Deemed Dividends on Convertible Debt Under Sec. 305(c)

By Robert A. Velotta, CPA, MT, Cleveland

Editor: Anthony S. Bakale, CPA, M.Tax.

Over the past decade or so, several public companies have issued convertible debt instruments that provide for a conversion rate adjustment (CRA) so that a conversion rate is changed if a distribution is made on corporate stock. One of the CRA's primary purposes is to prevent a convertible debt holder from being diluted upon a distribution to the shareholders by adjusting the conversion rate on the stock to increase the number of shares that the debt holder can obtain in a conversion of the bond to shares of the company.

To understand a CRA in its simplest form, consider the following.

Example: Bondholder holds $1 million of debt that is convertible into 20,000 common shares of Company A (20 shares of Company A's common stock per $1,000 of principal amount of the debenture, or an initial conversion rate of 20). Company A pays a dividend to common shareholders of $0.25 per share. The company's share price immediately prior to the ex-dividend date is $40 per share. Under the formula prescribed in the debt instrument, the conversion rate is adjusted as follows: [old conversion rate (20) × share price immediately preceding the ex-dividend date ($40)] ÷ [share price ‒ cash per share distributed ($40 ‒ $0.25)]. Accordingly, the new conversion rate after the dividend is 20.1258 (20.1258 shares per $1,000 of principal). Assuming the share price remains at $40, the CRA's economic value to the convertible bondholder is $5.032 per $1,000 of bonds (CRA adjustment of 0.1258 × $40 per share), for a total increase in value to the bondholder of $5,032.

CRAs come in various forms. The convertible debt of a company may provide for a CRA for any distributions paid, whereas a company with a fairly steady distribution history may issue debt providing for a CRA only to the extent that the distributions exceed a specified threshold.

Under Sec. 305(c), a change in the conversion ratio or conversion price or a similar transaction is treated "as a distribution [by the corporation] with respect to any shareholder whose proportionate interest in the earnings and profits or assets of the corporation is increased by such change." Under Sec. 305(d), the term "shareholder" includes a holder of rights or convertible securities for Sec. 305(c) purposes.

Regs. Sec. 1.305-7(b)(1) states that an adjustment in the conversion ratio or price made under a bona fide, reasonable adjustment formula will not be considered to be a deemed distribution of stock. Examples of these types of formulas are anti-dilution provisions including a conversion price adjustment related to new stock issuances below the conversion price and return-of-capital distributions.

However, if the adjustment is to compensate the debt holder for cash or property distributions to other shareholders that are taxable under Sec. 301 (or other sections), it will not be considered as made pursuant to a bona fide adjustment formula under Regs. Sec. 1.305-7(b). Accordingly, CRAs that are based on nontaxable distributions (i.e., return of capital) are not taxable. However, CRAs that are based on dividend payments under Sec. 301 made to common shareholders will be considered to be deemed-dividend payments to bondholders even before the bondholders convert the debt to equity.

In the example above, assuming the corporation had sufficient earnings and profits, the convertible debt holder would be deemed to have received dividend income of $5,032.

Sec 305(c) is not a new rule, but it has gained attention because of proposed regulations (REG-120282-10) issued under Sec. 871(m) related to U.S. tax withholding on dividend-equivalent payments made to non-U.S. recipients. Sec. 871(m) was added as part of the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147, enacted on March 18, 2010. One of the primary concerns addressed in Sec. 871(m) was the use of derivative instruments to avoid U.S. withholding tax for foreign recipients.

In a simple example, without Sec. 871(m), a foreign investor could avoid being subject to U.S. withholding taxes on dividend payments made by a U.S. company by using a total return swap (a notional principal contract under Regs. Sec. 1.446-3) on an equity position and obtain a return comparable to a direct investment in the company without being the direct recipient of dividend income subject to U.S. tax withholding. Sec. 871(m) affirmatively eliminated this possibility by requiring withholding agents to withhold U.S. tax on payments that are deemed to be equivalent to a dividend, including payments on certain notional principal contracts and other similar instruments.

The proposed regulations would consider a dividend-equivalent payment on certain convertible bonds held by non-U.S. persons to be a deemed dividend subject to withholding to the extent the bond references dividend-paying U.S. stocks. However, Prop. Regs. Sec. 1.871-15(c)(2) specifically states that a payment under Sec. 871(m) is not a dividend equivalent to the extent the payment is treated as a distribution taxable as a dividend pursuant to Sec. 305. This exception was based on the premise that U.S. tax withholding is already required on those amounts under Sec. 1441.

Specifically, even though the CRA is a deemed, and not actual, dividend to bondholders, Regs. Sec. 1.1441-2(d) requires a withholding agent to withhold on the deemed dividend to a foreign bondholder to the extent the withholding agent has control or custody of money or property owned by the recipient or beneficial owner and has knowledge of the facts that give rise to the payment.

This exception in the proposed Sec. 871(m) regulations and the requirement under Regs. Sec. 1.1441-2(d) that withholding agents have knowledge of the facts before U.S. tax withholding is required of them caused the New York State Bar Association (NYSBA) Tax Section to devote several pages of its Report on Proposed Regulations Under Section 871(m) (May 20, 2014) to the coordination of Sec. 305 with the proposed regulations.

In its report, the NYSBA said,

In practice . . . although . . . a typical convertible debt offering document will indicate that section 305 may apply to changes in the instrument's conversion ratio, brokers and other withholding agents that would be required to do the reporting and withholding with respect to section 305 "deemed" dividends are not made aware of changes that have occurred in the instrument's conversion ratio or the amount of the resulting "deemed" dividend, leading to a lack of actual withholding tax.

The NYSBA also suggested a real-time reporting regime for CRAs to allow for timely knowledge and U.S. tax withholding by the "withholding agency."

The NYSBA did acknowledge that, starting in 2016, issuers of convertible debt and similar instruments will be required by Sec. 6045B to report certain organization actions that affect basis (on Form 8937, Report of Organizational Actions Affecting Basis of Securities), and this reporting would seemingly include deemed dividends under Sec. 305(c). However, this reporting may not be timely enough to allow for appropriate U.S. tax withholding.

The deemed-dividend rules of Sec. 305 for CRAs are certainly not new but have been brought to the forefront because of the issuance of the proposed regulations. As a result of this new scrutiny, many tax practitioners in the financial services industry have spent an increasing amount of time ensuring that their procedures to identify deemed dividends under Sec. 305(c) are appropriate, and they have had a significantly heightened awareness of these rules.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.