On October 31, 2018, the Internal Revenue Service (“IRS”) issued proposed regulations (the “Proposed Regulations”) which likely will facilitate (i) the making of loans by foreign corporate subsidiaries to a U.S. parent corporation (or its U.S. affiliates) and (ii) guarantees by foreign corporate subsidiaries, and pledges of 100% of the stock of those subsidiaries, to support debt incurred by a U.S. parent corporation (or its U.S. affiliates).
Under Section 956 of the Internal Revenue Code of 1986, as amended (the “Code”), a loan to a “U.S. shareholder” (as specially defined for this purpose) from a foreign corporate subsidiary that is classified as a “controlled foreign corporation” (a “CFC”) generally is treated as a taxable deemed dividend to the extent of the CFC’s earnings and profits (as determined for U.S. federal income tax purposes). Similarly, a CFC’s guarantee of debt incurred by a U.S. shareholder of the CFC, or the pledge of 2/3 or more of the stock of a CFC as security for such debt, can give rise to a deemed dividend under Section 956. For this reason, most credit agreements involving U.S. borrowers do not require CFC guarantees or pledges of more than 65% of the stock of any CFC.
Treatment of Actual Dividends from CFC to corporate U.S. shareholder Under Current Law
Following the enactment in December 2017 of the tax reform legislation known as the Tax Cuts and Jobs Act, P.L. 115-97 (the “Act”), a U.S. parent corporation generally can receive dividends from its CFCs tax-free for U.S. federal income tax purposes. This tax-free treatment is achieved by way of a 100% dividends received deduction under new Section 245A of the Code. No such deduction existed for CFC dividends under prior law. One of the quirks of the Act is that deemed dividends under Section 956 are not eligible for the dividends-received deduction under Section 245A and therefore are still generally taxable.
In the preamble to the Proposed Regulations (the “Preamble”), the IRS noted that one of the main purposes of Section 956 is to ensure symmetry between the tax treatment of actual dividends from a CFC and deemed dividends. In order to achieve that purpose, the Proposed Regulations provide the equivalent of a dividends-received deduction for deemed dividend inclusions of corporate U.S. shareholders under Section 956. In particular, the Proposed Regulations provide that the amount that a corporate U.S. shareholder of a CFC would have to include in income as a deemed dividend under Section 956 is reduced to the extent the shareholder would have been allowed a dividends-received deduction under Section 245A if the shareholder had received an actual rather than a deemed dividend from the CFC.
The Preamble explains that absent the Proposed Regulations, corporate U.S. shareholders of CFCs would have to carefully monitor the potential application of Section 956 to their operations, “including provisions related to loans, guarantees, and pledges” to ensure that CFC earnings were only repatriated by way of actual dividends (which are generally eligible for the dividends-received deduction) as opposed to deemed dividends under Section 956.
Impact of Proposed Regulations
Under the Proposed Regulations, CFCs could make loans to a U.S. parent corporation (or its U.S. affiliates) without triggering a deemed dividend inclusion under Section 956 (to the extent an actual dividend would have qualified for the 100% dividends-received deduction). Similarly, under the Proposed Regulations, a guarantee provided by a CFC (or a pledge of 2/3 or more of the stock of a CFC) to support debt incurred by a U.S. parent corporation (or its U.S. affiliates) generally would not give rise to a deemed dividend inclusion under Section 956. As a result, U.S. corporate borrowers presumably will be more willing to provide this additional credit support. The Proposed Regulations may also trigger provisions in some existing credit agreements which require such additional credit support to the extent it would not result in adverse tax consequences to the borrower.
Non-Corporate Shareholders Unaffected
Because only corporate U.S. shareholders are eligible for the dividends-received deduction under Section 245A, the relief provided by the Proposed Regulations is likewise limited to corporate U.S. shareholders. Accordingly, a U.S. shareholder that is an individual or a partnership (including a limited liability company classified as a partnership for U.S. federal income tax purposes) will still as a general matter want to avoid CFC guarantees, CFC stock pledges in excess of 65% or other provisions that could trigger the application of Section 956.
The rules set forth in the Proposed Regulations would be effective for taxable years of a CFC beginning on or after the date of publication of the rules as final regulations in the Federal Register. However, the Preamble provides that a taxpayer may rely on the Proposed Regulations for taxable years of a CFC beginning after December 31, 2017, provided that the taxpayer and U.S. persons that are related to the taxpayer (within the meaning of Section 267 or 707 of the Code) consistently apply the Proposed Regulations with respect to all CFCs in which they are U.S. shareholders.