United States: The 7% Solution: Structured Dividend Received Deduction Transactions Face Internal Revenue Service Audit Scrutiny

Last Updated: June 6 2013
Article by Mark H. Leeds

Keywords: Structured dividend, IRS, corporate taxpayers, corporate tax

It appears that a 7% effective tax rate can have addictive properties to corporate taxpayers in much the same way that the 7% cocaine solution had to Sherlock Holmes in Nicholas Meyer's 1974 novel entitled, The Seven Percent Solution. Specifically, Section 243(c)(1) of the Internal Revenue Code of 1986, as amended (the "Code") provides corporate taxpayers who hold at least 20% of the outstanding stock of a US corporation, determined by voting power and value, with a deduction equal to 80% of the amount of dividends received on such stock.1 This deduction, referred to as the dividend received deduction or "DRD," currently lowers the effective tax rate on intercorporate dividends to 7%.2 Recently, the Internal Revenue Service (the "IRS") released three separate pieces of audit guidance in which the IRS challenged the right of corporate taxpayers to claim DRDs in various transactions. In the same way that the literary version of Dr. Sigmund Freud sought to keep Holmes away from his 7% solution, the IRS appears to be on a similar mission against corporate taxpayers that have structured into their 7% solution. This article describes and analyzes these developments.


FAA 20131701F addressed the financial plumbing behind a DRD structured transaction. It's an interesting piece of authority because it analyzes certain Code § 1258 conversion transaction issues and does not directly address DRD issues. In the front end of the transaction, a parent corporation ("Parent") that filed a consolidated federal income tax return with a corporation that had losses ("Subsidiary") purchased 80% of the common stock of a newly-formed corporation called "Special Purpose Vehicle" or SPV. A financial institution ("Bank") purchased the remaining 20% of the SPV common stock. Bank also purchased a substantial amount of SPV preferred stock.3 The SPV preferred stock was stock described in Code §1504(a)(4), sometimes referred to as "plain vanilla preferred." The plain vanilla preferred stock did not affect whether Parent and SPV were members of the same affiliated group eligible to file a consolidated federal income tax return.4 Parent sold a call option to Bank which would allow Bank to purchase 80% of the SPV common stock held by Parent.

A. The Transactions Among The Parties

SPV then lent the monies that it received as capital contributions to Subsidiary, as more fully described below. The FAA recites that SPV did not expect to incur a tax liability on the interest accrued or paid on this loan because SPV believed that it could shelter its income with Subsidiary's pre-existing losses. If SPV and Subsidiary had been members of the same affiliated group filing a consolidated federal income tax return, this result would have occurred.5 The FAA states in separate advice that the IRS had concluded that the fact that Parent granted a call option on the SPV stock to Bank prevented SPV and Subsidiary from being considered part of the same affiliated group.6

Subsidiary used the loan proceeds that it received from SPV to prepay its obligations under a forward contract with a non-US subsidiary of Subsidiary ("Euro International"). The prepaid forward contract required Euro International to deliver a portfolio of high-grade corporate bonds to Subsidiary.7 The delivery date under the forward contract corresponded to the 5-year due date of the note issued by SPV to Subsidiary in exchange for the cash loan. In general, Subsidiary could satisfy its obligations under the loan from SPV by delivering the bonds that it would receive from Euro International, instead of repaying such loan in cash. Thus, if the reference bonds fell in value, SPV (and ultimately, Bank, who owned substantially all of SPV through the plain vanilla preferred stock8) would bear this loss. For this reason, the loan from SPV to Subsidiary was referred to as a "credit linked note."

The prepaid forward contract between Subsidiary and Euro International had a feature that, in the absence of a default on a bond in the portfolio, ensured that Subsidiary would earn a profit on the transaction. Specifically, all interest paid on the portfolio during the duration of the forward contract was to be invested in additional bonds that would be delivered to Subsidiary at the termination of the forward contract. Accordingly, if the forward contract were respected as such and the bond portfolio remained valued at par, Subsidiary could expect a gain on its position equal to all interest that accrued on the bonds during the duration of the contract.

Given that Subsidiary would not receive current payments on the forward contract with Euro International, a mechanism was needed to provide Subsidiary with cash flow to make interest payments on the credit linked notes.

Accordingly, Subsidiary and Parent entered into an unusual 5-year interest rate swap. Under this swap, Parent made periodic payments to Subsidiary equal to the product of the par amount of the credit linked notes and the LIBOR-based interest rate thereon. These payments were equal to the payments that Subsidiary needed to make interest payments on the credit linked notes it issued to SPV. The timing of these payments also matched the timing of the interest payments under the credit linked notes. In exchange for this stream of payments, Subsidiary was required to make a single payment to Parent equal to a fixed rate per annum (and compounded at a LIBOR-based rate) at the maturity of the swap. Subsidiary would be able to satisfy this delayed delivery obligation when it received payment from Euro International under the forward contract.

Parent entered into a 5-year fixed-to-floating interest rate swap with Euro International. The notional amount of this swap was equal to the principal amount of the credit linked notes. Under this swap, Parent paid the product of the notional amount and a fixed interest rate. In exchange for these payments, Euro International paid the product of a floating rate and the same notional amount.

SPV then entered into a third 5-year fixed-tofloating interest rate swap with another non-US subsidiary of Parent ("Euro Finance"). Again, the notional amount of this swap was equal to the principal amount of the credit linked notes. Under this swap, Euro Finance paid the product of the notional amount and a fixed interest rate. In exchange for these payments, SPV paid the product of a floating rate and the same notional amount. Euro Finance entered into a mirror interest rate swap with Bank. All of the terms of the mirror interest rate swap were identical with the swap between Euro Finance and SPV except, under this last swap, Euro Finance received the fixed rate leg and paid the floating rate leg. Assuming that the plain vanilla preferred stock issued by SPV to Bank bore a fixed interest rate, the swaps among Bank, Euro Finance and SPV had the effect of converting this yield to a floating rate to Bank.

After the transaction had been running for some time (presumably about 5 years), Bank exercised its call option to buy the 80% of the SPV common stock that it did not own. The exercise of the call option corresponded with the delivery of the bonds under the prepaid forward contract between SPV and Subsidiary. Presumably, at this time, all of the swaps terminated as well.

B. Federal Income Tax Reporting On The Transaction

Although there was some ambiguity in the reporting of the transactions described above, the taxpayers appear to have reported the transactions as follows:

  1. Subsidiary deducted the interest accrued on the credit linked notes that it issued to SPV.
  2. Subsidiary did not include any income attributable to the appreciation in its position under the forward contract. There is a suggestion that Subsidiary either sold its position under the forward contract shortly prior to settlement or, at settlement, the bonds that it received at that time. Upon whichever of these events occurred, Subsidiary claimed to recognize a capital gain that it sheltered with existing capital losses.
  3. All of the swaps were treated as notional principal contracts and income and expense was accrued under the regulations applicable to such contracts.9

The author speculates that the use of the capital losses possessed by Subsidiary was at the heart of the transaction. Within the Parent consolidated federal income tax return, Subsidiary's interest deduction should have been matched by the interest income earned by SPV, making these items a wash. The recognition of the interest income by SPV would have generated earnings and profits within SPV, allowing SPV to treat distributions made on the preferred stock taxable as a dividend.10 Bank claimed an 80% DRD on such dividends. Through the initial interest rate swap between Parent and Subsidiary, Parent effectively lent the cash in respect of the interest payments on the credit linked note to Subsidiary. When Subsidiary recognized the income (under the prepaid forward contract) necessary to repay this loan, Subsidiary was able to shelter this income from federal income tax through the use of its capital losses. Thus, if the transaction had worked as planned, it would have accomplished the Herculean task of generating a capital gain without any speculation on the price of an asset that would be treated as a capital asset in Subsidiary's hands.

As an aside here, it is the view of the author that the need for this type of planning appears to be patently unfair. To the author, it remains a mystery as to why corporate taxpayers should not be permitted to use capital losses to shelter ordinary income. For individuals, the reason is clear: long-term capital gains are tax preferenced items and individuals should be required to "ring-fence" capital losses against capital gains. But given that there is no tax preference for capital gains recognized by corporations, there does not appear to be a tax-policy justification for the limitation on the use of capital losses by corporations.

C. The IRS Attack On The Tax Reporting For The Transactions

The IRS did not challenge the characterization of the prepaid forward contract between Subsidiary and Euro International as a forward contract for federal income tax purposes. The IRS further recognized that the bonds to be delivered to Subsidiary by Euro International would have a basis equal to the upfront payment made by Subsidiary and that, ordinarily, any gain recognized by Subsidiary on the disposition of either the forward contract or the bonds would be capital gain. Importantly, the IRS did not assert that there was an embedded time value of money element that should be taxed on a current or deferred basis to Subsidiary. The IRS did, however, find a basis to challenge the character of the gain recognized by Subsidiary as capital gain.

1. Application of the Straddle Rules

The IRS asserted that Subsidiary's positions under the prepaid forward contract and the credit linked notes constituted a straddle within the meaning of Code § 1092(c). A straddle exists when a taxpayer holds off-setting positions in personal property, including debt instruments (such as the bonds to be delivered to Subsidiary under the forward contract). Under proposed Treasury Regulations, the IRS treats positions in debt instruments (such as the credit linked notes issued by Subsidiary) as part of a straddle when one or more payments are linked to the value of personal property.11 Since the credit linkage under the credit linked notes and debt instruments to be delivered under the prepaid forward contract were "substantially similar," the IRS found that Subsidiary's positions under the credit linked notes and the prepaid forward contract were off-setting positions with respect to the high grade bonds referenced in each position, even though there was not a complete overlap between the two reference portfolios.

Interestingly, the IRS also asserted that a straddle existed between Subsidiary's position under the interest rate swap with Parent and the prepaid forward contract. Since Subsidiary prepaid its obligations under the forward contract, a fixed discount rate must have been used to determine the prepayment. Under the swap between Subsidiary and Parent, Subsidiary received floating rate payments. From these facts, the IRS found that if interest rates fell and the value of the position under the swap fell, Subsidiary would have a more valuable position under the forward contract. Vice versa, if interest rates rose and Subsidiary's position under the forward contract fell in value, its position under the interest rate swap would have increased in value. The fact that the IRS had already found a straddle involving the forward contract did not prevent the finding of a second straddle involving the same position.

When the straddle rules apply, a taxpayer is not entitled to deductions for interest and other carrying charges incurred on positions within a straddle to the extent that deductions exceed income from the property comprising the straddle.12 Instead, these amounts are capitalized into the straddle positions. The IRS, under this rule, denied Subsidiary an interest deduction for the interest paid on the credit linked notes and for accruals on the swap with Parent. The denial of the deductions to Subsidiary, however, should not have affected whether SPV had income or whether SPV had sufficient earnings and profits to support the treatment of distributions on the SPV preferred stock as dividends. This determination would have increased the income of the Parent group for each year of the transaction until the straddle was unwound in 2011.

2. Application of the Conversion Transaction Rules

Code § 1258(a) provides that gain from the disposition of a capital asset which is recognized on the disposition or termination of any position held as part of a "conversion transaction" can be treated in whole or in part as ordinary income. A conversion transaction is defined to include a transaction that satisfies two tests:

  1. Substantially all of the taxpayer's expected return is attributable to the time value of the taxpayer's net investment in the transaction; and
  2. It constitutes one of the following types of transactions:
    1. the holding of property and the entering into a substantially contemporaneous contract to sell property at a price determined in accordance with that contract;
    2. a straddle; or
    3. a transaction that is marketed or sold as producing capital gains from a transaction that meets the first test stated above.13

The legislative history accompanying the enactment of Code § 1258 elaborates on the first requirement:

In a conversion transaction, the taxpayer is in the economic position of a lender – he has an expectation of a return from the transaction which in substance is in the nature of interest and he undertakes no significant risks other than those typical of a lender.14

A taxpayer's net investment in a conversion transaction "generally will be the aggregate amount invested by the taxpayer in the conversion transaction less any amount received by the taxpayer for entering into any position held as part of the conversion transaction." Accordingly, in order for any transaction to be treated as a conversion transaction, it must provide the taxpayer with a return that is akin to the yield that a lender would receive and not pose risks greater than those that a lender would normally bear.

The IRS held that the straddle relationship between the prepaid forward contract and the credit linked notes caused the two positions to be considered a "conversion transaction" in Subsidiary's hands. The IRS held that Subsidiary did not earn its return from a speculative position in the portfolio of bonds referenced in the prepaid forward contract because any loss on the portfolio could be passed through to SPV under the credit linked notes15 and Subsidiary's return was "economically linked to the interest earned on those securities." Since the IRS found that a straddle existed and Subsidiary's return was attributable to the time value of money, the IRS held that the conversion transaction rules caused the gain on the settlement of the forward contract transaction to be ordinary income and not capital gain. Accordingly, the IRS sought to prevent Subsidiary from using its capital losses against the gain recognized on the forward contract settlement.


In contrast to the bilateral transaction between unrelated parties encountered in FAA 20131701F, the IRS chose to challenge the availability of a DRD in a solely related party transaction in CCA 201320014. In an unusually erudite evaluation of an operational restructuring to obtain a DRD, the IRS found that a series of transactions admittedly undertaken for the purpose of converting interest income to dividend income eligible for the DRD would not be respected for federal income tax purposes. In this highly structured transaction, from the outset, the parties knew and intended that a US shareholder of a controlled foreign corporation (a "CFC") would be required to dispose of stock in the corporation that paid the DRD eligible income prior to the last day of the CFC's taxable year in order to prevent the DRD eligible income from being recharacterized as subpart F income that would not carry out a DRD. The analysis contained in the CCA hinges on the fact that the parties knew and executed these transactions for the sole purpose of enhancing the after-tax return on the interest income from the federal income tax rechacterterization.

The taxpayer involved in the transactions described in CCA 201320014 was a US bulge-bracket investment bank. It received collateral deposits from clients and counterparties. The taxpayer was required to pay interest on such collateral deposits. The taxpayer was required to, and in fact did, invest the collateral deposits in high grade liquid assets. The taxpayer earned more interest on the investments than it was required to pay to its clients (such excess, the "Spread"). The taxpayer's internal documents stated that the impetus for the transactions described below was a desire to undertake a transaction that would decrease the amount of federal income tax that it earned on the Spread.

A. Transaction Steps

Simplified, the taxpayer undertook a nine step restructuring plan involving the following steps:

  1. What appear to be different branches of a first tier subsidiary of the taxpayer (for example, the US branch and the London branch) exchanged client collateral for cash collateral pursuant to a securities lending agreement.
  2. The branch that received the cash collateral transferred the cash to the taxpayer.
  3. The taxpayer transferred the cash to a CFC ("FSub-1") for common and preferred stock in FSub-1.
  4. FSub-1 transferred the cash received from the taxpayer to a regulated investment company (the "RIC") in exchange for RIC stock.
  5. The RIC invested the cash received from FSub-1 in high grade liquid debt instruments.
  6. Prior to the end of FSub-1's tax year, FSub-1 distributed the cash that it received from RIC (net of expenses) to the taxpayer.
  7. FSub-1 then terminated its interest in the RIC and RIC liquidated.
  8. Parent sold all of its FSub-1 stock to a domestic partnership.
  9. FSub-1 liquidated.

The CCA does not make clear whether FSub-1 was newly formed pursuant to the transactions described above. The Advice does state, however, that FSub-1 did not possess any dedicated employees. It does appear, however, that employees of other taxpayer affiliates were dual-hatted as FSub-1 employees. It further does not appear that FSub-1 was subject to any non- US taxes on the income that it received from RIC.

B. Tax Reporting Of The Nine Step Transaction

The RIC did not pay any federal income tax on the interest income and capital gains that it earned by claiming a dividend paid deduction. The dividend paid deduction is available only in limited circumstances to certain specified corporations, but was available to the RIC.16 Even though FSub-1 was a CFC and the taxpayer would have had to include the income paid to FSub-1 as subpart F income and not as a dividend if taxpayer had held the FSub-1 stock at year end, taxpayer took the position that since it disposed of the stock of FSub-1 to another US taxpayer prior to the end of FSub-1's tax year, the DRD rules applied.17 Under applicable rules, even though FSub-1 was a non-US corporation, dividends paid by FSub-1 were eligible for the DRD in full because 100% of the income of FSub-1 was derived from US sources.18

We note that, as a technical matter, the IRS did not dispute that this reporting was consistent with the literal provisions of the Code. The taxpayer defended its reporting position on the basis that the transactions were undertaken "to increase its return on the investment of the Customer Funds by the amount of the section 245 DRD." As more fully described below, the IRS refused to accept this business purpose as a valid non-tax business purpose.

C. The IRS Challenges To The Taxpayer's Reporting Of The Transactions

The IRS began its attack on the taxpayer's claim of a DRD with respect to the distributions that FSub-1 made to Parent with a discussion of the substance versus form doctrine. The IRS stated that the "routing of the investment and investment returns through FSub-1 and RIC did not serve a meaningful business purpose" and such steps were a "contrivance to avoid US federal income tax." In support of this conclusion, the IRS noted that the taxpayer planned to terminate its direct ownership of FSub-1 prior to FSub-1's tax year for the purpose of avoiding a Subpart F inclusion. The IRS further cited to the fact that the rerouting of the monies through the structure did not enable the taxpayer to enhance the pretax return on the investments. In fact, the "significant costs" of the transactions actually reduced the pre-tax return. The transactions also raised regulatory concerns. The taxpayer undertook a "liquidity test" in which the structure was unwound and reconstituted on the same day to ensure that the structure would not inhibit the taxpayer from accessing the client funds. The IRS cited to this fact that the transactions actually had a deleterious non-tax effect and that the only reason that the taxpayer implemented the transactions was to obtain a DRD. The IRS also discounted any benefit that the taxpayer could receive with respect to asset management, given the taxpayer's professed expertise in this area. Thus, in the view of the IRS, the substance of the transaction did not comport with its form.

Next, the IRS directly considered whether the transactions should be considered to be within the intent of Congress in enacting and refining the DRD rules. The IRS cited legislative history almost 100 years old for the proposition that DRD only applies "when 'the issuing corporation has already been taxed on the earnings' and the dividends remain in corporate solution." The IRS also analyzed the income earned by the RIC and found that the "RIC received no dividends that would qualify for a DRD if RIC were allowed a DRD, and therefore none of RIC's distributions were eligible for the DRD." This conclusion was reinforced by the fact that, under Code § 881(e), the RIC was not required to withhold US federal income tax on distributions made to FSub-1 because the distributions retained their character as withholding tax-free interest even when distributed in the form of a RIC corporate dividend. The IRS acknowledged that the taxpayer would dispute these legislative purposes on the ground that the statute is clear on its face and does not impose a requirement that tax be imposed on the corporate earnings in order for a distribution to constitute a DRD eligible dividend.

To the author, the IRS found itself on its firmest footing for disallowing the DRD when it analyzed the subpart F aspects of the transactions. In this section of the CCA, the IRS concluded that the transactions should not be respected in the form in which they were undertaken. While the taxpayer correctly determined that there would not be a subpart F inclusion if it disposed of the FSub-1 stock prior to the end of the tax year of FSub-1, the IRS countered that this provision:

[I]s not a tool for tax avoidance; rather, it is a necessary rule to prevent both the current and former shareholders from being subject to tax with respect to the same amount of the CFC's subpart F income.

A court could concur with the IRS on this point in light of the facts that the taxpayer transferred the stock of FSub-1 to a related partnership in a transaction that was intended from the outset of the initial acquisition of the stock and undertaken solely for the purpose of enabling the taxpayer to claim a DRD. The IRS's underlying point is that the subpart F inclusion rules were not intended to allow a former US shareholder to achieve a better result by transferring its interest to a related party then holding the interest.

The IRS rounded out its challenges to the taxpayer's claim by asserting that it could apply the step transaction doctrine to challenge the availability of the DRD to the taxpayer. A full discussion of the step transaction doctrine is beyond the scope of this article. For our purposes, it suffices to note that the IRS found that the routing of funds through RIC and FSub-1 would have been "fruitless" without the completion of the subsequent steps, including the planned disposition of the FSub-1 stock prior to the year-end of FSub-1. The IRS found that the purpose of the transaction was not to create a RIC or to transfer ownership of the assets, but to "have FSub-1 distribute RIC dividends to [the taxpayer] and to have [the taxpayer] dispose of its shares in FSub-1 just before the end of FSub- 1's tax year." The liquidity test was viewed as evidence that Parent did not lose control of the funds even while they were held by RIC. Accordingly, the IRS found that insertion of FSub-1 and RIC into the transactions did not possess an independent business purpose. FSub- 1 did not retain any profit on the transaction and its activities were directed by employee of the taxpayer. The combination of these factors led the IRS to assert that it could successfully challenge the involvement of RIC and FSub-1 in the transactions.

Lastly, the IRS made two additional attacks on the taxpayer's reporting of the transactions. First, the IRS asserted that the subpart F inclusion, not the DRD rules, should apply even though the taxpayer disposed of the stock of FSub-1 prior to the end of FSub-1's tax year. This argument was based on the fact that the taxpayer continued to possess the ability to control the stock following the disposition to the related partnership. Second, the IRS asserted that the use of the statutes in the manner in which they were used was contrary to the intent of the statutes. As a result, the taxpayer should not be entitled to directly plan such results for a tax- avoidance purpose.


A corporate holder of stock is entitled to a DRD only if it meets certain holding period requirements with respect to the stock. Specifically, with respect to common stocks, the shareholder must hold the stock for at least 46 days during the 91 day period beginning on the date that is 45 days before the ex-dividend date; and with respect to preferred stocks, is at least 91 days during the 181 day period beginning on the date that is 90 days before the ex-dividend date.19 Code § 246(c)(4) provides that for purposes of maintaining the required holding period for DRD eligibility, a taxpayer's holding period will be reduced for periods when "under regulations prescribed by the Secretary, a taxpayer has diminished his risk of loss by holding one or more other positions with respect to substantially similar or related property." Treasury Regulation § 1.246-5(c)(1)(ii) provides that when a taxpayer is holding more than 20 stocks and defeases risk through shorting an index (or a like transaction), the taxpayer's holding period for the stock will be suspended only if the two positions "substantially overlap." If the two positions do not substantially overlap, however, the Regulations also contain two antiabuse rules, either of which will toll the taxpayer's holding period if they apply.

Treasury Regulation § 1.246-5(c)(1)(vi) setsforth an anti-abuse rule pursuant to which, even if a taxpayer passes the "substantial overlap" rules of Treasury Regulation § 1.246-5(1)(ii), will toll the taxpayer's holding period if: (1) changes in the value of the position or the stocks reflected in the position are reasonably expected virtually to track (directly or inversely) changes in the value of the taxpayer's stock holdings, or any portion of such holdings and other positions of the taxpayer and (2) the position is held or acquired as part of a plan a principal purpose of which is to obtain tax savings (including deferral), the value of which is significantly in excess of the expected pre-tax economic profits from the plan.20 This anti-abuse rule addresses the potential avoidance of the substantial overlap test by acquiring stock that is not formally reflected in a short index position, but that is comparable to, or highly correlated with, such stock. Thus, the taxpayer must hold a position in stock and also hold (or benefit from) a contra position, which would then be tested to determine if it offsets the taxpayer's long stock holdings. Furthermore, such contra position must "virtually" track the value of the stockholdings (a high threshold), and be acquired or held as part of a plan, a principal purpose of which is to obtain tax savings significantly in excess of the expected pre-tax economic profits from the plan.

Treasury Regulation § 1.246-5(c)(6) provides that positions held in related party or pass-through structures "with a view towards avoiding this section (the holding period requirement)" can be re-characterized as diminishing risk of loss. Specifically, the Regulation provides that:

Positions held by a party related to the taxpayer within the meaning of sections 267(b) or 707(b)(1) are treated as positions held by the taxpayer if the positions are held with a view to avoiding the application of this section or § 1.1092(d)-2. In addition, a taxpayer is treated as diminishing its risk of loss by holding substantially similar or related property if the taxpayer holds an interest in, or is the beneficiary of, a pass-through entity, intermediary, or other arrangement with a view to avoiding the application of this section or § 1.1092(d)-2.

This anti-abuse rule addresses situations in which a taxpayer owns stock directly and also owns an interest in a related person or pass-through entity that holds off-setting short positions with respect to its long stock positions. Furthermore, this rule can also apply when the taxpayer owns an interest in an entity that holds stock, with respect to which the taxpayer has entered into an off-setting position in the hedge.

Proposed regulations contained an example for the related party anti-abuse rule which was deleted in the final regulations for reasons that are not entirely clear. The deleted example offered the following guidance:

On January 1, 1993, L Corporation purchased for $100,000 a basket of preferred stocks of companies in the utility industry. Also on January 1, 1993, L causes R Corporation, a wholly-owned subsidiary of L Corporation, to sell short $100,000 worth of utility index RFCs. Changes in the fair market value of the basket of preferred stocks are reasonably expected to approximate changes in the utility index. For purposes of section 246(c)(4)(C), the basket of preferred stocks of the utility companies held by L Corporation is substantially similar or related to the RFCs on the utility index held by its subsidiary, R Corporation. In addition, changes in the fair market values of the positions (the basket of preferred stocks and the short position in a RFC on the utility index) vary inversely. Thus, L Corporation is treated as having diminished its risk of loss on the basket of preferred stocks for purposes of section 246(c)(4)(C).21

In FAA 20131920F, a wholly-owned subsidiary of a common parent corporation ("X"), included in a consolidated federal income tax return, held a portfolio of dividend-paying stocks. These stocks paid dividends and X, on its consolidated federal income tax return, claimed DRDs. During the years at issue, X entered into a series of put and call options on the S&P 500 index. X conceded that its purpose in entering into the option transactions was to "mitigate the risk of holding a portion of its equity portfolio." X also stated that "tax considerations were not sought, asked about or addressed in the establishment of the option program." X conceded that the options qualified as substantially similar or related property for purposes of the DRD rules. As a result, there is no discussion in the FAA as to the substantial overlap standard or the anti-abuse rules discussed above.

The sole issue addressed in the ruling was whether the DRD mandated holding period for the subsidiaries could be tolled by off-setting positions held by the corporate parent. The IRS cited to Treasury Regulation § 1.246-5(c)(6) for the proposition that positions held by related parties are treated as held by the corporate shareholder "if the positions are held with a view to avoiding the application of [the DRD rules]." The FAA then concludes that the risk mitigation purpose of the holding of the options is such a purpose and the holding period for the stock portfolio is tolled. As a result, the taxpayer was denied the DRD.

The concessions made by the taxpayer in FAA 20131920F make the issuance of the guidance somewhat curious.22 The related party hedge issue addressed in the FAA is not a controversial one or one that seemingly needed much, if any, interpretation. The real issue seems to be whether the portfolio bore a relationship to the S&P 500 options either under the mechanical 20 stock test or the anti-abuse rules. But these issues were conceded by the taxpayer for purposes of the Advice. One cannot help but wonder if the question asked by the Field Auditor was really the question at issue.


1 The determination of whether a corporate shareholder holds at least 20% of the outstanding stock of a US corporation is made without considering stock described in Code § 1504(a)(4).

2 35% (the maximum corporate tax rate) x 20% = 7%. 3 It appears that the plain vanilla preferred stock issued to Bank bore a fixed rate.

4 See Code § 1504(a)(4).

5 See Treasury Regulation § 1.1502-11(a).

6 See Treasury Regulation § 1.1502-4(b)(2).

7 It was unclear as to whether the bonds deliverable under the prepaid forward contract could be fixed rate bonds, floating rate bonds or both. The forward contract specified only that the bonds had to have a yield at least equal to US dollar LIBOR.

8 The plain vanilla preferred stock likely constituted the overwhelming majority of the capitalization of SPV. As a result, any losses would be borne by Bank as the holder of such stock.

9 See Treas. Reg. § 1.446-3(c).

10 See Code § 316(a).

11 Prop. Treas. Reg. § 1.1092(d)-1(d).

12 Code § 263(g).

13 Code § 1258(c). Conversion transactions include any other transactions identified by the IRS in regulations, but no such transactions have been designated by the IRS as such. Code § 1258(c)(2)(D).

14 Code § 1258(c). Conversion transactions include any other transaction identified by the IRS in regulations, but no such transactions have been designated by the IRS as such. Code § 1258(c)(2)(D).

15 The IRS referred to the positions under the prepaid forward contract and the credit linked notes as "nearly identical."

16 See Code § 852(b)(2)(D).

17 See Code § 951(a).

18 Code § 245(a)(5)(B).

19 Code § 246(c)(1), (2).

20 See T.D. 8590 (Mar. 20, 1995).

21 See, Prop. Treas. Reg. § 1.246-5(d), Ex. 8 (FI-22-92 (5/27/1993)).

22 At least one other commentator has observed that this FAA is a case of strange facts making strange law. See Anthony Tuths, letter to the Editor, Tax Notes Today (May 28, 2013).

Originally published June 5, 2013

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions