On Tuesday, April 7th, the IRS released final and proposed regulations dealing with so-called hybrid mismatches between the U.S. and foreign tax treatment of certain items. All global organizations should immediately review their cross-border tax profiles for the application of these rules. The implication of these regulations, in most cases, is the loss of a deduction, or the inclusion of income. The regulations apply the rules throughout a global structure, applying not only to U.S. entities, but also CFCs.  In certain instances, these rules may even apply to transactions with unrelated parties.

The regulations are organized around three different types of mismatches.  We have outlined those generic mismatches below.  To ensure the applicability to the vast number of structures and transactions, the writers were forced to issue complex and dense regulations in this area.  Many taxpayers will find these regulations difficult to digest and apply. As an assist, we have included a short high-level explanation of the regulations below, a short list of fact patterns that are likely implicated, and a link to a more comprehensive discussion of the regulations for those who may be affected.

For the most part, these regulations are already in effect and may apply to prior periods.  The final regulations dealing with hybrid instruments/entities under section 267 are generally effective for tax years ending on or after December 20, 2018. The final regulations dealing with hybrid dividends under section 245A(e) apply to distributions made after December 31, 2017, provided those distributions occur during tax years ending on or after December 20, 2018.  For the final regulations issued under sections 267A and 245A(e), taxpayers may either apply the final regulations or the 2018 proposed regulations to earlier periods but must apply either set of regulations in their entirety.  Note that the final regulations under both sections have special effective dates for certain rules.  

We expect taxpayers will pursue unwind transactions in response to these regulations. We further expect that the unwind transactions themselves will have thorny cross-border tax issues. We will be working with our clients to address these issues and unwind applicable transactions and structures in short order to avoid adverse tax consequences under these regulations. We suggest all global organizations follow suit.

As discussed above, there are generally three different types of mismatches that the regulations address.  These mismatches arise in the following three categories of outcomes: 

• A double-nontaxation outcome - Non-inclusion of income under either foreign or U.S. law.  An example of this result may occur when a foreign corporation pays a dividend to its U.S. corporate parent if the foreign corporation is allowed a local country deduction (or other tax benefits) for paying the dividend and the U.S. corporation receives a 100% dividends received deduction (participation exemption deduction).
• A double deduction outcome - Two deductions for the same item (i.e. one in the U.S. and one in a foreign country).  An example of this result may occur when a Foreign parent corporation owns a U.S. group of companies that have a common U.S. parent company that is a reverse hybrid entity (e.g. a U.S. partnership that elected to be classified as a corporation for U.S. tax purposes, but that is a pass-through entity for foreign tax purposes). In the absence of the anti-hybrid provisions, losses incurred by the U.S. parent company would be deductible for U.S. tax purposes, in consolidation, against the income of other U.S. group companies. At the same time, the losses of U.S. parent corporation would pass through under foreign tax law providing a second deduction for the foreign parent corporation.
• A deduction/no-inclusion outcome (D/NI outcome) - A deduction for U.S. tax purposes (including at the level of a CFC) and no income inclusion for foreign tax purposes.  An example of this result may occur when a U.S. corporate subsidiary makes an interest payment to its foreign corporate parent on an instrument that is treated as debt for U.S. tax purposes and equity in the foreign corporate parent’s local country.  Assuming the foreign corporate parent’s local country has a participation exemption for dividends, this transaction would result in a deduction in the U.S. and no income inclusion in the local country.    

Prior to the TCJA, whether a foreign-related item was deductible for U.S. tax purposes was generally determined under U.S. tax principles, without consideration of the effect of that item under foreign tax law (i.e. without regard to whether the item was part of an arrangement that yields any of the types of mismatches described above). An exception to that general principle can be found in the dual consolidated loss (DCL) rules, which fall in the double deduction outcome category and disallows the use of the same loss to offset the income of both a domestic affiliate and a foreign affiliate.

Largely as a result of the OECD’s Base Erosion and Profit Shifting (BEPS) initiatives (which can be found here), TCJA enacted two new sets of rules dealing with hybrid arrangements.   

• Double-nontaxation outcomes: Section 245A(e) disallows the 100% participation exemption for dividends from foreign subsidiaries, or can give rise to subpart F income in certain instances, where the dividend is paid from earnings that have not been taxed (or have received some major tax benefit) in the country of the subsidiary.  
• Double deduction outcome or D/NI outcome: Section 267A disallows deductions of U.S. taxpayers, as well as CFCs, if the amount in question is part of an arrangement that would otherwise result in either a double deduction outcome or a D/NI outcome.

The new final regulations address the TCJA hybrid rules of sections 245A(e) and 267A, as well as the DCL rules that predate the TCJA.   The new proposed regulations deal with related matters, such as the adjustment of hybrid deduction accounts for the impact of disallowances on the E&P of CFCs and the allocation of disallowed deductions to GILTI.

Luckily, we have two pieces of good news.  First, the definition of “interest” in these regulations is scaled back, in response to comments that were submitted with respect to the proposed section 163(j) regulations.  Specifically, the hybrid regulations no longer treat “Income, deduction, gain, or loss from a derivative, as defined in section 59A(h)(4)(A), that alters a person’s effective cost of borrowing with respect to a liability of the person … as an adjustment to interest expense of the person.”  While there is no guarantee that the definition of interest in the yet-to-be-released final section 163(j) regulations will be the same as the definition of interest in the anti-hybrid regulations, the final regulations may be a harbinger of similar treatment in the final section 163(j) regulations (especially because the proposed anti-hybrid regulations and the proposed section 163(j) regulations were published on the same day, December 28, 2018, and it may be presumed that the development of the two regulation packages was coordinated to some extent). 

Second, not all taxpayers will be affected by these hybrid rules.  Due to their complexity, it is difficult to provide a comprehensive list of the taxpayers that may be adversely affected.  That being said, here is a list of structures and transactions that create a high risk of adverse tax consequences under these rules:

• If you are a US corporation that owns at least 10 percent of the vote or value of one or more CFCs and either
  • Any of these CFCs get a local country deduction or other tax benefits for dividends paid or
  • Any of these CFCs get a notional interest deduction or any other interest deduction with respect to equity in their local country.These arrangements may give rise to adverse consequences even if local country rules suspend, or in some cases disallow, the deduction or other tax benefit (including by application of their hybrid rules).
• If you are a US taxpayer, or a US branch of a foreign taxpayer, which pays or accrues interest or royalties to a foreign person that are directly or indirectly not (or that you expect would not be) fully included in the gross income of that foreign person (or another foreign person who funds the transaction).
• If your structure includes a U.S. non-corporate entity that has made a check-the-box election on or after December 20, 2018 to be classified as a corporation for U.S. tax purposes (i.e., a reverse hybrid entity) and is the parent company of an affiliated group of domestic corporations that file a consolidated return. 

In the event that your structure or transactions are at a high risk of adverse tax consequences under these rules, or you would just like to experience their complexity for yourself, you can click here for a more comprehensive discussion of the final and proposed regulations.