MONTHLY INCOME PREFERRED
SECURITIES: A NEW HYBRID THAT COMBINES THE BEST OF EQUITY AND DEBT

By John L. Crain and Gisele Jackson

U.S. companies are selling a new type of security that appears to deliver the best characteristics of both equity and debt, effectively allowing issuers to deduct dividend payments for tax purposes and yet classify the security as equity for financial reporting purposes. These new securities, called monthly income preferred securities (MIPS), have become so popular that they accounted for more than 70% of all the preferred stock issued by corporations to the public in 1995.

Corporations and their investment bankers have long been faced with the challenge of creating a financial instrument that would deliver the benefits of equity, but still qualify as debt for tax purposes. Several early efforts to meet this challenge met with only limited success. For example, some commercial banks have used a type of convertible capital that starts as debt but can be exchanged by the issuer for preferred stock. However, these securities are not viewed as equity in their initial form. In another case, several foreign companies, with the aid of Merrill Lynch, created a perpetual preferred stock issued through an offshore subsidiary to U.S. investors with the proceeds loaned back to the foreign parent company. In some countries, this structure provides the issuer with the desired equity classification and tax deductions for the interest paid to the subsidiary. However, the structure did not work for U.S. companies since they were not allowed the tax deduction.

One of the most significant disadvantages of traditional preferred stock is that issuers must use after-tax dollars to make preferred dividend payments. Goldman Sachs & Co., along with Texaco Inc., set out to solve this dilemma. As the product of their efforts, MIPS seem to be the most workable solution to this problem to date. MIPS are treated as debt for tax purposes and preferred equity for financial reporting purposes. In other words, by effectively allowing issuers to deduct preferred dividend payments, MIPS help firms lower both their cost of funds and debt ratios. MIPS also allow issuers to lock in today's relatively low interest rates, providing financing at interest rates competitive with those available through long-term debt. These features make MIPS extremely attractive to issuers as a source of capital. Since the first issue by Texaco in October 1993, dozens of MIPS offerings have been made. In 1993 only about four percent of preferred stocks issued were in the form of MIPS; however, these securities accounted for 52% of the preferred issued in 1994 and over 70% of the preferred issued in 1995.

Insurance and utility companies both have traditionally relied on preferred stock as a significant source of capital, and in fact, these two types of businesses account for about 60% of MIPS issues. The banking industry, historically another frequent user of preferred stock, has mostly continued using traditional preferred issues, primarily because regulators do not treat MIPS as a component of the top-tier equity capital that banks must maintain at certain levels.

Basic Structure

Technically, MIPS are shares of preferred stock issued by a special purpose foreign or domestic limited life company (LLC). The LLC, in turn, is wholly owned by the U.S. parent corporation. The structure is designed with two specific objectives in mind. First, the parent corporation claims tax deductions for the interest payments on the loan from the LLC. Second, the parent corporation is able to treat the preferred stock issued by the wholly owned LLC as equity for financial accounting purposes. The sequence of events in the creation of a typical MIPS issue is as follows:

1. The parent company sets up a 100% owned subsidiary designed to qualify as a limited life company. Initially, all the subsidiaries were set up in the Turks, Caicos, and Cayman Islands. In 1994, however, the SEC issued a series of no-action letters clearing the way for domestic LLCs to also be used in creating MIPS.

2. The LLC sells preferred stock (in the form of MIPS) to individual investors.

3. Proceeds from the sale of the MIPS are transferred to the parent corporation in the form of a loan by the LLC.

4. Dividends on the MIPS are payable to holders monthly in arrears on the last day of each calendar month. The funds to pay the dividends are generated from interest payments made by the parent to the LLC for the loan. The timing of the interest payments corresponds to the MIPS dividend payments.

Corporate issuers must use after-tax dollars to make dividend payments on regular preferred stocks. With MIPS, the interest payments made by the parent corporation to the LLC are tax deductible. The LLC then uses the interest payments received from the parent corporation to pay the dividends on the preferred shares it has issued to investors.

A key requirement in achieving the desired tax treatment for MIPS is that the LLC is classified as a partnership for U.S. Federal income tax purposes. An organization is classified as a partnership for tax purposes if the entity lacks two of the following four characteristics of corporations: 1) centralized management, 2) limited liability, 3) free transferability of interests, and 4) continuity of life. LLCs used in MIPS offerings do not possess continuity of life, and since the parent corporation is prohibited from transferring its interest in the LLC, free transferability of interest is also not present. Because the LLC is recognized as a partnership for tax purposes, it acts as a tax conduit so that the full amount of the interest payments on the loan flows through to holders of the MIPS. In addition, partnership treatment means that MIPS distributions to any foreign holders escape the 30% withholding tax normally required for corporate dividends paid to foreign investors. For financial reporting purposes, the loan from the wholly owned LLC to the parent corporation is virtually ignored, resulting in the desired financial statement result--preferred equity treatment.

MIPS issues generally have 50-year lives that can be extended if certain conditions are met. At the maturity of the loan between the parent corporation and the LLC, the MIPS are redeemed. To lure investors, MIPS issues offer as much as ³/4 of a percentage point above regular preferred stock and 1¹/4 to 1¹/2 points above the yield of long-term government bonds. For example, in late February 1995, GTE sold a $450 million issue of MIPS with a dividend yield of 8.75% compared to an 8% yield on its regular preferred and a 7.5% yield at the time for 30-year Treasury bonds. MIPS are typically listed for trading on the NYSE similarly to regular preferred shares. The table provides a list of selected MIPS issues, many of which are from widely recognizable companies. Only two of the issues reported in Table 1 (Enron and Texaco) occurred in 1993; the other issues took place in 1994 and 1995.

Advantages of MIPS

The advantages of MIPS for issuing corporations are obvious. The security combines the traditional benefits attributed to equity capital with the tax-deductible structure normally reserved for debt financing. The cost savings for the corporations issuing MIPS can be significant when compared to traditional preferred stocks. For corporations in the 35% Federal tax bracket, the issuing company can save over $3 million in annual after-tax costs for every $100 million in financing provided by MIPS as compared to regular preferred stock. More importantly, these tax-related savings are obtained without raising the corporation's debt ratio. This dramatic result has not gone unnoticed by corporations who are redeeming existing preferred stock and replacing it with MIPS with increasing frequency.

MIPS also offer investors several advantages. For example, the securities typically offer a much higher yield than is available on alternative investments such as certificates of deposit and money-market funds. In addition to these relatively high yields, investors seeking current income are lured to MIPS for the monthly dividend payment schedules. Although MIPS were designed to make monthly dividend payments mainly because this feature ensures they satisfy the "accrual" tax requirement for partnerships, monthly payments also strongly appeal to the retail customer base to which MIPS are largely targeted. Another advantage is that MIPS provide a convenient vehicle for smaller individual investors to invest in what is substantially equivalent to long-term corporate debt. Individual investors with relatively small amounts to invest previously lacked this opportunity because corporate debt is usually issued in minimum denominations of $1,000 per unit and must be bought and sold in relatively large blocks to keep transaction costs at reasonable levels. Most MIPS issues have been priced initially at $25 a share, making even a single round lot (100 shares) affordable to the smaller investor.

Disadvantages of MIPS

Though MIPS have many advantages, they do have some negative features. For example, MIPS do not possess the same level of investment security as most corporate bonds. From a creditor standpoint, this simply means that MIPS are generally subordinated to all of the parent corporation's debt, making the MIPS more risky. Also, the parent corporation, if it is not in default on the loan from the LLC, usually has the right to defer the payment of interest (in some cases for as long as five years). During periods that interest payments are deferred, no dividends are paid to MIPS holders, although income is allocated to the holders.

Another concern is that market values of MIPS are not guaranteed. Prices of MIPS rise and fall largely in concert with the bond market as prevailing interest rates change. Also, most corporations that have issued MIPS have included redemption features in the stock. With this feature, the issuer can typically redeem the MIPS after five years. This tends to place a cap on the appreciation potential of the MIPS shares but does not provide a corresponding guarantee of a minimum price. In other words, upside market price potential is usually limited but downside market price risk is not.

Still another disadvantage is that MIPS require more difficult and costly tax reporting by investors because dividends paid on MIPS are reported on a partnership tax form (K-1), rather than the standard 1099 used ordinarily for dividends. A K-1 is required because MIPS, while guaranteed by a parent corporation, are issued by an LLC which is viewed as a special purpose partnership for tax purposes. However, investment bankers have already developed a new twist to simplify this aspect of the MIPS structure. With this new type of MIPS, the corporation issues the securities from a trust rather than an LLC in order to simplify tax treatment and reporting. Merrill Lynch has already put together several MIPS issues for corporations using this new structure which has been dubbed "trust originated preferred securities."

Finally, MIPS come with a certain amount of tax risk. To date, the IRS has been agreeable with the favorable tax treatment of MIPS, allowing corporations to treat the interest payments to the LLCs as deductible expenses. There is always the risk, however, that the IRS may decide to contest this treatment. As a form of protection in the event of such occurrence, many MIPS issues include "tax event" clauses that allow the corporation to redeem the shares in the event that the IRS is successful in challenging the securities' tax status.

Too Much of a Good Thing

MIPS are one of the most recent of the continuing revolution in financial instruments. Corporations find MIPS attractive because the securities are treated as debt for tax purposes and equity for financial accounting purposes. MIPS are appealing to investors because of the relatively high yields and monthly dividend payment schedules. In addition, MIPS are readily available to the small investor.

Investment bankers and corporations are busy creating new types of MIPS that offer such features as variable payment rates and convertibility. With the overwhelming success of MIPS to date, more issues can certainly be expected in the future. Of course, if MIPS grow too much in popularity, there is always the danger that Congress may become concerned about the potential loss of tax revenue and act to limit the use of these new securities by corporations. This has certainly happened before when new "tax advantaged" corporate financing techniques have become extremely popular. For example, the explosion in popularity of publicly-traded partnerships in the 1980s was effectively dealt a fatal blow with the passage of the 1987 Omnibus Budget Reconciliation Act and its corporate "recharacterization" provisions. However, only time will tell if Congress will develop a similarly dim view of MIPS. *

John L. Crain, PhD, CPA, is a professor of accounting and Gisele Jackson, PhD, CPA, an assistant professor of accounting at Southeastern Louisiana University.

TABLE

SELECTED MIPS ISSUES

Editor:

Milton Miller, CPA

Consultant

Contributing Editors:

Andrew B. Blackman, CFP, CPA\PFS

Shapiro & Lobel LLP

David Kahn, CPA

Goldstein Golub Kessler &
Company PC