Tax Reform Part 3: Restructuring & Insolvency Related Provisions - Pledges and Guarantees
This is the third part in a series of articles discussing certain restructuring and insolvency related provisions of the tax reform currently being considered by the US Congress. Previously we discussed net operating losses (“NOLs”) and cancellation of the debt (“COD”). In this installment we will consider how the House (“House Plan”) and the Senate Plan (“Senate Plan,” together with the House Plan, collectively “Tax Reform”) impact the lending habits of US-based multinational corporations (“MNCs”), and specifically the ability of affiliated companies to provide pledges and guarantees on intercompany and third-party lending arrangements.
Under present law, a US company with foreign operations is required to include in its US taxable income, certain foreign-sourced income (generally passive income), regardless of whether such income is repatriated to a US member of the group. However, certain other foreign-sourced income is deferred, not being subject to US tax until those earnings are repatriated back to the US. This deferred amount has been the subject of many headlines in 2017 along the lines of: “US Corporations Park Trillions Offshore.”
Current tax law attempts to prevent US MNCs from the tax-free repatriation of this otherwise deferred amount of foreign earnings. One such rule polices certain loans the US MNC (or its US affiliates) receives from a foreign affiliate. The theory is that a loan of cash and a dividend of cash should be treated, for the most part, as equivalent. The theory is extended to provide that to the extent the foreign affiliate guarantees the US company’s borrowing (from whomever) or if the stock of the foreign affiliate is pledged to the lender (with accompanying restrictions and negative covenants), those acts are the economic equivalent of a loan from the foreign affiliate to the US company.
The tax regime described in the prior two paragraphs led to rules that are familiar to all tax and bankruptcy attorneys: lending agreements generally (1) should not include guarantees by foreign affiliates and (2) should not pledge 66 2/3% or more of the voting stock of a foreign affiliate, if the arrangement also includes certain negative covenants or restrictions on the shareholder (together the “956 Rules”). (Internal Revenue Code Section 956 is broader than this, but herein we will use this narrow definition.) Failing to satisfy the 956 Rules could be catastrophic, as a mere borrowing arrangement could accelerate the taxation of offshore earnings that might not otherwise be subject to tax for decades.
As a simple example, if a foreign affiliate with $100 million of deferred earnings, guarantees a US affiliate’s $200 million borrowing, the cost of the borrowing could be a $35 million tax.
Well, the Tax Reform would change all of this. First, the Tax Reform has forced repatriation, subjecting offshore cash (or equivalents) to a tax of 14%, and offshore illiquid assets to a tax of 7%. Second, going forward, because the Tax Reform proposes moving to a hybrid-territorial taxation regime, whereby most foreign earnings are not subject to US tax, even if distributed back to the US, there is no longer a need for the 956 Rules for US MNCs.
The impact to restructuring and insolvency is significant. The forced repatriation means that US companies with significant deferred foreign earnings potentially will be subject to immediate tax. To the extent such a company has been in decline, this tax may come at an inopportune time and, at a minimum, if the company recently has been generating NOLs, such NOLs might have to be used to offset the repatriation tax. To the extent possible, this may call for pre-year end restructuring to manage these tax consequences.
On the positive side, the US-based MNC would have more assets to serve as collateral for borrowing, as the less-than 66 2/3% limit on pledges of foreign stock would no longer apply, and in fact the foreign affiliate could guarantee the borrowing of the US-based MNC. Lenders and borrowers alike should be aware of how the proposed repeal of the 956 Rules for corporations impacts the US MNC’s borrowing capacity. Advisors would likely see an increase in the participation of foreign affiliates in US bankruptcies as such affiliates begin to guarantee US company debt.
The forced repatriation would also make assessing damages in a malpractice suit, for failure to comply with the 956 Rules, easier to calculate, as the benefit of future deferral would come to an end on December 31, 2017, should the Tax Reform become law in its present form.