TAXATION OF FINANCIAL PRODUCTS

DEFINITION OF FAST-PAY STOCK IN PROPOSED REGULATIONS

By Viva Hammer, Esq.,
PricewaterhouseCoopers LLP

Many corporations could be subject to new reporting requirements because of a very broad definition of "fast-pay" stock included in recently issued proposed regulations. This definition could apply to different types of stock instruments (e.g., tracking stock). The proposed regulations would recharacterize, for tax purposes, financing arrangements involving fast-pay stock.

Stock would be treated as fast-pay if it is structured to provide for dividends that economically represent a return (in whole or in part) of the holder's investment rather than only a return on the holder's investment. Under the proposed regulations, a corporation that has fast-pay stock outstanding at any time during the taxable year generally would have to attach a statement to its Federal income tax return setting forth specified information.

The regulations generally are proposed to apply to taxable years ending after February 26, 1997. Thus, all amounts accrued or paid on or after the first day of the first taxable year ending after February 26, 1997, would be subject to the regulations, regardless of when a particular share of the stock or a particular debt instrument was issued. The reporting requirement under the regulations would apply to taxable years ending after the date final regulations are published.

Note: The February 26, 1997, date has meaning because it is the day preceding the day the IRS issued Notice 97-21, stating that the IRS expected to issue regulations recharacterizing financing arrangements involving fast-pay stock "to prevent tax avoidance." The IRS stated that this notice was issued in response to an extensively marketed multiparty financing arrangement that required very little time to implement. In many cases, the fees associated with implementation were fully refundable upon enactment of regulations that would eliminate the benefits of the arrangement.

Definition of Fast-Pay Stock

Generally, whether stock is fast-pay would be determined based on all the facts and circumstances, including any related agreements such as options or forward contracts. The determination would be made when the stock is issued and whenever there is a significant modification in the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances.

Stock would be presumed to be fast-pay if it has, by design, a dividend rate that reasonably is expected to decline or an issue price that exceeds the amount at which the holder can be compelled to dispose of the stock. A taxpayer could rebut these presumptions only by clearly showing that no dividend represents an economic return (in whole or in part) of the holder's investment. For example, companies may have outstanding tracking stock that is tied to a discrete pool of assets that has performed very well, resulting in high dividends to the tracking stock shareholders. However, if the company as a whole has performed poorly, the return on the tracking stock could be treated as a return of the original investment. In this case, the tracking stock may be recharacterized under the proposed regulations as fast-pay stock. The company would then be subject to the reporting and withholding requirements under the proposed rules.

Recharacterization

The proposed regulations would identify fast-pay arrangements--i.e., any financing arrangement in which a corporation has outstanding two or more classes of stock, one of which is fast-pay stock--and recharacterize certain of them as arrangements directly between the holders of the fast-pay stock and the other shareholders (the benefited shareholders) in the corporation.

The fast-pay arrangement would automatically be recharacterized if the corporation with outstanding fast-pay stock is either a regulated investment company (RIC) or a real estate investment trust (REIT). For other corporations, the IRS could (at its discretion) recharacterize the fast-pay arrangement in cases where the IRS determines that a principal purpose for the structure of the fast-pay arrangement is the avoidance of tax. The IRS states that it will closely scrutinize fast-pay arrangements in which the corporation with outstanding fast-pay stock is a foreign corporation.

Reporting and Withholding

The regulations would impose reporting requirements on certain corporations with outstanding fast-pay stock and on certain shareholders that participate in fast-pay arrangements. The regulations would also affect issuers of fast-pay stock, holders of fast-pay stock, and other shareholders that may claim tax benefits asserted to result from arrangements involving fast-pay stock. In addition to the reporting requirements, a corporation that issues fast-pay stock would become a withholding agent for payments made (or deemed made) under a fast-pay arrangement. Generally, if a fast-pay arrangement is recharacterized under the automatic recharacterization rules, withholding taxes would be required in accordance with the transaction as recharacterized. *

Editor:
Viva Hammer, Esq. PricewaterhouseCoopers LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.