Proposed Regs Clarify Amount and Timing of Deemed Distributions from Adjustments to Stock Rights.

(Parker Tax Publishing APRIL 2016)

The IRS has issued proposed regulations that resolve ambiguities concerning the amount and timing of deemed distributions that are, or result from, adjustments to rights to acquire stock under Code Sec. 305(c). The proposed regulations also provide guidance regarding withholding obligations with respect to such deemed distributions. REG-133673-15.

Background

A corporation's distribution of its own stock to its shareholders in their capacity as shareholders generally is not taxable. This general rule in Code Sec. 305(a) also applies to a corporation's distribution of rights to acquire its stock. Rights to acquire stock may provide for applicable adjustments (e.g., an adjustment to the number of shares the holder would receive on exercise) that grant the holder of a right to acquire stock (deemed shareholder) economic benefits that correspond to distributions of stock, cash, or other property made to actual shareholders.

An applicable adjustment may have the effect of increasing the deemed shareholders' proportionate interests in the assets or earnings and profits of the corporation. If this increase has a result described in Code Sec. 305(b) (e.g., a distribution in lieu of money, or disproportionate distributions), then under Code Sec. 305(c) the applicable adjustment is a deemed distribution to the deemed shareholder, and is taxable under Code Sec. 301.

The current regulations are unclear regarding the amount of a deemed distribution to a deemed shareholder. They can be interpreted as providing either that such a deemed distribution is treated as a distribution of a right to acquire stock (the amount of which is the fair market value of the right), or that such a distribution is treated as a distribution of the actual stock to which the right relates (the amount of which is the fair market value of the stock). The current regulations are also unclear as to the timing of such a distribution.

The proposed regulations issued in REG-133673-15 (4/13/16) would amend the current regulations under Code Secs. 305(b) and (c) to clarify the amount and timing of such deemed distributions.

The proposed regulations also provide guidance to withholding agents regarding their obligations to withhold under Code Secs. 1441 and 1442, and under Code Secs. 1471 through 1474 on deemed distributions made to foreign persons.

The proposed regulations are generally effective when finalized, but taxpayers and withholding agents may rely on the regulations for deemed distributions under Code Sec. 305(c) that occur prior to such date.

Amount and Timing of Deemed Distributions

Under the proposed regulations, an "actual" shareholder is defined as a holder of stock (not including rights to acquire stock) and a "deemed" shareholder is defined as a holder of a right to acquire stock. A deemed distribution is defined as a transaction or event, other than an actual distribution of stock, money, or other property, that is a distribution under Code Sec. 305(b) and (c).

According to the IRS, under the terms of a convertible instrument, a distribution of cash or property to actual shareholders may increase the number of shares the holder of the convertible instrument would receive on conversion. Similarly, a distribution of cash or property to actual shareholders may increase the number of shares the holder of other rights to acquire stock, such as warrants or options, would receive upon exercise. In either case, the increase is an applicable adjustment and a deemed distribution of additional rights to acquire stock to the holders of the rights to acquire stock. Under the proposed regulations, the amount of such deemed distribution is the excess of:

(1) the fair market value of the right to acquire stock immediately after the applicable adjustment over

(2) the fair market value of the right to acquire stock without the applicable adjustment.

Also, under the terms of a convertible debt instrument or other right to acquire stock, a payment of cash or property to a deemed shareholder may cause a reduction in the number of shares the holder would receive on conversion or exercise. Such a reduction is an applicable adjustment that increases the actual shareholders' proportionate interests in the assets or earnings and profits of the corporation. Thus, the applicable adjustment results in a deemed distribution of stock to the actual shareholders, and Code Sec. 301 applies to the deemed distribution.

Under the proposed regulations, the amount of such deemed distribution is the fair market value of the stock deemed distributed, determined in accordance with Reg. Sec. 1.305-3(e), Examples 8 and 9 (relating to deemed distributions to shareholders resulting from certain redemptions of stock from other shareholders).

With regards to timing, the proposed regulations provide that when an applicable adjustment is or results in a deemed distribution, the deemed distribution occurs at the same time as the applicable adjustment occurs, in accordance with the instrument setting forth the terms of the right to acquire stock. Such deemed distribution occurs no later than the date of the distribution of cash or property that results in the deemed distribution (taking into account Reg. Sec. 1.305-3(b)).

For an applicable adjustment relating to a right to acquire publicly-traded stock, if the instrument setting forth the terms of such right does not provide the date and time the applicable adjustment occurs, the deemed distribution would occur immediately prior to the opening of business on the ex-dividend date for the distribution of cash or property that results in the deemed distribution.

Withholding on Deemed Distributions under Code Section 305(c) The proposed regulations apply to withholding under Code Secs. 1441 and 1442, and under Code Secs. 1471 through 1474 on payments made to foreign persons.

The proposed regulations clarify that a withholding agent has a general obligation to withhold on a deemed distribution (as defined in Reg. Sec. 1.305-1(d)(7)) that is made on a security.

In general, a withholding agent would be required to satisfy its withholding obligation by withholding on the earliest of:

(1) the date on which a future cash payment is made with respect to the security;

(2) the date on which the security is sold, exchanged, or otherwise disposed of (including a transfer of the security to another account not maintained by the withholding agent or a termination of the account relationship); or

(3) the due date (not including extensions) for filing Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, with respect to the calendar year in which the deemed distribution occurred.

For a discussion of the taxability of stock dividends, see Parker Tax ¶ 44,310.

For a discussion of withholding on payments to nonresident aliens and foreign entities, see Parker Tax ¶ 202,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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