IRS to address conversion ratio adjustments for convertible debt
Clarification expected on adjustments triggered by dividends
INSIGHT ARTICLE |
Convertible debt instruments (convertibles) are widely used in corporate finance. The value of a corporation’s convertibles can decrease significantly if a corporation engages in mergers or change of control transactions, or pays higher-than-expected dividends.
To protect holders of convertibles against these decreases in value, many convertibles provide for conversion ratio adjustments. The IRS is working on guidance expected to address whether events that trigger the conversion rate adjustments are treated as taxable distributions to the holders of convertibles.
Deemed taxable distributions to holders of convertibles (or preferred stock or one of multiple classes of common stock) can arise under section 305 of the Tax Code when changes are made to the holders’ rights. However, conversion ratio adjustments that protect against potential dilution of value are not supposed to result in current taxable events. A regulation generally protects these anti-dilution adjustments from taxable distribution treatment (Reg. section 1.305-7(b)(1)). This regulation, however, excludes adjustments based on corporate distributions from its protection.
Distribution-based conversion adjustment provisions are a common feature of convertibles; without this type of adjustment, an extraordinary dividend could significantly decrease the value of the convertibles. Given that they are not protected by the regulation, it is not clear whether this type of adjustment may trigger taxable distribution treatment under section 305.
Convertible offering disclosures often state that whether conversion ratio adjustments are taxable is uncertain. An industry group has advocated permitting the distribution-based adjustments. The IRS is working on guidance that is expected to address the issue. At a tax conference on March 4, 2016, IRS Associate Chief Counsel (Corporate) Bob Wellen described the forthcoming IRS guidance as a clarification.
In the absence of clearer guidance addressing the tax treatment of conversion ratio adjustments, taxpayers should carefully consider the impact of these adjustments and seek tax advice when structuring or marketing convertibles, and again if the adjustment is triggered.