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Aug. 1 — An association of regulated funds is questioning whether IRS rules on deemed distributions on convertible securities make sense from a policy standpoint.
The proposed regulations (REG-133673-15) issued in April provide guidance to corporate issuers and withholding agents on their withholding and reporting obligations relating to deemed distributions resulting from adjustments to conversion ratios on convertible bonds and other rights to acquire stock. The rules address situations where a deemed distribution of stock occurs because the conversion ratios change in a way that increases a person’s interest in a corporation under tax code Section 305(c) (135 DTR G-5, 7/14/16).
“Although we appreciate that the IRS and Treasury Department has issued proposed guidance on the application of section 305(c) to convertible securities, we do question whether, as a policy matter, that application is sensible,” the Investment Company Institute said in a July 20 letter to the Internal Revenue Service.
“The rules in section 305(c) were meant to address earnings stripping, which generally is not an issue for the vast majority of convertible bonds in the market,” the group said.
It is unclear whether there is a good policy rationale for requiring holders of convertible debt to take deemed distributions into income based on a conversion ratio change, rather than waiting until a conversion actually takes place, the group said. The ICI asked the IRS to consider these concerns and make a determination on whether that application makes sense.
The association said if the IRS decides the proposed guidance will apply, it should address several issues that are important to the mutual fund industry that it failed to mention in the April rules.
Specifically, in the proposed regulations, the IRS doesn't clarify if deemed distributions on convertible securities under Section 305(c) can be characterized as qualified dividend income under Section 1(h)(11) or qualify for the dividends received deduction under Section 243, the association said. Both qualifications have tax advantages.
The institute said such deemed distributions should be eligible for treatment as a QDI and for the deduction based on current law, and that this change should be reflected in final rules.
“We believe that section 1(h)(11) supports this conclusion,” because it states that QDI means dividends received during the taxable year from domestic corporations and certain qualified foreign corporations, the association said.
“Sections 243 and 246 similarly apply to ‘dividends' from a corporation,” the group wrote. A taxpayer who receives a deemed distribution on a convertible security under Section 305(c) is treated as receiving a taxable dividend. Therefore, “the statute suggests that a deemed distribution can qualify as QDI and for the DRD,” the ICI said.
The group noted that there is some uncertainty on whether holding period requirements under Sections 1(h)(11) and 246 preclude this favorable treatment. The ICI concluded that it should apply, “provided that the taxpayer holds the convertible debt instrument for the same number of days that a shareholder must hold shares of stock, i.e. at least 61 days for QDI and 46 days for the DRD.”
The mutual fund industry would like the IRS to clarify whether tax accounting for deemed distributions under Section 305(c) is a method of accounting under Section 446, the association said.
The rules don't specify whether a change in method of accounting occurs when a taxpayer who hasn't been accounting for deemed distributions on convertible securities begins to do so, the ICI said.
“If it is a method change, then the taxpayer must seek permission for the IRS to make such a change,” the group said.
“Until the IRS clarifies this point, RICs and other taxpayers are left with substantial uncertainty regarding the amount and extent of their tax liabilities for prior years,” according to the association. A RIC is a regulated investment company.
The proposed regulations on Section 305(c) transactions have also raised concerns from international central securities depositories like Clearstream Banking and Euroclear Bank.
The ICSDs said in an April 22 letter that the IRS should adopt a Section 302-like procedure for 305(c) and 871(m) transactions. Section 871(m) applies to products that produce a dividend-like return, such as securities loans, sale-repurchase transactions, specified notional principal contracts and equity-linked instruments.
Clearstream and Euroclear are qualified intermediaries—foreign financial institutions that have agreed to act as U.S. withholding agents.
“Their concern is that for 871(m) transactions and 305(c) transactions they’re not going to have the knowledge of when there is a triggering event,” for withholding on such payments, said Laurie Hatten-Boyd, a principal in KPMG LLP's Information Reporting and Withholding Services Group.
“We know that Wolters Kluwer and Bloomberg and service providers like that plan on having a service offering for these transactions,” but groups like Clearstream and Euroclear are worried that if the information is not made public by these service providers, they’re not going to get the information they need regarding the product and will be held liable for improper reporting or withholding, Hatten-Boyd told Bloomberg BNA.
In the proposed regulations on Section 302, the IRS provided an out for foreign banks. The agency said that even if the foreign entity is a withholding QI, it doesn't have withholding responsibility for related payments and the liability falls to the U.S. withholding agent.
In the letter, the ICSDs said applying a similar procedure to Section 305(c) and 871(m) transactions would lower the risk of incorrect reporting.
She noted that the IRS could go a different route to provide relief to foreign banks, by adding a provision somewhere in the rules saying if the QI relies on a service provider, that will be the limit to its knowledge. Basically, “if it’s not published by a service provider, then you’re not going to be held responsible,” she said.
Even though these groups have expressed their concern to the IRS, Hatten-Boyd and her colleague Jay Freedman, a principal in KPMG LLP’s financial services tax practice, said the IRS is unlikely to put the requested changes in writing.
Hatten-Boyd said the IRS often uses the argument that the groups requesting relief should be able to solve the problem on their own and remain compliant because they are large institutions with smart employees and significant resources to do so.
Additionally, the IRS is largely unsympathetic because it believes that it has added reasonable accommodations to the 305(c) and 871(m) regulations and the foreign institutions can figure the rest out for themselves, Freedman added.
It is probable that the IRS will provide assistance and relief for foreign entities—such as pushing all of the withholding responsibility to the U.S. agents or implementing some mechanism to help groups get the information they require—because it realizes that foreign QIs offer significant benefits, Hatten-Boyd said. However, it unlikely that the agency will put those changes in writing, she said.
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Texts of comments from the ICI and Euroclear Bank, Clearstream Banking-Luxembourg are in TaxCore.
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