The intercorporate dividends received deduction (DRD) is an area of increasing complexity, and Congress continues to be on the lookout for evidence of abuse. The IRC's "anti-abuse" rules can further complicate the implementation of the Sec. 243 DRD.

GENERAL RULES OF SECS. 243 TO 245

The amount of the DRD allowed under the general rule of Sec. 243 hinges upon the percentage of stock owned by the corporation receiving the dividend. If the recipient corporation owns less than 20% of the distributor's stock, the recipient corporation is allowed a deduction of 70% of dividends paid out of distributor's tax earnings and profits (E&P). When the recipient of the dividend has at least 20% but less than 80% ownership by vote or value in the distributor, an 80% DRD is allowed under Sec. 243(c). Finally, Sec. 243(a)(3) allows a 100% deduction for "qualifying dividends," when a corporation receives dividends from another corporation that is a member of the same affiliated group.(1) Sec. 243(b)(5) requires that the Sec. 1504(a) definition of affiliated corporations for consolidated statements be applied to Sec. 243 qualifying dividends.

Sec. 244 Preferred Stock

Certain dividends received from preferred stock of a public utility under Sec. 244 are not considered dividends for purposes of Sec. 243. In that case, Sec. 244 provides a special formula for computation of the DRD, recognizing that the utility takes a deduction for dividends paid under Sec. 247.

Sec. 245 Dividends Received Deduction for Foreign Corporations

The DRD is available to a U.S. corporation under Sec. 245 only for the U.S. income portion of a dividend from a "qualified 10%-owned foreign corporation."(2) The U.S. source portion is defined by Sec. 245(a)(3) as the ratio of the dividend payor's "post-1986 undistributed U.S. earnings" to its "total post-1986 undistributed earnings" computed in accordance with Sec. 902(c)(1). In keeping with the intention of Secs. 243 to 246 to mitigate the effect of multiple taxation, the U.S. source of income is the net U.S. source portion of the income of the U.S. business that was subject to income tax.

The post-1986 earnings are attributed to both a U.S. branch operation and an 80%-owned subsidiary. In order for a dividend paid by a U.S. corporation to a foreign corporation to be considered U.S. source income and receive DRD treatment, the foreign corporation must own 80% of the U.S. corporation by vote and value. Subsidiaries of foreign corporations operating in the U.S. are not allowed the DRD. A foreign tax credit is denied to the U.S. source portion of the dividend to a U.S. corporation, thereby eliminating the possibility of receiving both benefits.

ANTI-ABUSE RULES APPLYING TO THE DIVIDENS RECEIVED DEDUCTION

Sec. 246(b)(I) provides a limitation on the aggregate amount of DRD allowed under Secs. 243 to 245. This aggregate amount is not to exceed 70% of the taxable income for less than 20%-owned corporations or 80% of the taxable income for 20%- to 80%-owned corporations. Taxable income is computed without inclusion of Sec. 172 net net operating loss deduction, Sec. 243 DRD, Sec. 244 DRD on preferred stock, Sec. 245 dividends from 10%-owned foreign corporation deduction, and the Sec. 247 dividends paid deduction on preferred stock of public utilities. The tax treatment of intercorporate dividends can be changed by unrelated net operating losses of the payee corporation, because the percentage of income limitation does not apply in a year when there is a net operating loss. For example, a corporation is allowed a current unrestricted DRD when it has an overall net operating loss resulting from a large unrelated loss that exceeds the dividend income reduced by the unrestricted DRD. On the other hand, if this loss is smaller than the dividend income reduced by an unrestricted dividends received deduction, the limitation on the aggregate amount of net income will apply. This limitation can result in a "cliff effect" on net income and a trap for the unwary. A corporation with an unrelated loss slightly less than dividend income reduced by the unrestricted DRD will find its deduction limited. But, if the loss can be increased just enough to exceed the dividend less the unrestricted dividends

eived deduction, no limitation will apply. Assuming more than 20% stock ownership, 80% of the dividends receive is deductible as long as net income after the 80% deduction is either above 20% of the dividends received or below zero. There is a range from zero to 20% of dividends where tax planning can have an effect.

The Holding Period Requirement

The general rule under Sec. 246(1)(A) will deny the taxpayer a DRD under Secs. 243 to 246 when the taxpayer does not hold the stock at least 46 days or when the taxpayer has any commitment involving "...related payments with respect to positions in substantially similar or related property," including short sales.(3)

Any holding period requirement is essentially arbitrary and based upon the assumption that short-term investments are more likely to be abusive, tax motivated transactions. However, this is not always the case, in that short-term investments also may be made for non-tax reasons. Nevertheless, a corporation willing to hold a dividend paying stock for a longer period will receive the benefits a longer period will receive the benefits of the DRD, unless the dividend is classified as an extraordinary dividend. Without a holding period requirement, a perceived abuse would occur when a corporation purchases control of another corporation, pays itself a large dividend and utilizes the DRD. The market value and the stockholder's basis in the stock should reflect the earnings accumulated prior to the distribution; therefore, the payout of a large dividend should cause a decline in the stock's market value. The stockholder could then benefit from a loss on a quick sale. If the tax advantages surpassed the tax burden, the shareholder would gain from what would be discerned as a tax motivated transaction.

Offsetting Positions Including Short Sales

When corporate taxpayers are not materially at risk for the investments giving rise to dividends, they are denied a DRD under Sec. 246(1)(B). In addition, a taxpayer can be denied credit toward the 45- day holding period requirement during periods where the risk of loss is diminished. Sec. 246(c)(4) provides examples of several transactions where the risk of loss is considered to be diminished. The taxpayer is considered to have a diminished risk of loss when he or she has a grant or an option, a contract to sell or is involved in a short sale, or holds "offsetting positions" when the holdings satisfy "the substantially similar or related property standard."

Establishment of the Substantially Identical Standard

Transactions in stock and securities have received special scrutiny from Congress because of the possibility of formulating tax avoidance schemes. Historically, Congress has especially scrutinized wash sales and short sales. The wash sale first received special attention with the addition of Sec. 1091 to the IRC in 1921. In general, a wash sale is the sale of property immediately followed by the purchase of "substantially identical" property. The Sec. 1233 short sale rules were added to the IRC in 1950. A short sale is defined under Sec. 1233 as a contract to sell stock for securities that are borrowed or not intended to be sold, and the ensuing delivery of "substantially identical" stock or securities purchased, at which time the seller is entitled to the proceeds of the first sale. Under a short sale the taxpayer has diminished risk of loss. The selling of borrowed stock or securities coupled with the subsequent return of identical property resembles in some respects debt-financed portfolio stock and arouses similar tax abuse concerns.

For example, Rev. Rul. 72-521 allowed the taxpayer to sell stock short before an ex-dividend date and, upon receipt of the dividend, to pay a fully deductible amount equal to the dividend to the lender of the stock. The stock could be sold at a capital loss, because of the decline in value equivalent to the dividend payment. This "in lieu of dividend" payment could be considered similar to an interest payment and deductible as an expense for production of income under Sec. 212. When the short sale is considered a borrowing, a perceived abuse results when, similar to debt-financed portfolio stock, a corporate taxpayer could couple an interest deduction with the DRD. Sec. 263(h) was added to the IRC to limit this perceived abuse.

The "substantially identical" standard was initially applied to the wash sale rules under Sec. 1091 and later extended to the short sale rules with the addition of Sec. 1233 to the IRC. The definition of "substantially identical or similar" is crucial to the taxpayer under Sec. 246 because classification of stock of securities as substantially identical will deny the holder credit toward the 45-day holding period, thereby prohibiting the conversion of ordinary income to dividend income sheltered under the DRD. Reg. 1.246-3 indicates that "substantially identical property" under Sec. 246 "is to be applied according to the facts and circumstances in each case," but "in general, the term has the same meaning as the corresponding terms in Secs. 1091 and 1233" involving wash sales or short sales. Reg 1.1233-1(d)(1) provides that "stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation." However, this could change in a reorganization, where "there may be circumstances where the stock and securities of predecessor and successor corporations are substantially identical property." Also, bonds or preferred stock of a corporation are not usually considered substantially identical; however, this could change if a preferred stock or dividend is convertible into common stock of the same corporation.

Development of the "Substantially Identical" Standard

Early litigation on the "substantially identical standard" generally involved bonds. The landmark decision was Hanlin v. Commissioner, affirmed by the Third U.S. Court of Appeals in 1941. The case involved a series of sales and purchases of bonds which the Commissioner contended were substantially identical and, therefore, should be classified as wash sales. The Board of Tax Appeals was faced with a choice between a broad or a narrow interpretation of the terms "substantially identical." The Board surmised that "the difficulty lies in...the indefiniteness of the expression "substantially identical'." The majority felt that the term identical would have been used alone if the intention of Congress had been an exact correspondence between the subjects. Therefore, "the term 'substantially identical' is looser than 'identical' and was unquestionably so intended." Thus, the Board interpreted the term "substantially" as having a comparable meaning to "in the main," although the dissenting judges preferred a narrower interpretation.

On appeal, the Third Court of Appeals agreed that the substantially identical standard requires "something less than precise correspondence." The court further stated that this "something less" requirement consists of "economic correspondence exclusive of differentiations so slight as to be unreflected in the acquisition and proprietary habits of holders of stocks and securities." The controlling factor in the classification as is whether the difference in detail affects the decision made to purchase or to keep the securities. The Third Circuit felt its role was to consider whether the economic position of the taxpayer has in substance changed, thereby eliminating the potential for "fictitious losses."

Examples from The Conference Agreement

Congress broadened the Sec. 246 DRD language in the Deficit Reduction Act of 1984 from "substantially identical stock or securities" to "positions in substantially similar or related property." The intent was a broader interpretation than the concept of substantially identical stock or securities, but not to be so broad as to borrow the concept of "offsetting positions" from the Sec. 1092 straddle loss deferral rules. The Conference Agreement provides examples of transactions that would be included under this broadened coverage. The first example involves a short sale of common stock, while holding convertible preferred stock of the same issuer, or a short sale of convertible preferred while holding common stock, where the market valuation of the securities reflects the convertibility attribute. Rev. Rul. 77-201 provides an example where the taxpayer sold common stock at a loss and on the same day purchased convertible preferred stock, both in the same corporation. The stock had the same voting rights, dividend restrictions, and for a "...substantial time prior to the sale of the common stock," the stock prices did not "vary significantly" from the conversion ratio. The price of the convertible preferred was fluctuating on the market with the price of the common, therefore, the market was treating the convertible preferred stock as a common stock equivalent. A convertible securitity can be their prices do not "vary significantly" from the conversion ratios. However, Rev. Rul. 77-201 does not define the criteria used to determine when a price does not "vary significantly."

A Second Example

The second example provided by the Conference Agreement is comprised of several types of transactions encompassing the acquisition of short positions in a regulated futures contract on a stock index, while holding the stock of an investment company, or a portfolio that mirrors the market behavior of stocks included in the stock index. The Conference Agreement further provides that even though common stocks of different issuers are normally not considered substantially similar or related, similarities of the issuers could invoke application of the rule. On the other hand, the holding of a single instrument designed to reduce risk, or the acquisition of a regulated futures contract or an option on a stock index, while possessing a diversified portfolio, would not be considered offsetting positions diminishing risk.

Anti-Straddle Rules are Changed

Initially, the Sec. 1092 anti-straddle rules applied only to "offsetting positions with respect to personal property," thereby excluding stock. This was changed with the addition of Sec. 1092(d)(3)(9), by the 1984 tax act, providing situations where stocks are considered offsetting positions. These exceptions include "any stock which is part of a straddle at least one of the offsetting positions of which is an option with respect to such stock or substantially identical stock or securities, or under regulations a position with respect to substantially similar or related property (other than stock)." Offsetting positions involving only stock or short sale of stock are not included under Sec. 1092.

Other situations involving substantially identical stock and securities have been covered by the issuance of revenue rulings. Generally, the revenue rulings have considered stocks or securities not substantially identical if they are substantially different in any material feature, or because of differences in several material features considered together (Rev. Rul. 76-346). On the other hand, "relaive values and price changes...that are so similar," can make stocks or securities substantially identical, for example, in the convertibility of warrants to shares of common stock (Rev. Rul. 56-406). There is no strict statistical test for determining substantially similar, identical, or related property. The courts have focused on the economic substance and whether the similarity is material enough to affect the actions of a purchaser or holder of the stocks or securities. The regulations and courts have pointed out that the comparison is to be on a case by case basis. Statistical analysis has been suggested as providing evidence of whether the relative values or price changes of stocks or securities are so similar as to fall within the substantially similar or related property criteria, thereby reducing risk. Stock and bond valuation models have been used to test for the existence of substantially similar or related property. The Black-Scholes Model has been used in valuation of warrants and call options, and the Dividend Valuation Model has been used in the valuation of stock.(4) Another recommendation in evaluating the existence of a substantially identical or similar convertible instrument should be within 10% of its stock or stock index conversion value to be classified as substantially identical or similar.(5)

SFAS 80 provides the GAAP basis for determining whether two position reduce economic risk substantially enough to be considered a hedge. This should also provide a basis for whether one position is substantially similar to another position.(6) Under SFAS 80 the following two criteria must be met in order for a futures contract to be considered a hedge:

1. The item to be hedged exposes the enterprise to price (or interest rate) risk.

2. The futures contract reduces that exposure and is designated as a hedge. At the inception of the hedge and throughout the hedge period, high correlation of changes in a) the market value of the futures contract(s) and b) the fair value of, or interest income or expense associated with, the hedged item(s) shall be probable so that the results of the futures contract(s) will substantially offset the price or interest rate changes on the exposed item(s).

DEBT-FINANCED PORTFOLIO STOCK

The intent of Sec. 246A was to attack leveraged stock investment by corporations, especially in preferred stock, and the perceived tax abuse potential of coupling the interest deduction of Sec. 163(a) with the corporate DRD of Sec. 243. Coupling these two deductions encouraged debt-financed protfolio stock investments that were not economically sound without the tax benefits. Corporate acquisitions could be partially financed by the DRD on leveraged stock purchases. The potential acquirer could make large, noncontrolling investments in a target and use the benefits to generate sufficient savings to pay part of the cost of acquisition.

Sec. 246A(a) provides for a reduction in the percentage for the DRD if a dividend is received in a situation where indebtedness is directly attributable to investment in the stock. Generally, stock is portfolio stock if the taxpayer does not possess 50% ownership by vote or value. However, if five or fewer coporation shareholders own 50% of the voting power and stock value, the taxpayer only has to own 20% to escape characterization as a portfolio investor. The major interpretative problem of Sec. 246A involves the definition of the term "directly attributable." The linkage between borrowing and investing is necessary to trigger a disallowance.

The Conference Committee Report indicates that Sec. 246A applies to indebtedness attributable to the carrying as well as the acquisition of portfolio stock. The conferees concluded that when a corporation purchases stock with internally generated funds and then obtains funds through borrowing secured by the portfolio stock, the indebtedness will be directly attributable to the investment in the stock if the corporation could reasonably have been expected to sell the stock rather than incur the indebtedness.

Despite an invitation by Congress to issue regulations thus far the Treasury has not responded. However, in Rev. Rul. 88-66 the IRS offered several examples to explicate the "directly attributable" criterion. In one example, a mortgage borrowing was ruled not to be attributable to portfolio indebtedness. A corporation owned protfolio stock and other liquid assets to meet its reasonably anticipated business needs. It acquired a new facility by borrowing rather than liquidating its stock portfolio. The IRS concluded there was no direct relationship between the mortgage debt and the carrying of the portfolio stock, because under the circumstances, the IRS felt it would not be reasonable to expect the borrower to sell the stock in lieu of obtaining a mortgage loan. In the first place, a mortgage loan is customary to finance such an acquisition. Furthermore, the portfolio stock was not used as collateral for the loan.

Rev. Rul. 88-66 also provides an example where a parent holding company purchased portfolio stock with proceeds of a loan from its wholly owned bank. The IRS stated that the inside loan would not fall under the "directly attributable" criterion because intercompany loans do not create the potential for tax avoidance due to their nature as wash transactions. Because the only outside indebtedness of the parent/bank group was the bank's deposits, the IRS concluded there was no indebtedness directly attributable to portfolio stock because these deposits were received by the bank in the ordinary course of business.

Even if the debt's ultimate purpose is not to carry portfolio stock, a short-term investment may cause problems. With the intention of beginning construction of a new plant within 18 months, Y corporation borrowed and temporarily invested the proceeds in portfolio stock. The IRS ruled that the indebtedness was directly attributable to the portfolio stock investment. The IRS then reasoned that there is no ultimate purpose criterion in Sec. 246A; thus, the fact that the loan proceeds were actually used to buy portfolio stock was controlling. Commercial paper or unsecured debt uses for working capital traceable to uses other than stock investments would not be "directly attributable" to portfolio stock. This feature may be unfair to smaller firms which rely on secured funding that triggers the Sec. 246A disallowance, while corporations large enough to utilize unsecured debt escape this disallowance. To the extent the trap of Sec. 246A cannot be avoided, a portion of the DRD will be disallowed. The reduction is geared to a formula that reduces the percentage of the deduction to the product of the normal percentage (80% or 70%) time (100% minus the average indebtedness percentage).

EXTRAORDINARY DIVIDENDS

If a dividend is "extraordinary," Sec. 1059 will allow the DRD but makes the corporate recipient "pay" for it by reducing share basis by the amount of the deduction. An "extraordinary dividend" is one which equals 10% of the share-holder's basis or stock value (5% for preferred stock) and the stock has been held less than two years. But if the distribution is part of a partial liquidation or is not pro rata, it will be "extraordinary" even if the two-year holding requirement is met. In applying the 10% rule all dividends which have ex-dividend dates within the same period of 85 consecutive days are treated as one dividend.

Would a corporate shareholder prefer dividend rather than exchange treatment in spite of the "extraordinary" rules? If the intention is to hold the shares for a significant period, dividend treatment may be preferred because the tax effect of the basis reduction is deferred until the shares are sold. But, if there is no intention to gain this deferral advantage by holding the stock for a significant period, structuring the distribution as an exchange will at least allow the gain to be offset by whatever basis is available.

ADJUSTABLE RATE PREFERRED STOCK

The operation of some of the roadblocks to the DRD can be seen by looking at adjustable rate preferred stock (ARPS). The dividend rate of ARPS is tied to short-term interest rates or a percentage thereof. If the DRD is available, corporate investors may be willing to purchase ARPS even at lower rates than commerical paper investments.

Even though the rate on ARPS is similar to a short-term interest rate, typical ARPS issues may have enough equity characteristics to qualify as stock. In Rev. Rul. 90-27, the IRS stated that although ARPS is an investment alternative to short-term debt, the legal rights of the holder are more like preferred stock in certain circumstances.

The 46-day holding period requirement discussed previously is satisfied in the ruling because the dividend rate is reset every 49 days. At that time, the shareholders can submit a bid to a designated auction agent to either hold the shares for another 49-day period, hold the shares only if the dividend rate exceeds a rate specified by the share-holder, or tender its shares for sale.

The IRS did not feel that the Dutch Auction ARPS terms sufficiently diminished the risk of loss to stop the share-holder's investment from counting toward the 46-day holding period. But, suppose a broker-dealer agreed to guarantee the success of each auction. The shareholder in such a case "would have had the equivalent of an option to sell its stock at each auction." Also, if the issuer "were in such a position that it has no practical alternative but to redeem the stock in the event of a failed auction, the combination of the auction mechanism and the forced redemption would give the shareholder the equivalent of an option to sell its stock." These facts were not present in the ruling because there was neither a formal option to sell nor rights equivalent to an option to sell.

Perhaps the most uncertain aspect of the ruling is the question of the effect of a forced redemption. Even if there is no express agreement that ensures the ability of a shareholder to sell its stock, an agreement that a high penalty rate will apply when all the shares are not successfully remarketed could force the issuer to redeem the shares. In such a case, the IRS hints that the investor's risk will be so limited that the instrument may not resembly equity.

The other roadblocks have no unique application to ARPS except the substitution of 5% (in place of 10%) of shareholder's basis in the definition of an extraordinary dividend.

PROCEED CAREFULLY

The availability of the dividends received deduction is subject to certain anti-abuse rules. The perdentage of income limitation as modified by the loss limitation as modified by the loss limitation rule may create a trap for the unwary. The 45-day holding period requirement is complicated by the rules in Sec. 246(c)(4) which deny credit toward this holding period when the risk of loss is diminished by holding substantially similar property--options, short sales, or other offsetting positions. The "substantially similar" criterion raises many questions and is applied on a case by case basis diespite efforts by the treasry and the courts to specify situations where risk has been so reduced tat allowing the DRD would frustrate the will of Congress. The DRD is reduced if indebtedness is directly attributable to an investment in portfolio stock. A recent revenue ruling gives some guidance on the meaning of "directly attributable" but many questions remain. The basis reduction required by the extraordinary dividend rules may cause corporations to structure distributions as exchanges, particularly when the corporation intends to dispose of the stock in the near future.

Adjustable rate preferred stock presents a particularly interesting application of some of these rules. The IRS has recently issued a revenue ruling that raises as many questions as it answers.

(1)Under Sec. 243(a)(2), the special 100% deduction is allowed for corporations that quality under the Small Business Investment Act of 1958. Excluded from Sec. 243 treatment are Sec. 591 mutual savings bank dividends, Sec. 854 limitations on regulated investment companies, and dividends received from a Subchapter M real estate investment trust. The Sec. 243-246 dividends received deduction also does not apply to charitable corporations exempt from taxation under Sec. 501 and certain dividends of Federal Home Loan Banks under Sec. 246(1).

(2)The stock ownership attribution rules do not apply to Sec. 245; personal holding companies and passive foreign investment companies are excluded, very much narrowing the application of Sec. 245. Also under Sec. 245(a)(1), as added by TAMRA 88, amounts received from the sale or exchange of a controlled foreign corporation that are treated as dividends under Sec. 1248 are not considered dividends for purpose of the DRD.

(3)Sec. 246(c)(2) requires a 90-day holding period for certain preferential dividends "which are attributable to a period or periods aggregating in excess of 366 days."

(4)For example, see Emmel, Drew, "Wash Sales and Stock Options: How does the 'Substantially Identical' Rule Apply?" The Tax Lawyer, Vol. 42, No.4, 1989, pp. 1073-1088.

(5)See Willens, Robert, "IRS Sheds Light on the Meaning of Substantially Similar or Related Property," Tax Advisor, Vol.18, No. 6, June 1989, p. 412.

(6)Bush, John and Ahron H. Haspel, "The Dividends Received Deduction and Substantially Similar Property," Journal of Taxation of Investments, Vol.3, No.4, pp. 358-363, Summer 1986.