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On October 31, 2018, the Treasury Department released proposed regulations (the “Proposed Regulations”) that reduce certain amounts otherwise includible in the taxable income of a corporate U.S. shareholder of a controlled foreign corporation (“CFC”) under Section 9561 to align the taxation of actual and deemed distributions of the earnings and profits of a CFC following the enactment of the Tax Cuts and Jobs Act of 2017 (the “TCJA”).  This alert highlights the impact of the Proposed Regulations on lending transactions involving pledges of CFC stock or assets and/or guarantees by CFCs.2

Historically, a U.S. borrower would object to a pledge of its foreign subsidiary’s stock or assets or a guarantee by its foreign subsidiary (assuming the foreign subsidiary was a CFC), unless such pledge, or guarantee, were structured to avoid an income inclusion under Section 956.  A U.S. borrower would typically pledge no more than 65% of the voting equity (while pledging up to 100% of the non-voting equity) of a first-tier CFC as collateral.  Additionally, the CFC would not guarantee the borrowing or pledge its assets as security for the benefit of the U.S. borrower.  These limitations were intended to avoid the application of existing rules under Section 956, which would otherwise treat such a pledge or a guaranty beyond these limitations as a deemed taxable distribution of the CFC’s earnings without regard to whether any amount was actually distributed to the U.S. borrower.

Under Section 245A, as added by the TCJA, earnings of a CFC that are repatriated to a corporate U.S. shareholder as a dividend will generally be exempt from U.S. taxation because, if such Section’s provisions are satisfied (including eligibility and holding period requirements), the shareholder is generally afforded an equal and offsetting dividends received deduction.  A Section 956 inclusion, however, is not eligible for the dividends received deduction under Section 245A and would be subject to current U.S. taxation absent the Proposed Regulations.  The Proposed Regulations are designed to maintain symmetry with allowable Section 245A deductions by eliminating certain otherwise includible income under Section 956 from a corporate U.S. shareholder’s taxable income.  With respect to lending transactions, the disparate treatment of actual and deemed distributions of CFC earnings under Section 245A has the potential of creating a trap for unwary taxpayers absent the Proposed Regulations.  The Proposed Regulations, if finalized in their current form, would significantly reduce the complexity, costs and compliance burdens for certain U.S. borrowers monitoring the application of Section 956 to their loan, pledge and guaranty agreements by eliminating the risk of Section 956 inclusions in many circumstances.

The application of these rules in practice, however, is complicated, and where one potential trap for the unwary closes another opens.  For example, not all dividends received from a CFC are eligible for the dividends received deduction under Section 245A.  Not all U.S. corporations are eligible.  S corporations, real estate investment trusts and regulated investment companies are examples of entities classified as corporations for tax purposes that are not eligible for the Section 245A dividends received deduction.  Thus, while the Proposed Regulations may permit additional collateral or security with respect to CFCs of corporate U.S. borrowers in many circumstances, certain corporate U.S. borrowers may still be at risk of a Section 956 inclusion.

Corporate U.S. borrowers must also determine whether to have the Proposed Regulations apply now–which determination may be required by a lender, or to continue to have the existing Section 956 rules apply until the Proposed Regulations are finalized.  Taxpayers generally may rely on the Proposed Regulations for taxable years of a CFC beginning after December 31, 2017, provided that the taxpayer and related U.S. persons consistently apply the Proposed Regulations with respect to all CFCs in which they are U.S. shareholders. Lenders and borrowers still need to undertake a thorough analysis of the tax impact of requiring the pledge of more than 65% of the voting stock of first-tier CFCs or guarantees (and the pledge of additional security) from CFCs.

For further information about the impact of the Proposed Regulations on your particular circumstances, please contact a member of the BCLP tax team.


1. All Section references are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated thereunder, unless otherwise specified.

2. This alert assumes a simplified organizational structure where the U.S. borrower is the sole record and beneficial owner of a CFC’s voting and non-voting equity.