Found Money? Or Self Imposed Liability? Tax Pitfalls of Securing U.S. Loans with Foreign Assets

In good times lenders will look for any source of collateral when renewing or underwriting a loan. In bad economic times, the search for collateral is intensified, as both the borrower and the lender look for ways to support and justify the loan and to obtain better terms for the borrower. For a United States entity borrower (a “Borrower”) with foreign subsidiaries, using property of a foreign subsidiary as a form of credit enhancement for the Borrower’s loans may be viewed as “found money.” Doing so, however, can have unintended tax consequences for the borrower as the act of guaranteeing a loan to a domestic parent, even directly or in a form other than a formal guaranty, can cause the domestic parent to recognize taxable income.

Assuming the Borrower owns 100% of the stock of a non-United States entity, the foreign entity (“Foreign Sub”) will constitute a controlled foreign corporation (“CFC”) under Section 957(a) of the Internal Revenue Code of 1986, as amended (the “Code”). If the Foreign Sub either (i) guarantees the loan to the lender, or (ii) pledges its assets as security for the Borrower’s obligations to repay the loan, the Foreign Sub will be deemed under Code Section 956(d) to have made an investment in United States property (as defined in Code Section 956) in an amount equal to the unpaid principal portion of the loan. Under Code Section 951(a)(1)(B), the value of the deemed investment must be included currently in gross income by the Borrower, to the extent of the Foreign Sub’s earnings and profits. The result, for U.S. income tax purposes, is that the Foreign Sub will be deemed to have, in effect, paid a dividend to the Borrower despite the fact that the Foreign Sub did not actually pay a dividend to the Borrower. Whether or not a tax is actually due on this deemed repatriation will depend on whether (i) the Foreign Sub possesses earnings and profits, (ii) those earnings and profits have been previously taxed to the Borrower as an investment in United States property under Code Section 956, and (iii) those earnings and profits have been previously taxed to the Borrower as Subpart F income under Code Section 959(c)(1).

A guaranty can be found to exist even in the absence of a formal guaranty agreement by the Foreign Sub. In Field Service Advice Memoranda 200216022 (Apr. 19, 2002), the Internal Revenue Service (“Service”) held that CFCs of a domestic parent had indirectly guaranteed a parent’s debt under Code Section 956(a) and (d) when the CFCs entered into a series of covenants with a bank, even though the CFCs had not entered into any traditional guaranty agreements. In their agreements with the bank (which were intended to replace traditional guaranty agreements), the CFCs agreed (i) to pay dividends to the parent to support the parent’s liquid net worth, (ii) to refrain from entering into transactions that would affect its financial condition, (iii) not to guarantee any debt of the domestic parent or its subsidiaries without first guaranteeing the parent’s debt on an equal basis, (iv) to subordinate any debt of the parent to the CFC to the debt to the bank, and (v) to a series of other negative covenants. The Service concluded that the agreements giving the bank “de facto veto power over the [parent’s] right to impair its and its CFCs’ assets” together with the promises by the CFCs to pay dividends to the parent in the event that the parent defaulted on its obligation to the bank, constituted indirect guarantees by the CFCs.

In addition to the income to a Borrower that may arise by taking security in the assets of a Foreign Sub (directly through a guaranty, or indirectly through another mechanism), merely taking a pledge of stock of a Foreign Sub can also cause imputed income. Under Treas. Reg. § 1.956-2(c)(2), if the Borrower pledges at least 66 2/3 percent of the stock of a Foreign Sub as collateral for its loan, the Foreign Sub will also be deemed to have made an investment in United States property if the pledge of stock is accompanied by one or more negative covenants or similar restrictions effectively limiting the Foreign Sub’s discretion with respect to the disposition of its assets and the incidence of liabilities other than in the ordinary course of business. In this event, Treas. Reg. § 1.956-1(e)(2) provides that the Foreign Sub will be deemed to have made an investment in United States property in an amount equal to the unpaid principal portion of the loan. This amount must be currently included by Borrower as gross income under Code Section 951(a)(1)(B).

As with a guaranty or lien of assets, whether or not a tax is actually due under the prior paragraph depends on whether (i) the Foreign Sub possesses earnings and profits, (ii) those earnings and profits have been previously taxed to Borrower as an investment in United States property under Code Section 956, and (iii) under Code Section 959(c)(1), those earnings and profits have been previously taxed to Borrower as Subpart F income.

Accordingly, both borrowers and lenders need to be aware of the tax impact of taking a lien or other interest in a foreign subsidiary or its property as credit enhancement for a U.S. loan. By obtaining a pledge of less than two-thirds of the stock of a foreign subsidiary, and receiving negative covenants from its Borrower (and not from the Foreign Sub) the lender may be able to increase its security without creating unintended income for the Borrower. In addition, although it is beyond the scope of this article to describe in any detail, appropriate professionals should be consulted to determine if the Borrower is in an excess foreign tax credit position such that inclusions under Code Section 956 might be offset by available U.S. foreign tax credits.

The information contained in this article is intended to supply general information and is not intended to provide legal advice. All those interested in assessing their own situation are strongly encouraged to discuss their particular circumstances with legal counsel and other professional advisors.