By Anthony Diosdi
International or cross-border tax arbitrage is the name, frequently given to arrangements designed to produce tax savings through exploitation of differences between the U.S. and foreign tax rules on such matters as determining the source of income and deductions, classification of entities and determining the residence of entities for tax purposes. In the context of direct investment abroad there are many opportunities for such arbitrage. Some of the more significant of these lie in the use of hybrid entities (and particularly hybrid branches), which is facilitated by the check-the-box regulations.
A simple illustration of how cross-border arbitration has taken place in the past can be illustrated as follows: suppose a U.S. corporation owns a smaller than ten percent interest in the voting equity of a foreign joint venture set up in a form of business organization under foreign law that must be treated as a corporation for U.S. tax purposes under the check-the-box regulations. Because the U.S. corporation owns less than ten percent of the voting stock of the foreign corporation, the U.S. corporation would not be entitled to a foreign tax credit for foreign corporate taxes imposed on the joint venture corporation’s income. If, however, the joint venture is organized as a limited liability company or other entity under foreign law that qualifies as an “eligible entity” under the check-the-box regulations, an election can be made to have the joint venture entity characterized as a partnership for U.S. tax purposes. Under this election, the foreign taxes would be credible by the U.S. corporation as a direct foreign tax credit. This was so because a partner was deemed to pay its share of income tax paid by the hybrid entity, which is treated as a partnership for U.S. tax purposes even though it is treated as a corporation for foreign tax purposes.
Using a foreign hybrid entity as the vehicle for a direct investment that is wholly or majority owned by a U.S. corporation was also able to produce tax benefits. These benefits were particularly significant if the investment is made in a high-tax foreign country.
Below, please see Illustration 1 which demonstrates how a foreign hybrid entity was able to produce tax benefits.
USC, a U.S. corporation, owns 100 percent of the equity shares of FC, a limited liability company organized under the laws of Country A. The company is treated as a taxable entity under the laws of Country A. The company is treated as a taxable entity for Country A tax purposes, and its income is taxed at the rate of 40 percent. If USC makes a loan of working capital to FC, FC will typically be entitled to deduct for Country A tax purposes the interest that it pays to USC. But if an election is made under the check-the-box regulations to have FC treated for U.S. tax purposes as a disregarded entity (i.e., a hybrid branch of USC), the interest will not be taxed in the United States because it is simply regarded as an intra-entity transfer within USC. The effect is the foreign tax of FC, but without a correlative income inclusion to USC. A similar benefit can be achieved if the hybrid branch makes other payments to USC that are deductible for Country A tax purposes, such as royalties, rents, and payments for services. See Taxation of International Transactions, West Publishing (2005), Charles H. Gustanfson, Robert J. Peroni, Rihard Crawford Pugh at 13,050.
Significant benefits have also historically been available if the U.S. corporation operates abroad through a wholly owned tax haven foreign base company, which is a controlled foreign corporation (“CFC”) and is the parent of an operating company organized in a second foreign country.
Below, please see Illustration 2 which demonstrates how a U.S. corporation could obtain tax benefits through a CFC organized in a tax haven country (i.e. a country or independent area where taxes are levied at a low rate).
USC, a U.S. corporation, owns all of the stock of FC1, a foreign base company incorporated under the laws of Country A, a tax haven. FC1 is a CFC. FC1, in turn, owns all of the stock of FC2, a company organized as a limited liability company under the tax laws of Country B. FC2 is engaged in the manufacture and sale of widgets in Country B. This manufacturing company is taxed as a corporation in Country B. If an election is made under the check-the-box regulations to have FC2 treated as a disregarded entity (i.e., a hybrid branch) for U.S. tax purposes, payment such as interest and royalties paid by FC2 to FC1 will normally be deductible for Country B tax purposes and will result in a reduction in the Country B corporate income tax payable by FC2. However, these payments would not be treated as subpart F income to FC1 because the payments are regarded simply as intra-entity payments within FC1. See Taxation of International Transactions, West Publishing (2005), Charles H. Gustanfson, Robert J. Peroni, Rihard Crawford Pugh at 13,050.
In both illustrations, a deduction reduces the foreign income tax payable without a correlative income inclusion that can be taxed. In both, the inconsistent treatment of the payments concerned is the result of an election under the check-the-box regulations to have the payor treated as a disregarded entity for U.S. tax purposes although it is treated as a taxable entity for foreign tax purposes. The election gives rise to inconsistent characterizations of FC2 in Country A and Country B that create the tax arbitrage opportunity. The combination of a deduction in the foreign country of the payor and no correlative income inclusion to the payee is sometimes described as a “double dip” transaction.
In the second example, the subpart F regime is being subverted by the election to have FC2, the Country B limited liability company (which is a taxable entity in Country B), treated as a transparent or disregarded entity for U.S. tax purposes with the result that it is treated as a hybrid branch of FC1, the controlled foreign corporation.
Opportunities for tax savings through international tax arbitrage arise when there are inconsistencies between the rules in two countries for determining the residence of corporations. For example, a corporation organized in the United States is treated as a U.S. resident, subject to U.S. tax on its worldwide net income with losses wherever incurred being deductible. Under Section 1501 of the Internal Revenue Code and regulations issued pursuant to Section 1502, a U.S. corporation is permitted to file a consolidated tax return with other U.S. corporations in an affiliated group. An affiliated group consists, broadly speaking, of one or more chains of U.S. corporations connected by stock ownership (excluding certain preferred stock) of at least 80 percent of the vote and value with a common U.S. parent. If two or more U.S. corporations are members of an affiliated group that files a consolidated return, the losses of any one of the group generally may offset or eliminate tax on the income of another member of the group.
For tax purposes, inconsistencies would arise because some other countries use criteria other than place of incorporation to determine whether a corporation is a domestic resident for their tax purposes. For example, countries, such as the United Kingdom and Australia, treat a corporation as a domestic resident if it is managed or controlled there, regardless of where the corporation is incorporated. If a corporation is a resident under this test, it will typically be taxed by the country of residence on its worldwide net income with losses wherever incurred being deductible. If certain conditions are met, these countries allow losses of a resident corporation to reduce or eliminate tax on income of other commonly controlled domestic corporations. See Staff of Joint Comm. on Tax’n, 100’n 100th Cong., 1st Sess., General Explanation of the Tax Reform Act of 1986, at 1063 (1987)
Because of the application of different criteria for determining corporate residence it is possible for a U.S. corporation to incorporate a foreign subsidiary under the laws of a foreign country that determines the residence of a corporation not on the basis that it is incorporated there but on the basis of where the corporation’s management or control is located. If the foreign corporation’s top management is located in the United States but the corporation is not engaged in business operations in the United States, the corporation might be exempt from income tax in the United States and in the country in which it is incorporated. In a sense, the converse is the case in which the management of a U.S. corporation is located in a country, such as the United Kingdom or Australia, that treats it as a domestic corporation because its management is located there. Under these circumstances the corporation has dual residence (i.e., is a dual resident corporation) and will often be subject to the corporate income tax imposed by both the United States and the foreign country concerned.
A dual resident corporation is frequently the U.S. parent corporation of one affiliated group of corporations in the United States and another affiliated group in the foreign country that also treats the group as a taxable resident. Such a dual resident corporation might find opportunities to engage in “double-dipping” with respect to losses and expense items that may be deducted under the tax laws of both the United States and the foreign country concerned.
Absent legislation to prevent “double-dipping,” if a corporation is a resident of both the United States and a foreign country is allowed the loss of the dual resident corporation to offset the income of another foreign corporation (frequently a member of a foreign affiliated group filing a consolidated return), then the dual resident corporation could use any loss it generated twice. The loss could offset income that was subject to U.S. tax but not foreign tax and also offset income subject to foreign tax but not to U.S. tax. It could arise from an operating loss or from interest on loans used to finance other members of the group. In other words, the U.S. corporation could use the same deduction for U.S. and foreign purposes.
To deal with the double-dip international tax arbitrage opportunities for dual resident corporations, Congress enacted Section 1503(d) as part of the 1986 Tax Reform Act (hereinafter “Act”). Internal Revenue Code Section 1503(d)(1) provides that the dual consolidated loss of a dual resident corporation for any tax year cannot reduce the taxable income of any other U.S. member of the affiliated group for that or any other tax year. A dual consolidated loss is defined essentially as a net operating loss of a U.S. corporation that is taxed by a foreign country on its worldwide income or on a residence basis. See IRC Section 1503(d)(2)(A). The Staff of the Joint Committee describes the thrust of Section 1503(d) as follows:
The Act provides that if a U.S. corporation is subject to a foreign country’s tax on worldwide income or on a residence basis as opposed to a source basis, any net operating loss it incurs cannot reduce the taxable income of any other member of a U.S. affiliated group for that or any other taxable year. A company may be subject to foreign tax on a residence basis because its place of effective management is in a foreign country or for other reasons. Where a U.S. corporation is subject to foreign tax on a residence basis, then, under the Act, for U.S. purposes, its loss will be available to offset income of that corporation in other years, but not income of another U.S. corporation. Regulatory authority is provided to exempt a U.S. corporation from this rule to the extent that its losses do not offset the income of foreign corporations for foreign tax purposes.
Congress did not perceive any relevant distinction between a deduction that arises on account of interest expenses and one that arises on account of some other expense, or between a deduction for a payment to a related party and one for a payment to an unrelated party. Therefore, the provisions apply to any dual consolidated loss regardless of the type of deductions that caused it.
The Act’s provisions apply to losses of dual resident companies whether or not any of the income of any foreign corporation that the dual resident corporation’s loss may reduce in the foreign country is or will be subject to U.S. tax. Congress applied this provision to all foreign corporations that could benefit from a dual resident corporation’s net operating loss, whether or not the foreign corporation’s earnings are or will be subject to U.S. tax, for two reasons.
The IRS and Treasury promulgated temporary and final regulations for Section 1503(d). Following the intent of Congress, the regulations state the general principle that a dual consolidated loss cannot offset the taxable income of any U.S. affiliate for the tax year of the loss or any other tax year. The regulations state that the Section 1503(d) limitations are aimed at dual-resident corporations (hereinafter “DRC”). A DRC is a domestic corporation subject to a foreign country’s income tax on either a worldwide or a resident basis. See Treas. Reg. Section 1.1503(d)-1(b)(2). (A DRC also includes foreign insurance corporations treated as U.S. corporations under Section 953(d) that are members of an affiliated group, regardless of whether such a corporation is subject to foreign income tax). A corporation is taxed on a residence basis if it is taxed as a resident under foreign laws. A typical example of a DRC is a U.S. corporation managed and controlled in Bermuda. The fact that a U.S. corporation or foreign entity does not have an actual income tax liability to a foreign country is not taken into account when determining whether it is subject to tax.
The same limitation on loss use applies to a separate unit of a U.S. corporation as if the separate unit were the corporation’s wholly subsidiary. See Treas. Reg. Section 1.1503-2(b)(1). “Separate unit” includes either of the following that is carried on or owned, directly or indirectly (indirect ownership means through a partnership, disregarded entity, or grantor trust, regardless of whether such entities are U.S. persons), by a U.S. corporation (including a DRC): 1) a foreign business operation that, if carried on by a U.S. person, would constitute a foreign branch (foreign-branch separate unit) within the meaning of Temp. Regs. Section 1.367(a)6T(g)(1) or (2) an interest in a hybrid entity (hybrid-entity separate unit) under Regs. Section 1.1503(d)-1(b)(4)(i). A hybrid entity is an entity that is not taxable for U.S. tax purposes but is subject to a foreign country’s income tax at the entity level on its worldwide income or on a residence basis. If a U.S. corporation that is not a DRC is considered to directly carry on or own a foreign branch, as defined in Temp. Reg. Section 1.367(a)6T(g)(1), such business operation will not be characterized as a foreign branch separate unit, provided the business operation is not treated as a permanent establishment under a U.S. income tax treaty or is not otherwise subject to tax on a net basis under the treaty. See Treas. Reg. Section 1.1503(d)-1(b)(4)(iii). If the U.S. corporation carries on such business operation through a hybrid entity or a transparent entity, the operation will constitute a foreign branch separate unit.
Once the existence of a DRC or separate unit of a U.S. corporation is established, the next step is to determine whether the DRC or separate unit occurred a dual consolidated loss. A DCL is generally defined as a Section 172(c) Net Operating Loss (“NOL”) incurred in a year in which the entity is a DRC. See Treas. Regs. Section 1.1503(d)-1(b)(5)(i). To determine if the DRC has income or an NOL, only items of income, gain, deduction, or loss incurred by the DRC in the current year will be taken into account. Under Treas. Reg. Section 1.1503(d) 5(b)(2), items that will not be taken into account include 1) the DRC’s net capital losses; 2) carryover or carryback losses; and 3) items of income, gain, deduction, and loss attributable to a separate unit or a transparent entity of the DRC. If a DRC is a member of an affiliated group, the determination of whether it has income or a DCL will be made under Section 1502; the treatment of items for foreign tax purposes is irrelevant. See Treas. Reg. Section 1.1503(d)-5(d).
A DRC may offset U.S. income with a DCL if the DCL makes a domestic use election under Treasury Regulation Section 1.1503(d)-6(d) and the taxpayer certifies that there has not been, and will not be, a foreign use of the DCL during a certification period. The certification period is defined in Treasury Regulation Section 1.1503(s)-1(b)(20) as the five-year period following the year the DCL was incurred. Under Treasury Regulation Section 1.1503(d)-3, foreign use occurs when a DCL is made under foreign income tax laws to offset income that U.S. tax principles consider to be income of a foreign corporation or hybrid entity owner. An elector must file a domestic-use agreement by the due date (including extensions) of the elector’s U.S. income tax return for the tax year in which the DCL is incurred. Such agreement must follow the format and include the required information stated in Treas. Regulation Section 1.1503(d)-6(d)(1). The elector must also file a certification, labeled “Certification of Dual Consolidated Loss” at the top page of the tax return, by the due date (including extensions) of its income tax return for each year during the five-year certification period. See The Tax Adviser, Final Regulations on Dual Consolidated Losses: A Practical Guide (Part 1), August 31, 2007, by Karen Jabobs; Peg O’Connor; and Margie Rollinson.
The regulations also contain a “Mirror legislative rule.” The mirror legislation rules in Treasury Regulation Section 1.1503(d)-3(e) prevent a domestic use election when a foreign jurisdiction has legislation like Section 1503(d) preventing foreign use of the DCL. This is determined by assuming that such foreign country had recognized the DCL in such a year. A foreign use is deemed to occur if:
1) the income tax laws of a foreign country deny any opportunity for foreign use of the DCL because the DRC or separate unit is subject to tax in another country;
2) The DCL can offset income under the laws of another country; or
3) The deductibility of a DCL input depends on another country’s laws.
Mirror legislation prevents domestic or foreign use of the DCL, leaving it stranded. If that happens, Treasury Regulation Section 1.1503(d)-6(b) provides another exception to the DCL domestic use limitation.The intent of the rule is to prevent the foreign country from enacting a law that would give a taxpayer the sole option of using dual consolidated loss to offset U.S. income.
On April 18, 2007, the IRS and Treasury issued new regulations applicable to DCLs in tax years beginning on or after April 18, 2007.
Under these 2007 rules, domestic reverse hybrids have been used to obtain double deduction outcomes because they were not subject to limitation under the regulation promulgated under Internal Revenue Code Section 1503(d). A domestic reverse hybrid is basically a U.S. entity that elects under Treasury Regulation Section 301.7701-3(c) to be treated as a corporation for U.S. tax purposes but a passthrough entity or fiscally transparent under the tax laws of a foreign country. In 2007, the IRS concluded that it would not or could not apply the DCL rules to domestic reverse hybrids, because such structures involved neither a dual resident corporation nor a separate unit of another domestic corporation.
Foreign corporations typically owned the majority of the domestic reverse hybrids. Under the 2007 regulations, a reverse hybrid structure could lead to double deduction outcomes. A domestic reverse hybrid structure typically involves a U.S. limited partnership that checks the box to be treated as a corporation solely for U.S. tax purposes. Such a structure could permit a foreign partner to access deductions while avoiding additional U.S. tax by generating deductions to offset other payments made to a lower-tier disregarded entity. Taxpayers and their representatives do not believe that the regulations under Internal Revenue Code Section 1503(d) apply to these structures because the domestic reverse hybrid is not a DRC (because it is not subject to tax on a residence basis or on its worldwide income in the foreign parent country), and is not a separate unit of a domestic corporation.
The New DCL Regulations
The 2018 Tax Cuts and Jobs Act provided changes to the tax laws governing hybrid instruments. The IRS and Treasury also recently issued new proposed hybrid regulations under Internal Revenue Code Sections 1503(d) and 7701 to curb double deductions. In order to do so, the definition of DCL in Treasury Regulation Section 1.1503(d)-1(b)(2) has been broadened to include a “domestic consenting corporation.” This term is defined in Treasury Regulation Section 301.7701-3(c)(3)(i) or as an entity that has elected to be taxed as a corporation.
Prop Reg. Section 1.1503(d)-1(c) states that a domestic consenting corporation is treated as a DRC if both requirements are satisfied:
1. Under the tax laws of a foreign country where a “specified foreign tax resident” resides, the specified foreign tax resident derives items of income or loss of the domestic consenting corporation because, for example, the domestic consenting corporation is fiscally transparent under foreign tax law; and
2. The specified foreign tax resident bears a relationship to the domestic consenting corporation that is described in Section 267(b) or Section 707(b) (that is to say, direct or attributed ownership or more than 50 percent of value).
Concerning a domestic corporation, fiscal transparency is determined under Reg. Section 1.894-1(d)(3)(ii) and (iii)(relating to income affected by treaty), regardless of whether a specified foreign resident is a resident of a country that has a tax treaty with the United States. Under these rules, “fiscally transparent” basically means that the domestic consenting entity’s tax items flow through to its owners under the laws of the entity’s or the interest holder’s jurisdiction.
A specified foreign tax resident is a corporate body or other entity or body of persons liable as a resident to tax under the tax law of a foreign country.
If a domestic entity has elected to be treated as a corporation before December 20, 2018, the entity is deemed to consent to be treated as a DCR for its first tax year beginning after the end of a 12-month transition period. Deemed consent can be avoided, however, if the entity elects to be treated as a partnership or disregarded entity before then.
The proposed regulations to Sections 1503(d) and 7701 require that a reverse hybrid that is being treated as a corporation for U.S. tax purposes consent to being treated as a dual-resident for purposes of Internal Revenue Code Section 1503(d). The new proposed regulations also discuss a structure in which a parent corporation borrows from a third party lender and contributes the proceeds to a wholly owned consolidated subsidiary may be disregarded for tax purposes.
The new proposed regulations resolve the domestic reverse hybrid structure problems by treating these entities as DRC if they have elected to be treated as corporations in the U.S. and are transparent in their home jurisdictions. However, a number of international tax arbitrage issues remain that the DCL proposed regulations did not address. For example, the new proposed regulations do not address payments to domestic corporations that are regarded for foreign tax purposes, but disregarded for U.S. tax purposes. This is one issue that is saved for another day and another article.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.