(c). Second, the decrease creates a windfall for the common shareholders as their equity share increases as the preferred holders' share of the issuer's profits decreases. Third, the common holders' residual share of the issuer's profits will rise disproportionately while others (e.g., preferred holders) receive property in the form of cash dividends. (83)

The public policy underlying section 305(c) is to prevent the favoring of one class of shareholders over another where the former group gains an additional equity stake in the issuer without incurring any tax. It seems inappropriate that an automatic auction or formula-shift in pro rata interests should be taxed as sections 305(b)(2) and 305(c) events. Adjustments to VRP rates are merely mechanical levers used to preserve principal value in response to changes in interest rates.

Considering the nature of VRPs and the purpose of the adjustment mechanism, a VRP holder does not receive, either actually or constructively, a taxable dividend when an adjustment occurs. A change in the rate merely gives the holder a higher or lower dividend distribution only when it receives cash or its equivalent, not when the adjustments are made. Rate changes should be a neutral factor because the only purpose of an adjustment is to leave the value of the VRP the same before and after the adjustment. The adjustment, therefore, ensures that the holder will enjoy a dividend "return" corresponding to other rate-driven instruments. Assuming, for the sake of argument, that the adjustment constitutes a deemed distribution, the next issue is to determine if the adjustment has a fair market value that is taxable under the statute. (84) Clearly, if the adjustment is a "neutral" event, the change should have no fair market value for purposes of section 301. Other practical reasons for not

taxing holders on a rate adjustment include: (a) the prohibitive administrative burden placed on both the issuer and the IRS to account for taxable adjustments that may occur as often as seven to eight times a year, and (b) the public policy argument that views fluctuations in rates as events beyond the reach of section 305(c).

F. No Authority for Applying Section

305(c) to VRP Adjustments

The absence of authorities should not lull VRP holders into the potentially disastrous misconception that a rate adjustment is not taxable under section 305(c). The private rulings provide little guidance in this area. (85) The rulings simply do not address the tax consequences of a rate adjustment triggered by pre-set formulas or auctions. In fact, the rulings affirmatively avoid any conclusions as to the applicability of section 305(c) as support for their holdings. The absence of rulings, moreover, deprives planners of the ultimate assurance that an adjustment is safe-harbored from the section 305(c) tax. Consequently, the investor will have to make its investment decision in a vacuum where cautious deliberation is a paramount concern.

CONCLUSION

Although debt-equity law remains rather unfocused and difficult to apply to exotic financial products, it appears on balance that VRPs should be classified as equity rather than debt for purpose poses of the sections 243 and 246A DRD. The controversy over debt-equity classifications has been complicated by the lack of regulatory guidance and the need to resort to often confusing and sometimes contradictory case law decisions. In this regard, the untimely death of the section 385 regulations in 1983 left corporate investors without a consistent and reliable set of rules for establishing a conclusive determination of the nature of certain financial products.

Despite these handicaps, investors may take some comfort from the factor analysis supporting equity treatment for VRPs as equity. Although the dividend provisions of these instruments might militate against their equity classification, other factors may tilt the balance toward such a finding. So long as VRPs do not have a fixed maturity date nor are required to make dividend payments, the only difference between them and regular preferred stock will be that their dividend rates are variable. In order to predict equity classification for a particular issue of VRPs, the specific terms of the instrument must be examined. Investors should be aware that as recently as 1987 Congress gave serious consideration to denying the DRD for equity having certain non-stock characteristics (including VRPs). The mere possibility that the legislation might be enacted at all halted all plans to market new VRP issues in the fall of 1987, forcing issuers to offer debt instead of MMPs to finance their cash needs. Supporters of this proposal may again seek to enact this measure in future sessions of Congress.

Section 305(c) could theoretically apply to VRP dividend rate adjustments whereby the fair market value of the increase could itself be an immediately taxable dividend to the investor. Although there are no authorities on point, section 305(c) should not apply unless an adjustment results in an actual or constructive cash payment. The public policy argument against the application of section 305(c) is that adjustments merely preserve the price stability of VRPs as market rates change and, further, that applying this provision would impose an onerous administrative burden on investors if a tax were imposed every time there was an adjustment. Conceptually, section 305(c) should create no adverse tax consequences to investors except in the case where an upward adjustment is made in a taxable year prior to the year in which the associated payment would have normally been taxable under section 301.

Footnotes - - Variable Rate Preferred Stock: Current Status and Prospects

for a Continuing Favorable Tax Climate in the 1980s and 1990s

(1) All references to sections, unless otherwise noted, are to The Internal Revenue Code.

(2) Under The Revenue Act of 1987, where the recipient corporation owns less than 20 percent of the voting power and value (as defined in section 1504) of all equity (including VRPs) of the issuing corporation, the 80-percent DRD is reduced to 70 percent in respect of the dividends received or accrued after December 31, 1987, in taxable years ending after the effective date of the Revenue Act of 1987. The remaining 20 and 30 percent of the distribution is taxed at a regular maximum corporate tax rate of 34 percent, resulting in an effective tax rate of 6.8 percent and 10.2 percent, respectively, on the investment. If the taxpayer falls under the corporate alternative minimum tax (AMT), regime, the effective tax rate will be 13 percent at current rates because (a) 50 percent of the excess of adjusted net book income is subject to tax under the AMT and (b) book income is not reduced by the DRD, 65 percent of the distribution is taxed at 20 percent. This "spread" will increase to about 16.5 percent when the "adjusted current earnings and profits" preference item replaces the book income preference after 1989.

(3) See H.R. 3545, The Revenue Act of 1987 (Pub. L. 100-391), [Section] 10132, at 1342-43 (1987). In October 1987, the House passed H.R. 3545, amending section 246 and eliminating the section 243 DRD on payments on auction-rate determined preferred stock. The measure did not survive the Conference Committee's deliberations of the 1987 Act. On June 21, 1988, Chairman Rostenkowski of the House Ways and Means Committee proposed new legislation that would reduce the portfolio DRD to 60 percent in 1989 and to 50 percent by 1991. See BNA Daily Tax Report No. 120, June 22, 1988, at G-6. That proposal was not included in the tax legislation enacted at the end of the 100th Congress.

(4) See BNA Daily Tax Report No. 99, May 23, 1988, at G-1. The Treasury official is identified as O. Donaldson Chapoton, Assistant Secretary of the Treasury for Tax Policy.

(5) Barrons, Aug. 13, 1984, at 1. ARPs were the first variation of variable or adjustable dividend rate preferred stock instruments and were introduced in 1981. This product was a very attractive "play" among investors where the issuer was a large, publicly held company that had an excellent history of uninterrupted cash dividend payments to its common shareholders. The investment community desired an equity vehicle whose dividends would track the fluctuations in interest rates. As with most preferred stock, ARPs pay a quarterly dividend where the rate is adjusted or reset quarterly, typically at a fixed spread from the highest of three Treasury base rates (i.e., 3-month bills, 10-year notes, and 20-year bonds). Thus, an upper and lower limit is established for the floating rate. Although an ARP holder cannot cause a redemption, many ARPs provide for a call option by the issuer, typically in the fifth year.

(6) Indifference to ARPs persists even though dividends are adjusted to keep in line with changes in the yields of Treasuries. These adjustments, however, have not been responsive enough to keep trading prices of ARPs at their issue prices.

(7) To ensure that a security will be sold as close to its original issue price as possible, the issuer can commit itself to buy back any shares that investors may wish to tender the issuer upon a decision to convert to the issuer's common stock. Every three months, after a dividend is declared, the CAP holder may exercise the right to convert the CAP to common of the issuer for a price on the common whose fair market value is equal to the par value of the common. The holder can then dispose of the common and, thus, cash out of his initial investment.

(8) See H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 814-15 (1984), which states: "The conferees intend that an investment in preferred stock coupled with an option to sell the stock will not be treated as a single instrument, for purposes of applying the substantially similar standard without regard to whether the option trades separately from the stock."

(9) Auction-rate determined preferred stock such as MMPs differ in one important respect from the other branches of the adjustable rate preferred family. Whereas dividends on adjustable rate preferreds are set by a predetermined formula, the MMP dividend is set directly at an auction where investors bid the price up or down depending on market conditions. The theory underlying the use of MMPs is that the issues should always trade at par, thereby making them unusually liquid. A key to the attractiveness of this investment is a high after-tax yield. This means that the issuer must have an unusually strong credit rating to mitigate the fact that, in context of insolvency, MMPs as equity are junior in position to alternative non-equity investments.

(10) Although MMPs initially did not attract widespread attention among investors because of their seeming complexity and the assumed unpredictability of a "Dutch" auction, corporate cash managers soon overcame any misgivings they might have had about investing in them.

(11) The auctions are held every 49 days in order to comply with the amendmants made to section 246(c) (1)(A) by the Tax Reform Act of 1984, which increased the period for holding equity shares to more than 45 days in order to claim the 80-percent or 100-percent DRD under section 243, 244, or 245.

(12) See Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 26 Tax Law Rev. 369 (1971), for an excellent and critical exposition of the confusion in the tax law over the classification of corporate financing instruments that existed considerably before and shortly after section 385 was enacted.

(13) Prop. Reg. [Subsection] 1.385-1 to 1.385-10, promulgated December 29, 1980, were withdrawn on July 6, 1983. See T.D. 7920 (Nov. 2, 1983).

(14) Letter Ruling No. 8610016. Although a private letter ruling cannot be cited as a precedent, the logic of this ruling involving CAPs can be used by analogy to analyze and extend the rationale for equity treatment of ARPs and MMPs.

(15) See 1985 P-H Federal Tax Service [paragraph] 13096 for a tabulation of cases analyzing, comparing, and contrasting the facts in each decision. See also, Note, Toward New Modes of Tax Decision-Making--The Debt-Equity Imbroglio and Dislocation in Tax Lawmaking, 83 Harv. L. Rev. 1695 (1970); Eustice, Corporations and Corporate Investors, 25 Tax L. Rev. 509 (1970); Hickman, The Thin Corporation: Another Look at an Old Disease, 44 Taxes 883 (1966).

(16) See Texas Farm Bureau v. United States, 725 F.2d 307 (5th Cir. 1984).

(17) 725 F.2d 307 (5th Cir. 1984). Other appellate courts have taken opposing views about whether the issue of capital contributions constitute debt or equity is a question of fact or of law. See Bauer v. Commissioner, 748 F.2d 1365 (9th Cir. 1984) (the question of capital contributions versus loans is a question of fact that is subject to review under the clearly erroneous standard); Smith v. Commissioner, 370 F.2d 178 (6th Cir. 1966) (whether advances to a corporation were capital or debt is a question of fact that is reviewable under the clearly-erroneous standard).

(18) 464 F.2d 394 (5th Cir. 1972).

(19) Texas Farm Bureau v. United States, 725 F.2d 307 (5th Cir. 1984); Estate of Mixon, 464 F.2d 394 (5th Cir. 1972); Tyler v. Tomlinson, 114 F.2d 844 (5th Cir. 1969), (status of an investment was held to be debt in the absence of a dispute over the facts); Slappey Drive Industrial Park v. United States, 561 F.2d 572 (5th Cir. 1977), (question of law); Berkowitz v. United States, 411 F.2d 818 (5th Cir. 1969), (where there were no disputed facts, classification is a question of law). But see Piedmont Minerals Co. v. United States, 429 F.2d 560 (4th Cir. 1970) (issue of debt/equity is a question of fact).

(20) Byram v. United States, 705 F.2d 1418 (5th Cir. 1983); Pullman Standard v. Swint, 456 U.S. 273 (1982)

(21) 725 F.2d 307.

(22) 464 F.2d 394, 407. But see Ragland Investment Co., 52 T.C. 867, 876 (1968) (intent of the parties seen as a "highly" significant factor).

(23) Zilkha & Sons, Inc. v. Commissioner, 52 T.C. 607 (1969), where the IRS argued unsuccessfully that what the taxpayer had called stock was in fact debt in order to deny the DRD claimed by the taxpayer on receipt of a dividend from another corporation.

(24) Rev. Rul. 83-98, 1983-2 C.B. 40. Here, the IRS analyzed the characteristics of a purported debt instrument--an Adjustable Rate Convertible Note (ARCN)--and concluded that the issuer's intent was to create an equity instrument simply because it offered the ARCNs under circumstances in which investors would convert them into stock under the most likely circumstances. Thus, the vexing and nebulous "likelihood of conversion" test was born--a standard that predictably hampered proliferation of ARCNs as debt instruments. Issuers believed on the basis of the very mechanical valuation criteria of the proposed section 385 regulations relating to "hybrids" that these novel instruments were in fact debt. Realizing that the application of the section 385 regulations might require it to classify ARCNs as debt, the IRS quickly withdrew the regulations and issued Rev. Rul. 83-98, 1983-2 C.B. 40. The ruling concluded that ARCNs were equity, leaving future innovative financing instruments subject to the vicissitudes of the ambiguous standards found in prior case law.

(25) Texas Farm Bureau v. United States, 725 F.2d 307 (5th Cir. 1984).

(26) E.q., U.S. Steel Corporation Prospectus Supplement, Money Market Cumulative Preferred Stock Series S-A, Jan. 24, 1985, at 3-6, 15-21.

(27) Texas Farm Bureau v. United States, 725 F.2d 307 (5th Cir. 1984).

(28) For any issuer to provide for an absolute redemption date requirement may violate state law. For example, Cal. Corp. Code [Section] 500 prohibits the payment of dividends (or redemptions) unless the corporation has profits.

(29) U.S. Title Guaranty & Trust Co., 133 F.2d 990, 994-95 (6th Cir. 1943).

(30) For example, in Ragland Investment Company, 52 T.C. 867, 878 (1968), the Tax Court took the view that preferred stock does not have a fixed maturity date in a debt/equity context if a redemption is contingent on the existence of otherwise legally available financing. This is true even where controlling shareholders have assented to proceed on a best efforts basis to ensure that the redemption would occur even though they may not have a legally enforceable right to force the corporation to effect the redemption. Similarly, in Zilkha & Sons, Inc., 52 T.C. 607 (1967), the Tax Court decided that a fixed redemption date was not conclusive of debt status if the redemption was in fact contingent on the earning potential of the issuing corporation. Although the existence of a fixed maturity date is relevant to the question presented, it is by far not conclusive. Ragland, 52 T.C. at 878.

(31) Gordon Lubricating Co., 24 T.C.M. 697, 711 (1965).

(32) See also Slappey Drive Industrial Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977); Midland Distributors Inc. v. United States, 481 F.2d 730, 733 (5th Cir. 1973); Dillin v. United States, 434 F.2d 1097, 1103 (5th Cir. 1970).

(33) 52 T.C. 867 (1968).

(34) 110 F.2d 611 (2d Cir. 1940).

(35) The most critical characteristic of VRPs that distinguishes them from normal preferred stock--its fluctuating rate--actually strengthens the long-term nature of VRPs because the variable dividend closely parallels long-term interest rates. The structure of these financial products allows the instrument to adjust its dividend rate to stay in line with market rate fluctuations without having to refinance the instrument every time the market changes. The very fact that the rate changes automatically to meet market conditions (for ARPs, at least) and at relatively frequent auctions for MMPs relieves the issuer from the pressure of calling the issue if it were not for the variable feature. This unique characteristic, therefore, virtually eliminates the possibility of a call of the issues and automatically ensures the long-lived nature of these financial products.

(36) 52 T.C. at 877. (37) Zilkha & Sons, Inc. v. Commissioner, 52 t.C. 607, 616 (1969).

(38) See U.S. Steel Corporation Prospectus, supra, note 26, at 20-21.

(39) On the other hand, query whether saying that the holder of $100 of preferred stock can receive his $100 plus accrued dividends is any different than saying that a holder of $100 note can "accelerate" the $100 of debt principal plus accrued interest on the note.

(40) Most issuers of MMPs are preferred credit risks, typically rated as single-A or better on Moody's barometer of credit worthiness. When U.S. Steel, with a triple-B credit rating, brought out its MMPs in 1985, it provided special incentives for investors to buy the issues by insuring investors against the voluntary or involuntary liquidation of the Company with a provision called a "Standby Event" (i.e., upon failure to pay a dividend, or the failure to redeem shares or the non-existence of sufficient clearing bids as of a certain date). The Prospectus acknowledges that, in the case of a payoff under the Standby Obligation, it was unclear whether or not investors would be entitled to claim a dividend-received deduction under such circumstances.

(41) The U.S. Steel prospectus states that counsel had advised that the MMP issue is classifiable as equity under existing law. That opinion of counsel, however, was qualified, disclosing that competing interpretations of the character of the issue are entirely possible given the lack of income tax regulations, rulings, or cases governing the determination of the specific characteristics of these financial products. (42) Milwaukee & Suburban Transport Corp. v. Commissioner, 283 F.2d 279, 283 (7th Cir. 1960), cert. denied, 366 U.S. 965 (1960), remanded on another issue, 367 U.S. 906 (1961); Pacific Southwest Realty Co. v. Commissioner, 128 F.2d 815 (9th Cir. 1941). cert. denied, 317 U.S. 663 (1942).

(43) See Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986); Lane v. United States, 742 F.2d 1311, 1317 (11th Cir. 1984); Raymond v. United States, 511 F.2d 185, 191 (6th Cir. 1975); Austin Village, Inc. v. United States, 432 F.2d 741, 745 (6th Cir. 1970).

(44) See Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal, 25 Tax Law Review 369 (1971).

(45) See Helvering v. Richmond, 90 F.2d 971, 974 (1973); Ragland, 52 T.C. at 877. An apt example of this judicial attitude is found in Crawford Drug Stores, Inc. v. United States, 220 F.2d 292 (13th Cir. 1955) where the court said: "[I]t is normally an attribute of a creditor relationship that in the event of dissolution or liquidation, creditors share in the assets before stockholders, while the only right given the stockholders of preferred stock is that they be paid before the holders of any other class of stock are paid." 220 F.2d at 296.

(46) See Bauer, 748 F.2d at 136. See Estate of Mixon, 464 F.2d at 408; Foresun, Inc. v. Commissioner, 348 F.2d 1006, 1009 (6th Cir. 1965).

(47) Gilbert v. Commissioner, 248 f.2d 399, 407 (2d Cir. 1957). The Gilbert court viewed advances as venture capital to a subsidiary that was capitalized at a 300:1 debt/equity ratio.

(48) For a case taking a contrary position, see Sun Properties v. United States, 220 F.2d 171 (5th Cir. 1955), where the court held that, although examination of debt-equity ratios may be a relevant inquiry, it is not of primary importance in deciding whether an advance is debt or equity with a debt-equity ratio of almost 300:1. See also Baker Commodities v. Commissioner, 48 T.C. 374 (1967), aff'd, 415 F.2d 519 (9th Cir. 1969), cert. denied 397 U.S. 988 (1970) (a debt-equity ratio of 692:1 did not result in reclassifyng debt as equity).

(49) See Roth steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986).

(50) Raymond v. United States, 511 F.2d at 191; Estate of Mixon, 464 f.2d at 403; Stennets Pontiac Service v. Commissioner, 730 F.2d 648 (11th Cir. 1984).

(51) A put is an option to convert stock classifiable as a section 246(c)(4)(A) option to sell.

(52) Letter Ruling No. 8610016. The facts of the ruling are as follows: Two open-ended investment companies qualify for taxation as section 851 regulated investment companies. Their sole investment objective is to invest in higher levels of income that qualify for the section 243(b) 85-percent DRD with minimum fluctuations in capital. The funds invested in CAPs issued by X Corporation. The rate of X's CAPs is adjusted quarterly to reflect the highest of the average yeilds on various types of U.S. Treasury obligations, less a percentage adjustment for the dividend rate on the CAP. The adjustment may not exceed 11 percent per year nor fall below 5.5 percent per year of the original issue price of a share of CAP stock ($50). The adjustment percentage can be adjusted subject to this ceiling and floor and to additional undisclosed limitations until mid-1987, and thereafter may be adjusted in the sole discretion of X, subject only to the ceiling and floor previously described. Holders of X' CAPs can surrender it for conversion into X's common during an interval shortly before each dividend payment date. X CAPs are convertible into the number of X common having an aggregate fair market value (FMV) of $50 on the date of conversion, subject to a ceiling of two shares of X common for each share of X's CAP stock. X has the sole discretion of increasing or decreasing the ceiling after 1986 and prior to 1987, subject to the limitation that the maximum number of X common into which the CAPs can be converted cannot be decreased to a number less than 183 percent of the amount derived by dividing the original issue price by the CAPs current market value. No fractional shares of X common will be issued on a conversion but rather cash equivalent to the FMV will be paid instead of Fractional shares. No payment or adjustment will be made with respect to cash dividends payable on X common or X CAP stock on a conversion to X common. In lieu of complying with a demand that it convert shares of X's CAPs to X comon, X may elect to purchase any shares tendered for conversion into X common for an amount of cash that is equal to FMV of the common that would otherwise be due to the CAP shareholder.

(53) Commissioner v. Brown, 380 U.S. 563 (1964).

(54) 77 T.C. 9 (1981).

(55) Staff of the Senate Committee on Finance, 98th Cong., 1st Sess., The Reform and Simplification of the Income Taxation of Corporations. 79 (Comm. Print 1983).

(56) See Peacock & Pollard, Corporate Dividends-Received Deduction: Benefits Limited by Debt-Financed Portfolio Stock Rules and the Tax Reform Act of 1986, 39 Tax Executive 165 (1987); and Tax-Leveraged Investments: Section 246A, Section 7701(f) and Other Recent Developments, 13 Journal of Corporate Taxation 3 (1986).

(57) Pub. Law No. 98-369, 98 Stat (1984).

(58) I.R.C. [section] 246A(b).

(59) I.R.C. [section] 246A(c)(2).

(60) Under section 246A(a) and (e), the disallowance may not exceed the interest deduction attributable to the dividend. The average indebtedness percentage is calculated by dividing the average amount of portfolio indebtedness associated with the stock during a "base-period" by the average amount of the adjusted basis of the stock during the same period. Section 246A(d)(4) defines "base period" as the shorter of the period beginning on the most recent previous ex-dividend date and ending on the day before the ex-dividend date for the dividend in question or alternatively a one-year period of time terminating on the day before the ex-divided date in question. For a representative explanation of the IRS's oublic position on the meaning of "directly attributed," See Rev. Rul. 88-66, 1988-32 I.R.B. 7.

(61) Section 7701(f) provides:

"The Secretary shall prescribe such regulations as may be necessary or appropriate to prevent avoidance of the provisions of this title which deal with --

(1) the linking of borrowing to investment, or (2) diminishing risks, through the use of related persons, pass-through entities, or other intermediaries."

Several other sections of the Code might also be governed by future regulations in this area. For example, section 133 (loans by financial institutions to ESOPs); section 163(d) (limitations on interest expense deductions); section 246(c) (hedging with respect to preferred stock); section 279 (acquisitions financed by debt); section 291(e)(1)(B) (interest deductions related to the acquisition of tax-exempt securities by financial intermediaries); and section 871(h) (Eurobond portfolio interest).

(62) See H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 1041-42 (1984).

(63) See S. Rep. No. 169, Vol. II, 98th Cong., 2d Sess. 540-41 (1984).

(64) The following states have followed the federal rules in the treatment of MMPs; Alaska, Colorado, Delaware, Florida, Georgia, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Minnesota, Nebraska, New Mexico, Ohio, Oklahoma, Rhode Island, South Carolina, Vermont, and Virginia.

(65) The following states provide no exclusion for the DRD: Mississippi, Montana, New Hampshire, and Utah.

(66) the following states allow a partial DRD: Alabama, Arizona, Arkansas, California, Connecticut, Dist. of Columbia, Hawaii, Idaho, Kentucky, Louisiana, Massachusetts, Michigan, Missouri, New Jersey, New York, NO. Carolina, No. Dakota, Oregon, Pennsylvania, Tennessee, W. Virginia, and Wisconsin.

(63) See Wall street Journal, Nov. 17, 1987, at 47, col. 1 ("Floating-Rate Preferreds Is Vanishing in Face of Tax Bills Before Congress").

(68) H.R. Rep. No. 100-391, 100th Cong., 1st Sess. at 1094-95 (1987) (There is "concern that there are many instances in which stock that may take advantage of the dividends-received deduction may be issued to holders that are essentially anticipating an investment that has an enhanced likehood of recovery of principal or of maintaining a dividend or both, or that otherwise has certain non-stock characteristics").

(69) Treas. Reg. [section] 19301-1(b).

(70) I.R.C. [section] 246(a)(1)(A).

(71) See note 2, supra.

(71) I.R.C. [section] 305(b)(2).

(73) I.R.C. [section] 305(c).

(74) Treas. Reg. [section] 1.305-7(a).

(75) If a VRP adjustments is construed as a deemed distribution under section 305(c), the amount taxable is equal to the extent of its fair market value as prescribed in Treas. Reg. [sub-section] 1.301-1(d)(ii) and 1.305-2(b). Ex. 1.

(76) Treas. Reg. [section] 1.305-7.

(77) Treas. Reg. [section] 1.305-7(a).

(78) Treas. Reg. [secton] 1.305-7(a)(1).

(79) Treas. Reg. [section] 1.305-3(b).

(80) I.R.C. [sub-section] 305(b)(4) and 305(c) and Treas. Reg. [section] 1.305-5(d), Ex. 5.

(81) See Lee, The Reform Act Shareholder Changes: Stock Dividends, 23rd U.S.C. Tax Institute 191, 229-30 (1971).

(82) Treas. Reg. [section] 1.305-7(a).

(83) This is an event that could have a result described in section 305(b)(2)(A) & (B).

(84) Treas. Reg. [section] 1.301-1(d)(ii) and Treas. Reg. [section] 1.305-2(b), Ex. 1.

(85) Letter Ruling Nos. 82052056 and 8147102.
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