Business and International Tax Blog

The Service recently issued proposed regulations [REG-104352-18] at the end of 2018 pertaining to hybrid dividends and amounts paid or accrued in hybrid transactions or with hybrid entities. Hybrid payments, transactions and entities are often utilized in structuring relationships between domestic and foreign parties, including affiliates and related parties. The objective for employing a “hybrid” feature in many instances  is to achieve a favorable tax outcome across jurisdictions. In some cases an intended double benefit in the form of a deduction/ no income outcome or a double non-taxable income outcome.

Many cross-border transactions may be treated differently for US and foreign tax purposes because of differences in the tax law of each country. There are situations involving the US tax treatment of a transaction that does taken into account foreign tax law, such as with respect to withholdable payments to hybrid entities for which treaty benefits are claimed under section 894(c) and for dual consolidated losses subject to section 1503(d). In most instances, however, US tax treatment of a particular item or treatment of a transparent or non-transparent entity for US income tax purposes does not taken foreign tax law into account. In many instances the hybrid qualities of a particular transaction, payment or entity may be viewed by tax administrators as “gamesmanship” on the part of clever taxpayers and their tax advisors.

In response to international concerns regarding hybrid arrangements used to achieve double non-taxation, Action 2 of the OECD's Base Erosion and Profit Shifting (“BEPS”) project, and two final reports address hybrid and branch mismatch arrangements.[1] The Hybrid Mismatch Report seeks to neutralize the tax effects of hybrid arrangements that are viewed as exploiting  differences in the tax treatment of an entity or instrument under the laws of two or more countries, i.e., “hybrid mismatches”. The Branch Mismatch Report also attempts to neutralize the tax effects of certain arrangements involving branches that results in mismatches similar to hybrid mismatches, i.e., “branch mismatches”. Given the similar features and taxpayer desired tax avoidance outcomes involving hybrid mismatches and branch mismatches, the Branch Mismatch Report recommends that a jurisdiction adopting rules to address hybrid mismatches as well as rules to address branch mismatches.

As part of the Tax Cuts and Jobs Act enacted into law on December 22, 2017, sections 245A and 267A were enacted into law as hybrid transaction policing rules. Section 245A, which is effective for taxable years beginning after 2017, allows a participation exemption of 100% of a dividend received by a US shareholder that is a domestic corporation from a foreign corporation. Section 245A(e) denies the 100% dividends received deduction with respect to “hybrid dividends”.  Section 267A, which applies to tax years also beginning after December 31, 2017, denies certain interest or royalty deductions involving hybrid transaction or hybrid entities.

Hybrid Dividends and the Participation Exemption Under Section 245A(e)

With respect to section 245A(e), this provision is designed to prevent double non-taxation (involving two jurisdictions) by disallowing the 100% dividends received deduction for dividends received from a controlled foreign corporation (“CFC”) by a US shareholder, or by mandating subpart F inclusions for dividends received from a CFC by another CFC, if there is a corresponding deduction or other tax benefit in the foreign country.

The proposed regulations provide that a dividend is generally a hybrid dividend if it meets two conditions: (i) but for section 245A(e), the section 245A(a) deduction would be allowed, and (ii) the dividend is one for which the CFC (or a related person) is or was allowed a deduction or other tax benefit under a “relevant foreign tax law,” as such phrase is defined under the proposed regulations. The rule-making also provides guidance as to when a deduction or other tax benefit is considered a hybrid deduction and rules that address tiered corporations and hybrid dividends. The proposed regulations contain rules for “hybrid deduction accounts” regarding the stock of a CFC and provide rules that take into account transfers of the stock. The regulations also provide a special rule with respect to earnings and profits of a lower-tier CFC that are included in a domestic corporation’s income as a dividend. An anti-avoidance rule is also set forth in the proposed regulations.

Section 267A and Hybrid Payments

Section 267A denies a deduction for any “disqualified related party amount” paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. A disqualified related party amount is any interest or royalty paid or accrued to a related party to the extent that: (i) there is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, or (ii) such related party is allowed a deduction with respect to such amount under the tax law of such country.

A disqualified related party amount does not include any payment to the extent such payment is included in the gross income of a US shareholder under section 951(a). A related party is determined under section 954(d)(3), except that such section applies with respect to the payor as opposed to the CFC otherwise referred to in such section.

A hybrid transaction is any transaction, series of transactions, agreement, or instrument one or more payments with respect to which are treated as interest or royalties for Federal income tax purposes and which are not so treated for purposes of the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax. A hybrid entity is any entity which is either: (i) treated as fiscally transparent for Federal income tax purposes but not so treated for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, or (ii) treated as fiscally transparent for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax but not so treated for Federal income tax purposes.

The provision further provides that the Secretary shall issue regulations or other guidance as may be necessary or appropriate to carry out the purposes of the provision, including regulations or other guidance providing rules for: (i) denying deductions for conduit arrangements that involve a hybrid transaction or a hybrid entity, (ii) the application of this provision to foreign branches, (iii) applying this provision to certain structured transactions, (iv) denying all or a portion of a deduction claimed for an interest or a royalty payment that, as a result of the hybrid transaction or entity, is included in the recipient's income under a preferential tax regime of the country of residence of the recipient and has the effect of reducing the country's generally applicable statutory tax rate by at least 25%, (v) denying all of a deduction claimed for an interest or a royalty payment if such amount is subject to a participation exemption system or other system which provides for the exclusion or deduction of a substantial portion of such amount, (vi) rules for determining the tax residence of a foreign entity if the foreign entity is otherwise considered a resident of more than one country or of no country, (vii) sets forth exceptions to the general rule set forth in the general rule in section 267A, and (8) imposes requirements for record keeping and information in addition to any requirements imposed by section 6038A. The legislative history to the TCJA explains that section 267A is intended to be “consistent with many of the approaches to the same or similar problems [regarding hybrid arrangements] taken in the Code, the OECD base erosion and profit shifting project (“BEPS”), bilateral income tax treaties, and provisions or rules of other countries.” [2] The types of hybrid arrangements of concern are arrangements that “exploit differences in the tax treatment of a transaction or entity under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral.” Hybrid arrangements targeted by these provisions are those that rely on a hybrid element to produce such outcomes.

The proposed section 267A regulations address situations where hybrid payments or arrangements have the effect of a deduction for one related party and no inclusion for the other related party or so-called “D/NI outcomes” or “indirect D/NI outcomes”. The proposed regulations deny a deduction under  section 267A with respect to specified payments or accruals of interest or royalties for U.S. tax purposes to the extent of the D/NI outcome or indirect D/NI outcome. The regulations set forth definitional rules identifying the specific parties that are subject to section 267A and provide rules for determining the amount of a specified payment that is or is not included in income under foreign tax law. Hybrid and branch arrangements giving rise to disqualified hybrid amounts and when a specified payment is a disqualified hybrid amount are also addressed. Interest is broadly defined under the regulations. The proposed regulations set forth additional rules undersections 1503(d) and 7701 to prevent the same deduction from being claimed under the tax laws of both the US and a foreign country.

This post may not be relied upon by the reader as constituting legal advice by either Chamberlain Hrdlicka or this author. The post is intended solely for educational purposes. Any reader having questions concerning the subject addressed and/or content of this post should consult with the reader’s tax counsel or tax adviser.

[1] OECD/G20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report (October 2015) (the “Hybrid Mismatch Report”); OECD/G20, Neutralising the Effects of Branch Mismatch Arrangements, Action 2: Inclusive Framework on BEPS (July 2017) (the “Branch Mismatch Report”).

[2] See Senate Committee on Finance, Explanation of the Bill, at 384 (November 22, 2017).