Lenders Set Sights on Foreign Collateral, but Borrowers Need to be Cautious
V&E Tax Update, June 25, 2019
New regulations under section 956 give lenders more ammunition in demanding foreign collateral for U.S. loans, but U.S. borrowers need to draft carefully to avoid tax on foreign income.
- New regulations allow U.S. corporate shareholders of foreign corporations to pledge their stock or assets without paying additional tax, and some lenders are asking for this new collateral.
- U.S. borrowers need to ensure the new regulatory relief applies to them, and draft loan agreements carefully in either case.
New regulations under section 956 allow U.S. corporate shareholders of controlled foreign corporations, or CFCs, to pledge stock or assets of the CFCs without paying additional tax, and lenders are taking the new regulations into account and asking U.S. borrowers to pledge this foreign collateral. However, the regulatory relief applies solely to certain U.S. corporate shareholders and only in certain instances, so borrowers still need to be careful in using CFC stock or assets as collateral for U.S. loans.
In the past, U.S. borrowers could not pledge their interests in CFCs or have their CFCs guarantee their U.S. loans, or they risked paying U.S. income tax on the CFCs’ undistributed earnings. A CFC is a foreign corporation in which U.S. shareholders (each of whom owns at least 10%) together hold more than 50% of the vote or value of the company. A U.S. shareholder could be taxed on a portion of the CFC’s earnings (by a taxable inclusion in gross income), even if the CFC didn’t actually pay a dividend, if the CFC held investments in U.S. property. Having a CFC guarantee the U.S. parent’s loan, or pledging either assets or two-thirds of the voting equity in the CFC as collateral for the loan, gave rise to an investment in U.S. property by the CFC.
In 2017, Congress enacted the Tax Cuts and Jobs Act, which gives U.S. companies a 100% deduction for actual dividends from CFCs. However, the same treatment wasn’t given to inclusions arising from CFC investments in U.S. property. Many commentators pointed out the inconsistency in tax treatment between actual dividends from CFCs and inclusions arising from U.S. property investments. In response, the IRS finalized regulations creating an exception to inclusions from CFCs with investments in U.S. property to the extent they would be entitled to a deduction with respect to a dividend.
These shareholders can now use CFC assets or stock as collateral for domestic loans (or have the CFC guarantee the loan) without triggering a taxable income inclusion. As a result, many lenders are asking U.S. borrowers to pledge these assets as collateral. When deciding whether to pledge CFC stock or assets as collateral, U.S. borrowers should make sure they will be entitled to the exception throughout the term of the loan. Certain shareholders are not entitled to the exception, including individuals, less than 10% shareholders, certain partners holding shares through a partnership, and shareholders holding their CFC stock for less than a year. The exception also may not apply if there is or has been hybrid equity in the CFC (an interest in the CFC that is debt for purposes of foreign law, or otherwise received a foreign tax benefit).
These new regulations are complex and require careful consideration to determine whether the exception discussed above is applicable to any particular corporate taxpayer. Careful drafting of loan agreements can ensure that the pledge of the CFC’s assets or stock or the CFC’s guaranty will not take effect if borrowers are not entitled to the exception.
Visit our website to learn more about International Tax Developments. For more information, please contact Vinson & Elkins lawyers Natan Leyva, Wendy Salinas, or George Gerachis.