A controlled foreign corporation (CFC) is a foreign corporation that is more than 50% owned by shareholders who: (a) are U.S. citizens or residents, domestic entities, or U.S. trusts and estates; and (b) own 10% or more of the foreign corporation’s voting power. Under current law, a pledge of a CFC’s assets in certain loan transactions triggers a deemed distribution to the U.S. shareholders of the CFC for U.S. income tax purposes. This rule applies whether the pledge of the CFC’s assets is direct or indirect, meaning that a pledge of CFC stock could implicate a deemed distribution. Under a safe harbor rule, however, a pledge of less than two-thirds of the CFC’s stock (measured by voting power) will not be considered an indirect pledge of the CFC’s assets.
The proposed Tax Cuts and Jobs Act (the “Act”), which the House of Representatives passed on November 16, 2017, would eliminate the deemed distribution concern for U.S. corporations that own shares in a CFC, but the rule would remain unchanged for non-corporate U.S. shareholders.
Typically, lenders in banking and financing transactions seek to obtain a guaranty from CFCs, or a lien on the assets or capital stock of CFCs, owned by U.S. borrowers as a means of obtaining additional credit support. U.S. borrowers, however, are concerned that a guaranty from the CFC, or a lien on the assets or capital stock of the CFC, could trigger potential tax consequences that may result from a deemed distribution (as described above). As a means of avoiding the deemed distribution dilemma, U.S. borrowers often request that lenders structure the credit documents such that: (i) any pledge of applicable voting stock remains below the two-thirds threshold discussed in the paragraph directly above; (ii) CFCs and CFC holding companies are not required to guarantee any loans of the U.S. borrower; and (iii) any CFC or CFC holding company assets are excluded from the pledge that acts as security for the loan.
If the tax consequences that result from a deemed distribution are ultimately removed for U.S. corporate borrowers, the restrictions discussed above, which are typically contained in the credit documents, will need to be carefully tailored to address the changed landscape.
The above proposal represents just one piece of a complete overhaul of the tax code being considered by Congress. The Senate is considering its own tax bill which is still in committee. Accordingly, the likelihood of the Act being enacted in its current form and what modifications may occur before enactment, if any, is uncertain. White and Williams will continue to monitor the tax reform process and provide updates as appropriate.