IRS rules non-voting preferred stock in a buyout vehicle is "plain vanilla" preferred that does not break affiliation under Section 1504(a)(4)

Plain-English summary

A corporate parent that files a consolidated tax return set up a new subsidiary to buy a public company in an all-cash merger. To fund the deal, the subsidiary took on debt and also raised equity from an outside investor, part of it in the form of non-voting preferred stock. The parent wanted certainty that this preferred stock is "plain vanilla" preferred that the tax law ignores when testing whether the parent owns enough of the subsidiary to consolidate it. Under Section 1504(a)(4), preferred stock is disregarded for the 80% affiliation test only if, among other things, it does not participate in corporate growth to any significant extent and does not carry an unreasonable redemption premium. The IRS ruled in the parent's favor on both points: the fixed dividends on the non-voting preferred (including a bump-up rate if dividends are late) do not make it participate in corporate growth under Section 1504(a)(4)(B), and the excess of the stock's stated redemption amount over its purchase price is not an unreasonable redemption premium under Section 1504(a)(4)(C). Because the preferred is disregarded, the parent's ownership of the subsidiary's common stock can satisfy the affiliation requirement so the subsidiary can join the parent's consolidated group.

Ruling snapshot

• Question: Does the non-voting preferred stock qualify as stock described in Section 1504(a)(4) (so it is ignored for the affiliation test), given its dividend terms and redemption premium?
• Outcome: Approved (dividends do not participate in corporate growth under § 1504(a)(4)(B); no unreasonable redemption premium under § 1504(a)(4)(C))
• Key authorities: IRC § 1504(a)(2), (a)(4); § 305(c); Treas. Reg. § 1.305-5(b)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202211008 Third Party Communication: None
Release Date: 3/18/2022 Date of Communication: Not Applicable
Index Number: 1504.00-00
Person To Contact:
-------------------------------------------------- ------------------------, ID No. -----------------
-------------------------------------------- Telephone Number:
--------------------- --------------------
---------------------------------- Refer Reply To:
CC:CORP:3
PLR-117021-21
Date:
December 21, 2021

Legend

Parent = ------------------------------------------------------------------------------------------------
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Sub = ------------------------------------------------------------------------------------------------
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Investor = ----------------------------------------------

Target = ------------------------------------------------------------------------------------------------
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a = ----------------

b = ----------------

c = ----------------

d = --------------

e = ----------------

f = --------------

g = ----------------

h = ----------------

i = --------------

j = --------------
k = --------------

l = -------------

m = ---------------------------------------------------------------------------------

n = ---------------------------------------------------------------------------------

o = --

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

This letter responds to your authorize representative’s letter dated July 30, 2021,
requesting rulings under section 1504 of the Internal Revenue Code. The information
provided in that letter and in later correspondence is summarized below.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalties of perjury statement
executed by an appropriate party. This office has not verified any of the material
submitted in support of the request for rulings, but such material is subject to verification
on examination.

                                               Facts

Parent is the common parent of an affiliated group of corporations (the “Parent Group”)
that joins in the filing of a consolidated U.S. federal income tax return.

Parent has agreed to acquire Target, a public corporation, in an all-cash merger for a
total of $a. To effect this acquisition, Parent has formed Sub, a wholly owned limited
liability company treated as a corporation for U.S. federal income tax purposes. The
following steps are proposed to fund Sub’s acquisition of Target:

    1. Parent will contribute $b to Sub in exchange for Sub’s common shares.

    2. Sub, through a disregarded entity, will issue $c of debt: $d of senior secured term
    loans, $e of senior unsecured notes, and $f of senior secured notes. Of the total
    $c, $g will be used to refinance Target’s existing debt and $h will be used to
    purchase Target’s stock.

    3. Investor (an unrelated party) or its affiliates will contribute $i to Sub in exchange
    for Voting Units and $j to Sub in exchange for Non-Voting Units (described
    further below).

    4. Sub will use its cash to acquire the outstanding shares of Target.

Each Voting Unit in Sub consists of one share of Voting Preferred Stock and one zero-
strike Warrant for the common stock of Sub. Each Non-Voting Unit in Sub consists of
one share of Non-Voting Preferred Stock and one zero-strike Warrant for the common
stock of Sub. Holders of Voting Units or Non-Voting Units may separately dispose of the
shares of preferred stock and the warrants without restriction, and they are not
economically compelled to keep Units unseparated. The Warrants are treated as
common stock for U.S. federal income tax purposes.

Parent’s ownership of Sub’s stock will satisfy the requirements of section 1504(a)(2) if
and only if the Non-Voting Preferred Stock satisfies the requirements of section
1504(a)(4). The Non-Voting Preferred Stock has the following relevant terms:

• Stated Amount: The Non-Voting Preferred Stock has a total stated amount of $j.
(Of the $j purchase price of the Non-Voting Units, $k will be allocated to the Non-
Voting Preferred Stock and $l to the Warrants.)

• Dividend Rate: Dividends accrue at a rate of m% of the stated amount per year,
paid quarterly. If the dividends are not paid on time, they accrue at the higher
rate of n%.

• Voting: The Non-Voting Preferred Stock has no voting rights.

• Term: The Non-Voting Preferred Stock has a perpetual term. It must be
redeemed before Sub is liquidated.

• Sub’s Redemption Rights: Sub may redeem the Non-Voting Preferred Stock at
any time for the stated amount.

• Holder’s Redemption Rights: The holder of the Non-Voting Preferred Stock
cannot compel a redemption, but o years after issuance, the holder can compel
an initial public offering of Sub’s stock or a sale of substantially all of Sub’s
assets.

                                Representations

The taxpayer makes the following representations:

a. Aside from the issues addressed by the rulings below, the Non-Voting Preferred
Stock will satisfy the requirements of section 1504(a)(4).

b. Each of Parent and Sub is an includible corporation within the meaning of section
1504(b).

c. For U.S. federal income tax purposes, the Non-Voting Preferred Stock and the
Warrants are separate instruments.

d. No growth of Target’s business is necessary for Sub to make all payments on its
debts (and those of its disregarded entities) and to pay all dividends on the
Voting and Non-Voting Preferred Stock on time.

e. Under section 305(c) and Treas. Reg. § 1.305-5(b), the excess of the stated
amount of the Non-Voting Preferred Stock over its purchase price will be treated
as constructive distributions over a period of o years.

                                      Rulings

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

1. The dividends payable on the Non-Voting Preferred Stock do not cause it to be
  treated as “participat[ing] in corporate growth to any significant extent” within the
  meaning of section 1504(a)(4)(B).

2. The excess of the stated amount of the Non-Voting Preferred Stock over its
  acquisition price does not constitute an unreasonable redemption premium within
  the meaning of section 1504(a)(4)(C).

                                      Caveat

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

                             Procedural Statements

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any 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 the
letter ruling.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                   Sincerely,

                                   Gerald B. Fleming
                                   Senior Technician Reviewer, Branch 2
                                   Office of Associate Chief Counsel (Corporate)

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