A loan transaction is generally not thought of as resulting in a taxable event. But it can if the borrower is a U.S. corporation (U.S. Co.) with a foreign subsidiary (FS). More specifically, a loan transaction can trigger a deemed dividend from the FS to U.S. Co. if the credit agreement provides for any of the following: (i) a pledge by U.S. Co. of at least two-thirds of the voting power of FS; (ii) a guarantee of the loan by the FS; (iii) a pledge by the FS of its assets to secure the loan; or (iv) joint and several liability of the FS on the loan.
To illustrate, say a U.S. Co. owns an FS that has $50 million of earnings not previously subject to U.S. tax. If U.S. Co. borrows $25 million and the credit agreement provides for at least one of the four terms listed above, U.S. Co. would be deemed to have received a $25 million dividend from FS. The dividend would generally be subject to a 35% U.S. tax rate. Want a real life example? In October 2013, the Overseas Shipholding Group (OSG) announced that it would sue the law firm that advised it regarding a loan transaction. OSG claims that it had an unexpected tax liability of nearly $500 million from dividends triggered by the loan transaction that the law firm failed to advise them about.
To avoid adverse tax results on a loan transaction, U.S. corporations that own an FS should have their credit agreements reviewed by tax counsel, who can advise them on the tax consequences of the agreements and how the agreements might be restructured if there are potential adverse consequences.