When U.S.-based companies want to lower their financing costs, they can borrow against the assets of their foreign subsidiaries. But only to a point. Under the Internal Revenue Service's safe-harbor rules, companies can generally pledge up to 65 percent of the capital stock of their foreign subsidiaries as collateral. Anything more triggers a tax on the subsidiaries' earnings, which are regarded as so-called deemed dividends.

Can companies use their foreign subsidiaries to provide more credit support without incurring the IRS's wrath? One U.S. multinational believes it has found a way. Last July, chemical giant Huntsman Corp., which derives some 40 percent of its EBITDA from abroad, used intercompany unsecured loans from its domestic finance subsidiary to its foreign subs to help obtain a $2.6 billion financing (see "Anatomy of a Deal" at the end of this article). Intercompany notes in exchange for the loans supplemented the stock pledged by the foreign subs as collateral.

Such an arrangement provides "better collateral protection than otherwise would have been available, resulting in higher projected recovery value" in case of default, wrote Thomas Mowat, an analyst for Standard & Poor's, in a December 2005 report. Standard & Poor's gave Huntsman's $2.6 billion senior secured facility a BB- rating, with a recovery rating of 2.

If the Huntsman transaction is approved by the IRS, or survives a challenge by the agency, other U.S. multinationals can be expected to follow suit. The more they depend on foreign assets for revenues and profits, after all, the more their borrowing depends on those assets. The big question "is whether lenders will be satisfied" by arrangements that stop short of full foreign collateral, notes Lehman Brothers tax and accounting expert Robert Willens.

At this point the answer is unclear, as there's little indication of how much less banks charge on financing collateralized in this way. (Huntsman failed to respond to a request for an interview, as did Citigroup, the U.S. bank considered the most global in scope.) Mowat tells CFO that "there is not enough data" to answer the question, but he notes that S&P is "beginning to see an impact on pricing" when the rating agency is reassured on recovery rates, as it was in this case.

Shallow Harbor?
Of course, such questions could prove academic if the IRS seeks to curtail any trend stemming from the Huntsman transaction. The agency could very well argue that such intercompany loans are substantively no different from an indirect guarantee, says Jasper Cummings, a tax attorney in the Raleigh, North Carolina, office of Alston & Bird LLP and a former IRS chief counsel. Such guarantees violate rules the IRS promulgated in 1980 and 1984 to prevent companies from getting around its original position that the use of foreign collateral to back borrowing by U.S. taxpayers is taxable. (An IRS spokeswoman failed to respond to a request for comment on the Huntsman transaction.)

Those rules reflect a decades-old attempt by the IRS to prevent wealthy industrialist Daniel Ludwig from avoiding tax by using assets outside the country as collateral for loans made to him in the United States. After the U.S. Tax Court ruled in favor of Ludwig in 1977, the IRS carved out a safe harbor limiting such pledges of collateral to no more than 65 percent of the voting rights. While the Huntsman transaction does not exceed that percentage of the voting rights of its foreign subsidiaries' assets, it also pledges all of those of its domestic subsidiary's.

Huntsman is by no means the only corporate taxpayer to test the limits of the IRS rules in this area. Enron Corp., for one, came up with a typically complex arrangement involving dual classes of voting rights that allowed the energy-trading company not only to avoid tax on pledges of foreign collateral and deduct the interest on bank loans it backed, but also to deduct interest on a $750 million loan it made to itself. And while that arrangement, which Enron dubbed Apache, was the subject of congressional hearings in 2003 after accounting fraud led to the company's failure, legislators noted that the arrangement did not expressly violate IRS rules. So the agency tightened those rules to prevent companies from doing the same thing in the future.

All this leads some critics to suggest that Congress should come up with an entirely new system for taxing multinationals. "The deemed dividend approach leads to considerable complexity and planning opportunities," Reuven S. Avi-Yonah, a law professor at the University of Michigan, noted in a recent paper. "Instead of trying to close these loopholes one by one," wrote Avi-Yonah, "Congress should substitute direct taxation."

Somewhat Aggressive
That's unlikely to happen anytime soon. So companies that want to follow in Huntsman's footsteps have to hope the IRS will go along on a case-by-case basis, or that they, like Ludwig, can best the agency in tax court. Whether this particular transaction can do that, however, remains to be seen.

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