On Tuesday, April 7th, the IRS released final and proposed regulations dealing with so-called hybrid mismatches between the US and foreign tax treatment of certain items. 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 US tax purposes was generally determined under US 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 US 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 (discussed below) for the impact of disallowances on the E&P of CFCs and the allocation of disallowed deductions to GILTI. 

Hybrid Dividend Provisions

Introduction

The final regulations provide that a hybrid dividend is a dividend that is otherwise eligible for the section 245A 100% dividend-received deduction, but for which the CFC is or was allowed a “hybrid deduction.” A hybrid deduction is generally defined as a deduction or other tax benefit allowed under the relevant law of a CFC’s local country which relates to or results from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC and treated as stock for U.S. tax purposes, or is a deduction allowed to the CFC with respect to equity. Section 245A(e) denies the section 245A 100% dividends-received deduction for “hybrid dividends”, and any foreign tax credits or foreign tax deductions with respect to hybrid dividends. Thus, the section 245A(e) final regulations include a complex set rule for determining whether a dividend distribution came from earnings that benefited from a “hybrid deduction” or “other tax benefit” in the “relevant foreign country.”   

A tiered hybrid dividend is a dividend that is received by a CFC from another CFC to the extent that the dividend would be a hybrid dividend under the final regulations if the receiving CFC were a domestic corporation. Tiered hybrid dividends are treated as subpart F income, and the exemptions which are generally available to exclude related party dividends from subpart F income are not available for tiered hybrid dividends (the “same country” exception and the CFC look-through rule under section 954(c)(6)). 

Highlights of the final regulations

The final regulations provide that a specified owner of a CFC has to maintain a hybrid deduction account with respect to each share of stock it owns in the CFC. The hybrid deduction accounts are used to determine the extent that a dividend received by the specified owner is a hybrid dividend or tiered hybrid dividend, and therefore ineligible for the section 245A participation exemption.

Specified owner of a CFC 

For purposes of applying these rules, a person is a specified owner of a share of stock of a CFC if the person owns the share directly or indirectly through a partnership, trust, or estate, and is either:

• A domestic corporation that is a United States shareholder (USSH), as defined in section 951(b) (generally, a domestic taxpayer which owns directly, indirectly, or constructively at least 10% of the value or voting power of the stock) of the CFC or
• An upper-tier CFC that would be a USSH of the CFC if it were a domestic corporation.  

If the taxpayer is not a specified owner of a CFC, then the hybrid dividend provisions do not apply to them.

Hybrid deduction accounts

A hybrid deduction account is an account maintained by the specified owner with respect to each share of stock of the CFC that the shareholder owns and reflects the amount of hybrid deductions of the CFC that have been allocated to that share. Conceptually speaking, hybrid deduction accounts perform a function similar to that of previously taxed earnings and profits (PTEP) accounts; except that the latter deals with earnings that have been previously taxed by the U.S., while the former deals with earnings that have been previously tax benefited in a relevant foreign country.   

The requirement to maintain a hybrid deduction account is, needless to say, very burdensome. Luckily, the final regulations provide three categories of relief from this requirement for many taxpayers.

1. The hybrid dividend rule applies only to domestic corporations that are a USSH of the top tier CFC in the structure. Thus, individuals are not required to maintain a hybrid deduction account under these rules. 
2. The tiered hybrid dividend rule applies only to domestic corporations that are a USSH of both the upper-tier CFC and lower-tier CFC. Thus, individuals are not subject to these rules.  
3. CFCs are exempt from the requirement of providing information required to maintain a hybrid deduction account if there is no domestic corporation that is a USSH and owns (within in the meaning of I.R.C. section 958(a)) one or more shares of the stock of the upper-tier CFC as there is no USSH which must maintain the account in these instances.

Other taxpayer relief in the final regulations

The final regulations provide some measure of relief to taxpayers by including a general anti-duplication rule which provides that when deductions or other tax benefits under relevant foreign tax law are duplicated in multiple tiers of CFCs, the deductions or other tax benefits only give rise to a hybrid deduction for the highest-tier CFC that received the benefit.  The final regulations also clarify that when a section 338(g) election is made with respect to a CFC target, the hybrid deduction account does not carry over to the stock of the target after the acquisition.  

The final regulations did address comments dealing with the application of foreign hybrid mismatch rules. They provide that the determination whether a relevant foreign tax law allows a deduction or other tax benefit for an amount is made without regard to the application of foreign hybrid mismatch rules, provided that the amount gives rise to a dividend for US tax purposes or is reasonably expected for US tax purposes to give rise to a dividend that will be paid within 12 months after the taxable period in which the deduction or other tax benefit would otherwise be allowed.

Areas where comments were unaddressed

Unfortunately, there was not much good news for taxpayers in the final regulations. In spite of comments to the contrary, the final regulations generally retain the definition in the 2018 proposed regulations of “other tax benefits”. As a result, the phrase includes a notional interest deduction (NID), as well as the allowance of an interest deduction with respect to equity. Additionally, the final regulations did not adopt comments requesting that a deduction or other tax benefit not be a hybrid deduction if a local country rule disallows or suspends the deduction in the year the dividend is paid.  

A&M Taxand Comment: The failure to address local country law disallowing or suspending deductions as well the failure to provide a blanket exemption for amounts that are subject to foreign hybrid mismatch rules could give rise to a worst-case scenario: the taxpayer is not entitled to a deduction in the foreign country, while the transaction still gives rise to a hybrid or a tiered hybrid dividend. As a result, rather than preventing double non-taxation, this could create the possibility where the same income is taxed twice: once in the foreign country and once in the US. We strongly encourage companies to determine whether this possibility exists in their current structures and to take proactive measures to alleviate this adverse result where necessary.

Provisions Disallowing Deductions for Amounts Paid or Accrued Pursuant to Hybrid Arrangements

Introduction

A D/NI result may arise in multiple settings involving hybrid instruments and entities; for example, such a D/NI outcome can arise when a taxpayer is provided a deduction under US tax law, but a foreign payee does not have a corresponding income inclusion with respect to the same item under foreign tax law.   Section 267A seeks to address arrangements that result in D/NI outcomes by disallowing a deduction to a US tax resident or taxable branch (a specified party) for interest or royalties paid or accrued in certain hybrid transactions, where the D/NI outcome results from hybridity (rather than from other factors such as a low foreign tax rate). Section 267A generally does not attempt to address so-called double deduction outcomes.

The final regulations largely maintain the framework designed by the 2018 proposed regulations, albeit with some taxpayer-friendly revisions. As we generally believe that involvement in arrangements to which these regulations apply is less likely to be “accidental” (i.e., these are highly complex arrangements  which achieve pre-planned results as envisioned by “sophisticated” taxpayers), we, therefore, assume readers have some background on this subject; regardless, we concede that the operation of the rules under this finalized framework remains highly complex and burdensome, even for sophisticated taxpayers (and even where changes made were taxpayer favorable) and could result in traps for the unwary which may yield outcomes that are tantamount to double taxation. Moreover, it is worth noting that this summary highlights the key parts of the Final Regulations rather than attempt to discuss the whole scope of the proposed and final regulations combined; additional background and context may sometimes be relevant and required to grasp the full effect of these rules.

Highlights of the final regulations

Hybrid or branch arrangements

The regulations addressing hybrid or branch arrangements target D/NI outcomes where a tax resident or taxable branch (a specified party) makes a payment of interest or royalties (a specified payment) to a foreign payee and such payee does not include the amount received in income under foreign tax law. For example, this may apply where a US corporation makes a payment on a hybrid instrument that is treated as debt for US tax purposes but is treated as equity under the tax laws of the foreign recipient, where a local participation exemption applies. In such a scenario, without the section 267A regulations, the interest payment on the debt would have been deductible for US tax purposes but exempt under the foreign participation exemption. 

The final regulations retain the taxpayer-friendly rule of the 2018 proposed regulations excluding “amounts included or includible in US income” from the definition of “disqualified hybrid amount” subject to the deduction disallowance rules. The rule provides that a specified payment is not a disqualified hybrid amount to the extent it is either (i) included or includible in the income of a tax resident of the US or a US taxable US branch, or (ii) is taken into account by a USSH under the subpart F or GILTI rules. The final regulations clarify that an amount is treated as included in subpart F income without regard to the current year E&P limitation under section 952(c) and also provide similar treatment to certain amounts included by US residents under the rules dealing with qualified electing funds.

A&M Taxand Comment: The inclusion of this rule (as well as an exception limiting the application of the “disqualified imported mismatch” rule discussed below) largely renders US outbound structures (those parented by a US person) materially unaffected by section 267A considerations, to the extent relevant payments or deductions result in a corresponding inclusion in US gross income.  

US withholding tax liability and inclusions by foreign countries 

The final regulations clarify that the determination whether a deduction for a specified payment is disallowed under section 267A is made without regard to whether the payment is subject to US withholding tax and to whether such tax has been withheld. 

A&M Taxand Comment: The preamble argues, in part, that had Congress intended for US withholding tax to be taken into account for section 267A purposes it could have included a rule similar to the one included under section 59A. It is an interesting observation that Treasury and IRS exercised its “broad regulatory authority” provided by section 267A throughout the regulation package but choose not to do so here (which can result in the actual double US taxation in applicable scenarios). 

Long term deferral rule

The final regulations retain the rule treating long term (36 months) deferral of an income inclusion by the recipient as the equivalent of non-inclusion for purposes of defining a hybrid arrangement, with certain limited taxpayer-favorable changes related to the recovery of principal and to hybrid sale or license transactions. In addition, the final regulations provide that the determination of whether a payment will result in long-term deferral is based on a “reasonable expectation” standard applied at the time of the payment.

Treatment of payments to reverse hybrids

The 2018 proposed regulations contained rules determining when payments made to a reverse hybrid entity will be treated as hybrid payments for purposes of section 267A. For this purpose, a reverse hybrid entity is an entity treated as fiscally transparent for purposes of the tax law of the country in which it is established but as a nontransparent entity for purposes of the tax law of the owner of the entity. The final regulations retain the reverse hybrid rules (i.e. that a payment made to a reverse hybrid is a disqualified hybrid amount to the extent the investor in the reverse hybrid does not include the payment in income and the no-inclusion resulted from the payment being made to the reverse hybrid) while slightly expanding them to include payments to certain collective investment vehicles and similar arrangements where, under existing rules, neither the entity nor its investors were required to take the payment into income. The final regulations also include limited taxpayer relief such that an investor in a reverse hybrid will be treated as including the payment to the reverse hybrid in income (therefore causing the payment to the reverse hybrid not to be a disqualified hybrid amount) where the reverse hybrid distributes all of its current year income to its owner(s) on a current basis.

Disqualified imported mismatch rules

The regulations addressing disqualified imported mismatch arrangements target D/NI outcomes where the effects of a hybrid arrangement are indirectly imported into the US, such that interest or royalty income of a foreign payee is offset. For example, a US corporation makes a payment of interest on an instrument that is treated as debt for US tax purposes and under the tax law of the foreign payee, but a hybrid deduction of the payee (e.g., a deduction on equity) offsets such income inclusion such that the result is materially a D/NI result.  Similarly, a US corporation makes a payment of interest, which is offset at level of the foreign recipient by a payment of interest on a hybrid instrument (treated as debt under the tax law of the payor but as equity under the tax law of the holder), but where the holder of the instrument has no inclusion under its tax laws (e.g. because a local participation exemption applies), resulting again in a D/NI outcome. 

Despite comments as to their complexity and cumbersomeness, the final regulations largely maintained the disqualified imported mismatch rules included in the proposed regulations, that prevent the effects of an offshore hybrid arrangement from being imported into the US tax network through the use of a non-hybrid arrangement. However, in response to such comments and in recognition of the complexity involved, the final regulations adopted certain modifications to the rules, some of them taxpayer friendly. One such taxpayer-friendly modification is the inclusion in the final regulations of an exclusive list of deductions that constitute hybrid deductions with respect to a tax resident or taxable branch the tax law of which contains hybrid mismatch rules – i.e., in the case of such tax resident or taxable branch, a taxpayer need only consider arrangements with respect to (i) equity, (ii) interest-free loans (and similar arrangements), and (iii) amounts that are not included in income in a third foreign country. 

Treatment of NIDs and IFLs  

The final regulations retain the rule treating notional interest deductions (NIDs; generally, taxable deductions imputed to a taxpayer with respect to its equity, such as those available under the tax laws of Brazil or Belgium) allowed to a tax resident under its tax law as hybrid deductions generating a D/NI result, as included in the proposed regulations. In addition, the final regulations confirm the view of the IRS that a D/NI outcome results from the imputation of interest expense on interest free loan (IFL) arrangements (i.e. a TP adjustment under local tax law imputed to the debtor in an interest free loan scenario), where the creditor of the IFL is to required to impute interest income inclusion under its tax laws. 

Such IFL and NID arrangements should, therefore, be treated as resulting in the disallowance of a deduction under the disqualified hybrid amount and/or disqualified imported mismatch amount rules. Similar to the section 245A(e) final regulations, the rules addressing NIDs and IFLs apply for tax years beginning on or after December 20, 2018.

Amounts included in US income  

Similar to the discussion above related to hybrid amounts included in the gross income of a US taxpayer, the final regulations also make adjustments to the disqualified imported mismatch rules, so as to limit their application to amounts not included or includible in US income. 

Structured arrangements  

In response to comments, under the Final Regulations, an arrangement would be a structured arrangement (an arrangement with an unrelated party involving a specified payment which would have been a disqualified hybrid amount or a disqualified imported mismatch amount if the arrangement was with a related party) provided that, based on all the facts and circumstances  (including the terms of the arrangement and whether the benefit of a hybrid deduction is priced into such terms), the arrangement is designed to produce a hybrid mismatch. The amended rule also incorporates a “reason to know” standard for the application of the rule to a specified party. The final regulations would apply the structure arrangements rule to specified payments made pursuant to such an arrangement only for taxable years beginning after December 31, 2020.

A&M Taxand Comment:  A structured arrangement can actually bring payments involving an unrelated party into the scope of these rules. Again, these types of arrangements are unlikely to be entered into “accidentally.”  Taxpayers need to be aware that the scope of these can be applied to transactions with unrelated parties and avoid entering into them in the future and ensure that any current arrangements that fall under these rules are unwound prior to the effective date. 

Other Highlights

The final regulations include a $50,000 de minimis threshold that applies to the total amount of interest or royalty deductions involving hybrid or branch arrangements. 

The final regulations also retain the “General Anti-Avoidance Rule” that provides that a specified party’s deduction for a specified payment is disallowed to the extent it gives rise to a D/NI outcome, and a principal purpose of the plan or arrangement is to avoid the purposes of the regulations under Section 267A, but only where a D/NI outcome is reached as a result of such hybrid or branch arrangement. 

DCL Provisions

Introduction

The DCL regulations were already complex prior to the TCJA. Thankfully, the addition to the DCL rules made by these new regulations does not add significantly to the complexity.   

Changes to the Check-the-Box Rules to Address Double Deduction Outcomes

In order to address double deduction outcomes, the new DCL-related regulations provide that a domestic eligible entity can elect to be treated as a corporation pursuant to the check-the-box rules only if it consents to be treated as a dual resident corporation under the DCL regulations. Under prior law, a domestic reverse hybrid (i.e., domestic entities that are fiscally transparent for foreign tax purposes but not fiscally transparent for US tax purposes) was not a dual resident corporation.

As a result, domestic reverse hybrid entities that make a check-the-box election after the effective date, will be dual resident corporations subject to the DCL rules. As a result, net operating losses of domestic reverse hybrid entities will be treated as dual consolidated losses if they flow through to (or otherwise offset the income of) a foreign affiliate under foreign tax law. Any such DCLs will therefore not be available for offset against the income of an affiliated domestic corporation, unless the corporation makes a domestic use election and the foreign owner foregoes the deduction.

A&M Taxand Comment: There may still be some planning possibilities for the use of domestic reverse hybrid entities in connection with start-up operations in the US by foreign companies. We are happy to discuss them with you.

Effective Date

This new required consent to be treated as a dual resident corporation is applicable, as a general rule, to any domestic eligible entity that filed an election to be classified as an association on or after December 20, 2018 (regardless of whether the election is effective before December 20, 2018). However, a special transition rule is provided for situations where, as a result of the applicability date, a domestic eligible entity that is classified as an association has not consented to be treated as a domestic consenting corporation. For those cases, the domestic eligible entity is deemed to consent to be so treated as of its first taxable year beginning on or after December 20, 2019. The deemed consent may be avoided by electing, on or after December 20, 2018 and effective before the entity’s first taxable year beginning on or after December 20, 2019, to be re-classified as a non-corporate entity.  For this purpose, the 60-month waiting period requirement to change a classification election is waived.  

Continued Study of Disregarded Payment Structures

The preamble to the final regulations indicates that the Treasury Department and the IRS continue to study disregarded payment structures and may in the future issue guidance addressing these structures.  This relates to structures involving payments from foreign disregarded entities to their domestic corporate owners that are respected for foreign tax purposes but disregarded for US tax purposes. The concern is that these structures “give rise to significant policy concerns that are similar to those arising under sections 245A(e), 267A, and 1503(d)” (presumably referring to D/NI outcomes). Actually, these structures are more likely to give rise to a trap for unwary taxpayers.   For more on that subject see Brewer, The Disregarded Entity Dual Consolidated Loss Boogeyman, Tax Notes, March 21, 2016 by clicking here.   

Provisions in the Proposed Regulations

The proposed regulations provide for a reduction in the hybrid deduction account for three categories of income.

1. Subpart F inclusions: The amount the hybrid deduction account is reduced by is calculated based on a complicated formula that is meant to allocate hybrid deductions to the subpart F income of the CFC. Note that this is not a dollar for dollar decrease.  
2. GILTI: As with subpart F income, the amount the hybrid deduction account is reduced by is calculated based on a complicated formula meant to allocate hybrid deductions to tested income.  Note that this is not a dollar for dollar decrease.
3. Section 956 Investments in US Property: The hybrid deduction account is reduced by an amount included in the gross income of a domestic corporation associated with section 956, to the extent it was included in the gross income of a USSH by reason of section 245A(e).  

The proposed regulations also expand the scope of the conduit financing rules by expanding the definition of equity interests that may be treated as a financing transaction by taking into account the tax treatment of the instrument under the tax law of the relevant foreign country. 

Lastly, the proposed regulations extend the anti-abuse rule in the final GILTI regulations dealing with transfers of property from a CFC to a related CFC during the “disqualified period” (generally the period after December 31, 2017, the final E&P measuring date for the Toll Charge under I.R.C. section 965, and before the date on which GILTI applies) to certain pre-payments of income between related CFCs made during the “disqualified period.” 

A&M Taxand Says

If your company’s group structure includes arrangements (whether intentional or not) that create any of the perceived abuses associated with hybrid arrangements, it will most likely be desirable to unwind those arrangements as soon as possible. The final regulations appear to leave no stone unturned in seeking to prevent any of the perceived hybrid abuses. Thus, there may be little to be gained from maintaining hybrid structures. What’s worse is that, in their attempt to prevent double nontaxation, double deduction and deduction/non-inclusion outcomes, the regulations appear to give rise to a new trap for the unwary: double taxation outcomes when the US hybrid rules are applied in concert with the hybrid rules of other countries.