IRC Section 305(c): Deemed distributions and related regulations
Section 305(c) of the U.S. Internal Revenue Code addresses deemed distributions to domestic and foreign holders of convertible securities in a corporation – such as warrants, rights or convertible debt.
IRS rules proposed in 2016 clarify tax reporting and withholding implications for convertible securities holders when corporate actions have increased the underlying value or equity of those securities. These regulations specify when holders are required to recognize taxable income from such transactions. Certain transactions may also activate withholding requirements for custody agents for foreign investors who receive deemed distributions considered by the IRS to be taxable income as a result of corporate actions.
Under 305(c) regulations, a deemed distribution occurs when a convertible security holder’s right to acquire stock has a conversion rate adjustment (CRA) as part of the instrument. This typically means a dividend has been declared for a convertible security’s underlying stock, thereby raising the convertible security’s value via its CRA. If a CRA-triggering event occurs, the rightsholder is entitled to additional shares of stock. In essence, a convertible security holder is considered, under the 305(c) regulations, to have received a taxable deemed dividend as a result of such a transaction.
Cash, stock and property dividends – as well as stock splits and other corporate actions – are all examples of 305(c) triggering events.
For the deemed distribution to be taxable, two criteria must be met. First, the triggering event must be taxable to the security issuer’s actual shareholders (e.g., a disproportionate distribution or a cash or property dividend). Second, the rightsholder must have an increased proportional interest in the issuer’s earnings and profits as a result of the change in the CRA.
A rightsholder who receives a deemed dividend must report the additional taxable income on their tax return and adjust the basis in the securities held. Since a deemed dividend is not an actual dividend, there’s no receipt or exchange of cash. As such, the amount of taxable income to report should be determined based on the calculation of the deemed dividend as explained in the reporting process section below.
There’s one key exception to the deemed distribution rules worth noting. If a CRA adjustment formula reflects a change that’s merely anti-dilutive with respect to total shares received upon conversion – meaning no “dividend event” as described above has actually occurred – then the 305(c) regulations don’t apply.
With the proposed regulations in effect, the process for completing required reporting now involves several steps.
1. The security issuer must identify the triggering events. The IRS requires the issuer to file Form 8937 with the IRS for all 305(c) deemed dividends. They’re also required to do one or more of the following:
2. The security issuer must calculate the deemed distribution amount reflected in Form 8937 or the equivalent statement they’re required to provide. The formula for calculating this, included below, can be found in the 305(c) proposed regulations:
“The amount of the deemed distribution [is] the excess of (i) the fair market value of the right to acquire stock immediately after the applicable adjustment over (ii) the fair market value of the right to acquire stock without the applicable adjustment.”
Note: Within the industry, some providers have been using an option-pricing-model approach to calculate the change in fair market value if a market price is not available.
3. The custody agent must determine whether a withholding tax liability is applicable to foreign holders. Since the 305(c) deemed distributions don’t involve the exchange of cash, the withholding amount is due to the IRS on whichever of the following dates occurs first:
At U.S. Bank, we utilize a subscription service in identifying and performing 305(c) transaction calculations from a custody and fund tax reporting perspective when applicable.
At U.S. Bank, we keep you up to date on regulations that impact your business and offer comprehensive solutions to support your needs so that you can focus on reaching your goals. To learn about the fund administration services we offer, including tax support services, please visit us at usbank.com/globalfundservices. For additional information, connect with a global fund services expert.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.