Multi-Nationals: Financing of Special Dividends 

publication 

May 2005 - (Canadian Treasurer, April/May 2005. )

Canadian Treasurer, April/May 2005.

Canadian subsidiaries now may be able to borrow to enable their U.S. parent to use a one-time U.S. tax incentive for capital repatriation.

The U.S. government recently enacted The American Jobs Creation Act of 2004 that added new Section 965 to the U.S. Internal Revenue Code (IRC). In general, the new legislation creates a temporary incentive, proposed by the U.S. Treasury Department, to encourage U.S. multi-nationals to repatriate capital from any subsidiary which is a "controlled foreign corporation" ("CFC"). Subject to limitations touched upon below, the U.S. parent of a CFC will get favourable tax treatment for a cash dividend that it receives from its CFC and reinvests in the U.S. This incentive will only be available for tax years of the U.S. parent that begin before October 21, 2005.

One of Lang Michener's bank clients, Bank of Montreal, asked us about the various legal implications of providing credit facilities to the bank's Canadian customers that are CFCs in the context of Section 965. We consulted our colleagues at the U.S. law firm Nixon Peabody LLP, and together with them, we developed some guidelines to consider if Canadian CFCs wish to borrow to finance dividends paid to their U.S. parents to allow their U.S. parents to take advantage of this opportunity.

Under new Section 965 of the IRC, a CFC may incur debt to fund a cash dividend it pays to its U.S. parent, and if the U.S. parent uses the dividend proceeds to make a permitted investment, the U.S. parent may elect, for one taxable year, to take an 85% "dividends received deduction" ("DRD") with respect to the dividend received from its CFC. In other words, the dividend is received almost tax free. If the U.S. parent uses the dividend proceeds to repay debt it owes to an unrelated party, the U.S. parent may be able to demonstrate that the repayment is a permitted investment even though the total debt of the U.S. parent and its CFCs, taken in the aggregate, is not reduced.

In addition, and most importantly, if the facts and circumstances are such that, in substance, the U.S. parent (rather than its CFC) is the obligor of the debt nominally incurred by the CFC, DRD treatment will not be allowed. This is the holding of the U.S. courts in the Plantation Patterns case and its progeny.

The legal issue for the U.S. parent and its Canadian CFC is how to eliminate or minimize the risk that a bank loan taken out by the CFC to finance a dividend will be assessed by the IRS as being "nominally incurred" by the CFC. Here, in summary fashion, are four of some seven suggested guidelines we developed for consideration, subject to the general caveat set out below:

  • Generally speaking, there can be no argument that the debt has been "nominally incurred" where the CFC actually incurs the debt on its own without any guarantee from its U.S. parent, or any other agreement between the U.S. parent and the lender (such as a put agreement or inventory repurchase agreement) which might have the effect of allowing the lender to look to the U.S. parent for repayment of the loan in addition to the CFC.
  • The U.S. parent could consider entering into an agreement with the lender in the nature of a comfort letter, as opposed to a guarantee. The U.S. parent could agree not to change its contracts with the CFC in a way that would be materially adverse to the CFC and could agree to maintain a minimum capital contribution or equity in the CFC. However, if this type of an agreement is to be in lieu of a guarantee, the agreement cannot alter the basic premise that the CFC should be able to succeed or fail on its own without an assurance that the U.S. parent will save it.
  • In circumstances where the lender nonetheless requires that a guarantee be granted by the U.S. parent out of custom or habit, the U.S. parent's tax position will be improved to the extent that it can demonstrate that the CFC is not thinly capitalized and that the CFC would have been able to incur the debt by itself on normal commercial terms (such as debt service, leverage, earnings ratios, etc.).
  • The CFC could consider engaging a third-party business valuator to give an opinion to the U.S. parent on whether the CFC is thinly capitalized and whether there is a reasonable expectation that the business will succeed on its own.

The Plantation Patterns case outlines some factors used by the IRS to determine whether a loan, obtained from a lender that holds a guarantee from a shareholder, would be viewed as debt or equity. These factors are not enumerated in this edited article but are obviously significant and are set out in the unexpurgated text available, without cost or obligation, from us.

As a general caveat, the reader should be aware that the factors identified in the Plantation Patterns case are not equally significant, nor is any single factor determinative. Moreover, due to the myriad factual circumstances under which this question can arise, all of the factors are not relevant to each case. The tests used by the various courts have been less than consistent and clear safe-harbors are not available. Accordingly, there is an element of risk in structuring these loans with any guarantee or credit enhancement provided by the U.S. parent.

Under the Income Tax Act (Canada), interest payable on money borrowed by a CFC to pay a dividend in these circumstances will generally be deductible in computing the CFC's income, provided that the amount borrowed to pay the dividend does not exceed the CFC's retained earnings computed on an unconsolidated basis. To the extent that the amount borrowed exceeds such accumulated profits, the interest referable to the excess amount will not be deductible.

The requirements of Section 965 are complicated and there are technical limits on the amount of any dividend which is eligible for DRD treatment. Also, Section 965 specifies the requirements for investment of the dividend by the U.S. parent in the U.S. in an authorized reinvestment plan. Appropriate consultation should be made with legal and tax advisors in both Canada and the U.S. to ensure that any proposed dividend will be eligible under Section 965 and any related borrowing is properly structured.