By Anthony Diosdi
The Internal Revenue Service (“IRS”) has issued final regulations (T.D. 8611) relating to conduit financing arrangements under authority granted by Section 7701(l). These regulations were effective September 10, 1995. Under the anti-conduit regulations, the IRS may disregard the participation of a conduit entity and recharacterize separate financing transactions to which a conduit is a party as a direct financing between the ultimate provider and ultimate recipient of the financing. For such an intermediate entity to be a conduit: 1) there must be two or more “financing” transactions linked by the common “immediate entity” or group of related entities (i.e., “financing arrangement”), 2) the participation of the intermediate entity must have the effect of reducing U.S. tax, and 3) the participation of the intermediate entity must be pursuant to a tax avoidance plan.
The result of the anti-conduit regulations is that intermediate entities (“conduits”) are disregarded in the determination of U.S. taxes on international financing arrangements, which may include loans, leases, and licenses. The key factors that will result in the recharacterization of a conduit entity are:
1) The participation of the intermediate entity or entities which reduces the tax imposed by Section 881 of the Internal Revenue Code Section 881(a) imposes a 30-percent tax on “interest, dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.”
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 anti-conduit regulations identify 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) 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 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 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. 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. The role of the conduit will be disregarded.
In 2020, the IRS issued anti-conduit regulations targeting hybrid entities and hybrid instruments. This article discusses these regulations.
Hybrid Entities
For U.S. tax purposes, a hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes. Hybrid entities provide the tax advantage of flow-through entity form (i.e., a partnership), while still providing the U.S. parent corporation with limited liability and a “corporate” presence in the host country. For example, an entity that is considered a branch or a partnership for U.S. tax purposes would allow losses to flow-through and be deducted by the U.S. parent corporation. Reverse hybrid entities on the other hand are treated as corporations by the U.S., but as flow-through entities by foreign countries.
The proposed anti-conduit regulations enacted in 1993 hybrid entities precluded transactions that exploit potential inconsistencies between the treatment of entities as disregarded for federal tax purposes but as “resident” in a treaty jurisdiction and therefore entitled to claim benefits for treaty purposes.
Below, please see Illustration 1 which demonstrates how the proposed regulations treated hybrid entities.
Illustration 1.
FP, a foreign corporation organized in a jurisdiction that does not have an income tax treaty with the United States (e.g., the Cayman Islands), lends $1 million to DS, a corporation organized in the United States, in exchange for a note issued by DS. A year after making the original loan, FP assigns the DS note to FS, a wholly-owned foreign subsidiary of FP organized in a jurisdiction that has an income tax treaty with the United States (e.g., the Netherlands) in exchange for a note issued by FS. The DS-FS income tax treaty eliminates withholding tax on interest and royalties. FS is a disregarded entity under the check-the-box regulations. After receiving notice of assignment, DS remits payment due under its note to FS without withholding tax. See Prop. Reg. Section 1.881-3(e), Ex 2.
As a condition to claiming benefits of an income tax treaty, a claimant must be a “resident” in the treaty country. Treaty residence turns on whether the claimant is generally liable to tax in that treaty jurisdiction. Because “residence” is specifically defined in treaty residence articles, an entity’s U.S. income tax classification generally is not relevant to this determination or its entitlement to treaty protection. Unless a particular treaty includes specific rules for hybrid entities, treaty residence depends solely on the entity’s non-U.S. income tax treatment. Accordingly, if the Netherlands subsidiary in Illustration 1 is liable to Netherlands corporate tax, it is a resident for purposes of the treaty. Such a disregarded entity could qualify as the “beneficial owner” of income for treaty purposes. Accordingly, in the transaction discussed above in Illustration 1, the disregarded entity may qualify as a treaty resident person.
Hybrid Instruments
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 HJ Woll, Hybrid Instruments- Current Issues, 553 PLI/TAX 175, 181 (2002). Below, please see Illustration 2 which provides an example of how the anti-conduit rules have been applied to hybrid instruments.
Illustration 2.
IE, an unlisted foreign corporation organized in an EU treaty jurisdiction, Country N, is owned by residents of that jurisdiction. IE lends $1 million to DS, a corporation related to IE and organized in the United States, in exchange for a note issued by DS. FP, a corporation organized in a country that has a less favorable income tax treaty with the United States advances funds to IE in exchange for a “perpetual” subordinated debt instrument. Country N tax rules allow IE to deduct payments on perpetual debt and do not subject these payments to withholding tax. Deductible payments on the perpetual debt are not significant enough in the aggregate to cause IE to fail to satisfy the LOB base erosion test in the U.S.-Country N treaty.
To the extent payments are deductible for local law purposes, this reduces or eliminates the effective tax on the issuer of the instrument (IE) from participating in the arrangement. Assuming the hybrid instrument is properly treated as equality for U.S. income tax purposes and is not redeemable by its terms, it may not be treated as a “financing transaction” within the definition of the anti-conduit regulations. See New York Bar Association Tax Section, Report On the Application of Anti-Conduit Regulations to Hybrid Entities and Instruments, August 27, 2009.
Section 267A
As indicated above, the appropriate treatment of hybrid instruments and entities raises difficult issues. In 2020, the IRS and Department of Treasury announced final and proposed regulations under Section 267A addressing hybrid financing regulations enacted to address hybrid instruments and hybrid entities. Section 267A was enacted as part of the 2017 Tax Cuts and Jobs Act. Section 267A denies a deduction for certain amounts paid or accrued to related parties pursuant to a “hybrid transaction” or by, a “hybrid entity.”
Internal Revenue Code Section 267A disallows a deduction for interest or royalties paid or accrued in certain transactions involving a hybrid instrument. This provision 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 3 and Illustration 4 which demonstrates two examples of hybrid instruments.
Illustration 3.
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 hybris 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 4.
Assume the facts for illustration 4 are the same as illustration 3. 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).
The Proposed Regulation discusses the circumstances in which a deduction is disallowed under Section 267A. According to the Proposed Regulations, a “specified party’s” deduction for any interest or royalty paid or accrued (an amount paid or accrued with respect to the specified party for a “specified payment”) is disallowed to the extent it produces a D/NI outcome such as: 1) a “disqualified hybrid amount;” 2) a “disqualified imported mismatch amount;” and 3) payments that satisfy the requirements of the Section 267A anti-avoidance rule. These rules do not apply if the amount of a specified party’s interest and royalty deductions are less than $50,000.
The above discussed Proposed Regulations only apply to a “specified party.” A “specified party” is defined as any one of the following: a “tax resident” of the United States; a controlling 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.” See Treas. Reg. Section 1.267A-5(a)(17).
Hybrid Transactions
Long Term Deferral
The 2018 Proposed Regulations disallowed a deduction for any specified payment to the extent that the specified payment produced a D/NI outcome as a result of a hybrid branch arrangement. 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. The final regulations retained the long-term deferral provisions but provided that a determination as to whether long-term deferral exists is made by establishing when the payment is “reasonably expected” to be included in income. This is discerned at the time the payment is made. The regulations also state that if a specified payment will never be recognized under the tax law of the specified recipient (the foreign tax law does not impose an income tax) the long-term deferral rule does 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 5 which discusses a hybrid sales/license transaction.
Illustration 5.
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, 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.
For example, let’s assume that Corp A, a domestic corporation, borrows from Corp B, a foreign corporation incorporated in Country X. The loan is treated as debt in the U.S. and Country X. However, the loan is interest free. Because the loan is interest free, the loan will be treated as a hybrid transaction under Treasury Regulation Section 1.267A-2(a)(4) and the interest paid by Corp A to Corp is treated as a disqualified hybrid imputed interest.
Reverse Hybrids
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).
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 provide that only the no-inclusion portion will give rise to a disqualified hybrid amount. The following example provides clarification for this rule.
Assume that a $100 specified payment is made to a reverse hybrid 60 percent 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 percent 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 includes 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 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. This approach prevents the routing of a specified payment through a low-tax third country to avoid Section 267A.
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. 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 Baker McKenzie, Tax News and Developments, North America, Final Anti-Hybrid Rules, Jeff Rubinger and Summer Ayers LePree.
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.
Ordering Rules
The final Section 267A regulations include ordering rules for offsetting income attributable to an imported mismatch payment against a hybrid deduction. When there are multiple mismatch payments, a hybrid deduction is first considered to offset income attributable to the imported mismatch payment that has the closest nexus to the hybrid deduction. The Final Regulations retain this approach with two clarifications. First, the final Section 267A regulations apply a hybrid deduction to offset income that is attributable to a “factually-related imported mismatch payment.” A factually-related imported mismatch payment” is essentially the imported mismatch payment with the closest nexus to the hybrid deduction. In other words, an imported mismatch payment is a factually related mismatch only if a design of the plan or series or related transactions was for the hybrid deduction to offset income attributable to the payment. Second, to the extent there is any excess hybrid deduction remaining after applying the deduction to the factually related imported mismatch payment, that excess should offset an imported mismatch amount that is not a “factually related imported mismatch amount” and which directly funds the hybrid deduction.
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 9 which provides an example of a disqualified imported mismatch amount.
Illustration 9.
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 Baker McKenzie, Tax News and Developments, North America, Final Anti-Hybrid Rules, Jeff Rubinger and Summer Ayers LePree.
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 discussed 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) 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 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.
The final 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.
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.
New Proposed Conduit Regulations
The conduit regulations allow the IRS to disregard a conduit entity in a conduit “financing arrangement” so that the financing arrangement is a transaction directly between the remaining parties. These rules are meant to prevent the use of a multiple party financing transaction to avoid withholding tax. Under the current conduit financing regulations, an instrument that is treated as equity for U.S. tax purposes will generally not result in a financing transaction, even if the instrument is treated as debt for foreign law purposes. The Treasury Department and the IRS determined that these types of instruments could be used inappropriately to avoid the application of the conduit financing regulations and raised similar D/NI concerns as those addressed by Sections 267A and 245A(e). The Proposed Regulations were issued to address these concerns.
The Proposed Regulations would expand the types of equity interests treated as financing transactions to include stock or a similar interest if the tax laws of a foreign country where the issuer is resident allow the issuer to take a deduction or other tax benefit for an amount paid, accrued or distributed with respect to the stock or similar interest. Similarly, if the issuer maintains a taxable presence (“PE”) in a country that allows a deduction (including a notional deduction) for an amount paid, accrued or distributed with respect to the PE’s deemed equity or capital, then the amount of the deemed equity or capital would be treated as a financing transaction. The Proposed Regulations would also treat equity as a financing transaction if a person related to the issuer is entitled to a refund (including a credit) or similar tax benefit for taxes paid by the issuer. If an equity interest constituted a financing translation because the issuer is allowed a NID, the Proposed Regulations would limit the portion of the financed entity’s payment that is recharacterized under Treasury Regulation Section 1.881-3(d)(1)(i). The recharacterization portion would equal the financing transaction’s principal amount as determined under Treasury Regulation Section 1.881-3(d)(1)(ii), multiplied by the applicable rate used to compute the issuer’s NID in the year of the financed entity’s payment.
Conclusion
The foregoing discussion is intended to provide the reader with a basic understanding of the anti-conduit and anti-hybrid regulations. It should be evident from this article, however, that this is a relatively complex subject. It is also important to note that this area is constantly subject to new developments and changes. As a result, it is crucial that anyone involved in a cross-border transaction consult with a qualified international tax attorney when planning a proposed transaction.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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.