Rev. Rul. 77-37

Advice has been requested whether an increase in the conversion ratio of convertible preferred stock to reflect a distribution of stock to the common shareholders under section 355 of the Internal Revenue Code of 1954 is a distribution to which section 301 applies because of the application of section 305(b) and (c).

X corporation has outstanding both common stock and convertible preferred stock. The preferred stock is convertible into the common stock at a fixed ratio. Pursuant to a consent decree entered into with an agency of the United States Government, X distributed all the stock in its wholly owned subsidiary, Y, to its common shareholders in a nontaxable spin-off under section 355 of the Code. No other property was distributed to the shareholders. Since the distribution of the Y stock diluted the conversion value of the preferred stock by decreasing the value of the X common stock, X increased the conversion ratio of the preferred stock to the extent necessary to fully protect the preferred shareholders' investments from such dilution.

Section 305(a) of the Code provides that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock, except as otherwise provided in section 305(b) and (c).

Section 305(b) of the Code provides exceptions under which section 305(a) shall not apply to a distribution (including a deemed distribution under section 305(c)) by a corporation of its stock, and the distribution shall be treated as a distribution to which section 301 applies.

Section 305(c) of the Code provides, in part, that the Secretary of the Treasury shall prescribe regulations under which a change in conversion ratio shall be treated as a distribution for purposes of section 305 with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change.

Section 1.305-7(b) of the Income Tax Regulations provides, in part, that for purposes of applying section 305(c) of the Code in conjunction with section 305(b), a change in the conversion ratio of convertible preferred stock made pursuant to a bona fide, reasonable, adjustment formula that has the effect of preventing dilution of the interest of the holders of such stock will not be considered to result in a deemed distribution of stock. The regulation adds that an adjustment in the conversion ratio to compensate for cash or property distributions to other shareholders that are taxable under sections 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b), or 857(b) will not be considered as made pursuant to a bona fide adjustment formula.

The increase in the conversion ratio of the convertible preferred stock in the instant case was made to the extent necessary to fully protect the preferred shareholders' investments from dilution caused by a nontaxable spin-off of the Y stock under section 355 of the Code.

For this reason, and since sections 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b), and 857(b) of the Code are not applicable to the spin-off, the increase in conversion ratio is made pursuant to a bona fide, reasonable, adjustment formula that has the effect of preventing dilution of the interest of the convertible preferred shareholders.

Accordingly, the increase in the conversion ratio of the preferred stock will not be treated as a deemed distribution of stock to which section 301 applies because of the application of section 305(b) and (c).