A corporation will sometimes issue stock rights to its existing shareholders. Often these rights relate to corporate governance issues, are non-transferable, and have no
separately tradeable market value.
However, in some cases, the rights do have pecuniary (money) value, such as the recent stock rights issuance by HSBC Holdings plc for subscription rights to purchase 5 billion new shares at a discounted price.
The HSBC rights offering raised almost $18 billion and impacted many U.S. holders of ADSs (American Depository Shares).
Another recent large stock rights issue affecting many U.S. holders of ADS's was the ING Groep NV offering of rights which expired 12/15/2009. Seven rights could be exercised to buy six shares of ING at a discounted subscription price of 4.24 Euros. Cost basis allocation is required for this rights issue because the market value of the rights was in excess of 15% of the combined market value.
The average 11/30/2009 first day trading price on the Amsterdam Euronext exchange for the ING rights was 1.809 Euros, and for ING was 6.358 Euros. The relative market values, and therefore the cost basis allocation, is determined as follows:
ING 6.358 € 77.85% ING rights 1.809 € 22.15% Total 8.167 € 100.00%
You can use our stock rights calculator by clicking on the image above. It has cost basis allocation factors for many recent stock rights issues in the database, such as Barclays plc, ING, Lloyds Banking Group, Bank of Ireland, and McEwen Mining.
The first step in accounting for stock rights is to determine the tax status, which is usually found in the "Income Tax" section of the prospectus or is sent to shareholders in a tax information letter. We recommend tearing out those pages of the prospectus and keeping them with your cost basis records to document the tax treatment for the rights you received.
If the tax status is taxable, the value will appear on your Form 1099-DIV at year-end and that amount becomes your cost basis for the rights. The holding period for rights received as taxable dividends starts with the day you received the rights.
If the tax status is non-taxable, the general rules for accounting for non-taxable stock rights are as follows: 1. If the market value of the stock rights is more than 15% of the market value of the shares on the date of distribution, part of your cost basis for the shares must be allocated to the stock rights in the same proportion as the relative market values. 2. If the market value of the stock rights is less than 15% of the market value of the shares on the date of distribution, you are not required to allocate any part of your cost basis to the rights, although you may do so if you so elect. 3. Your holding period is the same as the purchase date of the tax lot of the company's shares from which the rights were derived.
However, if you sold the rights, it is to your advantage to allocate basis because it will reduce your taxable capital gain. Notice how the IRS always makes it easy for you to pay more tax than you have to!
How do you elect to allocate basis? You simply attach a statement or schedule to your income tax return in the year the distribution occurs stating that you are electing to allocate your cost basis and give the particulars. (If your tax software does not allow you to attach any documents, select a supporting or miscellaneous statement and manually type in the information.) You must keep a copy of the election statement and the tax return with which it was filed in order to substantiate your basis allocation.
Click on the Microsoft Word document icon above for a sample election statement to attach to your 2009 income tax return for the HSBC ADS rights cost basis allocation example discussed below.
Let's look at an actual example, the HSBC rights offering, to see how to allocate basis. Holders of HSBC ADSs (NYSE symbol HBC) as of March 13, 2009, received the rights to purchase additional ADS shares of HSBC at an estimated subscription price of $17.75 per share, which was a discount from the current market value of HSBC ADS shares at that time.
Let's assume you owned 100 shares of HSBC Holdings plc ADS shares, purchased 7/31/2006 at $91.00 per share, for a total cost basis of $9,100.00.
You received 41.66667 ADS rights in the HSBC rights offering (100 ADS shares x 5 ADS rights per 12 ADS shares = 41.66667). No partial rights were issued, but cash in lieu of fractional rights was paid at the rate of $8.51 per stock right.
Rather than exercise your rights to buy more shares, you directed the rights agent to sell your rights on the open market if and when they became tradeable. You collected $369.05 in sales proceeds.
The tax opinion section of the prospectus for the HSBC stock rights issue states that "the Company believes that it is proper to take the position that a US Holder is not required to include any amount in income for US federal income tax purposes as a result of the receipt of the Rights."
That means that the stock rights were not a taxable dividend (in the opinion of HSBC) and you can follow the rules for non-taxable status. There is no taxable event until you sell them and you can use the acquisition date of your HSBC shares as the date your holding period begins for the rights. This is advantageous because the gain on the sale of the rights will be taxed at long-term capital gain rates rather than ordinary short-term capital gain rates (assuming you bought your HSBC shares more than one year ago.)
Are you required to allocate basis? No, because the total market value of your 41.66667 rights on the first day of trading (March 20, 2009, on the London exchange) is only 11% of the equivalent total market value of your 100 HSBC ADSs. It does not meet the 15% threshold where you are required to allocate part of your cost basis.
Are you going to allocate basis? Yes, because you don't want to pay capital gains tax on $369.05 of sales proceeds when you have basis that you can use to reduce your tax.
Your cost basis (CB) allocation to the rights is then computed by the following formula, using respective market values (MV) on the first day of trading:
(MV rights) ÷ (the sum of MV rights plus MV stock) x (CB original stock) = CB rights
The March 20, 2009, closing prices on the London exchange were 371 pence for the HSBC ordinary shares and 110 pence for the ordinary stock rights (referred to as nil-paid rights on the London markets.) Since the HSBC ADS shares represent 5 ordinary HSBC shares, the equivalent market values were as follows:
100 HSBC ADS shares x 5 = 500 ordinary shares x 371 pence = 185,500.00 pence 41.66667 ADS rights x 5 = 208.33 ordinary rights x 110 pence = 22,916.30 pence Total combined market value 208,416.30 pence
The HSBC stock rights cost allocation factors, based on the London trading closing prices on 3/20/2009, turned out to be:
HSBC ADS rights 10.9954% based on 22,916.30 pence divided by 208,416.30 pence HSBC ADS 89.0046% based on 185,500.00 pence divided by 208,416.30 pence
We can round the allocation factors to 11% and 89% for ease of calculation.
For the HSBC example, the math works out as follows:
Allocation factor of 11% x $9,100.00 = $1,001.00 cost basis of 41.66667 rights Your cost basis for the .66667 fractional right is .66667 ÷ 41.66667 x $1,001.00 = $16.02 Your cost basis for 41 full stock rights is 41 divided by 41.66667 x $1001.00 = $984.98 You received $5.67 cash in lieu payment for your .66667 fractional right. Your capital (loss) on the cash in lieu payment is $5.67 minus $16.02 = ($10.35) Your new cost basis for the 100 HSBC ADSs is $9,100.00 less $1001.00 = $8,099.00 Your capital (loss) on the sale of the 41 rights is $369.05 less $984.98 = ($615.93)
Your capital loss for the sale of the rights and for the cash in lieu payment are both long-term because your holding period for the rights began 7/31/2006.
What's the bottom line? You turned a $369.05 taxable capital gain item into a capital loss of ($615.93) which you can claim against other income to reduce your taxes.
You can use our stock rights calculator to calculate your own gain or loss. It has pre-filled data for Bank of Ireland, HSBC, ING, McEwen Mining, Societe Generale, and other recent stock rights issued.
It can be difficult to obtain the historical market values on the first day of separate trading for foreign stocks and stock rights. A "quick and dirty" method to approximate the allocation is to add the gross sales proceeds for the rights to the total market value of the stock to arrive at a total combined value. Then allocate your cost basis in proportion to the relative percentages of the total combined value. This method does not meet the technical IRS guidelines but the result should approximate the true allocation percentages. It at least gives you an idea of how much basis you can claim and whether you should go to the trouble of further digging.
Important note: If rights are allowed to expire without being exercised or sold, the cost basis of the stock is unchanged and the rights receive no allocation of basis.
What if you exercise the rights rather than sell them? You still allocate cost basis to the rights in the manner described above. Your cost basis for the shares received becomes the sum of the cost basis of the rights exercised and the subscription price paid for the additional shares.