Section 305(b)(2) Warrants
LTR 201213011 rules that a domestic corporation can generate a section 301 distribution to its shareholder(s), possibly for the purpose of creating capital gain, possibly to allow use of an expiring capital loss of the shareholder. Sec. 1212(a). The ruling is unusual both for its brevity and for dealing with section 305, which does not attract many letter rulings.
Facts. Taxpayer had outstanding common stock and at least two and possibly three classes of preferred stock: (1) cumulative preferred stock with dividends in arrears, (2) preferred stock convertible into common, and (3) other preferred stock. Taxpayer capitalized the dividends in arrears into some form of stock, which Reg. secs. 1.368-2(e)(5) and 1.305-7(c)(1)(ii) treat under section 305(c) as a deemed distribution to which sections 305(b)(4) and 301 apply. Then taxpayer issued common in exchange for some of the convertible preferred and also for other preferred that evidently was not convertible. Then taxpayer issued warrants to buy more common stock to all of its common shareholders as of the record date.
The taxpayer presumably wanted the warrant issuance to be taxable and the IRS so ruled, based on this conclusory statement: “The recipients of the YWarrants had a greater interest in Taxpayer than if they had not received the YWarrants,” citing sec. 305(b)(2) and 305(c).
Analysis. Section 305(b)(2) is the provision, which in connection with regulations, provides that an increase in the proportionate interest of some shareholders and a section 301 distribution of property to other shareholders will result in the increase in proportionate interest being treated as a deemed stock distribution that is a section 301 distribution.
The only distribution of property mentioned in this ruling was the exchange of new stock for dividend arrearage on the preferred. The increase in proportionate interest was attributed to the distribution of the warrants on the common. But a distribution of more common stock on common stock normally does not increase the proportionate interest of the common class, unless convertible stock or securities are outstanding and there is not a full adjustment to the conversion ratio to account for the warrants. Reg. sec. 1.305-3(e) Examples (2), (4) and (15).
The extremely brief ruling does not mention a conversion ratio. Its only explanation is the sentence quoted above that the warrant recipients, who were all of the common shareholders as of the record date, in fact obtained a greater interest than if they had not received the warrants. The statement does not attribute the increase in interest to anything but the warrants.
Because the common was not formally divided into classes, in order for there to have been a disproportionate interest created by the warrant distribution, either (1) there had to have been preferred stock remaining outstanding at the time of the warrant issuance in order for the common to have somehow increased in proportionate interest, or (2) regardless of the existence of a preferred class, perhaps the record date of the warrant issuance caused the warrants to be distributed only to the historic common shareholders and not to the converting preferred shareholders, thus creating two groups of shareholder for purposes of the section 305(b)(2) analysis.
Alternative (1) is simply inexplicable under known precedents and so will be discounted, unless there was no conversion ratio adjustment. Either the failure to mention a conversion ratio adjustment mechanism means there was none and so it could not be properly adjusted and so that was the cause of the disproportion; or the explanation for the ruling is alternative (2).
As to alternative (2), the ruling employs the usual ruling technique of identifying dates as 1, 2, 3 and 4. The record date for the warrant distribution is date 4, after the distribution on date 3. But of course the record date had to precede the distribution date. It could as well have preceded the date 2 of the conversion of the preferred stock to common. In that event the preexisting group of common shareholders would have increased their interest relative to the new group of common shareholders.
If alternative (2) is the explanation for the ruling it is a little troubling because many corporations continually issue new common stock. It cannot be that every distribution of common on common will be taxable because some new shareholders do not receive it due to the operation of the record date.
What was going on? Regardless of the explanation for the taxable warrants distribution, why did the taxpayer want it to be taxable? What was taxpayer trying to accomplish? Assuming that it did not have a non tax goal to actually increase some group of shareholders’ interest in the corporation, apparently it wanted both to defer income inclusion for the owners of the cumulative preferred and then trigger that inclusion without actually paying a cash dividend, and also to create a section 301 distribution on the common without actually changing the corporation’s capital structure. An unexercised warrant is essentially a nothing in corporate terms.
The ruling gave absolutely no information about the taxpayer, whether it was foreign or domestic, parent of a consolidated group, etc. This is highly unusual for letter rulings. The type of corporation whose shareholders sometimes like to receive section 301 distributions, and like to time those distributions, often is a foreign corporation that is a CFC. However, this taxpayer was not foreign because the ruling was issued by the Corporate Division, and the International Division issues rulings to foreign corporations. Rev. Proc. 2012-1, sec. 3.04.
So why would a domestic corporation want to create a section 301 distribution for common shareholders for no apparent reason but to have the tax results of a section 301 distribution? We do not know whether the taxpayer had earnings and profits or not, but the failure to pay the preferred dividends might indicate that it did not. If the section 301 distribution were not a dividend but a return of capital, then the common shareholders might not care about receiving a section 301 distribution, at least not right now. If the distribution produced a gain to them, then perhaps the common shareholder was a corporation that wanted a capital gain to offset expiring capital losses? But where is the refreshing of the losses, which usually is desired in such cases?
Refreshing capital losses on the hypothesized facts occurs when the basis of the common stock in effect shifts to the warrants, as shown in the following example.
Example: Historic common shareholder had basis of $100 in common stock and received warrant worth $500 in a section 301 distribution that was not a dividend. Shareholder will recognize a capital gain of $400 under section 301(c)(3), have no remaining basis in its common stock and have a $500 basis in the warrant. If the warrant expires unexercised, shareholder can deduct a $500 capital loss, subject to section 1211.