Rev. Rul. 75-320

Advice has been requested concerning the treatment of distributions made under the circumstances described below.

A corporation had preferred stock outstanding which was entitled, in accordance with its terms, to receive dividends when and as declared by the board of directors. The preferred stock dividends were cumulative and payable quarterly and were to be "declared and paid, or set apart for payment," before any dividend on the common stock was to be declared and paid, or set apart for payment. The preferred stock was redeemable at the option of the corporation at any time at $150 per share plus an amount equal to unpaid dividends on the stock accrued to the date fixed for redemption.

For several years dividends were paid on both common and preferred stock without violating the terms of the preferred stock. In January, 1973, the board of directors desired to pay a dividend and also contemplated a redemption of the preferred stock. At a meeting on January 28, 1973, the board of directors resolved that funds to pay a quarterly dividend on April 1, 1973, of $5 per share on the preferred stock be set apart on the books of the corporation, and that a quarterly dividend of $2 per share be declared on the common stock, payable on March 10, 1973, to shareholders of record on February 10, 1973. In contemplation of the redemption of the preferred stock and in order to avoid incurring a legal obligation to pay dividends on the preferred stock, no dividend was declared on such stock.

The dividend of $2 per share on the common stock was paid by the corporation on March 10, 1973. No dividend was declared and paid on the preferred stock. On March 14, 1973, the board of directors, by resolution, decided to redeem the preferred stock on April 30, 1973. The redemption price per share was computed as follows:

$150 Fixed redemption price of the stock 5 Accrued quarterly dividend for the period ending March 31, 1973 1 Accrued dividend for the period April 1, 1973, through April 30, 1973

The preferred stock was redeemed on April 30, 1973, for $156 per share.

Section 301 of the Internal Revenue Code of 1954 provides, in part, that a distribution by a corporation with respect to its stock is taxable as ordinary income to the extent it constitutes a dividend.

Section 302 of the Code provides an exception to the general rule of section 301. It provides that a distribution by a corporation in redemption of its stock will be treated as a payment in exchange for its stock that is not subject to section 301 if the redemption is not essentially equivalent to a dividend within the meaning of section 302(b)(1), is a substantially disproportionate redemption within the meaning of section 302(b)(2), or results in a complete termination of the shareholder's interest within the meaning of section 302(b)(3).

Rev. Rul. 69-130, 1969-1 C.B. 93, holds that an amount representing a dividend declared prior to the call of preferred stock for redemption that is included in the total redemption payment is a dividend distribution within the meaning of section 301 of the Code, and is not part of the amount paid in redemption or cancellation of the stock for purposes of section 302(a).

Rev. Rul. 69-131, 1969-1 C.B. 94, holds, in part, that the entire amount paid in redemption of preferred stock, including a dividend accruing (but not declared) on the date of redemption, is considered payment in exchange for the stock redeemed.

The issue in the instant case is whether the portion of the redemption payment attributable to accrued dividends (that is, $5 and $1) is subject to section 301 of the Code, or to section 302.

The preferred stock agreement in the instant case required that full cumulative dividends on the preferred stock for all previous dividend periods and for the current dividend period must be "declared and paid, or set apart for payment" before the corporation could declare or pay a common stock dividend. Merely setting aside funds for the preferred stock dividends does not satisfy this requirement. The "set apart" language of the agreement clearly modifies only the payment, and does not affect the declaration requirement. Therefore, under the agreement, the corporation could pay a common stock dividend only if it had previously either (1) declared and paid the accrued dividends on the preferred stock, or (2) declared the dividends and set aside funds sufficient to pay them.

To construe the preferred stock provisions as permitting the payment of a common stock dividend when the corporation had merely "set apart" funds sufficient to pay the preferred stock dividend would leave the interests of the preferred shareholders completely without protection since under such an interpretation the corporation could pay regular common stock dividends without ever paying dividends on the preferred stock as long as it "set apart" funds equal to the accrued preferred stock dividend.

Preferred shareholders are entitled to receive accrued dividends when dividends have been paid on the common stock in violation of the corporation's contract to first pay accumulated dividends on preferred shares. See Schaffner v. Standard Boiler & Plate Iron Co., 150 Ohio St. 454, 83 N.E. 2d 192 (1948); and West Chester and Philadelphia R. R. Co. v. Jackson, 77 Pa. 321 (1875).

Thus, the corporation, in violation of the preferred stock terms and contrary to previous practice, delayed the payment of the regular dividend of $5 on the preferred stock. The preferred shareholders did not exercise their legal right to obtain payment of such dividend. However, the redemption payment to which they were entitled would compensate them in an identical amount for such dividend. By comparison, the corporation did not delay the payment of the regular dividend on the common stock for which there would be no later compensating payment.

It is well established that tax consequences must turn upon the economic substance of a transaction and not upon the timing sequences or form of the transaction. See Commissioner v. Court Holding Co., 324 U.S. 331 (1945), Ct. D. 1636, 1945 C.B. 58; Higgins v. Smith, 308 U.S. 473 (1940), Ct. D. 1434, 1940-1 C.B. 127; Gregory v. Helvering, 293 U.S. 465 (1935), Ct. D. 911, 1935-1 C.B. 193; and Waterman Steamship Corp. v. Commissioner, 430 F. 2d 1185 (5th Cir. 1970).

In substance, there were two separate transactions on April 30, 1973. The first transaction was the late payment of a $5 dividend on the preferred stock which the corporation became obligated to pay on March 10, 1973. The second transaction was the redemption of the preferred stock for $151 comprised of the fixed redemption price of $150 plus a $1 accrued but unpaid dividend for a portion of the second quarter of 1973.

Accordingly, the quarterly dividends for the period ended March 31, 1973, are includible in the gross income of the preferred shareholders as a dividend distribution to the extent provided in section 301(c)(1) and section 316 of the Code. The preferred stock dividends accrued for the period April 1, 1973, through April 30, 1973, are considered as part of the amount received in full payment in exchange for the stock surrendered under section 302(a) provided section 302(b)(1), (2), or (3) applies.

See Arie S. Crown, 58 T.C. 825 (1972), aff'd per curiam, 487 F. 2d 1404 (7th Cir. 1973).