In the continuing stream of IRS guidance relating to the Tax Cuts and Jobs Act of 2017 (the “TJCA”), recent IRS guidance may impact not only a taxpayer’s tax situation, but ultimately the terms of a taxpayer’s credit facility.
Historically, Section 956 of the Internal Revenue Code of 1986, as amended (the “Code”) and its regulations (collectively, the “956 Provisions”), require a U.S. person that owns (or is deemed to own) 10% or more of the stock of a controlled foreign corporation (a “CFC”), to include in income its allocable share of the CFC’s unrepatriated earnings (i.e. a deemed dividend), if the CFC provided a guarantee or pledge of the debt borrowed by a related U.S. person. In order to avoid this result, typically, a U.S. borrower would limit its foreign collateral to a pledge of 65% of the voting stock of its first-tier foreign corporate subsidiaries. This practice has been the norm for a number of years, and is reflected in most credit agreements involving U.S. persons that own a CFC.
In a taxpayer friendly development, the TJCA substantially reformed the U.S. taxation of U.S. corporations that repatriate the earnings of a CFC. Under newly enacted Section 245A of the Code, a U.S. 10% corporate shareholder (an “Eligible U.S. Shareholder”) that receives an actual dividend from a CFC is generally entitled to deduct the dividend. As a result, subject to the technical requirements of Section 245A, an actual dividend from a CFC to an Eligible U.S. Shareholder is generally exempt from tax. However, the TJCA did not repeal the 956 Provisions, and deemed dividends under the 956 Provisions appeared to remain subject to tax.
On October 31, 2018, IRS issued proposed regulations (the “Proposed Regulations”), and clarified the 956 Provisions in light of the TJCA. The Proposed Regulations extended the tax-free repatriation of earnings under Section 245A to deemed dividends under the 956 Provisions. As a result, deemed dividends under the 956 Provisions are not subject to tax to the extent an Eligible U.S. Shareholder would be allowed a deduction under Section 245A.
This is great news and welcome guidance. That being said, lenders may now require CFCs (and the subsidiaries of CFCs), to pledge all of the CFC’s stock and to have those CFCs (and their subsidiaries), guarantee the debt obligations of their U.S. corporate borrowers, because the historical negative consequences of doing so may no longer apply. In addition, U.S. corporate borrowers may also seek to improve credit terms, because CFCs may now be available to provide credit support.
The Proposed Regulations will be effective when they are published in final form, however, a taxpayer may rely on the Proposed Regulations for the taxable years of a CFC beginning after December 31, 2017.
Finally, it is important to note that the Proposed Regulations do not apply to U.S. shareholders of a CFC that are not entitled to an exemption under Section 245A, thus, the Proposed Regulations do not affect the application of the 956 Provisions to individuals, partnerships, or other entities treated as individuals or partnerships for tax purposes.
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