When Payments on Debt Are Considered a Deemed Dividend

By Jeff Borghino, CPA, Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

Corporations & Shareholders

A primary distinction between debt and stock is that a debt holder receives interest on debt, and a stockholder receives dividends on stock. However, Sec. 305 provides that a debt holder can receive a deemed dividend under certain circumstances for federal income tax purposes. Recently, the IRS applied Sec. 305 in Letter Ruling 201446013 to determine that certain convertible debt provided its holders with a deemed distribution under Sec. 301. This item summarizes the current law and discusses the facts and ruling in Letter Ruling 201446013.

Sec. 301

Sec. 301(a) provides that a distribution of property by a corporation (the distributing corporation) to a shareholder of the distributing corporation's stock is treated by the shareholder according to Sec. 301(c). Sec. 301(c) treats the distribution as: 

  1. A dividend to the extent of the distributing corporation's earnings and profits (Secs. 301(c)(1) and 316(a));
  2. A reduction of the shareholder's adjusted basis in the distributing corporation's stock to the extent that the distribution is not a dividend (Sec. 301(c)(2)); and
  3. Gain from a sale or exchange to the extent that the nondividend portion of the distribution exceeds the shareholder's adjusted basis in the distributing corporation's stock (Sec. 301(c)(3)).

The amount of any distribution is the amount of money plus the fair market value (FMV) of other property received (Sec. 301(b)). The basis of property received in a distribution under Sec. 301(a) is the FMV of the property (Sec. 301(d) and Regs. Sec. 1.301-1(h)).

Sec. 317(a) defines property as money, securities, and any other property except stock in the distributing corporation (or rights to acquire that stock).

Sec. 305

Sec. 305(a) generally provides that gross income does not include a distributing corporation's distribution to its shareholders on its stock if it is made in distributing corporation stock (i.e., a stock distribution).

Sec. 305(b) provides certain exceptions to Sec. 305(a) including: (1) "distributions in lieu of money" under Sec. 305(b)(1); and (2) "disproportionate distributions" under Sec. 305(b)(2). If an exception under Sec. 305(b) applies to a stock distribution, the stock distribution is treated as a distribution of property to which Sec. 301 applies.

Sec. 305(b)(1) provides that a distribution in lieu of money is a distribution payable at the election of any recipient shareholder in either (1) distributing corporation stock; or (2) property (e.g., cash). Under Regs. Sec. 1.305-2(a), a distribution in lieu of money is treated as a distribution to which Sec. 301 applies regardless of:

  1. Whether the distribution is actually made in whole or in part in the distributing corporation's stock (or in stock rights);
  2. Whether the election or option is exercised or exercisable before or after the declaration of the distribution;
  3. Whether the declaration of the distribution provides that the distribution will be made in one medium unless the shareholder specifically requests the other;
  4. Whether the election is provided in the declaration of the distribution or corporate charter, or arises from the circumstances of the distribution; or
  5. Whether all or part of the shareholders can make the election.

Sec. 305(b)(2) provides that a disproportionate distribution is a distribution (or series of distributions) that has the result of (1) the receipt of property by some shareholders; and (2) an increase in the proportionate interests of other shareholders in the assets or earnings and profits of the distributing corporation.

In determining whether a distribution (or a series of distributions) has the result of a disproportionate distribution, a security that is convertible into stock of the distributing corporation is treated as outstanding stock (whether or not it is convertible during the tax year) (Regs. Sec. 1.305-3(b)(5)).

Sec. 305(c) provides that certain transactions may be treated as distributions under Treasury regulations. Specifically, Sec. 305(c) provides that a change in a conversion ratio may be treated as a distribution to any shareholder whose proportionate interest in the earnings and profits or assets of the distributing corporation is increased by that change.

For purposes of Secs. 305(b) and (c), the holder of a convertible security is a shareholder (Sec. 305(d)(2)).

Under Regs. Sec. 1.305-7(a), a change in conversion ratio is treated as a distribution to which Sec. 301 applies if (1) the proportionate interest of any shareholder in the earnings and profits or assets of the distributing corporation is increased by the change; and (2) the distribution has a result described in Sec. 305(b)(2), (3), (4), or (5). Such a distribution will be deemed to be a distribution of the distributing corporation's stock to the shareholder by the distributing corporation on its stock. Depending on the facts, the distribution may be deemed to be made in common or preferred stock.

Regs. Sec. 1.305-7(b)(1) provides that a change in the conversion ratio of convertible stock or convertible securities under a bona fide and reasonable adjustment formula will not be considered to result in a deemed distribution of stock if it has the effect of preventing dilution of the interest of the holders of the convertible stock or securities (the antidilution exception). However, the antidilution exception does not apply to an adjustment in a conversion ratio to compensate for cash or property distributions to other shareholders that are taxable under Sec. 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b), or 857(b).

Rev. Rul. 75-513

The IRS said in Rev. Rul. 75-513 that an increase in the conversion ratio of convertible debentures was treated as a deemed distribution under Sec. 301 because of Secs. 305(b)(2) and (c).

In Rev. Rul. 75-513, a real estate investment trust (X1) filed its tax return on a calendar-year basis. X1 had outstanding stock (the X1 shares) and debentures that were convertible into X1 shares under a specified conversion ratio (e.g., 10 X1 shares per debenture). The conversion ratio of the debentures was subject to an annual adjustment on Jan. 31 to reflect the difference between the interest rate of the debentures and the yield that could have been obtained by investing in X1 shares on the debentures' issue date. X1 paid a cash dividend to its shareholders in 1973. As a result of the cash dividend, the conversion ratio of the debentures was increased on Jan. 31, 1974 (the increase). The increase entitled the debenture holders to acquire additional X1 shares upon a conversion of the debentures.

The cash dividend and the increase resulted in (1) a receipt of property by some X1 shareholders (i.e.,the cash dividend to the X1 shareholders); and (2) an increase in the proportionate interest in the assets or earnings and profits of X1 of other X1 shareholders (i.e., the increase to the debenture holders). Thus, the IRS ruled that the increase constituted a deemed distribution of X1 shares to the debenture holders on Jan. 31, 1974, to which Sec. 301 applies because of Secs. 305(b)(2) and 305(c).

Rev. Rul. 76-186

The IRS confirmed in Rev. Rul. 76-186 that a deemed distribution to convertible debenture holders similar to Rev. Rul. 75-513, in fact, resulted in a dividend and increased the basis of the convertible debentures in their holders' hands.

The facts in Rev. Rul. 76-186 were substantially similar to Rev. Rul. 75-513. However, Rev. Rul. 76-186 also provided that the current earnings and profits of the distributing corporation exceeded the sum of actual distributions to its shareholders and the deemed distribution to the convertible debenture holders.

The IRS ruled that the deemed distribution was taxable as a dividend under Sec. 316 and includible in the gross income of the convertible debenture holders under Sec. 301(c)(1). The IRS also ruled that the basis of the convertible debentures was increased by the FMV of the deemed distribution under Sec. 301(d)(1) and Regs. Sec. 1.301-1(h).

Rev. Rul. 77-37

Contrary to Rev. Rul. 75-513 and Rev. Rul. 76-186, the IRS ruled in Rev. Rul. 77-37 that an increase in the conversion ratio of preferred stock was not treated as a deemed distribution under Sec. 301.

In Rev. Rul. 77-37, a corporation (X2) had outstanding common stock and convertible preferred stock. The preferred stock was convertible into common stock at a fixed conversion ratio. X2 distributed all of the stock of its wholly owned subsidiary, Y, to its common shareholders in a tax-free spinoff under Sec. 355. Because the distribution of the Y stock diluted the conversion value of the preferred stock (by decreasing the value of the X2 common stock), X2 increased the conversion ratio of the preferred stock to fully protect the preferred shareholders from dilution.

The IRS ruled that the increase in the conversion ratio of the preferred stock was not treated as a deemed distribution of stock under Secs. 305(b) and (c). The antidilution exception applied because the increase in the ratio was to protect the preferred shareholders from dilution, and Secs. 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b), and 857(b) did not apply to the tax-free spinoff of Y.

Letter Ruling 201446013

Similar to Rev. Rul. 75-513, the IRS concluded in Letter Ruling 201446013 that an increase in the conversion rate of a convertible debt resulted in a deemed distribution to the holders of the convertible debt.

In Letter Ruling 201446013, a corporation (the taxpayer) had issued outstanding common stock and convertible debentures (the convertible debt). The convertible debt could be converted for a specified amount of the common stock (the conversion rate). Under the terms of the convertible debt, the conversion rate would be increased (the adjustments) in connection with certain distributions the taxpayer made to its common stock shareholders (the distributions). The adjustments would entitle the convertible debt holders to a greater proportionate interest in the assets or earnings and profits of the taxpayer than what the holders of the convertible debt would have received if the adjustments were not made.

The taxpayer gave each common stock shareholder an election to receive the distributions (1) entirely in cash (the cash option); or (2) entirely in common shares. The cash option was subject to a maximum of cash available, but the taxpayer provided that the cash available would not be less than 20% of the aggregate value of the respective distributions.

The IRS ruled that any cash and common shares distributed in the distributions will be treated as distributions of property on the common stock to which Sec. 301 applied by reason of Sec. 305(b)(1).

In addition, the IRS ruled that the adjustments made in connection with the distributions to the convertible debt will constitute a deemed distribution of common shares to the holders of the convertible debt to which Sec. 301 applied by reason of Secs. 305(b)(2) and (c), citing Rev. Rul. 75-513. The antidilution exception would not apply to the adjustments because the distributions were taxable under Sec. 301.

Letter Ruling 201446013 appears to be consistent with Rev. Rul. 75-513 and prior rulings (see Letter Rulings 201312028 and 201247004).

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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