Nonqualified preferred stock.

On September 23, 1998, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning the tax treatment of transactions involving "nonqualified preferred stock." TEI's comments, which took the form of a letter from TEI President Lester D. Ezrati of Hewlett-Packard Company to Commissioner of Internal Revenue Charles O. Rossotti, were prepared under the aegis of the Institute's Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc.

In order to eliminate tax deferral on receipt of certain preferred stock received in connection with specified corporate transactions, the Taxpayer Relief Act of 1997 amended a number of provisions of the Internal Revenue Code. Specifically, taxpayers receiving "nonqualified preferred stock" (NQPS) in connection with specified transactions are to treat such stock as property other than stock, i.e, generally treat such stock as taxable "boot." The changes were made in respect of selected transactions that Congress believed improperly benefitted from deferral because the "taxpayer receive[d] relatively secure instruments in exchange for relatively risky instruments."(1)(*) Congress also authorized the Secretary of the Treasury to promulgate regulations to effect the specific purposes of the statutory changes.

Tax Executives Institute believes that the statutory changes have engendered significant confusion and recommends that the IRS use its authority to issue proposed regulations to clarify the definition of NQPS and the manner in which the definitions apply under the rules governing the specified transactions. In addition, the extent to which NQPS will be treated as property other than stock under the Code should be clarified. As a result, I am pleased to submit the following comments and recommendations on issues raised by the NQPS provisions of the 1997 Act.

Background

TEI is the principal association of corporate tax executives in North America. Our 5,000 members represent the largest 2,800 companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to the uniform and equitable enforcement of the tax laws, and to reducing the cost and administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to addressing the issues raised by the NQPS provisions.

Overview of Statutory Changes

The Taxpayer Relief Act of 1997 amended sections 351, 354, 355, 356 and 1036 of the Internal Revenue Code to, in general, treat certain preferred stock as "property other than stock" for purposes of the specified sections. More specifically, sections 351(g)(2) and (g)(3) define the terms and conditions under which preferred stock instruments are to be considered "nonqualified." Sections 351(g)(1), 354(a)(2)(C), 355(a)(3)(D), 356(e), and 1036(b) apply the NQPS definition and prescribe the tax treatment under the specified transactions. As "property other than stock," the NQPS will be treated as "boot" and, hence, the recipients will be taxed on the value of NQPS. Unless regulations provide otherwise, NQPS continues to be treated as stock for all other purposes of the Code, including determining the tax consequences to other participants to the same transaction. For example, a person transferring property to a corporation that receives stock and securities, including NQPS, in an exchange transaction described under section 351(a) is not accorded nonrecognition treatment in respect of NQPS.(2) In determining whether the transaction qualifies under section 351(a) -- in determining, for example, whether transferors of property meet the "control" requirement -- NQPS is counted as stock.(3) The treatment of NQPS as boot does not, moreover, enable the issuer to reclassify the stock as debt for which an interest expense deduction is permitted on payment of dividends.

Under section 351(g)(2)(A), "preferred stock," which is defined under section 351(g)(3) as "stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent," is treated as NQPS if any of the following criteria is satisfied:

(i) the holder has the right to require the issuer or a related person to redeem or purchase the stock,

(ii) the issuer or a related person is required to redeem or purchase such stock,

(iii) the issuer or a...