Locke Lord QuickStudy: IRS Issues Final Regulations under Section 956, With Few Changes from Proposed Regulations

Following its issuance of proposed regulations in November of last year, the IRS today published final regulations (84 FR 23716) under Section 956 of the Internal Revenue Code. The final regulations include very few changes to the proposed regulations and, like the proposed regulations, seek to establish symmetry between the effect of the Section 956 rules (which can result in essentially a “deemed dividend” from a foreign corporation to its United States owners in certain circumstances) and the treatment of actual dividends from the same foreign corporation (which in many instances would be excluded from income under recently-added rules). As an indirect effect, the provisions of the final regulations potentially broaden the guarantee and collateral packages that U.S. borrowers can provide to their lenders without incurring adverse tax consequences.

Briefly stated, Section 956 can result in phantom (non-cash) income to certain U.S. shareholders who own stock in a foreign corporation, triggered by the foreign corporation’s investment in U.S. property. The theory behind such income inclusion is that the investment by the foreign corporation in U.S. property could be viewed as a deemed distribution of the invested funds to such U.S. shareholders. Importantly for borrowers and lenders, a guarantee by a foreign corporation of a U.S. borrower’s debt (or pledges of the foreign corporation’s assets or more than 66 2/3% of voting equity to secure such debt) are generally viewed under the Section 956 provisions as a form of an investment in U.S. property. As a result, U.S. corporate borrowers and their lenders have traditionally structured their financing arrangements to avoid such guarantee and collateral arrangements.

Following the lead of the enactment (as a part of the recent Tax Cuts and Jobs Act) of new Section 245A, the IRS, first in last year’s proposed regulations and now in today’s final regulations, scaled back the potential application of Section 956 to eliminate the disparity wherein a deemed dividend under Section 956 would result in the above-described phantom income to certain U.S. shareholders while an actual dividend would have been excluded from income by the same shareholders under new Section 245A. (Section 245A generally permits U.S. corporations owning 10% or more of a foreign corporation to effectively exclude foreign-sourced dividends received from such foreign corporation.) To avoid this disparity, the final regulations provide that the amount initially determined under Section 956 will be reduced to the extent that an actual dividend of the same amount would have been excluded under Section 245A.

As a result, the general provisions of both Section 956 and Section 245A still need to be taken into account in determining the impact of the final regulations (that is, Section 956 is not repealed). In particular, Section 245A includes a number of requirements for and potential exceptions to its application that will need to be taken into account before agreeing to a broader security package. Please refer to our prior Quick Study “IRS Issues Proposed Regulations under Section 956, Potentially Impacting Certain Multinational Debt Structures,” December 21, 2018, for a more detailed description of the interaction of these two provisions and some of the applicable Section 245A limitations.

The final regulations are generally applicable to taxable years of foreign corporations beginning on or after July 22, 2019, and to taxable years of its U.S. shareholders in which or with which such corporate years end. Taxpayers may, however, elect to apply the final regulations to tax years beginning after December 31, 2017, provided that such election is applied consistently to all similarly situated foreign corporations in which they or certain related parties are shareholders.

In addition to potentially providing room for borrowers and lenders to expand collateral packages for new borrowings because of the added flexibility provided by the final regulations (for example, to provide for certain guarantees by, and pledges of the assets or equity of, foreign corporations), the impact of the final regulations on existing agreements will need to be taken into account. Credit documents often provide that certain limitations (for example, limitations on certain guarantees and pledges) intended to avoid the application of Section 956 will be imposed only to the extent such limitations are necessary to avoid adverse tax consequences to the borrower group. To the extent that the final regulations eliminate these adverse tax consequences, they may result in the need to provide additional collateral and guarantees under these documents. Perhaps most significantly from the standpoint of a U.S. borrower, the flexibility afforded by the final regulations offers the opportunity to expand borrowing availability and ease financial covenant pressures by including foreign subsidiaries as “credit parties” and increasing collateral valuation and, potentially, borrowing base calculations.

The application of the final regulations can vary depending upon the facts and circumstances surrounding the borrower group, so an analysis of these facts and circumstances will be very important in determining their effect. In addition, before enhancing a collateral package with respect to a new or existing borrowing, non-tax limitations, including foreign-law issues and costs in obtaining effective guarantees or collateral, should also be considered. Obtaining such security may necessitate engaging foreign counsel, and in many jurisdictions the available remedies to a secured lender are less advantageous than those available under U.S. laws.