US borrowers must tread carefully when using foreign assets to secure their financings. This is due to a tax “trap door” arising under Section 956 of the Internal Revenue Code (Section 956) which may result in the borrower incurring a “deemed dividend”. A deemed dividend is an amount attributed to a US borrower’s taxable income. It is triggered in the following scenarios:
- The borrower pledges more than 66.66 per cent of the shares of a controlled foreign corporation (the CFC) and the borrower agrees to certain upstream negative covenants with respect to the activities of the CFC.
- The CFC pledges its assets to secure the borrower’s financing.
- The CFC guarantees the borrower’s financing.
In each of these scenarios, the amount of the deemed dividend will generally be the lesser of either the average loan balance for the relevant year (minus any previously included income attributable to the CFC) or the US borrower’s pro rata share of the applicable earnings of the CFC for the year.
The deemed dividend may result in a potentially higher tax liability that may undermine the financial model on which the loan was based. The increased tax exposure may also result in a failure by a borrower to comply with the financial ratios under the loan agreement and in certain circumstances may jeopardise the solvency of the borrower.
Although, historically, the deemed dividend issue has mainly affected standard secured financings, it is becoming a significant issue in private equity transactions involving targets with overseas holdings.
This rule may impact a leveraged buyout (LBO) since the standard financing structure consists of a combination of equity and debt, the equity component of which is provided generally by the private equity sponsor and the debt component of which is provided for generally by thirdparty lenders and is secured by the target’s assets or cash flow.
The security from a target in an LBO varies according to the nature of the target business, the location of its assets and the source of its revenue streams. If the target has foreign subsidiaries with significant assets or revenue streams, lenders may require that these foreign assets secure the debt under one or more of the aforementioned scenarios.
In each of these scenarios, Section 956 is a potential “trap door”. Clearly, a pledge of a CFC’s assets, direct credit support from a CFC in the form of a guaranty, or a pledge by the target of more than 66.66 per cent of the capital stock of the CFC will result in a deemed dividend.
Lenders may therefore have to choose between a less than optimal collateral structure and a borrower with a reduced capacity to meet their periodic debt financing requirements. In either case, the risk may be passed to the borrower in the form of a reduced loan commitment or a higher interest rate.
One way to avoid triggering Section 956 is to limit foreign collateral support in an LBO by pledging less than 66.66 per cent of a borrower’s foreign subsidiaries. Other alternatives may be available, depending on the circumstances, the requirements of the foreign subsidiary’s jurisdiction and guidance offered by the Internal Revenue Service.
Parties to an LBO should consult with their legal and tax advisors to assess the risks of a particular structure and to investigate alternatives. Prudent practice also dictates that LBO sponsors notify their lenders as early as possible when considering an acquisition with significant foreign assets, giving them ample time to propose and implement a favourable structure and collateral package.