The Tax Cuts and Jobs Act introduced two Internal Revenue Code provisions targeting “hybrid arrangements.” The provisions include Section 267A and 245A(e) of the Internal Revenue Code. This article discusses how Section 267A and Section 245A(e) operate. Section 267A disallows U.S. deductions for interest or royalties paid to related parties if the payment results in a “deduction/no-inclusion” (D/NI) outcome due to hybrid transactions or entities. These rules, largely align with OECD BEPS Action 2 which prevent multinational companies from exploiting differences in tax laws between countries to avoid tax, particularly when a payment is deductible in the United States, but is not taxed in the recipient’s country.
Internal Revenue 245A(e), which denies a dividend received deduction under Section 245A with respect to hybrid dividends. By way of background, Section 245A(a) states that a US corporation is permitted a deduction equal to the foreign source portion of any dividend received from a specified 10-percent owned foreign corporation if the US corporation is a US shareholder with respect to such foreign corporation (participation exemption). Section 245A(d) disallows Section 245A(a) participation exemption to any dividend from a controlled foreign corporation (“CFC”) if the dividend is a hybrid dividend. A hybrid dividend is the amount received from a CFC for which (1) a deduction would be allowed under Section 245A(a) but this subsection, and (2) the CFC received a deduction (or other tax benefit) with respect to any income, war profits, or excess profits taxes imposed by any foreign country or possession of the United States.
Section 267A Overview
Internal Revenue Code Section 267A disallows a deduction for interest and royalties paid to a related party in connection with certain hybrid arrangements. For purposes of Section 267A, a related party is defined as a related person under Section 954(d)(3), modified to apply to the person making the payment. This term is also used in other places in the Internal Revenue Code, such as the passive foreign investment company provisions. An individual, corporation, partnership, trust or estate that controls or is controlled by a CFC is a “related person” with respect to CFCs. In addition, a corporation, partnership, trust or estate that is controlled by the same persons or persons that control a CFC is a “related person” with respect to the CFC.
For the purposes of this definition of related person, control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation. In the case of a partnership, trust or estate, control means direct or indirect ownership of more than 50 percent (by value) of the beneficial interests in the partnership, trust or estate. In measuring ownership for purposes of applying this definition, rules similar to the indirect and constructive ownership rules in Section 958.
Section 267A regulations provide the “exclusive circumstances in which a deduction is disallowed.” See Treas. Reg. Section 1.267A-1(b). First, the Section 267A deduction disallowance applies to “specified parties” only. See Treas. Reg. Section 1.267A-1(b). A “specified party” is defined as any one of the following: a “tax resident” of the United States; a controlled foreign corporation (unless it has no U.S. shareholder that owns, within the meaning of Section 958(a), at least 10 percent of its stock (by vote or value)); or a U.S. taxable branch.” Treas. Reg. Section 1.267A-5(a)(17).
A specified party’s deduction for interest or royalty, paid or accrued, is disallowed under Section 267A if it qualifies as a “specified payment.” A “specified payment” is the amount paid or accrued with respect to the specified party. The Section 267A regulations describe three types of “specified payments:” 1) a “disqualified hybrid amount;” 2) a “disqualified import mismatch amount;” and 3) payments that satisfy the requirements of Section 267A anti-avoidance rule. See Treas. Reg. Section 1.267A-2 and Treas. Reg. Section 1.267A-5(b)(6).
1. Disqualified Hybrid Amount.
A disqualified hybrid amount under Section 267A regulations is an interest or royalty payment made to a related party that is disqualified as a deduction because it creates a “deduction-inclusion” (D/NI) outcome. A D/NI outcome is a type of hybrid mismatch in international taxation where a payment is deductible by the payer in one jurisdiction but not included as taxable income by the recipient in their jurisdiction. Several provisions of the 2018 Proposed Regulations addressed long-term deferral, which resulted when there was deferral beyond a taxable period ending more than 36 months after the end of the specified party’s taxable year. In addition, the 2018 Proposed Regulations deemed a specified payment made pursuant to a hybrid transaction if differences between the U.S. tax law and the tax law on a specified recipient of the payment resulted in more than a 36-month deferral between the time the deduction would be allowed under U.S. tax law and the time the payment was taken into account in income under the specified recipient’s tax law. Finally, under the Proposed Regulations, a D/NI outcome is considered to occur with respect to a specified payment if under a relevant foreign tax law the payment is not included in income within the 36 month period. With certain modifications, the Section 267A regulations maintain the long-term deferral provisions contained in the Proposed Regulations.
2. Disqualified Imported Mismatch Amount
A disqualified imported mismatch amount under Section 267A is a payment to a foreign related party that is disallowed as a deduction because it directly or indirectly funds a “hybrid deduction” in a foreign country, effectively importing an offshore tax benefit into the U.S. A specified payment is a “disqualified imported mismatch amount” to the extent that the income attributable to the payment is directly or indirectly offset by a “hybrid deduction” that is incurred by a taxable person that is related to the specified party. Treas. Reg. Section 1.267A-4(b). Generally, a hybrid deduction is an amount for which a foreign tax resident or taxable branch is allowed an interest or royalty deduction under the tax laws of its jurisdiction of residence to the extent the deduction would be disallowed if that tax law contained rules substantially similar to those in the Regulations under Section 267A. The Section 267A regulations provide a list of deductions that constitute hybrid deductions for a tax resident if its jurisdiction of residence applies its own hybrid mismatch rules. See Treas. Reg. Section 1.267A-4(b)(2)(i). In addition, the regulations under Section 267 provides a list of deductions that would be disallowed under Section 267A, but may be allowed under the hybrid mismatch rules of the relevant foreign jurisdiction. These deductions include deductions with respect to 1) equity; 2) interest-free loans; and 3) amounts that are not included in the third foreign country. See Treas. Reg. Section 1.267A-4(b)(2)(i). Thus, if a tax resident is from a jurisdiction that contains hybrid mismatch rules, the tax resident will only need to consider the aforementioned deductions.
3. Anti-Avoidance Rule
The Section 267A anti-avoidance rule disallows a specified party’s deduction for a specified payment deduction for a specified payment to the extent that the payment satisfied the following test:
1) The payment (or income attributable to the payment) is not included in the income of a tax resident or taxable branch under Treasury Regulation Section 1.267A-3(a); and
2) “A principal purpose of the terms or structure of the arrangement (including the form and tax laws of the parties to the arrangement) is to avoid the application of the regulations in this part under Section 267A in a manner that is contrary to the purpose of Section 267A and the regulations in this part under Section 267A.” Treas. Reg. Section 1.267A-5(b)(6)(ii).
Under the first element of the above discussed test, Treasury Regulation Section 1.267A-3(a) provides the conditions for when a tax resident or taxable branch is treated as including a specified payment in income for the purposes of Section 267A. If a specified party makes a payment to a tax resident or taxable branch and the payment is not treated as included in income under Treasury Regulation 1.267A-3(a), that specified payment meets the first element of the anti-avoidance test. If that payment was structured or arranged with a principal purpose to avoid Section 267A, a corresponding U.S. deduction is permitted subject to the second element of the test discussed below.
Under the second element of the test, a specified payment is not included in income for purposes of Treasury Regulation Section 1.267A-3(a) if the payment is reduced or otherwise offset by “an exemption, exclusion, deduction, credit (other than for withholding tax imposed on the payment), or other similar relief particular to such type of payment.” Treas. Reg. Section 1.267A-3(a)(1)(ii). The regulations provide examples of reductions or offsets as follows: 1) participation exemption; 2) a dividends received deduction; 3) a deduction or exclusion with respect to a particular category of income (such as income attributable to a branch, or royalties under a patent box regime); 4) a credit for underlying taxes paid by a corporation for which a dividend is received; and 5) a recovery of basis with respect to stock or a recovery of principal with respect to indebtedness. Treas. Reg. Section 1.267A-3(a)(1)(ii). In addition, a payment will not be treated as a reduction or offset by a “generally applicable deduction or other tax attribute, such as a deduction for depreciation or a net operating loss. Treas. Reg. Section 1.267A-3(a)(1)(ii).
The Section 267A regulations state that a taxpayer must have “a principal purpose” in arranging or structuring the specified payment for purposes of avoidance of the application of Section 267A and its regulations in a manner contrary to their underlying purpose. See Treas. Reg. Section 1.267A-5(b)(6)(ii).
In addition to above discussed rules, the following might be covered under Section 267A:
1. Sale/repo transactions.The regulations under Section 267A that apply to repo transactions (include those defined in Treasury Regulation Section 1.861-2(a)(7) in which legal title to property is transferred and then reacquired, particularly when the transaction is treated as debt (interest) for U.S. tax purposes but not for foreign tax law purposes. According to Treasury Regulation Section 1.267A-5, a structured payment, such as substitute interest payment in a repo transaction, is treated as interest subject to Section 267A.
2. Interest-free loans. While the OECD generally does not disallow deductions for imputed interest on interest-free loans, Section 267A regulations are more restrictive.
3. Notional interest deductions. In order to understand the term “notional interest deductions,” it is necessary to definite the term “notional principal contractS” that could give rise to notional interest deductions. Treasury Regulation Section 1.446-3(c)(1)(i) and 1.863-7(a)(1) define a “notional principal contract” as a financial instrument providing “for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal contract amount in exchange for specified consideration or a promise to pay similar amounts.” Interest rate swaps, currency swaps, interest rate caps, interest rate floors and other similar agreements are notional principal contracts under this definition. Treas. Reg. Section 1.446-3(c)(1)(i). For example, suppose that DC, a US corporation, entered into an interest rate swap contract with FC, an unrelated foreign corporation. Under the contract, DC must pay FC fixed rate dollar amounts, and FC must pay DC floating rate dollar amounts, each of which is determined solely by reference to a notional dollar denominated principal that is specified in the contract. This contract constitutes a notional principal contract. See Treas. Reg. Section 1.863-7(d), Ex. Notional interest deduction is a tax incentive allowing companies to deduct a deemed notional interest expense on new equity financing from their taxable income.
4. Disregarded payments in excess of dual inclusion income. “Disregarded payments in excess of dual inclusion income” refers to a specific type of disqualified hybrid amount under Treasury Regulation Section 1.267A-2 when a company makes payments that are deductible for foreign tax purposes but are disregarded for US tax purposes. This amount is treated as a disqualified hybrid amount to the extent that it offsets income that is not subject to tax in both jurisdictions.
5. Deemed branch payments. The deemed branch payment rules begin by defining the term “specified party” to include a “U.S. taxable branch.” A branch is “a taxable presence of a tax residence in a country other than its country of residence as determined under either the tax resident’s tax law or such other country’s tax law.” Treas. Reg. Section 1.267A-5(a)(2). A “taxable branch” is one that “has a taxable presence under its tax law,” where “its” presumably refers to the law of the country in which the branch is located, as opposed to the country of its owner’s residence. A “U.S. taxable branch” is defined in regulations as a trade or business carried on in the United States by a tax resident of another country, except that if an income tax treaty applies, the term means a permanent establishment of a tax treaty eligible for benefits under an income tax treaty between the United States and a treaty country. See Treas. Reg. Section 1.267A-5(a)(25).
Treasury Regulation Section 1.267A-2(c)(1) provides that if a specified payment constitutes a deemed branch payment, it is treated as a disqualified hybrid amount if the payment is not taxed in the country of the home office. Treasury Regulation Section 1.267A-2(c)(2) defines a deemed branch payment as any amount of interest or royalties allowable as a deduction in computing the business profits of a U.S. taxable branch, to the extent 1) the amount is deemed paid to the home office (or other branch of the home office); 2) the payment is not regarded or otherwise taken into account under the home office’s tax law (or the other branch’s tax law); and 3) if the payment were regarded and treated as interest or a royalty, the home office (or other branch) would include the payment in income.
6. Payments to reverse hybrids. A reverse hybrid entity is a business structure viewed as fiscally transparent (similar to a partnership) in its home jurisdiction but as opaque (similar to a corporation) by investors in their home country. This tax treatment creates a “mismatch,” often allowing income to be untaxed by either country. Section 267A disallows payments to reverse hybrids that is a deductible expense (such as interest or royalties) paid by a US party to a related foreign entity that is treated as a corporation (not transparent) in its home country but as a partnership or disregarded entity (transparent) for U.S. purposes, often resulting D/NI outcome. The regulations promulgated under Section 267A clarify the application of the reverse hybrid rule in cases in which an investor of the reverse hybrid owns only a portion of the interests of the reverse hybrid and does not include in income a specified payment made to the reverse hybrid. In these cases, only the portion of the payment that is not included by the investor that occurs for its portion of the payment may give rise to a disqualified hybrid amount.
7. Disqualified Imported Mismatch Payments. The 2018 Proposed Regulations to Section 267A discussed an “imported mismatch” rule to prevent the importation into the United States’ taxing jurisdiction of certain foreign hybrid arrangements through the use of non-hybrid arrangements. The imported mismatch rule of the 2018 Proposed Regulations to Section 267A disallowed deductions for specified payments to the extent that the payment was a “disqualified imported mismatch amount,” which was an imported mismatch amount such that the income attributable to the payment was directly or indirectly offset by the hybrid deduction. See Prop. Treas. Reg. Section 1.267A-4(a). The regulations promulgated under Section 267A retain the imported mismatch rule with minor modifications.
8. Branch Mismatch Payments. The regulations under Section 267A address what is referred to as “branch mismatch payments.” See Treas. Reg. Section 1.267A-2(e). Under these rules, a specified payment is treated as a branch mismatch payment if 1) under the tax law of the home office, the payment is treated as attributable to a branch of the home office; and 2) under the tax law of the branch country, either the home office’s activities do not give rise to a taxable presence, or the payment is treated as attributable to the home office and not to the branch. A branch mismatch is generally a disqualified hybrid amount to the extent that the home office does not include the payment in income.
Section 267A Applies Only to Disqualified Hybrid Amounts
Section 267A only applies to specified payments made pursuant to a hybrid transaction to the extent of disqualified hybrid amounts to the extent that the specified payment produced a D/NI outcome as a result of a hybrid or branch arrangement. The specified recipient’s no inclusion is a result of the payment being made pursuant to a hybrid transaction. A specified recipient is defined as any tax resident that derives the payment under its law or a taxable branch to which the payment is attributable under its tax law. There can be more than one specified recipient with respect to a specified payment. A specified recipient is only taken into account if it is related to the specified party or is a party to a structured arrangement.
Only disqualified hybrid amounts (“DHA”) are impacted by Section 267A that can be classified as hybrid transactions. A hybrid transaction includes a series of transactions, agreements or instruments where one or more payments are treated as interest or royalties for U.S. tax purposes but not for the purpose of the tax law of a specified recipient of the payment. An example of a hybrid transaction would be an instrument classified as debt for US tax purposes but as equity under tax laws of the specified recipient.
A hybrid transaction includes a transaction where the specified recipient recognizes the payment under its tax laws in a taxable year that ends more than 36 months after the end of the taxable year in which the specified party is otherwise allowed a deduction under U.S. tax law.
Exception to Disqualified Hybrid Amount
Any amount that is otherwise a DHA (a “tentative DHA”) is reduced to the extent such amount:
1) Is included in the income of a specified recipient that is a tax resident of the US or a US taxable branch.
2) Is received by a CFC, and taken into account in calculating Subpart F income or tested income, but the regulations add: a) taken into account without regard to E&P limitation under Section 952; b) cannot use hybrid payments to convert Subpart f into tested income to achieve arbitrate with Section 250 deduction; or c) for hybrid payments included in income of US person pursuant to a Qualified Electing Fund (“QEF”) election for Passive Foreign Invest Corporation (“PFIC”) purposes.
These rules do not apply if the amount of a specified party’s interest and royalty deductions are less than $50,000.
Examples Involving Hybrid Instruments
Below, please see Illustration 1 and Illustration 2 which demonstrates two examples of hybrid instruments.
Illustration 1.
FX incorporated in Country Y and wholly owns USCO, a United States corporation. FX executed a hybrid loan instrument with USCO. USCO paid FX $100 in interest payments.The hybrid loan instrument classifies the interest payments as dividends in Country Y. Country Y does not tax foreign dividends. Thus, the $100 interest payment from USCO is not subject to tax in FX’s jurisdiction. Instead, in FX’s country, the $100 interest payment is treated as an excludable dividend for income tax purposes. The specified $100 payment will be treated as a DHA for U.S. tax purposes and the $100 interest payment is a non-deductible DHA.
Illustration 2.
Assume the facts for illustration 2 are the same as illustration 1. However, in this example, Country Y is taxed under a territorial regime which results in neither foreign source dividends nor foreign source interest being taxed. Since Country Y excludes the $100 specified payment (either as an interest or dividend) from taxation under its pure territorial taxing regime, the $100 the payment is not treated as a DHA. However, the $100 payment is not deductible per Treasury Regulation 1.267A-2(a)(1)(ii).
Below, please see Illustration 3 which discusses a hybrid sales/license transaction of intellectual property.
Illustration 3.
FCo is a CFC incorporated in Country Z. USCo, a corporation incorporated in the United States. USCo wholly owns FCo. Assume that FCo sells intellectual property to USCo. However, FCo does not transfer “all substantial rights” to the IP to USCo. USCo agreed to make annual payments for the use of intellectual property transferred to it from FCo. FCo is permitted to treat the transfer of intellectual property to USCo as an installment sale under the tax laws of Country Z. In addition, FCo is permitted to recover its basis in its intellectual property first. For U.S. tax purposes, USCo treats the payments to FCo as deductible royalties. The anti-hybrid rules permit such a transaction.
Interest-Free Loan Example
Under the Section 267A regulations, payments under interest free loans and similar arrangements are deemed to be made under a hybrid transaction to the extent that a payment is imputed (under Internal Revenue Code Sections 482 or 7872) and the tax resident or taxable branch to which the payment is made does not take the payment into account under its tax law because that tax law does not impute interest. An interest free loan includes an instrument that is treated as debt under both U.S. tax law and the holder’s tax law but provides no stated interest. Such an instrument would give rise to a D/NI outcome to the extent the issuer is allowed an imputed deduction, but the holder is not required to impute interest income.
Below, please see Illustration 4 which discusses an interest free-free hybrid transaction
Illustration 4.
Assume that USCo borrows from F1 (Country X) under a normal loan, treated as best both in the United States and in Country X. F-1 borrows from F2 (Country Y). This loan is also debt in both Country X and Y, but the loan is interest-free. F-1 is allowed an imputed interest deduction under Country X tax laws. However, F-2 is not required to impute interest income under Country Y-s tax laws. In this case, interest free loans are treated as hybrid transactions under Treasury Regulation Section 1.267A-2(a)(4) and the interest paid by USCo to F-1 is treated as a disqualified hybrid mismatch amount.
Reverse Hybrid Example
If a specified payment is made to a reverse hybrid, the payment is a DHA to the extent of: 1) an investor has no-inclusion; 2) the no-inclusion is a result of the reverse hybrid status of the entity, i.e., the non-inclusion would occur if the investor’s tax law treated the reverse hybrid as fiscally transparent (and treated the payment as interest or a royalty, as applicable).
A “reverse hybrid” is an entity (US or foreign) that is fiscally transparent where it is organized but not fiscally transparent under the tax laws of an investor.
Below, please see Illustration 5 which demonstrates a payment to a reverse hybrid.
Illustration 5.
In this example interest paid to the Bank is potentially deductible in F Co’s home country and the United States. Here, U.S. Partnership is wholly owned by F Co. Typically, under the regulations, the U.S. Partnership would be “fiscally transparent.” Which basically means that the domestic entity’s tax items flow through to its owners under the entity’s or the interest holder’s jurisdiction. However, in certain cases, this tax treatment can be avoided if the foreign owned entity is treated as a U.S. partnership or disregarded entity. Since, U.S. Partnership is treated as a partnership for U.S. tax purposes, the current hybrid entity regulations may permit a double deduction outcome.
Hybrid Deduction Example
A deduction is permitted to the foreign tax resident/taxable branch under its foreign tax law for an amount that is interest or royalty under such tax law, to the extent a deduction for the amount would be disallowed if such tax law contained rules similar to Treasury Regulations Section 1.267A-1-3 and 1.267A-5. A hybrid deduction includes notional interest deductions and deductions for payments made pursuant to interest-free loans.
Below, please see Illustration 6 which discusses a disqualified imported mismatch payment
Illustration 6.
Assume FY is a reverse hybrid because it is transparent for Country Y purposes and a regarded taxable entity for Country X purposes. Also assume that Country X does not tax FX on the specified payment under any anti-deferral taxing regime. As a result, the specified payment of $100 to FY is a DHA. This is because the interest payments are not subject to taxation in any foreign jurisdiction. As a result, the interest payments in the United States made to FY and FV are subject to 30 percent withholding tax. In addition, there are no treaty benefits available in this transaction.
Disqualified Imported Mismatch Payments Example
A disqualified imported mismatch payment is a specified payment (other than a DHA) to the extent that, under broad “set-off” rules, the income attributable to such payment is directly or indirectly offset by a “hybrid deduction” incurred by a foreign tax resident/taxable branch related to the specified party (or party to the structured arrangement).
Below, please see Illustration 7 which provides an example of a disqualified imported mismatch amount.
Illustration 7.
Assume that the foreign parent excludes a hybrid dividend from income under a participation exemption. As a result, the interest payment by a U.S. payor is a disqualified imported mismatch amount to the extent income attributable to the payment is offset by a “hybrid deduction” incurred by foreign payee related to the U.S. Payor. A “hybrid deduction” arises here because the foreign imported mismatch payee is allowed a deduction under its tax law that would be a DHA under Treasury Reg. Section 1.267A-2 if its country had applicable U.S. rules. The interest paid by the U.S. Payor is therefore a disqualified imported mismatch amount and the U.S. deduction is disallowed.
Section 245A(e) Overview
Internal Revenue Code Section 245A(e) generally denies the dividends received deduction (the “DRD”) under Section 245A for hybrid dividends (i.e., amounts received from a CFC if the dividend gives rise to a local country deduction or other tax benefit). A hybrid dividend is an amount received from a CFC for which a Section 245A a CFC for which a Section 245A DRD would otherwise allow, and for which the CFC received a deduction or a tax benefit with respect to that income in a foreign country.
The 2018 Proposed Regulations provide rules for identifying and tacking hybrid dividends and set forth standards for identifying hybrid deductions.The 2018 Proposed Regulations detailed rules about what constituted a hybrid deduction, how to calculate and track hybrid deduction accounts, and how to determine if a CFC made a hybrid dividend. The final Section 245(e) regulations keep much of these rules intact. However, some changes are made to the Proposed Regulations.
The regulations provide that the determination of whether a relevant foreign tax law allows a deduction or other tax benefit is made without regard to the foreign hybrid mismatch rules, provided that the amount gives rise to a dividend for U.S. tax purposes or is reasonably expected for U.S. tax purposes to give rise to a dividend that will be paid within 12 months after the taxable period in which the deduction would otherwise be permitted. The regulations also state that deductions with respect to equity, like NIDs, are hybrid deductions regardless of whether the deductions result from an actual payment, accrual, or distribution.
The Section 245(e) regulations retain most of the rules regarding the effect of transfers of stock on hybrid deduction accounts, but add some new rules. The new rules address Section 355 spin-off transactions, requiring taxpayers to allocate hybrid deduction accounts in the same manner as E&P. For mid-year transfers of stock, the final regulations generally allocate a hybrid deduction account between the seller and the buyer based on the number of days in the taxable year. In addition, the final rules add a new general anti-duplication rule that ensures that when foreign tax law deductions or other tax benefits are in effect duplicated at different tiers, the deductions only give rise to a hybrid deduction of the higher-tier CFC. Moreover, the regulations clarify that, in case of a Section 338(g) election, the shareholder of the “new target” does not succeed to the hybrid deduction account with respect to a share of the “old target.” See US IRS Proposes Regulations Implementing Anti-Hybrid Mismatch Rules and Expanding Scope of Dual Consolidated Loss Regulations, EY Global, Jan 4, 2019.
Tiered Hybrid Dividends
If a CFC with respect to a US corporation is a 10 percent US shareholder receives a tiered dividend from any other CFC with respect to which such US corporation is also a 10 percent US shareholder, then, notwithstanding any other provisions in the Internal Revenue Code:
1 The tiered hybrid dividend is treated as Subpart F income of the receiving CFC for the taxable year of the receiving CFC in which the dividend was received.
2 The 10 percent US shareholder includes in gross income an amount equal to the shareholder’s pro rata share of Subpart F income; and
3 Foreign tax credits are disallowed.
Below, please see Illustration 8, Illustration 9, and Illustration 10 which discuss tiered hybrid dividends, hybrid dividends, and the impact of the imputation systems.
Illustration 8.
In this example, there is accrued interest on hybrid debt between Holdco and Opco which gives rise to hybrid deductions to “hybrid deduction accounts” (“HDA”). An actual payment of interest/dividends is a hybrid dividend, which is subpart F income to Parent.
Illustration 9.
In this example, the shares of A and B are equally valued. During Year 1, under Country X tax laws, FX accrues $80x of interest with respect to Share A. FX is allowed a deduction. In year 2, FX distributes $30x on Share A and $30x on Share B. Both distributions are treated for U.S. tax purposes as a dividend eligible for the Section 245A DRD. See Treas. Reg. Section 245A(e)-1(g), Ex. 1(i).
Illustration 10.
FZ distributes a dividend to FX. Similar to Malta, Country Z allows a refundable credit to FX for 75 percent of the Z corporate tax paid for the earnings that funded the dividend to FX. As a result, FX dividend is treated as a hybrid dividend for the amount of the dividend that interpolates to the tax effected credit (in this case 70% of the dividend). If FZ imposes withholding tax on the dividend, that reduces or eliminates the hybrid dividend to the extent it negates the refundable credit.
Hybrid Deduction Accounts
Under Treasury Regulation Section 1.245A(e)-1(d), a dividend can be a hybrid dividend only to the extent of the sum of the US shareholders (or, in the case of tiered hybrid dividends, the CFC’s) hybrid deduction accounts, which must be maintained on a share-by-share basis with respect to each CFC by 10 percent US corporate shareholders. This is basically a tracking requirement that allows the rules to capture D/NI outcomes in cases where the dividend and hybrid deduction do not arise pursuant to the same payment or the same taxable year for US and for foreign tax purposes, and it does so by matching hybrid deductions to dividends paid in subsequent taxable years.
Proposed Section 245A(e) Regulations
Congress enacted Section 245A(e) to combat the double non-taxation effects of certain hybrid arrangements. However, when a U.S. shareholder has a subpart F or GILTI inclusion with respect to a CFC and Section 245A(e) provisions also apply, double taxation can result. To mitigate this concern, Treasury issued proposed regulations that allow for an adjustment to a CFC’s hybrid deduction account to the extent that the CFC’s hybrid deduction account to the extent that the CFC’s earnings are included in income under subpart F or GILTI rules. Rather than providing for a dollar-for-dollar reduction in the hybrid deduction account by the amount of the inclusion, the proposed rules require taxpayers to perform a complex calculation that takes into account the potential benefit of foreign tax credits and the Section 250 deduction.
The proposed regulations generally reduce a hybrid deduction account with respect to a share of stock of a CFC by an “adjusted subpart F inclusion” or an “adjusted GILTI inclusion” with respect to the share. This reduction, however, cannot exceed the hybrid deduction allocated to the share for the taxable year multiplied by the ratio of the subpart F income or tested income, as applicable, of the CFC to the CFC’s taxable income. The regulations also provide ordering rules for when adjustments are required under multiple provisions.
To calculate the adjusted subpart F inclusion, a taxpayer must first determine two amounts, on a share-by-share basis: 1) its pro rata share of the CFC’s subpart F income included in income in the taxpayer’s current year; and 2) the “associated foreign income taxes” with respect to that subpart F inclusion (determined by allocating foreign taxes to the subpart F income groups under Section 960 and the regulations thereunder). The following two step process must be followed. First, the taxpayer adds the pro rata share of the subpart F inclusion and associated foreign income taxes, which is intended to reflect the Section 78 gross-up. From that amount, the taxpayer then subtracts the quotient of the associated foreign income taxes divided by the corporate tax rate (21%), which is intended to equal the amount of income offset by the foreign taxes. See Baker McKenzie, Tax News and Developments North America, Client Alert May 15, 2020.
Expressed formulaically:Adjusted Subpart F Inclusion = Subpart F inclusion + Associated Foreign Income taxes
– Associated Foreign Income Taxes
0.21
The adjusted GILTI inclusion calculation follows a similar approach, but has three key differences. First, associated foreign income taxes are calculated by allocating foreign taxes to the tested income group and then multiplying by the taxpayer’s “inclusion percentage.” Second, after the first step, there is an interim step in which the taxpayer multiples the grossed-up inclusion by the difference between 100 and the percentage in Section 250(a)(1)(b) (currently at 50%). Third, in the final step, the taxpayer also multiplies the associated foreign income taxes by 80% to account for the GILTI reduction for foreign tax credits. Expressed formulaically:
Adjusted GILTI Inclusion = ((GILTI + Associated Foreign Income Taxes) x 0.5)
– 0.8 x Associated Foreign Income Taxes
0.21
These computations should be updated to take into consideration the adjustments made to the GILTI tax regime (renamed Net CFC Tested Income or (“NCTI”) for the 2026 tax year.
Conduit Regulations
Basic Mechanism of US Taxation on Foreign Persons
As a general rule, a nonresident alien or foreign corporation that conducts a US trade or business will be subject to the usual (individual or corporate) US tax rates on net (i.e., taxable) income “effectively connected with the conduct of a trade or business within the United States. IRC Sections 871(b)(1) and 882(a)(1). Appropriate deductions and credits will apply in the determination of U.S. tax liabilities.
Most forms of US -source income received by foreign persons that are not effectively connected with a US trade or business will be subject to a flat tax of 30 percent on the gross amount of income received. Section 871(a) (for nonresident aliens) and Section 881(a) (for foreign corporations) impose a 30 percent tax on interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income. This enumeration is often referred to as (“FDAP”). The collection of such taxes is effected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the IRS. Tax treaties generally provide for the reduction or elimination of withholding taxes on FDAP income.
Anti-Conduit REgulations
Congress in 1993 added Section 7701(l), which authorized the promulgation of regulations allowing for the “recharacterization” of multiple-party financing transactions as transactions directly among any two or more of the parties to it if such characterization “is appropriate to prevent avoidance of any tax * * *.” The IRS has implemented this authority by issuing so-called “anti-conduit” regulations. The principal result when the regulations apply is that intermediate entities (“conduits”) are disregarded in determining US taxes on international financing arrangements, which may include loans, leases, and licenses. The US tax result will then be determined as if the loan were made directly from the foreign lender to the US borrower. The definitional provisions governing the application of the anti-conduit rules were found in Treasury Regulation Section 1.881-3 and 4.
The key factors that triggered the exercise of power by the IRS to recharacterize conduit entities are as follows:
1) The participation of the intermediate entity or entities that reduces tax imposed by Section 881 of the Internal Revenue Code,
2) Such participation is “pursuant to a tax avoidance plan,” and either
3) The intermediate entity is related to the financing or financed entity or would not have participated in the financing arrangement but for the fact that the financing entity engaged in the transaction with the intermediate entity. See Treas. Reg. Section 1.881-3(a)(4).
The regulations also identified the factors that will determine whether there is a tax-avoidance purpose:
1 Is there a “significant reduction” in the tax otherwise imposed under Section 881?
2 Did the conduit have the ability to make the advance without advances from the related financing entity?
3 What was the period of time between the respective transactions?
4 Did the financing transactions occur in the ordinary course of business of the related entities? See Treas. Reg. Section 1.881-3(b)(2).
The regulations also established a rebuttable presumption in favor of the taxpayer if the conduit entity “performs significant financing activities with respect to the financing transactions forming part of the financing arrangement.” Such activities might include the earnings of rents and royalties from the active conduct of a trade or business or active risk management by the intermediate entity. Treas. Reg. Section 1.881-3(b)(3).
The effect of the anti-conduit regulations is that the payment will be deemed to be paid directly by and to the entities other than the conduit, usually the financing or financed entity. The role of the conduit will be disregarded. If these provisions were invoked in the case of a finance subsidiary, for example, the interest payment by a U.S. corporation that borrowed money from a foreign lender through the use of a financing subsidiary in a tax treaty country would be treated as if the interest were paid directly to the foreign lender. The treaty would not apply, and the 30 percent withholding tax would be imposed unless the “true” lender were a resident of another treaty country where withholding rates on interest were reduced or eliminated. The borrower is required to withhold the appropriate amount under the reclassified transaction.
The Anti-Conduit Proposed Regulations
The IRS and the Department of Treasury issued proposed regulations on April 7, 2020 that would restrict foreign persons’ ability to minimize US tax through “conduit” financing arrangements. On April 7, 2020, the IRS issued the 2020 Proposed Regulations under Section 881. Under the Proposed Regulations, certain interests treated as equity for US purposes are considered a “financing transaction.”
Below, please see Illustration 11 and Illustration 12 which discusses the conduit regulations.
Illustration 11.
Previously, the anti-conduit regulations generally did not attack a foreign finance company capitalized with equity under U.S. tax principles. The new proposed conduit regulations could now result in FS being a conduit because it is capitalized with a hybrid equity instrument.
Illustration 12.
Cayco owns valuable intellectual property and wishes to license it to an unrelated U.S. licensee. Typically, royalties from the intellectual property would be subject to 30 percent U.S. withholding tax. As a result, Cayco establishes a Hungarian corporation. The Hungarian corporation is opaque for U.S. and Hungarian purposes. Cayco sells intellectual property to the Hungarian corporation in exchange for a note. The U.S.-Hungarian tax treaty still does not have a limitation on benefits (“LOB”) provision. The treaty provides an exemption from U.S. withholding tax on royalties. The Hungarian corporation licenses the intellectual property to an unrelated U.S. licensee in exchange for royalties. The Hungarian corporation is not a hybrid entity and neither license nor note are hybrid instruments. As a result, Internal Revenue Code Section 267A does not apply to this transaction. Both license and loan are financing transactions under the conduit financing regulations. However, because the loan from Cayco to an unrelated U.S. licensee would have qualified for an exemption from U.S. withholding tax under Internal Revenue Code Section 881(c), the conduit financing rules do not apply to the above example.
Conclusion
The rules governing hybrid arrangements and conduit transactions have far reaching implications on cross border transactions. While the Section 245A and 245A(e) Regulations provide taxpayers with some clarity, the Proposed Regulations under the conduit rules may take some cross-border planners by surprise. Particularly because the 2020 conduit financing rules attack hybrid equity arrangements which were up until very recently utilized in international transactions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.
Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
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.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
