Neglected preferred stock! Yes, this article begins with an oxymoron. But as you read on, you will realize that Congress and the I.R.S. are capable of doing ANYTHING. If they can disturb the balance in the tax universe by introducing the Transition Tax and G.I.L.T.I., they can most certainly neglect one of the most desired investment instruments — preferred stock.
This article discusses the U.S. Federal income tax consequences of a redemption of non-voting preferred stock of a controlled foreign corporation ("C.F.C.") with an emphasis on the non-application of Code §1248, the redemption's effect on the C.F.C.'s earnings and profits("E&P"), and the lack of I.R.S. guidance on the subject.
REDEMPTION OF DOMESTIC STOCK
The U.S. Federal income tax treatment of a redemption of the stock of a corporation depends on whether the redemption is treated as a distribution in exchange for the stock or as a dividend.1 Where the redemption qualifies for exchange treatment under Code §302(a), the amount of gain or loss realized by the shareholder is determined by removing the shareholder's adjusted basis in the redeemed shares from the sum of cash plus the fair market value of property other than cash received in the redemption. On the other hand, if the redemption does not qualify under Code §302(a), the distribution is treated as dividend to the extent of the company's E&P. To the extent the amount of the distribution exceeds E&P, the balance of the distribution is treated as the recovery of the shareholder's adjusted basis in the stock.2 The portion of the distribution that exceeds the adjusted basis of the stock is treated as a capital gain.3
Typically, a payment in redemption of stock is accorded capital gains treatment if any of four tests identified in Code §302(b) is met. For purposes of applying these tests, explained further below, it is important to keep in mind that courts and the I.R.S. will apply the step transaction doctrine and Code §318 attribution principles.4
1 Code §302(a).
2 Code §301(c)(2).
3 Code §301(c)(3)(A). If the amount of the distribution does not exceed the adjusted basis of the stock redeemed, the regulations require that "proper adjustment" is made to the basis of the shareholder's remaining shares (Treas. Reg. §1.302-2(c)).
4 See, e.g., Merrill Lynch v. C.I.R., 120 T.C. 12 (2003), aff'd, 386 F.3d 464 (2d Cir. 2004), remanded, 131 T.C. 293 (2008), applying a "firm and fixed plan" standard to integrate cross-chain sales with a planned sale of a target affiliate to a third party. For a discussion of Code §318 in the Code §302(b) context, see U.S. v. Davis, 397 U.S. 301, reh'g denied, 397 U.S. 1071 (1970). The Court strenuously overrode the taxpayer's claim that Code §318 attribution should not be applied to the before and after snapshot approach of Code §302(b)(1), stating that to do so would nullify Congress's explicit directive.
This is an excerpt of a longer article, which you can find on our website via this link; Preferred Yet Neglected — A Plea For Guidance On Redemptions Of C.F.C. Preferred Stock In The Wake Of U.S. Tax Reform.