How is the 80-percent similar-ownership test measured when a corporation has preferred stock, common stock, and options?

Plain-English summary

RST had invested $13 million in IJK during 1984 and received 1.5 million Series A preferred shares and 500,000 Series B preferred shares. Other investors owned 306,000 common shares, with outstanding options to buy another 19,000 common shares. IJK planned to dissolve and transfer every asset to RST for debt owed to RST; RST would also make a guaranteed payment to IJK's common stockholders.

Tax Counsel David H. Levine said raw share counts could not establish substantially similar ownership when multiple types of ownership interests required relative valuation. Every person holding an ownership interest, including preferred and common stockholders, had to be included.

RST would satisfy Regulation 1595(b)(2) only if it owned at least 80 percent of IJK's total value. The source supplies no relative values, so no definitive answer could be made; an audit of IJK's actual books might be necessary.

Levine separately said RST's later contribution of the assets to a newly formed joint venture would not be taxable under Regulation 1595(b)(4), assuming RST received only a venture interest, with no liability assumption or other consideration. Neither proposed transfer is shown to have occurred.

Two proposed transfers, unresolved valuation, conditional second answer, and missing record

Levine responded on August 30, 1988 to a redacted representative's August 12 letter about asset transfers between partially related entities. The request and relationship records are absent.

For the first transfer, RST's $13 million 1984 investment produced 2 million preferred shares across Series A and B. Other investors held 306,000 common shares, and options existed for 19,000 additional common shares. The source gives no issue price or date beyond 1984; liquidation, dividend, voting, conversion, redemption, or priority rights; option holders, price, vesting, exercise, or dilution treatment; capital table; fair market value; appraisal; or books.

IJK would dissolve and transfer all assets to RST in exchange for debt IJK owed RST. RST would also pay IJK's common stockholders a guaranteed payment for their stock. The letter gives no asset list or value, debt instrument or amount, guarantor, guarantee terms or amount, payment allocation, dissolution document, creditor record, or agreement.

Levine explained that one stock class permits a straightforward share percentage. With two or more types of ownership interests, however, all persons and interests must be included and compared by their relative values. RST needed 80 percent of IJK's total value after the transfer, not merely a large preferred-share count. The letter does not separately decide whether or how the unexercised options enter value.

Because the respective stock values were not provided, staff did not give a definitive answer. Levine said determining relative preferred and common values might require an audit of IJK's actual books. The source supplies no later values, audit, finding, or exemption result.

The second question concerned RST's contribution of the received assets to a newly formed joint venture. The request said RST would receive a venture interest and no liability would be assumed. Assuming RST received no other consideration, Levine concluded sales tax would not apply under Regulation 1595(b)(4). The source gives no venture parties, ownership percentage, formation agreement, contributed asset list or value, debt search, capital account, other consideration, transfer, return, or later tax treatment.

The live annotation preserves the $13 million investment, preferred and common share counts, 19,000 options, planned dissolution, asset transfer for debt, guaranteed common-stockholder payment, later venture contribution, Regulation 1595(b)(2), all-owner valuation rule, missing stock values, lack of a definitive answer, possible books audit, 80-percent-total-value condition, and August 30, 1988 date. It omits the August 12 request; every missing valuation input and record; unresolved option treatment; the entire second question's no-liability and no-other-consideration assumptions; Regulation 1595(b)(4); conditional nontax conclusion; and absent completion or outcome.

What this means for you

Companies with multiple equity classes

Under this letter, a large preferred-share count did not itself establish an 80-percent value interest when preferred and common economic rights were unvalued.

Accountants and tax professionals

Document every holder and class, stock rights, options, appraisals, debt and guarantees, and reconcile those inputs to the actual books before applying a value-based ownership test.

Common questions

Q: Could the preferred shares alone determine the ownership percentage?
A: No. All persons and classes holding ownership interests had to be included.

Q: Was the test based on number of shares?
A: No. It was based on at least 80 percent of total corporate value.

Q: Why might an audit be necessary?
A: No relative stock values were supplied, and the actual books might be needed to determine them.

Q: Was the later joint-venture contribution taxable?
A: Not under the stated assumption that the transferor received only the new venture interest and no other consideration.

Q: Did staff decide whether RST met the 80-percent test?

A: No. It stated the total-value test but could not give a definitive answer without relative stock values.

Q: Did the letter explain how to value the outstanding options?

A: No. It identifies options for 19,000 common shares but does not state whether or how they enter the value calculation.

Q: What debt and guaranteed payment did RST provide?

A: The source says IJK owed debt to RST and common stockholders had a guaranteed payment, but gives no instruments, parties, terms, amounts, or allocations.

Q: Did the dissolution or either asset transfer occur?

A: The source does not establish that. It supplies prospective advice with no completed transaction, tax, audit result, payment, appeal, or outcome.

Citations and references

• California Sales and Use Tax Regulation 1595(b)(2) and (b)(4)
• August 12, 1988 request — identified but not included
• Corporate, shareholder, preferred and common rights, options, capitalization, appraisal, books, asset, dissolution, debt, guarantee, payment, venture, transfer, return, tax, audit, assessment, payment, appeal, and outcome records — described or implicated but not included

Verbatim support

From the official August 30, 1988 David H. Levine letter:

However, all persons holding an ownership interest in a corporation, including both preferred and common stockholders, must be included in calculating ownership interests when there are two or more types of ownership interests that must be compared to determine their relative values.

Ownership will be substantially similar after the transfer only if the transferee owns 80 percent of the total value of the corporation, and this calculation may require an audit of the actual books of the corporation.

You state that the transfer will be in exchange for an interest in the newly formed joint venture with no assumption of liability. Assuming there is no other consideration received by RST for the transfer, sales tax will not apply to the transaction.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Live annotation: Annotation 395.1575
• Original supporting opinion: 395.1575 PDF

Original ruling text

395.1575

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION
1020 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)
(916) 445-5550

August 30, 1988

Mr. L--- E. J--XXXX --- --- Drive
--- ---, CA XXXXX

Dear Mr. J---:

This is in response to your letter dated August 12, 1988 regarding the application of sales tax to transfers of assets between partially related entities. The first transaction involves a transfer of assets from IJK to RST. In 1984, RST invested $13 million in IJK and received 1,500,000 shares of Preferred Series A and 500,000 shares of Preferred Series B stock. Other investors own 306,000 of common stock of IJK with outstanding options to purchase 19,000 shares of common stock. IJK will be dissolved and all its assets will be transferred to RST in exchange for debt owed to RST. RST will also pay the common stockholders of IJK the payment which they have been guaranteed for their stock. RST will then contribute the assets of IJK to a joint venture. You ask whether the transfer of assets from IJK to RST satisfies the 80 percent rule of Regulation 1595(b)(2) for substantially similar ownership. When all ownership interests in a corporation are represented by one type of stock, it is easy to determine whether the 80 percent rule is satisfied: if the transferee owns at least 80 percent of that stock, the ownership will be substantially similar after the transfer. However, all persons holding an ownership interest in a corporation, including both preferred and common stockholders, must be included in calculating ownership interests when there are two or more types of ownership interests that must be compared to determine their relative values. Ownership will be substantially similar after the transfer only if the transferee owns 80 percent of the total value of the corporation, and this calculation may require an audit of the actual books of the corporation.

Mr. L--- E. J---

-2-

August 30, 1988
395.1575

You also ask whether RST’s transfer of assets to the newly formed joint venture will be subject to sales tax. You state that the transfer will be in exchange for an interest in the newly formed joint venture with no assumption of liability. Assuming there is no other consideration received by RST for the transfer, sales tax will not apply to the transaction. (Reg. 1595(b)(4).) If you have further questions, feel free to write again. Sincerely,

David H. Levine
Tax Counsel

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--- --- – District Administrator