Section 956 of the US Internal Revenue Code (“Section 956”) has historically loomed large in the context of finance transactions because it limited the ability of US borrowers to use overseas assets or revenues of foreign subsidiaries as additional collateral or credit support for such transactions. If finalized, recent regulations proposed by the US Internal Revenue Service on October 31, 2018 (the “Proposed Regulations”) will permit certain US borrowers to receive more robust credit support from their non-US subsidiaries while still complying with the requirements of Section 956.1
Background. Prior to January 2018, the offshore earnings of a domestic parent’s non-US subsidiaries generally were not subject to income tax until the earnings were actually distributed to the parent. Section 956 was an important exception to this rule and prevented US corporations from realizing benefits from overseas earnings “onshore” without first paying a tax on those earnings. Seeking to avoid the adverse tax impact of a “deemed dividend” under Section 956, lenders would often forgo the benefit of guarantees or other collateral support from a US borrower’s foreign subsidiaries when structuring lending transactions and ignore the earnings and assets of such foreign subsidiaries in their credit modeling. Accordingly, credit facilities with US borrowers typically have (i) not required these US borrowers to pledge more than two-thirds of the voting stock (and 100% of the non-voting stock) of any first-tier “controlled foreign corporation” (“CFC”) or any CFC holding company,2 (ii) not required CFCs or CFC holding companies to pledge their assets (including the stock of lower-tier subsidiaries) or (iii) not required CFCs or CFC holding companies to guarantee the US borrower’s obligations.
In December 2017, Congress enacted the bill informally known as the Tax Cuts and Jobs Act (the “Tax Act”). Section 245A under the Tax Act created a “dividends-received” deduction for dividends based on foreign income received by US corporate shareholders from most foreign subsidiaries.3 Contrary to expectations at the time, the Tax Act did not repeal Section 956, effectively breaking the parity between deemed dividends under Section 956 and actual distributions of cash. As a result, actual distributions of cash via dividend from a foreign subsidiary to its US corporate parent were generally tax-free in the United States, but guaranties and collateral provided by the foreign subsidiary in support of its US parent’s obligations constituted a deemed dividend taxed at a regular corporate rate (subject to the overlay of foreign tax credits).
Proposed Regulations. The Proposed Regulations seek to align the treatment of actual distributions with the treatment of deemed dividends under Section 956. Therefore, under the Proposed Regulations, a guaranty, grant of collateral or other credit support from a foreign subsidiary of a US borrower generally would not constitute a deemed dividend if the US borrower would be allowed to deduct a distribution of cash from its foreign subsidiary under Section 245A. Because Section 956 will continue to apply to borrowers that are not eligible for the Section 245A dividends-received deduction (such as non-corporate parent companies, regulated investment companies and real estate investment trusts), the negative tax impacts of Section 956 might still apply in some circumstances.
The Proposed Regulations generally will apply in the tax year of CFCs beginning on or after the date that the final regulations are published in the Federal Register. However, US corporate borrowers may elect to apply the Proposed Regulations prior to their effective date so long as it and its related persons consistently apply the Proposed Regulations with respect to all CFCs in which it is a US shareholder.
Impact on Financing Transactions. The Proposed Regulations make it possible for US corporate borrowers with significant overseas earnings to benefit from additional guaranties, collateral and other credit support by their foreign subsidiaries without incurring a tax liability caused by a deemed dividend under Section 956. Lenders would therefore be well-advised to consider the viability and impact of such credit support when underwriting and structuring new transactions. Additionally, many existing credit facilities contain springing obligations for foreign subsidiaries to provide guaranties, collateral and other credit support when providing this credit support would not cause a deemed dividend or other material adverse tax consequences. The Proposed Regulations eliminate the adverse impact of Section 956 for certain US borrowers and may give rise to an immediate requirement for the foreign subsidiaries of these borrowers to provide a pledge and/or guarantee. Lenders should review their existing agreements to determine whether borrowers are permitted (or required) to provide these additional pledges and/or guarantees. For both new and existing credit facilities, borrowers and lenders should carefully weigh the benefits of additional credit support against the costs and ultimate enforceability of such guaranties, collateral and other credit support.
Conclusion. The Proposed Regulations allow certain US parent borrowers to benefit from more fulsome credit support from their foreign subsidiaries. Lenders are advised to consider the impact of this additional credit support when underwriting and structuring new transactions and to review their existing credit facilities to determine whether changes to the existing collateral packages are permitted or required.
Mayer Brown’s team of experienced lending lawyers continues to monitor developments related to the “deemed dividend” rules and expects to provide additional updates as they arise.
1 For additional analysis of the Proposed Regulations and other related tax issues relevant to lending transactions, please see our Legal Updates “Proposed Regulations Change Calculus of Section 956’s ‘Deemed Dividend’ for US Corporate Shareholders” and “The Good, the Bad and the Ugly—Fundamental Tax Reform Is Enacted Into Law” and our Law360 article “The Impact of Tax Reform on Leveraged Lending Transactions.”
2 For purposes of this Legal Update, a “controlled foreign corporation” or “CFC” means a foreign corporation owned more than 50% by US shareholders measured by total voting power or total value of the stock, and a “CFC holding company” means a US holding company whose material assets constitute stock of a CFC. See IRC §957.