US Tax Code Section 956
Lenders to Non-US Businesses: Can you ask for more better pledges and guarantees?
Most US lenders to multinational enterprises eventually encounter the tax rules under Code Section 956.
Section 956 generally imposes a tax cost when certain non-US companies invest their earnings in US property, by deeming a dividend paid by the non-US company to its US owners. However, in an arguable overreach, Section 956 also often deems dividends when a non-US subsidiary guarantees the debt of its US parent, or serves as an indirect guarantor via a pledge of the non-US subsidiary’s equity.
Parties often avoid Section 956 in these circumstances by avoiding guarantees by the non-US subsidiary and pledges of two-thirds or more of the outstanding equity of the non-US subsidiary, much to the annoyance of many lenders. Many lenders we’ve worked with encounter these restrictions frequently, and have historically acquiesced to a pledge of only 65% of the subsidiary equity.
However, Congress overhauled many of the international tax rules of the Code in their 2017 tax act, including the treatment of dividends received from non-US corporations. In those changes, Congress added an effective exemption for most foreign dividends received by US corporations. In recent regulations, the IRS noted that this new exemption on actual dividends creates an inconsistency with the Section 956 treatment of deemed dividends, and therefore clarified that deemed dividends under Section 956 should be exempt from tax to the extent that the affected taxpayers would have benefited from an exemption on actual dividends under the new rules.
As a result, non-US subsidiaries of corporate parents may now guaranty the parent’s debt and/or the parent may pledge 100% of the subsidiary equity, without incurring the tax under Section 956.
Practically speaking, lenders may now require that borrowers with non-US subsidiaries revise their guaranty and pledge agreements to provide further security. Additionally, it is possible that some outstanding loan agreements may automatically require a further guaranty or equity pledge, where agreements used limiting language that only excused these guarantees or pledges to the extent any such guaranty or pledge caused materially adverse tax consequences.
Therefore, lenders should consider the effect of these regulations on their outstanding loans, as well as in negotiations on loans going forward. However, lenders and borrowers should seek tax counsel on these new rules, particularly given their limited application to corporate owners of non-US entities and the limited IRS authority that has been provided on these new rules.