CROSS-BORDER FINANCE Controlled Foreign Corporations

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1 CROSS-BORDER FINANCE Controlled Foreign Corporations Gabriel Yomi Dabiri October 20, 2017

2 CONTROLLED FOREIGN CORPORATIONS The Deemed Dividend Dilemma October 20, 2017

3 Learning Objectives 1. Discuss the recent case of Overseas Shipholding Group, Inc., 130 A.D.3d 415 (2015) 2. Recognize how to identify a Controlled Foreign Corporation (CFC) 3. Understand how transactions involving CFCs are impacted by Section 956 of the Internal Revenue Code 4. Consider suggestions for dealing with deemed dividends in finance documentation when CFCs are involved 5. Examine recent developments as they pertain to Section 956 of the Internal Revenue Code 2

4 Scope of Presentation Health Warning This presentation was created by finance attorneys for finance attorneys and for those who are new to or unfamiliar with this subject matter An in-depth exposition of tax law is beyond the scope of this presentation and will not be covered today Because of the generality of this presentation, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations 3

5 Introduction The modern economy has been defined by globalization This has given rise to opportunities to do business in foreign jurisdictions As a result, many US corporations have expanded their global footprint In 2012, earnings from US-controlled foreign corporations exceeded $793 billion 4

6 Introduction The US has no taxing authority over earnings from foreign corporations that have no connection to the US US-controlled foreign corporations may be subject to several different forms of US tax, some substantial Significant consequences may result if finance documentation does not adequately account for CFCs Cautionary tale of recently settled case involving Overseas Shipholding Group, Inc. 5

7 The Overseas Shipholding Group Case

8 Case Study: Overseas Shipholding Group, Inc., 130 A.D.3d 415 (2015) Lawyers revised credit agreement to impose joint and several liability rather than several liability Advised OSG to make a "check-the-box" election, which enlarged the prospective pool of taxable income Election could not be changed for five years OSG Case Identifying CFC Section 956 Deemed Dividends Recent Section 956 Developments 7

9 Case Study: Overseas Shipholding Group, Inc., 130 A.D.3d 415 (2015) The company argued that revision resulted in unexpected and avoidable tax liability in the amount of $463 million In 2013, company sued its former attorneys for legal malpractice The case recently settled OSG Case Identifying CFC Section 956 Deemed Dividends Recent Section 956 Developments 8

10 Question Raised in OSG Case When a US corporation borrows under a credit agreement, under what circumstances will the income of its foreign subsidiary be subject to US tax liability? Answer: When that foreign subsidiary is a considered by applicable tax law to be a CFC that has made a deemed dividend to its US parent. OSG Case Identifying CFC Section 956 Deemed Dividends Recent Section 956 Developments 9

11 Identifying a Controlled Foreign Corporation

12 What is a Controlled Foreign Corporation? A CFC is a foreign corporation in which at least one US person owns 10% or more of the voting shares of the corporation More than 50% of the combined voting power of all classes of stock is owned by one or more US Shareholders on any given day during the foreign corporation s taxable year AND OR More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 11

13 What is a Controlled Foreign Corporation? Let s unpack this definition More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 12

14 What is a Controlled Foreign Corporation? A CFC is a foreign corporation More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 13

15 Identifying a CFC Must be a Corporation The foreign entity must be a corporation for US tax purposes Certain foreign entities are always ("per se") corporations Other foreign entities are eligible ("foreign eligible entities") to be treated as corporations or not as corporations seek tax advice 14

16 Identifying a CFC Must be a Corporation Corporations organized in US commonwealths, territories and possessions are generally considered to be foreign corporations and may be treated as a CFC 15

17 Controlled Foreign Corporations A CFC is a foreign corporation that has at least one US person More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 16

18 Who is a US Person? Section 7701 of the IRS Code defines a US Person as: (A) a citizen or resident of the United States (B) a domestic partnership (C) a domestic corporation (D) any estate other than a foreign estate * A foreign estate is an estate the income of which comes from sources outside the US, and is not effectively connected with the conduct of a trade or business within the US 17

19 Who is a US Person? Section 7701 of the IRS Code defines a US Person as: (E) any trust if: (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust 18

20 Controlled Foreign Corporations A CFC is a foreign corporation in which at least one US person owns voting shares More than 50% of the combined voting power of all classes of stock is owned by one or more US Shareholders on any given day during the foreign corporation s taxable year More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 19

21 CFC Ownership Documents to Request Documents to request and review in order to determine ownership of foreign corporation: Foreign entity s stock certificates: who has ownership/control; percentage ownership Foreign entity s articles of incorporation: type of entity and type of shares issued Organizational chart: for direct/indirect ownership 20

22 CFC Ownership Types of Ownership Direct, indirect, and constructive ownership are used to determine whether a US person is a US Shareholder with respect to a foreign corporation Only direct and indirect ownership are used to determine the percentage of stock owned by a US Shareholder 21

23 CFC Ownership Direct Stock owned directly by a US person determined by reviewing the foreign entity s stock certificates 22

24 CFC Ownership Indirect Stock in a foreign corporation owned directly by a foreign entity is considered to be owned indirectly by the shareholders, partners or beneficiaries of that foreign entity 23

25 CFC Ownership Indirect Indirect ownership of shares of a foreign entity by partners, shareholders or beneficiaries is deemed to be in proportion to their ownership in the foreign entity For indirect ownership, only stock held by a foreign entity is considered, not stock owned by a domestic entity 24

26 CFC Ownership Constructive Constructive ownership means the effective ownership of stock actually owned by related persons (including entities) Stock owned directly or indirectly by the taxpayer s spouse, children, grandchildren or parents is considered in constructive ownership Constructive ownership rules are not considered in determining the exact proportion of a US Shareholder s inclusion 25

27 CFC Ownership Constructive A corporation, partnership, trust or estate that constructively owns more than 50% of the voting stock of a corporation is deemed to own 100% of the voting stock of that corporation 26

28 CFC Ownership Other Forms of Ownership Consider other ways the US person may have ownership in a foreign entity Nominee ownership: stock held for US person Signature authority: US person has effective control Voting agreement: US person has ability to select over 50% of board 27

29 Controlled Foreign Corporations A CFC is a foreign corporation in which at least one US person owns 10% or more of the voting shares of the corporation More than 50% of the combined voting power of all classes of stock is owned by one or more US Shareholders on any given day during the foreign corporation s taxable year AND OR More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 28

30 Who is a US Shareholder? A US Shareholder is defined as a US person who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of the foreign corporation s voting shares Section 951(b), IRS Code 29

31 Who is a US Shareholder? A US Shareholder is subject to CFC analysis only if: The foreign corporation was a CFC for an uninterrupted period of 30 days or more during the taxable year AND The US Shareholder owned stock in the foreign corporation on the last day of such taxable year 30

32 Controlled Foreign Corporations A CFC is a foreign corporation in which at least one US person owns 10% or more of the voting shares of the corporation More than 50% of the combined voting power of all classes of stock is owned by one or more US Shareholders on any given day during the foreign corporation s taxable year AND OR More than 50% of the total value of the stock is owned by US Shareholders on any day during the foreign corporation s taxable year 31

33 Identifying a CFC Voting Power Items to consider when determining the substantive voting control of US Shareholders are the powers to: elect, appoint or replace a majority of the board of directors (or corresponding governing group under local law) elect exactly half of the members of the board of directors and break a deadlock or exercise managerial powers during a deadlock elect the person who exercises the powers ordinarily exercised by the board of directors 32

34 CFC Holding Companies NTD Any domestic subsidiary that holds, directly or indirectly, no material assets other than the equity interests (or equity interests and debt) of subsidiaries that are CFCs 33

35 Identifying a CFC - Checklist CFC Checklist Determine if the entity is a foreign corporation Determine if the potential ownership of that foreign corporation s shares is by at least one US person Determine if the potential ownership of shares by one or more US persons actually constitutes ownership (direct, indirect or constructive) 34

36 Identifying a CFC Checklist CFC Checklist Determine if any US Shareholders potentially exercise any voting power or own any shares in connection with the foreign corporation If the voting power test appears to be applicable, determine whether the US Shareholder exercises over 50% of the combined voting power of all classes of the foreign company s stock Remember to consider domestic subsidiaries that could be CFC holding companies. These may also trigger tax implications 35

37 Identifying a CFC Annual Test CFC test is applied annually the foreign company s taxable year Foreign corporation may be a CFC in one year, but not in another 36

38 Impact of Section 956 on CFCs

39 The World Before Section 956 Prior to 1962, a CFC s earnings were only subject to US taxation when repatriated as dividends to its US parent Recognition that US corporations were obtaining an economic benefit from their foreign subsidiaries earnings These benefits took various forms, such as investments, loans and guarantees provided by those foreign subsidiaries Argument made that these benefits, in substance, were no different from the receipt of a dividend, and should be taxed 38

40 Section 956 of the Internal Revenue Code Section 956 of the Internal Revenue Code was enacted in 1962 to prevent a US parent company from avoiding tax liability while implicitly receiving the benefit of the income of their foreign subsidiaries 39

41 Deemed Dividend: Two-Thirds Pledge 1. US parent pledges two-thirds or more of the voting power of its CFC as security 40

42 Deemed Dividend: Upstream Guarantee 2. CFC provides upstream guarantee of its US parent s obligations 41

43 Deemed Dividend: Grant of Assets as Security 3. CFC grants or pledges its assets to secure the obligations of its US parent 42

44 Consequences of Triggering Section 956 The current federal income tax rate for corporations (not including any applicable state taxes) is 35% The consequences for not adequately drafting loan documentation for US corporations to account for the income of its CFCs can be significant 43

45 Navigating the Deemed Divided Dilemma

46 Navigating the Deemed Dividend Dilemma: Is Section 956 Applicable? Determine if Section 956 is Applicable If no foreign subsidiary making a guarantee or pledge (of shares or assets) is a CFC, then the guarantee or pledge will not be deemed a dividend and the US parent will not be subject to additional tax liability under Section

47 Navigating the Deemed Dividend Dilemma: Assess the Potential Tax Liability Determine if triggering Section 956 will give rise to significant tax liability Liability under Section 956 generally arises only to the extent the foreign subsidiary has current or accumulated earnings that have not already been subject to US taxation 46

48 Navigating the Deemed Dividend Dilemma: Limit Pledge of Voting Shares to 65% To avoid triggering Section 956, 65% pledge of foreign subsidiary capital stock has become the market approach Limit the Credit Support of Foreign Subs to 65% of Such Entity s Stock This diminishes collateral value for lenders by placing them behind trade and other creditors of the subsidiaries. Alternatives are pursued in instances where the foreign subsidiary is looked to as a primary source of repayment 47

49 Navigating the Deemed Dividend Dilemma: Consider Separate Loans Consider Separate Loans Request loans to the US parent in US dollars and separate loans to each CFC in its applicable foreign currency The separate loans to the CFCs will each be guaranteed by the US parent 48

50 Navigating the Deemed Dividend Dilemma: Consider Issuing Non-Voting Shares Section 956 is triggered for pledges of more than two thirds of voting shares (not capital stock) Consider Issuing Non-Voting Shares Pledging more non-voting shares as collateral provides the lender greater equity value and helps avoid triggering Section

51 Section 956: Recent Developments

52 Section 956: Recent Developments In 2016, The US Internal Revenue Service and Treasury issued final regulations (TD 9792) under Section 956 The final regulations provide that Section 956 anti-abuse rule may apply when a foreign corporation or partnership controlled by a CFC is funded by any means (not just by capital contributions or debt) The tax attributes (for example earnings and profits and foreign taxes) of the foreign corporation will be taken into account when determining the application of the anti-abuse rule. Implementation of these regulations will require tax advice. 51

53 Key Takeaways Section 956 of the IRS Code Section 956 prevents US corporations from avoiding tax liability while implicitly receiving the benefit of the income of their foreign subsidiaries; specifically CFCs Identifying a Controlled Foreign Corporation To be a CFC, at least one US person must own 10% or more of the voting shares of the foreign corporation, and one or more US Shareholders must own more than 50% of the foreign corporation s (a) voting power or (b) total value 52

54 Key Takeaways Navigating Deemed Dividends Capping at 65% any pledge to a US parent of shares in a CFC, separating the US corporation s loans from the loans to its CFCs and/or pledging to the lender non-voting shares as collateral are ways to avoid triggering Section 956 Impact of Section 956 on Controlled Foreign Corporations Inadvertently triggering Section 956 can cost your client hundreds of millions of dollars and result in an actionable claim for legal malpractice Seek Advice from Your Tax Specialists 53

55 Questions? Thank you for listening.

If you have foreign accounts, entities, or assets, chances are that you

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