Informal guidance from the IRS indicates that taxpayers that have received deemed distributions of dividends on convertible securities under Section 305(c) may submit accounting method change requests to address the potential liability for the income tax attributable to conversion rate adjustments.

Background

Under Section 305(c), when a corporation has an outstanding convertible bond, the convertible bond usually provides that the bond's conversion ratio will be adjusted upwards when a cash dividend is paid on the common stock into which the bond is convertible. For many years, the IRS has taken the position that these are deemed distributions to the bond holder, includible in income under Section 301, even though no cash is paid out. The bond holder's basis in the convertible security will also increase by the amount of the adjustment, although the increase would not benefit a taxpayer that was subject only to the gross basis US tax. Similar adjustments, and similar tax consequences, apply to warrants and convertible preferred stock. Therefore, the income that results from the conversion rate adjustment is likely to be subject to US income tax as dividend income. Consequently, US withholding tax would apply to non-US holders of such convertible securities. For many years, however, there was little compliance with this aspect of the US withholding tax regime because there is no cash payment from which to withhold funds, and many funds therefore have potential income and withholding tax exposure for prior years.

Accounting methods implications

From a bond holder's perspective, coming into compliance with Section 305(c) would constitute an accounting method change, because the inclusion of the dividend would also increase the basis in the bond, thus rendering the difference one of timing (although the gain or loss on the sale or other disposition of the bond would be tax-exempt for most foreign holders). Some taxpayers may benefit from filing for an accounting method change to address the potential liability for the income tax attributable to the conversion rate adjustments.

Under standard method change procedures, if a method change were granted to a taxpayer on this issue, the taxpayer would be required to agree to include in its income an amount corresponding to the dividend income on convertible bonds that it still held (a Section 481(a) adjustment). This amount would generally be included ratably over the four-year period starting with the year for which the change was granted (e.g., 2016, if the change is filed this year). Under standard method change procedures, if the method change were granted, the taxpayer would receive audit protection for all prior periods relating to this issue. That is, the IRS could not assess tax relating to any conversion ratio adjustment, whether or not that conversion ratio adjustment was reflected in the Section 481(a) adjustment. Existing guidance allows the IRS to treat the Section 481(a) adjustment as a dividend.

According to the informal guidance, the IRS is prepared to accept requests for accounting change methods filed on Forms 3115 on this issue. Any such request should be filed soon to increase the likelihood that the method change is granted before the taxpayer must send out Schedules K-1 for its 2016 tax year.

The withholding tax liability is a separate issue that we have been told informally would not be covered by the accounting method change request. EY is available to consult with companies on the applicability of the method change as well as the application of the withholding tax issue to any particular set of circumstances.

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