The Taxation of Dual Resident Corporations and the Anti-Hybrid Rules

We will begin with a discussion regarding the taxation of U.S. business entities. Foreign nationals may operate domestic entities through a “C” corporation or a “pass-through” entity such as a partnership. Generally, the earnings and profits or “E&P” of a “C” corporation is included in the gross taxable income of a shareholder when a dividend is received. On the other hand, a “pass-through” entity such as a partnership is generally not considered a taxable entity.  Income attributable to a partnership or other pass-through entity “flows through” to the owners and is taxable to them regardless of whether they receive the income or not.

These rules are also generally applicable to foreign business entities. One would think that a foreign business entity classified as a foreign corporation for U.S. tax purposes would generally only be subject to tax upon the receipt of a dividend or another payment from a foreign corporation, or upon the sale of his or her interest in the foreign corporation or the foreign corporation’s liquidation. The problem is the Internal Revenue Code has a number of anti-deferral tax regimes such as GILTI (Renamed to Net CFC Tested Income (“NCTI”) for 2026 as a result of the “One Big Beautiful Bill Act”)  and subpart F. These taxing regimes are designed to accelerate the recognition of foreign source income. Under the GILTI and subpart F tax regimes, a U.S. person may be required to include his or her share of the foreign corporation’s earnings in his income, regardless of whether the foreign corporation makes any distributions to its shareholders. To make matters worse, in certain cases, U.S. shareholders of foreign corporations cannot utilize a foreign tax credit to reduce his or her exposure to U.S. income tax.

Thus, in certain circumstances, it may be better for a U.S. person to operate a foreign business entity as a pass-through entity rather than a foreign corporation. A foreign entity treated as a pass-through entity may avoid the GILTI and subpart F tax regimes. A U.S. person operating a foreign business as a pass-through entity may also qualify to claim foreign tax credits to offset U.S. income.

In general, the Check-the-Box Regulations allow taxpayers to choose the U.S. classification of a foreign business entity that is not on the “per se” corporation list of Section 301.7701-2 (a “foreign Eligible Business Entity”). See 301.7701-2(b). If a Foreign Eligible Business Entity does not make an election, certain default rules determine the U.S. tax classification of the entity. A Foreign Eligible Business Entity can be classified as: 1) a corporation when all members have “limited liability;” 2) a partnership when one or more members do not have “limited liability;” or 3) a disregarded entity when a single member owner does not have “limited liability.” See Treas. Reg. Section 301.7701-3(b)(2). A foreign business entity that is on the “per se” corporation list of the Check-the-Box Regulations must be so classified for U.S. tax purposes. See Treas. Reg. Section 301.7701-2(b)(8) and Treas. Reg. Section 301.7701-3(a).

Under Treasury Regulation Section 301.7701-2 through 3, an entity organized under U.S. law as a corporation under state law is always treated as an association taxable as a corporation for federal tax purposes. The regulations sets forth a list of business entities organized under the law of identified foreign corporations that will always be treated as associations taxable as corporations for U.S. purposes. These include, for example, the Aktiengesellschaft of German and Swiss law, te sociedad anonima of Spanish and Mexican law and the societe anonyme of French law. This list of foreign entities that are automatically classified as corporations for U.S. tax purposes (often referred to as “per se corporations”) are expanded periodically.

The current list of entities considered Per Se Corporations under 26 CFR § 301.7701-2(b)(8) are:

American Samoa, Corporation

Argentina, Sociedad Anonima

Australia, Public Limited Company

Austria, Aktiengesellschaft

Barbados, Limited Company

Belgium, Societe Anonyme

Belize, Public Limited Company

Bolivia, Sociedad Anonima

Brazil, Sociedade Anonima

Bulgaria, Aktsionerno Druzhestvo.

Canada, Corporation and Company

Chile, Sociedad Anonima

People’s Republic of China, Gufen Youxian Gongsi

Republic of China (Taiwan), Ku-fen Yu-hsien Kung-szu

Colombia, Sociedad Anonima

Costa Rica, Sociedad Anonima

Cyprus, Public Limited Company

Czech Republic, Akciova Spolecnost

Denmark, Aktieselskab

Ecuador, Sociedad Anonima or Compania Anonima

Egypt, Sharikat Al-Mossahamah

El Salvador, Sociedad Anonima

Estonia, Aktsiaselts

European Economic Area/European Union, Societas Europaea

Finland, Julkinen Osakeyhtio/Publikt Aktiebolag

France, Societe Anonyme

Germany, Aktiengesellschaft

Greece, Anonymos Etairia

Guam, Corporation

Guatemala, Sociedad Anonima

Guyana, Public Limited Company

Honduras, Sociedad Anonima

Hong Kong, Public Limited Company

Hungary, Reszvenytarsasag

Iceland, Hlutafelag

India, Public Limited Company

Indonesia, Perseroan Terbuka

Ireland, Public Limited Company

Israel, Public Limited Company

Italy, Societa per Azioni

Jamaica, Public Limited Company

Japan, Kabushiki Kaisha

Kazakstan, Ashyk Aktsionerlik Kogham

Republic of Korea, Chusik Hoesa

Latvia, Akciju Sabiedriba

Liberia, Corporation

Liechtenstein, Aktiengesellschaft

Lithuania, Akcine Bendroves

Luxembourg, Societe Anonyme

Malaysia, Berhad

Malta, Public Limited Company

Mexico, Sociedad Anonima

Morocco, Societe Anonyme

Netherlands, Naamloze Vennootschap

New Zealand, Limited Company

Nicaragua, Compania Anonima

Nigeria, Public Limited Company

Northern Mariana Islands, Corporation

Norway, Allment Aksjeselskap

Pakistan, Public Limited Company

Panama, Sociedad Anonima

Paraguay, Sociedad Anonima

Peru, Sociedad Anonima

Philippines, Stock Corporation

Poland, Spolka Akcyjna

Portugal, Sociedade Anonima

Puerto Rico, Corporation

Romania, Societate pe Actiuni

Russia, Otkrytoye Aktsionernoy Obshchestvo

Saudi Arabia, Sharikat Al-Mossahamah

Singapore, Public Limited Company

Slovak Republic, Akciova Spolocnost

Slovenia, Delniska Druzba

South Africa, Public Limited Company

Spain, Sociedad Anonima

Surinam, Naamloze Vennootschap

Sweden, Publika Aktiebolag

Switzerland, Aktiengesellschaft

Thailand, Borisat Chamkad (Mahachon)

Trinidad and Tobago, Limited Company

Tunisia, Societe Anonyme

Turkey, Anonim Sirket

Ukraine, Aktsionerne Tovaristvo Vidkritogo Tipu

United Kingdom, Public Limited Company

United States Virgin Islands, Corporation

Uruguay, Sociedad Anonima

Venezuela, Sociedad Anonima or Compania Anonima

Hybrid Entities

One consequence of the check-the-box regulations is to facilitate the creation of entities, such as 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 called “hybrid entities.” The availability of controlled hybrid entities and branches have led to us by U.S. corporations and foreign corporations  controlled by U.S. corporations to reduce the foreign tax burden by having the foreign hybrid entity or branch (treated as a taxable corporation under foreign law) pay deductible royalties, interest, rents, and other payments to its parent entity. Because these payments would be deductible for foreign tax purposes, they would reduce the amount of foreign tax imposed on the hybrid entity.

Dual Resident Corporations

In the past, there were opportunities for tax savings through international tax arbitrage when there were inconsistencies between the rules in two relevant 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 worldwide net income with losses whenever incurred being deductible. Under Section 1501 of the Internal Revenue Code and regulations issued under Section 1502 of the Internal Revenue Code, 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 of one or more chains of U.S. corporations connected by stock ownership of at least 80 percent of the vote and value with a common 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. `

Inconsistencies may arise because some foreign 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 corporations.

As discussed above, sometimes U.S. corporations can be classified as a dual resident corporation. A dual resident corporation could be a U.S. parent of an affiliated group of corporations in the United States. Such a dual resident corporation might find opportunities to engage in so-called “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. Consequently, if a corporation was a resident of both the United States and a foreign country and the foreign country 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), than the dual resident corporation could use any loss is 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.

For example, assume a profitable U.K. company is a profitable U.S. target by establishing a dual resident holding company to own the shares of the U.S. target. The dual resident company borrows funds with which to buy the target. The interest expense of the dual resident company appears on both the U.K. and U.S. returns. It is conceivable that this type of affiliated group could have worldwide profits from operating in only two countries, the United Kingdom and the United States. At one time it was possible that such an affiliated group could have worldwide profits. However, by using dual residency devices, pay no current taxes to either the U.S. or the U.K.

In another example, assume that a U.K. corporation earned $100 of income before purchasing a U.S. target. The target produced $100 of income. To finance the purchase of the target, the U.K. corporation established a dual resident company that incurred an interest expense of $100. The dual resident company effectively shared its loss with its U.K. parent, so the group’s U.K. taxable income shrank from $100 to 0. In the United States, the dual resident company consolidated with its subsidiary, the U.S. target, so U.S. taxable income was zero. Despite worldwide profits of $100, earned solely in the United States and the United Kingdom, the group owned no current tax in any country..

In the examples above, the U.K. corporation reduced its U.K. tax on U.K. income (and its worldwide tax on worldwide income) by making the investment in the United States through the dual resident company device. That result occurred even though the target’s income exactly offset the expense of financing the acquisition. By contrast, if a similar U.S. corporation bought the same U.S. target corporation through the use of the same amount of debt, it would not reduce its tax.

An Introduction to the Anti-Hybrid Rules

The Tax Cuts and Jobs Act introduced two new Internal Revenue Code provisions targeting “hybrid arrangements.” The significance of the enactment of these new rules that targeted “hybrid arrangements” was to prevent dual resident corporations from utilizing arbitrage to avoid U.S. taxes. In particular, Internal Revenue Code Section 245A(e), denies a dividend received deduction under Section 245A with respect to hybrid dividends, and Section 267A denies certain interest or royalty deductions from hybrid transactions or hybrid entities. A hybrid arrangement generally seeks to exploit the differences in the tax treatment of a transaction or entity under the laws of two or more countries to secure double deductions, double exclusion from tax, or other tax benefits. The Tax Cuts and Jobs Act amendments to the Internal Revenue Code was a direct response to Action 2 of the Organization for Economic Co-operation and Development (“OECD”) Base Erosion and Profit Shifting (“BEPS”) Project that addressed hybrid and branch mismatch arrangements.

Section 267A

Internal Revenue Code Section 267A disallows a deduction for interest or royalties paid or accrued in certain transactions involving a hybrid instrument. Business entities often possess jurisdiction dependent tax characteristics. When such entities are inconsistently characterized by the foreign and domestic tax laws, they are called “hybrid.” They play a fundamental role in tax arbitrage transactions. See Gregg D. Lemein & John D. McDonald, Final Code Sec. 984 Regulation: Treaty Benefits for Hybrid Entity Payments, TAXES, Sept. 1, 2000, at 59. Although hybrid entities are not novel, over the years, their use has increased significantly when the Treasury released the check-the-box regulations, which permits taxpayers to choose to be treated as a corporation or a transparent entity for tax purposes.

Hybrid instruments are defined as financial instruments that have both debt and equity characteristics and could potentially be classified as equity by one jurisdiction and as debt by another. Hybrid instruments enable tax practitioners to create a class of transactions with disparate international tax treatment with respect to the “deductibility, inclusion, timing or character of payments made.” See Peter J. Connors & Glenn H.J. Woll, Hybrid Instruments- Current Issues, 553 PLI/TAX 175, 181 (2002).

Section 267A of the Internal Revenue Code was designed to address cases in which a taxpayer is permitted a deduction under U.S. federal tax law, but the taxpayer does not have a corresponding income inclusion under foreign tax law. This is known as a “deduction/no-inclusion” (“D/NI”) outcome.

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 “disqualified hybrid amount” (“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).

Background

Internal Revenue Code Section 267A disallows a deduction for interest or royalties paid or accrued in certain transactions involving a hybrid arrangement when a deduction is permitted under the Internal Revenue Code, but the payee does not have a corresponding income inclusion under foreign law (deduction/no-inclusion (D/NI)). A deduction for any interest or royalty paid or accrued is disallowed to the extent it is 1) a disqualified hybrid amount (as described in Treas. Reg. Section 1.267A-2); 2) a disqualified imported mismatch amount (as described in Treas. Reg. Section 1.267A-4), or 3) a specified payment for which the requirements of the anti-avoidance rule of Treasury Regulation Section 1.267A-5(b)(6) is satisfied. A specified party is generally a U.S. person, a controlled corporation or CFC or a U.S. taxable branch, and the payee must generally be related to the specified party.

Hybrid Transactions

Long Term Deferral

Long term deferrals of income may cause a D/NI issue. Several provisions of the 2018 Proposed Regulations addressed long-term deferral, which results when there is deferral beyond a taxable period ending more than 36 months after the end of the specified party’s taxable year. Thus, the inclusion of income must occur within 36 months after the end of the payor’s tax year to be considered an inclusion under Section 267A of the Internal Revenue Code.

The Final Regulations establish a reasonable expectation standard based on whether, at the time of the specified payment, it is reasonable to expect that the payment will be taken into account and included in income within the 36-month period. If a specified payment will never be recognized under the tax law of a specified recipient, the long-term deferral provision will not apply.

Hybrid Sale/License

In response to certain comments on the definition of hybrid transactions, the Final Regulations added a rule exempting hybrid sale/license transactions from the hybrid transaction rule. A hybrid sale/license transaction could occur, for example, when a specified payment is treated as royalty for U.S. tax purposes, and a contingent payment of consideration for the purpose of intangible property under the tax law of a specified recipient.

Below, please see Illustration 3 which discusses a hybrid sales/license transaction.

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 final anti-hybrid rules permit such a transaction.

Interest-Free Loans

Under the Final Regulations, payment under an interest free-loan and similar arrangements are deemed to be made under a hybrid transaction to the extent that a payment is imputed 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 the foreign 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. See Baker McKenzie, Tax News and Developments, North America, Final Anti-Hybrid Rules, Jeff Rubinger and Summer Ayers LePree.

Disregarded Payments

Dual Inclusion Income

The 2018 Proposed Regulations provide that a deduction for a disregarded payment is disallowed to the extent that it exceeds the specified party’s “dual inclusion income.” Dual inclusion income is defined by these rules as income included in both the income of the specified party and the tax resident or branch to which the payment is provided. In response to comments, Treasury and the IRS concluded in the final Section 267A regulations that an item of income of a specified party should be dual inclusion income even though, by reason of a participation exemption or other relief particular to a dividend, the item is not included in the income of the tax resident or taxable branch to which the disregarded payment is made, provided that the application of the participation exemption or other relief relieves double-taxation. See Treas. Reg. Section 1.267A-2(b)(3)(ii); Treas. Reg. Section 1.267A-6(c)(3)(iv). The final Section 267A regulations provide an identical rule in situations in which an item of income of a specified party is included in the income of the tax resident or branch to which the disregarded payment is made. However, the amount is not included in the income of the specified party by reason of a dividends received deduction.

Exception for Payments Otherwise Taken Into Account Under Foreign Law

Under the 2018 Proposed Regulations, a special rule ensured that a specified payment was not a deemed branch payment to the extent that the payment was otherwise taken into account under the home office’s tax law in such a manner that there was no mismatch. The 2018 Proposed Regulations did not, however, provide a similar rule in analogous cases involving disregarded payments. To provide symmetry between the disregarded payment rule and the deemed branch payment rule, the final Section 267A regulations add to the disregarded payment rule a special rule similar to the special rule in the deemed branch payment context.

Allocation of Interest Expense to U.S. Taxable Branches

The 2018 Proposed Regulations provided that a U.S. taxable branch of a foreign corporation was considered to pay or accrue interest allocable under Section 882(c)(1) to effectively connected income of the U.S. taxable branch. According to the Treasury and IRS, these rules are necessary to determine whether a U.S. taxable branch specified payment was made pursuant to a hybrid or branch arrangement.

The 2018 Proposed Regulations did not, however, obtain rules for tracing a foreign corporation’s distributive share of interest expense when the foreign corporation was a partner in a partnership that had a U.S. asset or rules for tracing interest that was determined under the separate currency pools method. The final Section 267A regulations therefore provide that a U.S. taxable branch must use a direct tracing approach to identify the person to whom interest described in Treasury Regulation Section 1.882-5(a)(1)(ii) or Treasury Regulation Section 1.882-59e) is payable.

In addition, in order to avoid treating similarly situated taxpayers differently under Section 267A, the final Section 267A regulations provide that foreign corporations should use U.S. booked liabilities to identify the person to whom an interest expense is payable, without regard to which method the foreign corporation uses to determine its interest expense under Section 882(c)(1).

Reverse Hybrids

A reverse hybrid is an entity that is fiscally transparent under the tax law of the country in which it is established but not under the tax law of an investor of the entity. A reverse hybrid entity has been used successfully by foreign corporations that want to pass through treatment in its host country while avoiding any U.S. repatriation costs in the form of either a withholding tax or a branch tax. In the past, a popular form of reverse hybrid entity has been a limited partnership for which the foreign owner has filed a Form 8832 that checks-the-box for U.S. corporate tax status.

Below, please see Illustration 5 which provides an example of a reverse hybrid entity.

Illustration 5.

P operates in country C. P would like to access the U.S. market. P forms a reverse entity in the U.S. (“Uncle Sam”), which is classified as a corporation for U.S. tax purposes and a limited partnership in country C. P can use the income that passes through Uncle Sam against its home country’s losses.

A reverse hybrid can present D/NI outcomes because it is not a tax resident in the country where it is established, and an investor is not considered to derive the payment under its home country’s tax law. A specified payment made to a reverse hybrid is generally a disqualified hybrid amount to the extent that an investor does not include the payment in income. Under the Final Regulations, an entity is fiscally transparent and a hybrid if under the tax law of the country where it is established if it is considered fiscally transparent under the definition of Treasury Regulation Section 1.894-1(d)(3)(ii) and (iii).

Current-Year Distributions from Reserve Hybrid

Under the 2018 Proposed Regulations, when a specified payment was made to a reverse hybrid, it generally was a disqualified hybrid amount to the extent that an investor did not include the payment in income. According to the preamble to the 2018 Proposed Regulations, although a subsequent distribution may have been included in the investor’s income, the distribution may not occur for an extended period and, when it did occur, it may have been difficult to determine whether the distribution was funded from an amount comprising the specified payment.

One comment to the 2018 Proposed Regulations noted that, if a reverse hybrid distributed all of its income during a taxable year, then current year distributions should have been taken into account for purposes of determining whether an investor of the reverse hybrid included in income a specified payment made to such reverse hybrid. The final Section 267A regulations provide that in these cases, a portion of a specified payment should relate to each of the current year distributions from the reverse hybrid. Treasury and the IRS have determined, however, that it would be too complex to take into account current year distributions in cases in which the reverse hybrid does not distribute all of its income during the taxable year. See Id.

Multiple Investors in a Reverse Hybrid

When an investor of a reverse hybrid owns only a portion of the hybrid’s interest and does not include in income its portion of a specified payment made to the reverse hybrid, the Final Regulations clarify that only the no-inclusion portion will give rise to a disqualified hybrid amount.

The preamble provides the following example to clarify this rule. Assume that a $100 specified payment is made to a reverse hybrid 60% of the interest of which are owned by a Country X investor (the tax law of which treats the reverse hybrid as not fiscally transparent) and 40% of the interests of which are owned by a Country Y investor (the tax law of which treats the reverse hybrid as fiscally transparent). If the Country X investor does not include any portion of the payment in income, then $60 of the payment would generally be a disqualified hybrid amount under the reverse hybrid rule, calculated as $100 (the no-inclusion that actually occurs with respect to the Country X investor) less $40 (the non-inclusion that would occur with respect to the Country X investor absent hybridity).

Exceptions Relating to Disqualified Hybrid Amounts

1. Effect of Inclusion to Disqualified Hybrid Amounts

Under the 2018 Proposed Regulations, a specified payment generally would be a disqualified hybrid amount to the extent that a D/NI outcome occurs with respect to any foreign country as a result of a hybrid or branch arrangement, even if the payment is included in income in another country. Although commentators asked the Treasury to remove the provision, or address it through general anti-avoidance rules, the Final Regulations retain the approach of the 2018 Proposed Regulations. According to the Preamble, that approach prevents the routing of a specified payment through a low-tax third country to avoid Section 267A, as well as the use of a hybrid or branch arrangement to place a taxpayer in a better position than would have been absent the arrangement.

2. Amounts Included or Includable in the United States

The Final Regulations revise the rule in the 2018 Proposed Regulations that would not treat a specified payment as a disqualified hybrid amount to the extent that it was included in the income of a tax resident of the United States or a U.S. taxable branch, or was taken into account by a U.S. shareholder under subpart F or GILTI rules. The determination of amounts considered taken into account under subpart F rules would be made without the earnings and profits limitation of Section 952. The Final Regulations also reduce the determination of amounts considered taken into account under GILTI to correspond with the reduced rates on GILTI inclusions resulting from the Section 250 deduction.

Below, please see Illustration 6 which demonstrates a payment by a reverse hybrid.

Illustration 6.

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.

3. Disqualified Imported Mismatch Payments

The 2018 Proposed Regulations applied 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. Generally, the imported mismatch rule of the 2018 Proposed Regulations 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 a hybrid deduction. The general approach taken in the 2018 proposed regulations with respect to the imported mismatch rule has been retained by the treasury and the IRS. However, changes have been made to reduce complexity of this rule. The final regulations narrow the definition of an imported mismatch payment to provide that a specified payment is an imported mismatch to the extent it is neither a disqualified payment nor included in income in the United States.

Below, please see Illustration 7 which discusses a disqualified imported mismatch payment

Illustration 7.

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. See Id.

Hybrid Deductions

An allowable deduction under a tax resident’s or taxable branch tax law is generally a hybrid deduction if the inclusion of rules are substantially similar to Treasury Regulation Sections 1.267A-1 through 1.267A-3 and 1.267A-5 in that tax law would result in the deduction’s disallowance. The Final Regulations clarify how this standard applies when the tax law of a tax resident or taxable branch contains hybrid mismatch rules. This list includes deductions for: 1) equity; 2) interest-free loans; and 3) amounts that are not included in the foreign country. See Treas. Reg. Section 1.267A-4(b)(2)(i). Consequently, if a tax resident is in a jurisdiction with hybrid mismatch rules, only these three deductions are considered.

The final regulations also continue to treat Notional Interest Deductions (“NID”) as hybrid deductions in the context of imported mismatch, but only to the extent that they are permitted for a tax resident under its tax law for accounting periods beginning on or after December 20, 2018.

Hybrid Deductions of CFCs

Under the 2018 Proposed Regulations, only a tax resident or a taxable branch that was not a specified party may have a hybrid deduction and make a “funded taxable payment.” This approach was intended to prevent potential double taxation under Section 267A of specified payments involving CFCs, because payments made to CFCs would generally be includible in income in the United States, and payments by CFCs are subject to disallowance as disqualified hybrid amounts.To prevent the avoidance of the imported mismatch rule through the use of CFCs that are not wholly owned by U.S. tax residents, the final Section 267A regulations permit CFCs to incur hybrid deductions and make funded taxable payments. Furthermore, if a CFC’s disqualified hybrid amount is only partially owned by U.S. tax residents, only a portion of the disqualified hybrid amount disallows a CFC payment from giving rise to a hybrid deduction or a funded taxable payment, because as the preamble to the final Section 267A regulations points out, disallowing the CFC a deduction for the disqualified hybrid amount will only partially increase the U.S. tax base, if at all. A hybrid deduction directly or indirectly offsets the income attributable to an imported mismatch payment to the extent that the payment directly or indirectly funds the hybrid deduction. Furthermore, ordering rules apply to offset income against the hybrid deductions which will be discussed below.

Funded Taxable Payments

For an imported mismatch payment to fund a hybrid deduction, the imported mismatch payee must directly or indirectly make a “funded taxable payment” to the tax resident or taxable branch that incurs the hybrid deduction. Furthermore, the final Section 267A regulations provide that another foreign tax resident or foreign taxable branch includes the amount in income, as determined under Treasury Regulation Section 1.267A-3(a), by treating the amount as the specified payment.

Payer-Payee Relatedness

A hybrid deduction offsets income attributable to an imported mismatch payment only if the tax resident or taxable branch incurring the hybrid deduction is related to the imported mismatch payer. An important mismatch payment indirectly funds a hybrid deduction if the imported mismatch payee, as well as each intermediary tax resident or taxable branch, is related to the imported mismatch payer.

Below, please see Illustration 8 which provides an example of a disqualified imported mismatch amount.

Illustration 8.

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. See Id.

Coordination with Foreign Mismatch Payments

1. Deemed Imported Mismatch Payments

The 2018 Proposed Regulations coordinate the U.S. imported mismatch rule with foreign imported mismatch rules through a special rule under which certain payments by non-specified parties were deemed to constitute imported mismatch payments. The deemed imported mismatch rule reduced the extent to which a payment of a specified party was treated as funding a hybrid deduction. The final Section 267A regulations modify the deemed imported mismatch rule so that it takes into account payments disallowed under a foreign imported mismatch rule, rather than payments for which a deduction is actually denied under the foreign imported mismatch rule.

2. Special Rules for Applying Imported Mismatch Rule

When the U.S. imported mismatch rule treats a deduction as a hybrid deduction, but a foreign imported mismatch rule does not, an inappropriate result may arise. Thus, the Final Regulations specify that the U.S. imported mismatch rule is first applied by taking into account only hybrid deductions that are unlikely to be treated as hybrid deductions for purposes of a foreign hybrid mismatch rule.

Anti-Avoidance Rule

The Section 267A anti-avoidance rule, as it appears in the final Section 267A regulations, disallows a specified party’s deduction for a specified payment to the extent that the payment satisfies the following conjunctive 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 its regulations in this part under Section 267A.”

With respect to the test’s first prong, 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 Section 1.267A-3(a), that specified payment meets the first prong of the anti-avoidance conjunctive test. If that payment was structured or arranged with a principal purpose to avoid Section 267A, Section 267A disallows the corresponding U.S. deduction.

There are two ways by which a payment is not considered included in income under Treas Reg 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. Said simply, this rule coupled with the anti-avoidance rule, disallows deductions for hybrid and branch arrangements resulting in long-term tax deferral.

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, credit (other than for withholding tax imposed on the payment), or other similar relief particular to such type of payment. The regulations provide the following examples of such reductions or offsets: “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 from which a dividend is received; and 5) a recovery of basis with respect to stock or recovery of principal with respect to indebtedness.” Furthermore, a payment is not treated as reduced or offset for this purpose if it is offset by a “generally applicable deduction or other tax attribute, such as a deduction for depreciation or net operating loss.”

Section 245A(e)

Internal Revenue Code Section 245A(e) disallows a dividends received deduction (the “DRD”) received by a U.S. shareholder from a Controlled Foreign Corporation or CFC if the dividend is a “hybrid dividend.” Section 245A(e) defines a “hybrid dividend” as an amount received from a CFC for which a deduction would be allowed under Section 245A(a) and for which the CFC received a deduction or other tax benefit in a foreign country.

Section 267A of the Internal Revenue Code disallows a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. Section 267A defines a “disqualified related party amount” as any interest or royalty paid or accrued to a related party where there is no corresponding income inclusion to the related party in the foreign country or where the related party is allowed a deduction with respect to such amount in the foreign jurisdiction.

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 Final 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.

These new rules address Section 355 spin-off transactions, requiring taxpayers to allocate hybrid deduction accounts in the same manner as earnings and profits. 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.

The 2018 Proposed Regulations also contained an anti-avoidance rule that requires adjustments to be made if a transaction or arrangement is engaged in with a principal purpose of avoiding the purpose of the regulations. The final Section 245(e) regulations retain this rule, but modify it to provide that the anti-avoidance rule does not apply to disregard a restructuring of a hybrid arrangement into a non-hybrid arrangement. Finally, to deal with an unintended result of the 2018 Proposed Regulations, the final regulations provide that the tiered hybrid dividend rule only applies to a domestic corporation that is the U.S. shareholder of both the upper-tier and low-tier CFC and, thus, does not apply to individuals.

Below, please see Illustration 9, Illustration 10, and Illustration 11 which discuss tiered hybrid dividends, hybrid dividends, and the impact of the imputation systems.

Illustration 9.

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 10.

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 11.

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, FZ 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. See Baker McKenzie, Tax News and Developments, North America, Final Anti-Hybrid Rules, Jeff Rubinger and Summer Ayers LePree.

Conclusion

This article is intended to provide a basic understanding of the rules governing the taxation of foreign business organizations for U.S. tax purposes. It should be evident from this article that this area of law can become extremely complicated. Thus, it is crucial when U.S. investors are considering establishing a foreign entity, the U.S. investors consult with a qualified international tax attorney to ensure that any proposed planning is appropriate and does not run contrary to U.S. tax law.

Anthony Diosdi is an international tax attorney 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.