United States: U.S. Corporate Financing Transactions Facilitated By IRS Proposed Regulation

Alan Winston Granwell is of Counsel in our Washington DC office.

William B Sherman is a Parnter in our Fort Lauderdale office.

Erez I Tucner is a Partner in our New York office.

HIGHLIGHTS:

  • The Internal Revenue Service has issued a proposed regulation that in many cases should eliminate the detrimental U.S. tax consequences to a U.S. corporation under Section 956 of the Internal Revenue Code when the corporation collateralizes or secures its debt obligation (or a debt obligation of a U.S. affiliate) through a pledge of more than two-thirds of the stock of a foreign subsidiary, a foreign subsidiary's pledge of its assets or a foreign subsidiary's guarantee.
  • This should provide U.S. corporate borrowers with greater flexibility than under current law to provide enhanced collateral packages to lenders with respect to their foreign subsidiaries and therefore achieve better credit and loan conditions.
  • It also will likely change lenders' practices with respect to collateral packages. Rather than allowing U.S. corporate borrowers to provide limited collateral with respect to their foreign subsidiaries to avoid potentially detrimental U.S. income tax consequences under Section 956 to the U.S. corporate borrower, lenders now will likely require more robust collateral packages where such potentially detrimental U.S. income tax consequences are eliminated.

The Internal Revenue Service (IRS) issued a proposed regulation (the Proposed Regulation) on Oct. 31, 2018, that in many cases should eliminate the detrimental U.S. tax consequences to a U.S. corporation under Section 956 of the Internal Revenue Code (the Code) when the corporation collateralizes or secures its debt obligation (or a debt obligation of a U.S. affiliate) through a pledge of more than two-thirds of the stock of a foreign subsidiary, a foreign subsidiary's pledge of its assets or a foreign subsidiary's guarantee.1

Under current law, the above-described collateral packages generally would result in a taxable income inclusion to the U.S. parent corporation. The Proposed Regulation generally would eliminate any detrimental income inclusion to the U.S. parent corporation based on a "dividends received deduction" (the DRD) under Section 245A of the Code, enacted as part of the Tax Cuts and Jobs Act in December 2017.

The Takeaway

This change in law is anticipated to have two principal consequences:

  1. It will provide U.S. corporate borrowers with greater flexibility than under current law to provide enhanced collateral packages to lenders with respect to their foreign subsidiaries and therefore achieve better credit and loan conditions.
  2. It likely will change lenders' practices with respect to collateral packages. Rather than allowing U.S. corporate borrowers to provide limited collateral with respect to their foreign subsidiaries to avoid potentially detrimental U.S. income tax consequences under Section 956 to the U.S. corporate borrower (or its U.S. affiliate), lenders now will likely require more robust collateral packages where such potentially detrimental U.S. income tax consequences are eliminated by operation of the new Proposed Regulation.

Lenders and borrowers should reconsider existing secured finance transactions involving U.S. corporate borrowers where credit support was limited to a pledge of 65 percent of the stock of a first-tier foreign subsidiary, and in future transactions should consider the potential benefits of providing additional collateral and/or credit support from foreign subsidiaries.

Evaluation of these opportunities will require that the U.S. corporate borrower confirm that it will not suffer detrimental U.S. tax consequences under the Proposed Regulation and, as is the case today, require compliance with the laws of the jurisdictions of any foreign subsidiaries, including – without limitation – potential limitations on upstream guarantees or other credit support.

Why Was This Proposed Regulation Issued?

Generally, Section 956 was originally enacted (in 1962) to ensure that the offshore earnings of a controlled foreign corporation (CFC) would be taxed when repatriated, either through a dividend or an effective repatriation substantially the equivalent of a dividend, such as through credit support provided by the CFC for a U.S. shareholder loan.

The Tax Cuts and Jobs Act in December 2017 significantly modified the U.S. taxation of international operations. One change was to enact a limited participation exemption system under which foreign source earnings of a CFC repatriated to a corporate U.S. shareholder as a dividend effectively would be exempt from U.S. income taxation through an offsetting DRD under Section 245A of the Code. However, since an inclusion under Section 956 (which is substantially equivalent to, but not, a dividend) would be taxable at the normal corporate rates, an asymmetry arose between the U.S. taxation of actual repatriations and effective repatriations.

The Proposed Regulations remedy this asymmetry by providing that the amount of a Section 956 inclusion of a U.S. corporate shareholder is reduced to the extent the U.S. corporate shareholder would have been allowed a DRD under Section 245A if the U.S. corporate shareholder had actually received a distribution from the CFC in an amount equal to the amount otherwise determined under Section 956. This reduction can be equal to the full amount of the Section 956 inclusion or a lesser amount, depending on the circumstances.

Thus, if a U.S. corporate shareholder can satisfy the requirements of the DRD under Section 245A, neither an actual dividend to a U.S. corporate shareholder nor a Section 956 inclusion to a U.S. corporate shareholder would result in additional U.S. tax. Note, if Section 245A were to apply, foreign taxes would not be allowed for taxes paid or accrued by the CFC with respect to that dividend; thus, by equating a Section 956 inclusion to an actual dividend subject to the Section 245A DRD, it will no longer be possible for a U.S. corporate shareholder to affirmatively use Section 956 for foreign tax credit planning.

Effective Date

The Proposed Regulation will be effective when published in final form. However, a U.S. corporate shareholder may rely on the Proposed Regulation for taxable years of foreign subsidiaries that begin after Dec. 31, 2017, and for tax years of a U.S. shareholder in which the tax years of the CFC end – in effect, now.

Practical Implications of the Proposed Regulation

  • Credit support transactions that potentially would have implicated a Section 956 inclusion now are possible, provided that the U.S. shareholder would have been allowed a deduction under Section 245A if the U.S. shareholder had received an actual distribution from the CFC in an amount equal to the amount otherwise determined under Section 956. Thus, all or a portion of a Section 956 inclusion may be exempted (through a reduction to the Section 956 inclusion of the Section 245A amount). To confirm the Section 245A reduction, careful analysis will be required of the underlying facts and the detailed requirements of Section 245A and the Proposed Regulations.

    • Under Section 245A, a 100 percent DRD is available for 1) the foreign-source portion of a dividend, 2) received by a domestic corporate shareholder, 3) from a specified 10-percent owned foreign corporation (i.e., a foreign corporation in which the domestic corporation is a U.S. shareholder that owns 10 percent or more of the vote or value of the foreign corporation).
    • A Section 245A deduction is not allowed where:
      • any portion of the earnings and profits from which the dividend is paid is derived from U.S. sources
      • the stock is held by the taxpayer for 365 days or less during the 761-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to such dividend
      • the U.S. corporate taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property
      • the dividend paid by the CFC is a "hybrid" dividend for which the CFC received a deduction or other tax benefit with respect to foreign income taxes
      • the corporate taxpayer held the stock for 45 days or less during the 91-day period beginning on the last day during the taxable year on which the foreign corporation is a CFC
  • In addition, consideration must be given to 1) local law considerations, costs, limitations and protections, 2) the new limitation on interest expense deductibility under Section 163(j) of the Code, enacted as part of the Tax Cuts and Jobs Act in December 2017, and 3) the U.S. and local law tax consequences of subsequent repatriation of funds.
  • Now, it would be possible: 1) for a CFC to pledge assets to support the debt of its U.S. corporate shareholder (or its domestic affiliates), 2) for a CFC to guarantee the debt of its U.S. shareholder (or domestic affiliates), or 3) for the U.S. shareholder to pledge the stock of a CFC as collateral for its debt (without regard to the two-thirds limit) and not trigger a Section 956 inclusion.
  • Existing credit agreements should be reviewed to ascertain whether under a "springing" provision, additional credit support now would be required (as a result of the Proposed Regulations) because the enhanced credit support would not result in detrimental tax consequences to the borrower.

Footnotes

1 It should be noted that Section 956 continues to apply to individual shareholders and any U.S. entity that would not be treated as a corporation; thus, limited liability companies (LLCs) that have not elected to be treated as a corporation would not be covered. The IRS has requested comments as to how the regulation should apply to U.S. corporations that own an interest in a CFC through a U.S. partnership or LLC.

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.

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