THE IRS CRACKED DOWN ON “FAST-PAY STOCK.
This is stock that pays such large dividends that the dividends represent not only a return on the shareholder’s investment, but also at least partly a return of that investment. An example is so-called step-down preferred shares that have an annual dividend rate of 11% of the issue price each year for the first 10 years, and then 3% thereafter. Another example is where the dividend rate remains 11% for as long as the shares remain outstanding, but the corporation has a right to redeem the shares for 40% of the issue price after 10 years. In each case, the dividend is at least partly a repayment of the issue price for the shares.
Fast-pay shares have features in common with debt. However, the company using them prefers to call its debt service “dividends.” There may be tax benefits from doing this. For example, a real estate investment trust, or REIT, borrowing from a foreign lender can reduce the US tax hit on income used to repay principal. REITs are passthrough entities. Shareholders are taxed on their shares of the REIT’s income like partners in a partnership. However, if principal paid to a foreign lender is called a “dividend,” then the other shareholders are not taxed on this income. The foreign lender is exposed to a US withholding tax, but at only a 30% rate, and the rate may be reduced by tax treaty.
The IRS said in proposed regulations the first week in January that it will recharacterize all fast-pay arrangements involving REITs and regulated investment companies, or RICs. It may recharacterize them in other cases where “a principal purpose” of the arrangement is to reduce US taxes. The IRS action is retroactive to February 27, 1997, perhaps as a sign of growing IRS impatience with aggressive tax planning.
Interestingly, the IRS seems concerned only about use of fast-pay stock to reduce US taxes. A fast-pay shareholder might still benefit in a foreign country from claiming payments are an equity return rather than a return on lending even where there is no US benefit.