United States

Proposed regulations under section 305 for convertibles and options

Proposal addresses deemed distribution amounts, timing and withholding



The Treasury Department and the IRS have issued proposed regulations (REG-133673-15) addressing conversion ratio adjustments for convertible debt (and similar adjustments for options). Adjustments to the conversion feature on a convertible debt can give rise to a taxable deemed distribution to the debt holders (or, in some instances, to existing shareholders) under section 305.

The proposed regulations would specify the amount and timing of these deemed distributions. Deemed distributions could result even for conversion ratio (or option) adjustments that are intended merely to restore losses of value caused by triggering events such as corporate distributions. Historically, many corporations have not reported adjustments to restore conversion feature or option value as deemed distributions.

The proposed regulations also would provide some relief to brokers and other intermediaries (brokers) who may be required to report and/or withhold tax as a result of the deemed distributions. Brokers’ obligations to report and/or withhold generally would be conditioned on either (a) their knowledge of the facts, or (b) timely completion of a Form 8937, Report of Organizational Actions Affecting Basis of Securities, by the corporation that issued the convertible debt (or option). This framework may put additional pressure on corporations to complete their Forms 8937 on a timely basis where required.

Deemed distributions based on conversion ratio adjustments

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.

Changes to the rights of a corporation’s convertible holders can result in taxable deemed distributions to the convertible holders. Similar deemed distributions can also be triggered by changes made to the rights of holders of preferred stock or other instruments.    

For convertibles, conversion ratio adjustments that protect against potential dilution generally do not result in a current taxable event. 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 adjustments are a common feature of convertibles; without this type of adjustment, an extraordinary dividend could significantly decrease the value of the convertible. Historically, many corporations have not treated these distribution-based adjustments as triggering taxable distributions even though they were not expressly protected by the favorable rule for anti-dilution adjustments.

The IRS’ historical position on this issue was that distribution-based conversion ratio adjustments triggered by taxable corporate distributions result in deemed distributions under section 305. The proposed regulations adhere to this historical approach, and reinforce the approach with a new rule addressing the amount of the deemed distribution.

This rule looks only to post-triggering event valuations, rather than comparing pre-trigger event and post-trigger event valuations. Where a deemed distribution is triggered by a conversion ratio adjustment (or similar option adjustment), the proposed regulations would provide that the distribution amount equals the excess of (1) the fair market value (FMV) of the conversion right (or option right) immediately after the adjustment, over (2) the FMV of the right without the adjustment at such time. Because this rule does not compare FMVs before and after the triggering event, the tax treatment of a conversion ratio adjustment (or similar option adjustment) may be counterintuitive. For example, a dividend-based adjustment that is mathematically computed based on restoration of a convertible’s value may result in a taxable deemed dividend when the adjustment is triggered.    

For conversion ratio adjustments made as a result of corporate distributions such as dividends, the proposed regulations also specify the deemed distribution date. They state that the deemed distribution take place in accordance with the convertible’s terms, but in no event later than the date of the distribution that triggers the conversion adjustment.  

The general tax consequences of a deemed distributions to a convertible (or option) holder would not be changed by these regulations. The deemed distribution would be a dividend to the extent it does not exceed available earnings and profits (E&P). To the extent it exceeds E&P, the deemed distribution would be a return of capital, or, to the extent it exceeds the holder’s tax basis, taxable gain (generally capital gain if the instrument is a capital asset).

The proposed deemed distribution regulations would be effective when finalized, but taxpayers may rely on the proposed regulations for transactions occurring at an earlier date.  

Information reporting and withholding

Like cash distributions from a corporation, deemed distributions under section 305 that are treated as dividends can trigger information reporting and withholding requirements. For example, these requirements may include filing Forms 1099-DIV to report dividends and Forms 1042-S to report withholding.    

Deemed distributions may be subject to the general gross basis withholding tax that applies to dividends paid to foreign persons or to withholding under the Foreign Account Tax Compliance Act (FATCA) provisions.

Brokers' systems generally are geared toward reporting and/or remitting withholding tax with respect to cash dividends. Deemed distributions under section 305 raise issues regarding brokers’ knowledge of what to report and whether and when to withhold. The proposed regulations directly address these issues with a set of rules intended to relieve brokers of certain responsibilities where the corporation undergoing the deemed distribution transaction does not timely report it on a Form 8937.

The deadline for completing Forms 8937 generally is the earlier of (a) 45 days after the transaction that triggers the reporting requirement, or (b) Jan.15 of the year following the calendar year the transaction occurred in. A corporation generally may satisfy its Form 8937 requirements by publishing the completed form on the corporation’s website for a 10-year period.

Failure to complete the Form 8937 on a timely basis after a deemed distribution may relieve brokers from the obligation to file necessary information reporting forms (such as Form 1099) and/or remit any applicable withholding. The corporation that issued the convertible (or option), however, would not be relieved on its obligations to file appropriate information returns or withhold and remit any tax due. Accordingly, these proposed rules may put more pressure on corporations to complete Forms 8937 on a timely basis.      

For situations where brokers remain subject to withholding requirements, the proposed regulations include rules regarding the timing of any required withholding. The proposed regulations regarding information reporting and withholding generally would apply to transactions on or after the date they are finalized, but taxpayers may rely on the proposed regulations in this regard for deemed distributions occurring on or after Jan. 1, 2016.   



How can we help you?

Contact us by phone 800.274.3978 or
submit your questions, comments, or proposal requests.



2019: Tax opportunities and challenges for manufacturers

  • January 23, 2019


Legislative changes and other tips for your tax planning

  • January 17, 2019