The IRS has issued proposed regulations (REG-133673-15) clarifying the determination of the amount and timing of Section 305(c) deemed distributions that result from adjustments to rights to acquire stock, including deemed distributions on convertible bonds arising from adjustments to conversion ratios, as well as addressing withholding and reporting obligations relating to these deemed distributions.

Amount and timing of deemed distributions under Section 305(c)

Section 305(a) provides generally that gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to their stock. Section 305(b) and (c) provide exceptions to the general rule, pursuant to which certain distributions of stock are treated as distributions of property to which Section 301 applies.

A holder of a right to acquire stock of a corporation is treated as a shareholder for purposes of Section 305 (a deemed shareholder), and in some instances such holder may be treated as in receipt of a distribution of property subject to Section 301. Corporations issue rights to acquire stock in various forms (e.g., convertible debt, warrants, subscription rights, and options). These rights may provide for certain adjustments ("applicable adjustments" for purposes of the regulations) that correspond to distributions of stock, cash or other property made to actual shareholders. For example, a convertible bond usually provides that the conversion ratio will be adjusted upwards when a cash dividend is paid on the common stock into which the bond is convertible. Otherwise, the value of the conversion feature or other right would be diminished. For many years, the IRS has taken the position that such conversion adjustments are "deemed distributions" under Section 305(b) and (c) to which Section 301 applies. However, the current regulations are unclear as to the amount and exact timing of the deemed distribution in these circumstances. Additionally, because the deemed distribution is not accompanied by any cash payment, it has been difficult for withholding agents to know when a deemed dividend has occurred, and a withholding agent would typically not have any cash out of which to withhold tax.

Regarding the amount of the deemed distribution payment, the preamble to the proposed regulations explains that the current regulations could be interpreted as providing that such deemed distributions may be treated either as a distribution of a right to acquire stock or as a distribution of the actual stock to which the right relates. In the former case, the amount of the distribution would be the fair market value of the right; in the latter, the amount would be the fair market value of the stock, which would generally result in a larger distribution. The preamble states that the IRS has concluded that deemed distributions are more accurately viewed as distributions of additional rights to acquire stock (the amount of which is the fair market value of that right). Specifically, under the proposed regulations, the amount of the deemed distribution would be the excess of (A) the fair market value of the right to acquire stock over (B) the fair market value of the right to acquire stock without the applicable adjustment, both determined immediately after the applicable adjustment. As a practical matter, for a convertible bond that is deeply in-the-money at the time of the adjustment, the amount of the deemed distribution will be close to the full value of the additional stock while in the case of a convertible bond that is far out-of-the-money, the amount of the deemed distribution will be relatively small.

As to the timing of a deemed distribution, when an applicable adjustment results in a deemed distribution, the proposed regulations provide that the deemed distribution occurs at the time the applicable adjustment occurs — in accordance with the instrument setting forth the right to acquire stock — but in no event later than the date of the distribution of cash or property that results in the deemed distribution.

In addition, if under the terms of a convertible instrument (or right to acquire stock), a payment of cash or property to the holder of the right causes a reduction in the number of shares that the holder would receive upon conversion or exercise, the reduction would increase the actual shareholders' proportionate interest in the assets or earnings and profits of the corporation. The increase in proportionate interest would constitute a deemed distribution to the actual shareholders subject to Section 301 under Section 305(b)(2) and (c). The proposed regulations would treat the deemed distribution as a distribution of stock, and the amount of the deemed distribution would be the fair market value of the stock distributed.

The proposed regulations under Section 305 would apply to deemed distributions occurring on or after the date they are adopted as final regulations. However, the preamble adds that taxpayers may rely on the proposed regulations prior to that date. The preamble also states that — due to the ambiguity in the current regulations — until new final regulations are issued, taxpayers may determine the amount of the deemed distribution by treating such distribution either as a distribution of a right to acquire stock or as a distribution of the actual stock to which the right relates.

Substitute dividend payment may include deemed payments

Under existing law, there is uncertainty regarding a security lender's treatment of a conversion ratio adjustment that occurs when the convertible bond has been lent out in a securities lending transaction. The proposed regulations would resolve that uncertainty in the government's favor by amending the definition of "substitute dividend payment" in Reg. Section 1.861-3(a)(6) to include a deemed payment made in the amount of a deemed distribution under Section 305(c). This rule would apply to payments made on or after the date of publication of final regulations; taxpayers may also rely on the proposed regulations for deemed payments occurring on or after January 1, 2016.

Issuer reporting under Section 6045B

In response to concerns expressed by brokers and withholding agents about the difficulty of complying with reporting and withholding obligations in the absence of information about the fact and amount of a deemed distribution under Section 305(c), the proposed regulations include amendments to Reg. Section 1.6045B-1 to require issuers to provide this information. The proposed regulations would require that an issuer file an issuer return (Form 8937, Report of Organizational Actions Affecting Basis of Securities) with the IRS and provide a written statement to each holder of record of a specified security. In the alternative, the issuer can publish the information on its website. Unlike the standard rules for Form 8937, the requirement for the issuer to provide the information (and perform the computation) with respect to the Section 305(c) applies even if all holders of the security are otherwise exempt from receiving such information. These proposed rules would apply to deemed distributions under Section 305(c) occurring on or after the date of publication of final regulations.

Withholding on deemed distributions or deemed payments under Section 305(c)

The proposed regulations would also provide guidance to withholding agents regarding their obligations to withhold on deemed distributions under Section 305(c) with respect to certain payments to foreign persons on amounts subject to withholding under Sections 1441 and 1442, and also on withholdable payments in accordance with FATCA (Sections 1471 — 1474). The changes in the proposed regulations aim to address concerns from withholding agents about ambiguities in the law, particularly when no cash payment corresponds to a deemed distribution or a withholding agent (other than the issuer) lacks knowledge of a deemed distribution.

The proposed regulations generally require withholding agents to withhold under Sections 1441 and 1442 on deemed distributions or a deemed payment of a deemed distribution (as defined in the proposed regulations). The proposed regulations clarify that a withholding agent includes the issuer of the security upon which a deemed distribution is made and also any person that holds directly or indirectly on behalf of the beneficial owner, or a flow-through entity that owns directly or indirectly, a security upon which a deemed distribution is made. (Of course, as under current law, an issuer paying a US bank, broker, etc., is not liable if the bank/broker does not actually perform withholding, unless the issuer knew at the time of payment that the bank/broker would not withhold.)

With regard to the amount subject to withholding, the proposed regulations allow a withholding agent (other than the issuer) to rely on the information provided by the issuer under Reg. Section 1.6045B-1 (reporting of certain actions affecting the basis of a specified security) to determine the amount of the deemed distribution or deemed payment unless the withholding agent knows such information is unreliable or incorrect.

With respect to when the obligation to withhold arises, the proposed regulations provide that the obligation of a withholding agent (other than the issuer) to withhold does not arise unless, prior to the due date (not including extensions) for the withholding agent's Form 1042 (March 15 of the next year), the issuer of the specified security provides the information required under Reg. Section 1.6045B-1 regarding the deemed distribution or the withholding agent has actual knowledge of the deemed distribution. However, in the latter instance, the obligation to withhold does not arise until January 15 of the following calendar year, even if the withholding agent became aware of the transaction before such date.

Once the obligation to withhold arises under the rules discussed above, the proposed regulations also specify when the withholding agent is required to withhold. Withholding is required on the earliest of: (1) the date on which a payment is made with respect to the security or securities lending or sale-repurchase transaction; (2) the date on which the security is sold, exchanged or otherwise disposed of (including the transfer of the security to a separate account not maintained by the withholding agent or a termination of the account relationship); or (3) the due date (not including extensions) for the withholding agent to file Form 1042 for the calendar year in which the deemed distribution or deemed payment occurred.

In some instances, a withholding agent will have a withholding tax liability but insufficient funds to satisfy the liability. The rules allow withholding agents to cure the shortfall by withholding on future payments to the beneficial owner, by liquidating other property that it holds in custody for the beneficial owner, or by obtaining additional contributions directly or indirectly from the beneficial owner.

The proposed regulations also permit withholding agents to assume that certain foreign entities that assume primary withholding responsibilities under Sections 1441 and 1442 and FATCA will withhold with respect to deemed distributions on a specified security or deemed payments if the withholding agent has provided the foreign entity the information required under Reg. Section 1.6045B-1.

These proposed withholding regulations would apply to payments made on or after the date final regulations are published. However, withholding agents may rely on these proposed regulations for deemed distributions under Section 305(c) occurring on or after January 1, 2016.

It must be emphasized that if a withholding agent does not (or is not obligated to) perform withholding under these rules, the beneficial owner still remains liable for the tax.

Domestic reporting of deemed distributions

The preamble to the proposed regulations assumes that reporting of deemed distributions made to US persons would be similar to reporting of actual distributions under Section 6042 (Form 1099-DIV) and requests comments on the Form 1099-DIV reporting requirements for these amounts.

Implications

Overall, the proposed regulations are welcome guidance for taxpayers. While the proposed regulations confirm that certain conversion right adjustments constitute deemed distributions subject to Section 301 by reason of Section 305, they reduce the amount of the deemed distribution compared to prior law. Prior to this guidance, the IRS had characterized the distribution as a deemed distribution of stock. Revenue Ruling 75-513, 1975-2 C.B. 114. Moreover, in the past, the IRS had issued private letter rulings concluding that the amount of the deemed distribution is the fair market value as of the date of the adjustment of the additional number of shares made available to the holder by reason of the adjustment, without regard to the likelihood that the holder would actually exercise the right to receive such shares. See, for example, PLR 201446013 (Nov. 25, 2013), PLR 201312028 (Dec. 20, 2012) and PLR 201247004 (Aug. 22, 2012). Concerns were expressed that this approach does not accurately measure the value of the economic change in position, particularly where the options/embedded options are not in-the-money. In response, the proposed regulations view the deemed distribution as a distribution of additional rights, and provide that the amount of the deemed distribution would be (i) the excess of the fair market value of the right to acquire stock immediately after the applicable adjustment over (ii) the fair market value of the right to acquire stock without the applicable adjustment. Accordingly, the amount of the distribution for purposes of Section 301 would be limited to the incremental change in value to the right as a result of the adjustment.

The proposed regulations provide clarity that a withholding agent with respect to a deemed distribution or deemed payment on a security is not limited to the issuer and includes custodians that hold the security directly or indirectly on behalf of the beneficial owner or that own the security directly or indirectly and thus, as withholding agents, will be obligated to withhold consistent with these proposed regulations.

The proposed regulations also suggest that the IRS would be willing, in cases where the amount withheld was based on the fiction of a deemed distribution of stock, to allow refunds or credits to beneficial owners for the difference between the amount withheld and the amount that would have been withheld by valuing a right to acquire stock. Affected persons should consider filing a claim for refund or credit to recover the amount of overpaid tax. As was expected, the proposed regulations do not address the issue of potential tax liability for prior years for either the holders of convertible bonds or withholding agents; resolution of that issue may depend on the issuance of additional guidance by the IRS. The proposed regulations also do not address whether an individual or corporate holder of a convertible bond may claim qualified dividend treatment or a dividends received deduction, respectively, for a deemed dividend under Section 305(c).

The regulations also have implications for (i) convertible bond issuers, who will need to determine and report the amount of the deemed distributions, and (ii) brokers, who are required to report cost basis for convertible bonds acquired on or after January 1, 2016. A deemed dividend under Section 305(c) will generally result in an increase in the holder's basis in the bond, and this increase should be taken into account by the broker when reporting basis on a Form 1099-B. As a result of the expansion of the issuer reporting under Section 6045B, brokers should have the information available to adjust basis for these deemed distributions and to correctly report basis upon a sale or disposition. The proposed regulations continue the current-law alternative public website issuer reporting exception. Effectively, this places the burden on the issuer to determine the value of the conversion adjustment for any convertible bond it has issued at the time of each distribution paid to actual shareholders that gives rise to a deemed distribution on the convertible bond.

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