Rev. Rul. 81-190

ISSUE Is the redemption premium reasonable, for purposes of section 305(b)(4) and (c) of the Internal Revenue Code, when a class of stock created for issuance in a reorganization between two widely held corporations is intended to have a 10 percent redemption premium, but as a result of an unanticipated market fluctuation it actually has a redemption premium in excess of 10 percent of the issue price?

FACTS

X and Y were unrelated domestic corporations engaged in similar businesses. Both X and Y had outstanding solely common stock and both the X stock and the Y stock were widely held and publicly traded. For valid business reasons, X desired to acquire the outstanding stock of Y, so that Y would become a subsidiary of X.

The Y management refused to endorse an exchange in which Y shareholders would receive X common stock. In May 1980, as a result of arm's length negotiations between the managements of X and Y, their financial advisors, and an independent investment banker, it was agreed: (i) X would issue a new class of $100 par value voting 18 percent noncumulative, nonconvertible, nonputable preferred stock, callable by X at a price of $110 per share at any time after 5 years from the date of its issuance; (ii) X would make a tender offer of 30 days duration to the Y shareholders to acquire all the outstanding Y stock in exchange solely for this X voting preferred stock at an exchange ratio that accurately reflected the relative fair market values of these stocks as of the date of the agreement; and (iii) the transaction would be consummated only if the Y shareholders tendered at least 85 percent of the outstanding Y stock. This agreement between the managements of X and Y formed the basis for a plan of reorganization that was included in a prospectus approved by the Securities and Exchange Commission (S.E.C.) and the X preferred stock was registered with the S.E.C. In October 1980, in accord with this reorganization plan, X acquired 92 percent of the outstanding Y stock in exchange solely for X voting preferred stock.

At the time the managements of X and Y agreed to the terms of the reorganization, the fair market value of the X preferred stock was $100 per share. Moreover, it was reasonably and independently estimated that this stock would have a fair market value of at least $100 per share at the time of its issuance. However, subsequent to S.E.C. review of the prospectus and the announcement of the tender offer, at a time when business constraints made it no longer possible to change the terms of the transaction, an unforeseen event occurred that reduced the market value of the X preferred stock. The actual fair market value of the X preferred stock on the date it was issued was only $91 per share, and there was a difference between the redemption price of the X preferred stock ($110) and its issue price ($91) of $19. This redemption premium of $19 represented approximately 21 percent of the issue price of the X preferred stock. LAW AND ANALYSIS

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 granted under section 305(c) of the Code, to be a distribution of additional stock on preferred stock. 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 this situation, there was a redemption premium of only 10 percent at the time the terms of reorganization were agreed to by the managements of X and Y and at the time the prospectus was submitted to the S.E.C. Moreover, it was reasonably anticipated by an independent advisor possessing relevant expertise that the redemption premium at the time of issue would not exceed 10 percent of the issue price of the preferred stock. The increase in the redemption premium to 21 percent arose from an event that was found not to have been reasonably foreseeable. This event caused the fair market value of the X preferred stock to be less on the date of exchange than it was on the date the terms for the transaction were agreed to.

In Rev. Rul. 75-468, 1975-2 C.B. 115, when an increase in redemption premium from 5 percent to 16 percent arose from an unanticipated change in a stock's fair market value, it was held that the difference between redemption price and issue price was a reasonable redemption premium since a redemption premium in excess of 10 percent was neither bargained for nor intended. The present situation differs from Rev. Rul. 75-468 in that: (i) the X preferred stock was a new class of stock which could have been created with a lower redemption premium whereas this possibility was not available with regard to the pre-existing stock issued in Rev. Rul. 75-468; and (ii) as of the date of the agreement, the redemption premium was 10 percent. However, neither of these differences warrants a different treatment for the shareholders in the present situation than that accorded the shareholders in Rev. Rul. 75-468. It is not improper for the terms of the stock issued in the exchange to be intended to afford the shareholders the benefit of the full 10 percent reasonable redemption premium. Nor is it the intent of the Service to restrain the use of tender offers or other forms of acquisition merely because they may be subject to unforeseen events arising between the time the terms of the transaction are agreed to and the time of consummation. The essential facts are that here: (i) when the agreement was made, a redemption premium in excess of 10 percent was not bargained for, it was not intended that the redemption premium exceed the amount of a typical call premium, and it was not reasonably foreseeable that it would exceed such amount; and (ii) subsequently, when the size of the redemption premium was foreseeable, business contraints made it no longer possible for the terms of the stock to be renegotiated.

HOLDING

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 section 305(b)(4) and (c).