Rev. Rul. 74-266

Advice has been requested as to the effect on earnings and profits of a corporation where preferred stock issued at par is redeemed for an amount in excess of par value plus dividends in arrears.

A corporation has outstanding two classes of stock, common and 7 percent preferred. The preferred shares have preference as to payment of dividends from the corporation's earnings and profits at a stated rate and no more. The preferred stock was issued at par and is redeemable at 105 percent of par value. During the year the corporation redeemed a portion of its preferred stock at 105 percent of par value plus dividends in arrears. The corporation incurred certain expenses in connection with the redemption.

Section 312(a) of the Internal Revenue Code of 1954 provides that as a general rule on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation are decreased by the sum of (1) the amount of money, (2) the principal amount of the obligations of the corporation, and (3) the adjusted basis of other property, so distributed. Section 316(a) provides, in general, that every distribution made by a corporation is made out of earnings and profits to the extent thereof. Section 312(e) provides for an exception to these general rules in the case of a redemption to which section 302(a) applies. Under section 312(e) the part of the distribution which is properly chargeable to capital account is not treated as a distribution of earnings and profits. The term capital account as used in this section is not defined in the Code or regulations.

Upon the redemption of common stock the proper charge to capital account includes the stock's allocable share of the capital paid in for the stock and its pro-rata share of other attributes including unrealized appreciation surplus of the corporation. The proper charge to earnings and profits is the redeemed stock's pro-rata share of the total earnings and profits of the corporation. See Rev. Rul. 70-531, 1970-2 C.B. 76.

The position expressed in Rev. Rul. 70-531 is equally applicable to a redemption of preferred stock. In the instant case, the pro rata portion of the total earnings and profits attributable to the preferred stock redeemed is the amount of dividends in arrears, which was paid at the time of redemption, and, thus, only such amount is chargeable to earnings and profits.

In addition, in United Nat. Corporation v. Commissioner, 143 F. 2d 580 (9th Cir. 1944), the United States Court of Appeals for the Ninth Circuit held that where outstanding preferred stock was redeemed for less than its subscription price the amount of such difference did not have an effect upon earnings and profits which could be subsequently distributed to shareholders as dividends. The redemption was viewed by the Court as a readjustment of the capital structure of the corporation. The excess of the issuance price over the redemption price was part of the capital that had been originally paid in for the preferred stock. Such excess never ceased to be capital even though there was no corresponding stock outstanding after the redemption.

Therefore, applying the court's rationale to the instant case, where the redemption price exceeds the subscription price of the redeemed stock, such excess (premium) is treated as a decrease in capital and does not affect the corporation's earnings and profits.

Further, the expenses incurred in connection with the redemption are also properly chargeable to capital. See Rev. Rul. 67-125, 1967-1 C.B. 31, and Rev. Rul. 69-561, 1969-2 C.B. 25, which hold that the expenses attributable to a redemption are capital in nature and not deductible as ordinary and necessary business expenses. Such expenses have, therefore, no effect upon earnings and profits.

Accordingly, it is held that in computing earnings and profits available for payment of dividends: (1) the dividends in arrears paid at the time of redemption are chargeable to earnings and profits; and (2) no part of the cost of redemption of 105 percent of the par value plus the expenses incurred in connection with the redemption is chargeable to earnings and profits. In addition, under section 312(e) of the Code the cost of redemption of 105 percent of the par value plus the expense incurred in connection with the redemption is properly chargeable to capital account as that account is defined in Rev. Rul. 70-531.