On October 31, 2018, the Department of the Treasury and the Internal Revenue Service ("IRS") issued favorable proposed regulations (the "Proposed Regulations")1 that would allow U.S. corporations to claim a dividends-received deduction with respect to dividends that are deemed to be received from controlled foreign corporations ("CFC")2 under Section 956 of the Internal Revenue Code of 1986, as amended (the "Code") in connection with the CFC's investment of its earnings in U.S. property. The IRS has described the Proposed Regulations as a means of ensuring that the application of Section3 956 is consistent with the changes applicable to actual dividend distributions from CFCs enacted under the Tax Cuts and Jobs Act ("TCJA") 4, passed on December 22, 2017. 

The dividends received deduction is expected to substantially reduce and in many cases eliminate the U.S. income taxes to corporations imposed on "deemed dividends" under Section 956. Lenders to U.S. corporations with valuable foreign subsidiaries will undoubtedly welcome the issuance of the Proposed Regulations as a potential means to enhance their credit support / collateral packages (as discussed below) because the deemed dividend tax regime under Section 956 has previously limited the degree to which such CFCs can guarantee indebtedness of their U.S. parent corporations and to which U.S. borrowers can pledge the equity of their foreign subsidiaries that are CFCs


Prior to the enactment of the Revenue Act of 1962 (the "1962 Act"), the earnings of foreign corporations were not taxable to U.S. shareholders of CFCs unless and until those U.S. shareholders received a distribution in the form of a dividend. However, pursuant to the "Subpart F" provisions of the 1962 Act, certain passive or highly mobile earnings of CFCs, including amounts that were effectively invested in the United States, became immediately subject to U.S. taxation, regardless of whether there was an actual distribution; earnings from active business operations generally remained outside of U.S. taxation until there was an actual distribution. Section 956 was enacted to protect against tax situations in which offshore earnings are not being taxed, but are used in a manner that was perceived as effective repatriation. Said another way, Section 956 was enacted to guard against tax avoidance and to ensure appropriate taxation.

Section 956 generally requires a "U.S. shareholder" (i.e. a U.S. individual or entity that owns 10% or more of the stock of a CFC by vote or value) to include in its income an amount equal to its share of any increase in the CFC's investment in U.S. property during the applicable taxable year (other than previously taxed earnings and profits of the CFC) even if the CFC makes no distributions in such year. For this purpose, U.S. property generally includes: (i) tangible property located in the United States; (ii) stock of a domestic corporation; (iii) a debt obligation of a U.S. obligor; or (iv) a right to use certain intellectual property in the United States. Notably, a CFC's guarantee of debt of a U.S. shareholder and a pledge of stock of a CFC by a U.S. shareholder representing more than 66 2/3% of the voting stock of such CFC generally is treated as an investment in U.S. property.

In order to prevent U.S. shareholders of CFCs from recognizing significant tax liability in connection with a deemed dividend, credit agreements and other financing documents for loans to U.S. shareholders with subsidiaries that are CFCs often exclude such CFCs from serving as guarantors and limit the pledge of stock of such CFCs to less than 66 2/3% of the voting stock of first-tier CFCs (and in many cases similarly exclude stock of U.S. subsidiary corporations where substantially all of the assets of such corporations are shares of one or more CFCs).

When the TCJA was enacted, it created a participation exemption with respect to the taxation of certain foreign income under Section 245A. Specifically, Section 245A generally permits a U.S. corporate shareholder of a CFC to claim a 100% deduction with respect to dividends received from the CFC (the "245A Deduction"). However, the dividends-received deduction under Section 245A did not apply to Section 956 deemed dividends because such inclusions are not technically dividends. The purpose of Section 956 was to equalize the treatment of such deemed repatriations and actual repatriations, by subjecting both to immediate taxation. However, as a result of the 245A Deduction, a U.S. corporation could be subject to additional U.S. federal income tax on a deemed dividend from a CFC pursuant to Section 956 even though an actual dividend received from such CFC would be exempt from U.S. tax because of the dividends received deduction under Section 245A. Accordingly, the Proposed Regulations have extended the 245A Deduction under the TCJA to deemed dividends pursuant to Section 956 to ensure equivalent tax treatment.

The Proposed Regulations

The Proposed Regulations eliminate this disparate treatment as between Section 956 and the 245A Deduction, by excluding corporate U.S. shareholders from Section 956, to the extent needed to maintain harmony between the taxation of actual and effective repatriations. The Proposed Regulations seek to effectuate this alignment by reducing the deemed dividend income inclusion by the amount that would have been exempted from U.S. income tax because of Section 245A if such domestic corporation had instead received an actual dividend distribution from such CFC. Therefore, assuming that the Proposed Regulations are finalized in substantially the same form, both actual and deemed distributions pursuant to Section 956 would in most circumstances be tax-free to U.S. corporate shareholders (assuming the requirements of Section 245A are met).

When thinking about the Proposed Regulations it is important to note that they only currently provide the benefits of the dividends received deduction to deemed dividends under Section 956 to corporate U.S. shareholders. Other U.S shareholders, including without limitation, individuals, regulated investment companies and real estate investment trusts, will not enjoy such modifications under the Proposed Regulations as they are currently ineligible for the 245A Deduction. Special rules will be provided for entities that are treated as partnerships, including limited liability companies and limited partnerships that are treated as partnerships for U.S. tax purposes which have U.S. corporations as partners. Further, corporate U.S. shareholders will not be eligible if they would not have satisfied the holding period and other requirements of Section 245A with respect to actual distributions. In addition, in order to be eligible for the dividends received deduction, the earnings deemed distributed must be from a foreign source (generally earnings that are not attributable to (i) income that is effectively connected with the conduct of a trade or business within the United States and (ii) dividends received from a domestic corporation at least 80% of the stock of which (by vote and value) is owned by the CFC). In addition, if a distribution by a CFC would give rise to hybrid dividends (generally distributions with respect to securities that are treated as equity for U.S. tax purposes but debt under the law of the CFC's country of residence), any such deemed distributions made by such CFC will not be eligible for the dividends received deduction. Accordingly, U.S. borrowers will need to evaluate their eligibility for claiming the dividends received deduction in light of their own particular circumstances.

In addition, in certain situations, a U.S. shareholder may actually achieve greater tax savings by claiming a foreign tax credit rather than the dividends received deduction with respect to the deemed distribution. In that case, it may be preferable for the U.S. shareholder to not rely on the Proposed Regulations and try to accelerate deemed distributions in years before the year in which the Proposed Regulations are finalized although after final regulations are issued the U.S. shareholder will be required to claim the dividends received deduction.

The Proposed Regulations are expected to become applicable to the taxable year of a CFC beginning on or after the date of publication of the final regulations in the Federal Register. Taxpayers are entitled to rely on the Proposed Regulations prior to their effective date and with respect to taxable years of CFCs beginning after December 31, 2017, provided that the taxpayer and its related persons consistently apply the Proposed Regulations with respect to all CFCs in which they are U.S. shareholders.

Implications for Financing Transactions

Assuming that the Proposed Regulations are finalized in substantially the same form, in many cases lenders may require U.S. corporate borrowers to pledge all of the voting and non-voting stock of their first-tier CFCs (and the subsidiaries of those CFCs) and to have those CFCs (and their subsidiaries) guarantee the debt obligations of the U.S. corporate borrowers because the adverse U.S. tax consequences of doing so may (and frequently will) not apply. In addition, U.S. corporate borrowers may seek to provide credit support from their CFCs (and their subsidiaries) to improve the terms of the financing, or to increase the amount those borrowers may borrow.

However, because there are some situations in which a U.S. corporate shareholder cannot claim a dividends received deduction, credit agreements may have a softer form of restrictions on credit support by CFCs. For example, market practice may evolve to adopt an approach currently used in some financing agreements to provide that CFC stock pledges and CFC subsidiary guarantees will be limited for so long as, and only to the extent that, such pledges or guarantees would cause an adverse tax consequence to the borrower.

With respect to existing credit agreements, lenders and borrowers should review the foreign collateral requirements, particularly with respect to the provisions that provide that CFC stock pledges and CFC subsidiary guarantees will be limited only to the extent such pledges or guarantees would cause an adverse tax consequence or other similar credit support limitations. If Section 956 no longer imposes an adverse tax consequence, U.S. corporate borrowers and their CFCs would be required to provide additional pledges or guarantees.

It is also important to note that, because of other provisions of the TCJA such as the GILTI and FDII tax regimes, some U.S. shareholders of foreign subsidiaries are converting those subsidiaries from corporations into partnerships or disregarded entities for U.S tax purposes. In those cases, the CFC impediments to guarantees and pledges would no longer apply.

Lenders to U.S. borrowers that own CFCs with material value should consider how to approach the guarantee and collateral requirements for future loans in light of the Proposed Regulations, potential augmentation of their guarantee and collateral packages under existing credit facilities, and non-tax considerations that are relevant to the foregoing. Similarly, in the context of the negotiation of a workout or restructuring of an existing credit facility, parties may want to consider their ability to obtain additional credit support in the form of guarantees by, and pledges of the equity interests of, foreign entities that are CFCs. It is likely that the Proposed Regulations will materially change common collateral packages for loans made to U.S. borrowers with foreign subsidiaries and lenders and borrowers are well advised to analyze the consequences for new and existing loans.


1 REG-114540-18.

2 A CFC is any foreign corporation if more than 50 percent of (i) the total combined voting power of all classes of stock of such foreign corporation entitled to vote or (ii) the total value of the stock of such foreign corporation is owned, or is treated as owned through the application of certain constructive ownership rules, by U.S. shareholders on any day during the taxable year of such foreign corporation.

3 References in this Special Bulletin to “Sections” refer to sections of the Code unless otherwise specified.

4 P.L. 115-97.

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.