Treasury issues proposed regulations on deemed distributions of stock

Tax Hot Topics: Deemed distributions of stockTreasury and the IRS issued proposed regulations (REG-133673-15) related to distributions of a corporation’s stock under Section 305. The proposed regulations are intended to clarify ambiguities in the current regulations regarding the amount and timing of certain distributions.

By way of background, Section 301(a) provides that a distribution of property by a corporation (Distributing) to a shareholder with respect to Distributing stock is treated by the shareholder according to Section 301(c) (e.g., a dividend).

Section 305(a) generally provides that gross income does not include a distribution by Distributing to its shareholders if it is made in Distributing stock. Section 305(b) provides certain exceptions to Section 305(a) including: (i) “distributions in lieu of money” under Section 305(b)(1); and (ii) “disproportionate distributions” under Section 305(b)(2). If an exception under Section 305(b) applies to a stock distribution, the stock distribution is treated as a distribution of property to which Section 301 applies.

The term “stock” includes rights to acquire such stock for purposes of Section 305, and a “shareholder” includes a holder of a right or convertible security for purposes of Sections 305(b) and (c) (a deemed shareholder).

Corporations often issue rights to acquire their own stock in the form of warrants, subscription rights, options and convertible debt. Those rights may be adjusted upon certain events, including an increase or reduction in the conversion ratio, conversion price, option price or the number of shares that a holder would receive upon a conversion or exercise (an applicable adjustment). For example, the shares that a holder of a warrant may receive upon exercise may increase when there are distributions of stock, cash or other property to actual shareholders.

Section 305(c) provides that an applicable adjustment may result in a deemed distribution to an actual shareholder or a deemed shareholder whose proportionate interest in the earnings and profits or assets of Distributing is increased by such applicable adjustment.

Under the current regulations, an applicable adjustment pursuant to a bona-fide and reasonable adjustment formula will not be considered to result in a deemed distribution of stock if the distribution has the effect of preventing dilution of the interest of the stockholders (the Anti-Dilution Exception). However, the Anti-Dilution 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 Sections 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b) or 857(b). See Treas. Reg. Sec. 1.305-7(b)(1).

The IRS has concluded in Rev. Ruls. 75-513 and 76-186 that it is clear that an applicable adjustment may result in a deemed distribution to a deemed shareholder if (i) the applicable adjustment increases the proportionate interest of either an actual shareholder or a deemed shareholder in the corporation’s assets or earnings and profits; (ii) such increase has a result described in Section 305(b); and (iii) the Anti-Dilution Exception does not apply.

However, the current regulations are unclear on how to determine the amount and timing of such a deemed distribution to a deemed shareholder. The proposed regulations would amend the current regulations under Sections 305(b) and (c) to clarify the amount and timing of a deemed distribution to a deemed shareholder.

Specifically, the proposed regulations provide that the amount of a deemed distribution of a right to acquire stock should be the fair market value of the right instead of the fair market value of the underlying stock. See proposed Treas. Reg. Sec. 1.305-7(c)(4). Treasury and the IRS acknowledged that the current regulations may be reasonably interpreted to provide that a deemed distribution is treated as a distribution of a right to acquire stock or a distribution of the actual stock, and that they will not challenge either position before final regulations are issued.

The proposed regulations also clarify that a deemed distribution due to an applicable adjustment generally occurs at the time that such applicable adjustment occurs, but in no event occurs later than the date of the distribution of cash or property that results in the deemed distribution. See proposed Treas. Reg. Sec. 1.305-7(c)(4).

The proposed regulations also provide additional guidance related to withholding requirements under Section 1441 and reporting requirements under Section 6045B related to distributions under Section 305. Comments on the proposed regulations are due by July 12, 2016.

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