We frequently act as Canadian counsel to lenders and borrowers in cross-border transactions where credit support is provided to a US parent company by one or more of its Canadian subsidiaries. In structuring the deal, a considerable amount of time can be spent determining the extent to which the collateral of the Canadian subsidiaries should secured.

The reason for this dilemma is because of section 956 of the US Internal Revenue Code, which creates a deemed dividend on the income of any controlled foreign corporations (CFCs) irrespective of whether or not the dividend is in fact papered and paid back to the US parent. A CFC is defined as any foreign company of which more than 50% of the total combined voting power of all classes of shares are entitled to vote or more than 50% of the total value of its shares are owned by US domiciled shareholders. Each "US Shareholder" of a CFC is required to include in their gross income as a deemed distribution their pro rata share of the amount determined under section 956 for that year. Typically, the US parent (or one of its US subsidiaries) would own 100% of the foreign company, which can trigger section 956 in the circumstances set out below.

By way of background, before section 956 was enacted in 1962, income produced by the foreign subsidiaries of a US company was only subject to US taxation if the foreign income was repatriated to the US entity by way of a dividend. Congress recognized that US companies were obtaining the economic benefit of this foreign income despite the fact that the income was not taxable in the US, and as a result enacted section 956 on the basis of the benefit received by the US parent on all past and future earnings of the foreign subsidiaries. Under section 956, when a foreign subsidiary provides credit support to its US parent, the accumulated earnings and profits of the foreign subsidiary are deemed to have been distributed to the US parent and therefore subject to US corporate tax.

The section 956 dilemma discussed between borrowers and lenders when structuring a credit deal largely revolves around the level of security a foreign subsidiary will grant to the lender in respect of the obligations of the borrower. If the CFC is a pledgor or guarantor of such obligation, the CFC is treated as holding an obligation of a US person and if one of the following three events occur, section 956 is triggered:

  • The foreign subsidiary grants a security interest to the lender in its assets to secure the obligations of the US parent;
  • The foreign subsidiary guarantees the obligations of the US parent; or
  • If 662/3% or more of the voting stock of the foreign subsidiary is pledged to the lender.

In many cases, having considered the tax implications, all three of the above occur in any event. The tax implications of section 956 will not necessarily be significant, however they can be, particularly if the business of the foreign subsidiary forms a material part of the company's consolidated EBITDA.

In recent years, there have been calls for the repeal of section 956 and many observers expected a repeal to be included with the recent Tax Cuts and Jobs Act as a result of the House and Senate committees' proposals to overhaul the US international tax regime. However, the final version of the Tax Cuts and Jobs Act which became law on December 22, 2017 did not include such repeal and we continue to be faced with section 956 considerations when credit deals are negotiated.

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