Understanding Code Sec. 302 F - CCH

1 Issue 7 Fall 2003 code Sec. 3021 Depositary Receipts2E-mail Notice4 Inside this issueUnderstanding code Sec. 302 From time to time a tax opinion on a corporateaction includes those mysterious words, subject to the tests of code Sec. 302. Whatdoes it mean? What should you do? This articlewill answer these questions and maybe a few moreyou never even thought for redemptionCode Sec. 302 only applies when a corporationredeems its stock. In this context a redemptionoccurs when a company acquires some or all of itsstock from shareholders in exchange for does not matter whether the company calls theacquisition of its stock a redemption. In fact, 302may apply to a corporate action, like a merger,reverse split or spin-off, that does not appear atfirst glance to involve a redemption, but forpurposes of the code it is still a redemption. See, , Granite State Bankshares, CCH CAPITAL CHANGESREP. (2-28-2003); Jefferson Smurfit Group PLC , CCHADR/GLOBAL CAPITAL CHANGES REP.

2 (9-3-2002).Whether or not a corporate action is called aredemption, the common thread in any 302 situationis that the shareholder gives up some or all of itsstock in a company and receives something in return,whether cash or some other property. So what happenswhen there is a corporate action, like a merger, whereshareholders give up their stock and receive somethingin return? What s all this about a test?A test of characterThe first thing to remember about the receipt ofproperty under 302 is that it is taxable. The purposeof the test is to determine if the property receivedin consideration for the redeemed security is treatedas a dividend or as a capital gain or s take a closer look at the first transaction citedabove. In Granite State Bankshares the companymerged into Chittenden Corp. and shareholderscould elect to receive either stock, cash or acombination of stock and cash. If a shareholderreceived solely stock in the exchange, it would benontaxable and 302 would not apply.

3 If, instead,the shareholder only received cash in the exchange,it would be taxable, subject to the tests of 302. Inother words, the cash received would be treated asa dividend or as capital gain or loss, but either wayit would be taxable. The third scenario was a littletrickier. Receipt of both stock and cash resulted inno loss recognized, but gain could be recognizedto the extent of the cash received or the total gainrealized, whichever was less. Under 302, the gainrecognized would be treated as a capital gain if itpassed any one of the following we graded on a curve?Pop quiz What does a redemption have to do toget a drink around here .. sorry, to be treated as asale? The short answer is: if it looks like a sale orexchange, it qualifies for capital gains treatment;otherwise, it gets taxed as a dividend. There are fourtests under code Sec. 302 to determine if aredemption looks sufficiently like a sale to get capitalgains treatment.

4 If it passes any one of them .. Not essentially equivalent to a dividendThe first test is that the redemption must not beessentially equivalent to a dividend. It soundsfairly straightforward, but in practice this rule hasproduced uncertain results and has been givenlimited , onlymeaningfulredemptions aredeemed to meet thistest; redemptionsthat result in asubstantial reductionof the shareholder sparticipation in on page 32 2003 CCH INCORPORATEDD epositary Receiptsdifferent amounts depending onhow much each depositary realizeson the sale. See, , Western AreasLtd., CCH ADR/GLOBAL CAPITALCHANGES REPORTER (1-16-2003).In a sponsored program, thecompany chooses the depositary,and their relationship is governedby a depositary agreement. Thisgives the company some controlover the terms of the depositaryprogram. It also allows the companyto raise capital and choose how theDR s are traded, depending on thelevel of the different levelsLevel one sponsored DR s are themost basic DR s available tocompanies that do not want toraise capital and do not want toor cannot list on an one DR s are traded on theOver-the-Counter (OTC) type of program does notrequire full SEC registration.

5 AnF-6 registration statement isenough to establish the forward, level onecompanies are exempt from regularSEC reporting requirements underRule 12g3-2(b). This exemptiononly requires the company toprovide summaries of documentsmade public or provided toshareholders or exchanges in itshome market. Level one programsdo not have to report accountsunder Generally AcceptedAccounting Principles (GAAP).Level two sponsored DR s aretraded on securities exchanges(NYSE or AMEX) or quoted onNASDAQ. This gives the programmore visibility and generally, moreactive trading. Full SECregistration is required to establishthe program. The companyCCH provides corporateaction information fordepositary receipts (DR s)representing companies all overthe world. This is the first in aseries that takes a closer look atDR s and how they basicsA DR is a negotiable instrument,issued by a bank acting as thedepositary, representing a specificnumber of underlying shares in acompany.

6 The company is usuallyincorporated in a country otherthan where the DR is traded. Theunderlying shares are technicallyowned by the depositary, but DRholders have a beneficial interestin them. As a result, DR holdershave virtually the same corporateand economic rights as thecompany s shareholders, withsome important exceptions thatwill be covered the United States, the mostcommon form of DR is theAmerican Depositary Receipt(ADR), which is how the stock ofmany international companies aretraded here. The primary benefit ofADR s is that they make it easy investors to purchase and holdsecurities of s trade in dollars, paydividends in dollars and settlethrough clearing houses,allowing investors to avoid costlycurrency s can be sponsored orunsponsored. Unsponsored DR sare created and offered toinvestors by one or moredepositaries without anyinvolvement by the companyissuing the underlying shares. Oneconsequence of this is whendistributing proceeds to investorsdifferent depositaries may pay outManaging EditorDenise Davidson, Ryndak, EditorsJeanne Waters, , Sabatini, Capital Changes Reporter has beenproviding continuous coverage of corporateactions affecting publicly traded companiessince 1928, with a historical database thatspans over 100 years.

7 Today, CCH offersdaily, weekly, and monthly reporting and foreign issuers, in a variety offormats, including Internet, Lotus Notes ,and Direct Data welcomes articles submitted byoutside authors for possible publicationin CAP EXCHANGE. Manuscripts andinquiries should be directed to the Editor,CAP EXCHANGE, CCH INCORPORATED,A WoltersKluwer Company, 2700 LakeCook Rd, Riverwoods, IL the bestJohn Q. Public: Gee, why don tyou cover every corporate action? CCH: Oh, that s because we justcover the very best securities. Weonly report on securities that areoutstanding! On the lighter sideDo CCH editors have too muchtime on their hands? For the grislydetails check out the latest corpo-rate action for Transylvania BloodBanks International (10-31-2003).Visit our boothCorporate Actions Processing ConferenceBayards at Hanover Square, New York CityNovember 19, 2003 The International Traders Expo -Booth 515 Bally s Hotel, Las VegasNovember 21-23, 2003 Continued on page 432.

8 Complete terminationThe next test is that the interestof the shareholder in the securitybeing redeemed must becompletely terminated. This oneis a lot easier to apply. Theshareholder must not haveanything left of the old way a shareholder could runafoul of this test is under the rulesof constructive ownership, aswhen a shareholder divests hisdirect interest in a company butkeeps an indirect interest througha spouse or child. Also, a divestingshareholder must be careful notto reacquire an interest in thatcompany for ten test can also cause problemswhen a company offers to buyback a limited number of individual shareholder maytender all of his shares, but if theoffer is oversubscribed, thecompany may prorate the sharesit accepts, leaving the shareholderwith a portion of his holding. AMN Healthcare Services, Inc.,CCH CAPITAL CHANGES REP. (10-8-2003); Descartes Systems Group Inc.(The), CCH ADR/GLOBAL CAPITALCHANGES REP. (7-11-2003).

9 By thesame token, a shareholder mightchoose to tender only a portionof his holdings and the resultwould be the same there wouldnot be a complete termination Substantially disproportionateEven if there is no completetermination of interest, if ashareholder has a substantiallydisproportionate amount of hisshares redeemed, the redemptionmay qualify for capital gainstreatment. This test might helpthe shareholder whose shares wereprorated in the previousparagraph. Unfortunately, thecriteria for meeting this test arefairly complicated and involveratio comparisons of votingpower, voting stock and commonstock before and after problem that might ariseunder this test is when a companyredeems only one class of Apartment Investment andManagement Co. CCH CAPITALCHANGES REP. (4-18-2002), forexample, the company redeemedits 8% class K convertiblepreferred in exchange for its classA common. Shareholders whoheld class A common before theredemption could fail this testsince the ratio of common stockowned after the redemptionwould probably Partial liquidationThe final test focuses on the effectof the redemption on thecompany.

10 If the companyliquidates part of its business anddistributes the proceeds to itsshareholders, the redemption istreated as a sale. See, , PLMI nternational, Inc., CCH CAPITALCHANGES REP. (11-3-2000).However, the distribution mustnot be essentially equivalent to adividend and it must be pursuantto a plan and occur within thetaxable year that the plan wasadopted or within the followingyear. Although there are othercriteria the company must meet,the key is that there should be agenuine contraction of thecompany s business and acorresponding reduction in thecapital you flunk?Sure, but what s so bad? Generally,if property received in aredemption does not qualify forsale treatment under any of thefour rules discussed above, it istreated as a dividend distributionthat is taxed as ordinary incometo the extent of the company scurrent and accumulated earningsand profits, with any excess treatedas return of capital in reductionof basis (but not below zero) andthen as capital good news is that, forindividuals receiving dividendsfrom 2003 through 2008,dividends may be taxed at capitalgains rates if the shareholder heldthe stock for at least 60 days.