The proposed modifications would create opportunities for enhanced CFC credit support.
On October 31, 2018, the US Treasury Department and the Internal Revenue Service (IRS) released proposed Treasury Regulations (the Proposed Regulations) under Section 956 of the Internal Revenue Code of 1986, as amended (the Code), which would modify the application of Section 956 in the context of certain financing transactions in which a lender seeks credit support from the foreign subsidiaries of a US borrower, as discussed in detail below. The Proposed Regulations provide that the amount of a Section 956 deemed income inclusion that would otherwise be taken into account by a corporate US parent of a controlled foreign corporation (CFC) subsidiary as a result of such subsidiary providing credit support will be reduced by the amount of the dividends received deduction that would be available to the corporate US parent under the new “participation exemption” of Section 245A if the earnings that would be included under Section 956 were instead actually distributed by the CFC subsidiary as a dividend.
As a general matter, the Proposed Regulations would enable a US corporate parent that owns CFC subsidiaries to pledge 100% of the stock of those CFC subsidiaries to a lender, and/or have those CFC subsidiaries provide guarantees or asset pledges to support the US corporate parent’s borrowing, without suffering adverse tax consequences. This change provides additional flexibility with respect to certain financing transactions, which may enable a US corporate parent of a multinational group to expand its overall borrowing capacity and may enable lenders to such a group to enhance their collateral packages. However, as discussed below, there are still circumstances in which a Section 956 income inclusion may have adverse tax consequences for a US shareholder of CFC subsidiaries.
Prior to the enactment of the tax law changes referred to as the Tax Cuts and Jobs Act (the TCJA) at the end of 2017, a US parent that owned a CFC subsidiary was generally not required to include the earnings of the CFC subsidiary in income prior to the repatriation of those earnings through an actual dividend, unless those earnings were treated as Subpart F income. Section 956 served as a backstop that required an income inclusion by the US parent when the earnings of a CFC subsidiary were effectively repatriated even though no actual dividend was paid by the CFC subsidiary. Under Section 956, an effective repatriation of CFC subsidiary earnings is deemed to occur when the assets of the CFC subsidiary serve as credit support for the obligations of the US parent. So, for example, an income inclusion under Section 956 can occur if a CFC subsidiary guarantees the borrowing of its US parent or if the assets of the CFC subsidiary are pledged to secure that borrowing. Moreover, a pledge of stock representing 66 and 2/3% or more of the total combined voting power of the CFC subsidiary’s stock is treated as an indirect pledge or guarantee by the CFC subsidiary, potentially triggering a Section 956 inclusion.
In order to avoid creating income inclusions for US borrowers under Section 956, financing transactions have typically been structured so that CFC subsidiaries (and certain domestic holding companies that hold one or more CFC subsidiaries) do not guarantee the obligations of their US parent and do not pledge their assets to support those obligations. In addition, the US parent is typically required to pledge no more than 65% of the voting stock of those entities.
The TCJA made significant changes to the US taxation of CFCs in order to transition to a partial territorial tax regime. As part of the broader set of changes, the TCJA added Section 245A. Under this new “participation exemption,” a US corporate parent that receives an actual dividend from its CFC subsidiary is entitled to a 100% dividends received deduction for the foreign-source portion of that dividend. Consequently, to the extent the dividend is derived from undistributed foreign earnings, the US corporate parent is not taxable on that dividend.
Notwithstanding the addition of Section 245A, the TCJA left Section 956 unchanged. This has created an asymmetry for a US corporate parent of a CFC subsidiary – actual dividends by the CFC subsidiary can be offset by the new dividends received deduction, but an income inclusion under Section 956 (which is not considered to be a dividend) does not generate a dividends received deduction under Section 245A. As a result, Section 956 inclusions have remained taxable despite the fact that an actual dividend distribution of the same earnings (to the extent foreign-source) to the US corporate parent can be effectively exempted from tax. Because of this asymmetry, the market practice for dealing with CFCs in financing transactions has generally remained as it was prior to the enactment of the TCJA.
The possibility of a Section 956 inclusion may, as a practical matter, be less of an issue than was the case prior to the enactment of the TCJA – the new GILTI regime, combined with the existing Subpart F rules and the consequences of actual dividend distributions, may result in all or a large portion of a CFC’s earnings being treated as previously taxed income or otherwise repatriated, so that a Section 956 inclusion would result in little, if any, incremental taxable income for a US shareholder. Nonetheless, the Proposed Regulations provide additional planning flexibility for US corporate borrowers for whom a Section 956 inclusion would remain problematic.
Proposed Regulations – Summary of Change
The Treasury Department and the IRS have acknowledged the asymmetrical treatment of actual dividends and Section 956 inclusions, and have determined that this asymmetry is contrary to the intended purpose of Section 956. Accordingly, the Proposed Regulations provide that the amount of the deemed income inclusion otherwise required to be taken into account by a corporate US parent of a CFC subsidiary under Section 956 will be reduced by the amount of the dividends received deduction that would be available to the corporate US parent under Section 245A if the earnings that would otherwise be included under Section 956 were instead actually distributed by the CFC subsidiary as a dividend.
Impact on Market Practice in Financing Transactions. Subject to the observations that follow, the Proposed Regulations afford both lenders and US corporate borrowers opportunities to expand the collateral package in financing transactions to include more credit support from the borrower’s CFC subsidiaries. Lenders may be able to obtain full pledges of CFC subsidiary equity, as well as guarantees or asset pledges by the CFC subsidiaries themselves, without creating adverse tax consequences for the US corporate borrowers. US corporate borrowers may wish to include their CFC subsidiaries in collateral packages, if doing so can enhance the overall terms of the financing from the borrower perspective without creating incremental tax costs. There are, however, still situations in which the Proposed Regulations will not completely protect a US corporate borrower from the adverse consequences of a Section 956 inclusion (including the circumstances noted below). Given this mix of considerations, it currently remains to be seen how, if at all, current market practice for dealing with CFCs in financing transactions will change.
Holding Period. In order to claim the dividends received deduction under Section 245A, a corporate US shareholder must hold the stock of the distributing foreign corporation for more than 365 days during the 731-day period that begins on the date that is 365 days before the share on which the dividend is paid becomes ex-dividend. Moreover, there are additional rules that can toll the running of the holding period. Financing transactions would need to be evaluated and structured so that they do not create unwanted Section 956 inclusions during periods when the holding period has not been satisfied.
Individuals, Partnerships, RICs, and REITs. The Proposed Regulations apply only to corporate US shareholders that may claim the dividends received deduction under Section 245A. Because individuals, partnerships, RICs, and REITs are not allowed the dividends received deduction, the Proposed Regulations do not alter the treatment of income inclusions under Section 956 for those taxpayers. The IRS has requested comments concerning how the Proposed Regulations should apply to US shareholders that are domestic partnerships and that have a combination of domestic corporations, US individuals, and other persons as partners.
Other Limits under Section 245A. As noted previously, Section 245A provides a dividends received deduction only to the extent that the dividend is attributable to undistributed foreign earnings. If the foreign corporation has earnings that are not foreign source (for example, because the foreign corporation conducts branch operations in the United States and earns effectively connected income), the Proposed Regulations would not completely eliminate the Section 956 inclusion amount. In addition, Section 245A(e) denies a dividends received deduction for “hybrid dividends” (which are dividends paid by a CFC for which the CFC is allowed a deduction or other tax benefit under the income tax regime of a foreign country or US possession), and treats hybrid dividends paid by a lower-tier CFC to an upper-tier CFCs as Subpart F inclusions for a US shareholder of those CFCs (rather than foreign earnings eligible for the participation exemption). The IRS has requested comments concerning the interaction of these limitations with the rule provided by the Proposed Regulations. It is possible that the final regulations could deny the benefit provided by the Proposed Regulations to the extent that the underlying earnings, if hypothetically distributed, would generate a prohibited deduction or tax benefit under the income tax regime of a foreign country or US possession and thus be treated as a non-deductible “hybrid dividend”.
Other Considerations. Apart from their impact in the context of financing transactions, the Proposed Regulations may have adverse consequences for other taxpayers. For example, the Proposed Regulations may prevent a U.S. corporate parent of a multinational group from accessing foreign tax credits in connection with a Section 956 inclusion. Thus, certain taxpayers may question the appropriateness or validity of the Proposed Regulations, or not elect to apply the Proposed Regulations at this time.
Effective Date. The Proposed Regulations will become effective for taxable years of a CFC that begin on or after the date they are published as final regulations in the Federal Register, and to taxable years of a US shareholder in which or with which such taxable years of the CFC end. However, a taxpayer may rely on the Proposed Regulations for taxable years of a CFC beginning after December 31, 2017, and for taxable years of a US shareholder in which or with which such taxable years of the CFC end, provided that the taxpayer and US persons related to the taxpayer consistently apply the Proposed Regulations to all CFCs in which they are US shareholders. Thus, the Proposed Regulations may have immediate relevance to parties currently negotiating financing transactions.