Rev. Rul. 68-601

Advice has been requested whether warrants and convertible debentures constitute `options' under section 318(a)(4) of the Internal Revenue Code of 1954, and, if so, how this result applies to section 302(b)(2) of the Code.

A corporation had outstanding 1,000 shares of common stock of which A and B each owned 100 shares. No stock was constructively owned by either A or B . The corporation offered each of its shareholders a 1,000 x dollar convertible debenture and a warrant to purchase 20 shares of its common stock in exchange for each 50 shares owned, but not to exceed one-half of each shareholder's common stock. Each debenture was convertible into 40 shares of the corporation's common stock. Only A and B accepted the offer and the exchange of 50 shares of the stock of each was effected in accordance with the terms of the offer.

The treatment of distributions in redemption of stock is governed by the provisions of section 302 of the Code. Pursuant to section 302(c)(1) of the Code, the constructive ownership rules of section 318(a) of the Code are applicable in determining the ownership of stock for purposes of section 302 of the Code. The question involved is whether the stock that could be acquired by A and B as a result of the exercise of the warrants and the conversion of the debentures will be attributed to them by virtue of the application of section 318(a)(4) of the Code, and, if so, whether their exchanges will be `substantially disproportionate redemptions' within the meaning of section 302(b)(2) of the Code.

Section 318(a)(4) of the Code provides, in part, that if any person has an option to acquire stock, such stock shall be considered as owned by such person.

Section 318 of the Code does not define the term `option.' Section 1.318-3(c) of the Income Tax Regulations, relating to options, does not outline the scope of the option attribution provision but simply contains an example of its application. The example deals with an option between shareholders to purchase stock which is already issued and outstanding. No reference is made to options to acquire stock from the corporation.

In order for a warrant to acquire stock to qualify as an option, the holder must have the right to obtain the stock at his election. When this right to acquire stock exists, warrants or convertible debentures are not realistically different from options as referred to in section 318(a)(4) of the Code. In each instance, stock may be acquired at the election of the shareholder and there exist no contingencies with respect to such election.

Accordingly, under these circumstances the warrants to purchase stock, and the debentures which are convertible into stock, constitute options to acquire stock within the meaning of section 318(a)(4) of the Code.

In order to qualify as `substantially disproportionate,' within the meaning of section 302(b)(2) of the Code, a redemption must satisfy the requirements of that section. Where a corporation has only one class of stock outstanding, this test requires that the percentage of the total outstanding voting common stock owned, directly and indirectly, by the shareholder immediately after the redemption be less than 80 percent of his percentage of ownership of such stock immediately before the redemption.

Section 1.302-3 of the regulations states, in part, that the constructive ownership of stock rules in section 318(a) of the Code `. . . shall apply both in making the disproportionate redemption test and in determining the percentage of stock ownership after the redemption.' The regulations further provide that the requirements under section 302(b)(2) of the Code are applied to each shareholder separately with respect to stock which is issued and outstanding in the hands of the shareholders. No mention is made as to what shares, if any, that may be acquired through the exercise of options are to be considered as issued and outstanding stock for this purpose.

Since the warrants and convertible debentures in this case constitute options under section 318(a)(4) of the Code, it is held that under section 302(b)(2) of the Code there should be considered as issued and outstanding, on a shareholder by shareholder basis without regard to the rights of unrelated shareholders to acquire unissued stock, those shares which a given shareholder may acquire by exercising his warrants and converting his debentures and those shares which that shareholder would constructively own by reason of other shareholders exercising their warrants and converting their debentures. In this connection, the Service will not follow the case of J. Milton Sorem, et al. v. Commissioner , 334 F.2d 275 (1964), reversing and remanding 40 T.C. 206 (1963), in regard to the issue of including in the total outstanding stock of the corporation options held by persons whose stock was not held directly nor indirectly by the redeeming shareholders.

In the instant case, A and B each owns after the redemption 50 shares of the corporation's common stock plus a warrant which may be exercised in order to obtain 20 shares of common stock and a debenture which may be converted into 40 shares of common stock. Thus, A and B each owns, actually and constructively, 110 shares of the corporation's stock after the transaction. The total outstanding stock of the corporation after the transaction for purposes of the computation under section 302(b)(2) of the Code, as applied to each shareholder separately, is 960 shares consisting of the 900 actual outstanding shares and the 60 shares which such shareholder could acquire by exercising his warrant and converting his debenture. Thus, A and B each owns 11.46 percent of the total outstanding common stock of the corporation after the exchange whereas A and B each owned 10 percent of such stock immediately before the transaction.

Accordingly, neither the distribution to A nor the distribution to B qualifies as a disproportionate redemption of stock within the meaning of section 302(b)(2) of the Code.