V. Determining the Tax Status of the Special Dividend
With the groundwork now laid, we turn to the first issue presented by the Special Dividend paid by DPSG to its pre-Merger shareholders: how do we calculate the tax status of the Special Dividend?
A. Effect of the Merger on Taxable Years and E&P
1. Effect of the Merger on DPSG’s and Keurig’s Taxable Years
The Merger clearly qualifies as a reverse acquisition: Keurig’s shareholders received more than half (specifically, 87%) of DPSG’s stock in exchange for their Keurig stock. Under the reverse acquisition rules, the DPSG Group is the terminating group, and the Keurig Group is the continuing group. More specifically, as a result of the Merger:
- The DPSG Group terminates. The taxable year of DPSG (and every other member of the DPSG Group) ends on the close of business on July 9th, the date of the Merger. This group would file its final consolidated return covering the short period from January 1st through the close of business on July 9th;
- The Keurig Group continues in existence. The taxable year of Keurig (and every other member of the historic Keurig Group) is unaffected by the Merger. This group’s 2018 consolidated return would include the operations of the historical Keurig Group from January 1st through September 30th, and the operations of the former DPSG Group from July 10th through September 30, 2018; and
- DPSG is the new common parent of the continuing Keurig Group.
2. Effect of the Merger on DPSG’s and Keurig’s E&P
Since the Merger qualifies as a reverse acquisition in which the former common parent continues in existence, it also qualifies as a group structure change. Under these rules, as discussed in Part III above, DPSG’s E&P is “adjusted immediately after” DPSG becomes the new common parent to include Keurig’s E&P. This appears to be the case even though DPSG’s taxable year has not yet ended, and DPSG does not enter the Keurig Group “for all Federal income tax purposes” until the following day, July 10th.
As a result, DPSG seems to have E&P equal to the combined DPSG-Keurig E&P on July 9th, immediately after the Merger but before the close of business on July 9th.
B. What Is the “Date of Payment” for the Special Dividend?
Under Revenue Ruling 62-131, “[t]he date of payment, rather than the date of declaration, constitutes the date of distribution of a dividend” for purposes of measuring the distributing corporation’s E&P. The tax status of the Special Dividend thus depends critically on whether its date of payment is July 9th or July 10th: if July 9th, then none of the post-Merger E&P of the Keurig-DPSG Group would be relevant; if July 10th, then the relevant E&P would be measured at September 30, 2018, the end of the Keurig Group’s (continuing) taxable year.
1. DPSG’s Position
The proxy statement includes the following disclosure about the tax status of the Special Dividend:
the special cash dividend will be considered a dividend for U.S. federal income tax purposes to the extent of the current and accumulated earnings and profits of DPSG and [Keurig] through the end of the taxable year of [Keurig] in which the merger occurs (which is assumed to be the year ending September 30, 2018) (“E&P”).
Based on this disclosure, the parties apparently decided that, under Revenue Ruling 65-23, the taxable status of the Special Dividend should be determined by reference to DPSG’s E&P, measured at the end of Keurig’s September 30, 2018 tax year. In order to reach this result, they must have determined that, for purposes of measuring DPSG’s E&P, the Special Dividend’s date of payment was July 10th, the day after the Merger. For if the Special Dividend were considered payable before that date, it would have been measured by reference to DPSG’s taxable year ending July 9th, the day DPSG’s taxable year ended when it entered the Keurig Group under the reverse acquisition rules.
2. Detailing the Timing of the Special Dividend Payment
To help decide whether July 9th or July 10th should be considered the Special Dividend’s date of payment, it will be helpful to present the following details on the Special Dividend’s payment mechanics:
- On June 26, 2018, DPSG’s board of directors (the “DPSG Board”) conditionally declared the Special Dividend and established July 6, 2018 (a Friday) as the record date for the Special Dividend. The Merger date was anticipated to be on July 9, 2018. The Special Dividend was to be made payable to the record holders at 12:01 a.m. EDT on July 10, 2018, one business day after the closing of the Merger, to the July 6, 2018 record holders.
Payment of the Special Dividend was specifically conditioned upon the closing of the transaction. This was necessary because, as discussed more fully in Part VI.A below, DPSG did not have the funds necessary to pay the Special Dividend absent the Merger (nor would DPSG have wished to pay such a large dividend absent completion of the Merger).
- On June 29, 2018, DPSG’s shareholders approved the transaction. The shareholders did not vote to approve the Merger directly. Rather, they voted to approve the issuance of DPSG Common as Merger consideration and to increase the number of authorized shares of DPSG Common (which increase was necessary to permit Keurig shareholders to receive the number of DPSG shares they were entitled to receive under the Merger Agreement).
- On July 9, 2018 (a Monday), DPSG’s acquisition subsidiary merged into Keurig. At the moment the Merger became effective with the Delaware Secretary of State (the “Effective Time”), each share of acquisition subsidiary stock was converted into a share of Keurig stock, and each share of Keurig stock was converted into a fixed number of shares of DPSG Common. Immediately after the Effective Time, DPSG owned 100% of Keurig’s stock, and the former Keurig shareholders owned approximately 87% of the outstanding DPSG Common. Of course, the DPSG Common stock received by Keurig shareholders was “ex-dividend”; the Keurig shareholders were not entitled to receive any part of the Special Dividend.
Also, at the Effective Time, pursuant to the Merger Agreement, the DPSG Board was reconstituted so as to consist of two previously-serving members of the DPSG Board (the “Continuing Members”), eight members appointed by Keurig, and two independent directors.
- Still on July 9, 2018, immediately after the Effective Time, DPSG deposited with Computershare Trust Company, N.A. (“Computershare”), its previously-designated third-party paying agent, the funds necessary to pay the Special Dividend. By the time the funds were contributed, all conditions precedent to the payment of the Special Dividend had been either waived or satisfied.
While DPSG’s agreement with Computershare does not appear to be publicly available, these are generally straightforward agreements under which, in cases such as this, DPSG would appoint Computershare as its agent to make a dividend payment. The distributing corporation must supply the paying agent with the funds needed to make the dividend payment, normally at least one day before payment occurs.
The Merger Agreement effectively prevented the newly-installed DPSG Board from rescinding the Special Dividend. Section 7.16 of the Merger Agreement required the affirmative vote of both the two Continuing Directors for the DPSG Board to:
[A]mend, modify, or waive . . . [any of the provisions regarding the Special Dividend] or take any action in connection with the Special Dividend. . . . The Continuing Directors . . . shall have the authority . . . to institute any action on behalf of DPSG or the Dividend Stockholders [i.e., the pre-Merger DPSG stockholders] to enforce obligations arising under or in connection with this Agreement.
- At 12:01 a.m. EDT on July 10, 2018, the Special Dividend became payable to DPSG stockholders who were stockholders of record on the July 6, 2018 record date. The paying agent then distributed the cash previously deposited with it by DPSG to the record holders entitled to receive the Special Dividend.
Why not make the Special Dividend payable on July 9th, immediately after the Effective Time? It is doubtless that payment on that date would have occurred if the Special Dividend had instead taken the form of sales proceeds or boot, since payment would have been included as part of the merger consideration. Payment immediately after the Effective Time also would have minimized the need to protect against possible rescission of the Special Dividend by the (post-Merger) DPSG Board, however unlikely. The reason for the delay may lie with the NYSE rules regarding ex-dividend trading. Under these rules, ex-dividend trading for extraordinary dividends begins on the payment date for the dividend. If the Special Dividend’s payment date were set for July 9th (the anticipated Merger date), the DPSG Common apparently would then have begun trading ex-dividend at the opening bell on July 9th. But this might well have been before the Effective Time of the Merger. And if for some reason the Merger were to be delayed (or possibly even abandoned), the ex-dividend trading would have generated significant problems, to say the least. Setting the Special Dividend’s payment date for 12:01 a.m. the day after the Merger date neatly avoided this potential problem, but gave rise to the tax issue discussed immediately below.
3. Determining the Payment Date of the Special Dividend for E&P Purposes
What was the “date of payment” of the Special Dividend for purposes of calculating E&P? The facts rather clearly support July 9th. DPSG was irrevocably committed to paying the Special Dividend once the Merger occurred on that date. At the Merger’s Effective Time, DPSG obtained the funds necessary to pay the Special Dividend, and those funds were immediately transferred to the paying agent. At that point, it was simply not possible to rescind the obligation to pay the Special Dividend. To prevent any backsliding, the Merger Agreement included specific contractual provisions designed to ensure that the Special Dividend was in fact paid. Failure to pay the Special Dividend—and retention by DPSG of the $18.7 billion in funds earmarked for its payment—would in any event have created a massive windfall to the former Keurig shareholders. In that situation, this group would then own 87% of the stock of a corporation that still held the $18.7 billion that was supposed to be paid entirely to the pre-Merger DPSG shareholders. No court would countenance such a brazen change of heart.
In this context, Computershare was simply a contemporary stand-in for the U.S. Postal Service, a messenger for the delivery of the Special Dividend. The teaching of Revenue Ruling 65-23 is that the E&P should be computed as of July 9th, when DPSG irrevocably transferred the funds to Computershare, and the only action left was for Computershare to deliver the funds to DPSG’s historic shareholders. But July 9th was the last day of DPSG’s first-half 2018 taxable year, with any E&P generated after that date irrelevant in determining the tax status of the Special Dividend. The tax status of the Special Dividend thus should have been determined as of July 9th, even though the Special Dividend was not paid to shareholders until 12:01 a.m. on July 10th.
C. Should DPSG’s E&P Pool for the Special Dividend Include Keurig’s Pre-Merger E&P?
Under the group structure change rules, as quoted above, DPSG’s E&P was “adjusted immediately after” DPSG became the new common parent on July 9th to include the E&P of Keurig on that date, the former common parent of the continuing Keurig Group. This appears to be the case even though DPSG’s taxable year does not end until the close of business on July 9th, and DPSG did not enter the Keurig Group until July 10th.
As a result of the “adjusted immediately after” language, it seems clear under the group structure change rules that DPSG’s E&P equaled the combined DPSG-Keurig E&P on July 9th, determined immediately after the Effective Time of the Merger. As discussed above, if DPSG were a newly-formed shell corporation, this may well be the proper result: had the former Keurig shareholders received a pre-Merger distribution from the old common parent (Keurig), the distribution would be considered a dividend out of Keurig’s E&P. On July 9th, former Keurig shareholders owned the bulk of the new common parent’s (DPSG’s) stock. Interposing DPSG between Keurig and its shareholders should not change the result as it pertains to the former Keurig shareholders. The group structure change rules are designed to ensure that the tax status of distributions received by them from the new common parent include the old common parent’s E&P.
But in this situation, the Special Dividend was received by none of Keurig’s former shareholders—that is, by none of the shareholders that the group structure change rules were designed to capture. Rather, only the pre-Merger DPSG shareholders, who had no ownership in Keurig (or claim to its E&P) before the Merger and who own a distinct minority interest (13%) in the combined company after the Merger, received the Special Dividend. From the perspective of DPSG’s historic shareholders, this is not a change in the structure of the DPSG Group but is instead an acquisition of DPSG by an unrelated corporation. That is certainly the teaching of the reverse acquisition rules. In this case, it makes little sense for a different part of the consolidated return rules to require that Keurig’s E&P be taken into account in determining the tax status of the Special Dividend paid to historic DPSG shareholders.
This disconnect arises from the inconsistent approaches taken by the reverse acquisition rules and the group structure change rules. These rules (1) treat the Keurig Group as the continuing group, which would suggest that the transaction should, for purposes of combining E&P, be tested as if DPSG merged into Keurig; but then (2) combine the two groups’ E&Ps as if Keurig merged into DPSG in a section 381 transaction. Had the corporations’ E&P been combined by assuming—consistent with the theory of the reverse acquisition rules—that DPSG merged into Keurig in a section 381 transaction then (1) DPSG’s year would have ended on the Merger date, (2) the Special Dividend would presumably have been paid on or before the Merger date (since DPSG’s shares would have gone out of existence when it merged into Keurig), and (3) DPSG’s E&P for purposes of testing the Special Dividend would not have included any of Keurig’s E&P. Is this not the more sensible answer?
DPSG’s position regarding the E&P pool for the Special Dividend—that the E&P pool should include the E&P of the combined DPSG-Keurig Parent group, determined as of the end of September 30, 2018, is certainly defensible, and may be the only possible reading of existing group structure change rules for combining E&Ps. But as argued above, the position that the Special Dividend was payable the day following the Merger is too formalistic, and the rule that includes any of Keurig’s E&P in the calculation of DPSG’s E&P illustrates a likely defect in the consolidated return regulations. This is a classic case of a well-intentioned rule producing unintended consequences when applied to a different set of facts than those assumed when the rule was first developed.
Stepping back from the situation, the overall economics of the Merger are that the historic DPSG shareholders’ percentage ownership in DPSG is reduced from 100% to 13% as a result of the Special Dividend, Merger, and related transactions. This fact opens up the discussion of the more general question addressed in the next Part: for tax purposes, was the Special Dividend really a dividend distribution at all?
VI. Was the Special Dividend a Dividend for Tax Purposes?
DPSG’s proxy statement wobbles a little when describing the tax status of the Special Dividend:
For U.S. federal income tax purposes, the special cash dividend is expected to be characterized as a distribution pursuant to Section 301(a) of the Code. Assuming this characterization applies, as a result, the special cash dividend will be considered a dividend for U.S. federal income tax purposes to the extent of the current and accumulated earnings and profits of DPSG and [Keurig] through the end of the taxable year of [Keurig] in which the merger occurs. . . . No tax opinion will be provided to DPSG or the holders of DPSG common stock in connection with the Transactions.
This statement hesitates around classifying the Special Dividend as a dividend distribution for tax purposes. As discussed below, while there is support under current law for treating the Special Dividend as a dividend distribution for tax purposes, there is also good reason to hesitate.
A. Detailing the Financing of the Special Dividend Payment
Part V.B.2 detailed the timing of the Special Dividend payment but deferred further discussion of the financing of that payment. We now take up the financing: how exactly did DPSG obtain the $18.7 billion needed to pay the Special Dividend? The proxy statement and related documents disclose the following:
- On January 29, 2018, the date the Merger Agreement was signed, Keurig obtained an equity commitment letter from its principal shareholder, under which the shareholder agreed to purchase, immediately prior to the Merger, additional Keurig equity aggregating $9 billion.
- On February 28, 2018, Keurig entered into a $2.7 billion term loan agreement and a $2.4 billion revolving credit agreement. Upon consummation of the Merger, the obligations under these agreements were contractually assumed by DPSG, with DPSG and all of its subsidiaries (including still Keurig and its subsidiaries) generally becoming liable as borrowers or guarantors under the term and revolving credit agreements.
- On May 25, 2018, Keurig (through an escrow issuer) issued a series of senior notes due between 2012 and 2048, aggregating $7.75 billion. Upon consummation of the Merger, the obligations under the senior notes were contractually assumed by DPSG, with DPSG and all of its subsidiaries (including still Keurig and its subsidiaries) generally becoming liable as borrowers or guarantors under the senior notes.
- On July 9, 2018, Keurig transferred $18.7 billion to DPSG. As discussed above, DPSG then deposited the $18.7 billion with Computershare to fund the Special Dividend payment.
One fact may be immediately apparent: the funds obtained to pay the Special Dividend came entirely from Keurig. In fact, Keurig was the party legally required to obtain the necessary financing. DPSG’s obligation to close the Merger was explicitly conditioned on:
[Keurig] having obtained the financing related to the merger at or prior to the closing date of the merger and the funding of such financing in accordance with the terms and conditions thereof at or prior to the closing of the merger, which proceeds, together with other immediately available and unconditional funds, will be sufficient to fund the transactions contemplated by the merger agreement and related fees and expenses.
Keurig’s failure to provide the necessary financing would trigger the payment of a $700 million termination fee by Keurig to DPSG.
There is also no doubt that both DPSG and Keurig viewed the cash represented by the Special Dividend as part of the consideration for the transaction. The DPSG proxy flatly states that “[t]he special cash dividend will not be paid to our stockholders unless the merger is completed.” The Proxy describes Keurig’s initial acquisition proposal in October 2017 as “an acquisition of DPSG in exchange for $66.00 per share in cash, payable in the form of a one-time [DPSG] dividend, and a 28% equity stake in the combined company to be retained by DPSG’s stockholders.” Additionally, DPSG’s financial advisors, in their fairness opinion on the transactions, considered the special cash dividend plus the retained DPSG Common to constitute the “DPSG consideration” received by DPSG’s stockholders.
B. Should a Distribution, Unaccompanied With an Exchange, Always Be Treated as a Dividend?
Recharacterizing corporate distributions for tax purposes is hardly a new phenomenon. As discussed below, there is strong precedent for treating certain exchanges as dividends, and certain dividends as exchanges, for tax purposes.
1. Recharacterizing an Exchange as a Dividend
The Code has several provisions that can recharacterize what is, in form, a stock sale as a dividend distribution for tax purposes. For example, when a corporation redeems its own stock, the sale will be recharacterized under section 302 as a distribution of property under section 301 by the redeeming corporation, unless the redemption satisfies one of three relevant tests showing that the redemption is not essentially equivalent to a dividend.
A redemption will be considered not essentially equivalent to a dividend under section 302 if, in general, the relevant shareholder suffers a meaningful reduction in its percentage stock ownership in the corporation as a result of the redemption and any related transactions. The complete termination of a stockholder’s interest in the corporation or a decline of more than 20% in a stockholder’s equity ownership (in each case subject to numerous additional conditions and qualifications and the application of section 318’s ownership attribution rules) provide safe harbors for sale or exchange treatment. In the context of a public shareholder in publicly-traded corporations, even a de minimis decline in that shareholder’s small percentage ownership is enough to qualify for sale or exchange treatment. In contrast, when such a shareholder’s ownership interest does not decline (or, in certain circumstances does not decline sufficiently) then the redemption will be considered dividend-equivalent.
Section 304 deals with a shareholder’s sale of stock in one corporation to another related corporation. This type of sale can be recharacterized as a dividend distribution to the selling shareholder in cases in which there is no meaningful decline in percentage ownership suffered by the selling shareholder (directly and indirectly) in the corporation whose stock was sold, after giving effect to the stock sale and any related transactions. Whether any decline in ownership is sufficiently meaningful to qualify for sale or exchange treatment is determined by reference to the dividend-equivalent tests outlined in section 302.
Section 356(a)(2) treats nonqualifying property (“boot”) received in a reorganization as gain from the sale or exchange of the surrendered property, except when the receipt of boot “has the effect of the distribution of a dividend.” Dividend-equivalence is once again tested by asking whether the shareholder in question suffered a meaningful decline in its percentage stock ownership of the resulting corporation, tested immediately after the reorganization and related transactions, determined by applying the section 302 tests for dividend-equivalence, adapted to reflect the two-corporation nature of the reorganization transaction.
Pursuant to the Supreme Court’s decision in Commissioner v. Clark, the specific test for the dividend-equivalence of boot in a reorganization assumes that the transferor shareholders receive acquiring corporation stock in lieu of the boot, and then have that hypothetical “extra” acquiring corporation stock redeemed for an amount equal to the boot actually received. If the transferor shareholder’s decline in its percentage stock ownership of the acquiring corporation resulting from this hypothetical redemption is sufficient under the tests developed in section 302, the boot is considered received in exchange for a portion of the shareholder’s acquired corporation stock; if the decline is not sufficient, the boot is considered to have the effect of a dividend and is taxed as such. For purposes of measuring E&P allocable to dividend-equivalent boot, it appears that only the transferor’s E&P is taken into account (although there is an argument that combined E&P should be used).
Finally, in Bazley v. Commissioner, the Supreme Court addressed whether the shareholders’ pro-rata exchange of par value stock in one corporation for an equal number of shares of no par value stock plus the corporation’s debenture was a “reorganization” or “recapitalization” of the corporation. Under then then-prevailing Code provisions, treatment as either a reorganization or recapitalization would have rendered receipt of the debentures tax free to the exchanging shareholders. In deciding that the transaction should be recharacterized as a (taxable) dividend of the debentures to the shareholders (rather than as consideration received for stock in the reorganization), the Supreme Court said:
In the case of a corporation which has undistributed earnings, the creation of new corporate obligations which are transferred to stockholders in relation to their former holdings, so as to produce, for all practical purposes, the same result as a distribution of cash earnings of equivalent value, cannot obtain tax immunity because cast in the form of a recapitalization-reorganization. . . . A “reorganization” which is merely a vehicle, however elaborate or elegant, for conveying earnings from accumulations to the stockholders is not a reorganization under § 112.
Even though the scope of Bazley is less well defined than the scope of the Code provisions discussed above, the precedents look through the “form” of a transaction “however elaborate or elegant” and apply federal tax law as if the transaction were “for all practical purposes” a different transaction, with a tax result more consistent with the underlying tax policies of the relevant statutes.
2. Recharacterizing a Dividend as an Exchange
When a corporation pays a dividend to its shareholders just before the corporation is acquired by another person, a series of precedents holds that the pre-sale dividend can be recharacterized as proceeds from the transfer of the target corporation’s stock to its new owner. Depending on the specific facts, the proceeds can be recharacterized as additional sales proceeds or boot in a reorganization.
The leading case in this area is Waterman Steamship Corporation v. Commissioner. There, a target corporation (Pan-Atlantic) was owned entirely by another corporation (Waterman). An unrelated corporation (McLean Securities) wished to acquire Pan-Atlantic for $3.5 million. If Pan-Atlantic were to sell its assets to McLean Securities and liquidate into Waterman under section 332, neither Pan-Atlantic nor Waterman would have recognized gain. Pan-Atlantic’s tax basis in its assets was at least $3.5 million, and Waterman’s $700,000 tax basis in its Pan-Atlantic stock would have been irrelevant under the nonrecognition provisions of section 332. Nevertheless, because of certain Interstate Commerce Commission (“ICC”) regulations, McLean Securities was advised by its attorneys to acquire Pan-Atlantic’s stock, and not its assets. Accordingly, the parties settled on the following plan, with all events occurring on January 21, 1955.
At noon on January 21, with ICC approval for the transaction having been obtained, Pan-Atlantic declared a $2.8 million dividend to persons who were stockholders of record (i.e., to Waterman) on January 20. While Pan-Atlantic had approximately $2.8 million of E&P—and based on the overall transaction had an equity value of $3.5 million—it had insufficient cash to fund the dividend, so the dividend took the form of a Pan-Atlantic promissory note payable one month after issuance. At 1:00 p.m., Waterman sold its Pan-Atlantic stock to McLean Securities for $700,180 pursuant to a contract of sale signed after the dividend was declared but before the sale of the Pan-Atlantic stock. At 1:30 p.m., McLean Securities and its principal shareholder collectively loaned Pan-Atlantic $2.8 million from funds they had borrowed from an unrelated party. Pan-Atlantic then immediately used the funds to pay off its $2.8 million dividend note.
By structuring the transaction as it did, under the then-prevailing Code and regulations, Waterman could receive the $2.8 million dividend both tax free and without reduction in the tax basis of its Pan-Atlantic stock, with the result that the entire $3.5 million was received tax free. In contrast, had Waterman simply sold the Pan-Atlantic stock to McLean Securities for $3.5 million, it would have recognized a $2.8 million gain. It is this latter view of the transaction that the Commissioner asserted in the litigation.
The Fifth Circuit held that:
The so-called dividend and sale were one transaction. The note was but one transitory step in a total, pre-arranged plan to sell the stock. We hold that in substance Pan-Atlantic neither declared nor paid a dividend to Waterman, but rather acted as a mere conduit for the payment of the purchase price to Waterman.
The court also noted, with apparent approval, the Commissioner’s argument that the funds needed to pay the dividend were supplied by the buyer of the stock.
Although Waterman Steamship arose in connection with the taxable sale of stock, its analysis has been expanded to apply to corporate distributions paid prior to, but in connection with, reorganization transactions. For example, in Revenue Ruling 75-360, based on the facts in McDonald v. Commissioner, the target corporation (E&M) entered into an agreement with an unrelated corporation (Borden) pursuant to which E&M would redeem preferred stock for $43,500 held by McDonald, its sole shareholder, with Borden then acquiring all of E&M’s common stock from McDonald for Borden stock. At Borden’s recommendation, E&M borrowed $43,500 on a short-term basis from a third-party trust company, redeemed the preferred stock, and a week later Borden acquired the E&M stock for Borden stock. Immediately thereafter, Borden contributed cash to E&M, which used the cash to repay the short-term loan. McDonald argued that the redemption should be considered a sale or exchange of the preferred stock (resulting in no gain to McDonald), with Borden’s acquisition of the E&M stock solely for Borden stock qualifying as a section 368(a)(1)(B) reorganization (“B reorganization”). The Service, on the other hand, apparently argued that the redemption and B reorganization were separate transactions. Viewed separately, the redemption was essentially equivalent to a dividend (McDonald owned all but a de minimis amount of E&M’s common stock after the redemption), and McDonald’s (full) basis in his preferred stock would be added to the tax basis in his Borden stock, instead of reducing gain recognized on the redemption of his E&M preferred stock.
Both the Tax Court’s decision and the Revenue Ruling are instructive. The Tax Court accepted the government’s stipulation that Borden’s acquisition of E&M common stock qualified as a B reorganization. But the Tax Court then integrated the acquisition with E&M’s redemption of McDonald’s preferred stock for purposes of testing the redemption for dividend-equivalence. As so integrated, McDonald’s equity ownership was reduced from 100% in E&M to a small minority interest in a large publicly-traded corporation. The section 302 tests for considering the redemption not essentially equivalent to a dividend were thus satisfied.
The Revenue Ruling states that the Service should not have stipulated that the transaction qualified as a B reorganization. Rather, it states that “since the acquisition [of E&M stock] was not solely for voting stock of the acquiring corporation but partly for cash, it is the position of the Service that the acquisition of stock of E&M did not constitute a reorganization.” The Service’s position thus assumes—similar to the court’s position in Waterman Steamship—that the cash McDonald received in redemption of his E&M preferred stock came from Borden, with E&M acting as a mere conduit, receiving cash from Borden and distributing it to McDonald for his preferred stock. So viewed, this cash consideration from Borden would have caused the transaction to fail as a B reorganization. This was the Service’s position even though the loan secured by E&M to redeem its preferred stock was neither supplied nor guaranteed by Borden.
The Service expanded this analysis in a Technical Advice Memorandum (“TAM”), discussing a transaction involving a dividend payment by a mutual insurance company (Target) to its policyholder owners. In that transaction, Target was to merge into another corporation (Taxpayer) in an A reorganization, immediately after Target paid an “extraordinary dividend” to its owners. The extraordinary dividend was intended to constitute a dividend to policyholders, deductible by Target under section 832(c)(11). Although the precise timing of the dividend declaration and payment mechanics are not entirely clear from the TAM, it is clear that the dividend was declared after the merger agreement was signed but before the merger date, payable to record holders of policies some number of days before the merger date, payable “on or about” the closing date, paid in connection with the merger, and actually distributed to policyholders via checks deposited in the mail within a short time after the merger. The dividend was contingent upon the fulfillment or waiver of all conditions precedent to Target’s merger with Taxpayer.
There is some dispute as to whether Target had sufficient capital for regulatory purposes to support payment of the special dividend. The TAM concludes that Target’s legal and financial ability to pay the extraordinary dividend is irrelevant, since Target did not in fact fund payment of the dividend:
Even if we accept Taxpayer’s assertion that Target had sufficient surplus to provide funding for the payment of the [extraordinary dividend] . . . we nonetheless conclude that having enough funds to pay a dividend is not dispositive of whether such payment is in fact a dividend. Rather, in this case the record shows that the [extraordinary dividend] . . . was a negotiated part of the consideration paid in the merger. . . . Target simply declared [the extraordinary dividend] . . . with Taxpayer furnishing the cash to make the purported . . . cash dividend. . . . The [extraordinary dividend] was declared as part of the merger, and it would not have been declared if all of the remaining steps in the transaction had not been lined up on the closing table and the merger did not in fact take place.
Based on this TAM and the other precedents discussed above, when a purported dividend is recharacterized as sale proceeds, the payment will give rise to additional gain (or reduced loss) to the receiving shareholders; if recharacterized as boot, then the boot will be tested for dividend-equivalency. If the receiving shareholders’ equity interest in the combined companies is reduced sufficiently, the boot will be considered gain from the sale or exchange of the shareholders’ stock. Interestingly, if the parties are forced by nontax considerations to have funds paid through a dividend distribution (rather than through a different, perhaps more direct form of payment), this may be relevant in determining whether the parties considered the payment a dividend or acquirer consideration, but is not dispositive as to the tax analysis outlined above.