Foreign subsidiary loan guarantees
Pledging a foreign subsidiary's assets to guarantee repayment of a loan to the parent company triggered income taxes.
The Susquehanna International Group, a quantitative trading firm, borrowed $1.5 billion from Merrill Lynch in 2007. Merrill Lynch insisted that the loan be guaranteed by more than 30 affiliated companies, including two offshore companies that were subsidiaries of SIH Partners LLLP, a partnership that was another affiliated entity.
The two offshore companies were considered “controlled foreign corporations” for US tax purposes, meaning that they were owned more than 50% by vote or value by US shareholders.
Before 2018, the United States did not tax US shareholders on the earnings of their offshore subsidiaries until the earnings were repatriated, but there were exceptions. One exception was it would look through the offshore subsidiary and tax any dividends, interest or other passive income received by the offshore subsidiary without waiting for it to be repatriated. Another exception was it would treat earnings parked in the subsidiary as having been repatriated if the subsidiary guaranteed repayment of a loan to a US affiliate.
Merrill Lynch insisted that the two offshore companies had to be included in the group of subsidiaries guaranteeing repayment in order to “ring fence” the transaction by preventing US subsidiaries from shifting assets overseas to move them outside the pool of assets securing repayment of the loan.
The two offshore companies paid actual dividends to the SIH partnership that owned them in 2011. However, on audit, the IRS determined that their entire earnings should have been treated as distributed to the partnership in 2007 when the two companies guaranteed repayment of the loan.
This led to a back tax bill of $378.3 million.
To add insult to injury, the IRS said the earnings had to be taxed at the full 35% corporate tax rate rather than the lower 15% rate in effect at the time for “qualified dividend income” on grounds that the repatriated earnings were not actual dividends.
The SIH partnership lost in both the US Tax Court and on appeal.
The case is SIH Partners LLLP v. Commissioner. The US appeals court released its decision in May.
The case is a reminder for US companies with earnings parked in offshore subsidiaries to exercise caution before doing anything that might be considered a use of the earnings in the United States. Any investment of the earnings in the United States may be considered a deemed repatriation. An asset pledge to secure repayment of a loan to a US company is considered such an investment.
The rules in this area have become more complicated since the US tax reforms in late 2017. The US has moved part way to a territorial tax system where US corporations are taxed only on income from US sources. An asset pledge by a foreign subsidiary to guarantee repayment of a loan to a US parent corporation is generally no longer a concern. However, some vestiges of the old regime remain as potential traps.