STOCK DIVIDENDS CONSISTENTLY REDEEMED BY FHLB WILL NOT BE TAXABLE.

Rev. Rul. 90-98

ISSUE

Whether any member bank receiving a stock dividend from a Federal Home Loan Bank has an election to receive stock or property within the meaning of section 305(b)(1) of the Internal Revenue Code?

FACTS

Rev. Rul. 83-68, 1983-1 C.B. 75, deals with stock dividends distributed by a Federal Home Loan Bank (FHLB). Pursuant to federal statute, an FHLB has the discretion to grant a member bank's request to retire any shares of stock held by the member bank in excess of the amount it is statutorily required to hold. Shares of its stock distributed as a stock dividend by an FHLB may be retired by an FHLB in the same manner and under the same regulations and policies that apply to all other shares.

The facts of Rev. Rul. 83-68 are that, in accordance with an established policy of the FHLB, all requests to redeem the distributed stock were honored. Furthermore, the FHLB had not refused to grant a request in the previous ten years, and it apparently would not refuse such a request, although the option to refuse redemption requests remained available.

Rev. Rul. 83-68 reasons that, although the FHLB retained discretion to redeem stock held by member banks, the established policy of the FHLB to honor all redemption requests in substance conferred on the distributee banks an option to retire any shares distributed in excess of their required stock holdings. Because all of the shares distributed to at least one member bank were in excess of its required stock holdings, the entire distribution received by each member was treated as one to which section 301 of the Code applied by reason of the application of section 305(b)(1).

LAW AND ANALYSIS

Section 305(a) of the Code provides the general rule that gross income does not include the amount of any distribution of stock by a corporation to its shareholders with respect to its stock.

Section 305(b)(1) of the Code provides that section 305(a) does not apply to a distribution by a corporation of its stock, and the distribution is treated as a distribution of property to which section 301 applies, if the distribution is, at the election of any of the shareholders (whether exercised before or after the declaration thereof), payable either in the corporation's stock or in property.

If any shareholder has the right to an election or option with respect to whether a distribution shall be made either in money or any other property, or in stock of the distributing corporation, then, with respect to all shareholders, the distribution of stock is treated as a distribution of property to which section 301 applies. This is so regardless of whether the election governing the nature of the distribution is provided in the declaration of the distribution or in the corporate charter or arises from the circumstances of the distribution and regardless of whether all or part of the shareholders have the election. Section 1.305-2(a)(4) and (5) of the Income Tax Regulations.

Thus, if a shareholder in substance has the ability to determine whether a distribution will be received in either the distributing corporation's stock or some other property, the shareholder has an election within the meaning of section 305(b)(1) of the Code. It is immaterial whether that ability is explicitly or implicitly granted by the distributing corporation, or whether that ability results directly from the terms of the distribution or indirectly from the facts surrounding the distribution.

In Frontier Savings Association v. Commissioner, 87 T.C. 665 (1986), aff'd sub nom. Colonial Savings Association v. Commissioner, 854 F.2d 1001 (7th Cir. 1988), cert. denied 109 S. Ct. 1556 (1989), acq., 1990-1 C.B. 1, the facts were essentially identical to those in Rev. Rul. 83-68. The court specifically rejected the conclusion of Rev. Rul. 83-68. Instead, the court held that discretion to approve redemption requests was not relinquished by the FHLB and that the member bank therefore did not have an election within the meaning of section 305(b)(1).

In reaching its conclusion, the court considered the purpose and structure of the FHLB system. The system was created by the Federal Home Loan Bank Act of 1932, 12 U.S.C. sections 1421-1449 (1988), with the explicit purpose of providing a means for creating meaningful and flexible liquidity in savings and loan associations and other members. 12 U.S.C. section 1425a(a) (1988) (prior to its repeal by section 720 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), Pub. L. No. 101-73, 103 Stat. 183, 423 (1989)). An FHLB is "a federal instrumentality organized to carry out public policy and its functions are wholly governmental. . ." Fahey v. O'Melveny & Myers, 200 F.2d 420, 446 (9th Cir. 1952), cert. denied, 345 U.S. 952 (1953), quoted in Colonial Savings Ass'n, 854 F.2d at 1013. An FHLB is exempt from federal, state, and local income tax. 12 U.S.C. section 1433 (1988).

A member of an FHLB must maintain a stock interest in the FHLB equal to a percentage of its net home mortgage loans outstanding and a fraction of its total borrowings from the FHLB. Prior to 1961, 12 U.S.C. section 1426(c) (redesignated 1426(b) by FIRREA section 706, at 416) permitted a member bank to have its excess shares redeemed on request. In 1961, then section 1426(c) was amended to provide that requests were to be granted in the discretion of the FHLB and subject to the approval of the Federal Home Loan Bank Board (FHLBB), the administrative agency in the Executive Branch of the federal government then responsible for the supervision of the FHLB. With that amendment, Congress made clear that the FHLB and the FHLBB, not the member banks, were to have the discretion to approve or deny redemption requests.

The structure of the system clearly evidences a Congressional intent to retain the broadest kind of federal control over the numbers, powers, capitalization, and existence of an FHLB. The substantial federal involvement in the FHLB system ensured that the discretion to deny redemption requests remained vested in the FHLB and the FHLBB and that each decision to grant a request was to be made by the FHLB and the FHLBB with due regard to the statutory objectives and the public interest the system was created to protect.

However, a pattern of approving redemption requests can in substance confer an election within the meaning of section 305(b)(1) of the Code since the stock distribution can be a "mere subterfuge for a cash distribution." Computer Frontier, 87 T.C. at 678. Thus, "[i]f a discretionary act of the board of directors of a shareholder corporation to redeem stock dividends becomes a routine matter, it might . . . develop into an 'option' that arises after the distribution or a distribution pursuant to a 'plan.'" Frontier, at 679 (Hamblen, J., concurring). See also Western Federal Savings & Loan Association v. Commissioner, T.C. Memo. 1988-107, aff'd, 880 F.2d 1005 (8th Cir. 1989).

Although, under the facts of Rev. Rul. 83-68, the FHLB never chose to exercise its discretion by denying a redemption request, Congress had specifically directed that discretion to redeem FHLB stock be vested in and exercisable by the FHLB, a tax exempt instrumentality of the federal government, and subject to the concurrence of the FHLBB, an administrative agency of the federal government. Further, decisions to approve any such requests were to be made with full consideration of the public purposes for which the FHLB system was created. Thus, the discretion to approve or deny redemption requests remained vested in the FHLB and the FHLBB. Under these limited circumstances, where the FHLB and the FHLBB have a duty imposed by federal statute to protect the public interest, the Service will not infer from a pattern of granting redemption requests alone that a particular FHLB or the FHLBB (or its successor) has relinquished authority to deny such requests. Accordingly, no member bank will be considered to have an election within the meaning of section 305(b)(1) of the Code.

HOLDING

Rev. Rul. 83-68 no longer represents the Service's position regarding whether any member bank receiving a stock dividend from an FHLB has an election to receive stock or property within the meaning of section 305(b)(1) of the Code. However, except in the case of an FHLB acting pursuant to a federal statutory directive and in protection of the public interest, the Service will continue to apply the principles underlying Rev. Rul. 83-68 and section 305(b)(l) to a pattern of granting redemption requests in determining whether in substance the pattern confers an election to receive stock or property.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 83-68 is modified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Theresa Abell of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling contact Ms. Abell on (202) 566-6212 (not a toll-free call).