On October 31, 2018, Treasury and the IRS released proposed regulations under Section 956 (the Proposed Regulations), which substantially limit the application of Section 956's "deemed dividend" rules to US corporations.1
This limitation on the application of Section 956 potentially increases the ability for US corporate borrowers to provide credit support in the form of guarantees by, and pledges of stock and assets of, their foreign subsidiaries/CFCs.
These rules not only impact new debt financings, but also outstanding credit facilities. The Proposed Regulations warrant a careful (re)examination of the tax and non-tax impacts of debt that is currently in place, because taxpayers are permitted to rely on the Proposed Regulations for tax years beginning on and after January 1, 2018.
Background on Section 956
Before the Tax Cut and Jobs Act of 2017 (the TCJA), with the notable exception of the subpart F and PFIC rules, US federal income tax was not imposed on the earnings of a foreign subsidiary/CFC2 until those earnings were distributed to its United States shareholder.3
That said, Section 956 requires United States shareholders to include as a "deemed dividend" a CFC's earnings to the extent the CFC has made an investment of those earnings in "United States property." For this purpose, a debt instrument is "United States property" if the obligor is a United States person. In addition, under Section 956, a CFC is treated as owning an obligation of a United States person (and therefore an investment in "United States property") if the CFC guarantees or secures the obligation with a pledge of its property.4 As a result, prior to the Proposed Regulations, a US parent corporation had a deemed dividend when its CFC provided a pledge or guarantee to secure the US parent's debt obligation. Accordingly, Section 956 has historically limited the ability of US corporations to use their overseas assets as collateral or credit enhancement for various financing transactions.
Section 956 was enacted to create consistency between the taxation of actual dividends distributed by CFCs and the taxation of other transactions that were equivalent to the repatriation of the CFC's earnings (ie, deemed dividends). The TCJA, however, created an inconsistency with its establishment of a "participation exemption," whereby US corporations receive a dividends-received deduction (DRD) for the foreign source portion of dividends received from their foreign subsidiaries. With the advent of this new DRD, Section 956 would, without any change, result in taxable deemed dividends even where the DRD would result in no US tax on an actual dividend.
The Proposed Regulations resolve this inconsistency by reducing the deemed dividend amount under Section 956 to the extent that the US corporation would have been allowed the DRD had an actual dividend been made. That said, the Proposed Regulations do not apply to individuals (regardless of whether or not an individual has elected to be taxed as a corporation under Section 962), partnerships, limited liability companies that have not elected to be treated as a corporation for US tax purposes, or any other disregarded entity.
A welcome benefit
The Proposed Regulations are a welcome benefit to US corporations with international operations that looking for credit support. US corporate borrowers may now generally pledge all of the voting and non-voting stock of their CFCs in support of their borrowings, and these CFCs may generally make guarantees on, and provide collateral for, US obligations without such credit support being considered a deemed dividend. As noted above, this new policy affects both new and existing credit facilities. For example, US corporate borrowers may seek to obtain interest rate reductions on existing borrowings by pledging all of their CFC stock (as opposed to the previous two-thirds limitation), having CFCs become guarantors on existing facilities, or increasing liquidity available within existing cash pool by adding CFC participants to the arrangement. Unquestionably, this should greatly simplify financing arrangements for US multinationals.
While the Proposed Regulations are in proposed form, taxpayers may rely on them for the tax years of their foreign corporations that start after December 31, 2017. However, taxpayers must also consider any collateral US tax effects before modifying any existing arrangements, such as the potential application of the significant modification rules that treat debt instruments as having been exchanged for new instruments.
Additionally, US corporations should also consider the potential impact of other provisions, such as the new global intangible low-tax income (GILTI) rules, the new base erosion anti-abuse tax (BEAT), the modified interest deduction limitation rules under Code Section 163(j), and the subpart F and previously taxed income rules. There are also certain limitations and exceptions to the application of the Proposed Regulations (eg, holding period requirements and hybrid dividend limitations), and we urge taxpayers to consult their US tax counsel before agreeing to any collateral packages that were previously prohibited.
Companies may also wish to consider the non-tax implications of any changes to existing or future financing arrangements. For example, there are numerous non-tax reasons for why US multinationals may prefer to continue to include existing limitations in their financing agreements, including higher cost of granting and perfecting security interest, local legal limitations, increased reporting obligations, transactional costs such as stamp duties and notary fees, and lesser protections for secured lenders.
For additional information or questions concerning this client alert or the Proposed Regulations, please contact Tom Geraghty, Mike Greenberg, Zachary Nolan or the DLA Piper tax contact whom you normally consult.
1 For this purpose, the term "US corporation" includes any US business entity electing to be taxed as a corporation.
2Generally defined as foreign corporations where more than 50 percent of the vote or value is owned by one or more "United States shareholders" (which, pre-TCJA, meant a US person having 10 percent or more of the voting power of the corporation).
3The TCJA modified the definition of United States shareholder to include US persons having 10 percent or more of the vote or value of the corporation.
4Additionally, a pledge of two-thirds or more of a CFC's stock is treated as an indirect pledge of the CFC's assets if the pledge is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation's discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.