Section 305 Proposed Regulations, Part 1:  The Amount of Deemed Distributions

I intend to go through some selected provisions of the new Proposed Regulations and today I’ll start with the provisions dealing with the amount of the deemed distribution.

As background, the proposed regulations primarily address changes in conversion ratios of convertible debt or warrants and other events that increase the holder’s proportionate interest in the assets or earnings and profits of the corporation.  A typical adjustment addressed in these regulations relates to an adjustment to a conversion ratio that occurs when cash is distributed to the stockholders.  In those cases, in order not to harm a convertible debtholder (or warrant holder), adjustments are made to their conversion ratio, often to the extent the cash distribution exceeds some established amount.

Before addressing the amount of the deemed distributions proposed regulations, the Preamble declares that the amount of the deemed distributions is ambiguous in the current regulations, suggesting that under the current regulations the deemed distribution could be treated as either (x) a distribution of rights to acquire stock or (y) an actual distribution of stock.   In the case of (y), a shorthand version of the amount of the distribution would be an amount equal to the number of additional shares that the holder could convert into multiplied by the share price.  In the case of (x), the amount of the distribution would largely be based on the incremental value of the implied “derivative” received by the holder.

I’m not entirely sure why Treasury needed to state that there is an ambiguity.  Current Treas. Reg. Sec. 1.305-7(a)(2)(flush language) specifically provides…“Such distribution will be deemed to be a distribution of the stock of such corporation made by the corporation to such shareholder with respect to his stock.”  That doesn’t seem all that ambiguous to me.  Of course, they do use the term “shareholder” and “stock” but Section 305(d) of the Code defines these terms more expansively to include the holders of rights of convertible securities and rights to acquire stock, respectively.  I’m guessing that Treasury is reading ambiguity into the provision as a way to make it more copacetic in allowing a flexible determination of the amount of the distribution prior to the finalization of the proposed regulations.

In any event, the proposed regulations take the position that the value of the deemed distribution should be determined as if it were a distribution of rights to acquire stock.  Specifically, Prop. Reg. Sec. 1.305-7(c)(4) provides that, for a deemed shareholder,…

the amount of the deemed distribution is the excess of– (A) The fair market value of the right to acquire stock held by the deemed shareholder immediately after the applicable adjustment, over (B) The fair market value, determined immediately after the applicable adjustment, of such right to acquire stock as if no applicable adjustment had occurred.

The proposed regulations also add some color to the definition of fair market value by stating that it does not take into account any particular facts pertaining to the deemed shareholder (e.g., the deemed shareholder would acquire a controlling interest in the corporation) or the possibility of future applicable adjustments.

As a broad generalization, it seems better to view to the distribution as a distribution of a right rather than the stock.  In many cases, the conversion feature of the debt or warrant may be out-of-the-money, making its treatment as a distribution of the actual stock a bad fit.

bad fit

Whether the value formulation in the regulations makes sense or is practicable is probably a question for people who know how to do such calculations.

Lastly, as mentioned above, while the proposed regulations are effective on the date they are finalized, the proposed regulations provide that the amount of the distribution can be determined either in accordance with the proposed regulations or by determining the amount of the deemed distribution by treating it as a distribution of stock.  I’m not sure who would do it this way but perhaps in some cases the relevant pricing data for method prescribed in the regulations will not be available or practicable.

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