On October 31, the Treasury Department issued Proposed Regulations that would in effect permit U.S. parent corporations to pledge the assets or 100% of the stock of their foreign corporate subsidiaries as security for obligations of the U.S. parent corporation and for foreign subsidiaries to guarantee the obligations without adverse U.S. federal income tax consequences.
Current Law
Under Section 956 of the Internal Revenue Code, if a foreign subsidiary of a U.S. corporation invests in “United States property,” then the amount of such investment is treated as a deemed dividend to the U.S. corporation and subject to U.S. federal income tax.
Treasury Regulations provide that a pledge of assets of a foreign subsidiary is treated as an investment in “United States property” and further provide that a pledge of more than two-thirds of the stock of a foreign subsidiary is treated as a pledge of assets. The Treasury Regulations also provide that a guarantee by a foreign subsidiary of a U.S. parent corporation’s obligation is treated as an investment in “United States property.”
In order to avoid significant adverse U.S. federal income tax consequences, foreign subsidiaries cannot be jointly and severally liable under a credit agreement with a U.S. parent corporation and a U.S. parent cannot pledge more than two-thirds of the stock of its foreign subsidiaries as security for its obligations under a credit agreement or other debt issuance.
As seen in the bankruptcy of Overseas Shipholding Group (OSG), the U.S. federal income tax consequences of the failure to comply with these rules can be devastating, resulting in taxable dividend income to the U.S. parent corporation in the amount of the pledged assets.
Changes to Pledge Rules
The Tax Cuts and Jobs Act effectively exempts U.S. domestic corporations from U.S. federal income tax on dividends paid by their foreign subsidiaries (subject to certain holding period requirements). However, prior to the issuance of the Proposed Regulations, an investment by the foreign subsidiary in “United States property” (including a pledge of the assets or stock of such foreign subsidiary by the U.S. parent) would trigger taxable income to the U.S. parent corporation under the rules described above. This would be the case even though the U.S. parent could have received a distribution of assets from the foreign corporation without the imposition of U.S. federal income tax.
Under the Proposed Regulations, an investment by a foreign subsidiary in United States property will be exempt from U.S. federal income tax to the same extent as a dividend distribution from the foreign subsidiary to its U.S. corporate parent would be so exempt.
As a result, a U.S. parent corporation may potentially pledge the assets or stock of its foreign subsidiaries as security for its obligations and a foreign subsidiary may guarantee those obligations without adverse U.S. federal income tax consequences. Lenders and borrowers should carefully review new and existing credit agreements and other relevant documents in light of these changes.
The Proposed Regulations are effective for taxable years beginning after the date on which the regulations are finalized. However, a taxpayer may rely on the Proposed Regulations for taxable years beginning after December 31, 2017.
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If you have any questions regarding these new regulations, please contact James C. Cofer (212-574-1688), Jonathan P. Brose (212-574-1615), Ronald P. Cima (212-574-1471), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210) or Brett R. Cotler (212-574-1269).
