© 2014 Thomson Reuters JUNE 16, 2014 n VOLUME 20 n ISSUE 2 | 3
Don J. Lonczak (L) is a partner in the Washington office of Baker Botts LLP, where he focuses his
practice on the tax aspects of domestic and international mergers and acquisitions, joint ventures and
corporate spin-offs, as well as public and private financings and derivative financial products. He can
be reached at [email protected] Jon Lobb (R) is a senior associate in the firm’s Houston
office, where he concentrates on federal income tax matters. His practice includes cross-border
transactions, mergers and acquisitions, securities offerings, and tax controversies and litigation. He
can be reached at [email protected]
The ‘deemed dividend’ dilemma: Obstacles in obtaining credit
support from foreign subsidiaries of U.S. borrowers
By Don J. Lonczak, Esq., and Jon Lobb, Esq.
Baker Botts LLP
This commentary focuses on the so-called
“deemed dividend” issue that can create
a federal income tax cost for a domestic
company whose foreign subsidiaries
are asked to provide credit support for a
borrowing. This issue is frequently discussed
among lenders and borrowers in connection
with the negotiation of loan agreements.
Lenders should understand the U.S. tax
rules relating to this issue and recognize that
there may be ways for foreign subsidiaries
to provide credit support without triggering
adverse tax consequences for borrowers.
OVERVIEW OF ANTI-DEFERRAL
Under the U.S. tax system, domestic
companies and other U.S. persons1 are
generally subject to current taxation on their
worldwide net income. If, however, a U.S.
company conducts business outside the
United States through a foreign subsidiary,
the subsidiary’s earnings generally are
not subject to U.S. tax until the company
receives a dividend on those earnings from
the subsidiary. As a result, taxation of the
foreign subsidiary’s earnings generally can
be deferred until the U.S. company needs to
access the earnings.
An exception to the general rule of deferral is
created by the “Subpart F” regime. Enacted
types of passive investment income (such as
dividends, interest, rents and royalties that
are not derived in connection with an active
business of the CFC) unless the income
is subject to foreign income tax at rates
comparable to the applicable U.S. tax rate.
Subpart F income can also include certain
sales and services income that the CFC
derives from transactions with or on behalf
in 1962, the regime is designed to combat
perceived tax abuses by U.S. persons who
use closely held offshore companies in lowtax
jurisdictions. For example, an offshore
company might hold passive investment
assets (such as stocks, bonds and other
securities) for the benefit of its shareholders
and be able to earn dividend and interest
income with little or no taxes imposed in the
jurisdiction of its formation.
Taxation of the foreign subsidiary’s earnings can generally be
deferred until the U.S. company needs to access the earnings.
The Subpart F rules apply to “U.S.
shareholders” (as specially defined for
purposes of Subpart F) that collectively own
more than 50 percent of the stock, in terms of
equity value or voting power, of a “controlled
foreign corporation,” or CFC The rules seek
to eliminate the benefit of U.S. tax deferral in
two principal ways.
First, U.S. shareholders of a CFC are
generally subject to current U.S. tax on
their share of the corporation’s “Subpart F
income” for each taxable year, regardless of
whether the income is distributed to the U.S.
shareholders during the relevant taxable
year. Subpart F income includes various
Second, Section 956 of the Internal Revenue
Code treats investments by a CFC in certain
types of “United States property” as the
equivalent of a dividend of the corporation’s
earnings to its U.S. shareholders, known as a
“deemed dividend.” U.S. property includes,
among other things, an investment by a CFC
in the stock of a U.S. affiliate, a loan by the
CFC to a U.S. affiliate, and certain tangible
property held by the corporation and located
in the United States. Thus, Section 956
effectively precludes a CFC from making its
earnings available to a U.S. shareholder,
such as through an equity or debt investment
in the shareholder, without the reporting of
dividend income by the shareholder.
LOANS, PLEDGES AND
Under Section 956, a loan by a CFC to a U.S.
parent company would typically result in a
deemed dividend to the parent in an amount
equal to the principal amount of the loan.
This rule is based on the theory that the loan
effectively allows the U.S. parent company to
access the CFC’s untaxed earnings. Section
956 also recognizes that the U.S. parent
company could achieve a comparable result
by simply borrowing from a third-party
lender and having the CFC guarantee the
loan or pledge its assets as security. Thus,
Section 956 rules generally treat a loan to a
4 | WESTLAW JOURNAL n BANK & LENDER LIABILITY © 2014 Thomson Reuters
U.S. borrower that is guaranteed by a CFC,
or secured by a pledge of the CFC’s assets, in
the same manner as a loan made directly by
the CFC to the borrower.
The Section 956 rules further provide, in a
vaguely worded rule that could be interpreted
as applying to a broad range of financial
arrangements, that the CFC will be viewed as
a pledgor or guarantor of a loan if its assets
“indirectly” serve as security for the loan. The
rules provide additional guidance in the case
of a pledge of the stock of a CFC, which is
viewed as an indirect pledge of assets if:
• At least 66 2/3 percent of the voting
stock of the CFC is pledged.2
• The pledge of stock is accompanied
by one or more negative covenants or
similar restrictions that effectively limit
the CFC’s discretion with respect to the
disposition of assets and the incurrence
of liabilities other than in the ordinary
course of business.
The Section 956 rules in effect establish a
safe harbor. Under it, a pledge of the CFC’s
stock will not be viewed as an indirect pledge
of its assets, and thus will not result in a
deemed dividend to the U.S. borrower, if the
pledge relates to less than 66 2/3 percent of
the CFC’s voting stock.
Aside from the above-described “two-thirds
safe harbor,” there is substantial uncertainty
in the U.S. tax law (largely attributable to the
vague wording of the indirect pledge rule and
the absence of much supplemental guidance
from courts and the Internal Revenue
Service) regarding the types of arrangements
that may be viewed as an indirect pledge of
a CFC’s assets for purposes of Section 956.
APPLICATION TO LOAN
Avoiding deemed dividends under Section
956 is a potentially significant concern for
U.S. borrowers, particularly those that have
CFC subsidiaries with substantial amounts
of untaxed accumulated earnings. Given the
potential tax and accounting consequences
of a deemed dividend, U.S. borrowers typically
seek at least the following restrictions on
credit support from their CFCs:
• Any pledges of the stock of a CFC must
be limited to less than 66 2/3 percent
(or, more commonly, 65 percent or less
to add some “cushion”) of the voting
stock of the CFC.
• The borrowing cannot be guaranteed by
any CFC of the U.S. borrower.
• The borrowing cannot be secured by a
pledge of any asset of a CFC of the U.S.
borrower (which would include the stock
of any subsidiary of the CFC).
These restrictions are customarily included
in loan agreements and are based on a
straightforward application of the existing
Section 956 rules, including the two-thirds
To guard against the uncertainties in the U.S.
tax law regarding the extent to which other
loan arrangements may be viewed as indirect
pledges of CFC assets, U.S. borrowers often
CFC (or the guarantee of the borrowing by
the CFC) would generally result in a deemed
dividend to the U.S. borrower. Nevertheless,
any resulting tax on the deemed dividend
may be fully or partially offset, by a credit for
the underlying foreign income taxes paid by
the CFC with respect to such earnings. In
such cases, the net U.S. tax cost to the U.S.
borrower may be significantly reduced. The
availability of this option depends on the U.S.
borrower’s domestic tax position (including
the ability to use foreign tax credits, which is
a complex and fact specific determination).
Example 2: Carryforwards
Assume that the U.S. borrower has net
operating loss carryforwards from prior
Subpart F income includes various types of passive investment
income, unless the income is subject to foreign income tax at
rates comparable to U.S. rates.
seek to impose further limitations on the
credit support provided by their domestic
and foreign subsidiaries. For example, U.S.
borrowers may insist that any pledges of the
stock of a U.S. subsidiary must be subject to
the two-thirds safe harbor if the subsidiary’s
assets consist in substantial part of the stock
of CFCs. Such a U.S. subsidiary is often
referred to as a “foreign subsidiary holding
U.S. borrowers may also insist that no such
foreign subsidiary holding company can be
a guarantor with respect to the borrowing.
These limitations reflect a concern that a
pledge or guarantee with respect to a foreign
subsidiary holding company in substance
may be viewed as a pledge or guarantee with
respect to the CFCs that are owned by the
foreign subsidiary holding company.
OBTAINING CREDIT SUPPORT:
Although U.S. borrowers will typically seek
the customary limitations described above,
some scenarios enable lenders to request
additional credit support from CFCs without
creating a significant U.S. tax cost to the
Example 1: Highly taxed earnings
Assume that the U.S. borrower has a CFC with
earnings that have been subject to a high rate
of foreign income taxes. The pledge of 66 2/3
percent or more of the voting stock of the
taxable years. The pledge of 66 2/3 percent
or more of the voting stock of a CFC (or the
guarantee of the borrowing by the CFC)
generally would result in a deemed dividend
to the U.S. borrower, but the amount of the
deemed dividend may be sheltered by the
NOL carryforwards. A U.S. borrower may
view the use of NOL carryforwards against
Section 956 deemed dividends as a waste
of an otherwise valuable U.S. tax attribute.
Therefore, the viability of this option may
depend on the borrower’s assessment of the
prospects for using the NOL carryforwards
against other income before the carryforward
period (which is generally 20 years) expires.
The borrower may express a view regarding
this assessment in its financial statements.
Example 3: Intercompany receivables
Assume that the U.S. borrower obtains
funds from a third-party lender. The U.S.
borrower, in turn, lends those funds to a CFC
to fund its operations or an acquisition and
then receives an intercompany note issued
by the CFC. The U.S. borrower pledges
the intercompany note as security for the
initial third-party borrowing. The assets
of the CFC might serve as collateral for the
intercompany note but not for the loan to the
U.S. borrower. There is strong support for the
position that this pledge should not result
in a deemed dividend to the U.S. borrower
because only assets of the U.S. borrower (in
this case, the intercompany note of the CFC)
support the loan to the U.S. borrower.
© 2014 Thomson Reuters JUNE 16, 2014 n VOLUME 20 n ISSUE 2 | 5
Example 4: Pledge of nonvoting stock
Assume that the U.S. borrower pledges
100 percent of the nonvoting stock, but less
than 66 2/3 percent of the voting stock, of a
CFC. This pledge arrangement would seem
to satisfy the two-thirds safe harbor because
only pledges of at least 66 2/3 percent of the
voting stock of a CFC result in an indirect
pledge of the CFC’s assets. However, the IRS
might challenge the arrangement if the only
purpose of the nonvoting stock is to avoid a
Section 956 deemed dividend.
THE FUTURE OF SECTION 956
Over the past few years, there have been
a number of legislative proposals that
would result in major reforms to the U.S.
international tax system. Several would
require U.S. taxpayers to include, in their
income for a taxable year, any income earned
by CFCs in such taxable year that is subject
to low rates of foreign income tax.3 Because
these proposals would substantially limit
U.S. taxpayers’ ability to defer low-taxed
income of CFCs, the backstop of Section 956
may no longer be viewed as necessary. This
could lead to the repeal of Section 956.
In light of these legislative proposals, lenders
may want to consider whether it is possible
to include a loan agreement clause that
requires CFCs of U.S. borrowers to provide
additional credit support (whether in the
form of a guarantee, a pledge of assets or
a pledge of the CFC stock) in the event that
Section 956 is reformed or repealed.
In negotiating loan agreements with U.S.
borrowers, lenders should understand the
deemed dividend risk that could arise under
Section 956 if they seek credit support from
foreign subsidiaries of the U.S. borrower.
Generally, U.S. borrowers are willing to
pledge the stock of CFC subsidiaries subject
to the two-thirds safe harbor, but they may
be reluctant to accept additional forms of
credit support from their CFC subsidiaries.
Additional diligence may be warranted in
appropriate circumstances to determine if
any such additional credit support would
create a significant tax cost to the U.S.
1 As used in this commentary, the term “U.S.
person” means a U.S. citizen or resident alien,
a corporation that is incorporated in the United
States or any state thereof, an estate that is subject
to U.S. tax on its worldwide income, and a trust
that is treated as a U.S. trust for U.S. tax purposes.
2 The Section 956 rules likely adopt a twothirds
threshold because this is the level of
voting control over a CFC that a shareholder
(including a creditor that forecloses on a loan
that is secured by a pledge of the CFC’s shares)
often would be required to have in order to
liquidate the CFC under local law and access
its assets. Thus, this type of voting control is
viewed as the equivalent of a pledge of the
CFC’s assets, particularly where there also
negative covenants with respect to the CFC.
3 The relevant proposals include the Tax
Reform Act of 2011, which was proposed by
House Ways and Means Committee Chairman
Dave Camp, R-Mich., in October 2011, and the
staff discussion draft of provisions to reform
international business taxation, which was
proposed by then-Senate Finance Committee
Chairman Max Baucus, D-Mont., in November
2013. Baucus left the Senate in February
to become the U.S. ambassador to China.
NEWS IN BRIEF
MAINE REGULATOR SAYS
FORECLOSURES SLOWING FOR
The Maine Bureau of Financial Institutions
said in a May 16 statement that although
foreclosure activity in the state is above prefinancial
crisis levels, it is lessening and does
not pose a threat to state-chartered banks
and credit unions. The bureau said that at
the end of the first quarter of this year, its
31 state-chartered banks and credit unions
held 63,000 mortgages, 251 of which are
in the process of foreclosure. In addition,
these institutions began 53 foreclosures
in the first quarter, while the number was
at 67 a year ago, according to the bureau.
The agency’s report on foreclosure activity
within the state is available at http://
FAILED MARYLAND BANK’S ASSETS
GO TO NEW INSTITUTION, FDIC SAYS
The deposits and a portion of the assets of
the failed Bel Air, Md.-based Slavie Federal
Savings Bank have been moved to Lutherville,
Md.-based Bay Bank, the Federal Deposit
Insurance Corp. said in a May 30 statement.
The Office of the Comptroller of the Currency
acted on liquidity concerns, closed Slavie
Federal and appointed the FDIC to act as
the bank’s receiver. The failed bank had
$111.1 million in deposits and $140.1 million
in assets as of March 31, the FDIC says. Bay
Bank agreed to purchase $129.9 million of
these assets, and the FDIC will dispose of the
remainder at a future date. Slavie Federal is
the ninth bank to fail this year and the first in
OCC SAYS 8 BANKS ARE EXCEEDING
LOCAL LENDING GOALS
The Office of the Comptroller of the Currency
said in a June 2 statement that out of
the 36 banks recently examined for local
lending efforts, eight institutions received
a rating of “outstanding.” The banks are
based in Arkansas, Indiana, Iowa, Kansas,
Massachusetts, Minnesota, Ohio and Texas.
The ratings appear in the agency’s new
report on compliance with the Community
Reinvestment Act. The CRA mandates that
financial institutions serve the credit needs
of low- and moderate-income customers
in their neighborhoods, and regulators
must periodically assess how each bank
is complying with these goals. The OCC
says the remaining 28 banks were rated
“satisfactory” with regard to local lending.
The agency’s CRA evaluations are available