Rev. Rul. 75-468

Advice has been requested whether a redemption premium, under the circumstances described below, represents a reasonable redemption premium for purposes of sections 305(b)(4) and (c) of the Internal Revenue Code of 1954.

The stock of X corporation and the stock of Y corporation were widely held and publicly traded. On July 14, 1974, the shareholders of Y corporation, pursuant to a plan of reorganization, agreed to the merger of Y into X and to exchange each share of their Y stock for one share of X preferred stock that paid annual dividends. On this date the fair market value of each share of Y stock was $20. The X preferred stock was callable by X after 5 years from the date of its issuance in the exchange at $21 per share. On October 1, 1974, Y was merged into X pursuant to the applicable state laws in a transaction that qualified as a reorganization under section 368(a)(1)(A) of the Code, and the Y shareholders exchanged each share of their Y stock for one share of X preferred stock with no gain or loss being recognized to them under section 354. On this date the fair market value of the Y stock had decreased in value, from the date the exchange ratio was determined, to $18 per share. Therefore, there was a difference between the redemption price of the X preferred stock ($21) and its issue price ($18) of $3. This redemption premium of $3 represented approximately 16 percent of the issue price of the X preferred stock.

Section 305(a) of the Code provides generally that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock, except as otherwise provided in section 305(b) or (c).

Section 305(b)(4) of the Code provides, in part, that section 305(a) will not apply to a distribution by a corporation of its stock, and the distribution will be treated as a distribution of property to which section 301 applies, if the distribution is with respect to preferred stock.

Section 305(c) of the Code provides, in part, that the Secretary shall prescribe regulations under which a difference between issue price and redemption price will be treated as a distribution with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by the transaction.

Section 1.305-5(b)(1) of the Income Tax regulations provides that if a corporation issues preferred stock which may be redeemed after a specific period of time at a price higher than the issue price, the difference will be considered under the authority under section 305(c) of the Code, to be a distribution of additional stock on preferred stock which is constructively received by the shareholders over the period of time during which the preferred stock cannot be called for redemption. However, section 1.305-5(b)(2) states that section 1.305-5(b)(1) will not apply to the extent that the difference between issue price and redemption price is a reasonable redemption premium, and that a redemption premium will be considered reasonable if it is in the nature of a penalty for the premature redemption of the preferred stock and if such premium does not exceed the amount the corporation would be required to pay for the right to make such premature redemption under market conditions existing at the time of issuance. Section 1.305-5(b)(2) also states that a redemption premium not in excess of 10 percent of the issue price on stock which is not redeemable for 5 years from the date of issuance shall be considered reasonable.

In the instant case, there was a redemption premium of only 5 percent at the time the exchange ratio was agreed upon by the Y shareholders. The increase in the redemption premium to 16 percent arose solely as a result of market conditions that caused the fair market value of the Y stock to be less at the date of the exchange for the X preferred stock than it was at the date the exchange ratio was agreed to. A redemption premium in excess of 10 percent was not bargained for nor was it intended, at the time the exchange ratio was agreed upon, to exceed the amount of a typical call premium.

Accordingly, the difference between the redemption price and issue price of the X preferred stock is a reasonable redemption premium. Therefore, the redemption premium will not be treated as a distribution of property to which section 301 of the Code applies by virtue of the application of sections 305(b)(4) and (c).