By Brian Abbey, Managing Director, International Tax Services
COVID-19, more commonly known as the coronavirus, has prompted the U.S. to take unprecedented actions to mitigate its spread. Not surprisingly, most economists are now forecasting a significant economic slowdown and recession. While U.S. corporate balance sheets are healthy and the Federal Reserve has announced efforts to provide liquidity to U.S. companies, cash needs will certainly increase. Repatriating cash through dividends is no doubt easier now than in the financial crisis of 2008-2009; however, now is the time for tax departments to get organized around returning cash to the U.S. through dividends or other means.
What is cash repatriation? Cash repatriation refers to methods used by U.S. multinationals to return cash from their foreign operations to the U.S. These methods include dividends, payment of intercompany loans, and loans to the U.S. group.
Payment of Intercompany Loans
The easiest way to return cash to the U.S. is for the U.S. to ask for prepayment of intercompany loan principal. However, this prepayment may come with Section 988 consequences that are not favorable. Also, the entity with the payable may not have cash available to pay the loan – presumably that was one of the reasons the loan was made in the first place. In addition, changing interest rates can affect loan values in the event of prepayment, triggering possible penalties between the parties.
An intercompany loan is another expedient way to return cash to the U.S. In the event that such a loan exceeds a CFC’s previously taxed earnings and profits (“PTEP”), the final 956 regulations issued in 2019 provide that the Section 956 investment is reduced to the extent a Section 245A dividends received deduction would have been available had the untaxed earnings been repatriated as a dividend. This change to Section 956 is welcome to taxpayers, but taxpayers should make sure that Section 245A would apply in the case of a hypothetical dividend to ensure that there isn’t an unforeseen tax liability on a Section 956 investment.
Some other things to consider in the case of a loan are the functional currency and interest rate. Companies do not want to incur unnecessary foreign exchange exposure for book or tax purposes. Therefore, consideration should be given to the currency considering the overall hedging posture of the company. If the U.S. dollar is used, it may be possible to use the safe harbor AFR interest rate under Treas. Reg. 1.482-2. This safe harbor alone has its own considerations under the European Union’s Mandatory Disclosure Rules such that reporting the use of a safe harbor rate will be necessary in the lender’s jurisdiction.
As a result of Section 965 and the constant inclusions under GILTI, most U.S. companies have a large amount of Previously Taxed Earnings and Profits (“PTEP”) sitting offshore. Consequently, now is the time to make sure PTEP is organized into the appropriate categories. In Notice 2019-1, the IRS provided 16 PTEP categories. The number of categories was reduced to 10 in the final Section 960 regulations. Although the Section 959 regulations that are intended to derive from the notice have not been issued, it is likely that they will follow the Section 960 regulations and have 10 categories as well. Whether 16 or 10 categories, organizing this PTEP is still a heavy lift, and making sure that the PTEP is up to date is important to correctly apply Section 986(c). As a reminder, Section 965 PTEP is deemed repatriated first then PTEP is distributed on a LIFO basis, pro rata among PTEP categories. To account for these variables, a model should be set up if one is not already to quickly estimate Section 986(c).
In the event that all the PTEP is distributed, dividends of untaxed earnings and profits (“E&P”) from a CFC will be eligible for Section 245A, provided that the holding period and other requirements are met. However, hybrid dividends (e.g., notional interest deductions, yield on Lux PECs/CPECs) are not eligible for 245A under Section 245A(e). Through regulations, Treasury and the IRS have expanded the hybrid dividend concept to hybrids between CFCs that could cause the receipt of a dividend by a CFC to result in subpart F income. See Prop. Reg. § 1.245A(e)-1. The mechanics of this provision will not be discussed here; however, if there are hybrids in the structure these regulations need evaluated.
Another Section 245A anti-abuse rule to consider has to do with gap year GILTI planning called an extraordinary disposition transaction. Generally, an extraordinary disposition transaction was a related party transaction outside of normal business operations completed by fiscal-year CFCs. These transactions created E&P that was not part of Section 965 and was earned before the respective CFCs were subject to GILTI. Temporary Section 245A regulations provide that only 50% of this untaxed E&P is eligible for Section 245A when paid to the U.S. Additionally, only 50% is eligible for Section 954(c)(6) if paid between CFCs.
If companies have cash in excess of the above, they should start thinking about CFC stock basis, especially if there is some doubt about the results of the Section 965 basis adjustment election. This way companies can gauge how much room they have to make additional tax-free distributions and to support basis in the event their financial statement auditors ask.
In prioritizing the above, taxpayers should start with the PTEP categories and then fully assess whether any of the Section 245A anti-abuse rules will apply.
For 2019, companies may have asserted that they were fully or partially permanently reinvested. Clearly, returning cash to the U.S. can jeopardize that assertion. Companies will need to consider their APB 23 policy and revise it accordingly.
As mentioned, the Federal Reserve and U.S. government are prepared to take significant action to assist the economy as it slows down. U.S. corporate balance sheets are also generally in good shape. However, the coronavirus is unprecedented and the full economic impact hard to predict. U.S. multinationals should start preparing now to answer the call from their CFO asking for foreign cash.
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