Cross-Border Finance: Controlled Foreign Corporationsmedia2.mofo.com/documents/171020-controlled-foreign-corporations.pdf2. Recognize how to identify a Controlled Foreign Corporation

CROSS-BORDER FINANCE Controlled Foreign Corporations

October 20, 2017

Gabriel Yomi Dabiri Morrison & Foerster LLP

CONTROLLED FOREIGN CORPORATIONS

The Deemed Dividend Dilemma

October 20, 2017

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

Learning Objectives

Morrison & Foerster LLP 2

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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

Scope of Presentation – Health Warning

Morrison & Foerster LLP

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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

Introduction


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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.

Introduction


The Overseas Shipholding Group Case


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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

Case Study: Overseas Shipholding Group, Inc., 130 A.D.3d 415 (2015)


OSG Case → Identifying CFC→ Section 956→ Deemed Dividends → Recent Section 956 Developments

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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

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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.

Question Raised in OSG Case



Identifying a Controlled Foreign Corporation


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What is a Controlled Foreign 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

OR More than 50% of the total value of the stock is owned by US Shareholders on any


OSG Case → Identifying CFCs → Section 956 → Deemed Dividends → Recent Section 956 Developments

A CFC is a foreign corporation in which at least one US person owns 10% or more of the voting shares of the corporation

AND

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More than 50% of the total value of the stock is owned by US Shareholders on any



Let’s unpack this definition

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A CFC is a foreign corporation

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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

Identifying a CFC – Must be a Corporation



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

Identifying a CFC – Must be a Corporation



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Controlled Foreign Corporations





A CFC is a foreign corporation that has at least one US person

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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

Who is a US Person?



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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

Who is a US Person?



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one or more US Shareholders on any given





A CFC is a foreign corporation in which at least one US person owns voting shares

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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

CFC Ownership – Documents to Request



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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

CFC Ownership – Types of Ownership



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Stock owned directly by a US person determined by

reviewing the foreign entity’s stock certificates

CFC Ownership – Direct



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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

CFC Ownership – Indirect



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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

CFC Ownership – Indirect



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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

CFC Ownership – Constructive



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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

CFC Ownership – Constructive



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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

CFC Ownership – Other Forms of Ownership



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one or more

US Shareholders on any given day during the

foreign corporation’s taxable year

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



AND

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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

Who is a US Shareholder?



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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

Who is a US Shareholder?



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More than 50% of the combined voting power

of all classes of stock is owned by one or more US Shareholders on any given


OR More than 50% of the total value of the stock is owned by US Shareholders on any




AND

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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

Identifying a CFC – Voting Power



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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

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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)

Identifying a CFC - Checklist



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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

Identifying a CFC – Checklist



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CFC test is applied annually – the foreign company’s taxable year

Foreign corporation may be a CFC in one year, but not in another

Identifying a CFC – Annual Test



Impact of Section 956 on CFCs


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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

The World Before Section 956



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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

Section 956 of the Internal Revenue Code



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Deemed Dividend: Two-Thirds Pledge


1. US parent pledges two-thirds or more of the voting

power of its CFC as security


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Deemed Dividend: Upstream Guarantee


2. CFC provides upstream guarantee of its US parent’s

obligations


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Deemed Dividend: Grant of Assets as Security


3. CFC grants or pledges its assets to secure the

obligations of its US parent

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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

Navigating the Deemed Divided Dilemma


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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 956


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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


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Navigating the Deemed Dividend Dilemma: Limit Pledge of Voting Shares to 65%


Limit the Credit Support of Foreign Subs to 65% of Such

Entity’s Stock


To avoid triggering Section 956, 65% pledge of foreign subsidiary capital

stock has become the market approach

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

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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

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Navigating the Deemed Dividend Dilemma: Consider Issuing Non-Voting Shares


Consider Issuing Non-Voting Shares


Section 956 is triggered for pledges of more than two thirds of voting shares

(not capital stock)

Pledging more non-voting shares as collateral provides the lender greater

equity value and helps avoid triggering Section 956

Section 956: Recent Developments


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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.

Section 956: Recent Developments



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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 OSG Case → Identifying CFCs → Section 956 → Deemed Dividends → Recent Section 956 Developments

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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

Key Takeaways


Questions? Thank you for listening.