Chief Counsel (Corporate) has advised the field that cumulative preferred stock on which the dividend mandatorily cumulated until redemption (and so section 305(c) applied) was section 1504(a)(4) preferred because it did not have a redemption premium (reasonable or unreasonable). CCA 201152016 (Sept. 1, 2011). As a result, the taxpayer was limited to a 70% rather than a 80% dividends received deduction, which also means that the AMT will apply and section 246A(c) will apply. This was definitely not the tax results on which the taxpayer and the issuer had priced the preferred stock and set its dividends.
Facts: The taxpayer had bought two classes of preferred stock (voting and nonvoting) in a special purpose subsidiary of a bank. Taxpayer counted on receiving deemed dividends under section 305(b)(4) and claiming an 80% dividends received deduction due to owning more than 20% of the subsidiary by vote and value. The bank evidently had tried to fashion the nonvoting class of preferred stock NOT to be section 1504(a)(4) stock by requiring that the dividends paid after the first two dividends must cumulate and be paid at redemption. This is thought to produce a redemption premium when viewed in substance rather than form (i.e., you get more back than you paid) Whether this was the bank’s or the taxpayer’s plan is unclear, as the CCA calls the taxpayer’s theory “post hoc.”
CCA’s Analysis: The Chief Counsel basically opined that the fact that the mandatorily cumulated dividend created what is commonly called a redemption premium that is unreasonable for section 305 purposes (and thus requires annual deemed dividends) was not relevant to defining the “reasonable redemption or liquidation premium” that is allowed for section 1504(a)(4) stock in subsection (C). A reasonable redemption premium does not disqualify the preferred, because it does not evidence a participation in earnings.
Having rejected the analogy to the section 305 definition of unreasonable redemption premium, Chief Counsel did not need to come up with its own definition of a reasonable redemption premium for section 1504(a)(4)(C) purposes because it did not believe the cumulated dividends paid at redemption would be a redemption premium at all. Instead, Chief Counsel believed that their character had been determined when section 305 was applied to them: section 305 recharacterized them as dividends deemed paid annually and that precluded treatment of the actual payment as redemption premium. This is odd reasoning given the fact that it was the existence of an unreasonable redemption premium in the first place that causes section 305(c) to apply to create the deemed dividends.
Chief Counsel seems to reason that the tax characterization of the deemed dividends both (1) prevented the redemption premium from being a redemption premium because it had already been taken into income, and (2) thereby precluded treatment of the premium as a premium for section 1504 purposes. This reasoning is deeply flawed because it ignores the purposes for the 1984 addition to section 1504(a)(4) of the exception for reasonable redemption premium.
Admittedly there was no dispositive legislative history for that 1984 change. However, a contemporaneous New York State Bar Report explained the type of preferred stock that the provision was trying to protect (meaning the type of preferred that could be issued without disaffiliating the subsidiary):
Both money market and adjustable rate preferred stocks are generally callable at the option of the issuer at their issue price plus a reasonable redemption premium, which effectively assures that they will have a limited participation in corporate growth. Peaslee and Stern, Report on Tax Reform Act of 1984, 28 Tax Notes 895 (Aug. 19, 1985)
The report went on to state that the regulations under section 305 should be analogized and recommended that likewise regulations should be written to explain that a reasonable redemption premium was in the nature of a penalty for calling the stock early, and call premiums in the market would provide a guide. Call premiums in the market clearly do not reflect cumulative dividends.
This is an eminently sensible approach. The section 305 regulations to which the report referred were in existence at the time of the 1984 amendment to section 1504(a)(4) and section 305(c) was a well recognized example of the treatment of redemption premiums in the tax law on the basis of substance rather than form. Section 305 treated a redemption price that exceeded the actual original issue price of the stock as a redemption premium by referring to a difference between issue price and redemption price. There certainly would be such a difference in the case of the CCA, and it is not relevant that section 305 will have been applied to convert the redemption premium into current dividends.
The CCA admitted that the IRS had once thought section 1504 should be analogized to section 305 in this regard, but that the change of the section 305 regulations in 1995 made that impossible, improperly citing the Dubroff treatise for this conclusion.
Conclusion: The addressee of the CCA, a Financial Products Appeals Officer, presumably will follow the advice. Whether anyone has an interest in litigating this issue may depend on the dollars involved and whether this sort of instrument was widespread in the market. What is perhaps most surprising about the case is that agents even picked it up. That was likely due to the unusual fact of someone wanting to avoid section 1504(a)(4) status.