VEDDERPRICE ® Finance and Transactions Group October 2008 The Practical Lender Cross-Border Lending Introduction IRC § 956-The “Deemed subsidiary’s current and accumulated earnings and Globalization of business has Dividend Rule” profi ts are less than the amount accelerated. In order to remain Under Internal Revenue Code of the U.S. obligation, then all competitive, lenders must be (“IRC”) § 956, the obligation of a of the foreign subsidiary’s prepared to structure U.S. corporate parent to a future earnings and profi ts will transactions with cross-border lender will trigger a “deemed be subject to the deemed lending features—loans to dividend” of the controlled distribution up to the amount of foreign borrowers or loans foreign subsidiary’s current and the U.S. loan obligation (after against the value of foreign accumulated earnings and subtracting prior deemed borrowers’ assets. Cross- profi ts up to the amount of the distributions). border lending requires lenders U.S. loan obligation if any one Borrowers and lenders often to address issues related to of the following three events assume that a U.S. parent taxes, security and available occurs: (a) 66⅔ percent or cannot pledge the stock of a remedies. This article briefl y more of the foreign subsidiary’s foreign subsidiary and that a discusses these issues and outstanding voting stock is foreign subsidiary cannot focuses on the laws of Canada pledged to the U.S. parent’s guarantee or pledge its assets and Mexico relative to security lender (accompanied by certain in support of the loan to the and insolvency. Practical tips restrictions on the disposition of U.S. parent because of the tax are denoted in bold. the foreign subsidiary’s assets); consequences outlined above. (b) the foreign subsidiary is a Tax Issues However, there are many guarantor with respect to the situations in which the Two tax issues that must be loan made to the U.S. parent; or application of IRC § 956 has no addressed in every cross- (c) the foreign subsidiary grants material adverse impact on the border transaction are: (1) the a security interest in its assets borrower including: (a) the U.S. “deemed dividend” rule; to secure the loan to the U.S. foreign subsidiary has no and (2) the foreign jurisdiction’s parent. accumulated earnings and withholding tax rules. Usually If a deemed distribution is profi ts and is not expected to the deemed dividend issue triggered, all of the foreign have any in the future, or the comes to the forefront when a subsidiary’s current and foreign subsidiary historically borrower informs a lender that accumulated earnings and repatriates its income to the it can only take a pledge of less profi ts are immediately subject U.S.; (b) the consolidated tax than 2/3 of a controlled foreign to U.S. income tax, up to the group has operating losses that subsidiary’s stock. amount of the U.S. loan reduce or eliminate the deemed obligation. If the foreign distribution; (c) the IRC already VEDDERPRICE requires inclusion of the foreign dividends) paid by a resident of borrower to compensate the subsidiary’s earnings and the foreign jurisdiction to a lender for any withholding tax profi ts in the U.S. parent’s nonresident. Thus, a U.S. imposed by a foreign income prior to repatriation for lender that contemplates jurisdiction. As a result of other reasons; (d) U.S. tax making a loan to a foreign withholding taxes, a local credits for taxes paid by the borrower must consider lending source in the foreign subsidiary in the foreign whether the laws of the jurisdiction of the foreign jurisdiction may largely offset foreign jurisdiction will subsidiary may be necessary. the U.S. tax liability from the require that a portion of its Tax rules, in addition to the deemed dividend; and (e) the interest payment be withheld deemed dividend and foreign entity is treated like a and paid to a foreign taxing withholding tax rules, may partnership for U.S. tax authority. The amount of apply to a transaction and may purposes. withholding tax imposed may have an effect upon the loan Thus, the application of IRC be reduced or eliminated by structure. The lender will need § 956 may not have a material treaty between the jurisdictions to consider tax rules in the U.S. adverse impact, depending on or by other legislation. An and in the foreign jurisdiction. the circumstances. The lender amendment to the Canada-U.S. should require the borrower treaty was signed on Collateral Security to provide an analysis of the September 21, 2007, which, Many countries do not have a impact of IRC § 956 before when ratifi ed by both countries, uniform procedure for taking a deciding that it cannot obtain will eliminate withholding tax on security interest in tangible and a pledge of the equity most non-related party interest. intangible assets sought by interests in, or a guaranty or In addition, Canada has secured lenders, such as the asset pledge from, a foreign enacted independent legislation Uniform Commercial Code (the subsidiary. In situations where that has eliminated withholding “UCC”) in the U.S. and the IRC § 956 does have a material tax on most non-related party Personal Property Security Act adverse impact, other payments of interest on or after (the “PPSA”) in Canada (or structuring alternatives will January 1, 2008. Thus, with pursuant to the Civil Code of need to be considered. For certain exceptions, after Quebec (the “CCQ”) in the example, the lender’s affi liate January 1, 2008, U.S. lenders Province of Quebec). Instead, organized in a foreign are able to make cross-border security in many countries is jurisdiction may be able to loan loans to Canadian borrowers dictated by multiple statutory directly to a subsidiary without the imposition of a schemes and common law, organized in that jurisdiction withholding tax on interest which are sometimes and close any collateral payments. The treaty between overlapping and contradictory. defi ciencies by obtaining the U.S. and Mexico limits the The lack of a unifi ed scheme collateral from subsidiaries withholding tax on interest paid for taking security often deters located in other foreign by a resident of Mexico to a U.S. lenders from making loans jurisdictions. resident bank of the U.S. to 4.9 to foreign borrowers or against percent. foreign assets located in those Most lenders consider any Withholding Tax Issues jurisdictions. withholding tax liability to be the In the U.S., lenders are Many foreign jurisdictions responsibility of the borrower. accustomed to being able to impose a withholding tax on As a result, most loan take a blanket or fl oating lien certain income (e.g., interest, agreements contain a “gross- over the current and future management and up” clause, which requires the administration fees and assets of its borrower to secure 2 The Practical Lender Q October 2008 current or future debt. This is location of the debtor. The personal property security not the case in some foreign location of the debtor, within system is set forth in the CCQ. jurisdictions. In some countries, the meaning of the UCC, will In Quebec, the hypothec allows the lender may be able to take a differ depending on the type of a lender to obtain a charge on pledge only over specifi cally debtor and the laws of the current and future movable or described existing assets and jurisdiction in which the debtor immovable property, and allows may not take a lien on any after- is located. UCC § 9-301(1) for registration of security under acquired property. In other does not change depending the Register of Personal and countries, the lender may be upon the location of the Movable Real Rights able to take a lien over after- collateral. However, it would (“RPMRR”). Thus, in Canada, acquired property, but not with be a mistake for a lender to lenders may obtain a fl oating ease (e.g., the account debtors rely on UCC § 9-301(1) as lien over accounts, inventory must be specifi cally identifi ed granting it the rights the lender and other assets. With certain and notifi ed of the lien). The U. needs against a foreign exceptions, a lien is perfected, S. lender’s inability to take a borrower or in collateral in a PPSA jurisdiction, by fi ling blanket lien over current and located in or arising from a a fi nancing statement in the future assets to secure current foreign jurisdiction. The UCC personal property security and future indebtedness often will not supply the law registry in the applicable impedes a U.S. lender’s ability to determine the perfection province or territory and, in to make asset-based loans in and/or priority of the U.S. Quebec, by fi ling a registration those jurisdictions. lender’s lien with respect to with the RPMRR. Like the There is large variation from a foreign borrower or for UCC, the PPSA allows a lender country to country in the scope collateral located in or to pre-fi le, but the CCQ does of assets that may be covered arising from a foreign not; under the CCQ, an by a lien, whether after-acquired jurisdiction. executed security agreement or property may be covered by a hypothec is needed to fi le. lien, the priority of creditors that Collateral Availability Both the PPSA and CCQ may be repaid ahead of a permit a lender to obtain The following is a brief lender’s lien and the procedures security in deposit accounts. description of collateral relating to the realization on the Unlike the UCC, the PPSA and availability in Canada and lender’s collateral.