GT Alert

Practice Pointer: Section 956 Tax Issues Involved in U.S. Financing Transactions

Foreign subsidiary stock pledges, or guarantees provided by foreign subsidiaries, may create deemed dividends to U.S. shareholders/borrowers.

March 2004
By Fred Adam, Greenberg Traurig, Silicon Valley Office

  View or download the PDF version of this Alert here.

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.

Footnotes

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

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