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Treasury & Taxation

Latest Tax Change Favors MNC Dividends

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January 10, 2019

Section 956: has the IRS made deemed-dividend tax avoidance easier?

IRS and dollarForeign affiliates providing loans and/or credit support to US-based headquarters and other US entities just got easier—effective immediately.

Prior to the Tax Cuts and Jobs Act passed in 2017, the IRS’s Section 956 aimed to prevent US companies from directly or indirectly bringing the untaxed income of an overseas affiliate back the US—so-called deemed dividends—without triggering US tax. That included the “controlled foreign corporation” (CFC) lending to US affiliates, because the rule interpreted a guarantee by a CFC and a pledge of its assets to be investments in US property and subject to tax.

The tax reform introduced a worldwide tax on foreign affiliates’ income—albeit at a much lower rate than the previous tax on repatriated income—and was expected to remove Section 956. Mysteriously, however, the provision remained in the tax code. Tax reform did, however, exempt actual dividends that a US corporation receives from CFCs, creating the unusual situation of exempting actual dividends while taxing deemed ones.

The IRS and Treasury Department noted that asymmetry and proposed a regulation in October that effectively treats deemed dividends as actual ones.

“In other words, ‘real’ dividends and ‘deemed’ dividends will be taxed the same way and generally not treated as income to a US corporate shareholder of a CFC,” said law firm Paul Weiss in a note to clients.

The rules are proposed to be effective for taxable years of a CFC beginning on or they are published in the Federal Register. However, Paul Weiss notes, corporates can rely on the proposed regulations for taxable years of the CFC beginning after December 31, 2017, adding, this “effectively means the regulations are applicable now if a taxpayer (or its lender) wants.”

In a November meeting of the NeuGroup’s Assistant Treasurers’ Leadership Group (ATLG), a participant asked fellow members about the proposed regulation, which most had yet to hear about. One noted that it opens the door for US companies to borrow from cash pools. “Instead of a dividend [that may trigger Section 956], a company can take money back as a loan in the interim.”

Paul Weiss noted that under a combination of existing Subpart F rules and tax reform’s new “GILTI” rules, companies in many instances could have avoided Section 956. And yet except for some distressed scenarios, most companies didn’t seek that credit support.

“If anything, however, the Proposed Regulations make the additional credit support more obvious and easier by eliminating some of the modeling exercises and actual distributions that would have been required before … time will tell how the market evolves.”

Kathleen Dale, principal, international tax, KPMG, said the proposal means cash can be loaned or otherwise invested in the US without triggering Section 956, but there remain circumstances in which it may still apply.

“Also, there could be other tax consequences to repatriating cash, such as withholding tax and foreign currency exchange again or loss,” Dale said, “So again, treasurers should consult with their tax departments before undertaking a repatriation transaction.”

Among the practical consequences Paul Weiss identifies, lenders may be more likely to require US corporate borrowers to include CFCs in credit support, and borrowers may readily provide that additional support to obtain better terms or increase the amount they borrow.

“In most cases, CFCs can now guarantee the debt of US corporate parent entities and pledge assets, and 100% of all CFC stock can now be pledged (including for all tiers of CFCs, not just first-tier CFCs), in each case, without any deemed dividend concern under Section 956,” the law firm states. “In addition, the Proposed Regulations may create opportunities for CFCs to lend money to US affiliates, which could be useful where foreign jurisdictions have significant dividend withholding taxes.”

In a November report about the change, PWC notes that only US corporations benefit from the proposal. “Section 956 will continue to apply to US shareholders that are not corporations, such as individuals, regulated investment companies, and real estate investment trusts,” PWC says.

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