SERVICE RULES THAT INVESTMENT UNIT CONSISTING OF COMMON STOCK AND TRADEABLE CONTINGENT PAYMENT RIGHT IS A CASH SETTLEMENT PUT OPTION.

Rev. Rul. 88-31

ISSUES

1. If a corporation issues investment units such that each unit consists of a share of its common stock and a separately tradeable contingent payment right the value of which varies inversely with the value of the stock, what is the proper characterization of the contingent payment right for federal income tax purposes?

2. What are the federal income tax consequences to a taxpayer that holds both a share of the issuing corporation's common stock and a contingent payment right if the taxpayer sells the right or the share of stock, or if the taxpayer receives a payment upon maturity of the right? Alternatively, what are the tax consequences to a taxpayer that holds only a contingent payment right if the taxpayer sells the right or receives a payment upon maturity of the right?

3. What are the federal income tax consequences to the corporate issuer of the investment units upon the issuance of the units, upon a repurchase of a contingent payment right, or upon a payment by the issuer upon maturity of a right?

FACTS

X is a domestic corporation the common stock of which is widely held and publicly traded on a national securities exchange. In order to raise capital, X publicly issued investment units (Units), each of which consisted of one share of X common stock and one contingent payment right (Right). For a short period after the issuance of a Unit, the common stock and the Right were not separately transferable. Thereafter, the Right and the common stock could be traded separately on a national securities exchange.

The Units were issued for $10 each on a date when the X common stock was trading at $8 per share. The Rights provide that on the date (Payment Date) two years from the issue date, X will pay to the holder of a Right an amount (Payment) equal to $11 minus the then market price of a share of X common stock, subject to a maximum of twice the value, as of the Payment Date, of a share of X common stock. In any event, a $0. 10 minimum Payment will be made in satisfaction of each Right.

Thus, under the terms of a Right, the maximum Payment that the holder of a Right may receive is $7.33, which will be received if the market price of X common stock on the Payment Date is $3.67. ($11 minus $3.67 equals $7.33, which does not exceed twice the value of X common stock ($3.67 x 2 = $7.34).) If the market price of X common stock on the Payment Date is less than $3.67, the holder will be limited to a payment of twice the value of the stock. Accordingly, the value of a Right varies inversely with the value of the underlying X common stock at X common stock prices between $10.90 and $3.67.

At its election, X can make the Payment by transferring its common stock of equal value (determined as of the Payment Date), by paying cash, or by transferring any combination of its common stock and cash. On the Payment Date, the rights of a holder of a Right will terminate without any action by the holder and will be automatically converted to the right to receive the Payment. The Payment, whether in cash, X common stock, or any combination thereof, will be mailed to holders of the Rights within five business days following the Payment Date.

The holder of a Right does not possess the right to vote, the right to receive dividends, the right to receive assets on liquidation of X, or the pre-emptive, preferential, or other right of first refusal to subscribe for or purchase stock of X

LAW AND ANALYSIS

1. CHARACTERIZATION OF THE RIGHTS

The federal income tax consequences of the issuance of the Units, sale of a Unit or a Right, or payment, or receipt of Payment, upon maturity of a Right first depend on whether the Rights are regarded as property separate from the common stock or are regarded as an attribute of the common stock giving the holder of a Unit the right to a distribution with respect to the stock. For the Rights to be considered an attribute of the stock, the right to Payment on the Payment Date generally must be inseparable from the other rights inherent in the stock. Rev. Rul. 75-33, 1975-1 C.B. 115, concerns a contingent right that is attached to convertible preferred stock to receive additional dividends if certain events occur during a 10-year period. The ruling concludes that the contingent right is a right inherent in the stock because the right is extinguished on conversion of the preferred stock into common stock. Compare Rev. Rul. 78-142, 1978-1 C.B. 111 (finding a single item of property), WITH Rev. Rul. 70-108, 1970-1 C.B. 78 (finding two items of property).

In the present situation, because the Rights may be traded separately from the stock, a holder of a Right could receive the Payment on the Payment Date without owning a share of stock in X. The short period after issuance during which the Rights cannot be traded separately from the common stock does not significantly affect the fact that the properties generally may be traded separately. In addition, a holder of both a Right and a share of X stock may receive Payment on the Right without giving up the share of X stock. Thus, the Rights are unlike conversion rights on certain instruments, which rights are not separate from the property that may be converted pursuant to the rights. Moreover, the value of the Rights varies inversely with the value of the common stock. Accordingly, for federal income tax purposes, the Rights are property that is separate from the common stock.

In order to determine the basis of each item of separate property that comprises the Unit, the $10 purchase price of a Unit must be allocated between the share of common stock and the Right on the basis of the fair market value of each on the date of issuance. Cf. section (1.1012-1(d) of the Income Tax Regulations. Thus, the portion of the $10 purchase price of the Unit that is attributable to the fair market value of the common stock on the date of issuance, $8, is the cost and basis of the stock, and the balance of the purchase price, $2, is the cost and basis of the Right. Section 1012 of the Code.

The federal income tax consequences resulting from transactions involving the Rights, as property separate from the common stock, depend on the nature of these Rights.

A "put" is an option to sell specified property, including corporate stock, at a stipulated price (the strike price) on or before a specific future date. This option to sell is granted by the writer to the holder and is generally granted for consideration, such as a cash payment. See Rev. Rul. 78-182, 1978-1 C.B. 265. A put is distinguishable from a stock purchase right, such as a call or a warrant. The value of a stock purchase right increases as the value of the stock increases. In contrast, as the value of the underlying property decreases, the value of the put increases. Thus, there is an inverse relationship between the value of a put and the value of the underlying property.

Section 1234(c)(2)(A) of he Code provides that, for purposes of section 1234(a) and (b), a cash settlement option shall be treated as an option to buy or sell property. Section 1234(c)(2)(B) defines a cash settlement option as any option that on exercise settles in (or could be settled in) cash or property other than the underlying property. Thus, cash settlement options call for, or permit, payment of trading profits or losses rather than delivery of the underlying property.

Over a wide range of reasonably anticipated values of X common stock, the holder of a Right in the instant case is in an economic position identical to the holder of a put with respect to X common stock. This is so because, in that range, the value of a Right increases as the value of the X common stock decreases. Further, the holder of a Right has a right to receive property based on the selling price of the X stock on a specific future date which right was granted for consideration. The fact that the holder of the Right does not have to deliver the underlying property to X but receives the payment as if the holder had purchased the property and sold it to X is characteristic of a cash settlement put option. Accordingly, for federal income tax purposes, a Right is a cash settlement put option. The facts that the Payment may be made in either cash or X stock at the option of X, that the Payment is to be made on a specified date, and that the Payment is limited by a ceiling of $7.33 and a floor of $0.10 are not inconsistent with characterizing a Right as a cash settlement put option. See section 1234(c)(2)(B) of the Code.

2. TAX CONSEQUENCES TO THE HOLDER

Rev. Rul. 78-182, 1978-1 C.B. at 267, holds that the cost of a put is a nondeductible capital expenditure.

Section 1234(a)(1) of the Code provides, in relevant part, that, in the case of the holder of an option to buy or sell property, the gain or loss attributable to the sale or exchange of, or loss attributable to the failure to exercise, the option is considered gain or loss from the sale or exchange of property with the same character as the property to which the option relates would have in the hands of the taxpayer. Section 1234(a)(2) provides that, if an option lapses (that is, expires without being exercised), it is deemed to have been sold or exchanged on the date it expires. Section 1234(c)(2)(A) provides that a cash settlement option is treated as an option to buy or sell property for purposes of section 1234(a) or (b). The purpose of section 1234(c)(2)(A) is "to clarify that gain or loss on the sale, exchange, lapse, or exercise of the [cash settlement] option is capital gain or loss with respect to grantors or holders." H.R. Rep. No. 861, 98th Cong., 2d Sess. 904 (1984), 1984-3 (Vol. 2) C.B. 158. Accordingly, if a cash settlement option is in fact settled in cash, the transaction is treated as a sale or exchange of the option. Thus, if the underlying property would be a capital asset in the hands of the taxpayer, gain or loss on the transaction is considered gain or loss from the sale or exchange of a capital asset.

Section 1234A of the Code provides, in relevant part, that gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property (as defined in section 1092(d)(1)) which is (or on acquisition would be) a capital asset in the hands of the taxpayer shall be treated as gain or loss from the sale of a capital asset.

Section 1092(c)(1) of the Code provides that a "straddle" means offsetting positions with respect to personal property. Pursuant to section 1092(c)(2)(A), a taxpayer holds offsetting positions with respect to personal property if there is a substantial diminution of the risk of loss from holding any position with respect to personal property by reason of holding one or more other positions with respect to personal property, whether or not of the same kind.

Section 1092(d)(2) of the Code defines a "position" as an interest, including a futures or forward contract or option, in personal property.

Section 1092(d)(1) of the Code defines the term "personal property" as any personal property of a type which is actively traded. Section 1092(d)(3)(B)(I) provides that stock is "personal property" if the stock is part of a straddle in which at least one of the offsetting positions is an option with respect to that stock or substantially similar stock or securities.

Section 1092(a)(1)(A) of the Code provides that any loss with respect to one or more positions shall be taken into account for any taxable year only to the extent that the amount of such loss (the deferred loss) exceeds the unrecognized gain (if any) with respect to one or more positions which were offsetting positions with respect to one or more positions from which the loss arose. Section 1092(a)(1)(B) states that any loss which may not be taken into account under section 1092(a)(1)(A) for any taxable year can be carried forward to the succeeding taxable year, subject to the limitations of section 1092(a)(1)(A). Section 1092(a)(3)(A) provides that for any position held by the taxpayer at the close of the taxable year, unrecognized gain is the amount of gain that would be taken into account if the position were sold at its fair market value on the last business day of the taxable year.

Section 1.1092(b)-2T(a)(1) of the temporary Income Tax Regulations provides that a taxpayer's holding period for any position that is part of a straddle does not begin earlier than the date that the taxpayer no longer holds directly or indirectly (through a related person or flow-through entity) an offsetting position with respect to that position. However, pursuant to section 1.1092(b)-2T(a)(2), this holding period rule does not apply to a position that, before a straddle that includes such position is established, is held by a taxpayer for the long term capital gains holding period (or longer).

Section 1.1092(b)-2T(b)(l) of the temporary regulations provides that a loss sustained on the disposition of one or more positions of a straddle is treated as long-term capital loss if: (i) on the date the taxpayer entered into the loss position, the taxpayer held directly or indirectly (through a related person or flowthrough entity) one or more offsetting positions with respect to the loss position; and (ii) all gain or loss with respect to one or more positions in the straddle would be treated as long-term capital gain or loss if such positions were disposed of on the day the taxpayer entered into the loss position.

In the present situation, as concluded above, a Right is a cash settlement put option, which is treated as an "option to buy or sell property" under section 1234(c)(2) of the Code. Therefore, a Right is an option within the meaning of section 1092(d)(3)(B)(i)(I). Because a Right serves to diminish substantially a stockholder's risk of loss from a decline in value of the X common stock, the Unit is a straddle as defined in section 1092(c)(1). A taxpayer is a holder of a straddle during the period the taxpayer holds both a Right and a share of X stock, regardless whether they were acquired as a Unit or separately.

For purposes of the following analysis, it is assumed that Rights or shares of X common stock are capital assets in the hands of the holder thereof, that the holder is not a dealer, and that no other positions offsetting to either the Rights or shares of X common stock are held by the holder thereof or by a related person to the holder within the meaning of section 1092(d)(4)(B) of the Code.

SALE OF A RIGHT

If a purchaser of a Unit sells the Right prior to the Payment Date, any gain or loss realized is a short-term capital gain or loss. Section 1.1092(b)-2T(a)(l) of the temporary regulations. Pursuant to section 1092(a) of the Code, if a loss is realized on the sale of the Right, recognition of the loss generally is deferred until the share of stock is sold. If, however, the loss from sale of a Right exceeds the unrecognized gain with respect to the stock, the loss can be recognized currently to the extent of the excess. The deferred loss can be carried forward to a succeeding taxable year subject to the rule set forth in section 1092(a)(1)(B). Under section 1.1092(b)- 2T(a)(l), the holding period for the stock begins on the date the Right is sold.

If a taxpayer acquires only a Right and, at the time of the acquisition of the Right, the taxpayer has held a share of X common stock for less than the long-term capital gains holding period, or if the taxpayer acquires only a Right and then acquires a share of X common stock during a period less than the long-term capital gains holding period after the acquisition of the Right, the tax consequences to the taxpayer on the sale of the Right are the same as the tax consequences with respect to a taxpayer that purchased the Right, and the share of X common stock as a Unit.

If, at the time of the acquisition of the Right, a taxpayer has held a share of X common stock for the long-term capital gains holding period (or longer), any loss on the sale of the Right is a long-term capital loss. Section 1.1092(b)-2T(b)(1) of the temporary regulations. However, any gain on the sale of a Right under these circumstances is short-term capital gain. Section 1. 1092(b)- 2T(a)(1).

If, at the time of acquisition of a share of X common stock, a taxpayer has held a Right for the long-term capital gains holding period (or longer), the holding period for the Right begins on the date it was originally acquired, and any gain or loss on a sale of the Right is a long-term capital gain or loss. Section 1.1092(b)- 2T(a)(2).

LAPSE OF A RIGHT

If the value of the X common stock as of the Payment Date is $10.90 or more, a taxpayer holding a Right receives a Payment of $0.10 from X. The return of this de minimis amount in all events does not detract from the fact that, in substance, the Right has lapsed. The taxpayer's loss equals the amount paid for the Right less the $0.10 paid by X. For example, if the taxpayer acquired the Right on the issuance of the Units, the taxpayer's loss is $1.90 ($2.00 - $0.10). The characterization of the loss as short or long term and the timing of the recognition of the loss is the same in the case of a lapse of a Right as in the case of its sale, as discussed above. Section 1234A of the Code.

RECEIPT OF PAYMENT ON THE PAYMENT DATE

If a taxpayer holds a Right on the Payment Date and receives a Payment of more than $0.10, the taxpayer is treated as having exercised a cash settlement put option. As discussed above, exercise of a cash settlement option is treated as a sale or exchange of the option. Accordingly, the taxpayer realizes capital gain or loss in an amount equal to the difference between the amount of the Payment and the premium paid for the Right. The characterization of the gain or loss as short or long term and the timing of the recognition of the loss is the same in the case of a Payment as in the case of the sale of a Right, as discussed above.

If the Payment is made in X stock, the amount of the Payment is the fair market value of the stock. The taxpayer's basis in the X, stock equals the fair market value of that stock. Section 1012 of the Code. The holding period for the X stock begins on the day after the Payment Date. Rev. Rul. 70-598, 1970-2 C.B. 168.

SALE OF STOCK

If a taxpayer owns a Right and a share of X common stock, and sells the share of X common stock while retaining the Right, the characterization of the gain or loss as short or long term and the timing of the recognition of the loss on the sale of the share of X common stock is determined under the same principles that apply to the sale of a Right, as discussed above.

TAXPAYER ACQUIRES ONLY A RIGHT

If the taxpayer acquires only a Right and either sells the Right or receives a Payment on the Payment Date, section 1092 of the Code and the regulations thereunder do not apply to the sale, lapse, or exercise of the Right. Accordingly, any gain or loss realized by the taxpayer on the sale, lapse, or exercise of a Right is recognized as a short- or long-term capital gain or loss, depending on the holding period for the Right. Section 1222.

3. TAX CONSEQUENCES TO THE ISSUER

If the writer of a put is also the issuer of the stock that is subject to the put, the rules applicable to a writer of a put apply, unless specific rules applying to transactions in which a corporation deals in its own stock override the rules applicable to the writer of a put.

Rev. Rul. 78-182 holds that the premium received for writing a put is not included in income at the time of receipt. Instead, it is carried in a deferred account until the writer's obligation expires through the passage of time, until the writer purchases the underlying stock pursuant to the exercise of the put, or until the writer engages in a closing transaction.

Section 1234(b)(1) of the Code provides that, in the case of a writer of an option in "property" as defined in section 1234(b)(2)(B), gain or loss from any closing transaction with respect to, and gain on lapse of, the option in property shall generally be treated as a gain or loss from the sale or exchange of a capital asset held for less than the long-term capital gains holding period. A closing transaction is defined in section 1234(b)(2)(A) as any termination of the taxpayer's obligation under an option in property other than through the exercise or lapse of the option. As discussed above, if a cash settlement option is in fact settled in cash, the transaction is treated as a sale or exchange of the option. Thus, for purposes of section 1234(b)(2)(A), cash settlement is treated as a closing transaction.

Section 1032(a) of the Code provides that no gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. Section 1032(a) further provides that no gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option to buy or sell its stock (including treasury stock).

In the present situation, the writer of the Rights, which are cash settlement put options, is also the issuer of the stock that is the subject of the Rights. Section 1032(a) of the Code provides specific rules governing the tax consequences to an issuer on the lapse or acquisition of an option to buy or sell its stock. Since cash settlement of an option is treated as a sale or exchange of the option, transfer of Payment upon maturity of the Rights is treated as an acquisition of a put option with respect to the issuer's stock. Therefore, pursuant to section 1032(a), X recognizes no gain or loss on repurchase of the Rights (including transfer of Payment) or on their lapse (for example, a payment of $0.10). X also does not recognize a gain if it makes the Payments by issuing its own stock to a holder. See Rev. Rul. 62-217, 1962-2 C.B. 59.

Because, as discussed above, X recognizes no gain or loss on the repurchase of the Rights, or on Payment, X also recognizes no gain or loss on the issuance of the Rights, and X does not have to establish a deferred account for the proceeds from the issuance of the Rights.

HOLDINGS

1. A Unit issued by X is comprised of two separate items of property, a share of X common stock and a Right. A purchaser of a Unit has a basis in the common stock of $8 and a basis in the Right of $2. For federal income tax purposes, a Right is a cash settlement put option.

2. Because a Right substantially diminishes a stockholder's risk of loss from a decline in value of the X common stock and a Right constitutes an option within the meaning of section 1092(d)(3)(B)(i)(I) of the Code, a Unit is a straddle as defined in section 1092(c)(1). A taxpayer is a holder of a straddle during the period the taxpayer holds both a Right and a Share of X common stock, regardless whether they were acquired as a Unit or separately.

The characterization of any gain or loss as short or long term and the timing of the recognition of any loss is governed by section 1092(a) of the Code and the temporary regulations under section 1092(b) in the following situations: The taxpayer is a holder of a straddle consisting of a Right and a share of X common stock and (a) the taxpayer sells the Right or the share of X common stock prior to the Payment Date, (b) the Right lapses (that is, there is a Payment of $0.10), or (c) the taxpayer receives a Payment of more than $0.10 on the Payment Date.

If the taxpayer acquires only a Right and then either sells the Right or receives a Payment on the Payment Date, section 1092 of the Code and the regulations thereunder do not apply. Accordingly, any gain or loss recognized by the taxpayer on the sale of the Right or on the lapse of or on the exercise of the Right is a short- or long- term capital gain or loss, depending on the holding period for the Right.

3. X recognizes no gain or loss on the issuance of the Units, on repurchase of the Rights (including transfer of Payment), or on lapse of the Rights.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Nelson F. Crouch of the Corporation Tax Division and Jonathan Kushner of the Interpretative Division. For further information regarding this revenue ruling contact Mr. Crouch on (202) 566-3501 (not a toll-free call).