Deemed Distributions Under Section 305(c): IRS Issues Proposed Regulations That Address the Amount and Timing of Deemed Distributions Under Section 305(c) With Respect to Convertible Instruments and Related Withholding Obligations

Sullivan & Cromwell LLP - April 27, 2016
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Under Section 305(c) of the Internal Revenue Code of 1986 (the “Code”) and associated Treasury Regulations, a holder of rights or convertible securities in a corporation, such as warrants, rights or convertible debt (collectively, “Convertible Instruments”), may be deemed to receive a taxable distribution (a “Deemed Distribution”) upon the occurrence of a conversion rate adjustment (a “CRA”) that increases the number of shares that the holder would receive upon a conversion or exercise of the Convertible Instrument.  There has historically been significant uncertainty regarding the amount and timing of such Deemed Distributions, and in particular whether, and in what manner, a withholding agent is obligated to impose withholding tax on any Deemed Distributions that are made ‎to foreign investors.  The IRS and Treasury Department recently issued proposed regulations (the “Proposed Regulations”) that address these issues.  As discussed in more detail below, if the Proposed Regulations are finalized, withholding agents could be subject to "cashless" withholding, in which case withholding agents would need to ensure that they have collateral or other indemnity arrangements to ensure that they do not bear the cost of withholding taxes on such Deemed Distributions.  The Proposed Regulations would generally be effective when finalized but may generally be relied upon for Deemed Distributions occurring on or after January 1, 2016.  The Proposed Regulations do not address the treatment of withholding agents that did not withhold on Deemed Distributions in prior taxable years; we understand that it is expected that the IRS will issue further guidance that will address this issue.