Under Section 382(l)(3)(A)(iv) of the Code, options are treated as exercised for purposes of determining whether or not a loss corporation undergoes an ownership change under Section 382, if such exercise would cause the loss corporation to have an ownership change. The general rule was severely scaled back, however, with the issuance of the option attribution regulations in Treas. Reg. Section 1.382-4(d). The option attribution regulations provide that unless the option or interest similar to an option violates one of three anti-abuse type tests (ownership, control, and income), then the option is not treated as exercised in determining whether or not an ownership change under Section 382 has occurred upon the issuance or transfer of such option. Thus, as a practical matter, most options issued in the ordinary course of a loss corporation’s business, such as employee stock options, warrants issued with a debt instrument, convertible debt, etc., do not result in a taxpayer loss corporation treating such options as exercised in performing their owner shift analyses under Section 382.
In a recent private letter ruling, PLR 201126002 (March 29, 2011),1 the IRS appeared to expand its view under the option rules in a taxpayer-favorable manner. In the PLR, the taxpayer had four classes of stock, one class of common stock and three classes of preferred stock that are described as qualifying as Section 1504(a)(4) ["pure" or "plain vanilla"] preferred stock. The significance of this designation is that generally Section 1504(a)(4) pure preferred stock is not taken into account as an equity interest in determining whether or not a loss corporation has undergone an ownership change under Section 382.
In the PLR one of the classes of preferred stock was issued to a shareholder along with warrants to purchase common stock. On its face, this combination would appear to mirror the issuance of convertible preferred stock, which is generally treated as stock and an option under the regulations (Treas. Reg. Section 1.382-4(d)(9)(ii)). There is an exception, however, under this rule for convertible stock "if the terms of the conversion feature permit or require consideration other than the stock being converted." This appears to be language that the IRS is interpreting by finding that the warrants issued with the preferred stock will not be treated as exercised under Section 382(l)(3)(A)(iv) because the taxpayer makes representations that the preferred stock is redeemable only for cash and the exercise price of the warrants can only be paid in cash. The taxpayer also makes the standard anti-abuse representations that indicate that the holder of the warrants, along with his or her ownership in stock or other options cannot acquire a more than 50 percent interest in the loss corporation, and that the warrants neither provide for facilitation of income nor entitle the holder to any participatory rights in the loss corporation, including voting, etc. In addition, the taxpayer represented that at the time of the warrants issuance, it was more likely than not that the warrants would not be exercised.
This PLR provides a helpful view into the IRS’s current thinking with respect to issues that arise when interpreting the option attribution rules of Treas. Reg. Section 1.382-4(d). Because there are very few authorities in this area, a PLR that includes these types of significant details is helpful in determining how the option attribution rules can be applied in similar situations. For example, the taxpayer made a representation that at the time of the issuance of the warrants, it was more likely than not that the warrants would not be exercised, thus, indicating they were likely out of the money at that time. The taxpayer also provided the statement that there will not be any reciprocal options between prospective buyers and sellers of the warrants, indicating a desire by the IRS to assure arm’s-length dealing between the parties. As with any principal purpose test, when determining whether the option attribution rules should be applied to treat an option as exercised under Section 382, careful consideration must be given to the underlying economics and motivations of the parties at the time of the issuance of the relevant instruments, and it should be noted that these inquires are not mechanical, but must generally go to the true economic purposes of entering into the transaction.