The Limitations Placed on Hybrid Entity Tax Planning

Multinational corporations investing in the United States often rely on U.S. income tax treaties to reduce or eliminate the 30% U.S. withholding tax imposed on payments of U.S. source fixed or determinable, annual or periodical (“FDAP”) income. Sometimes foreign investors utilize a series of companies as part of a strategy to reduce or eliminate the 30% withholding tax imposed under Sections 871, 881, 1441, or 1442. Multinational corporations often operate in a multi-layered network where a parent company controls businesses through intermediate holding companies across a number of different countries. Through the so-called check-the-box regulations, eligible business entities can choose how they are taxed for U.S. federal income tax purposes.

One consequence of the check-the-box regulations has been to facilitate the creation of entities, such as civil law limited liability companies, that are treated as separately taxable corporations under foreign law but as flow-through entities (either as partnerships or wholly owned entities that are disregarded) for U.S. tax purposes. Such dual character entities are often referred to as “hybrid entities.” The term “hybrid entity” includes an entity that is fiscally transparent for U.S. federal income tax purposes, but is treated as a corporation for purposes of foreign tax law purposes. A reverse hybrid is an entity that is fiscally transparent for purposes of the tax law of the country in which it is established but not for purposes of the tax law of an investor of the entity. The ready availability of dual status entities has often resulted in their use by U.S. and foreign multinational corporations to reduce U.S. and foreign tax liabilities. The IRS use of dual status entities has not gone unnoticed by Congress. Congress has enacted a number of laws attacking the use of hybrid entities. This article discusses the laws enacted by Congress designed to curb the use of hybrid structures in multi-national tax planning.

Anti-Conduit Regulations

Congress in 1993 added Section 7701(l) to the Internal Revenue Code. Section 7701(l) authorizes the Internal Revenue Service (“IRS”) to enact regulations to “recharacterize” multi-party financing transactions as a transaction directly among 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 of the anti-conduit regulations is that intermediate entities (“conduits”) are disregarded in determining U.S. taxes on international financing arrangements, which may include loans, leases, and licenses. Although the anti-conduit regulations are not directly aimed at hybrid entities or reverse hybrid entities, these dual status companies are often used in international financing arrangements and as a result of the anti-conduit regulations, a hybrid entity could be identified as being part of an international financing arrangement.

Section 7701(l) authorizes the promulgation of regulations allowing for the “recharacterization” of multi-party financing transactions as a transaction 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 is that intermediate entities (“conduits”) are disregarded in determining U.S. taxes on international financing arrangements, which may include loans, leases, and licenses.

The key factors that will trigger the exercise of power by the IRS to recharacterize conduit entities are:

1. The participation of the intermediate entity or entities reduces tax imposed by Section 881 (Section 881 of the Internal Revenue Code imposes a flat 30% tax on U.S.-source passive income received by foreign corporations that is not actively connected to a U.S. trade or business);

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 identify 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 establish 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 arrangements.” Such activities might include earnings such as rents and royalties from the active conduct of a trade or business. See Treas. Reg. Section 1.881-3(b)(3).

The effect of invoking the anti-conduit regulations is that the payments will be deemed to be paid directly by and to the entities other than the conduit and as a result, the role of the conduit will be disregarded in a corporate chain of ownership for U.S. tax purposes. The anti-conduit rules tend to  target multinational corporate structures that establish subsidiaries in countries the U.S. has a favorable tax treaty. Through a treaty, a subsidiary may be utilized to reduce U.S. tax through a treaty. The foreign subsidiary may be treated as a transparent entity for U.S. tax purposes to avoid income inclusion through the downward attribution rules. The IRS may utilize the anti-conduit regulations to disregard the foreign subsidiary established in the favorable jurisdiction merely for tax purposes. A foreign subsidiary is also subject to attack by the IRS if it is capitalized with a hybrid equity instrument See Treas. Reg. Section 1.881-3(a)(2)(ii)(B)(1)(iv). A hybrid instrument is a financial investment that combines the features of both debt and equity, or blends a standard security with an embedded derivative.

Treaties and Hybrid Entities

The existence of hybrid entities may impact upon the administration of income tax treaties. For example, suppose a foreign entity is treated as a partnership for U.S. tax purposes. It is organized in Country A, with which the United States has no income tax treaty. One of the partners, Partner X, is a citizen and resident of Country B, with which the United States has a tax treaty. However, the entity is treated as a corporation under the laws of Country A and Country B. The foreign entity, organized in Country A, realizes U.S. source interest income, a portion of which is allocable under U.S. law to Partner B. U.S. source interest payments to corporations organized in Country A are subject to a withholding tax of 30 percent. U.S.-source interest payments to Partner X, as a resident of Country B, would be exempt from tax with Country B.

Section 894(c) of the Internal Revenue Code expressly limits the availability of treaty benefits in certain hybrid situations. Section 894(c)(1) denies treaty benefits for income derived through a partnership or other entity treated as transparent for U.S. tax purposes in certain situations even though the partner is a resident of a resident of a foreign treaty country. The application of the provision depends largely upon the law of the treaty country. Withholding tax reductions or exemptions provided in a treaty will be denied to a partner, even if the entity is treated as a partnership or other transparent entity under U.S. tax law, if the item of income is not treated under the tax law of the treaty country as income of the partner, the treaty itself contains no provision addressing its applicability in the case of income derived through a partnership and the foreign treaty country does not tax the distribution of such item of income from the partnership to the partner. In the example discussed above, since Partner X is not subject to tax in Country B (the treaty country) on income realized by the entity (because it is treated as a corporation under the laws of Country B), Section 894(c)(1) applies and Partner X is not entitled to the treaty exemption for interest payments from U.S. sources.

Treasury Regulation Section 1.894-1(d)(2)(i) further provide that treaty benefits will not be available to foreign interest holders of an entity classified as a corporation under U.S. law, even though the entity may be classified as a transparent entity under the laws of a treaty country (a reverse hybrid). Income items paid by a domestic entity classified as a corporation under U.S. law will be treated as income to interest holders regardless of the classification of the entity under foreign law and the character of the income will be determined by applying U.S. legal standards.

Special regulations address situations in which a payment is made from a domestic entity to a related reverse hybrid entity which in turn makes a payment to a related foreign interest holder.

It should be understood that Section 894(c)(2) typically limits treaty benefits when payments are received by a fiscally transparent entity for U.S. or foreign purposes only if the home foreign country of the entity at issue treats the item income at issue as not belonging to the foreign entity claiming a treaty benefit.

The Anti-Hybrid Regulations

In addition to the anti-conduit regulations and Section 894(c)(2), the IRS and the Treasury issued regulations regarding hybrid arrangements and entities. The regulations under Section 245A(e) denies dividends received deduction for hybrid dividends and the regulations under Section 267A denies deductions arising from certain hybrid arrangements.

The Anti-Hybrid Rules Enacted Under Section 267A

Congress enacted Section 267A to disallow a deduction for any “disqualified related party amount” paid or accrued  “pursuant to a hybrid transaction or by, or to, a hybrid entity.” IRC Section 267A(a). The regulations under Section 267A disallows a specified party’s deduction for a specified payment to the extent that the payment satisfies 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 the 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.”

For the first prong of the Section 267A test, Treasury Regulation Section 1.267A-3(a) states that the conditions when a tax resident or taxable branch is treated as a specified payment if a specified party makes a payment to a tax resident or taxable branch and the payment is not treated as included in income in the tax resident’s or taxable branch’s home country. If that payment was structured or arranged with a principal purpose to avoid recognizing taxable income in the tax resident’s or taxable branch’s home country, Section 267A disallows the corresponding U.S. deduction.

There are two ways by which a payment is not considered included in income under Treasury Regulation Section 1.267A-3(a). First, a specified payment is not considered included in income if the royalty or interest, for which there was a corresponding U.S. deduction, is not included in income under foreign law within 36 months after the end of the specified party’s taxable year. Treas. Reg. Section 1.267A-3(a)(1)(ii). Second, 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, or credit (other than withholding tax).”

Congress enacted Section 245A(e) of the Internal Revenue Code to deny the dividends received deduction (the “DRD”) under Section 245A for hybrid dividends for amounts received from a CFC if the dividend gives rise to a local country deduction or other tax benefit. By way of background, the DRD is a U.S. federal tax deduction that allows corporations to deduct a large portion of dividend income they receive from foreign corporations.

Conclusion

The availability of controlled or wholly owned hybrid entities and branches has led to their use by multinational corporations to reduce U.S. and foreign tax liabilities. Although multinational corporations have historically effectively used hybrid entities to reduce U.S. and foreign taxes, Congress has issued a number of rules and regulations that significantly limit or curtail multinational corporations’ ability to utilize hybrid entities to reduce their U.S. and global tax liabilities. The limitations imposed by Congress should be carefully considered by any time the use of a hybrid entity is being considered for tax planning.

We have substantial experience advising clients on the consequences of the check-the-box regulations and the use of hybrid entities.

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 other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.