Following tax reform at the end of 2017, cash dividends from a foreign corporate subsidiary to a domestic corporate 10 percent shareholder are exempt from U.S. income tax because the shareholder is permitted a “dividends-received deduction” equal to the amount of the dividend. However, this new deduction was not expanded to cover “deemed dividends” from foreign corporate subsidiaries under Section 956 resulting from full pledges of the stock of, or guarantees by, such foreign corporate subsidiaries.  As a result, loan security arrangements for U.S. borrowers that have foreign corporate subsidiaries have continued to be driven by the Section 956 “deemed dividend” rules, and credit agreements have continued to include “deemed dividend”-driven restrictions.  Those restrictions typically provide that foreign subsidiaries are not required to guarantee, or pledge any assets in support of, a loan to a U.S. borrower and a U.S. loan party is not required to pledge more than 66% of the stock of a foreign subsidiary.   

Recognizing the inconsistent treatment of cash dividends from a foreign corporate subsidiary to a domestic corporate 10 percent shareholder, the Internal Revenue Service and Treasury issued proposed tax regulations on October 31, 2018 that treat Section 956 “deemed dividends” the same as cash dividends. Under the proposed regulations, a domestic corporate borrower is potentially exempt from U.S. income tax on “deemed dividends” resulting from pledges of the stock of, and guarantees by, foreign corporate subsidiaries. The proposed regulations do not change the “deemed dividend” rules for certain borrowers such as individuals, domestic partnerships (or LLCs treated as partnerships for tax purposes), real estate investment trusts, or regulated investment companies.

Although the regulations are not final, they may be relied on by most taxpayers (generally, calendar year taxpayers with calendar year controlled foreign corporate subsidiaries), provided the taxpayer and parties related to it consistently apply the proposed regulations to all foreign corporate subsidiaries in which they are 10 percent shareholders. As a result of this reliance rule, starting immediately, obligations of domestic corporate borrowers can be supported by full guarantees from, and full pledges of the stock of, foreign corporate subsidiaries without triggering a taxable “deemed dividend.”