Recent Developments in the Section 956 Deemed Dividend Rules<br></font>

As companies seek to capitalize on today's rapidly globalizing economy, they often look into doing business in foreign countries. Even the largest and most firmly established U.S. corporations, such as Apple, Microsoft and Pfizer, have recently expanded their footprints offshore. See, “Apple, Microsoft and Eight Other Corporations Each Increased Their Offshore Profit Holdings by $5 Billion or More in 2012: 92 Fortune 500 Corporations Boosted Their Offshore Stash by Over $500 Million Each,” Citizens for Tax Justice (March 11, 2013). A popular conduit for operating in a foreign country is a controlled foreign corporation (CFC). In 2012, U.S.-controlled foreign corporation earnings topped $793 billion as the world economy became increasingly interconnected. See, IRS, Statistics of Income.

How does the aforementioned trend impact the legal profession? That question was answered when a prominent New York-based law firm was sued over a credit agreement it drafted for its client Overseas Shipping Group (Overseas). Overseas brought suit to make the law firm pay for the legal services rendered attributed to Overseas, incurring an estimated $463 million tax liability. See, Overseas Shipholding Group, Inc. v. Proskauer Rose, LLP, 130 A.D.3d 415 (2015). The central issue in the case was whether the law firm gave due warning to Overseas of the potential tax ramifications of Internal Revenue Code (Code) Section 956. Section 956 governs the taxation of CFCs. See, 26 U.S.C. §956.

This article takes an in-depth look at Section 956. It sheds light on the critical aspects of the conflict between Overseas and its attorneys related to the tax laws applicable to CFCs. Guidance is provided on how to advise clients endeavoring to compete in today's global marketplace.

Overseas's Claim Against Its Attorneys

The origin of Overseas's §956 cause of action dates back to 2000. In that year, Overseas started using certain credit agreements amended by its attorneys. The contracts provided that Overseas and two of its wholly-owned subsidiaries would each borrow funds on the basis of “joint and several” liability. One of the subsidiaries, OSG International, Inc. (OIN), was a CFC used to conduct business outside of the United States.

OIN did not have significant earnings. OIN had lower-tier subsidiaries that did, however. In 2005, Overseas made a federal check-the-box election to treat the lower-tier subsidiaries as disregarded entities. Overseas claimed this decision was made pursuant to its attorneys' recommendation.

In 2003 and 2006, Overseas entered into more lending transactions using the contracts its attorneys provided in 2000 as a template. Overseas hired the same law firm again in 2011. Around that time, one of the law firm's attorneys purportedly discovered that some of the language used in the agreements could be a potential tax problem. Nevertheless, the attorney is said to have advised Overseas that the language provided no cause for alarm and that the CFC was not required to repay Overseas's borrowings. Overseas took the advice as informed and correct and drew down the remaining $343 million from the 2006 credit facility in 2012.

As a consequence of the contract provisions binding Overseas and its subsidiaries to joint and several liability and the election to treat OIN's lower-tier subsidiaries as disregarded entities, the Internal Revenue Service (IRS) determined that Overseas owed a $463 million tax liability. The IRS's theory was that the joint and several provisions were tantamount to a taxable guarantee by OIN of Overseas's borrowings. Overseas sued its attorneys, claiming they failed to provide proper advice on how to avoid tax under §956.

Internal Revenue Code §956

Generally, shareholders pay tax on their proportionate share of corporation earnings when the corporation declares a dividend. Before the enactment of §956, this requirement could be easily circumvented. Instead of receiving cash out of retained earnings, a shareholder could force its CFC to issue a loan without declaring a dividend. Alternatively, a shareholder could borrow money from a bank by pledging the shares of the CFC as collateral. In each case, a shareholder could effectively access the earnings of its corporation without paying U.S. taxes. Section 956 was adopted to put an end to the use of these types of tactics.

Section 956 precludes shareholders of CFCs from deferring tax on their corporations' earnings when the shareholders receive the functional equivalent of a dividend. A shareholder receives the functional equivalent of a dividend when a CFC has earnings and profits and holds certain U.S. property. See, generally, 26 U.S.C. §956. Section 956 defines such property to include loans from a CFC to its shareholders and pledges and guarantees in support of other obligations of the shareholders. See, 26 U.S.C. §956(d).

In 2015, the IRS issued proposed regulations applicable to IRC Sec. 956. These rules were drafted to prevent taxpayers from circumnavigating the statute using a foreign partnership. The proposed regulations are designed to make multiple notable changes. Under the proposed rules, an obligation of a foreign partnership is an obligation of its partners for purposes of IRC Sec. 956. See, Proposed Reg. §1.956-4(c). In the absence of this regulation, a U.S. shareholder could theoretically gain tax free access to its CFCs earnings by having the CFC hold U.S. property through a foreign partnership.

How to Handle The §956 Potential 'Deemed Dividend' Issue

When a borrower is a member of a group of related corporations, some lenders will ask for every one of the entities to sign on the dotted line guaranteeing the debt. Taking asset pledges from borrowers is another typical way banks protect their interests when lending money. While credit support techniques such as these may have traditional appeal, they can also have disastrous tax consequences if the borrower is a shareholder of a CFC with earnings and profits.

Accordingly, when representing a borrower owning shares in a foreign corporation, issues raised by §956 must be carefully considered. A few issues of particular import follow.

Consider the Classification of A Client's Foreign Corporation

Section 956 applies only to CFCs. See, 26 U.S.C. §956(a). A CFC is defined as a foreign corporation in which more than 50% of the total combined voting power of all classes of stock entitled to vote is owned by U.S. shareholders on any day during the year or more than 50% of the total value of the stock is owned by U.S. shareholders on any day during the year. A U.S. shareholder for the purposes of §956 is one who owns 10% or more of the total combined voting power of all classes of stock entitled to vote in a foreign corporation. See, 26 U.S.C. §957.

If a U.S. shareholder can receive a deemed dividend in a year when either the 50% annual ownership threshold or the 10% combined voter power threshold has not been crossed, then liability under §956 can be avoided. (If by a foreign corporation guaranteeing the debt of a U.S. shareholder or by having its stock pledged as security the loan is not a CFC, then the deemed distribution rules of §956 do not come into play. The CFC can thus guarantee a loan or have its stock pledged without the U.S. shareholder being deemed to have received a dividend.)

Consider Whether the CFC Has Untaxed Current or Accumulated Earnings

Liability under §956 arises only to the extent that a CFC has current or accumulated earnings that have not already been taxed in the U.S. For that reason, it may be advisable for your client to put off, if possible, CFC loans, stock pledges or guaranties until such time as the borrower's CFC lacks current or past accumulated untaxed earnings.

For the purposes of §956, a CFC's earnings and profits may include those of its lower-tier subsidiaries if an election has been made to treat the subsidiaries as disregarded entities. See, Proposed Reg. §1.956-2(a). It may thus benefit a CFC's shareholders to have revoked any election of its CFC to treat its lower-tier corporations as disregarded entities if the lower tier entities have earnings and profits.

Consider Whether a Client's CFC Has Taxable Basis In U.S. Property

The amount of §956 deemed dividend income a CFC shareholder has depends in part on the type of assets the CFC holds. Income tax may be deferred if the property a CFC owns is limited to the following:

1. U.S. government obligations, money, or bank deposits with a bank;
2. Property located in the U.S. purchased in the U.S. for export to or use in foreign countries;
3. Any obligation of a U.S. person arising in connection with the sale or processing of property if the amount of such obligation outstanding at no time during the taxable year exceeds the amount which would be ordinary and necessary;
4. Transportation assets used in foreign commerce;
5. An amount of assets of an insurance company equivalent to the unearned premiums or reserves ordinary and necessary for the conduct of an insurance business;
6. The stock or debt of unrelated corporations; and
7. Continental shelf exploration assets.

26 U.S.C. §956(c)(2)

Conversely, basis giving rise to current income tax may result from any property a CFC acquired after Dec. 31, 1962, which is:

1. Tangible property located in the United States;
2. Stock of a domestic corporation;
3. An obligation of a United States person; or
4. Any right to the use in the United States of the assets below which is acquired or developed by the controlled foreign corporation for use in the U.S. –

(i) A patent or copyright; (ii) An invention, model, or design (whether or not patented); (iii) A secret formula or process; or (iv) Any other similar right.

26 U.S.C. §956(c)(1)

Pledges of CFC stock by the CFC's shareholders and guarantees by CFC's of debt of related U.S. persons will also establish basis for current income taxes. Additional rules of note apply in the case of pledges of CFC stock. They include those found in Treasury Regulation §1.952-2(c)(2), which provides, in relevant part:

[T]he pledge of stock of a controlled foreign corporation will be considered as the indirect pledge of the assets of the corporation if at least 66 2/3% of the total combined voting power of all classes of stock entitled to vote is pledged and if the pledge of stock is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation's discretion with respect to the disposition of assets and the incurrence of liabilities other than in the ordinary course of business.

For the reason above, if a pledge of stock is required for a lending transaction a borrower should consider limiting the pledge to less than 66 2/3% of the voting stock of the corporation. A borrower should also consider pledging non-voting shares if a mutually acceptable agreement for such collateral can be reached with the lender.

It should also be noted how broadly the IRS interprets the term guarantor for the purposes of §956(d) of the Code. By its terms, §956(d) applies if a controlled foreign corporation is a guarantor of a CFC's shareholder's obligation. According to Revenue Ruling 76-125, however, §956(d) also applies when the borrower/shareholder alone signs a loan agreement offering loan support conditioned on the borrower/shareholder defaulting.

Moreover, borrowers owning shares in CFCs that indirectly hold U.S. property through foreign partnerships should be forewarned about the new §956 proposed regulations. Some practitioners, including this author, believe the recently proposed regulations merely shed light on the way the IRS interprets existing law. In that case, the IRS may determine under current law whether the borrower's CFC holds taxable basis in U.S. property, thus giving rise to a deemed dividend.

Conclusion

When negotiating lending transactions for clients involved in overseas business operations, it's important to understand the omnipresent risk of §956 deemed dividends. Please contact your local tax adviser to learn more about how your clients can operate overseas without incurring unforeseen tax consequences.

***** Marcus Dyer, a tax manager at WithumSmith+Brown, is an experienced CPA serving companies on a wide array of accounting, tax, and other regulatory compliance matters. In the field of law, he has represented clients in commercial and tax disputes before state courts, Federal District Court and the United States Tax Court. He can be reached at [email protected] or 609-520-1188.