Various Nuances in the Capital Structure

Capital structure � Debt v Equity • • characteristics # Priority of claim # Fixed v residual claim tax treatment # int deductible # dividends not, but receive special treatment if received by a corporation What is debt? • Debt and equity are the two extremes of a continuum • Courts have considered a large number of factors in classifying debt and equity # Debt-to-equity ratio. No ratio is too high or too low, but as the risk of the debt increases the debt takes on characteristics of equity # Proportion held by shareholders. For example, if shareholders hold debt in proportion to their equity, shareholders receive the benefits of debt without a loss of residual claim. # Intent # Other factors ..... Section 385 • Enacted in 1969 in response to judicial uncertainty. • Amended over time to address various concerns such as # inconsistent treatment by issuer and holder # hybrid securities # earnings stripping # see section 163 • Instructs Treasury to issue regulations • Still waiting.... Dividends • Distributions from corporations are taxed as dividends to the extent that the firm has “earnings and profits” • Distributions in excess of E&P are a non-taxable return of capital • Distributions in excess of E&P and basis are capital gains • Need not be cash: # Property # Stock Other ways to get money out of the corporation • Compensation • Interest • Rent • Royalties • BUT, attempts to disguise a dividend as some other form could be construed as constructive dividends and taxed accordingly • Share repurchases Share repurchases • Stock repurchases that qualify as “redemptions” are taxed as though the shareholder sold the stock back to the corporation (get to recover basis) • If the repurchase does not qualify as a redemption the entire amount is taxed as a dividend • To avoid dividend taxation there must be a # “disproportionate” reduction in shareholder’s interest, or # a complete termination Implication: you can’t buy back a flat percentage of all shareholder’s shares Seagram - DuPont (1995) � In 1981 Seagram purchased 27.9 million shares of Conoco stock (32.6%) for $2.57 billion as part of a take-over attempt. � DuPont won the tender offer (over Seagram and Mobil). � Conoco shares were exchanged for 47.4 million DuPont shares, representing 20% of Dupont. � Seagram increased its holding of Dupont - by 1995 they held 24% of the company. Total basis in DuPont stock in 1995 was $2.893 billion. MCA � On April 9, 1995 Seagram agreed to purchase 80% of MCA from Matsushita for $5.7 billion in cash. � Transaction was completed on June 5, 1995. Seagram’s problem � How could it convert its DuPont shares into cash to finance the acquisition? � One solution: sell the shares MV shares ~$10 billion on April 3, book value ~ $2.9 billion If sold all, after-tax proceeds = 10 - (10-2.9)(.35) = 10 - 2.5 = $7.5 billion Would pay tax of ~$2.5 billion The transaction � On April 6, 1995 DuPont agreed to redeem 156 million shares of its stock held by Seagram (95%). � In exchange, Seagram received: • $1 billion cash • $7.336 billion in 90-day DuPont notes • DuPont warrants valued at $440 million, which allowed Seagram to purchase # 48 million shares $89.33 for 60 days # 54 million shares $101.14 for 60 days # 54 million shares $113.63 for 60 days DuPont traded at $61/share on April 3 Rules for a stock redemptions � Stock redemptions are viewed as preferable to dividends since you get to recover basis and (potentially) pay taxes at the capital gains rate. � A redemption is a sale if the redemption • is not essentially equivalent to a dividend • is substantially disproportionate with respect to the shareholder post-redemption ownership < 80% of pre-redemption ownership • is in complete termination of the shareholder’s interest, or • results from a partial liquidation of the distributing corporation (noncorporate shareholders only) � Otherwise the redemption is a dividend. Seagram � Was Seagram’s redemption a dividend? Some additional information: • Options are counted toward ownership. As a result, Seagram’s ownership of DuPont is unchanged. There was no disproportionate reduction. � Payment to Seagram was classified as a $8.776 billion dividend. Tax consequences of dividend treatment Seagram received $ 8.776 billion Less DRD (.8*8.776) 7.021 billion Taxable income 1.755 billion Tax @ 35% 0.614 billion After tax income 8.162 billion