Recently proposed IRS regulations materially change the way stock and assets of foreign corporations that are “controlled foreign corporations” (CFCs) can be used to support debt of U.S. affiliates. In the commercial lending market, this has the potential to impact long-standing approaches to obtaining guarantees and collateral from CFCs. In some cases, this may lower a company’s cost of borrowing or provide additional collateral support, particularly in asset-backed/borrowing base loan structures.
Lenders have generally accepted that to minimize adverse tax consequences for U.S. borrowers, they would often avoid requiring direct guaranties or collateral from foreign affiliates of U.S. borrowers. Instead, lenders have often required a pledge of up to 65 percent of the capital stock of CFCs to secure loans.
However, as a result of proposed regulations the IRS issued last month, the adverse tax consequences that could result from guarantees and collateral support from CFCs owned by U.S. corporations have been mitigated, which could make obtaining guarantees and collateral support from CFCs more attractive to lenders and, in some instances, corporate borrowers. Lenders could have access to greater direct credit support from CFCs without adverse consequences for borrowers.
This is because the regulations turn off the application of the tax provision that effectively caused a deemed distribution from the CFC of a U.S. corporation. The relief applies where an actual distribution of earnings from the CFC would be exempt from U.S. tax under provisions enacted as part of the Tax Cuts and Jobs Act of 2017 (Section 245A).
Thus, lenders and U.S. corporations that are borrowers may wish to include guarantees and assets from CFCs, under some circumstances, where such credit support by foreign affiliates can lead to more flexible covenants, lower pricing or increased borrowing base availability to a borrower. However, lenders and borrowers should proceed cautiously. For example, U.S. LLCs and LPs are still subject to deemed dividend rules, and consequently the adverse tax consequences would continue to apply to these types of entities. In addition, credit support fees paid to a CFC by a U.S. affiliate can attract adverse withholding and other tax consequences.
Borrowers should carefully consider the assets and liabilities of the CFC, the borrower’s own tax strategy, and the cost-benefit analysis involved in bringing non-U.S. entities into their loan arrangements. There are other implications that affect foreign tax credit, intellectual property, acquisition and other planning, but these points should be considered separately.
The regulations will be effective when finalized. However, taxpayers may elect to apply the rules for taxable years of foreign affiliates beginning after Dec. 31, 2017.