This post was also written with assistance from Abbey Mansfield .

Overseas Shipping Group (“Overseas”) recently sued its former attorneys, a prominent New York-based law firm, for legal malpractice in drafting credit agreements that resulted in the company incurring an estimated $463 million in tax liability. The suit alleges that the tax liability arises from the fact that the credit agreement holds two foreign subsidiaries jointly liable with their American parent, Overseas. This suit raises an important question: under what circumstances will a foreign subsidiary’s income be subject to tax liability in the United States as a result of being a party to a credit agreement with their U.S. parent?

Section 956 of the Internal Revenue Code (“Section 956”) was enacted in 1962 to prevent a U.S. parent company from avoiding tax liability while implicitly receiving the benefit of the income of their controlled foreign subsidiaries (“controlled foreign corporations” or “CFCs”). Prior to the enactment of Section 956, a CFC’s profits and earning were only subject to taxation in the U.S. at the time they were repatriated as dividends to the U.S. parent. Under Section 956, however, investments made by CFCs in specified “United States property” are considered to be a constructive dividend and subject to U.S. taxation. A CFC’s earnings and profits are considered a constructive or deemed dividend subject to U.S. taxation if the subsidiary is the “pledgor or guarantor” of its U.S. parent’s debt obligations.

Section 956 in U.S. Loan Transactions:
A CFC is deemed to have made a taxable dividend in the context of a U.S. loan transaction if (i) its U.S. parent pledges two-thirds or more of the voting power of the CFC as security, (ii) the CFC provides an upstream guarantee of the obligations of its U.S. parent, (iii) the CFC grants or pledges its assets to secure the obligations of its U.S. parent or, as illustrated by the recent suit brought by Overseas, (iv) the CFC is jointly and severally liable for the obligations of its U.S. Parent (which will be deemed an “upstream guarantee” under Section 956). Given the general federal corporate income tax rate of 35%, this can have serious consequences for companies not planning to pay taxes on those deemed dividends.

Suggestions in dealing with a potential “deemed dividend” problem:
When negotiating a U.S. loan transaction, Borrowers and their counsel must consider issues raised by Section 956, and consider practical solutions to avoid paying taxes on deemed dividends, some of which are identified below:

  • Determine whether Section 956 is applicable. If the company making the pledge or guarantee is not a CFC (defined as having more than 50% of its shares held by US shareholders), then the pledge or guarantee will not be a deemed dividend and the company will not be subject to additional tax liability under Section 956.
  • Determine if triggering Section 956 will cause a tax issue for these companies. Liability under Section 956 generally will arise only to the extent the foreign subsidiary has current or accumulated earnings that have not already been subject to U.S. taxation.
  • Consider whether it makes sense for the lender to make loans in dollars to the U.S. parent and separate loans in a foreign currency to the CFCs guaranteed by the U.S. parent. In such a case, the CFCs grant liens to secure the loans advanced to them, but provide no guarantees or liens to support the loans extended to the U.S. Borrower.
  • Section 956’s trigger point for pledges being deemed a dividend is measured by two-thirds of voting power – and not two-thirds of the value of all capital stock. Consider whether the CFC should issue more nonvoting stock with all of the economic attributes of the currently outstanding voting stock to be pledged as collateral and provide the lender greater equity value.

Without forethought, Section 956 can have serious consequences on an international company’s tax liability. However, with deal specific analysis and negotiation, Borrowers can obtain the loans needed to optimize business objectives and Lenders can obtain the security necessary to make such loans.