Firm Warns Against Applying Proposed Regs to Convertible Debt

On behalf of Citadel, LLC, we are pleased to submit the following comments regarding the newly proposed regulations addressing dividend equivalent payments under section 871(m). We want to thank you and your staffs for the consideration given to prior comments from industry participants and your willingness to adjust the proposed guidance to reflect comments received. We particularly appreciate your willingness to act quickly to delay the effectiveness of the proposed guidance to apply only to equity-linked instruments (ELIs) issued on or after 90 days after the final regulations are issued. The prompt issuance of Notice 2014-14 was very important to avoid a significant market disruption and is greatly appreciated.

While the most immediate problem was resolved by issuance of Notice 2014-14, we remain concerned about the over-breadth of the proposed rule and its application to convertible debt. Unlike the previously proposed regulations, the newly proposed regulations would apply U.S. withholding tax to all ELIs with a "delta" of .70 or higher. Thus, for the first time, the withholding tax on dividend equivalents would apply to convertible debt -- an important and longstanding financing tool for many U.S. corporations -- even though convertible debt provides little or no potential for avoidance of dividend withholding tax.

We believe that applying section 871(m) to convertible debt would shrink foreign demand in the convertible debt market and negatively impact the ability of U.S. companies to raise funding efficiently. Moreover, because of the need to determine deltas at any given time, the rule will require extensive infrastructure and complex determinations that will often differ among market participants, leading to uncertainly, differing results, and disputes. We also believe that including convertible debt under the definition of ELIs is a highly expansive interpretation of section 871(m) that overrides other sections of the Internal Revenue Code specifically addressing when payments on convertible notes should be treated as giving rise to dividends and whether they should be subject to withholding.

Accordingly, we respectfully request that convertible debt instruments be excluded from the definition of ELIs. This will avoid disrupting an important source of financing for U.S. companies and imposing unnecessary compliance burdens on market participants. While we do not believe it is necessary, an anti-abuse rule could be provided to protect against the highly unlikely event that convertible debt could be used to access dividends to avoid withholding tax.

Alternatively, if the final regulations do not exclude convertible debt from the definition of ELIs, we request that:

As a hybrid instrument that protects principal like a bond but also allows investors the potential to share in the appreciation of a company's stock price, convertible debt is an attractive asset class for investors and lowers the cost of funding for issuers efficiently. Convertible debt plays an important and unique role in the capital markets for many companies. The convertible debt market is compelling for these companies for several reasons: convertible debt can be issued with a lower coupon rate than the equivalent non-convertible debt; there are additional sources of demand (compared to the conventional corporate bond market);² and convertible debt instruments typically require fewer restrictive covenants and can be issued more expediently than ordinary corporate bonds.

More than 100 significant U.S. companies have separately raised more than $50 million in the convertible debt market in the past 5 years. The largest borrowers in this market have been leaders in the high tech, manufacturing and health care sectors. Ford Motor Company, General Motors, Gilead Sciences, Intel, Micron Technology, Microsoft, NVIDIA, Priceline.com, Salesforce.com, Sandisk, Tesla Motors, United Technologies, Wellpoint, and Yahoo have each raised $1,000,000,000 or more in the convertible debt market in the past 5 years.

The terms of convertible debt are not standardized, but vary based on the issuer's financial needs and position. Among the many variables in terms are the coupon, initial premium, maturity date, put and call options, and default terms. All of the different variables must be taken into account in pricing the bonds.

Because of the hybrid nature of convertible debt, the pricing is dependent on both the instrument's bond features and the option component. If a convertible note is deeply out-of-the-money, its pricing is based more on the bond features; conversely, if it is deep-in-the-money, the instrument behaves more like equity. Unlike conventional options, the extent to which a convertible note is in the money depends not only on the underlying stock, but also on the bond value. As a result, the pricing at issuance and in the secondary market is complex and driven by numerous factors, the importance of which will vary over time based on current market conditions and movements. Among the most important factors taken into account in pricing convertible debt at any time are:

• Issuer creditworthiness and credit risk premium;

• Coupon rate and market interest rates;

• Bond maturity;

• Liquidity of the bond and bond market volatility;

• Structural protections and elements, including puts, calls, call protection, takeover protection, etc.;

• Equity price and conversion value;

• Equity volatility, time decay and volatility skew; and

• Financing rates and stock borrow rates.

The determination of delta for convertible debt is also not standardized. The determination of delta for a convertible note depends on the various components of bond value and option value. Because of the varied inputs into the analysis, convertible valuations and sensitivities with respect to underlying stock prices differ widely with varying assumptions about the value drivers and modeling approach.³ In particular, there can be significant variability of assumptions by market participants regarding creditworthiness and volatility.⁴ As a result, the determination of delta varies among market participants: it is common to have a +- 5-10% delta range for a bond that is on the less speculative side of modeling and a +- 50-100% delta range for a distressed investment.

As described more fully below, the number of variables for pricing (other than dividends) makes convertible debt highly inefficient as a mechanism for an investor to gain exposure to dividends. Thus, it is highly unlikely that convertible bonds could be used viably to avoid dividend withholding.

Application of the Proposed Rule to Convertible Debt

A withholding tax on convertible notes purchased with a delta of .70 or greater will reduce demand for convertible debt by foreign investors in the secondary market. Some non-U.S. investors might decide to offer less to be compensated for the reduced after-tax return while others may simply target alternative assets. Reduced demand will lead to lower value for such bonds in the secondary market. Moreover, the depth of demand and potential value in the secondary market impacts the initial offering. The risk of lower value in the secondary market due to withholding tax will reduce the price and demand for convertible debt at the initial issuance.

The second factor impacting non-U.S. demand for convertible debt will be the attendant uncertainty and administrative costs of applying complex withholding rules to these instruments. As described above, with respect to convertible debt, the determination of delta is dependent on weighing numerous factors, is highly subjective, and highly variable. Absent a consensus in approach, the determination of delta will differ among participants, causing uncertainty, creating different withholding consequences for foreign investors holding identical bonds, and leading to disputes with the IRS.

Also, the proposed regulations' reliance on delta to determine withholding obligations on convertible debt will impose significant administrative and compliance burdens on issuers, withholding agents and investors. Issuers and withholding agents will be required to determine whether a convertible note in the hands of a particular beneficial owner is subject to section 871(m) withholding, the timing and amount of any dividend equivalent, and the amount of tax to be withheld. All of these are dependent upon continuously determining delta. In addition, upon request by brokers and investors, issuers and agents must be able to provide the delta when the bond was acquired, when the dividend equivalent was determined, and any other time the delta is relevant.

Thus, operational implementation to comply with the proposed regulations would be expensive and difficult, and would require fundamental changes in accounting systems, tracking capabilities and risk models. Also, issuers and their agents would have increased risk and liability for any withholding tax not collected, or for making withholding payments ultimately determined not to have been owed. The administrative cost and operational risk associated with implementation of a delta-based withholding regime may encourage issuers and underwriters to target solely the U.S. domestic market. This will further decrease foreign demand and increase the cost of funding. The potential pricing impact of applying section 871(m) to convertible debt may harm the competitiveness of U.S. companies relative to foreign companies, whose cost of funding will be unhampered by the regulations.

Implementation of the proposed regulation will also disrupt trading of convertible debt. First, price discovery would be impaired, particularly as the .70 delta is approached. In fact, application of the proposed rule would actually change the theoretical delta around the threshold; the bond will be worth less when the delta increases through the .70 delta threshold. Moreover, the same CUSIP could have several different values, based on delta at the time of purchase. This could impair trading on the secondary market.

As discussed above, the fixed income components would include credit risk; interest rate risk; the terms and conditions including bond maturity, and optional redemption features; liquidity; convertible note market volatility; and other more complex considerations. The effect of these variables on pricing changes daily, adding to the unpredictability and risk. The impracticality of using convertible bonds to create dividend equivalents is compounded by the different structural terms in each bond issuance governing these variables. Moreover, unlike swaps and other similar instruments, the terms and conditions of convertible notes are not tailored to particular investors as in bilateral transactions, but rather their terms are uniform across investors and are dictated by issuers based on their capital formation needs.

Besides the inherent complexity, the difficulty of using convertible debt to avoid withholding on dividends is exacerbated by the cost of transacting in the convertible debt market. The bid-ask spreads on convertible notes are much higher than the spread on equities and would be significant in comparison to the dividend yield. All of these considerations make convertible debt a terribly inefficient and impractical mechanism to gain exposure to dividends. As a result, it is highly unlikely that convertible debt would be used as a means to access dividends and avoid dividend withholding tax, and we are not aware of any such circumstances.

We believe it is an extremely expansive reading to apply section 871(m) to convertible notes, which do not generally provide their holders with any payments determined by reference to dividends (or that act as disguised dividends). We understand that the proposed regulations assume a putative "payment" from the issuer to the purchaser because the bond purchase price reflects the absence of any dividend payments. This is a novel concept in constructive tax ownership -- taxpayers are treated as owners of streams of payments specifically because they did not pay for them.

The application of the imputed dividend payment is particularly unfair in the context of convertible debt investors that hedge their equity exposure. These investors might have a long investment in a convertible debt instrument and a short ELI position in the same company. The proposed regulation would impute a dividend equivalent on the convertible debt instrument even though the investor received no actual dividend equivalent payment and had little or no net exposure to the company's stock.

Moreover, there is no reference in the legislative history or elsewhere that Congress was concerned about the use of convertible debt to avoid dividend withholding tax. Congress is well aware of convertible debt, which has been used by U.S. corporations to raise capital for more than a century. In fact, Congress has considered the issue of withholding on convertible notes previously and decided to exempt them from the contingent interest withholding in section 871(h). Thus, if Congress had such a concern, it would seem that Congress would have specified the application of dividend withholding to convertible debt in the statute and overridden the portfolio interest exemption.

Finally, Congress and Treasury have already specifically addressed when payments on convertible notes should be treated as dividends under section 305. In cases where there is an adjustment to the conversion ratio of a bond because of a change in the issuer's dividend policy, section 305 will treat the adjustment as a deemed dividend. Current law does not impute a dividend absent an adjustment.

The Regulation Should Target Abuses and Carve Out Convertible Debt

For the reasons described above, we believe application of the proposed regulation to convertible debt will be harmful to the efficiency and liquidity of the convertible debt market and is unnecessary to prevent avoidance of dividend withholding tax. Convertible debt is an important financing tool that allows U.S. companies to raise capital at lower rates than conventional bond financing.

Despite the lack of potential for abuse, the proposed regulations would impose significant administrative and compliance burdens, as well as potential withholding tax liability, that will reduce foreign demand and raise the cost of funding to U.S. issuers. We believe it is a mistake to impede foreign investment in the United States unnecessarily, particularly at a time when the U.S. capital markets are still recovering from the financial crisis. Recently, in its FY 2015 budget proposal relating to FIRPTA, the Administration recognized the importance of foreign investment and that, in today's market, foreign investors have numerous viable options for investment outside their home countries. The same logic applies here. We should not place U.S. convertible debt issuers at a disadvantage relative to the other choices available to foreign investors.

We therefore respectfully request that convertible debt be excluded from application of the proposed rule. To protect against the unlikely case that Treasury identifies circumstances where convertible debt is used to access dividends in order to avoid withholding tax, an anti-abuse rule could be provided.

If Treasury is unwilling to carve out convertible debt from section 871(m) withholding, we alternatively request that:

² For instance, according to reports, Tesla Motor's sale of $2 billion of convertible debt to help fund its battery factory (and other expansion) allowed Tesla to gain access to institutional investors focused on longer-term investments, without diluting its share price. See, e.g., "Tesla Convertible Debt Electrifies Long-Term Investors," Wall Street Journal (March 2, 2014).

³ It is these differences in estimating and weighing variables among participants that helps create trading markets.

⁴ This is particularly true with respect to the many issuers in the convertible bond market who do not have other credit instruments outstanding or do not have a liquid options market.