Practice Pointer: Section 956 Tax Issues Involved in U.S. Financing
Foreign subsidiary stock pledges, or guarantees provided by foreign
subsidiaries, may create deemed dividends to U.S. shareholders/borrowers.
By Fred Adam, Greenberg
Traurig, Silicon Valley Office
View or download the PDF version of this Alert
In financing transactions, corporate and individual borrowers are called
upon to pledge assets and/or have their subsidiaries act as guarantors to
secure the relevant financing. Whether assets or shares should be pledged
with respect to domestic subsidiaries of a U.S. borrower is a business decision
that will be made based on considerations specific to the transaction. Pledges
and guarantees provided with respect to domestic subsidiaries is not the
focus of this Alert. This Alert is focused on the significant tax issues
that may result when the pledge or guarantee involves the stock or assets
of a controlled foreign corporation (“CFC”).1
|"Section 956(d) provides that
a CFC shall be considered as holding an obligation of a U.S. person
if such CFC is a pledgor or guarantor with respect to such obligation."
Generally speaking, section 9562
provides that in the case of any CFC, a U.S. shareholder3
of a CFC will have a deemed dividend inclusion (under section 951(a)(1)(B)
of the Code) for any taxable year in an amount that is the lesser of—
(1) the excess (if any) of— (A) such shareholder’s pro rata share of
the average of the amounts of United States property held (directly
or indirectly) by the CFC as of the close of each quarter of such taxable
year, over (B) the amount of earnings and profits (“E&P”) previously included
in income under section 956 and 951(a)(1)(B) with respect to such shareholder,
or (2) such shareholder’s pro rata share of the applicable earnings
of such CFC.
More simply stated, the rule is applied by measuring the fair market
value of United States property (“U.S. Property”)4
held by a CFC at the end of each quarter and averaging the value of such
U.S. Property over the four quarters during the taxable year to determine
the amount of the potential deemed dividend inclusion under section 951(a)(1)(B)
for such year. The inclusion for such year will then be the excess of the
average value of U.S. Property during the year (the average loan balance
during the year) over previously included amounts (under section 956) limited
only by the E&P of the foreign corporation. Thus, if the average loan balance
for the year is $10.0 million, but the E&P of the foreign subsidiary that
owns a U.S. Property interest is only $1.0 million, then only $1.0 million
should be included in the U.S. shareholder’s income under section 951(a)(1)(B).
Pertinent to this Alert is the definition of U.S. Property where pledges
and guarantees involving foreign subsidiaries exist. Section 956 generally
results in an income inclusion to the U.S. shareholder, be it an individual
or other business entity, of any foreign earnings of its CFCs that are brought
back to the U.S. through certain investments, or deemed investments, in
U.S. Property. U.S. Property5
for section 956 purposes includes any obligation of a U.S. person. Section
956(d) provides that a CFC shall be considered as holding an obligation
of a U.S. person if such CFC is a pledgor or guarantor with respect to such
obligation. Such inclusion can arise by virtue of an improperly structured
pledge of foreign subsidiary stock, or the pledge of any asset, by guarantee
or otherwise, by a foreign subsidiary. The section 956 regulations provide
specific provisions relating to pledges and guarantees.
From the borrower’s point of view, a U.S. shareholder can generally pledge
a certain amount of the stock of its first tier foreign subsidiaries and
not create a U.S. tax problem. Industry standard is 65%, but the regulations
only allow up to 66 2/3% in the presence of certain negative covenants and/or
restrictions. However, if (i) any foreign subsidiary acts as a guarantor,
(ii) the stock of a second tier or lower tier foreign subsidiary is pledged
by its foreign owner; or (iii) any asset of any foreign subsidiary is pledged
or otherwise used to securitize the debt of the U.S. shareholder, then the
U.S. shareholder will be deemed to have dividend income to the extent of
the loan proceeds, limited only by the E&P of the relevant foreign subsidiary/subsidiaries.
Anti-abuse rules exist to address attempts to structure around the regulations.
From the lender’s point of view, although assets might normally be sought
to securitize a debt, when looking at assets that are outside the U.S. it
is usually more expensive and time consuming process to securitize assets,
and could jeopardize the borrower’s financial health if the borrower is
unaware of the potential dividend issue—of course this needs to be weighed
against the borrower’s tax exposure and the lender’s sense of risk. Thus,
in any case the focus may change to seeking a pledge of stock to secure
the debt of the U.S. shareholder, instead of assets, due to the U.S. tax
issues that could arise for the borrower if assets are used to securitize
the debt. Generally, the primary concern from the lender’s viewpoint is
that if the borrower is put into a situation where it has significant deemed
income with no cash to pay the tax, then the borrower’s financial health
could be jeopardized. This puts the lender into a tenuous position vis-à-vis
its loan, not to mention that it potentially requires the borrower to use
available operating capital or loan proceeds to pay taxes instead of servicing
debt or for revenue generation.
Conclusion: When acting on behalf of a borrower or lender in a transaction
that involves pledges or guarantees involving foreign subsidiary stock or
assets, please be aware that the borrower could be subject to deemed dividends
as a result of improperly structured pledges or guarantees. It is true that
such deemed dividends may be accompanied by foreign tax credits, but this
is an issue that requires complex planning due to foreign tax credit limitations,
overall foreign losses, and a multitude of other issues that could create
unnecessary and unexpected tax burdens on our borrower clients, or jeopardize
the loans of our lender clients.
Practical Tip: If we have knowledge of financing transactions that may
subject a borrower client to these issues lenders generally will agree to
restructure the security arrangement to accommodate the borrower and, typically,
will only request to be made whole for expenses (i) related to redrawing
the documents, (ii) obtaining the local jurisdiction share pledge security,
and, on occasion, (iii) incurred to originally securitize the assets in
the foreign jurisdiction.
With respect to lenders, lenders should monitor their borrowers carefully
and review borrower financial statements to assess whether the tax issues
raised by this Alert have been accounted for and/or lenders should consider
the potential for such a contingent tax liability when extending or otherwise
restructuring subsequent credit lines and other debt. Generally, careful
consideration should be given to approaching a borrower to request redrawing
original transaction documentation.
1 Controlled foreign corporation is defined
under section 957 of the Internal Revenue Code of 1986, as amended, and
the regulations thereunder, (the “Code”).
2 Section references are to the Code, unless
otherwise expressly referenced.
3 U.S. shareholder is defined at section 951(b).
4 U.S. Property is defined at section 956(c).
5 Although not within the scope of this Alert,
obligations of the United States, money, or deposits with persons carrying
on the banking business are specifically excluded from the “U.S. property”
definition (provided the deposits do not serve directly or indirectly as
a pledge or guarantee of a U.S. person). Accordingly, the mere depositing
of cash by the U.S. shareholder’s foreign subsidiaries in segregated bank
accounts held by the foreign subsidiaries should not be considered an investment
in U.S. property for section 956 purposes.
© 2004 Greenberg Traurig
For more information, please review our Tax Practice description, or
feel free to contact one of our attorneys.
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys provide
practical, result-oriented strategies and solutions tailored to meet our clients’
individual legal needs.