DUTCH-AUCTION MECHANISM DOES NOT PRECLUDE DIVIDENDS RECEIVED DEDUCTION, SERVICE RULES.

Rev. Rul. 90-27

ISSUES

(1) Does the dutch-auction rate preferred stock described below represent an equity interest in the issuing corporation?

(2) If a corporation holding the dutch-auction rate preferred stock described below receives a dividend distribution with respect to the stock, do the terms of the issue cause the distribution to fail to qualify for the dividends received deduction under section 243(a) of the Code?

FACTS

X, a publicly-held domestic corporation, issued 1000 shares of dutch-auction rate preferred stock for $100 million. The stock carries a liquidation preference of $100,000 per share. As a condition of sale, each prospective purchaser was required to execute a purchaser's letter, agreeing to sell shares of the X preferred only through a "dutch-auction" proceeding, to an authorized broker-dealer, or to a purchaser who similarly has executed a purchaser's letter.

The initial dividend rate for the preferred shares was set by X at the time of issue. Under a prearranged schedule (generally every 49 days), the rate is then reset pursuant to a "dutch auction," a process in which orders to purchase or sell the preferred stock are submitted through registered broker-dealers to a designated auction agent. In each auction, existing holders that wish to increase the number of shares held and potential new holders bid to purchase shares offered for sale. The stock is designed to trade at the liquidation preference ($100,000). Therefore, each bid consists of a proposed dividend rate at which the bidder is willing to purchase the offered shares at a price equal to the liquidation preference.

An existing holder may choose to hold its preferred shares at whatever rate is set for the next dividend period. Alternatively, an existing holder may place a bid order to hold its shares provided the applicable rate for the next dividend period is not below the rate specified in the bid. If the applicable rate for the next dividend period is below the specified rate, then the bid is treated as a sell order. Lastly, an existing holder may place an order to sell its shares regardless of the applicable rate. A holder may place differing orders for each of its shares.

The lowest dividend rate bid that enables all the shares offered for sale to be sold to potential purchasers is the rate that applies to all shares for the next dividend period. If all of the current holders of the preferred shares elect to hold their shares without specifying a minimum dividend rate (place hold orders on their shares), the dividend rate for the next period is 59% of the AA Composite Commercial Paper Rate.

If there are insufficient bids to purchase all of the shares offered for sale, the auction "fails" and the dividend rate is then the applicable maximum bid rate for that auction. The maximum bid rates are expressed as a percentage of the AA Composite Commercial Paper Rate. The rate applicable to a particular auction depends on the prevailing rating for the preferred stock as determined by a designated investor service:

         Prevailing Rating                  Percentage

Dividends with respect to the X preferred stock are cumulative and must be declared by the Board of Directors and paid out of legally available funds. Holders have no direct right to compel the payment of dividends, and there is no arrangement ensuring that dividends will be paid. However, although the preferred shares generally have no voting rights, if accrued dividends remain unpaid for a specified period, the holders of the preferred stock obtain the right to vote as a class for seats on the Board of Directors.

With proper notice, x may redeem part or all of the preferred shares at any time at par ($100,000) plus accrued but unpaid dividends. Holders, however, may not compel redemption. In the event of any voluntary or involuntary dissolution, liquidation, or winding up of the affairs of X, the holders of the preferred stock are entitled to be paid before holders of shares ranking junior. The liquidation preference is at par plus any unpaid accrued dividends. The claims of the holders of the preferred are subordinate, however, to the claims of X's creditors.

Corporation Y acquired ten shares of the auction rate preferred stock issued by X.

LAW AND ANALYSIS

DEBT/EQUITY ISSUE

The initial question with respect to dutch-auction rate preferred stock is whether it is equity or debt for federal income tax purposes. This classification depends on the facts and circumstances of each case. No particular fact is conclusive in making such a determination. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946), 1946-1 C.B. 191.

From the perspective of the holders, dutch-auction rate preferred stock is an investment alternative to commercial paper or other short-term debt. In certain critical respects, however, the legal rights embodied in the dutch-auction rate preferred described above are similar to those found in traditional preferred stock and are unlike those usually associated with debt. As a holder of the preferred, Y has no right to receive a sum certain either on demand or on a specified date, and, at liquidation or in bankruptcy, Y's rights are subordinate to the claims of X's creditors. Subject to that limitation, X may redeem the stock, but the holder cannot compel redemption. Moreover, X has not guaranteed or otherwise arranged to ensure that Y can sell its stock in an auction. Y's receipt of dividends is dependent upon dividends being declared by X and paid out of legally available funds.

The terms of the dutch-auction rate preferred stock issued by X, including those discussed above, cause the stock to be equity for federal income tax purposes.

HOLDING PERIOD

The remaining question is whether section 246(c) of the Code limits Y's holding period in the X preferred and thus precludes the dividends received deduction under section 243(a).

Under section 243(a)(1) of the Code, a corporation generally is allowed a deduction equal to 70 percent of the amount received as dividends from a domestic corporation.

Section 246(c)(1) of the Code excludes from the deduction allowed under section 243 any dividend on a share of stock that is held by the taxpayer for 45 days or less.

Section 246(c)(4) of the Code reduces the holding period of the taxpayer for any period in which (A) the taxpayer has an option to sell, is under a contractual obligation to sell, or has made (and not closed) a short sale of, substantially identical stock or securities, (B) the taxpayer is the grantor of an option to buy substantially identical stock or securities, or (C) under regulations prescribed by the Secretary, a taxpayer has diminished its risk of loss by holding one or more positions with respect to substantially similar or related property.

The dutch-auction mechanism in this case serves the dual function of resetting the dividend rate on the preferred stock and providing a vehicle for the purchase and sale of the shares. Each successful auction resets the dividend rate on the preferred stock to the rate that allows the shares to trade at par. Thus, so long as auctions are successful, the holder of the stock is protected from fluctuations in value of the stock that otherwise would result from changes in interest rates and the credit rating of the issuer. Although this protection insulates the holder from certain market risks, the legislative history of the Tax Reform Act of 1984 expressly states that an instrument providing a similar type of protection (adjustable rate preferred stock that is indexed to the Treasury bill rate) does not offer the risk diminution proscribed by section 246(c)(4)(C) of the Code. See H.R. Conf. Rep. No. 816, 98th Cong., 2d Sess. 817, 818 (1984), 1984-3 (Vol. 2) C.B. 71.

The auctions also provide a vehicle for the purchase and sale of shares. Although a holder of the preferred stock has the expectation of being able to sell its stock in any auction, there is no guarantee that a holder will be able to do so. In other words, the holder does not have an option to sell.

Section 246(c)(4) may apply not only if the holder has a formal option to sell, but also if the holder has rights equivalent to an option to sell. For example, if a broker-dealer had agreed to guarantee the success of each auction, Y would have had the equivalent of an option to sell its stock at each auction. Similarly, if X were in such a position that it had no practical alternative but to redeem the stock in the event of a failed auction, the combination of the auction mechanism and the forced redemption would give Y the equivalent of an option to sell its stock. Such facts, however, are not present here.

If an auction fails, the dividend rate for the next dividend period automatically resets to the maximum rate. This rate, which depends upon the rating of the preferred stock and is determined as a percentage of the commercial paper rate, may substantially exceed the rate that would be anticipated in a successful auction. The resulting rate may provide X with an incentive to redeem the stock rather than pay the increased dividends. On the facts presented, however, the maximum rate is not so high that it assures Y that the failure of an auction will be followed by a redemption of the stock. Moreover, the circumstances under which an auction is likely to fail (e.g., unforeseen financial difficulties of X) raise serious doubts as to whether X would be able to redeem the preferred stock even if the reset dividend rate provided it with a significant incentive to do so. Thus, the combination of the auction mechanism and the dividend increase following a failed auction do not give Y rights equivalent to an option to sell.

HOLDINGS

(1) The dutch-auction rate preferred stock described above represents an equity interest in the issuing corporation.

(2) Neither the dutch-auction mechanism, the dividend increase required following a failed auction, nor any other term of the dutch- auction rate preferred stock described above prevents a corporation receiving a dividend distribution with respect to the stock from claiming the dividends received deduction under section 243(a) of the Code.

APPLICATION

The terms of some existing issues of dutch-auction rate preferred stock are distinguishable from those of the stock described in this ruling and provide holders additional rights that result in greater diminution of risk and that are of a type usually associated with debt. Pursuant to the authority contained in section 7805(b) of the Code, with respect to any dutch-auction rate preferred stock issued before March 15, 1990, the Internal Revenue Service will not seek: (1) to recharacterize the stock as debt; or (2) to apply the limitations under section 246(c)(4) to the stock on the basis of the terms of the stock or other arrangements entered into in connection with the issuance of the stock. This relief does not apply where there exists an agreement or other arrangement that effectively guarantees that a holder can sell its shares. In these situations, section 246(c)(4) applies to reduce the holding period of the taxpayer for purposes of section 246(c)(1).

Although this ruling deals only with dutch-auction rate preferred stock, no adverse inference is intended with respect to issues of preferred stock in which a remarketing arrangement is used to reset the dividend rate.

DRAFTING INFORMATION

The principal author of this revenue ruling is Robert N. Deitz of the Office of Assistant Chief Counsel (Financial Institutions & Products). For further information, contact Mr. Deitz on (202-566- 3241) (not a toll-free call).