The Internal Revenue Service (IRS) has released proposed regulations (the Proposed Regulations) providing guidance to corporate issuers and withholding agents on their withholding and reporting requirements in connection with deemed distributions resulting from adjustments to conversion ratios on convertible bonds and other rights to acquire stock.
Current Treasury Regulations under Section 305 of the Internal Revenue Code of 1986, as amended,1 provide certain circumstances in which a change to the conversion ratio or redemption price on a convertible bond, warrant or other stock right (a right to acquire stock) may be treated as a distribution (a deemed distribution) by the corporation that is taxable as a dividend. Following the enactment in 2010 of Section 871(m), which treats “dividend equivalent” payments on equity swaps and certain “equity linked instruments” (including rights to acquire stock) as U.S. source dividends subject to U.S. federal withholding tax, withholding agents expressed concern over their withholding tax obligations on deemed distributions. Final Treasury Regulations under Section 871(m) released in September 2015 clarified that the amount of any dividend equivalent on a right to acquire stock is reduced by the amount treated as a dividend under Sections 305(b) and (c). The Proposed Regulations provide guidance on the withholding and reporting obligations of issuers and withholding agents with respect to any amount treated as a deemed distribution.
Determination and Amount of Deemed Distribution
A deemed distribution may occur with respect to the holder of a right to acquire stock (a deemed shareholder) if an adjustment to the right to acquire stock, such as an increase in the conversion ratio or a reduction in the conversion price (an applicable adjustment), has the effect of increasing the deemed shareholder’s proportionate interest in the assets or earnings and profits of the issuer. Likewise, an applicable adjustment that reduces the deemed shareholder’s proportionate interest in the assets or earnings and profits of the issuer may give rise to a deemed distribution to actual shareholders of the corporation’s stock (actual shareholders) as of the time of the applicable adjustment. The amount of a deemed distribution to a deemed shareholder is the excess of the fair market value of the right to acquire stock immediately after the applicable adjustment over the fair market value of the right to acquire stock immediately after the applicable adjustment without the applicable adjustment. For a deemed distribution to an actual shareholder, the amount of the deemed distribution is the fair market value of the stock deemed distributed. The determination of fair market value will not take into account any particular facts pertaining to a deemed shareholder or any value or reduction in value attributable to the possibility of future applicable adjustments that may result from actual or deemed distributions.
Timing of Deemed Distribution
Under the Proposed Regulations, a deemed distribution will be treated as occurring at the time the applicable adjustment occurs as set forth in the terms of the right to acquire stock, but in no event later than the actual distribution of cash or property that results in the deemed distribution. If the right to acquire stock does not set forth the time of the applicable adjustment and the stock of the issuer is publicly traded, then the deemed distribution is treated as occurring immediately prior to the opening of business on the ex-dividend date for the distribution of the cash or property that results in the deemed distribution. If the right to acquire stock does not set forth the time of the applicable adjustment and the stock of the issuer is not publicly traded, the deemed distribution occurs on the date that a holder is legally entitled to the distribution of cash or property that results in the deemed distribution.
The Proposed Regulations require withholding agents to withhold tax on deemed distributions even if there is no actual cash payment made to the holder during the calendar year of the deemed distribution. However, if the withholding agent is not the issuer, the withholding agent is generally required to withhold on a deemed distribution only if (1) the issuer reports the amount and date of the deemed distribution to the withholding agent (or posts such information on a public website) prior to March 15 of the calendar year following the deemed distribution or (2) the withholding agent has actual knowledge of the deemed distribution. A withholding agent may generally rely on information reported by the issuer to determine the amount of a deemed distribution unless the withholding agent knows that such information is incorrect or unreliable.
The withholding agent is generally required to withhold on a deemed distribution by the earlier of (1) the date when a cash payment is made on the security upon which the deemed distribution is made, (2) the date on which the security is sold, exchanged or otherwise disposed of (including the transfer of the security to an account with a different withholding agent or the termination of the account) or (3) March 15 of the calendar year following the deemed distribution.
The Proposed Regulations also permit a withholding agent to satisfy its withholding obligation from property it holds in custody for the beneficial owner of the deemed distribution.
Issuer Reporting Requirements
The Proposed Regulations require the issuer to report the amount and date of a deemed distribution to the IRS and to holders of stock or rights to acquire stock within 45 days of the deemed distribution, or if earlier, January 15 of the calendar year following the deemed distribution. Alternatively, the issuer may post the relevant information on a public website in lieu of filing a return with the IRS and holders.
The Proposed Regulations would apply to deemed distributions occurring on or after the publication date of final regulations. Taxpayers may rely on the Proposed Regulations until then.