Opportunity for Increased Foreign Subsidiary Credit Support: New IRS Proposed Tax Regulation Limiting "956 Deemed Dividend" Tax Impact

On October 31st, the IRS announced a proposed regulation (the "Proposed Regulation") which, if finalized, would substantially diminish (and potentially eliminate) the adverse tax impact of "956 Deemed Dividends" triggered when a foreign subsidiary provides a guarantee or collateral to support a loan made to its U.S. parent (or other U.S. affiliate).^[1]  If finalized, the Proposed Regulation would remove a major obstacle to lenders receiving foreign subsidiary credit support, and in certain situations would enable lenders to significantly improve their collateral positions and provide increased opportunities to lend against the value of foreign subsidiaries. 

Currently under the U.S. tax code, any of the following types of foreign subsidiary credit support could trigger a material taxable 956 Deemed Dividend for a U.S. borrower: (1) a guaranty by the foreign subsidiary, (2) a lien on any of the assets of the foreign subsidiary, or (3) a pledge of 66^2/3% or more of the voting stock of the foreign subsidiary, in each case, to secure a loan made to the U.S. borrower.  The amount of the taxable 956 Deemed Dividend is the lesser of (i) the total principal amount of the loan that is 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. For example, if such foreign subsidiary guarantees a $100 million loan made to its U.S. parent, all of such foreign subsidiary's previously untaxed earnings and profits up to $100 million (i.e., up to the amount of the loan made to its U.S. parent) could be taxed in the U.S. as a 956 Deemed Dividend.[2]  Because of the potential material tax impact of 956 Deemed Dividends, U.S. borrowers often are unwilling to even entertain allowing their foreign subsidiaries to provide any credit support in respect of their loans, other than a 65% equity pledge (which 65% pledge would only have limited collateral value because, among other things, it would rank behind all of the secured and unsecured creditors of the foreign subsidiary, and then would only entitle the lender to 65% of whatever is left-over after all of such creditors have been paid in full). 

As noted above, if finalized, the Proposed Regulation would substantially diminish (and potentially eliminate) the above-noted 956 Deemed Dividend adverse tax impacts and could result in lenders receiving valuable guarantees and collateral from foreign subsidiaries, and 100% equity pledges (instead of just 65% equity pledges) in respect of foreign subsidiaries, in each case to support loans to U.S. borrowers. However, equity sponsors and U.S. borrowers may still object to providing such foreign subsidiary credit support due to increased transaction costs to effectuate such support (such as foreign counsel fees and expenses), and due to concerns with triggering issues under applicable foreign law (such as corporate benefit laws that are common throughout the world and restrict foreign subsidiaries from guaranteeing the debt of others, and financial assistance laws which limit the ability of foreign subsidiaries to provide credit support for leveraged acquisitions).  Additionally, in certain instances, even if the Proposed Regulation becomes fully effective, 956 Deemed Dividend taxes may still apply with respect to U.S. shareholders that are not corporations.[3] That said, in the right situations, lenders may now be able to obtain valuable foreign subsidiary credit support which previously was off-limits.

Even though the Proposed Regulation is not yet final, the Proposed Regulation provides, subject to certain exceptions, that it may be relied on now by U.S. taxpayers with respect to tax years post 2017--- so at least in theory, the Proposed Regulation may allow lenders immediately to seek additional foreign subsidiary credit support without triggering taxable 956 Deemed Dividends even prior to the Proposed Regulation being finalized.[4] That said, U.S. borrowers/equity sponsors may be reluctant to rely on the Proposed Regulation until it is final.[5]

As a result of the Proposed Regulation, lenders should consider the following:

• Updating Form Loan Documents / Form Term Sheets to Require Increased Foreign Subsidiary Credit Support: To the extent 956 Deemed Dividend taxes are no longer applicable (which hopefully will be the majority of situations after giving effect to the Proposed Regulation), lenders should update their form loan documents to require the below-noted expanded foreign subsidiary credit support. While borrowers/equity sponsors may object to such expanded foreign subsidiary credit support requirements due to concerns about the Proposed Regulation not yet being final or that 956 Deemed Dividend taxes may continue to apply in limited situations even after the Proposed Regulation is final, those concerns could be addressed by providing that the expanded support would only be required to the extent it would not trigger a material Deemed Dividend tax.

• 100% Equity Pledges of First-Tier Foreign Subsidiaries (rather than 65% equity pledges): Note, simply increasing the percentage of the equity pledge should not result in incremental transaction expense and is unlikely to cause issues under applicable foreign law.

• Guarantees from Foreign Subsidiaries: Note, it may be possible to effectuate the foreign subsidiary guarantee simply by having the foreign subsidiary become a signatory to an existing U.S. Subsidiary Guaranty, which arguably should not involve significant incremental transaction expense. However, the borrower/equity sponsor may still push back because of concerns that the foreign subsidiary guarantee could trigger issues under applicable foreign law (such as foreign corporate governance laws or financial assistance laws referred to above). A middle-ground provision would be that the foreign subsidiary guarantee would be required only to the extent that it does not trigger such issues.

• Direct Liens on Assets of Foreign Subsidiaries: Note, such liens generally would need to be granted under applicable foreign-law governed collateral documents, and generally would need to be drafted and reviewed by foreign counsel. So while such foreign collateral may no longer trigger a 956 Deemed Dividend tax, the borrower/equity sponsor may still object due to the increased transaction expenses to effectuate such foreign collateral. Additionally, the same foreign law issues noted above with respect to foreign subsidiary guarantees likely also apply to foreign collateral grants. A middle-ground provision would be that the foreign collateral would only be required to the extent it does not cause issues under applicable foreign law, and is cost justified.

• Reviewing/Revising Loan Document Provisions re "Loan Party" Permitted Intercompany Transactions: Credit Agreements often allow Borrowers and Subsidiary Guarantors to freely make intercompany loans, investments and other asset transfers among each other since they are all obligated under the Credit Facility. As a result of the Proposed Regulation, it is likely that "Foreign Subsidiary" Guarantors (as opposed to just "Domestic Subsidiary" Guarantors) will be more common. While this change is generally good news for lenders, it could result in issues for lenders under their existing loan documents. Hopefully the lender's existing loan documents only allow such intercompany free-flow of money and other assets to "Domestic" Subsidiary Guarantors and not to "Foreign" Subsidiary Guarantors --- this is because even if the Foreign Subsidiary is a Guarantor, the applicable foreign laws and foreign courts often are not sufficiently reliable for the lender to recover against the Foreign Subsidiary Guarantor. Unfortunately, many Credit Agreements are drafted such that Loan Parties are permitted to freely transfer cash and other assets to any Subsidiary Guarantor, and do not make a distinction between a "Foreign" or "Domestic" Subsidiary Guarantor (possibly because the parties thought due to 956 Deemed Dividend issues there would never be a Foreign Subsidiary Guarantor). As Foreign Subsidiary Guarantors now are more likely to exist, these provisions should be revisited and tightened.

• "Shoring-Up" Foreign Collateral/Guarantees" in a Work-Out: With respect to loans that are now in default or otherwise in distress, when available, lenders should consider insisting on foreign subsidiary credit support being added to help improve their collateral positions. Because of long-held 956 Deemed Dividend concerns, foreign subsidiary guarantees and collateral often are excluded from guarantee/collateral packages delivered at the loan closing. Especially after giving effect to the easing of taxable 956 Deemed Dividends resulting from the Proposed Regulation and from last year's tax reforms, if the loan later becomes distressed, the lender, should reconsider such exclusion. Given applicable "bankruptcy preference periods" and other insolvency concerns, and given that it often takes prolonged periods of time to implement foreign guarantees/collateral, if the lender determines that additional foreign credit support should be required, the lender should move swiftly to obtain such support.

• Lending Against the Value of Foreign Subsidiaries: Going forward, if lenders are able to obtain increased foreign subsidiary credit support, they may be able to provide more credit to their borrowers based on the value of such foreign subsidiaries. Given the increasingly global nature of businesses, this could have significant positive effects for both lenders and borrowers.

Please feel free to contact us if you would like to further discuss any of the issues noted above.

jonathan.cooper@goldbergkohn.com	stephen.legatzke@goldbergkohn.com

1] Currently, under Section 956 of the Internal Revenue Code (the "Code"), if a controlled foreign corporation (a "CFC") makes an investment in "United States property," the U.S. shareholders of such CFC generally are deemed to receive a taxable dividend from the CFC. In lending transactions, currently a guaranty by, or the grant of a lien on the assets of, a foreign subsidiary that is a CFC to support a loan made to its U.S. affiliate, or a pledge of 66^2/3%  or more of the voting stock of such foreign subsidiary to secure such a loan, each are treated as an investment in United States property, and each may trigger significant taxable 956 Deemed Dividends. The Proposed Regulation allows for 956 Deemed Dividends to be excluded from the federal taxable income of the CFC's corporate U.S. shareholders to the same extent as an actual dividend from the CFC is excluded under new Code Section 245A, which was enacted as part of the Tax Act in December 2017. Code Section 245A permits a new dividends received deduction for domestic corporations owning at least 10% of the stock of a CFC, pursuant to which the domestic corporation could deduct from its gross income for US federal income tax purposes the foreign source portion of the dividend derived from the CFC's previous untaxed foreign earnings and profits. In other words, such domestic corporation shareholders are generally not subject to US federal income taxes on actual foreign earning dividends when paid from their CFCs. 

[2] To make matters even worse, the taxable 956 Deemed Dividend is triggered not only with respect to the earnings and profits of such foreign subsidiary as of the time the loan is first made to its U.S. parent, but is also triggered with respect to earnings and profits generated by the foreign subsidiary from time to time thereafter while its guaranty remains in effect (capped only by the amount of the outstanding loan to its U.S. parent).

[3] Code Section 245A does not apply to certain types of dividends called hybrid dividends (generally dividends that the CFC could deduct in determining its own foreign tax liability) and only applies if the domestic corporation held the stock and was at least a 10% shareholder at all times more than 365 days prior to the date the share went ex-dividend. As the Proposed Regulation permits the domestic U.S. shareholder corporation to deduct from the amounts that otherwise would be includible in income under Code Section 956, those amounts that would have been excludible under Section 245A if the 956 Deemed Dividend had been an actual dividend, the corporate shareholder will have to meet  the one-year holding period requirements prior to the last day of the taxable year of the CFC, when the 956 Deemed Dividend arises, for the 956 Deemed Dividend to be excluded. Further, as noted above, the Proposed Regulation does not protect other U.S. shareholders of the CFC who are individuals, LLCs, partnerships or trusts (i.e., who are not corporations) from having 956 Deemed Dividend inclusions. Moreover, depending on how a State determines taxable income of a corporate shareholder, the Proposed Regulation may not eliminate state income taxes on the 956 Deemed Dividends. Most States compute taxable income by starting with federal taxable income and then have specific additions or subtractions, but each State will need to determine for itself how to apply Section 245A and the Proposed Regulation.

[4] The Proposed Regulation is stated to be effective generally with respect to taxable years of a CFC beginning after the date the Proposed Regulation is final; however, subject to certain limitations, taxpayers are entitled to rely on the Proposed Regulation for taxable years of a CFC beginning after December 31, 2017.

[5] The IRS spent much of the Proposed Regulation's preamble justifying its authority to issue the Proposed Regulation, suggesting to many that, although the Proposed Regulation should not be controversial (it generally results in exempting from U.S. federal income taxation a "956 Deemed Dividend," in much the same way as last year's tax reform exempts "actual dividends" from CFCs), the IRS is aware that the Proposed Regulation may not be fully supportable by applicable law. 

Jonathan Cooper Principal	Stephen Legatzke Principal