Rev. Rul. 88-49
1988-1 C.B. 297, 1988-25 I.R.B. 22.
Internal Revenue Service
Revenue Ruling
ELECTION; FAIR MARKET VALUE; CORPORATIONS' AGGREGATION OF DIVIDENDS
Published: June 13, 1988
Section 1059. - Corporate Shareholder's Basis in Stock Reduced by Nontaxed Portion of Extraordinary Dividends
Election; fair market value; corporations' aggregation of dividends. For purposes of the dividend aggregation rules in section 1059(c)(3)(A0 and 1059(c)(3)(B) of the Code, rules are provided for determining the fair market value of stock if a corporate shareholder makes the election under section 1059(c)(4).
ISSUE
If a corporate shareholder makes the election under section 1059(c)(4) of the Internal Revenue Code to substitute the fair market value of stock as of the day before the ex-dividend date for the shareholder's adjusted basis in the stock in determining whether a dividend is 'extraordinary,' how is the fair market value determined in situations to which the dividend aggregation rules in section 1059(c)(3)(A) and 1059(c)(3)(B) apply?
FACTS
Situation 1
On November 30, 1986, corporation W purchased common stock in corporation X for $90 a share. During 1987, X made dividend distributions, as shown in Table 1, which W received. On July 1, 1987, W sold its shares of X stock for $90.20 a share. W made the election under section 1059(c)(4) of the Code to substitute the fair market value of the X stock for W's adjusted basis in that stock in determining whether the aggregated dividend is an extraordinary dividend.
TABLE 1
Amount of Declaration Payment Ex-Dividend FMV on Day Before
Dividend Date Date Date Ex-Dividend Date
_________ ___________ _______ ___________ _________________
$5.00 February 1, March 31, March 1, $100
1987 1987 1987
$4.80 April 1, May 31, May 1, $ 95
1987 1987 1987
Situation 2
On November 30, 1986, corporation Y purchased common stock in corporation Z for $90 a share. During 1987, Z made dividend distributions, as shown in Table 2, which Y received. On December 1, 1987, Y sold its shares of Z stock for $80 a share. Y made the election under section 1059(c)(4) of the Code to substitute the fair market value of the Z stock for Y's adjusted basis in the stock in determining whether the dividends are extraordinary.
TABLE 2
Amount of Declaration Payment Ex-Dividend FMV on Day Before
Dividend Date Date Date Ex-Dividend Date
_________ ___________ _______ ___________ _________________
$7.00 February 1, March 31, March 1, $ 99
1987 1987 1987
$6.00 June 1, July 31, July 1, $ 92
1987 1987 1987
$6.00 October 1, November 30, November 1, $ 86
1987 1987 1987
Situation 3
The facts are the same as in SITUATION 2 except that Y did not sell its Z stock on December 1, 1987, and as shown in Table 3, in the spring of 1988, Z made an additional dividend distribution, which Y received. On May 1, 1988, Y sold its shares of Z stock for $103 a share. Y made the election under section 1059(c)(4) of the Code to substitute the fair market value of the Z stock for Y's adjusted basis in the stock in determining whether the dividends are extraordinary.
TABLE 3
Amount of Declaration Payment Ex-Dividend FMV on Day Before
Dividend Date Date Date Ex-Dividend Date
_________ ___________ _______ ___________ _________________
$7.00 February 1, March 31, March 1, $ 99
1987 1987 1987
$6.00 June 1, July 31, July 1, $ 92
1987 1987 1987
$6.00 October 1, November 30, November 1, $ 86
1987 1987 1987
$7.00 March 1, April 30, April 1, $120
1988 1988 1988
LAW AND ANALYSIS
Section 1059(a)(1) of the Code, as amended by section 614(a)(1) of the Tax Reform Act of 1986 (1986 Act), 1986-3 (Vol. 1) C.B. 168, provides that, in general, if a corporation receives an extraordinary dividend with respect to any share of stock and such corporation has not held such stock for more than 2 years before the dividend announcement date, the basis of such corporation in such stock shall be reduced (but not below zero) by the nontaxed portion of the dividend.
Under section 1059(b) of the Code, the nontaxed portion of any dividend generally equals the amount of any deduction allowable with respect to such dividend under section 243, 244, or 245.
Under section 1059(c)(1) of the Code, the term 'extraordinary dividend' generally means any dividend with respect to a share of stock if the amount of the dividend equals or exceeds the 'threshold percentage' (5 percent for preferred stock, 10 percent otherwise, as specified in section 1059(c)(2)) of the taxpayer's adjusted basis in the share of stock.
Under section 1059(c)(3)(A) of the Code, all dividends that are received by a taxpayer with respect to any share of stock and that have ex-dividend dates within the same period of 85 consecutive days are treated as one dividend. Under section 1059(c)(3)(B), all dividends that are received by a taxpayer with respect to any share of stock and that have ex-dividend dates during the same period of 365 consecutive days are treated as extraordinary dividends if the aggregate of the dividends exceeds 20 percent of the taxpayer's adjusted basis in the stock (determined without regard to section 1059).
Section 1059(c)(4) of the Code, as added by section 614(b) of the 1986 Act, 1986-3 (Vol. 1) C.B. 169, provides that if the taxpayer establishes to the satisfaction of the Secretary the fair market value of any share of stock as of the day before the ex-dividend date, the taxpayer may elect to apply sections 1059(c)(1) and (3) by substituting this value for the taxpayer's adjusted basis.
Rev. Proc. 87-33, 1987-29 I.R.B. 11, provides guidance to corporate shareholders on how to establish the fair market value of stock for purposes of the election under section 1059(c)(4) of the Code.
Section 1059(d)(6) of the Code defines the term 'dividend announcement date,' with respect to any dividend, as the date on which the corporation declares, announces, or agrees to the payment of the dividend, whichever is the earliest.
Under section 614(f) of the 1986 Act, 1986-3 (Vol. 1) C.B. 171, section 1059(c)(4) of the Code generally applies to dividends declared after July 18, 1986, the tax years ending after that date.
Section 1059 was added to the Code by section 53(a) of the Tax Reform Act of 1984, 1984-3 (Vol. 1) C.B. 73. Congress was concerned with several types of tax-motivated transactions that were encouraged primarily by the fact that a corporation owning stock in another corporation generally is allowed a dividend deduction (equal to 80 percent under section 243(a)(1), 85 percent prior to the amendment by section 611(a)(1) of the 1986 Act) of the amount of any dividends received with respect to that stock. A corporation would buy stock in another corporation (before the ex-dividend date) in anticipation of receiving a large (extraordinary) dividend that would be eligible for the dividends received deduction and that would reduce the value of the stock after receipt of the dividend. After receiving the dividend, the corporation would then sell the stock and claim the loss resulting from the decline in value of the stock as short-term capital loss that could offset unrelated short-term capital gain. See S. Rep. No. 169, 98th Cong., 2d Sess. 170 (1984).
Congress enacted section 1059 of the Code to prevent this type of transaction and similar tax-motivated transactions. As originally enacted, section 1059 provided generally that if a corporate shareholder received an extraordinary dividend on stock and disposed of the stock without having held it for more than 1 year, then the basis of the stock must be reduced by the nontaxed portion of the dividend.
Section 1059 of the Code proved to be an inadequate deterrent to the tax- motivated transactions at which the provision was directed because, simply by holding stock beyond the 1-year holding period, taxpayers were able to obtain the tax benefits that Congress intended to curtail. Therefore, in the 1986 Act Congress amended section 1059 by providing for a holding period beginning 2 years before the dividend announcement date, rather than the original holding period extending 1 year after the date of acquisition.
Congress decided, however, that it was appropriate:
to mitigate the application of [the modification of the holding period] to extraordinary dividends as defined under present law where the shareholder can demonstrate that the stock has significantly appreciated since the shareholder's original investment. Accordingly, the [Senate] bill provides an alternative test for whether a dividend is extraordinary based on the fair market value of the stock, but only in situations in which the taxpayer is able to establish the fair market value of the stock to the satisfaction of the Commissioner.
S. Rep. No. 313, 99th Cong., 2d Sess. 250 (1986), 1986-3 (Vol. 3) C.B. 250.
The above-described legislative history indicates that although section 1059 of the Code was enacted as an anti-abuse provision, the legislative intent of the fair market value election in section 1059(c)(4) was to provide relief from the basis reduction rule of section 1059(a)(1) in situations where the fair market value of stock has significantly appreciated.
Section 1059(c)(3)(A) of the Code treats dividends received by a taxpayer within the same 85-day aggregation period as one dividend. By contrast, section 1059(c)(3)(B) treats dividends received by a taxpayer within the 365-day aggregation period as
separate dividends, although the amounts of those dividends are aggregated for purposes of making the extraordinary dividend determination. Because the aggregation periods operate differently, different rules are appropriate for determining the fair market value of stock under the two aggregation rules.
The proper value to use in the case of the 85-day aggregation period is the fair market value of the stock on the day before the first ex-dividend date. Under section 1059(c)(3)(A) of the Code, multiple dividends within the aggregation period should have the same tax result as a single dividend for the aggregated amount. A single dividend has only one ex-dividend date, and the value of the day before that ex-dividend date has not yet been reduced by the stock going ex-dividend. Analogously, because section 1059(c)(3)(A) treats multiple dividends as a single dividend, only one ex-dividend date in the 85- day aggregation period should be used in applying the test, and the value taken into account should be unaffected by the stock being ex-dividend with respect to any portion of the aggregated dividends. The only date the value of the stock is unaffected by the payment of the dividends is the day before the first ex-dividend date. Moreover, if favorable market conditions cause the fair market value of the stock to increase, using a value other than that on the day before the first-dividend date, such as the highest value, could result in an extraordinary dividend being cured by a subsequent dividend. In other words, the aggregated dividend tested against the higher value might not be extraordinary, even though the first dividend, standing alone, would have been extraordinary. There is no reason to believe that section 1059(c)(3)(A) contemplates the possibility of such a cure.
With respect to the 365-day aggregation period, the Code does not treat multiple dividends as one. Rather, the aggregate amount of dividends is used to determine whether each dividend is extraordinary. Because the election in section 1059(c)(4) is designed to mitigate the effects of appreciation, the rule for determining fair market value must take into account that over a 365- day period there is a greater likelihood of appreciation in the value of the stock than over the 85-day period. The fair market value on the day before the first ex-dividend date will not reflect subsequent appreciation in the value of the stock within the 365-day aggregation period. However, the use of a weighted average of the fair market values of the stock on the days before the ex- dividend dates most accurately reflects the value of the stock when the multiple dividends are made. Therefore, for purposes of the 365-day aggregation period of section 1059(c)(3)(B), corporate shareholders making the section 1059(c)(4) election must use the weighted average of the fair market values of the stock on the days before the ex- dividend dates.
HOLDINGS
Situation 1.
Because the February 1, 1987, and April 1, 1987, dividends have ex-dividend dates within the same period of 85 consecutive days, section 1059(c)(3)(A) of the Code requires that the two dividends be treated as one dividend in the amount of $9.80. In determining whether that dividend is an extraordinary dividend within the meaning of section 1059(c), W must use the fair market value of the X stock ($100) on February 28, 1987, because that fair market value was the fair market value of the X stock on the day before the first ex- dividend date in the aggregation period. Because the amount of the aggregate dividend ($9.80) does not equal to exceed 10 percent of the fair market value ($100) of the X stock on February 28, 1987, the dividend is not an extraordinary dividend under section 1059(c).
Situation 2.
Because the February 1, 1987, June 1, 1987, and October 1, 1987, dividends have ex-dividend dates within the same period of 365 consecutive days, section 1059(c)(3)(B) of the Code requires that the amounts of the three dividends be aggregated. In determining whether the three dividends are extraordinary dividends, Y must use the weighted average of the fair market values of the Z stock on the days before the ex-dividend dates. Because the aggregated amount of the three dividends ($19) exceeds 20 percent of that weighted average ($92.68, which was derived as [(7 x $99) k (6 x $92) k (6 x $86)]/19, the three dividends are treated as extraordinary dividends. Moreover, because Y did not hold the Z stock for more than 2 years before the dividend announcement dates, Y must reduce its basis in the Z stock by the nontaxed portion of the dividends.
Situation 3.
Because, as in Situation 2, the February 1, 1987, June 1, 1987, and October 1, 1987, dividends have ex-dividend dates within the same period of 365 consecutive days, and because the aggregated amount of these dividends exceeds 20 percent of the weighted average of the fair market value of the Z stock on the days before the three ex- dividend dates, the three dividends are extraordinary.
Section 1059(c)(3)(B) of the Code requires that the amounts of the June 1, 1987, October 1, 1987, and March 1, 1988, dividends be aggregated to test for extraordinary dividends, because these dividends also have ex-dividend dates within a period of 365 consecutive days. Every 365 day period must be tested independently. The aggregated amount of these three dividends ($19) does not exceed 20 percent of the weighted average fair market value of $100.42 ([(6 x $92) k (6 x $86) k (7 x $120)]/19). However, because the June 1, 1987, and October 1, 1987 dividends are already extraordinary dividends, these two dividends remain extraordinary. Only the March 1, 1988, dividend is not an extraordinary dividend.
DRAFTING INFORMATION
The principal author of this revenue ruling is Paul F. Handleman of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Handleman on (202) 566-6203 (not a toll-free call).
Rev. Rul. 88-49, 1988-1 C.B. 297, 1988-25 I.R.B. 22.