HOLDING PERIOD WILL BE SUSPENDED ON STOCK-LIKE INSTRUMENT THAT GIVES HOLDER RIGHTS OF CREDITOR.

Rev. Rul. 94-28

ISSUE

Does section 246(c)(4) of the Internal Revenue Code apply to an instrument that affords the holder the rights of a creditor and is not stock for corporate law purposes but is stock for federal income tax purposes?

FACTS

X, a domestic corporation, issued instruments that are not stock for corporate law purposes but that, based on all the facts and circumstances, are stock for federal income tax purposes. The instruments mature, and pay a fixed amount (the principal), on a specified date. The holders of the instruments have the rights of creditors under applicable law with respect to X's obligation to repay the principal due on the instruments. Another domestic corporation, Y, purchased the instruments.

LAW AND ANALYSIS

Under section 243(a), a corporation is allowed a deduction equal to a specified percentage of amounts received as dividends from a domestic corporation.

Section 246(c)(1)(A) provides that no deduction is allowed under section 243 with respect to any share of stock that is held by the taxpayer for 45 days or less.

Section 246(c)(4) provides that, for purposes of section 246(c), the holding period of stock is reduced 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, the taxpayer has diminished its risk of loss by holding one or more other positions with respect to substantially similar or related property.

The purpose of section 246(c)(4) is to suspend a taxpayer's holding period, for purposes of meeting the 45-day holding period requirement of section 246(c)(1)(A), for any period during which the taxpayer is protected from the risk of loss otherwise inherent in the ownership of an equity interest.

On the facts presented, Y's right to the principal upon retirement of the instruments at maturity is an option to sell, or a contractual obligation to sell, the instruments for purposes of section 246(c)(4)(A).

The instruments in this case are distinguishable from shares of mandatorily redeemable preferred stock that do not afford a holder creditors' rights. Although a mandatory redemption provision may be viewed as a contractual obligation to sell, section 246(c)(4)(A) generally is interpreted as containing an exception for traditional mandatory redemption rights that are common in the terms of many preferred stocks. This exception, however, must be construed narrowly. It does not extend to instruments, such as those in this case, that afford the holders the right to a fixed payment on a specified date and allow the holders to sue as creditors to enforce this right.

The instruments in this case also are distinguishable from the dutch auction rate preferred stock that was the subject of Rev. Rul. 90-27, 1990-1 C.B. 51. That ruling considered the applicability of the dividends received deduction to amounts received on preferred stock on which the dividend rate was periodically reset under an auction procedure to a rate that would enable the stock to sell at par. The ruling concluded that the dividends qualified for the dividends received deduction. Although the holder of the stock was to some degree insulated from the risks of stock ownership through the expectation of being able to sell the stock in an auction, there was no guarantee that a holder would be able to do so. Moreover, the legal rights of the holder in the ruling were similar to those found in traditional preferred stock and were unlike those usually associated with debt. The holder had no right to receive a sum certain on demand or on a specified date and, at liquidation or in bankruptcy, the holder's rights were subordinate to the claims of the issuer's creditors. In addition, the holder could not compel redemption of the stock. Thus, in contrast to the holder of the instruments in this case, a holder in Rev. Rul. 90-27 possessed no contractual right to receive a fixed amount on a specified date in exchange for that holder's stock.

HOLDING

Section 246(c)(4) applies to an instrument that affords the holder the rights of a creditor and is not stock for corporate law purposes but is stock for federal income tax purposes.

APPLICATION

This ruling does not address the availability of the dividends received deduction in the case of applicable high yield discount obligations under section 163(e)(5)(B).

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 90-27 is distinguished.

DRAFTING INFORMATION

This revenue ruling was drafted in the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information, contact Andrew Kittler at (202) 622-3940 or Nicholas G. Bogos at (202) 622-3920 (not a toll-free call).