What Was the Problem?
The creation of the nonqualified preferred stock rule in 1997 was aimed at transactions like this: Bigco puts cash into Newco, and some shareholders of Target put Target common stock into Newco for nonqualified preferred stock; Newco then buys the rest of the Target stock for cash. The shareholder who got Newco preferred stock can be very secure and can delay gain recognition until a more convenient time.
Congress thought the shareholder who got the preferred stock ought to recognize gain or loss in the Target stock if the preferred stock had certain identified debt-like features. The legislative history stated that Treasury could extend the application of nonqualified preferred stock to Section 304 transactions, but Treasury never did so.
Presumably, Congress foresaw exactly the case that now appears to be troubling the Administration:
Example: Foreignco owns Domestic Sub 1 and Domestic Sub 2. Foreignco sells Sub 1 to Sub 2 for nonqualified preferred stock. Foreignco realizes substantial gain, but as a foreign person, does not owe U.S. tax on the gain unless it is converted into a dividend. Section 304 could convert it into a dividend because Section 351 does not apply, because Foreignco got no stock in the exchange (the nonqualified preferred stock is treated as boot to Foreignco). However, when Section 304 is then applied to the transaction, Foreignco is deemed to contribute its Sub 1 stock for stock of Sub 2, which is then deemed to be redeemed for the nonqualified preferred stock. That is a recapitalization of Sub 2 in which only boot is distributed, because a company’s own stock is not property for purposes of Section 304, according to section 317. Therefore, there is no distribution for Section 304 to apply to and treat as a dividend, leaving Foreignco to recognize a capital gain and owe no U.S. tax.
Conversely, the seller of stock in exchange for nonqualified preferred stock may realize a loss and would like to recognize the loss. Because the seller is deemed to receive no stock in an exchange when nonqualified preferred stock alone is received, it can recognize its loss without concern about Section 304 or Section 351 (because Section 351 does not apply—no stock was received). The recognized loss might, however, be deferred under Section 267 if the buyer and seller are sufficiently related.
Evidently, the Administration has decided that the threats of assisting losses and avoiding Section 304 are too serious to try to fix with regulations and have decided to simply throw out the whole nonqualified preferred stock regime. Perhaps the thought is that recipients of the preferred stock won’t or don’t hold onto it long anyway, and so will recognize their income soon enough? The proposal would apply to preferred stock issued after this year.
A second Administration proposal is to change Section 356(b), which now provides that a shareholder can have its gain realized in a reorganization exchange treated as a dividend only up to the extent of the gain and not more.
Example: X bought Foreign Y for $100 and it is still worth $100. X sells Y to its Foreign Sub Z for $100 cash and Y liquidates. The transaction is treated as a D reorganization: Y exchanges all of its assets for a deemed issuance of a nominal share of Z stock, plus cash, and Y liquidates. Z has lots of earnings and profits. Because X got a deemed issuance of stock, as well as cash, Section 356—and not Section 354—applies. Also, because X does not realize any gain on the stock exchanged for the cash, Section 356 cannot recharacterize any gain to the dividend and X simply receives a return of capital.
The dividend-within-gain limitation is ancient, and never made any sense; it was likely a drafting error. Its repeal is more likely than repeal of nonqualified preferred stock, except for the fact that it is even more loved by tax planners.