Variable rate preferred stock: current status and prospects for a continuing favorable tax climate in the 1980s and 1990s.

• Author: Bernardi, George F.

Variable Rate Preferred Stock: Current Status and Prospects for a Continuing Favorable Tax Climate in the 1980s and 1990s

1. OVERVIEW

   Until this decade, aggressive investors and chief financial officers showed little interest in inventing in preferred stock. The basic drawback to preferred stock investments has historically been their erratic price swings in reaction to fluctuations in interest rates and their inability to preserve principal value. The investment climate changed in 1981 with the entry of certain financial products called variable interest rate preferred stock (VRP), resulting in a virtual flood of such offerings. The attraction of traditional preferred stock among corporate investors has always been the availability of the section 243(a)(1) (1) dividends received deduction (DRD). (2) The continued availability of the full DRD for VRPs may be in doubt considering proposals to limit the deduction introduced in recent sessions of Congress. The most recent attack occurred in the Revenue Act of 1987, though the proposal was stricken in Conference. (3) More recently, a Treasury official, reflecting the Treasury's concern over perceived abuses of "junk food" financing in leveraged buyouts, stated that the issue of distinguishing debt from equity is "an active area of discussion" in the Treasury Department. This official further stated that the Treasury may include the matter in a proposal for changes of the debt-equity rules in the Subchapter C study that may be issued in late 1988. (4)

   Although VRPs provide a very competitive after-tax rate of return on investment by adjusting their prices for changes in market rates and, thereby, preserving principal value, several critical issues face investors who intend to commit funds in VRPs:

   * Are VRPs debt or equity for the purpose of determining whether payments are dividends or interest income?

   * Does the convertibility feature of certain VRPs (e.g., Convertible Adjustable Preferred Stock--so-called CAPs) constitute a "put option" under section 246(c)(4)(A) and, therefore, toll the 46-day and the 6-month holding periods?

   * What is the effect, if any, on VRPs of the sections 246A and 7701(f) amendments introduced by recent tax reform legislation?

   * As a policy matter, what are the implications of eliminating or severely limiting the DRD for VRPs?

   * Should increases in a VRP's dividend rate (e.g., where an investor's proportionate share in the issuer's earnings increase) be considered an additional, extraordinary dividend to the extent of the fair market value of the increase under section 305(c)?

   To overcome the drawbacks of traditional preferred stock, ingenious Wall Street minds created VRPs. The first version of these instruments were Adjustable Variable Preferred Stock (ARP) which experienced an immediate and astonishing degree of investor acceptance. (5) Once the market's initial appetite for ARPs was stated, (6) ARPs were replaced by "Convertible Adjustable Preferred" Stock (CAP), (7) whose dividend rate was set at a level where it would trade as close to par as possible. This mechanism protected principal and theoretically discouraged investors from converting CAPs into the related common stock. CAPs soon lost their appeal, however, when investors became concerned that the IRS would disallow the DRD by ruling that CAPs were "put options" (that is, options to sell). (8) This concern and the search for new investment alternatives accelerated the rise of auction rate-determined preferred stock. (9) "Money market preferred" (MMP) stock became the best known of these instruments, (10) representing a significant departure from other forms of VRPs. The difference was that, whereas the dividend rate on standard VRPs fluctuates in a range pre-determined by formula, MMP dividend rates were set at a "Dutch auction" of investors. (11) Under the auction mechanism, rates were set directly as investors bid prices up or down as market conditions warranted and allowed MMPs to trade at par value, providing exceptional stability and liquidity.

2. VRPs AND EQUITY STATUS

   1. Debt or Equity?--The Threshold

      Question

      Establishing that VRPs are equity instruments is absolutely essential for obtaining the 70-percent or 80-percent DRD. Historically, debt-equity classification determinations have been muddled by inconsistent and often-conflicting judicial decisions. (12) These inconsistencies have proven particularly confounding in respect of exotic equity-flavored securities. To address the problem, Congress in 1969 enacted section 385 and directed the IRS to issue guidelines for classifying interests as debt or equity.

      After a lapse of about 11 years, the Treasury first issued and then withdrew the proposed regulations under section 385, forcing taxpayers to rely again on the much-maligned case law for guidance. (13) There are no cases or rulings directly on point determining the debt-equity status of VRPs. A recent private letter ruling, (14) however, does support, by implication, the equity status of CAPs. (The ruling made no reference to the status of mMPs and ARPs.). (15)

   2. Traditional Criteria for

      Determining Debt-Equity Status

      Without regulatory guidance, the courts again became the arbiters of debt-equity controversies. (15) In Texas Farm Bureau v. United States, (16) the Fifth Circuit identified several factors that should be analyzed in distinguishing debt from equity. The court's analysis, which was directed at whether advances of funds by shareholders to a subsidiary were debt or contributions of capital, are equally applicable in ascertaining the equity status of publicly-traded securities. At bottom, the Fifth Circuit employed a balancing test--did the financing instrument exhibit more of the indicia of equity than debt? This "laundry list" of commonly accepted, relevant factors cited in Texas Farm Bureau (17) were originally enumerated by the same court in the Mixon Estate case. (18) The following discussion examines these criteria and then compares and contrasts them to the characteristics exhibited by VRPs.

      1. Intent of the Issuer. Generally, classifying a corporate advance of funds ultimately presents a question of law. (19) An exception arises when a court must depend on the subjective intent of the issuer, which presents a question of fact, (20) because as soon as a court's analysis of other, objective factors fails to provide a clear indication, the determination of intent then becomes a question of fact. (21) In Mixon, the court explained that, where "the objective facts of the case are ambiguous and do not result in a clear manifestation of objective intent, then subjective intent is relevant to the issue." (22) Following the withdrawal of the section 385 regulations, the determination of intent will once again prove to be difficult to deal with because taxpayers will have to rely on earlier conflicting case law and IRS rulings. For example, in Zilkha & Sons, Inc. v. Commissioner, (23) the Tax Court held that a party's debt-equity intent can be inferred from the way that the instrument has been labelled. Although this ruling would seem to dispose of the issue once and for all, the holding in Rev. Rul. 83-98 (24) may cast some doubt on the resolution of the issue. That revenue ruling involved the classification of hybrid securities and concluded that merely labelling an instrument did not conclusively establish the issuer's intent. In Texas Farm Bureau, the court stated that intent will not be relevant unless the court's analysis of the objective factors fail to clarify the status of the corporate instrument. (25) In the context of VRPs, certain proxy statements and prospectuses (26) show that some issuers have carefully documented that their intent was to offer equity not debt.

      2. Absence of a Fixed Maturity Date. The absence of a fixed maturity date on an instrument has historically implied equity status. For example, even if an issuer has coupled a preferred stock offering with a redemption date, many courts have held that the instrument was equity. (27) There are, however, some exceptions. (28) Such a provision convinced at least one court that a preferred stock issue was actually debt--a decision so dated that it may no longer be valid law. (29)

         Nevertheless, the wise inventor should avoid acquiring VRPs with fixed redemption dates in which holders can compel a redemption on a fixed date. (30) Such a right could ma the equity flavor of the instrument. Therefore, unless there is an overriding reason for doing so, VRPs should not be issued with a fixed redemption date. Even where there is such a "flaw," the perpetual nature of VRPs (particularly where the holders do not have a put option on them) should still make VRPs resemble equity more than debt because there is no guarantee of a return when they are issued.

      3. The Term of the Instrumemt. Placing funds at risk indefinitely in the issuer's trade or business has been historically considered to be an indicium of equity. (31) the risk is measured by the length of time that funds are invested in abusiness. Since funds to purchase VRPs are considered to be invested indefinitely, this attribute should support equity status for VRPs. (32) Despite this implication, the Tax Court in Ragland (33) ruled that equity has been issued even though the security was theoretically redeemable within four years of issuance.

         Although investors should not place excessive reliance in this interpretation, additional support for this theory can be found in a 1940 case, Schmoll Fils Association, (34) which held that the mere discretionary right of the issuer to redeem its corporate security will not, by itself, jeopardize the equity status of the security. Although some VRPs (e.g., ARPs) may be callable after five years, this attribute is not necessarily inconsistent with the long-term nature of equity instruments. Inasmuch as ARPs are perpetual and have no explicitly fixed maturity date, the call feature is...