Rev. Rul. 75-179

Advice has been requested whether, under the circumstances described below, a call premium in excess of ten percent of the "issue price" of convertible preferred stock exchanged for common stock in a reorganization described in section 368(a)(1)(A) is includible in the gross income of the acquired corporation's shareholders under section 305(b)(4) and (c) of the Internal Revenue Code of 1954.

X, a publicly held corporation, acquired the property of Y, also a publicly held corporation, in a statutory merger which qualified as a reorganization within the meaning of section 368(a)(1)(A) of the Code. In the reorganization, each Y shareholder received one share of a new series of X eight percent voting convertible preferred stock in exchange for each share of Y common stock surrendered. On the date of the exchange, the fair market value of the Y common stock was $6 per share. The issue price of the X convertible preferred stock was also $6 per share. The new preferred stock of X is (1) convertible at any time into .55 shares of X common stock, (2) not callable by X for a period of five years from the date of issuance, and (3) callable anytime thereafter, provided the fair market value of the X common stock into which the preferred stock is convertible has a fair market value at least 25 percent greater than the call price on the date of the call. The redemption price after the end of the five year period is initially $11 a share and thereafter declines at the rate of 10 cents a year to $10.50 per share.

Section 305(a) of the Internal Revenue 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 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 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 ten percent of the issue price on stock which is not redeemable for five years from the date of issuance shall be considered reasonable.

In the instant case, the redemption premium of $5 (redemption price of $11 less the issue price of $6) is approximately 83 percent of the issue price. Since the redemption premium exceeds the ten percent "safe harbor" provisions of section 1.305-5(b)(2) of the regulations, the facts and circumstances underlying the premium must be examined to determine if it is reasonable. Such an examination must include an evaluation of the probable effects on redemptions of the limitation on the corporation's right to redeem its preferred stock.

In the instant case, X is prohibited from redeeming its preferred stock unless the redemption price of the preferred stock is less than the value of the common stock into which the preferred stock can be converted. For example, the preferred stock cannot be called for redemption at $11 unless the value of .55 shares of common stock is 25 percent greater than $11, or approximately $13.75. Thus, it would be to a shareholder's economic benefit to convert the preferred stock into common stock rather than to have the preferred stock called for redemption. Consequently, the redemption provisions will encourage the preferred shareholders to convert this stock into common stock so that, theoretically, redemptions should never occur and, if they do, it would be through the inadvertence of the preferred shareholders in not converting this stock into common stock.

Accordingly, under the facts and circumstances of the instant case, the difference between the issue price and redemption price of the preferred stock is a reasonable redemption premium under section 1.305-5(b)(2) of the regulations and, therefore, section 305(b)(4) and (c) of the Code are not applicable.