Distributions of Stock and Stock Rights

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[CO-8-91]

RIN 1545-AQ42

Distributions of Stock and Stock Rights

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document proposes amendments to regulations relating to

constructive distributions on preferred stock. The proposed regulations

concern the treatment of stock redeemable at a premium by the issuer.

Under the proposed regulations, a call premium is generally treated as

giving rise to a constructive distribution only if redemption pursuant

to the call provision is more likely than not to occur. The proposed

amendments to the regulations also reflect 1990 amendments to section

305(c) of the Internal Revenue Code.

DATES: Written comments must be received by October 24, 1994. Outlines

of oral comments to be presented at the public hearing scheduled for

November 14, 1994, must be received by October 24, 1994.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (CO-8-91), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (CO-8-91), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. The hearing will be held in the IRS auditorium, 1111

Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Kirsten L. Simpson, (202) 622-7790 (not a toll- free number);

concerning submissions and the hearing, Carol Savage, (202) 622-8452

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collection of information should be sent to

the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC

20224.

The collection of information is in Sec. 1.305-5(b)(5). This

information is required to notify the IRS that the issuer and holder of

stock subject to section 305 have made inconsistent determinations as

to whether there is a constructive distribution under Sec. 1.305-5(b).

The likely respondents are individuals or households and business or

other for-profit institutions.

The estimated total annual reporting burden: 333 hours. The

estimated annual burden per respondent varies from 5 minutes to 15

minutes, depending on individual circumstances, with an estimated

average of 10 minutes. The estimated number of respondents: 2000.

Estimated annual frequency of responses: one.

Background

This document proposes amendments to the Income Tax Regulations (26

CFR part 1) under section 305 of the Internal Revenue Code of 1986.

Section 305(a) provides that gross income generally does not include

stock dividends. Section 305(b)(4) provides an exception for certain

distributions with respect to preferred stock.

Section 305(c) provides that, under regulations, a difference

between redemption price and issue price, or any transaction having a

similar effect, shall be treated as a distribution. This provision

addresses methods ``devised to give preferred stockholders the

equivalent of dividends on preferred stock which are not taxable as

such under present law.'' S. Rep. No. 552, 91st Cong., 1st Sess. 151

(1969). For example, ``a corporation may issue preferred stock for $100

per share which pays no dividends, but which may be redeemed in 20

years for $200. The effect is the same as if the corporation

distributed preferred stock equal to 5 percent of the original stock

each year during the 20-year period in lieu of cash dividends.'' Id.

Current Sec. 1.305-5(b)(1) provides that if a corporation issues

preferred stock which may be redeemed after a specified period of time

at a price higher than the issue price, the difference is considered a

distribution of additional stock on preferred stock which is

constructively received by the shareholder over the period of time

during which the preferred stock cannot be called for redemption.

Current Sec. 1.305-5(b)(2) provides that this rule does not apply

to the extent that the higher redemption price represents a reasonable

redemption premium. A safe harbor is provided under which a redemption

premium is considered reasonable if it is not in excess of 10 percent

of the issue price on stock not redeemable for five years from the date

of issuance. A redemption premium that does not meet this safe harbor

is considered reasonable if it is in the nature of a penalty for

premature redemption and is not larger than the premiums being paid for

this purpose by other issuers of similar stock at the time of issuance.

Current Sec. 1.305-5(b)(1) can apply to preferred stock that is

redeemable solely at the option of the issuer. The holder generally

must treat a call premium as a constructive distribution under

Sec. 1.305-5(b) to the extent that the premium is unreasonable.

Section 305(c) was amended by the Revenue Reconciliation Act of

1990 (the 1990 Act), Pub. L. 101-508, which changed the treatment of

stock redeemable at a premium. The amendments provide that: (a) If the

issuer is required to redeem stock at a specified time, or the holder

has the option to require the issuer to redeem stock, at a premium, the

redemption premium will result in a constructive distribution if it

exceeds a de minimis amount computed under the principles of section

1273(a)(3); (b) a redemption premium will not fail to be treated as a

distribution (or series of distributions) merely because the stock is

callable; and (c) in any case where a redemption premium is treated as

a distribution (or series of distributions), the premium will be taken

into account under principles similar to those of section 1272(a).

The amendments to section 305(c) did not alter the requirement that

constructive distributions resulting from a redemption premium be

treated as distributions to which section 301 applies only if they have

the effect described in section 305(b), including section 305(b)(4).

Rather, the amendments were adopted because Congress believed that

``the economic accrual rules applicable to debt instruments issued with

[original issue discount (OID)] also should generally apply to certain

preferred stock issued with a redemption premium if the stock will be

redeemed, or if it can reasonably be assumed that the stock will be

redeemed, on a fixed date.'' H.R. Rep. No. 881, 101st Cong., 2d Sess.

347 (1990). The legislative history to the 1990 amendments indicates

that Congress did not intend to limit the authority of the Treasury and

the IRS to determine the proper treatment of redemption premiums on

callable preferred stock. Id. at 348-49.

Explanation of Proposed Regulations

1990 Act Amendments. Proposed Sec. 1.305-5 (b)(1) and (b)(2)

restate the basic rules concerning the treatment of mandatorily

redeemable and puttable stock in conformity with the 1990 Act. The IRS

and Treasury anticipate that other issues raised by the 1990 Act will

be addressed in subsequent guidance.

Treatment of issuer call rights. The primary focus of the proposed

regulations is on the treatment under section 305(c) of stock callable

at a premium at the option of the issuer.

If stock is subject to an issuer call, the holder cannot control

whether the stock will be redeemed at the premium amount. Moreover, if

the payment of a call premium merely reflects increases in the value of

the holder's stock resulting from market fluctuations after the date of

issuance, the call premium is not the equivalent of a distribution and

its payment is more appropriately taxable only upon realization.

If, on the date of issuance, however, it is more likely than not

that an issuer will exercise its call option based on the economic

terms of the stock, the holder's anticipated increase in the earnings

and assets of the issuer through the call premium is equivalent to a

periodic return on the stock that should be taxed over time as a

distribution. Such a call has the effect of a mandatory redemption

provision, and should produce comparable tax consequences.

Accordingly, proposed Sec. 1.305-5(b)(3) requires constructive

distribution treatment with respect to an issuer call only if, based on

all of the facts and circumstances as of the issue date, redemption

pursuant to the call right is more likely than not to occur. Even if

redemption may be likely, however, constructive distribution treatment

does not result if the redemption premium is solely in the nature of a

penalty for premature redemption. A penalty for premature redemption is

a premium paid as a result of changes in economic or market conditions

over which neither the issuer nor the holder has control. Examples

include changes in prevailing dividend rates or in the value of the

common stock into which the stock is convertible. Calls in such cases

reflect increases in the value of the holder's stock resulting from

events that occur after the date of issuance, and the premiums paid

thereon therefore represent a penalty for premature redemption rather

than the equivalent of a periodic return on the stock.

Under a safe harbor, constructive distribution treatment does not

result from an issuer call if the issuer and the holder are unrelated,

there are no arrangements that effectively require the issuer to redeem

the stock, and exercise of the option to redeem would not reduce the

yield of the stock.

The standard in the proposed safe harbor is similar to the standard

for taking into account call options in determining the yield of debt

instruments potentially subject to the accrual of OID. See Sec. 1.1272-

1(c)(5). However, the determination of whether a redemption premium

should be treated as a constructive distribution is not based solely on

the effect of an issuer call on yield.

Proposed Sec. 1.305-5(b)(1) does not provide any exception from

constructive distribution treatment for stock that is immediately

callable by the issuer. Under proposed Sec. 1.305-5(b)(3), a

constructive distribution by reason of the issuer call would only occur

in cases where a call is more likely than not to occur, based on the

facts and circumstances as of the issue date. The holder is treated as

constructively receiving the premium as a distribution over the period

from the issue date to the date on or by which redemption is most

likely to occur.

Under the proposed regulations, the tax consequences of callable

preferred stock are intended to reflect the economic expectations of

the parties and to afford issuers flexibility to issue stock on terms

that reflect their business needs. The proposed regulations are also

intended to foreclose corporations from attempting to use issuer calls

to create constructive distributions solely for tax planning reasons.

However, no inference is to be drawn from the proposed regulations as

to the appropriate treatment of such call rights under current law.

Such provisions are subject to scrutiny under general tax principles

(e.g., substance over form).

De minimis exception. Proposed Sec. 1.305-5(b)(1) would replace the

``reasonable redemption premium'' exception under current Sec. 1.305-

5(b)(2) with the statutory de minimis rule under section 305(c)(1) for

mandatorily redeemable and puttable stock, and extend the statutory

rule to issuer calls. Extending this rule to issuer calls differs from

the treatment discussed in the legislative history of the 1990 Act, but

is appropriate because the proposed regulations limit constructive

distribution treatment with respect to issuer calls to circumstances in

which the stock is economically similar to mandatorily redeemable

stock. In those cases, the call premium cannot fairly be said to be

``in the nature of a penalty for premature redemption.'' Since those

cases are outside of the intended scope of the exception in the current

regulations, there is no reason to retain current Sec. 1.305-5(b)(2)

for callable stock.

Conforming changes. The proposed regulations would conform the

examples in Secs. 1.305-3 and 1.305-5 to the proposed changes described

above. In addition, the proposed regulations would conform language in

Sec. 1.305-7(a) to the proposed changes described above.

Effective dates. Proposed Sec. 1.305-5(b)(6) contains the effective

date rules. In general, the regulations are proposed to apply to stock

issued on or after the date final regulations are filed with the

Federal Register.

The committee reports to the 1990 Act indicate that Congress did

not intend to limit the authority of the Secretary to promulgate

regulations relating to the accrual of redemption premiums on callable

preferred stock. However, the reports indicate that Congress

anticipated any such regulations would be prospective. H.R. Conf. Rep.

No. 964, 101st Cong., 2d Sess. 1095 (1990).

Although the proposed regulations do not apply to stock issued

before the date final regulations are filed with the Federal Register,

the rules of sections 305(c) (1), (2), and (3) apply to stock described

therein issued on or after October 10, 1990, except as provided in

section 11322(b)(2) of the 1990 Act. The committee reports to the 1990

Act express Congress' intention that the economic accrual and OID de

minimis rules generally apply as of the effective date of the 1990 Act

without regard to when regulations are amended to reflect such rules.

H.R. Conf. Rep. No. 964, 101st Cong., 2d Sess. 1095 (1990).

The committee reports note that, in general, the OID de minimis

rule will not apply to preferred stock that is callable solely at the

option of the issuer (unless such stock is subject to a mandatory

redemption or is puttable). However, the economic accrual rule will

apply as of the effective date of the 1990 Act to the entire call

premium on stock that is callable solely at the option of the issuer

(but not mandatorily redeemable or puttable) if such premium is

considered to be unreasonable under the current regulations. In such

cases, except as provided in regulations, the entire call premium will

be accrued over the period of time during which the preferred stock

cannot be called for redemption. It should be noted that the committee

reports also authorize the Secretary to treat stock that, in form, is

merely callable as being subject to a mandatory redemption or a put if

the existence of other arrangements effectively requires the issuer to

redeem the stock. H.R. Conf. Rep. No. 964, 101st Cong., 2d Sess. 1095

(1990).

Comments invited. The IRS and Treasury invite public comment on the

proposed regulations and on any issues involving the implementation of

the 1990 Act amendments to section 305(c), including the extent to

which OID principles should be adopted in the section 305(c) context

and the appropriate treatment of unpaid cumulative dividends.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for November 14, 1994, at 10

a.m., in the auditorium. Because of access restrictions, visitors will

not be admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by October 24, 1994, and submit an outline of

the topics (signed original and eight (8) copies) to be discussed and

the time to be devoted to each topic by October 24, 1994.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Kirsten L.

Simpson of the Office of Assistant Chief Counsel (Corporate), IRS.

However, other personnel of the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

the following entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.305-3 also issued under 26 U.S.C. 305.

Section 1.305-5 also issued under 26 U.S.C. 305.

Section 1.305-7 also issued under 26 U.S.C. 305. * * *

Par. 2. Section 1.305-3 is amended as follows:

1. In paragraph (e), remove the parentheses from the numbers in the

headings for Examples (1) through (15).

2. Paragraph (e), Example 15 is revised to read as follows:

Sec. 1.305-3 Disproportionate distributions.

* * * * *

(e) * * *

Example 15. (i) Facts. Corporation V is organized with two

classes of stock, class A common and class B convertible preferred.

The class B stock is issued for $100 per share and is convertible

into class A at a fixed ratio that is not subject to full adjustment

in the event stock dividends or rights are distributed to the class

A shareholders. The class B stock pays no dividends but it is

mandatorily redeemable in 10 years for $200. Under sections 305(c)

and 305(b)(4), the entire redemption premium (i.e., the excess of

the redemption price over the issue price) is deemed to be a

distribution of preferred stock on preferred stock which is taxable

as a distribution of property under section 301. This amount is

considered to be distributed over the 10-year period under

principles similar to the principles of section 1272(a). During the

year, the corporation declares a dividend on the class A stock

payable in additional shares of class A stock.

(ii) Analysis. The distribution on the class A stock is a

distribution to which sections 305(b)(2) and 301 apply since it

increases the proportionate interests of the class A shareholders in

the assets and earnings and profits of the corporation and the class

B shareholders have received property (i.e., the constructive

distribution described above). If, however, the conversion ratio of

the class B stock were subject to full adjustment to reflect the

distribution of stock to class A shareholders, the distribution of

stock dividends on the class A stock would not increase the

proportionate interest of the class A shareholders in the assets and

earnings and profits of the corporation and such distribution would

not be a distribution to which section 301 applies.

(iii) Effective date. This Example 15 applies to stock issued on

or after the date final regulations are filed with the Federal

Register. For previously issued stock, see 26 CFR part 1 edition

revised April 1, 1994, Sec. 1.305-3(e) Example (15).

Par. 3. Section 1.305-5 is amended as follows:

1. Paragraph (b) is revised.

2. In paragraph (d), remove the parentheses from the numbers in the

headings for Examples (1) through (9).

3. Paragraph (d), Examples 4, 5, and 7 are revised.

4. The revisions read as follows:

Sec. 1.305-5 Distributions on preferred stock.

* * * * *

(b) Redemption premium--(1) In general. If a corporation issues

preferred stock that may be redeemed under the circumstances described

in this paragraph (b) at a price higher than the issue price, the

difference (the redemption premium) is treated under section 305(c) as

a constructive distribution (or series of constructive distributions)

of additional stock on preferred stock that is taken into account under

principles similar to the principles of section 1272(a). However,

constructive distribution treatment does not result under this

paragraph if the redemption premium does not exceed a de minimis

amount, as determined under the principles of section 1273(a)(3).

(2) Mandatory redemption or holder put. Paragraph (b)(1) of this

section applies to stock if the issuer is required to redeem the stock

at a specified time or the holder has the option to require the issuer

to redeem the stock.

(3) Issuer call--(i) In general. Paragraph (b)(1) of this section

applies to stock by reason of the issuer's right to redeem the stock

(even if the right is immediately exercisable), but only if, based on

all of the facts and circumstances as of the issue date, redemption

pursuant to that right is more likely than not to occur. However, even

if redemption is more likely than not to occur, paragraph (b)(1) of

this section does not apply if the redemption premium is solely in the

nature of a penalty for premature redemption. A penalty for premature

redemption is a premium paid as a result of changes in economic or

market conditions over which neither the issuer nor the holder has

control.

(ii) Safe harbor. For purposes of this paragraph (b)(3), redemption

pursuant to an issuer's right is not treated as more likely than not to

occur if--

(A) The issuer and the holder are not related within the meaning of

section 267(b) or 707(b);

(B) There are no arrangements that effectively require the issuer

to redeem the stock; and

(C) Exercise of the right to redeem would not reduce the yield of

the stock, as determined under principles similar to the principles of

section 1272(a).

(iii) Effect of not satisfying safe harbor. The fact that a

redemption right is not described in paragraph (b)(3)(ii) of this

section does not affect the determination of whether the right to

redeem is more likely than not to occur.

(4) Coordination of multiple redemption provisions. If the

provisions of stock permit redemption at more than one time, the time

and price at which redemption is most likely to occur must be

determined based on all of the facts and circumstances as of the issue

date. Any constructive distribution under paragraph (b)(1) of this

section will be construed to result only with respect to the time and

price identified in the preceding sentence. However, if redemption does

not occur at that identified time, the amount of any additional premium

payable on any later redemption date, to the extent not previously

treated as distributed, is treated as a constructive distribution over

the period from the missed call or put date to that later date, to the

extent required under the principles of this paragraph (b).

(5) Consistency. The issuer's determination as to whether there is

a constructive distribution under this paragraph (b) is binding on all

holders of the stock, other than a holder that explicitly discloses

that its determination as to whether there is a constructive

distribution under this paragraph (b) differs from that of the issuer.

Unless otherwise prescribed by the Commissioner, the disclosure must be

made on a statement attached to the holder's timely filed Federal

income tax return for the taxable year that includes the date the

holder acquired the stock. The issuer must provide the relevant

information to the holder in a reasonable manner. For example, the

issuer may provide the name or title and either the address or

telephone number of a representative of the issuer who will make

available to holders upon request the information required for holders

to comply with this provision of this paragraph (b).

(6) Effective date. This paragraph (b) (and Examples 4, 5, and 7 of

paragraph (d) of this section) apply to stock issued on or after the

date final regulations are filed with the Federal Register. For rules

applicable to previously issued stock, see 26 CFR part 1 edition

revised April 1, 1994, Sec. 1.305-5(b) and (d) Examples (4), (5), and

(7). Although this paragraph (b) and the revised examples do not apply

to stock issued before the date final regulations are filed with the

Federal Register, the rules of sections 305(c)(1), (2), and (3) apply

to stock described therein issued on or after October 10, 1990, except

as provided in section 11322(b)(2) of the Revenue Reconciliation Act of

1990 (Pub. L. 101-508).

* * * * *

(d) * * *

Example 4--(i) Facts. Corporation X is a domestic corporation

with only common stock outstanding. In connection with its

acquisition of Corporation T, X issues 100 shares of its 4%

preferred stock to the shareholders of T, who are unrelated to X.

The issue price of the preferred stock is $40 per share. Each share

of preferred stock is convertible at the shareholder's election into

three shares of X common stock. At the time the preferred stock is

issued, the X common stock has a value of $10 per share. The

preferred stock does not provide for its mandatory redemption or for

redemption at the option of the holder. It is callable at the option

of X at any time beginning three years from the date of issuance for

$100 per share. There are no other arrangements that would affect

X's decision to call the preferred stock.

(ii) Analysis. The preferred stock is described in the safe

harbor rule of paragraph (b)(3)(ii) of this section because X and

the former shareholders of T are unrelated, there are no

arrangements that effectively require X to redeem the stock, and

calling the stock for $100 per share would not reduce the yield of

the preferred stock. Therefore, the $60 per share call premium is

not treated as a constructive distribution to the shareholders of

the preferred stock under paragraph (b) of this section.

Example 5--(i) Facts--(A) Corporation Y is a domestic

corporation with only common stock outstanding. On January 1, 1995,

Y issues 100 shares of its 10% preferred stock to an unrelated

holder. The issue price of the preferred stock is $100 per share.

The preferred stock is--

(1) Callable at the option of Y on or before January 1, 2000, at

a price of $105 per share plus any accrued but unpaid dividends; and

(2) Mandatorily redeemable on January 1, 2005, at a price of

$100 per share plus any accrued but unpaid dividends.

(B) The preferred stock provides that if Y fails to exercise its

option to call the preferred stock on or before January 1, 2000, the

holder will be entitled to appoint a majority of Y's directors. It

is reasonably anticipated that Y will have available funds

sufficient to exercise the right to redeem.

(ii) Analysis. Under paragraph (b)(3)(i) of this section,

paragraph (b)(1) of this section applies because, by virtue of the

change of control provision and the absence of any contrary facts,

it is more likely than not that Y will exercise its option to call

the preferred stock on or before January 1, 2000. The safe harbor

rule of paragraph (b)(3)(ii) of this section does not apply because

the provision that failure to call will cause the holder to gain

control of the corporation is an arrangement that effectively

requires Y to redeem the preferred stock. Under paragraph (b)(4) of

this section, the constructive distribution occurs over the period

ending on January 1, 2000. Redemption is most likely to occur on

that date, because that is the date on which the corporation

minimizes the rate of return to the holder but yet prevents the

holder from gaining control. The de minimis exception of paragraph

(b)(1) of this section does not apply because the $5 per share

difference between the redemption price and the issue price exceeds

the amount determined under the principles of section 1273(a)(3) (5

x .0025 x $105 = $1.31). Accordingly, $5 per share, the

difference between the redemption price and the issue price, is

treated as a constructive distribution received by the holder on an

economic accrual basis over the five year period ending on January

1, 2000, under principles similar to the principles of section

1272(a).

* * * * *

Example 7--(i) Facts--(A) Corporation Z is a domestic

corporation with only common stock outstanding. On January 1, 1995,

Z issues 100 shares of its 10% preferred stock to C, an unrelated

individual. The issue price of the preferred stock is $100 per

share. The preferred stock is--

(1) Not callable for a period of 5 years from the issue date;

(2) Callable at the option of Z on January 1, 2000, at a price

of $110 per share plus any accrued but unpaid dividends;

(3) Callable at the option of Z on July 1, 2001, at a price of

$120 per share plus any accrued but unpaid dividends; and

(4) Mandatorily redeemable on January 1, 2003, at a price of

$150 per share plus any accrued but unpaid dividends.

(B) There are no other arrangements between Z and C concerning

redemption of the stock.

(ii) Analysis. Under paragraphs (b)(3)(i) and (b)(4) of this

section, paragraph (b)(1) of this section applies because, absent

any other facts indicating a contrary result, the fact that

redemption on January 1, 2000, would reduce the yield of the stock

and produce the lowest yield indicates that exercise of the option

to call on that date is more likely than not to occur. The safe

harbor rule of paragraph (b)(3)(ii) of this section does not apply

to the option to call on January 1, 2000, because the call would

reduce the yield of the stock. The de minimis exception of paragraph

(b)(1) of this section does not apply because the $10 per share

difference between the redemption price payable in 2000 and the

issue price exceeds the amount determined under the principles of

section 1273(a)(3) (5 x .0025 x $110 = $1.38). Accordingly, $10

per share, the difference between the redemption price and the issue

price, is treated as a constructive distribution received by the

holder on an economic accrual basis over the five year period ending

January 1, 2000, under principles similar to the principles of

section 1272(a).

(iii) Coordination rules--(A) If Z does not exercise its option

to call the preferred stock on January 1, 2000, paragraph (b)(4) of

this section provides that the principles of paragraph (b) of this

section must be applied to determine if any remaining constructive

distribution occurs. Under paragraphs (b)(3)(i) and (b)(4) of this

section, paragraph (b)(1) of this section applies because, absent

any other facts indicating a contrary result, the fact that

redemption on July 1, 2001, would produce the lowest yield indicates

that exercise of the option to call on that date is more likely than

not to occur. The safe harbor rule of paragraph (b)(3)(ii) of this

section does not apply to the option to call on July 1, 2001,

because, as of the first call date, a call by Z on July 1, 2001, for

$120 would reduce the yield of the stock. The de minimis exception

of paragraph (b)(1) of this section does not apply because the $10

per share difference between the redemption price and the issue

price (revised as of the missed call date) exceeds the amount

determined under the principles of section 1273(a)(3) (1 x .0025

x $120 = $.30). Accordingly, the $10 per share of additional

redemption premium that is payable on July 1, 2001, is treated as a

constructive distribution received by the holder on an economic

accrual basis over the period between January 1, 2000, and July 1,

2001, under principles similar to the principles of section 1272(a).

(B) If Z does not exercise its second option to call the

preferred stock on July 1, 2001, then the $30 additional redemption

premium that is payable on January 1, 2003, is treated as a

constructive distribution under paragraphs (b)(2) and (b)(1) of this

section. The de minimis exception of paragraph (b)(1) of this

section does not apply because the $30 per share difference between

the redemption price and the issue price (revised as of the second

missed call date) exceeds the amount determined under the principles

of section 1273(a)(3) (1 x .0025 x $150 = $.38). The holder is

treated as receiving the constructive distribution on an economic

accrual basis over the period between July 1, 2001, and January 1,

2003, under principles similar to the principles of section 1272(a).

Par. 4. Section 1.305-7 is amended by revising the fourth sentence

in the concluding text of paragraph (a) to read as follows:

Sec. 1.305-7 Certain transactions treated as distributions.

(a) * * *

* * * For example, where a redemption premium exists with respect to a

class of preferred stock under the circumstances described in

Sec. 1.305-5(b) and the other requirements of this section are also

met, the distribution will be deemed made with respect to such

preferred stock, in stock of the same class. * * *

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-14971 Filed 6-21-94; 8:45 am]

BILLING CODE 4830-01-U