When non-U.S. subsidiaries of a U.S. borrower provide credit support for loans made to their U.S. parent, unexpected and often significant U.S. tax costs can result. When structuring lending and credit support arrangements that involve U.S. borrowers and non-U.S. credit support, both borrowers and lenders should consider how to avoid unintentionally giving rise to these potential costs.
The Deemed Dividend Problem
Under U.S. federal income tax rules, certain credit support provided by non-U.S. subsidiaries of a U.S. borrower can cause the U.S. parent to be deemed, for U.S. tax purposes, to receive an annual dividend from the non-U.S. subsidiary to the extent of that subsidiary's earnings (generally up to the amount of the loan). Such deemed dividends can have significant adverse tax consequences for the U.S. parent, since they can cause non-U.S. earnings that might not otherwise be subject to U.S. tax to become subject to U.S. tax prior to those earnings actually being repatriated to the United States. In addition, because no actual distribution of cash occurs under these deemed dividend rules, the U.S. parent may be required to pay U.S. tax on these dividends without necessarily having the cash on hand to satisfy the resulting U.S. tax liability.
To avoid creating an unnecessary U.S. tax bill (money that could otherwise be used to fund operations or service the debt), lenders and borrowers often agree to limit the amount of credit support provided by non-U.S. subsidiaries of U.S. borrowers in order to avoid creating a deemed dividend problem.
What to Avoid
The following types of credit-support scenarios commonly give rise to a deemed dividend problem:
- a non-U.S. subsidiary guarantees a U.S. parent borrower's debt obligations;
- a non-U.S. subsidiary directly or indirectly pledges its assets to secure the repayment of the U.S. borrower's debt obligations;
- a U.S. borrower pledges stock representing 66 2/3% or more of the total combined voting power of its non-U.S. subsidiary and agrees (as is common in credit agreements) to limit the non-U.S. subsidiary's ability to dispose of its assets or incur liabilities outside the ordinary course of business; or
- where there are multiple tiers of non-U.S. subsidiaries (eg. USCo owns ForCo1, which owns ForCo2), the U.S. borrower pledges stock in a lower-tier non-U.S. subsidiary (ie. causes stock of ForCo2 to be pledged).
As a result, market practice in the United States often finds U.S. borrowers providing credit support from all their U.S. subsidiaries, but limiting credit support from non-U.S. subsidiaries to 65% of the voting stock of the U.S. borrower's first-tier non-U.S. subsidiaries.
A U.S. borrower may be persuaded to provide additional credit support from its non-U.S. subsidiaries if any of the following facts (which diminish deemed dividend concerns) are present:
- the non-U.S. subsidiary has very little or no accumulated earnings and little prospect for future earnings (since the amount of any deemed dividend in any given taxable year is limited under these rules to the amount of the subsidiary's earnings);
- the U.S. borrower would already be required to pay U.S. tax on the earnings of its non-U.S. subsidiary, which may be the case if, for example, the subsidiary is expected to make actual current distributions of its earnings to the U.S. parent (e.g., to service the loan) or the subsidiary generates income that is already taxable to the U.S. parent on a current basis under other U.S. tax rules (such as the U.S. "Subpart F" regime); or
- the U.S. borrower is expected to receive U.S. tax credits for non-U.S. taxes paid on the subsidiary's earnings or has other tax attributes available (such as net operating loss carryforwards) that are sufficient to offset any U.S. tax payable on the deemed dividend inclusions.
Where a deemed dividend problem is expected but additional non-U.S. credit support is desired or required, structural alternatives may also sometimes be available. For example, it may be possible for a lender to advance separate loans to the U.S. borrower and to its non-U.S. subsidiaries. In such a separate-stream financing arrangement, the U.S. borrower often provides a downstream guaranty or pledge of its own assets to secure the obligations of its non-U.S. subsidiaries, while the non-U.S. subsidiaries secure their own loans by granting liens on their assets. The non-U.S. subsidiaries generally do not, however, provide guarantees or pledge assets to support the U.S. borrower's loans. Because no impermissible credit support is provided by non-U.S. subsidiaries on the U.S. parent's debt, no deemed dividend problem generally results. However, depending on the nature of the transaction, other withholding tax and foreign currency exchange considerations and costs may be implicated. In addition, if the non-U.S. subsidiaries do not actually use or repay the separately borrowed funds, the separate financing streams may not be respected for U.S. tax purposes.
Alternatively, because non-voting stock in non-U.S. subsidiaries can be pledged without restriction under these deemed dividend rules, it may occasionally be possible to recapitalize the U.S. borrower's non-U.S. subsidiary with non-voting stock that represents a significant proportion of the subsidiary's value. That non-voting stock (and, in addition, up to 65% of the voting stock) could then be pledged to secure the U.S. borrower's obligations. However, there is a risk that the IRS will not respect the recapitalization transaction, particularly if the transaction is motivated by a desire to avoid the application of the deemed dividend rules.
William Corcoran represents private equity funds and investors on fund formation, management and operation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.