IRS issues guidance on treaty application to reverse foreign hybrids

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The IRS recently released AM 2025-002, concluding that a reverse foreign hybrid entity with effectively connected income (ECI) attributable to its U.S. permanent establishment (PE) is entitled to a reduction in the rate of branch profits tax (BPT) under section 884 under an applicable bilateral tax treaty. 

Scenario under consideration

The Sept. 19 memorandum addresses a scenario in which a reverse hybrid (RFHX) is formed under Country X and is treated as a corporation for U.S. tax purposes, but is treated as transparent under Countries X, Y, and Z. RFHX has four equal owners:

• A, an individual resident in Country Y;
• B, a publicly traded Country Y corporation;
• C, a privately held Country Y corporation wholly owned by an individual resident in Country Z; and
• D, an individual resident in Country Z.

RFHX distributes all ECI to its owners as earned and does not reinvest in its U.S. business. Thus, such income is subject to U.S. federal corporate income tax and BPT, with the dividend equivalent amount (DEA) generally taxed at 30% under Section 884 in the absence of any treaty relief.

The U.S. has an income tax treaty with Country Y, but not with Countries X or Z. The U.S.-Country Y treaty includes a BPT provision which allows a contracting state to impose a BPT on the portion of business profits comprising a DEA of a company (resident in the other contracting state) that has a PE in the taxing contracting state to which the profits are attributable, with the applicable BPT rate subject to reduction if the company meets the 12-month residence requirement. To align with the object and purpose of this provision, the IRS interprets the term “company” by reference to U.S. law, under which RFHX is treated as a corporation subject to BPT.

In addition, the U.S.-Country Y income tax treaty includes a fiscally transparent entity (FTE) provision, consistent with the 2016 U.S. Model Income Tax Convention (2016 Model). This provision treats an item of income, profit or gain derived by or through an entity treated as fiscally transparent under the laws of either the source state or residence state as derived by a resident of a contracting state to the extent the item is subject to tax in such contracting state as income of a resident.

IRS conclusion

The IRS adopts a modified look-through approach in applying the FTE provision in the context of a DEA to profits derived through an FTE to take into account such entity’s tax attributes and characteristics under the source state’s law. Thus, RFHX’s U.S. business is treated under the U.S.-Country Y treaty as an enterprise of a resident of Country Y to the extent RFHX’s owners are residents of Country Y.

The IRS concluded that RFHX is entitled to a reduction in the BPT rate on the portion of its DEA corresponding to the interests held by A and B, since these owners (1) are residents of Country Y and taxable on their share of RFHX’s profits under Country Y law, (2) have satisfied the treaty’s 12-month residence requirement, and (3) meet the applicable limitation on benefits test.

The IRS also specifically noted that the same result would be obtained under treaties containing the FTE provisions in the 1996 and the 2006 U.S. Model Income Tax Convention, notwithstanding slight differences in wording from the 2016 Model, as the IRS does not view those differences as substantive. In addition, the IRS indicated that similar conclusions would apply under treaties containing the FTE provision of the draft 1981 U.S. Model Income and Capital Tax Convention.

While AM 2025-002 is not binding precedent and future guidance may ultimately address this issue, it provides useful insight into the IRS’s current interpretation regarding the potential application of treaty relief to reverse foreign hybrids subject to the BPT. Taxpayers with similar structures may review their current positions to assess whether this development could affect their BPT exposure.

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