Proposed regulations: Amount, timing of deemed distributions of stock

Amount, timing of deemed distributions of stock

The Treasury Department and IRS today released for publication in the Federal Register proposed regulations (REG-133673-15) regarding deemed distributions of stock and rights to acquire stock, in an effort to resolve ambiguities concerning the amount and timing of deemed distributions that are or result from adjustments to rights to acquire stock.

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The proposed regulations [PDF 264 KB] also include guidance for withholding agents regarding their current withholding and information reporting obligations with respect to deemed distributions. 

The proposed regulations generally would be effective with respect to deemed distributions occurring on or after the date final regulations are published in the Federal Register.

Reason for proposed regulations

According to the preamble, section 305(b) and (c) and the related current regulations are clear as that an adjustment in a conversion ratio, conversion price, option price, or number of shares a holder could receive upon exercise or conversion can constitute a deemed distribution under sections 305(b) and (c). However, the current rules are unclear as to the amount of a deemed distribution to a deemed shareholder (a holder of a right to acquire stock), and may reasonably 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 preamble to the proposed regulations states that for deemed distributions to deemed shareholders occurring before final regulations are published, the IRS will not challenge either position.

The IRS and Treasury also have found that current regulations are unclear as to the timing of such a distribution. Under the proposed regulations, such a distribution generally would be deemed to occur at the time the applicable adjustment occurs, in accordance with the instrument setting forth the terms of the right to acquire stock, but in no event later than the date of the distribution of cash or property that results in the deemed distribution. Today’s proposed regulations would amend the current regulations under section 305(b) and (c) only to clarify the amount and timing of such deemed distributions, not the fact of their occurrence which, according to the preamble, is clear under current law.

Proposed regulations

Amount of deemed distribution: The preamble to the proposed regulations states that a deemed distribution of a right to acquire stock is more accurately viewed as a distribution of additional rights to acquire stock, and the amount is the fair market value of the right. 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 upon 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 would constitute 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 the deemed distribution would be 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. In determining the fair market value of a right to acquire stock, any particular facts pertaining to the deemed shareholder’s rights—including the number of actual shares of stock or rights to acquire stock held by such deemed shareholder—would be disregarded.

Also, under the terms of a convertible debt instrument or other right to acquire stock, a payment of cash or property to the holder may cause a reduction in the number of shares the holder would receive upon conversion or exercise. Such a reduction would be 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 section 301 applies to the deemed distribution. Under the proposed regulations, the amount of this deemed distribution would be the fair market value of the stock deemed distributed, determined in accordance with the methodology in current Reg. section 1.305-3(e), Examples 8 and 9 (relating to deemed distributions to shareholders resulting from certain redemptions of stock from other shareholders).

Timing of deemed distributions: The preamble explains that when an applicable adjustment is or results in a deemed distribution to a deemed shareholder or an actual shareholder, the deemed distribution occurs at the time when the applicable adjustment occurs, in accordance with the instrument setting forth the terms of the right to acquire stock, but in no event later than the date of the distribution of cash or property that results in the deemed distribution. 

  • 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 set forth the 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. 
  • For an applicable adjustment relating to a right to acquire non-publicly traded stock, if the instrument setting forth the terms of such right does not set forth the time the applicable adjustment occurs, 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.

Withholding rules: The proposed regulations also include rules concerning withholding with respect to deemed distributions. 

Today’s proposed regulations provide guidance to withholding agents regarding their obligations to withhold on deemed distributions under section 305(c), and as noted in the preamble, this is intended to resolve uncertainty faced by withholding agents that assert ambiguities in the current law have made it difficult for them to satisfy their withholding obligations because, in particular, deemed distributions often occur when there is no cash payment that corresponds to the deemed distribution (thus making it difficult for them to satisfy their withholding obligation on the date of the deemed distribution). 

The proposed regulations, accordingly, include rules for withholding on deemed distributions, an exception to withholding for deemed distributions on specified securities, as well as rules for when and how to withhold. Withholding agents may rely on the proposed regulations for payments, deemed payments, or deemed distributions described in the regulations that occur on or after January 1, 2016, until the date the regulations are finalized. No inference, however, as to the application of these provisions under current law is intended by permitting reliance on the proposed regulations.

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