Clinton's Tracking Stock Proposal Based on False Assumptions

Monday, June 14, 1999

OnLine

The Clinton Administration based its proposal to tax the issuance of tracking stock on false assumptions about the nature of this financial product, which allows investors to purchase an indirect interest in one or more assets of a company, rather than a share of the entire business.

Broad legislative opposition to the proposal may mean there is little hope for the administration to win approval of this idea this year.

The administration contends that a corporation is spinning off a subsidiary when it issues tracking stock. The use of tracking stock is clearly outside the contemplation of subchapter C of the Internal Revenue Code and, "as a result, a principal consequence of treating such a stock interest as stock of the issuer is the potential avoidance of these provisions," the Clinton Administration wrote in 1999’s General Explanations of the Administration’s Revenue Proposals.

State corporate law and creditors rights provisions, however, ensure that tracking stock remains an investment in the overall corporate entity, and not a separate interest in the particular assets or subsidiary being tracked, analysts say.

Treating the issuance of tracking stock as a sale of the tracked assets also does not reflect the economic realities of the transaction, in which the issuing corporation generally retains full management and control of the assets.

A majority of the House Ways and Means Committee  in May wrote to the panel’s chairman Rep. Bill Archer, R-Texas, objecting to the proposal. Opposition from the House tax-writing panel members does not guarantee the proposal will die, but it does mean the chances of defeat are high.

The greatest threat now comes from the Senate Finance Committee, which may find the $522 million in tax revenues that the staff of the Joint Committee on Taxation claims the proposal would raise over five years irresistible. There is reason to believe that the Senate tax panel will reach a different conclusion than the House tax panel.

The following illustrates the underlying weakness of the administration’s assumption that the issuance of tracking stock is the same as the sale of a subsidiary, according to experts:

• Corporate assets are not separated when tracking stock is issued, so an investor’s return is subject to the economic risks of the issuer’s entire operation;
• The holder of tracking stock retains voting rights with the issuer, not in a tracked subsidiary;

• Dividend rights are determined by the parent/issuer’s board of directors, as well as by state law limits on the parent/issuer’s ability to pay without regard to a tracked subsidiary’s ability to pay;

• Liquidation rights may be determined by reference to the value of tracked assets, but investors in tracking stock have no special right to those assets; instead, they are entitled to share in all of the issuer’s assets on a pro rata basis; and
• Some portion of the issuer’s earnings or assets on liquidation are "shared," resulting in a "commingling" of economic interests.

Clinton’s Proposal

The proposal to tax the issuance of tracking stock is the administration’s reaction to its perception that corporations are using this technique to avoid paying taxes. The tracking stock may be issued without the recognition of gain or loss, although the subsidiary may remain a member of the parent's consolidated group. A distribution of the shares is tax-free to the shareholders and to the issuer.

To fight this perceived abuse, the Clinton Administration proposed that a corporation floating tracking stock must recognize gain upon the issuance of the stock, or upon the recapitalization of other stock or securities into tracking stock.

Issuances of tracking stock occurring on or after the date of the enactment of the proposed legislation effectively would be treated as a sale or exchange of the underlying assets, at least for purposes of gain recognition. Such gain would be equal to the excess of the fair market value of the applicable assets over their adjusted basis.

The Clinton Treasury would define "tracking stock" as stock that relates to, and tracks the economic performance of, less than all of the assets of the issuing corporation (including the stock of a subsidiary), and where either the dividends are directly or indirectly determined by reference to the value or performance of the tracked entity or assets, or the stock has liquidation rights directly or indirectly determined by reference to the tracked entity or assets.

Numerous technical issues would arise if the proposal were enacted, & analysts say. For instance, should the issuer receive a stepped-up basis when the tracking stock is issued? If there is to be no step-up in basis, how many levels of tax should be levied? How should the system treat "shared" earnings or liquidation rights? These technical issues further demonstrate the shortsightedness of the proposal, according to analysts.

If tracking stock represented a perfect substitute for a tax-free spin-off, as assumed by the Clinton Administration, the market would contain many more examples of tracking stock than currently exist, analysts agree. Genzyme, Tele-Communications Inc., US West, and General Motors have issued tracking shares in acquisitions.

GM’s use of tracking stock illustrates how such stock works in the marketplace. The class E stock used by GM in the 1984 acquisition of Electronic Data Systems (EDS) resembled subsidiary stock in terms of dividend yield. Class E stock dividends were intended to be as close a reconstruction of hypothetical EDS earnings as possible, so shareholders had the benefit of owning something like separate EDS stock. The class E shares were unlike separate EDS shares in that they carried one quarter vote per share in GM (not EDS), and holders had no special claim on the assets of EDS assets on liquidation.

Analogy with Partnerships

An analogy between corporate and partnership law also can help understand why the issuance of tracking stock should not be taxed.

The economics of tracking stock are no different from the economics of a special allocation of partnership income to a partner, analysts believe. Though the Internal Revenue Service would never consider a special allocation a taxable deemed disposition, the proposal would treat unfairly the issuance of tracking stock as a taxable event, analysts say.

If the purpose of the proposal is to prevent disguised asset sales, the focus should be on rights to control the underlying tracked assets as opposed to rights that transfer the earnings stream generated by those assets. The issuance of shares that provide dividends based upon the earnings of tracked assets is not the legal or economic equivalent of a sale of the assets themselves.

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