Hold Constant Principle approved for a § 382 ownership analysis

Plain-English summary

The IRS ruled that a corporate loss group may use a reasonable method employing the Hold Constant Principle to measure ownership changes under IRC § 382(l)(3)(C). The proposed method accounts for changes in the relative value of different classes of stock separately for each shareholder and adjusts for later issuances and redemptions. The ruling also provides that a value-for-value conversion of specified preferred stock into common stock may be disregarded, with the replacement stock treated as acquired when the exchanged stock was acquired. The method must be used continuously during the applicable consistency period, and the ruling does not decide several separate questions about testing dates, options, or whether the conversion will in fact be value-for-value.

Ruling snapshot

• Question: May the taxpayer use the Hold Constant Principle to measure ownership changes under § 382?
• Outcome: Approved
• Key authorities: IRC §§ 382, 857, 1502, 1504, and 6110; Treas. Reg. §§ 1.1502-91, 1.382-2, and 1.382-4; Notice 2010-50

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201043019 Third Party Communication: None
Release Date: 10/29/2010 Date of Communication: Not Applicable
Index Numbers: 382.00-00, 382.12-00,
382.12-06 Person To Contact:
----------------------, ID -------------
------------------------------ Telephone Number:
--------------------------------------------------------- -------------------
-------------------------------- Refer Reply To:
-------------------------- CC:CORP:04
------------- PLR-113794-10

                                                              Date: July 23, 2010

Legend

Parent = ------------------------------------

Exchange = --------------------------------------------

Company 1 = -----------------------------------------------------------------------

Company 2 = -----------------------------------------------------------------------
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Date 1 = -----------------------

Date 2 = ----------------------

Date 3 = --------------------------

Date 4 = ----------------------

Date 5 = ------------------

Date 6 = --------------------------

Date 7 = -----------------------

Date 8 = --------------------------

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Date 9 = ---------------------------

Date 10 = --------------------------

Date 11 = ------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

Year 5 = -------

A = -------------

B = -----------------

C = ----

D = --------------

E = ----

F = ---------------

G = --------------

H = ---------------

I = --

Dear --------------------:

   We respond to your letter dated March 26, 2010, in which you requested rulings

as to certain federal income tax consequences of the transactions discussed below.
The information submitted in that letter and in later correspondence is summarized
below.

  The rulings contained in this ruling letter are based on facts and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed

PLR-113794-10 3

by an appropriate party. This office has not verified any of the materials submitted in
support of the request for rulings. Verification of the information and other data may be
required as part of the audit process.

                                Summary of the Facts

   Parent is the common parent of an affiliated group of corporations that file a

consolidated Federal income tax return (the “Parent Group,” also referred to as the
“Taxpayer”).

      Parent has authorized A shares of common stock (the “Common Stock”). On

Date 1, Parent issued D shares of its Series C Preferred Stock (the “Preferred C”) for
$E a share and received net proceeds of $F. The Preferred C (i) is entitled to receive
quarterly dividends; (ii) has an initial liquidation preference of $E per share, subject to
increase for accrued but unpaid dividends (the “Preferred C Liquidation Preference”);
(iii) is non-voting, except in the event that the preferred dividends are in arrears for six
or more quarterly periods; and (iv) is not convertible into or exchangeable for any other
property, securities, or stock. Upon redemption, the Preferred C shareholders are
entitled to receive an amount equal to the Preferred C Liquidation Preference. The
Preferred C stock is not redeemable prior to Date 9. On or after Date 9, Parent, at its
option and upon giving the required notice, may redeem the Preferred C, in whole or in
part, for cash equal to the Preferred C Liquidation Preference.

    Parent has been taxable as a Subchapter C corporation since Date 2. Prior to

Date 2, Parent was taxed as a real estate investment trust (“REIT”) under § 857.
However, Parent’s REIT status terminated retroactively to Date 2, at which time it
became taxable as a subchapter C corporation as a result of its failure to meet the REIT
distribution requirement for the tax year ended Date 3. The Parent Group has been a
loss group within the meaning of Treas. Reg. § 1.1502-91(c)(1) since Date 4.

    On Date 5, Parent issued G shares of its Series D Preferred Stock (the

“Preferred D”) to Company 1 and Company 2, for $E a share, receiving net proceeds of
$H. The Preferred D (i) is entitled to receive daily dividends at a rate of I% per annum;
(ii) has an initial liquidation preference of $E per share, subject to increase for accrued
but unpaid dividends (the “Preferred D Liquidation Preference”); (iii) is convertible into
the Common Stock; and (iv) is entitled to vote as one class with the Common Stock on
an as-converted basis. No conversions have occurred with respect to the Preferred D
since its issuance. The Preferred D shareholders are entitled to receive an amount per
share equal to the greater of (a) the Preferred D Liquidation Preference, or (b) the
amount entitled to receive upon its conversion to Common Stock.

  Parent’s only stock-based compensation plan is a Year 1 Incentive Stock Plan,

under which Parent can issue options and stock awards to compensate the Parent
Group’s employees and other service providers. As of Date 8, all options had been

PLR-113794-10 4

granted at exercise prices greater than or equal to the estimated fair value of the
underlying stock at the date of grant. The outstanding options generally vest equally
over four years and expire ten years after the date of grant. In addition, Parent has
granted restricted stock in Year 3 that vests five years after its issuance. Parent did not
grant restricted stock in either Year 4 or Year 5.

   The Common Stock was publicly traded on Exchange through Date 6. However,

the Common Stock was delisted from Exchange on Date 7 due to its declining trading
price. Specifically, on Date 10, Parent had B shares of Common Stock outstanding with
a closing trading price of $C per share.

  As a result of the Preferred D purchase on Date 5 (as previously described), both

Company 1 and Company 2 became 5% shareholders of Parent within the meaning of §
382, and remain as the only two 5% shareholders.

   Parent is contemplating a transaction in which all the outstanding Preferred C

and Preferred D would be exchanged for Common Stock (the “Conversion Transaction”)
based on conversion values negotiated at arm’s-length. It is the intention of all parties
concerned that the Conversion Transaction will result in the holders of the Preferred C
and Preferred D stock exchanging their respective shares for Common stock in a value-
for-value exchange. It is expected that the Conversion Transaction will occur on or after
Date 11, which is at least three years after the issuance of the Preferred D on Date 5.

    Parent requests a ruling that for purposes of factoring out changes in the

proportionate ownership of its stock that are attributable solely to fluctuations in the
relative fair market value of different classes of stock under § 382(l)(3)(C), it be allowed
to apply a reasonable method employing the Hold Constant Principle. Broadly stated,
under the Hold Constant Principle, the value of a share, relative to the value of all other
stock of the corporation, is established on the date that share is acquired by a particular
shareholder. On subsequent testing dates, the percentage interest represented by that
share (the “tested share”) is then determined by factoring out fluctuations in the relative
values of the loss corporation’s share classes that have occurred since the acquisition
date of the tested share. Thus, as applied, the Hold Constant Principle is individualized
for each acquisition of stock by each shareholder. Moreover, the ownership interest
represented by a tested share is adjusted for the dilutive effects of subsequent
issuances and the accretive effects of subsequent redemptions following the tested
share’s acquisition date.

                               Representations

   Taxpayer has submitted the following representations regarding its request:

  1. Parent Group has been a loss group within the meaning of Treas. Reg. §

1.1502-91(c) since Date 4.

PLR-113794-10 5

   2. There have been no classes of Parent stock outstanding that constituted

“stock” within the meaning of § 382(k)(6) and Treas. Reg. § 1.382-2(a)(3) at any time
from Date 4 through the date of issuance of this ruling letter, other than the following:
the Common Stock and the Preferred D.

  3. The Preferred C satisfies all the requirements under § 1504(a)(4) and thus has

not been treated as stock for purposes of the ownership shift computation of § 382.

   4. Other than the shares of the Preferred D class issued on Date 5, Parent did

not issue any additional shares of the Preferred D class or any rights to acquire shares
of the Preferred D class.

   5. Parent did not issue, nor did any Parent Group member issue, any contingent

purchase, warrant, convertible debt, put, stock subject to a risk of forfeiture, contract to
acquire stock, or option with a principal purpose of avoiding or ameliorating the impact
of an ownership change.

   6. To the best of Parent’s knowledge, the amount of tax liability on any of

Parent’s federal income tax returns filed to date would not be affected by whether or not
Parent takes into account the effect of fluctuations in the relative values of different
classes of stock for purposes of determining owner shifts and ownership changes under
§ 382.

    7. For purposes of identifying its direct shareholders or indirect owners who are

5% shareholders through reliance on the existence or absence of SEC filings under
Temp. Treas. Reg. § 1.382-2T(k)(1)(i), Parent, to the best of its knowledge, has located
all relevant SEC filings from Date 4 through Date 10.

  8. The conversion terms in connection with the Conversion Transaction have

been or will be negotiated in an arm’s-length transaction.

   9. The Conversion Transaction will be undertaken as a value-for-value exchange

of the Preferred C and Preferred D for Common Stock.

                                Rulings

Based solely on the information submitted and representations made, we rule as

follows:

    (1) For purposes of factoring out changes in the proportionate ownership of

Parent’s stock that are attributable solely to fluctuations in the relative fair market value
of different classes of stock under § 382(l)(3)(C), Parent may apply a reasonable
method employing the Hold Constant Principle to determine the increase in percentage

PLR-113794-10 6

ownership of each of its 5% shareholders on each of its testing dates since Date 5 (and
to identify which such testing dates are change dates for purposes of § 382), provided
that Parent continuously employs such method in the applicable “consistency period” as
defined in Notice 2010-50.

   (2) In applying the Hold Constant Principle, a value-for-value conversion of the

Preferred D into Common Stock shall be disregarded, and the exchanging shareholder
shall be considered to have acquired such newly issued stock as of the date it acquired
the stock exchanged therefore. The stock received in the exchange will also retain the
same hold-constant characteristics as the surrendered shares (see Notice 2010-50).

                                  Caveats

    Except as expressly provided herein, no opinion is expressed or implied about

the federal income tax consequences of any aspect of any transaction or item
discussed or referenced in this ruling letter. Specifically, no opinion is expressed as to
whether: (i) any warrants or options should have been treated as exercised under
Treas. Reg. § 1.382-4(d), (ii) Parent had a testing date on any given date, and (iii) any
exchange of stock pursuant to the Conversion Transaction will represent a value-for-
value exchange. Furthermore, no opinion is expressed as to whether the Preferred C
constitutes stock within the meaning of § 1504(a)(4). One or more rulings covered in
this ruling letter deal with issues that may be addressed in subsequent published
guidance. See section 11 of Rev. Proc. 2010-1, 2010-1 I.R.B. 1, 47-51, regarding the
circumstances, including published guidance, which may result in the revocation or
modification of a ruling letter.

                                Procedural Matters

  This ruling letter is directed only to the taxpayer who requested it.         Section

6110(k)(3) provides that it may not be used or cited as precedent.

   A copy of this letter must be attached to any federal income tax return to which it

is relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of this letter.

PLR-113794-10 7

   In accordance with the power of attorney on file in this office, a copy of this letter

is being sent to your authorized representative.

                                   Sincerely,



                                   ______________________________
                                   Marie C. Milnes-Vasquez
                                   Senior Technician Reviewer, Branch 4
                                   Associate Chief Counsel (Corporate)