Group Criticizes Treatment of Conversion Adjustments on Convertibles

On behalf of the Concerned Convertible Bondholders Coalition, we are submitting the attached submission for your consideration. The Concerned Convertible Bondholders Coalition respectfully requests the opportunity to meet with you and your staff to discuss the matters addressed therein in the near future, and one of its members will call you to schedule this meeting.

A Conversion Right may never be exercised, and is often not exercisable at the time of the Conversion Adjustment; thus, the position of a Convertible holder is not the same as that of a shareholder in the classic section 305 situation noted above.⁵ A Convertible holder has no option to receive cash in such circumstances, and, even if a Conversion Adjustment is made with reference to the dividend, there is no certainty that the holder will ever receive stock or the amount of additional stock that might be issued by reason of the Conversion Adjustment. Moreover, the Convertible holder does not have a right that is economically equivalent to the shareholder's right to cash and any rule that seeks to approximate the option value before exercise must necessarily be complex and imprecise as well. The existing section 305 regulations certainly do not provide meaningful guidance as to how such amounts could be determined. The assumption that the dividend inclusion should be the value of the extra stock is flawed, because the holder of the Convertible may have the right to get more stock, but the amount of shares is often indeterminate until maturity, and the holder will only receive such stock if exercising the Conversion Right makes economic sense. Thus, any current imputation rule would always mandate an erroneous result in the significant number of cases where the conversion right is never exercised -- in those cases there never should have been an imputation to the Convertible holder (and certainly not at the date on which the Conversion Adjustment is made).⁶ Even if the Conversion Right is ultimately exercised, current imputation while that right remains subject to contingencies will always rest on essentially arbitrary and often inaccurate premises. A basis adjustment would, moreover, be insufficient to eliminate the harm caused by a current imputation rule to holders who do not exercise, because it would, at best, result in character mismatch.

These substantial defects in a current imputation rule -- as well as the decades of administrative practice that has never sought to tax Conversion Adjustments currently -- make clear that there should be no change in the status quo, i.e., no current taxation of Conversion Adjustments, until it is first determined, as a policy matter, whether current taxation of such adjustments is appropriate at all, and, if it were so determined, understandable and accurate rules for calculation of such inclusions are promulgated with adequate advance notice to affected investors. Thus, the immediately needed action is issuance of a notice by the Treasury that there will be no effort to tax Conversion Adjustments under existing rules unless and until understandable and administrable guidance is issued.

Even ignoring the difficulties associated with and presented by attempting to tax Conversion Adjustments currently, we believe, as a matter of tax policy, that Conversion Adjustments for dividends do not present an appropriate occasion for taxation of Convertible holders who have not exercised their conversion rights in the first place.

First, as has already been discussed, the Conversion Right embedded in the Convertible may never be exercised, and often is not even exercisable unless and until certain stock price triggers have occurred.⁸ In that circumstance, current imputation always means that the Convertible holder has been both overtaxed and taxed too early on "phantom" income that will never be received.

Second, Conversion Adjustments (including adjustments for dividends) are arm's-length bargains between unrelated parties with adverse interests; they are not accessions to Convertible holder's wealth. Conversion Adjustments are made, under a formula agreed to by the parties at the time the Convertible is issued, to prevent payment of dividends from eroding the holder's original investment, not to alter the bargain to the holder's benefit. The erosion in value of a Convertible that would occur in the absence of such an adjustment is economically similar to the value erosion that could arise from corporate capital transactions, which the regulations recognize as justifying nontaxable anti-dilution adjustments. Typically, the Conversion Right was priced under the assumption that the issuer would not pay dividends or would not pay dividends in excess of a specified annual amount. Thus, the adjustment is effectively a purchase price adjustment.⁹ Taxing such "make whole" adjustments constitutes inappropriate overtaxation of holders of Convertibles.

Third, taxing Convertible holders on Conversion Adjustments violates the principles of horizontal equity. Holders of options, which may be converted into an underlying stock or security upon exercise, but which are not issued by the issuer of the underlying ("Market Options"), are not subject to tax on changes in the conversion ratio that occur by operation of the terms of such options, even if there is an adjustment that is similar to a Conversion Adjustment. The only essential difference between a Convertible that is an option and a Market Option is the identity of the writer of the option. Thus, it is inequitable to tax holders of Convertibles on Conversion Adjustments, because the determination of whether to tax such adjustments should not turn on the identity of the writer of such instruments.

Finally, it would be very difficult to devise an administrable valuation formula that would accurately measure the value to be imputed by reason of a Conversion Adjustment. In virtually all circumstances, that value is less than the Convertible's hypothetical ratable portion of the underlying dividend itself and, in most circumstances, substantially less. The existing section 305 regulations offer no guidance whatever as to how such a calculation should be made.

All these circumstances demonstrate that current taxation of Conversion Adjustments is both inappropriate as a matter of tax policy and very difficult to accomplish on any basis that even reasonably approximates value.¹⁰ For these reasons, we believe that the appropriate tax policy result is that Conversion Adjustments should not be currently taxed. Whatever benefit the Conversion Adjustment may ultimately confer would, as it always has been, be taxed upon disposition of the Convertible when it can be accurately measured. Other solutions, such as recharacterizing a portion of the gain upon disposition are possible, although in our view unnecessary and inconsistent with how other provisions tax Convertibles.¹¹ But the benefit of both such "wait and see" solutions is that they recognize the open transaction optionality embedded in Convertibles and avoid inaccurate formulary valuation of potential future economic benefits that may never be received.

Convertibles were first issued by the earliest American steam railways to finance westward expansion, and have since been a vital source of capital for U.S. growth companies. Contemporary Convertibles issuers include Apple, Gilead Sciences, Intel, Linkedin, Priceline, SolarCity, SunPower, Tesla Motors, and Twitter. Holders of Convertibles include U.S. individual investors, mutual funds, pensions, endowments, and foreign investors. These investors seek safety of principal, steady interest income, low volatility, and potential for capital appreciation. Current uncertainty about withholding taxes is already having an adverse effect on the Convertibles market because investors are unsure about both the amount and timing of tax that may be imposed on such instruments. Moreover, the mechanics of implementing the proposed withholding tax would impose tremendous new burdens and liabilities on U.S. market participants, which would be required to track Convertible bond transactions and then calculate and withhold taxes.

Convertibles are particularly relevant today because the U.S. financial markets are forecasted to enter a rising interest rate environment, a period when we typically see a significant increase in the number of corporations issuing Convertibles, due to the more favorable interest rates versus the straight bond market. The total capitalization of the U.S. Convertible securities market is approximately $230 billion -- the largest and most liquid Convertible market in the world, which gives U.S. companies an advantage in raising capital at lower interest rates compared with non-U.S. companies raising capital in foreign markets. The global Convertibles market is $480 billion, which demonstrates that American companies compete with the rest of the world for this valuable source of capital. A rising rate environment will have a drastic negative effect on the market prices of intermediate and long-term fixed income securities, which decline in value proportionately with increasing interest rates. The Convertibles market, in contrast, generally becomes more attractive during rising interest rate environments, both because of the typically shorter duration of convertible bonds and because Convertibles may participate in the appreciation of the underlying stocks that is likely to accompany a period of economic growth and rising interest rates.

Convertibles provide U.S. corporations with an essential source of growth capital at lower interest rates than straight bonds. Cost-efficient access to Convertibles has enabled many great American growth corporations to blossom into dividend-paying bulwarks, as revenue and profitability grew over time. Reduced access to the Convertibles market would lead to higher costs of capital and negatively affect U.S. corporations' capital access and, thereafter, capital spending and hiring. Such corporate consequences would weaken the U.S. economy, impair job creation, and impede the development of growth companies and delay or forestall their contributions to society (e.g., green technology).

In addition, a relative increase in the cost of capital for U.S. issuers will effectively reduce the competitiveness of U.S. corporations versus their overseas competitors, and reduced access to the Convertibles market will encourage companies in high-growth industries to be formed, based, and operate outside of the United States.¹² Curtailment of the financing flexibility that the Convertibles market has long provided to American business should not occur without careful consideration of the consequences. Moreover, if such uncertainty reduces foreign investment in the U.S. Convertibles market, there is little potential for revenue gain from withholding taxes on Conversion Adjustments, and decreased revenue from collateral effects on economic activity will offset, and may outweigh, any potential revenue gain.

The adverse market effects of the proposed withholding tax should not occur through inertia -- as will happen if the Treasury allows current uncertainty to continue and fails to adopt a moratorium. Rather, the Treasury should promptly announce that Conversion Adjustments will not be currently taxed pending the issuance of administrable guidance. The Treasury should then consult with knowledgeable participants in the Convertibles markets to determine what the future tax treatment of Conversion Adjustments should be. If, after this consultation, the Treasury is still considering taxing Conversion Adjustments, it should then conduct a cost-benefit analysis to compare the revenue it would expect to raise (taking into account reduced withholding taxes and decreased Convertible issuances in the U.S.) from such tax against the costs such tax would impose and the revenue losses such tax would entail (including foreseeable negative impact on cost-of-capital for U.S. companies and their ability to hire America employees and compete in a global marketplace).

² A Conversion Adjustment adjusts the conversion ratio of a Convertible if the issuer increases the amount or rate of dividend distributions on the underlying stock above the amount or rate that existed when the bonds were issued (the "benchmark rate"). This adjustment is designed to ensure that the occurrence of distributions above the benchmark rate do not erode the value of the Conversion Right. Increases in dividend distributions above the benchmark rate would reduce the value of the Conversion Right on a dollar-for-dollar basis absent a proportionate increase in the number of shares into which the bond may be converted. The Conversion Adjustment is a form of principal protection; essentially a fair value adjustment to protect the Convertible investor from erosion in the value of the Convertible's embedded call option. This protection ensures that the entitlements provided by the Conversion Right are preserved over the life of the Convertible despite post-issuance changes in corporate dividend policies. The Conversion Adjustment, in-and-of-itself, however, does not carry any explicit or definitive monetary value. It is not intended to increase the value of a Convertible; rather, it is intended to protect the value of the Convertible from erosion due to increasing dividend payments, in short, it is a buoy, not a balloon.

³ Some REITs have treated Conversion Adjustments as distributions, at least when the adjustments occurred as part of a distribution of stock and cash or as a purging distribution. See, e.g., Rev. Rul. 75-513, 1975-2 C.B. 114; GCM 36138; and PLRs 7308310670A, 200615024, 201247004, and 201446013.

⁴ See [https://books.google.com/books?isbn=1119975905] Handbook of Corporate Equity Derivatives and Equity Capital Markets, Juan Ramirez, 2011, "Mandalay Resort stock holders received a cash offer from MGM. Mandalay Resorts did not include a cash takeover protection and their [convertible] bond holders logged staggering losses." Since that event, investors have demanded, and market practice for Convertibles now includes, make whole adjustments for changes in control, merger events, and any dividends in excess of a threshold amount.

⁵ For example, Convertible debt retains its legal character as a fixed income security until the holder (or the issuing company) takes formal written action to exercise the contractual right to convert the bond into stock. In fact, investors in Convertible debt forgo equity dividends and 100% participation in stock appreciation in exchange for seniority in the capital structure, interest income and limited participation in equity price appreciation. This remains true even if the bond trades in the market as though the option to convert had already been exercised (i.e., the bond has a delta -- or price sensitivity to the underlying stock -- of 100). For example, the holder of a convertible debenture that is heavily in-the-money is protected by a corporate guarantee to pay regular coupon payments plus par at maturity unless and until the bond has been successfully exchanged for the underlying common shares. Conversion is a contractual event; it is never de facto until it is de jure.

⁶ For many years, Convertible offering disclosures have stated that there is uncertainty in the tax law concerning Conversion Adjustments and that they could be taxable. Until recently, however, little, if any, tax was being paid by reason of such adjustments.

⁷See, e.g., Treas. Reg. § 1.1273-2(j) (embedded option is indivisible from the principal of convertible debt).

⁸ If a Conversion Right is not exercisable until certain stock price triggers have occurred, it may be viewed as an embedded ("knock-in") barrier call option. Barrier call options typically have lower values than vanilla call options (and, at best, have the same value as vanilla call options) because they restrict a holder's Conversion Rights, and prohibit exercise in certain economically desirable circumstances.

⁹ This is distinguishable from a situation in which a Convertible holder receives cash or a separate property interest in order to prevent dilution; if the holder receives cash or a separate property interest, he should be taxed currently. See, e.g., Rev. Rul. 83-42, 1983-1 C.B. 76 (distribution of common stock taxed currently).

¹⁰ Any formula valuation for imputation will always result in improper income measurement and overtax the holder when there is no conversion. Even when conversion occurs, a formula for current imputation will get the actual economic benefit ultimately realized right only by happenstance.

¹¹See, e.g., Treas. Reg. § 1.1273-2(j) (embedded option is indivisible from the principal of convertible debt).

¹² The investor makeup of the Convertibles market is global in scope. Best estimates are that approximately 60% to 70% of Convertible investors are U.S. Persons, while 30% to 40% of Convertible investors are Non-U.S. Persons. All things being equal, foreign investors would be expected to reduce their holdings of U.S. Convertibles and avoid new issuances from American companies, in favor of Convertibles issued by foreign companies that are not burdened by withholding obligations.