Merrill: convertible preferreds mostly not affected by elimination of dividend tax

By Ronda Fears

Nashville, Jan. 9 - Since most convertible preferred holders are actually paid interest rather than dividends on the shares, they will not be affected by the Bush administration's proposal to eliminate double taxation of stock dividends, said Merrill Lynch & Co. analysts.

Martin Mauro, manager of financial economics at Merrill, said only dividends paid to shareholders would qualify - which excludes most convertible securities described as preferreds since they are generally hybrid structures.

"The payments are routinely called dividends, but payments on hybrid preferreds (such as trusts and senior debt preferreds) are actually interest, because the company can deduct the payments (i.e. no double taxation)," Mauro said in a report.

That category also includes the majority of convertible preferreds, except those that are perpetual, he said in an interview.

In a report in mid-December, Mauro and Merrill fixed-income strategist William Scapell noted that the current market of preferred stocks traded publicly is comprised mostly of debt-based hybrid instruments.

Thus the impact of the legislation will be very limited for preferred holders and could be a negative for the structure, the analysts said.

"Concerned about lost tax revenues stemming from the growing use of hybrid shares in the late 1990s, the Clinton Administration pursued equity tax treatment for debt-based hybrids. Debt tax treatment held sway in the end, but as a corollary to the heated debate, most issuers began to imbed broad rights allowing them to call or otherwise alter hybrid shares should tax laws change," the analysts said.

"Our initial expectation is that laws would not change significantly enough to induce issuers to use these provisions, but it is something to watch.

"Since it could make dividend income more appealing, dividend tax relief could be a negative for debt-based hybrids. It is unclear whether relative value would swing meaningfully enough to be a material market concern, but our initial read is that it is unlikely to be."

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