Sometimes corporations return cash to stockholders in a capital repayment which is a "deemed redemption" even though no shares of stock were sold. In a normal return of capital, the payment is applied first to cost basis and any excess is capital gain. The deemed redemption type of corporate action differs from a normal return of capital because even though no shares were sold, gain or loss is recognizable for the deemed redemption. In contrast, loss would not normally be recognized for a return of capital unless it was part of a total liquidation.
The cost basis for the deemed redemption is calculated by taking the redemption amount divided by the total fair market value of the stock just before the redemption times the cost basis. The capital gain or loss is then the difference between the redemption payment received and the cost basis allocated to the redemption. The "deemed redemption" tax treatment depends on the issuer meeting certain tests such as the payment being "not essentially equivalent to a dividend." The tax treatment is considered favorable because (1) you can recognize a loss currently before selling all of your shares, and (2) the payment is not taxed as dividend income.
Deemed Redemption Calculator
A prime example of this was the capital repayment made by ASML Holding NV this past year followed by a reverse split. ASML referred to the corporate action as a "synthetic buyback."
Click on the picture above to access our deemed redemption calculator.
How do you know if the payment you received was a "deemed redemption" rather than a return of capital? The corporation will tell you or else look on the investor relations website for the Form 8937 Report of Organizational Action for that tax year.
The deemed redemption tax treatment is based on Section 302 of the Internal Revenue Code.