Exploiting and Sharing Tax Benefits Case

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Eastern Illinois University *

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Jan 9, 2024

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1.) When Du Pont repurchased its stock from Seagram, what were the two possible tax treatments for the redemption? The two possible tax treatments for the redemption between Du Pont and Seagram are sale treatment and dividend treatment. Individual shareholders usually prefer sale treatment because only the excess of the distribution above basis is taxable. Corporate shareholders generally prefer dividend treatment in distributions because of the dividends received deduction (DRD). This deduction is 70% of dividends received for corporations that own less than 20% of the dividend-distributing corporation. If the shareholder corporation owns between 20% and 80% of the distributing corporation, the DRD is 80%. Stock ownership of 80% or more of the distributing corporation results in a 100% DRD. 2.) As a corporation, which of these two tax treatments did (does) Seagram prefer? Why? Seagram prefers dividend tax treatment because of the DRD. When comparing the tax savings Seagram’s had because of the acquisition being taxed as a dividend instead of a sale, we can see that they would, hypothetically, shave off $1.496 billion when ignoring the lower accepted redemption price per share. This is largely in part to the DRD that, in the given example, reduced Seagram’s taxable income from $6028, when using sale treatment, to only $1755 when using dividend treatment. 3.) What tax treatment do individual investors generally prefer in stock redemptions? Why? Individuals usually prefer sale treatment in stock redemptions because the DRD is not available to them. This means that they only have a portion of the redemption taxed instead of the entire thing being included in taxable income.

4.) I.R.C. § 302 governs the tax treatment of stock redemptions. (a.) Under what circumstances is a redemption treated as a sale for tax purposes? (b.) Under what circumstances is a redemption treated as a dividend for tax purposes? A. A stock redemption is treated as a sale for tax purposes if it meets one of the following 4 qualifications: 1. The redemption is not essentially equivalent to a dividend; 2. The redemption is substantially disproportionate, with respect to the shareholder; 3. The redemption is in complete termination of a shareholder’s interest; or 4. The redemption results from a partial liquidation of the distributing corporation (noncorporate shareholders only). B. A stock redemption is treated as a dividend for tax purposes when it does not qualify as a sale. This means that the total distribution is treated as a dividend for tax purposes. 5.) As of April 3, 1995, how large was the built-in gain on Seagram’s Du Pont holdings (the total value of the 164.2 million shares or just the shares that Du Pont repurchased)? If the redemption were taxed as a sale, how large of a tax liability, approximately, would Seagram incur (on the sale of the shares sold only)? In order to find the size of the built-in gain on Seagram’s Du Pont holdings, we would need to find the excess of the fair market value over the tax basis of the shares as of the conversion date. For this, our formula would look like this: 164.2 ∗ $ 61/share = $ 10,016 FMV

We then would just subtract the current tax basis from the FMV. $ 10,016 FMV − $ 2,893 Tax Basis for shares redeemed = $ 7,123 gain To find out what the tax liability of the transaction would have been on April 3, 1995, had the transaction been treated as a sale, we would first find the FMV of the redeemed stock: 156 Shares ∗ $ 61/share = $ 9,516 FMV We then would simply subtract the proportionate tax basis from the FMV. $ 9,516 FMV − $ 2,748 Tax Basis = $ 6,768 CaptialGain To find our tax liability, we would then take our capital gain and multiply it by the tax rate. $ 6,768 ∗ 35% = $ 2,369 IncomeTax 6.) Given the figure computed in the prior question, how can/did Seagram and Du Pont structure the transaction to avoid sale treatment for tax purposes? Be specific, including reference to the relevant tax code sections. In order to avoid sale treatment for tax purposes in the transaction, Seagram and Du Pont had to work together in order to fail the substantially disproportionate test I.R.C. § 302(b)(2). This test states that substantially disproportionate redemptions occur when a shareholder’s post-redemption ownership percentage is less than 80 percent of the pre-redemption ownership and less than 50 percent of the total outstanding shares. In order to maintain at least 80 percent of their previous holdings, Seagram’s and Du Pont structured the transaction to result in Seagram’s losing 0 percent of their ownership in DuPont for tax purposes. This was done by DuPont issuing warrants for all 156 million shares redeemed by Seagram’s because an option to acquire stock is considered as ownership of the

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underlying stock for tax purposes. Warrants aren’t specifically defined as options under I.R.C. § 318(a)(4), however Revenue Ruling 89-64, 1989-1 CB 91 supports the argument that the DuPont warrants qualify as options. 7.) What was Seagram’s immediate tax liability under the transaction as structured? What would Seagram’s tax liability have been had the transaction been taxed as a sale (given total consideration as the transaction was completed - $56.26/share)? Seagram’s immediate tax liability under the transaction as structured was $614. We can see this figure in Table 1 where they show the $8,776 in consideration being reduced by a DRD of $7,021 to create taxable income of only $1,755. This is then multiplied by the tax rate of 35% to give us $614 in income tax expense. Had the transaction been taxed as a sale, Seagram’s immediate tax liability would have been much greater as seen in Table 1. They would have reduced the $8,776 in consideration by the basis of the stock redeemed, which was $2,748, leaving them with $6,028 in Long-Term Capital Gains. To find income tax, they would simply multiply the long-term capital gains by the tax rate of 35% to get $2,110 in Income tax. 8.) How much, approximately, did Seagram save as a result of structuring the transaction in a tax favorable manner? Don’t forget to account for the fact that Seagram received less from DuPont than it would have had the transaction not been structured to minimize taxes. Assume that the fair market value of the DuPont stock was $61 per share at the time of transaction. Recompute your answer, but assume the fair market value of the DuPont Stock was $63 per share? Recompute your answer, but assume the fair market value of the DuPont Stock was $65.25 per share?

Seagram was able to save approximately $1,015 million as a result of structuring the transaction in a tax favorable manner. We find this number by computing the Net after-tax consideration they received under the transaction as structured and then reducing it by the net after-tax consideration they would have received had they sold the shares for $61/share while using sale treatment. $ 8,162 Net After Tax Consideration − $ 7,147 Net AfterTax Consideration = $ 1,015 Savings Assuming the fair market value of the DuPont Stock was $63/share we are able to find that the net after-tax consideration would be $7,350 under sale treatment. This would lead to our savings equaling $812. $ 8,162 Net AfterTax Consideration − $ 7,350 Net After Tax Consideration = $ 812 Savings We finally would do the same computation but for a share price of $65.25. $ 8,162 Net AfterTax Consideration − $ 7,578 Net After Tax Consideration = $ 584 Savings

9.) What did DuPont get in return for cooperating with Seagram in the structuring transaction? For cooperating with Seagram in the structuring transaction, DuPont was able to retain the shares of their stock at a bargain price. This purchase price resulted in cost savings of about $740 million [($61 - $56.26) * 156 million shares] for DuPont. This means that DuPont was able to realize about 42.17 percent of the total tax benefits generated from the stock redemption. This gain is also not taxed for them because they do not recognize a taxable gain when it buys and sells its own equity securities, as stated under I.R.C. § 1032. 10.) How much (per share) would Seagram have had to sell the 156 million DuPont shares to a third party to have as much after-tax as the deal was actually structured. To find how much Seagram would have had to sell the shares to a third party in order to have as much after-tax as the deal was actually structured, I found it easiest to create an Excel workbook where I was able to input different amounts for the FMV that would compute the Net After-Tax Consideration for me. Through this I was able to find that a selling price of $71.01/share got me to a net after-tax consideration of $8,162, the exact same amount as what Seagram was actually able to save. This means that Seagram’s would have had to sell their DuPont shares at a 16.4% premium to a 3 rd party in order to generate the same amount of savings. 11.) Some in the financial press were critical of Seagram’s management for selling the DuPont stock for below current market price. Specifically, commentators said that

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Seagram’s management sold the DuPont stock at $4.50 per share less than market value ($61-$56.26) which damaged the wealth of Seagram’s shareholders. Do you agree? I think that the financial press had good reason to be critical of Seagram’s selling of the 24.3% stake because of DuPont’s major role in the earnings of Seagram’s, making up a generous 65% of their net income during the 1982-1995 period. As stated in the article, the possibility of Seagram’s wealth declining due to an overpayment for MCA is unlikely. This is because much of Seagram’s losses occurred during the period March 31 through April 6, a period during which the market did not have information about the purchase price of MCA. I think that these facts lead us to the conclusion that Seagram’s sold the DuPont stock at an undesirably low cost that may have saved them in immediate tax liability, but realistically took away their largest form of income in order to purchase shares in a seemingly downward sloping corporation. 12.) What tax basis did Seagram have in the remaining DuPont shares post- redemption? Seagram had a remaining tax basis of $0 because the reduction completely reduced the previous basis of $2.893 billion by the nontaxable portion of the dividend ($7.021 billion), also recognized as the amount of the dividend received deduction. The unused portion of the adjustment ($4.128 billion) would be reported as a gain when the remaining 8.2 million shares are liquidated. Seagram is unlikely to liquidate these remaining shares, however, since the cash loss they would incur would be more than $1 billion.