June 13, 2019 / 3:27 PM / 2 months ago

US tax change to favor companies over lenders in next downturn

NEW YORK, June 13 (LPC) - Companies that fund their businesses with highly leveraged loans and bonds are set to benefit from changes to the US tax code that will allow them to raise cheap new financing by guaranteeing the debt with foreign assets, although the move could penalize existing lenders.

As well as offering cheaper borrowing costs, the tax change could be a lifeline for distressed companies that allows them to survive the next downturn by accessing new funds backed by foreign collateral at market rates, rather than paying punitive pricing.

The changes could weaken existing lenders’ positions if companies run into trouble, as they could be barred from making direct claims on the revenue generated by foreign assets and subsidiaries.

The Treasury Department and the Internal Revenue Service (IRS) published final regulations to section 956 of the tax code in May that allows US companies to guarantee debt with revenue from foreign entities without incurring US taxes. This has previously been an obstacle to pledging overseas assets and revenue.

“If the borrower has the ability and desire to do their homework…the spectrum of possibilities, especially for corporations, is much larger as to what they can do without incurring tax in the US,” said Elena Romanova, a partner at law firm Latham & Watkins.

Access to new collateral to raise financing in the US$1.2trn loan market to repay debt or fund operations is expected to be cheaper and could even help distressed companies to avoid bankruptcy.

“There is now an open door for qualifying borrowers and lenders who could potentially come to a better economic deal if they can obtain more foreign credit support without incurring US tax,” Romanova said.

Existing lenders could, however, be barred from making direct claims on the revenue generated by foreign entities, which could further reduce recovery rates, which are projected to sink in the next downturn after years of aggressive underwriting and ‘covenant-lite’ lending with little protection, as investors snapped up floating-rate loans to hedge against US interest rate rises.

US loans have historically been backed by US collateral – either revenue generated by a US business or physical assets including units of plants that could be sold in a restructuring to pay back creditors.

Using earnings from foreign businesses to guarantee loans would be a ‘deemed dividend’ for US income tax purposes and previously forced borrowers to pay corporate tax on those assets.

After President Donald Trump signed the Tax Cuts and Jobs Act in 2017, which allowed companies to repatriate revenue from foreign entities without being taxed, the IRS and Treasury sought to bring the 956 rule in line with the changes.

The new regulation allows companies to obtain new financing by securing it with earnings of a foreign subsidiary known as a controlled foreign corporation (CFC) – a foreign corporation with more than 50% of combined voting power held by a US shareholder – and avoid the previous tax burden. The 956 adjustment was finalized in May and is set to take effect on July 22, 2019.


Since the rule was finalized on May 23, borrowers, advisors and lenders have been analyzing their tax arrangements to determine how the changes will affect them, Romanova said.

“Any US taxpayer that is thinking of borrowing money and potentially exploring the possibility of giving a foreign guarantee or foreign collateral needs to do a lot of homework,” she said. “This needs to happen before we see significant changes in the market.”

Several steps must be met to take advantage of the 956 change. Each foreign jurisdiction has its own rules, but the tax change looks likely to be an opportunity for companies.

“There is more flexibility for borrowers going forward,” Chris Housman, EY’s financial services organization international tax leader, said. “Before you wouldn’t want to do that.” (Reporting by Kristen Haunss. Editing by Tessa Walsh and Jon Methven)

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