Par. 4. Section 1.305-7 is revised to read as follows:
(a) Applicable adjustment. For purposes of section 305, §§ 1.305-1 through 1.305-6, and this section, the term applicable adjustment means an adjustment to a right to acquire stock (as defined in § 1.305-1(d)(3)), including—
(1) With respect to a convertible instrument and a holder thereof, an increase in the conversion ratio or a reduction in the conversion price of such instrument;
(2) With respect to a warrant, subscription right, stock right, option, or other similar right and a holder thereof, an increase in the number of shares to be received by the holder upon exercise or a reduction in exercise price;
(3) With respect to a convertible instrument and a holder of actual stock into which such instrument may be converted, an increase in the conversion price or a reduction in the conversion ratio of such instrument;
(4) With respect to a warrant, subscription right, stock right, option, or similar right and a holder of actual stock into which such instrument is exercisable, an increase in the exercise price or a reduction in the number of shares to be received by the holder upon exercise; and
(5) An adjustment in the terms of a right to acquire stock having an effect similar to the effects of the adjustments described in paragraphs (a)(1) through (a)(4) of this section, including, for example, an extension or reduction of the term during which a right to acquire stock may be exercised.
(b) Transactions treated as distributions —(1) In general. Under section 305(c), an applicable adjustment, a change in redemption price, a difference between redemption price and issue price, a redemption that is treated as a distribution to which section 301 applies, or any transaction (including a recapitalization) having a similar effect on the interest of any shareholder is treated as a distribution of stock to which sections 305(b) and 301 apply if such transaction increases a shareholder's proportionate interest in the assets or earnings and profits of the corporation deemed to make such distribution, and the distribution has the result described in section 305(b)(2), (3), (4), or (5). Depending upon the facts presented, the distribution may be deemed to be made in shares of actual stock or in additional rights to acquire stock (which, in either case, may be common or preferred stock).
(c) Applicable adjustment to right to acquire stock —(1) Increase in deemed shareholder's proportionate interest. Under section 305(c), if an applicable adjustment has the effect of increasing a deemed shareholder's proportionate interest in the assets or earnings and profits of the corporation, and if such increase has the effect described in section 305(b)(2), (3), (4) or (5), the applicable adjustment is a deemed distribution to the deemed shareholder of a right to acquire stock, and section 301 applies to the deemed distribution. Applicable adjustments that can have this effect include, with respect to a convertible instrument, an increase in the conversion ratio or the number of shares of stock to be received upon conversion or a reduction in the conversion price.
(2) Increase in actual shareholder's proportionate interest. If an applicable adjustment has the effect of reducing a deemed shareholder's proportionate interest in the assets or earnings and profits of the corporation and thereby increasing an actual shareholder's proportionate interest, and if such increase has the effect described in section 305(b)(2), (3), (4), or (5), then the applicable adjustment is a deemed distribution of stock to the actual shareholder, and section 301 applies to the deemed distribution. Applicable adjustments that can have this effect include, with respect to a convertible instrument, a reduction in the conversion ratio or in the number of shares to be received upon conversion, or an increase in the conversion price.
(3) Exception. For purposes of applying section 305(c) in conjunction with section 305(b), an applicable adjustment that is made pursuant to a bona fide, reasonable adjustment formula (including but not limited to an applicable adjustment made to compensate for a distribution of stock to another shareholder) and that has the effect of preventing dilution of the proportionate interest of the holders of actual stock or rights to acquire stock does not result in a deemed distribution of stock. An applicable adjustment that is made to compensate for a cash or property distribution to another shareholder and that is taxable under section 301, 356(a)(2), 871(a)(1)(A), 881(a)(1), 852(b), or 857(b) is not made pursuant to a bona fide adjustment formula described in the preceding sentence.
(4) Amount of deemed distribution —(i) Deemed distribution to deemed shareholder. For a deemed distribution under section 305(b) and (c) that is made to a deemed shareholder and is an applicable adjustment, the amount of the deemed distribution is the excess of—
(A) The fair market value of the right to acquire stock held by the deemed shareholder immediately after the applicable adjustment, over
(B) The fair market value, determined immediately after the applicable adjustment, of such right to acquire stock as if no applicable adjustment had occurred.
(ii) Deemed distribution to actual shareholder. For a deemed distribution under section 305(b) and (c) that is made to an actual shareholder and results from an applicable adjustment, the amount of the deemed distribution is the fair market value of the stock deemed distributed, determined in accordance with the methodology set forth in § 1.305-3(e), Examples 8 and 9.
(iii) Fair market value standard. In determining the fair market value of a right to acquire stock for purposes of this paragraph (c)(4),
(A) Any particular facts pertaining to the deemed shareholder, including the number of rights or shares such deemed shareholder owns, will be disregarded, and
(B) Any value or reduction in value attributable to the possibility of future applicable adjustments that may result from actual or deemed distributions will not be taken into account.
(5) Date and time of deemed distribution. When an applicable adjustment is a deemed distribution under paragraphs (c)(1) or (2) of this section, the deemed distribution occurs at the time such applicable adjustment occurs, in accordance with the instrument setting forth the terms of the right to acquire stock, but in no event later than the date of the distribution of cash or property that results in the deemed distribution (taking into account § 1.305-3(b)). For such applicable adjustment relating to a right to acquire publicly-traded stock, if the instrument setting forth the terms of such right does not set forth the time the applicable adjustment occurs, the deemed distribution occurs immediately prior to the opening of business on the ex-dividend date for the distribution of the cash or property that results in the deemed distribution. For such an applicable adjustment relating to a right to acquire non-publicly traded stock, if the instrument setting forth the terms of such right does not set forth the time the applicable adjustment occurs, the deemed distribution occurs on the date that a holder is legally entitled to the distribution of cash or property that results in the deemed distribution.
(6) Examples. The following examples and the examples in §§ 1.305-3(e) and 1.305-5(d) illustrate the application of section 305(c) and paragraphs (a), (b) and (c) of this section.
Example 1.
(i) Facts. Corporation U has two classes of actual stock outstanding, class A and class B. Each class B share is convertible into class A stock. In accordance with a bona fide, reasonable antidilution provision, the conversion price is adjusted downward if the corporation transfers class A stock to anyone for consideration below the conversion price. The corporation sells class A stock to the public at the current market price, which is below the conversion price. Pursuant to the antidilution provision, the conversion price is adjusted downward.
(ii) Analysis. Although such a reduction in conversion price is an applicable adjustment, under paragraph (c)(3) of this section the reduction is not a distribution under section 305(c) for the purposes of section 305(b).
Example 2.
(i) Facts. Corporation X has outstanding one class of actual common stock and convertible debt securities. The convertible securities have a bona fide, reasonable antidilution provision that provides for an increase in conversion ratio in the event stock dividends or rights to acquire stock are distributed to the common shareholders. Corporation X distributes to the common shareholders an actual stock dividend that results in an increase in the conversion ratio of the convertible securities. Pursuant to the antidilution provision, the conversion ratio is increased.
(ii) Analysis. Under section 305(d) and § 1.305-1(d)(4), the holders of convertible securities are shareholders for purposes of section 305(b) and (c). The convertible securities are rights to acquire stock and are stock for purposes of section 305. The increase in conversion ratio caused by the distribution of the stock dividend to the common shareholders is an applicable adjustment. Because the applicable adjustment is made pursuant to a bona fide, reasonable adjustment formula within the meaning of paragraph (c)(3) of this section, the applicable adjustment is not a deemed distribution under section 305(c) of rights to acquire stock.
Example 3.
(i) Facts. Corporation X has outstanding one class of publicly-traded common stock and convertible debt securities. The terms of the convertible securities provide for an increase in the conversion ratio in the event stock, cash, or property is distributed to the holders of the common stock. Corporation X distributes cash to the holders of the common stock, and the distribution results in an increase in the conversion ratio of the convertible securities.
(ii) Analysis. Under section 305(d) and § 1.305-1(d)(5), the holders of the convertible securities are shareholders for purposes of section 305(b) and (c). The conversion rights in the convertible securities are rights to acquire stock (as defined in § 1.305-1(d)(3)) and is stock for purposes of section 305. The increase in conversion ratio resulting from the cash distribution to the holders of common stock is an applicable adjustment. Because the applicable adjustment is not made pursuant to a bona fide, reasonable adjustment formula within the meaning of paragraph (c)(3) of this section, it is a deemed distribution to the holders of the convertible securities of rights to acquire stock under section 305(c) and paragraph (c)(1) of this section. Because the proportionate interests of these deemed shareholders in the assets or earnings and profits of Corporation X are increased by the change in conversion ratio, the distribution has the result described in section 305(b)(2) and is treated as a distribution to which section 301 applies. The amount of the deemed distribution is determined in accordance with paragraph (c)(4)(i) of this section, and the date and time of the deemed distribution are determined in accordance with paragraph (c)(5) of this section.
(d) Recapitalizations —(1) In general. A recapitalization (whether or not an isolated transaction) will be deemed to result in a distribution to which section 305(c) and this section apply if—
(i) It is pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation, or
(ii) A shareholder owning preferred stock with dividends in arrears exchanges his stock for other stock and, as a result, increases his proportionate interest in the assets or earnings and profits of the corporation. An increase in a preferred shareholder's proportionate interest occurs in any case where the fair market value or the liquidation preference, whichever is greater, of the stock received in the exchange (determined immediately following the recapitalization), exceeds the issue price of the preferred stock surrendered.
(2) Amount of distribution. In a case to which paragraph (d)(1)(ii) of this section applies, the amount of the distribution deemed under section 305(c) to result from the recapitalization is the lesser of—
(i) The amount by which the fair market value or the liquidation preference, whichever is greater, of the stock received in the exchange (determined immediately following the recapitalization) exceeds the issue price of the preferred stock surrendered, or
(ii) The amount of the dividends in arrears.
(3) Definition. For purposes of applying paragraphs (d)(1) and (2) of this section with respect to stock issued before July 12, 1973, the term issue price of the preferred stock surrendered shall mean the greater of the issue price or the liquidation preference (not including dividends in arrears) of the stock surrendered.
(4) Examples. For an illustration of the application of this paragraph (d), see Example 12 of § 1.305-3(e) and Examples 1,2, 3, and 6 of § 1.305-5(d).
(e) Redemption premiums with respect to preferred stock. Under section 305(c), if a redemption premium exists with respect to a class of preferred stock under the circumstances described in § 1.305-5(b) and the other requirements of this section are met, the distribution will be deemed made with respect to such preferred stock, in stock of the same class. Accordingly, the preferred shareholders are considered under section 305(b)(4) and (c) to have received a deemed distribution of preferred stock to which section 301 applies.
(f) Coordination with section 871(m). For coordination of sections 305 and 871(m), see § 1.871-15(c)(2)(ii).
(g) Effective date. This section applies to deemed distributions under section 305(c) occurring on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register . A taxpayer, however, may rely on these proposed regulations for deemed distributions under section 305(c) that occur prior to such date. For purposes of determining the amount of a deemed distribution to a deemed shareholder occurring prior to the date of publication, a taxpayer may determine the amount of the deemed distribution by treating such distribution either as a distribution of a right to acquire stock or as a distribution of the actual stock to which the right relates.