[Federal Register Volume 59, Number 119 (Wednesday, June 22, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-14971]


[[Page Unknown]]

[Federal Register: June 22, 1994]


-----------------------------------------------------------------------

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.

-----------------------------------------------------------------------

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