The IRS issued proposed regulations Tuesday (REG-133673-15) intended to clarify the amount, timing, and reporting of deemed distributions of stock and rights to acquire stock. The proposed regulations also clarify with respect to deemed distributions the responsibilities of withholding agents under Code Chapter 3 (withholding on U.S.-source income of nonresident aliens and foreign corporations) and Chapter 4 (the Foreign Account Tax Compliance Act (FATCA)). They provide a new exception from FATCA withholding obligations with respect to certain deemed distributions.
A right to acquire stock includes warrants, convertible instruments (including debt convertible into shares of stock), and similar rights to acquire stock of the issuing corporation. A holder of such rights but not of the corporation’s actual stock is a “deemed shareholder” under the proposed regulations.
Actual and deemed shareholders may receive an actual or deemed distribution from transactions or events described in Secs. 305(b) and (c). Under Sec. 305(c), changes in conversion ratios or redemption prices and similar transactions can be treated as taxable distributions. When applied to a right to acquire stock, these changes are termed “applicable adjustments” in the proposed regulations.
The proposed regulations would provide that a distribution of cash or property to actual shareholders that increases the amount of stock a holder of rights to acquire stock would receive on conversion or exercise is an applicable adjustment and a deemed distribution of additional rights to acquire stock to the holders of the rights to acquire stock. The amount of the deemed distribution is the excess of the fair market value (FMV) of the right to acquire stock immediately after the applicable adjustment, over its FMV without the applicable adjustment.
A distribution of cash or property to actual shareholders that reduces the amount of stock a holder of rights to acquire stock would receive on conversion or exercise is an applicable adjustment increasing the actual shareholders’ proportionate interests in the corporation’s assets or earnings and profits and thus results in a deemed distribution to the actual shareholders to which Sec. 201 applies. In that case, the regulations propose that the amount of the deemed distribution is the FMV of the stock deemed distributed, determined under current Regs. Sec. 1.305-3(e).
The proposed regulations provide that when applicable adjustments are, or result in, deemed distributions, the deemed distributions occur at the time the applicable adjustment causing them occurs, under the terms of the instrument setting forth the terms of the right to acquire stock, but in no event later than the date of the distribution of property or cash resulting in the deemed distribution. If the instrument does not prescribe a date and time of the applicable adjustment, the deemed distribution for publicly traded stock occurs immediately prior to the opening of business on the ex-dividend date for the distribution of property or cash that results in the deemed distribution; for non-publicly traded stock, the deemed distribution occurs on the date that a holder is legally entitled to the distribution of cash or property that results in the deemed distribution.
In the wake of the enactment of FATCA, withholding agents have commented on uncertainty in how to fulfill their Chapter 3 and 4 obligations with respect to deemed distributions under Sec. 305(c), which generally lack any cash payment and may not be communicated to them, the IRS said. The proposed regulations clarify that a withholding agent has an obligation to withhold on a deemed distribution that is made on a security. They also clarify that an issuer of a security upon which a deemed distribution is made and any person that holds, directly or indirectly, a security on behalf of the beneficial owner of the security, or a flowthrough entity that owns directly or indirectly (through another flowthrough entity) a security, is considered to have custody of or control over the deemed distribution made on the security and, therefore, is a withholding agent with respect to the distribution.
With regard to Chapter 3 reporting, the proposed regulations provide guidance on when and how to withhold, when foreign entities assume withholding responsibilities, and when a withholding agent may rely on issuer information reporting. With regard to Chapter 4 reporting, the proposed regulations provide similar guidance, as well as guidance regarding the treatment of substitute dividends that are deemed payments and issuer reporting under Sec. 6045B, which requires an issuer of a specified security to file a return relating to certain actions that affect the basis of the security.
Finally, in the preamble to the proposed regulations, the IRS specifically requests comments on the reporting of deemed distributions to U.S. persons under Sec. 6042 on Form 1099-DIV, Dividends and Distributions.
The proposed regulations generally would be effective when published as final in the Federal Register and apply to deemed distributions occurring after that date; taxpayers may rely on the proposed regulations for deemed distributions under Sec. 305(c) that occur before that date.
—Paul Bonner (email@example.com) is a Tax Adviser senior editor.