Most Read Contributor in United States, March 2017
Overseas Shipping Group ("Overseas") recently sued its
former attorneys, a prominent New York-based law firm, for legal
malpractice in drafting credit agreements that resulted in the
company incurring an estimated $463 million in tax liability. The
suit alleges that the tax liability arises from the fact that the
credit agreement holds two foreign subsidiaries jointly liable with
their American parent, Overseas. This suit raises an important
question: under what circumstances will a foreign subsidiary's
income be subject to tax liability in the United States as a result
of being a party to a credit agreement with their U.S. parent?
Section 956 of the Internal Revenue Code ("Section
956") was enacted in 1962 to prevent a U.S. parent company
from avoiding tax liability while implicitly receiving the benefit
of the income of their controlled foreign subsidiaries
("controlled foreign corporations" or "CFCs").
Prior to the enactment of Section 956, a CFC's profits and
earning were only subject to taxation in the U.S. at the time they
were repatriated as dividends to the U.S. parent. Under Section
956, however, investments made by CFCs in specified "United
States property" are considered to be a constructive dividend
and subject to U.S. taxation. A CFC's earnings and profits are
considered a constructive or deemed dividend subject to U.S.
taxation if the subsidiary is the "pledgor or guarantor"
of its U.S. parent's debt obligations.
Section 956 in U.S. Loan Transactions:
A CFC is deemed to have made a taxable dividend in the context of
a U.S. loan transaction if (i) its U.S. parent pledges two-thirds
or more of the voting power of the CFC as security, (ii) the CFC
provides an upstream guarantee of the obligations of its U.S.
parent, (iii) the CFC grants or pledges its assets to secure the
obligations of its U.S. parent or, as illustrated by the recent
suit brought by Overseas, (iv) the CFC is jointly and severally
liable for the obligations of its U.S. Parent (which will be deemed
an "upstream guarantee" under Section 956). Given the
general federal corporate income tax rate of 35%, this can have
serious consequences for companies not planning to pay taxes on
those deemed dividends.
Suggestions in dealing with a potential "deemed
When negotiating a U.S. loan transaction, Borrowers and their
counsel must consider issues raised by Section 956, and consider
practical solutions to avoid paying taxes on deemed dividends, some
of which are identified below:
Determine whether Section 956 is applicable. If the company
making the pledge or guarantee is not a CFC (defined as having more
than 50% of its shares held by US shareholders), then the pledge or
guarantee will not be a deemed dividend and the company will not be
subject to additional tax liability under Section 956.
Determine if triggering Section 956 will cause a tax issue for
these companies. Liability under Section 956 generally will arise
only to the extent the foreign subsidiary has current or
accumulated earnings that have not already been subject to U.S.
Consider whether it makes sense for the lender to make loans in
dollars to the U.S. parent and separate loans in a foreign currency
to the CFCs guaranteed by the U.S. parent. In such a case, the CFCs
grant liens to secure the loans advanced to them, but provide no
guarantees or liens to support the loans extended to the U.S.
Section 956's trigger point for pledges being deemed a
dividend is measured by two-thirds of voting power – and not
two-thirds of the value of all capital stock. Consider whether the
CFC should issue more nonvoting stock with all of the economic
attributes of the currently outstanding voting stock to be pledged
as collateral and provide the lender greater equity value.
Without forethought, Section 956 can have serious consequences
on an international company's tax liability. However, with deal
specific analysis and negotiation, Borrowers can obtain the loans
needed to optimize business objectives and Lenders can obtain the
security necessary to make such loans.
This article was written with the assistance of Abbey
This article is presented for informational purposes only
and is not intended to constitute legal advice.
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