On May 23, 2019, the U.S. Internal Revenue Service and the Department of the Treasury published final regulations (Regulations) excluding corporate U.S. shareholders from the application of Section 956 of the Internal Revenue Code of 1986, as amended (Code)1, to the extent necessary to maintain symmetry between the taxation of actual repatriations of earnings from foreign subsidiaries and the taxation of deemed repatriations2. In many circumstances, this change will allow U.S. corporate borrowers with valuable foreign subsidiaries to provide significantly more credit support to their lenders than current practice in the U.S. credit markets.
Prior to the changes in the Regulations, credit support provided by foreign subsidiaries of a U.S. parent entity, such as guarantees or security over assets (including the pledge of stock of foreign subsidiaries), to support the repayment of debt of a U.S. parent entity could result in additional U.S. tax to a U.S. parent entity and its equity holders. This is because Section 956 deems certain U.S. parent entities that have borrowed in the credit markets to have received a (possibly taxable) repatriating distribution each year that the debt is outstanding if the assets of a controlled foreign corporation (CFC) or certain foreign partnerships (collectively, Applicable Foreign Subsidiaries) serve, subject to certain limited exceptions, at any time as credit enhancement for the borrowing by its U.S. parent entity. The amount of the deemed distribution is limited to the lesser of (i) the amount outstanding under the borrowing and (ii) the earnings and profits of the Applicable Foreign Subsidiary. To avoid this result, it has been customary for a U.S. borrower to limit the credit support made available to its lenders by:
- not providing guarantees by, or security from, any first-tier Applicable Foreign Subsidiaries (or any domestic holding companies that solely own Applicable Foreign Subsidiaries, commonly referred to as FSHCOs)
- limiting pledges of the U.S. borrower’s equity interests in its foreign subsidiaries to 65 percent of the voting equities in the borrower’s first-tier Applicable Foreign Subsidiaries
- limiting pledges of the U.S. borrower’s equity interests in any FSHCO to 65 percent of the voting equity in such FSHCO
- not providing liens on real estate or personal property, such as accounts receivable, inventory, equipment and intellectual property, owned by foreign subsidiaries
- not providing any credit support from any direct or indirect subsidiaries (including domestic subsidiaries) of first-tier Applicable Foreign Subsidiaries or FSHCOs
The 2017 tax reform legislation known as the Tax Cuts and Jobs Act (Tax Act) substantially changed how the income of and distributions from Applicable Foreign Subsidiaries are taxed by the U.S. Pursuant to the Tax Act, Section 245A now provides that a U.S. parent corporation generally is entitled to a 100 percent deduction for any actual distribution from a specified 10-percent-owned foreign corporation. However, the deemed distribution rules under Section 956 remained in place. As a result, the Tax Act created an asymmetry in which an actual cash distribution from a foreign subsidiary to its U.S. corporate parent could be tax-free to the U.S. corporate parent, but a deemed distribution under Section 956 from the same foreign subsidiary providing credit support to its U.S. parent entity would be fully taxable. The Regulations are intended to bring parity between actual and deemed distributions.
Summary of the Regulations
- Reduction of the Section 956 amount. The Regulations do not repeal Section 956 (only Congress can do so). Instead, they reduce the amount of the Section 956 deemed distribution treated as received by a U.S. shareholder by the amount that the U.S. shareholder would be able to deduct under Section 245A if the U.S. shareholder treated the deemed distribution as an actual distribution. Because Section 245A provides a 100 percent deduction for actual dividends, the amount of deemed distribution under Section 956 in many circumstances can be reduced to zero. However, there remain circumstances in which Section 956 will continue to apply (see below for practical implications).
- Effective dates. The Regulations will be effective for the taxable years of a CFC that begin on or after July 22, 2019. However, a U.S. corporation is permitted, but not required, to apply the Regulations to any deemed distributions occurring in the taxable year of the applicable CFC that begins on or after December 31, 2017. To do so, the U.S. corporation, and certain of its affiliates, must consistently apply the Regulations with respect to any credit support offered by any of their CFCs.
- Borrowing by U.S. corporate groups may permit additional credit support. Suppose X, a U.S. corporate parent, has a 100-percent-owned Applicable Foreign Subsidiary. Suppose further that Applicable Foreign Subsidiary had $200 of earnings and profits not otherwise subject to U.S. tax. Applicable Foreign Subsidiary operates in a foreign jurisdiction that does not impose a local law corporate tax. X borrows from L, a federally chartered bank lender, $100 under a revolving credit agreement, and the Applicable Foreign Subsidiary guarantees the entire borrowing for the benefit of L. X has no foreign operations or sales other than through Applicable Foreign Subsidiary. As a result, there are no available foreign tax credits.
- Under old law (i.e., pre-Tax Act), an actual distribution by Applicable Foreign Subsidiary of $100 would have resulted in a $35 tax to U.S. corporate parent ($100 dividend times 35 percent U.S. corporate tax rate). The guarantee by Applicable Foreign Subsidiary in the example would have resulted in the same $35 tax to the U.S. corporate parent (i.e., guarantee triggers deemed distribution from Applicable Foreign Subsidiary to U.S. corporate parent in the amount of the loan, all of which is out of earnings and profits).
- Under the new law (including the Regulations), Applicable Foreign Subsidiary’s actual distribution of $100 would result in no tax to U.S. corporate parent because of new Section 245A (i.e., $100 of foreign dividend income minus a deduction of $100 (100 percent of $100)). Similarly, for years in which the Regulations are effective, Applicable Foreign Subsidiary’s deemed distribution under Section 956 as a result of the guarantee in favor of L would be zero (i.e., $100 deemed dividend minus $100 (100 percent of $100)). The same result would occur if Applicable Foreign Subsidiary were to grant L a lien over Applicable Foreign Subsidiary’s real or personal property.
- Thus, as this example shows, solely as a U.S. tax matter, U.S. corporate groups with significant foreign subsidiaries may be able to provide credit support from their foreign subsidiaries in respect of borrowings by the U.S. corporate parent without incurring an adverse U.S. tax consequence. However, this was a simplified example. The determination and calculations in a particular case can be complicated and may change the result (e.g., holding period for recent acquisitions, multiple tiers of foreign subsidiaries, foreign tax credit calculations, earnings and profits calculations).
- Foreign subsidiaries owned by real estate investment trusts (REITs) and regulated investment companies (RICs) may not be able to provide similar credit support. The Regulations provide relief only to U.S. corporate borrowers. A U.S. borrower that is a REIT or a RIC, which borrows and wishes to provide credit support from a CFC, may not benefit from the Regulations because Section 245A limits the 100 percent deduction to U.S. shareholders of a CFC that are “domestic corporations,” and the Regulations turn off Section 956 only to the extent a Section 245A deduction would be available in the case of an actual distribution.
- Foreign subsidiaries owned by domestic partnerships may be able to provide similar credit support depending on the identity of the partners. The Regulations include a look-through rule that reduces the Section 956 inclusions to the extent one or more domestic corporate partners would be entitled to a Section 245A deduction if the partnership were to receive a distribution from a CFC. A U.S. borrower that is a partnership (including many limited liability companies) for tax purposes (e.g., a domestic private equity fund partnership or a family investment partnership) may be able to provide similar credit support if its sole beneficial owners are corporate U.S. shareholders. However, a domestic partnership will be treated as receiving some Section 956 deemed distributions to the extent one or more of the beneficial owners are not corporate U.S. shareholders (e.g., U.S. individuals).
- Section 956 is still applicable to some U.S. corporate borrowers. While the Regulations provide relief to corporate borrowers that may now be able to provide more credit support to their lenders without suffering adverse U.S. tax consequences, borrowers should be aware that under certain circumstances Section 956 and the adverse U.S. tax consequences related to it may still apply. For example, Section 956 might still apply where:
- the CFC stock was held for 365 days or less in a two-year period (e.g., a recently acquired target company)
- the CFC has income that was effectively connected with a U.S. trade or business
- the CFC’s dividends to the U.S. corporate parent were deductible under foreign tax law
- Changes to credit support should be made only after consultation with borrowers’ tax advisers. In light of the foregoing and the technical nature of the Regulations, a borrower should obtain advice from its tax adviser with respect to whether it is able to provide additional credit support without adverse tax consequences as a result of the Regulations. This analysis may be time consuming and require early consultation with outside advisers in order to complete the analysis within the timeframe of documenting any new financing.
- The Regulations may impact existing debt documents. Borrowers should review existing debt documents, including credit agreements and indentures, to determine whether any springing guarantees, liens or pledges (i.e., collateral that “springs” into existence for the benefit of lenders in the future when it becomes clear that the grant of the collateral would not result in adverse tax consequences under Section 956) or other provisions are affected by the Regulations and, if so, whether any borrower action is required pursuant to the terms of those debt documents.
- Obtaining foreign credit support can be challenging and costly. Upstream credit support in some foreign jurisdictions is subject to substantial corporate and bankruptcy law restrictions on the validity and enforceability of the credit support, such as corporate benefit and minimum capital requirements, financial assistance restrictions and rules on fraudulent conveyances. Also, obtaining liens on real estate and personal property in many foreign jurisdictions can be a labor-intensive, time-intensive and costly exercise (including foreign counsel fees). In some cases, credit support notionally provided will be of limited value relative to the transaction cost. Moreover, some jurisdictions do not recognize trust arrangements such as where a security agent holds collateral interests on behalf of creditors. When structuring transactions involving foreign credit support, careful consideration should be given to the impact of these factors, including the possible application of foreign withholding taxes and currency controls on payments on (or in connection with) guarantees and asset pledges (together with the U.S. foreign tax credit aspects associated with any such foreign withholding taxes).
1 All “Section” references herein are to the Code.
2 For a discussion of the proposed regulations that preceded the Regulations, please see our prior Sidley Update New Proposed Treasury Regulations May Significantly Change U.S. Cross-Border Lending Practices (November 2, 2018).
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.