The final regulations, which are consistent with proposed Section 956 regulations issued in November 2018, immediately impact underwriting on many deals for United States C corporation borrowers with foreign subsidiaries.
It has been market practice for U.S. corporate borrowers with foreign subsidiaries to pledge 65 percent―and no more―of their voting stock in foreign subsidiaries as collateral to secured lenders. But final regulations issued in May 2019 under Section 956 of the Internal Revenue Code (IRC) in many cases eliminate the need for such a limitation. The final regulations for Section 956 also permit foreign subsidiaries to provide guaranties and direct and indirect pledges of assets in support of a U.S. parent corporation’s debt.
The final regulations, which are consistent with proposed Section 956 regulations issued in November 2018, immediately impact underwriting on many deals for United States C corporation borrowers with foreign subsidiaries. In addition, existing credit agreements may limit the required pledge of stock of foreign subsidiaries to the extent that a pledge of the balance of the stock would result in material adverse tax consequences. Agreements may be drafted so that a pledge of 100 percent of the voting securities of foreign subsidiaries will be deemed to “spring” into place (without any action) upon issuance of the final regulations. However, some credit and security agreements may require amendment.
Historically, the earnings of a foreign subsidiary controlled by a U.S. corporate parent are generally subject to U.S. income tax only after being distributed to the U.S. parent. Under Section 956 of the IRC, if a foreign subsidiary acted as a guarantor or directly or indirectly pledged its assets as collateral for the benefit of the U.S. parent, then the income of the foreign subsidiary could be treated as a “deemed dividend” and taxed prior to any actual distribution to the parent. To avoid the negative tax consequences of a deemed dividend, lenders and U.S. corporate loan parties have generally limited credit support from controlled foreign subsidiaries to a pledge by U.S. loan parties of no more than two-thirds (or 65 percent) of voting equity, or 100 percent of its nonvoting equity, in such foreign subsidiaries. For the same reason, controlled foreign subsidiaries are usually not required to provide a guaranty, or to directly or indirectly pledge assets as collateral, in support of credit for U.S. loan parties.
In some cases, the deemed dividend rule has resulted in inefficient alternative structures (e.g., segregated U.S. and foreign borrowing facilities). It has also caused lenders to disregard foreign assets within a corporate family and limited access by U.S. corporate borrowers to secured credit based on those assets.
The final regulations follow the 2017 enactment of Section 245A of the IRC, which provided generally that distributions made by foreign subsidiaries as a dividend to a U.S. C corporation parent could qualify for a “dividends-received deduction.” This in effect eliminated income tax on distributions from a foreign subsidiary to its U.S. C corporation parent. It also created an illogical inconsistency, which was that a “deemed dividend” to a U.S. C corporation parent under Section 956 could result in U.S. income tax on the earnings of a foreign subsidiary providing credit support, while an actual dividend from the foreign subsidiary would be effectively tax free due to the dividends-received deduction of Section 245A. The final regulations harmonize the two provisions by eliminating the deemed dividend under Section 956 to the extent that the U.S. C corporation parent would be able to deduct a cash distribution received as a dividend from its controlled foreign subsidiary under Section 245A. It should be noted, however, that the Section 245A dividends-received deduction will not apply where the U.S. borrower is not a C corporation or the U.S. borrower is a REIT or a regulated investment company. In those cases, the Section 956 “deemed dividend” rule will continue to be potentially applicable and credit support from foreign subsidiaries may still have to be limited.
While the final regulations have broad applicability, like any tax issue, every case requires specific review and analysis to determine whether existing rules, regulations, exceptions and authorities are applicable. Lenders and loan parties should consult with tax professionals before making a determination as to the applicability of Sections 245A and 956 of the IRC and the final regulations.
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