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Firm Seeks Withdrawal of Proposed Regs on Deemed Distributions

OCT. 27, 2016

Firm Seeks Withdrawal of Proposed Regs on Deemed Distributions

DATED OCT. 27, 2016
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October 27, 2016

 

 

Honorable Mark Mazur

 

Assistant Secretary of the Treasury for Tax Policy

 

 

Thomas West

 

Tax Legislative Counsel

 

 

Department of the Treasury

 

1500 Pennsylvania Avenue, N.W.

 

Room 3120

 

Washington, D.C. 20220

 

 

Dear Messrs. Mazur and West:

By letter dated September 26, 2016, the Securities Industry and Financial Markets Association (SIFMA) submitted comments on the proposed section 305(c) regulations. Understandably, SIFMA is seeking clarification that withholding agents, as intermediaries "with no skin in the game," can rely on issuer reporting and are seeking rules that will properly insulate them from exposure. A withholding agent's objective is to be able to rely on clear rules. This approach is consistent with long-standing practice -- a practice that we believe is fundamental to the proper functioning of our comprehensive system of information reporting and withholding.

The reason we are writing is that the SIFMA letter by focusing on withholding takes the theory of the proposed section 305(c) regulations as a given. It did not address two threshold questions: (1) the mis-guided policies giving rise to the proposed regulations and (2) the inordinate and inappropriate burden imposed on issuers by the proposed regulations. Significantly, the SIFMA letter does not address the adverse impact on capital formation that will result from the proposed regulations.

We addressed these points in our prior comment letter dated April 23, 2015, and have enclosed another copy for your convenience. In brief:

  • The genesis and legislative history of section 305(c) make clear that the provision was targeted at abusive transactions. In contrast, the proposed regulations are targeted at a "converts" market that did not exist when that provision was enacted, and do not pose the abuse concerns that prompted enactment of section 305(c). The modern "converts" market provides efficient access to capital by domestic issuers, fosters the development of nascent industries, and contributes to market stability by providing access to capital during economic downturns and to companies that have suffered reversals of fortunes. These benefits are potentially jeopardized by a proposed regulation that seeks to tax holders on value that might prove illusory.

  • As the SIFMA letter makes clear, the administrative burden of complying with this rule falls solely on issuers, who are required to engage in speculative valuation exercises often as frequently as four times each year, and face potential IRS challenges regardless of the value they determine, especially if they adopt the entirely reasonable position that the proper value is zero.

  • Despite the SIFMA letter focus on cross-border withholding, the primary tax burden imposed by the regulations falls primarily on US taxpayers, directly and indirectly by reason of their mutual fund investments.

 

The current final section 305(c) regulations contain two conflicting rules relating to changes in the conversion feature of convertible bonds. The regulations provide that where the change is made pursuant to a "bona fide, reasonable adjustment formula" that has the effect of preventing dilution, it is not a deemed distribution of stock. Nevertheless, the same provision also provides that an adjustment made to compensate for a taxable distribution to other shareholders is not considered as made pursuant to such a bona fide, reasonable adjustment formula. No explanation is provided for the apparent inconsistent treatment even if the goal of both adjustments is to prevent dilution. For many years the market has generally treated all conversion adjustments alike, as anti-dilutive, because they are all designed to prevent the loss of value and not disguise a dividend. Treasury now proposes to tax the value of anti-dilution adjustments for taxable distributions on a current basis, which results in a noneconomic timing and character mismatch of income to investors, and which seemingly relies on either (or both) the unjustifiable assumption that the conversion feature will always be exercised or the assumption that, contrary to the inherent legal rights, the conversion rights are separable from the convertible bond. No policy justification has been provided for this change in the application of the rules other than that there is "potential" value in any additional stock into which the issue is convertible. But, if such additional conversion rights have value it is only because the corpus of the instrument has declined in value. Yet, the decline in value can not be recognized on a current basis by most taxpayers.

Our concern is also a practical one. Determining the change in the value of a convertible bond due solely to a minor change in the conversion rate is a particularly challenging exercise. Convertible bonds contain inseparable debt and equity features and frequently include complex contractual provisions such as put rights, contingent call rights and other path dependent triggers mechanisms. Valuations are at best an estimate prepared by financial engineers using Monte Carlo simulations, binomial lattice models or partial differential equations applied to numerous unobservable factors, primarily stock price volatility, expected dividends, expected interest rates and credit risk premium. Simply speaking, there is no way to determine if an increase to a conversion right will be exercised without knowledge of the future. Consequently investors will reach different valuation estimates based on subjective pricing assumptions. Thus, this rule change will result in significant administrative reporting costs to issuers and intermediaries. Issuer estimates of value can, moreover, vary significantly from the valuations that each investor might calculate. This could lead to inconsistent reporting. The additional cost to the tax system and capital formation to sort out these valuations is simply unjustified for a market of this global importance.

For these reasons we once again urge the Treasury Department to withdraw the proposed regulations.

We appreciate your consideration of this matter and are happy to answer any questions and provide any additional information that may be of assistance.

Sincerely yours,

 

 

Fred T. Goldberg, Jr.

 

Edward E. Gonzalez

 

Skadden, Arps, Slate, Meagher & Flom, LLP

 

Washington, DC
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