Understanding deemed dividends and taxes
E*TRADE from Morgan Stanley
When reviewing your Form 1099-DIV, you may notice either qualified or ordinary dividends that do not match with the cash distributions you received during the year. Under Section 305 of the Internal Revenue Code, certain actions taken by a company may result in a deemed dividend to holders of convertible securities, even though no actual cash was distributed. If this treatment applies, the deemed dividend is subject to tax reporting and withholding rules, as it is considered income to the convertible security holder.
For holders of convertible bonds or warrants, a deemed dividend may occur when the company makes an adjustment to the conversion ratio for the convertible security. The conversion ratio is the rate used to determine how many shares of stock the holder receives when the convertible security is exchanged for company shares. For example, if a shareholder has 100 convertible bonds with a conversion ratio of 1.01, the shareholder would receive 101 shares upon conversion.
When a company adjusts its conversion ratio, the number of shares convertible security holders are entitled to receive may increase. In the above example, if the rate is changed from 1.01 to 1.02, holders would be entitled to receive 102 shares after the rate change (from 101 previously). This increase may result in a deemed dividend to the convertible security holders.
When the change results in a deemed dividend, the dividend amount is intended to capture the value of the increased rate. This may be based on a rate provided by the company or determined by market data. Returning to the above example, if the company provided a deemed dividend rate of 0.125 for the increase in the conversion ratio, the deemed dividend would be (100 * 0.125) = $12.50.
Deemed dividends are reportable to investors and the Internal Revenue Service (IRS). Depending on the status of the convertible security holder, here’s what this may mean:
- For US-based investors: The deemed dividend is reportable at year-end on Form 1099-DIV as either a qualified or ordinary dividend. In addition, the dividend amount is taxed at a rate of 24% for investors subject to US backup withholding tax.
- For foreign certified investors: The deemed dividend is reportable on Form 1042-S and subject to tax withholding at a rate of 30% or lower, depending on whether tax treaty rates apply.
Because deemed dividends are not cash distributions, the tax withholding amount (if applicable) is charged against the account after the deemed distribution takes place.
Please keep in mind that deemed dividends may result in an increase in the adjusted basis of the affected convertible securities. For more information about cost basis adjustments and deemed dividend income, please visit irs.gov or consult your tax advisor.