Post by alanbond on Jun 26, 2019 9:19:00 GMT 4
United States: Upstream Guarantees And Security By Foreign Subsidiaries Of A U.S. Corporate Borrower May Now Be Available Without Adverse U.S. Federal Income Tax Consequences To The U.S. Parent
Last Updated: June 24 2019
Article by Deborah K. Staudinger and Scott R. Lilienthal
Hogan Lovells
Tax structuring under the previous regime
Prior to the issuance of the final regulations described below, under Section 956 of the Internal Revenue Code of 1986 and its related Treasury Regulations, for U.S. tax purposes, a dividend was deemed created when a U.S. borrower pledged, as security for its obligations under a credit facility, two-thirds or more of the voting stock in a foreign subsidiary considered to be a "controlled foreign corporation" (CFC) or if the CFC guaranteed or pledged its assets as security for the U.S. parent's obligations. As a result, the U.S. parent was required to include in its U.S. taxable income an amount equal to the lesser of (i) the total principal amount of the loan that was supported by the foreign subsidiary credit support, and (ii) the amount of such foreign subsidiary's earnings and profits that previously have not been taxed in the U.S.
To avoid this tax exposure, credit agreements that included a U.S. entity as a borrower have typically been drafted to exclude CFCs as guarantors, to exclude the pledge of any assets of a CFC, and to limit any pledge of voting stock of a CFC to no more than 65 percent of the voting stock. These provisions often treated domestic subsidiaries with no assets other than stock in one or more CFCs to be the equivalent of CFCs.
The origin of the Section 956 deemed dividend rules was the fact that a U.S. parent was generally able to defer paying U.S. taxes on earnings of a CFC (with certain exceptions) until the earnings were actually distributed to the U.S. parent. The purpose of the Section 956 deemed dividend rules was to prevent a U.S. parent from benefiting from the earnings of a CFC (for instance, by the pledge of its voting stock or by causing the CFC to guarantee or pledge its assets in support of a borrowing by the U.S. parent) without paying the U.S. taxes that would result from an actual distribution of the earnings to the U.S. parent.
The Tax Cuts and Jobs Act
One of the major changes included in the Tax Cuts and Jobs Act (TCJA), enacted in December 2017, was a participation exemption system effectively exempting from U.S. federal income taxation the foreign-sourced portion of dividends that were paid to a U.S. corporation by a foreign corporation with respect to which the U.S. corporation was a 10 percent or greater shareholder. So now, after the TCJA changes, subject to certain exceptions, there is no U.S. taxation on dividends actually received from a CFC to its U.S. corporate parent.
Since an actual dividend from a CFC to its U.S. corporate parent is generally not subject to U.S. taxation under the TCJA provisions, both the House and Senate versions of the TCJA logically also included provisions that would have repealed the deemed dividend rules of Section 956 for U.S. corporations with CFCs that qualify for the new participation exemption. However, inexplicably, the final enacted version of the TCJA did not include the repeal of those rules for U.S. corporations. As result, the TCJA created a trap for the unwary by retaining the rules under which a pledge or guarantee by a CFC in support of a debt of its U.S. corporate parent could result in deemed dividends subject to U.S. taxation, even though an actual dividend would not result in U.S. taxation.
Changes under the regulations
To address this failure to repeal the deemed dividend rules of Section 956 for U.S. Corporations with CFCs, in October of 2018, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) published proposed regulations under Section 956 (the Proposed Regulations), which, in most situations, eliminated the deemed dividend that otherwise would have resulted from the U.S. borrower's pledge of the voting stock of a CFC or a pledge of assets or guarantee by a CFC in support of the debt of its U.S. corporate parent. The Proposed Regulations fixed the disparity between the U.S. tax treatment of actual and deemed dividends from CFCs by reducing the amount to be included in taxable income as a result of Section 956 to the extent that an actual dividend paid by the CFC would not be subject to U.S. federal income tax as a result of the participation exemption system enacted under the TCJA.
Interestingly, the Proposed Regulations included a provision that allowed taxpayers to rely on the Proposed Regulations for taxable years of a CFC beginning after 31 December 2017, and for taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end, provided the taxpayer and U.S. persons who are related to the taxpayer consistently apply the Section 956 Regulations for all CFCs in which they are U.S. shareholders. Notwithstanding this provision, few U.S. corporations relied on the Proposed Regulations, opting to wait for the Proposed Regulations to become final.
On May 23, 2019, the IRS issued final Section 956 Regulations that, consistent with the Proposed Regulations, apply to taxable years of a CFC beginning on or after July 22, 2019, and to taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end.
Potential impact on agreed security principles in credit agreements
On new transactions
As a result of the final Section 956 Regulations, CFCs of U.S. corporate borrowers will generally be able to provide guarantees and 100 percent pledges in support of their U.S. corporate parents' debt immediately without triggering adverse U.S. federal income tax consequences for the U.S. parent corporation. Accordingly, lenders may well ask that the agreed security principles in credit agreements with U.S. borrowers reflect this change and require guarantees by CFCs and/or direct or indirect pledges of 100 percent of the voting stock of CFCs and possibly a pledge of the assets of CFCs.
However, care needs to be taken when considering this issue because the final Section 956 Regulations generally address only corporations eligible for the participation exemption system enacted under the TCJA and may not be applicable to other corporate forms such as limited liability companies. This means that the pledge of more than 65 percent of the voting stock or the CFC pledges and guarantees still may result in adverse tax consequences, including in the following circumstances:
If the U.S. borrower is not a corporation (except to the extent the borrower is a partnership for U.S. tax purposes and its partners are corporations that would be entitled to the participation exemption if the partnership received a distribution)
If not all of the CFC's earnings are foreign source (e.g., CFC has income from a U.S. trade or business or from a U.S. subsidiary of the CFC)
If the CFC has issued instruments which pay "hybrid dividends," i.e., for which the CFC receives a deduction or other tax benefit related to taxes imposed by a foreign country
If the U.S. borrower does not meet certain holding period requirements, e.g., has owned the CFC for fewer than 365 days over a specified period.
It should also be noted, of course, that non-tax considerations (such as local law issues) will still need to be considered in determining whether credit and/or collateral support from a foreign subsidiary are feasible.
On legacy transactions
Existing credit agreements should be reviewed to determine whether covenants which prohibit the pledge of more than 65 percent of the voting stock of the CFC and/or the pledge of assets or guarantees by CFCs only apply where the pledge or guarantee would result in adverse tax consequences to the borrower. If such covenants are indeed conditional upon adverse tax consequences to the borrower, such CFC pledges and guarantees may now be required.