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November 30, 2018

Proposed Modification of Section 956 Application to US Corporations Could Result in Increased Credit Support from Non-US Subsidiaries


The US Internal Revenue Service and the US Department of the Treasury recently released proposed Treasury regulations (Proposed Regulations) that modify the application of Section 956 to certain US corporations. These modifications generally are intended to result in US taxation of such corporations that is consistent with the new participation exemption system enacted by the recent Tax Cuts and Jobs Act (Tax Act).


As a component of the "anti-tax deferral" rules, Section 956 generally subjects certain undistributed and untaxed earnings of a "controlled foreign corporation" (CFC) to current US taxation when such income effectively is repatriated to the United States through an investment by the CFC in so-called "US property." The purpose of Section 956 generally is to prevent US shareholders of a CFC from circumventing US taxation of a CFC's earnings by transferring such earnings to the United States through non-taxable transactions that are substantially equivalent to taxable dividends.

In general, a non-US corporation is a CFC if at least 50 percent of the total vote or value of the corporation is owned (directly, indirectly or constructively) in the aggregate by one or more US persons, each owning at least 10 percent of the vote or value of such corporation (each of such persons, a US shareholder). An investment in "US property" generally includes, among other things, the acquisition of any tangible property located in the United States, stock of a US corporation and any obligation of a US person. Additionally, a guarantee by a CFC of an obligation of its US shareholder, or a pledge of the CFC's assets or at least two-thirds of the CFC's voting stock to secure such an obligation, directly or indirectly, generally also is treated as an investment in US property.

The Tax Act introduced major changes to US federal tax law, including, among other things, a participation exemption system that exempts from tax certain dividends from non-US subsidiaries. Specifically, newly enacted Section 245A allows a US corporation, subject to certain exceptions, to fully deduct the non-US source portion of a dividend received from a non-US corporation that is owned at least 10 percent by such US corporation. A US corporation, however, is not allowed a deduction in respect of any dividend from a non-US corporation that such US corporation holds for 365 days or less during a specified period.

Section 956 was not amended by the Tax Act. Thus, absent the modifications under the Proposed Regulations, an investment in US property by a CFC would continue to be currently taxable to its corporate US shareholders, even though an actual distribution by such CFC to a 10 percent corporate US shareholder generally would not be subject to tax.

Summary of the Proposed Regulations

The preamble to the Proposed Regulations provides that the continued application of Section 956 to a corporate US shareholder would result in disparate treatment between actual distributions from a CFC and income inclusions under Section 956, which is inconsistent with the purpose of Section 956. To maintain symmetry between the taxation of actual distributions and income inclusions under Section 956, the Proposed Regulations generally provide that the taxable amount otherwise determined under Section 956 with respect to a 10 percent corporate US shareholder is reduced to the extent that the shareholder would be allowed a deduction under Section 245A if the shareholder had received an actual distribution from the CFC. Thus, in most cases, the deemed dividend rule of Section 956 will no longer apply to a 10 percent corporate US shareholder of CFCs.

Section 956 will continue to apply without modification to US shareholders other than 10 percent corporate US shareholders, such as individuals. Section 956 also will continue to apply to regulated investment companies and real estate investment trusts, as these types of entities do not qualify for a deduction under Section 245A.

The changes in the Proposed Regulations will apply to tax years beginning on or after the date the Proposed Regulations are published as final regulations. Prior to that time, a taxpayer may rely on the Proposed Regulations for tax years beginning after December 31, 2017, provided that the taxpayer and certain other related US persons consistently apply the Proposed Regulations for all CFCs of which they are US shareholders.


As a result of the Proposed Regulations, we may begin to see lenders requesting that US corporate borrowers provide guarantees from their non-US subsidiaries or pledges of all of the stock or assets of such non-US subsidiaries. There may be, however, other obstacles to obtaining credit support from non-US subsidiaries that must be considered, such as restrictions under the local law of the non-US subsidiaries. In terms of existing loan agreements, such agreements should be reviewed to determine whether provisions that prohibit pledges and guarantees by CFCs only apply to the extent the pledge or guarantee results in negative tax consequences to the borrower. If such conditions do exist, CFC pledges and guarantees may now be required as a result of the Proposed Regulations.

© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.