Firm Raises Issues With Deemed Stock Distribution Regs

We would like to thank you and your colleagues for taking the time to meet with us on July 12th and exchange views regarding section 305(c). As a result of our meeting, we have a better understanding that the Proposed Regulation is based on a reading of current regulation (Treas. Reg § 1.305.7) which was promulgated over 40 years ago when convertible obligations with the features at issue did not exist. We believe this reading is not required on technical grounds and -- as currently drafted -- is not justified on policy and administrative grounds.

We intend to submit more detailed comments but would like to take the opportunity to summarize our views.

The Proposed Regulations require the current payment of tax on deemed income that does not represent an accretion to wealth and that may never be realized by the holder of the convertible obligations. For a domestic taxpayer, the result is a timing and character mis-match where deemed income is subsequently set off by a capital loss or reduced gain.

Critically, the determination of the amount of the income inclusion also presents significant valuation issues and imposes significant compliance burdens on issuers, intermediaries, taxpayers, and the IRS. The calculation of convertible fair market values and delta are dependent upon a variety of subjective model assumptions and practically impossible to measure objectively. We discussed this point only briefly during our meeting. We believe it is an important consideration meriting additional attention.

As we noted, the anti-dilution provisions are only intended to preserve the value of the convertible bond -- to preserve the holder's original bargain. This is very different from the transactions that were the target of section 305 -- two class arrangements in which one class received cash dividends and the other class received an increased interest in the corporation with the objective of manipulating the basic rule that the distribution of stock is not subject to tax. The consequences summarized above are being brought about by trying to apply a rule to a fact pattern for which it was not designed, did not exist when the regulation was issued and which does not have any potential for abuse.

We also think that consideration should be given to the disruption to the capital markets for a product that is a useful capital raising tool for banks and developing companies. The imputation of deemed dividend income will make the convertible less attractive for issuers (given the compliance burden it imposes and potential increased interest costs), unattractive for mutual funds (because of the requirement to distribute their income annually) who are significant purchasers and undesirable for foreigners who while not major holders can be the difference between a successful offering and a failed offering.

Finally, we question whether the net added tax revenues(if any) justify the disruption, particularly if the interest costs for borrowers are increased resulting in larger interest deductions.

Again, many thanks for taking the time to meet with us.