The Case of the Disappearing Dividend Tax

Chapter 10 Digging Deeper

Contents:

THE CASE OF THE DISAPPEARING DIVIDEND TAX

1.During the last few years, U.S. banks and offshore hedgefunds have developed a novel technique for avoiding thetax on dividends entirely. The strategy involves the use of financial

derivatives. A simple version of the strategy is calleda stock swap. In the swap, a U.S. bank buys a block of stockfrom an offshore hedge fund. The bank and the hedge fundalso enter into a derivatives contract. The contract requiresthe bank to make payments to the hedge fund equal to thetotal return on the stock (both increases in fair market valueand dividends) for a designated time period. These paymentsequal the income and gain the stock would have providedto the hedge fund if it had continued to own thestock. In exchange for these payments, the hedge fund

agrees to pay the bank an amount based on some benchmark interest rate. The hedge fund also agrees that it willpay the bank an amount equal to the loss if the fair marketvalue of the stock declines.

After purchasing the stock from the hedge fund, thebank receives taxable dividend income. For tax purposes,however, the dividend income is completely offset by theexpense of payments made to the hedge fund under thederivatives contract. In return, the bank receives compensation

from the hedge fund equal to a benchmark interestrate. The overseas hedge fund no longer receives taxabledividend income, and the swap payments received are notsubject to U.S.taxation. As a result, taxable dividend incomeis converted to tax-free income.

Some experts estimate that the strategy has allowedhedge funds to avoid paying more than $1 billion a year intaxes on U.S. dividends. The Federal government is now investigating the banks and offshore hedge funds that use these techniques. While these entities have confirmed that they use stock swaps and similar techniques to reduce tax liability, they argue that they are working within the rules of the U.S. tax law. Expect additional developments in this area over the coming year as investigations continue.

TAX TREATMENT OF CONSTRUCTIVE DIVIDENDS

2. Global Tax Issues—Deemed Dividends from Controlled Foreign Corporations.U.S. multinational companies often conduct business overseas using foreign subsidiaries.One might think that these controlled foreign corporations (CFCs) would be idealfor income tax avoidance if incorporated in a low-tax jurisdiction (a tax haven country).In the absence of any rules to the contrary, the higher U.S. tax on foreign earnings could bedeferred until the earnings are repatriated to the United States through dividends paid to theU.S. parent.

To prevent this deferral, the tax law compels a U.S. parent corporation to recognizesome of the unrepatriated earnings of a CFC as income. The U.S. parent’s basis inthe CFC stock is increased by the amount of the taxed but unrepatriated earnings. Subsequently,when cash or property is actually paid to the U.S. parent (i.e., when taxedearnings are repatriated), no income results. Thus, the CFC rules preclude some deferralbut do not lead to double taxation.

STOCK DIVIDENDS—§ 305

3. For each of the exceptions listed below, stock distributions may be taxed.

Distributions payable in either stock or property, at the election of the shareholder.
Distributions of property to some shareholders, with a corresponding increase in the proportionate interest of other shareholders in either assets or E & P of the distributing corporation.
Distributions of preferred stock to some common shareholders and of common stock to other common shareholders.
Distributions of stock to preferred-stock shareholders.
Distributions of convertible preferred stock, unless it can be shown that the distribution does not result in a disproportionate distribution.

STOCK RIGHTS

4. The rules for determining the taxability of stock rights are identical to those for determining the taxability of stock dividends. If the rights are taxable, the recipient recognizes gross income to the extent of the fair market value of the rights. The fair market value then becomes the shareholder-distributee's basis in the rights.1 If the rights are exercised, the holding period for the new stock begins on the date the rights (whether taxable or nontaxable) are exercised. The basis of the new stock is the basis of the rights plus the amount of any other consideration given.

If the stock rights are not taxable and the value of the rights is less than 15 percent of the value of the old stock, the basis of the rights is zero. However, the shareholder may elect to have some of the basis in the formerly held stock allocated to the rights.2 The election is made by attaching a statement to the shareholder's return for the year in which the rights are received.3 If the fair market value of the rights is 15 percent or more of the value of the old stock and the rights are exercised or sold, the shareholder must allocate some of the basis in the formerly held stock to the rights.

Example:A corporation with common stock outstanding declares a nontaxable dividend payable in rights to subscribe to common stock. Each right entitles the holder to purchase one share of stock for $90. One right is issued for every two shares of stock owned. Fred owns 400 shares of stock purchased two years ago for $15,000. At the time of the distribution of the rights, the market value of the common stock is $100 per share, and the market value of the rights is $8 per right. Fred receives 200 rights. He exercises 100 rights and sells the remaining 100 rights three months later for $9 per right.

Fred need not allocate the cost of the original stock to the rights because the value of the rights is less than 15% of the value of the stock ($1,600/$4,000 = 4%). If Fred does not allocate his original stock basis to the rights, the tax consequences are as follows.

Basis in the new stock is $9,000 ($90 exercise price 100 shares). The holding period of the new stock begins on the date the stock was purchased.
Sale of the rights produces long-term capital gain of $900 ($9 sales price 100 rights). The holding period of the rights starts with the date the original 400 shares of stock were acquired.

If Fred elects to allocate basis to the rights, the tax consequences are as follows.

Basis in the stock is $14,423 ($40,000 value of stock/$41,600value of rights and stock  $15,000 cost of stock).
Basis in rights is $577 ($1,600 value of rights/$41,600 value of rights and stock $15,000 cost of stock).
When Fred exercises the rights, his basis in the new stock will be $9,288.50 ($9,000 cost + $288.50 basis in 100 rights).
Sale of the rights would produce a long-term capital gain of $611.50 ($900 sales price - $288.50 basis in the remaining 100 rights).

DISPROPORTIONATE REDEMPTIONS AND COMPLETE TERMINATION REDEMPTIONS

5.Disproportionate Redemptions.A redemption of stock qualifies for sale or exchange treatment under § 302(b)(2) as a disproportionate redemption if two conditions are met.

After the distribution, the shareholder owns less than 80 percent of the interest owned in the corporation before the redemption. For example, if a shareholder owns a 60 percent interest in a corporation that redeems part of the stock, the shareholder’s percentage of ownership after the redemption must be less than 48 percent (80 percent of 60 percent).
After the distribution,the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.

In determining a shareholder’s percentage of ownership before and after a redemption, the stock attribution rules apply.

Example:Bob, Carl, and Dan, unrelated individuals, own 30 shares, 30 shares, and 40 shares, respectively, in Wren Corporation. Wren has 100 shares of stock outstanding and E & P of $200,000. The corporation redeems 20 shares of Dan’s stock for $30,000. Dan paid $200 a share for the stock two years ago. Dan’s ownership in Wren Corporation before and after the redemption is as follows.

Total Shares / Dan's
Ownership / Ownership
Percentage / 80% of Original
Ownership
Before redemption / 100 / 40 / 40% (40/100) / 32% (80%  40%)
After redemption / 80 / 20 / 25% (20/80)*
*The denominator of the fraction is reduced after the redemption (from 100 to 80).

Dan’s 25% ownership after the redemption meets both tests of § 302(b)(2). It is less than 80% of his original ownership and less than 50% of the total voting power. The distribution qualifies as a stock redemption that receives sale or exchange treatment. Therefore, Dan has a long-term capital gain of $26,000 [$30,000 - $4,000 (20 shares  $200)].

Assume instead that Carl and Dan are father and son. The redemption described previously would not qualify for sale or exchange treatment because of the effect of the stock attribution rules. Dan is deemed to own Carl’s stock before and after the redemption. Dan’s ownership in Wren Corporation before and after the redemption is as follows.

Total
Shares / Dan's Direct
Ownership / Carl’s
Ownership / Dan's Direct and Indirect Ownership /
Ownership
Percentages / 80% of Original
Ownership
Before redemption / 100 / 40 / 30 / 70 / 70% (70/100) / 56% (80%/70%)
After redemption / 80 / 20 / 30 / 50 / 62.5% (50/80)

Dan's direct and indirect ownership of 62.5% fails to meet either of the tests of § 302(b)(2). After the redemption, Dan owns more than 80% of his original ownership and more than 50% of the voting stock. Thus, the redemption does not qualify for sale or exchange treatment and results in a dividend distribution of $30,000 to Dan.

Complete Termination Redemptions.If a shareholder terminates his or her entire stock ownership in a corporation through a stock redemption, the redemption will qualify for sale or exchange treatment. The attribution rules generally apply in determining whether the shareholder's stock ownership has been terminated. However, the family attribution rules do not apply to a complete termination redemption if both of the following conditions are met.

The former shareholder has no interest, other than that of a creditor, in the corporation after the redemption (including an interest as an officer, director, or employee) for at least 10 years.
The former shareholder files an agreement to notify the IRS of any prohibited interest within the 10-year post-redemption period and to retain all necessary records pertaining to the redemption during this time period.

A shareholder can reacquire an interest in the corporation by bequest or inheritance, but in no other manner. The required agreement should be in the form of a separate statement signed by the shareholder and attached to the return for the year in which the redemption occurs. The agreement should state that the shareholder agrees to notify the IRS within 30 days of reacquiring a prohibited interest in the corporation within the 10-year period following the redemption.4

Example:Kevin owns 50% of the stock in Green Corporation, while the remaining interest in Green is held as follows: 40% by Wilma (Kevin's wife) and 10% by Carmen (a key employee). Green redeems all of Kevin's stock for its fair market value. As a result, Wilma and Carmen are the only remaining shareholders, now owning 80% and 20%, respectively. If the requirements for the family attribution waiver are met, the transaction qualifies as a complete termination redemption and results in sale or exchange treatment. If the waiver requirements are not satisfied, Kevin is deemed to own Wilma's (his wife's) stock, and the entire distribution is taxed as a dividend(assuming adequate E & P).

If Kevin qualifies for the family attribution waiver for the redemption, he treats the transaction as a sale or exchange. However, if he purchases Carmen's stock seven years after the redemption, he has acquired a prohibited interest, and the redemption is reclassified as a dividend.

Summary of the Qualifying Stock Redemption Rules

Type of Redemption / Requirements to Qualify
Not essentially equivalent to a dividend[§ 302(b)(1)] / Meaningful reduction in shareholder’s voting interest. Reduction inshareholder’s right to share in earnings or in assets upon liquidationalso considered.
Stock attribution rules apply.
Substantially disproportionate
[§ 302(b)(2)] / Shareholder’s interest in the corporation, after the redemption, must beless than 80% of interest before the redemption and less than 50% oftotal combined voting power of all classes of stock entitled to vote.
Stock attribution rules apply.
Complete termination [§ 302(b)(3)] / Entire stock ownership terminated.
In general, stock attribution rules apply. However, family attribution rulesmay be waived. Former shareholder must have no interest, other thanas a creditor, in the corporation for at least 10 years and must file anagreement to notify IRS of any prohibited interest acquired during10-year period. Shareholder must retain all necessary records during10-year period.
Partial liquidation [§ 302(b)(4)] / Not essentially equivalent to a dividend.
Genuine contraction of corporation’s business.
Termination of an active business.
Corporation has two or more qualified trades or businesses.
Corporation terminates one qualified trade or business whilecontinuing another.
 Contracted business was not acquired in a taxable transaction within five years.
Distribution may be in form of cash or property.
Redemption may be pro rata.
Stock attribution rules do not apply.
Redemption to pay death taxes
[§ 303] / Value of stock of one corporation in gross estate exceeds 35% of value ofadjusted gross estate.
Stock of two or more corporations treated as stock of a singlecorporation in applying the 35% test if decedent held a 20% or moreinterest in the stock of the corporations.
Redemption limited to sum of death taxes and funeral and administrationexpenses.
Generally tax-free because tax basis of stock is FMV on date of decedent’s death and value is unchanged at redemption.
Stock attribution rules do not apply.

Stock redemptions offer several possibilities for tax planning.

The alternative to a qualifying stock redemption is dividend treatment. The15 percent (0 percent for taxpayers in the 10 or 15 percent marginal income tax brackets) preferential tax rate on dividend income reduces some of the adverse consequences of a nonqualified stock redemption. A nonqualified redemption may even be preferable if the distributing corporation has little or no E & P or the distributee-shareholder is another corporation. In the latter situation, dividend treatment may be preferred due to the availability of the dividends received deduction.
Stock redemptions are well suited for purchasing the interest of a retiring or deceased shareholder. Rather than the remaining shareholders buying the stock of the retiring or deceased shareholder, the corporation uses its funds to redeem the stock from the retiring shareholder or from the decedent shareholder’s estate. The ability to use the corporation’s funds to buy out a shareholder’s interest is also advantageous in property settlements between divorcing taxpayers.
A third party who wishes to purchase all the stock of a corporation can use a stock redemption to obtain the needed purchase money. This technique is referred to as a ‘‘bootstrap acquisition.’’ The third party first purchases a small amount of stock from the shareholders. The corporation then redeems all of its outstanding stock except that of the third party. The third party becomes the sole shareholder of the corporation, but the corporation furnished most of the purchase money.
A not essentially equivalent redemption provides minimal utility and generally should be relied upon only as a last resort. Instead, the redemption should be structured to satisfy the objective tests required of one of the other qualifying redemptions. These include disproportionate redemptions, complete termination redemptions, or redemptions to pay death taxes.

STOCK ATTRIBUTION RULES

6. A stock redemption that qualifies for sale or exchange treatment generally must result in a substantial reduction in a shareholder’s ownership in the corporation. If this does not occur, proceeds received for a redemption of the shareholder’s stock are taxed as ordinary dividend income. In determining whether a shareholder’s interest has substantially decreased, the stock owned by certain related parties is attributed to the shareholder whose stock is redeemed.5 Thus, the stock attribution rules must be considered along with the stock redemption provisions. Under these rules, related parties include the following family members: spouses, children, grandchildren, and parents. Attribution also takes place from and to partnerships, estates, trusts, and corporations (50 percent or more ownership required in the case of regular corporations). The exhibit below summarizes the stock attribution rules.

Deemed or Constructive Ownership
Family / An individual is deemed to own the stock owned by his or her spouse, children, grandchildren, and parents (not siblings or grandparents).
Partnership / A partner is deemed to ownthe stock owned by a partnership to the extent of the partner's proportionate share in the partnership.
Stock owned by a partner is deemed to be owned in full by a partnership.
Estate or trust / A beneficiary or heir is deemed to ownthe stock owned by an estate or trust to the extent of the beneficiary's or heir's proportionate interest in the estate or trust.
Stock owned by a beneficiary or heir is deemed to be owned in full by an estate or trust.
Corporation / Stock owned by a corporation is deemed to be owned proportionately by any shareholder owning 50% or more of the corporation's stock.
All stock owned by a shareholder who owns 50% or more of a corporation is deemed to be owned by the corporation.

Example:Larry owns 30% of the stock in Blue Corporation, the other 70% being held by his children. For purposes of the stock attribution rules, Larry is treated as owning 100% of the Blue stock. He owns 30% directly and, because of the family attribution rules, 70% indirectly.

Example:Chris owns 50% of the stock in Gray Corporation. The other 50% is owned by a partnership in which Chris has a 20% interest. Chris is deemed to own 60% of Gray: 50% directly and, because of the partnership interest, 10% indirectly.

LIQUIDATIONS—PARENT-SUBSIDIARY SITUATIONS

7.Section 332, an exception to the general rule of § 331, provides that a parent corporationdoes not recognize gain or loss on a liquidation of a subsidiary. In addition,the subsidiary corporation recognizes neither gain nor loss on distributions of propertyto its parent.6

The requirements for applying § 332 are as follows.

The parent must own at least 80 percent of the voting stock of the subsidiaryand at least 80 percent of the value of the subsidiary’s stock.
The subsidiary must distribute all its property in complete cancellation ofall its stock within the taxable year or within three years from the close ofthe tax year in which the first distribution occurred.
The subsidiary must be solvent.7

If these requirements are met, nonrecognition of gains and losses becomes mandatory.However, if the subsidiary is insolvent, the parent corporation will have an ordinaryloss deduction.