The IRS recently released proposed regulations (REG-104352-18
) implementing anti-hybrid provisions enacted by the Tax Cuts and Jobs Act (TCJA). The regulations exercise a broad grant of authority provided under Sections 267A and 245A(e) to implement far-reaching rules targeting hybrid dividends, hybrid transactions and other transactions with hybrid entities.
TCJA added two new provisions targeting so-called “hybrid arrangements.” Hybrid arrangements generally look to 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, double deductions, or other tax benefits resulting from inconsistent treatment between local law and U.S. law.
The TCJA amendments came on the heels of an international response to hybrid arrangements in Action 2 of the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting Project that addressed hybrid and branch mismatch arrangements. The new provisions include Section 245A(e), which denies the dividends received deduction under Section 245A with respect to hybrid dividends, and Section 267A, which denies certain interest or royalty deductions involving hybrid transactions or hybrid entities.
The proposed regulations were released under Sections 245A(e), 267A, 1503(d), 6038, 6038A, 6038C, and 7701. In addition to implementing the provisions under Sections 245A(e) and 267A, the rules also provide new reporting requirements, and amend existing regulations addressing “dual consolidated losses” under Section 1503(d).
Many of the rules are proposed to be retroactively effective for hybrid distributions or payments on hybrid arrangements made after Dec. 31, 2017. However, a number of provisions, such as the reporting requirements and the changes to the dual consolidated loss rules, have later effective dates that are applicable to either tax years beginning on or after Dec. 20, 2018, or taxable years ending on or after Dec. 20, 2018, depending on the provision. Taxpayers should begin assessing how the proposed rules would affect them, and start planning for mitigation of hybrid arrangements negatively impacted by the rules. More details on the proposed regulations provided summarized below.
The TCJA replaced the current system of taxing U.S. corporations on foreign earnings of their foreign subsidiaries when the earnings are repatriated with a partial territorial system. The system provides a 100% dividends-received deduction (DRD) to domestic corporations for foreign-source dividends received from 10%-or-more owned foreign corporations. The TCJA also allows a DRD on certain deemed income inclusions resulting from the disposition of lower-tier controlled foreign corporations (CFCs) and subjects hybrid dividends received by a CFC from another CFC to Subpart F resulting in income inclusion for U.S. shareholders of that CFC. The DRD is not allowed for “hybrid dividends.” A hybrid dividend is an amount received from a CFC if the dividend gives rise to a local country deduction or other tax benefit.
The TCJA also created new Section 267A to deny a deduction for interest and royalties paid to related parties in connection with a hybrid transaction, including amounts paid by, or to, a hybrid entity. Interest or royalties cannot be deducted under the provision to the extent there is no corresponding income inclusion to the related party under the tax law of the country where the related party is resident or otherwise subject to tax, or to the extent such related party is provided a deduction in the local country. Section 267(e) provides Treasury broad, open-ended authority to issue regulations or other guidance to address situations involving conduit arrangements, branch transactions, structured transactions, tax preference items, participation regimes and dual residence situations, and other areas.
A “hybrid transaction” is any transaction, series of transactions, agreement, or instrument where payments 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 the recipient. A hybrid entity is any entity which is either (1) treated as fiscally transparent for U.S. income tax purposes but not treated that way under the tax law of the foreign country where the entity is resident for tax purposes or is subject to tax, or (2) treated as fiscally transparent for purposes of the tax law of the foreign country of which the entity is a tax resident or is subject to tax but not so treated for federal income tax purposes.
The proposed regulations generally implement provisions that deny the Section 245A DRD with respect to a hybrid dividend received by a domestic corporation from a CFC. The rules provide that if a U.S. shareholder of a CFC receives a “hybrid dividend” the recipient is not allowed a DRD and foreign tax credits and deductions are also disallowed with respect to the dividend.
In general, a dividend is a “hybrid dividend” if it would otherwise qualify for the Section 245A DRD, and the CFC (or a related person) paying the dividend is or was allowed a hybrid deduction or other tax benefit under relevant foreign tax law with respect to such dividend. The regulations provide rules that define hybrid deductions, and provide operating rules that require a connection between the hybrid deduction or other tax benefits under the relevant foreign tax law and the instrument that is stock for U.S. tax purposes.
The regulations also provide rules related to hybrid dividends of tiered corporations and require an inclusion under Section 951(a) with respect to a hybrid dividend received by a CFC from another CFC in a tiered structure to the extent that the amount would be a hybrid dividend if the receiving CFC were a domestic corporation. If a CFC receives a tiered hybrid dividend from another CFC, then the tiered hybrid dividend is treated as subpart F income by the CFC receiving it and the U.S. shareholder must include in income its pro rata share of the subpart F inclusion. Foreign tax credits and deductions are also disallowed with respect to the subpart F inclusion. General exceptions to subpart F income, such as the look-through rules, do not apply to exempt the amount from subpart F. The regulations clarify that distributions of previously taxed earnings and profits are not treated as hybrid dividends or tiered hybrid dividends and also clarify that certain amounts treated as dividends under Section 1248 may be treated as hybrid dividends.
Situations may arise where the dividend and the hybrid deduction are recognized in different taxable years. To address this issue, the regulations institute a tracking system. The tracking system requires maintenance of a “hybrid deduction account” by either the domestic corporation or the CFC receiving the dividend. A dividend paid by a CFC to a shareholder that has a hybrid deduction account is generally treated as a hybrid dividend or a tiered hybrid dividend to the extent of the shareholder’s balance in all of its hybrid deduction accounts with respect to the CFC.
Finally, the proposed regulations include an anti-avoidance rule that may result in “appropriate adjustments,” including adjustments that would disregard a transaction or arrangement it is undertaken with a principal purpose of avoiding the proposed regulations.
Grant Thornton Insight: The anti-abuse rule in the Section 245A(e) regulations is broadly drafted. The proposed regulations include examples of transactions that involve the transfer of shares to shift or eliminate the hybrid deduction account and also transactions that look to fail the holding period requirement to avoid having a dividend be classified as tiered hybrid dividends. When restructuring transactions and structures, taxpayers should take note of this rule and its potential breadth.
Related party amounts involving hybrid transactions and hybrid entities
The proposed regulations implement the provisions of Section 267A by disallowing deductions of “specified parties” for certain interest and royalty payments made to related parties. Section 267A did not limit the scope of the provision to any specific category of persons. However, the proposed regulations would narrow the scope to “specified parties.” A specified party is defined to be either a tax resident of the U.S., a CFC with at least one U.S. shareholder (i.e., a U.S. person that owns at least 10% directly or indirectly by vote or value of the stock of the CFC), or a U.S. taxable branch of a foreign corporation. They also provide a de minimis exception exempting specified parties from the rules if, for any taxable year, the sum of its interest and royalty deductions (plus interest and royalty deductions of any related specified parties) is below $50,000.
The proposed regulations generally disallow deductions only where there is a deduction without a corresponding income inclusion (referred to as “D/NI”). Double deductions are not addressed in the Section 267A proposed regulations, but are covered in other provisions (for example, under the dual consolidated loss rules discussed below). Additionally, the proposed regulations provide that a deduction is disallowed only to the extent that the no-inclusion portion of the D/NI outcome is a result of hybridity.
The deduction disallowed under Section 267A is limited to the amount of the no-inclusion aspect of a D/NI situation. The proposed regulations provide that only “tax residents” or “taxable branches” are considered to include an amount in income. A payment is included in income of a tax resident or taxable branch to the extent that under its local tax law it is included in the tax base and taxed at the full marginal tax rate imposed on ordinary income and not reduced or offset by exemptions, credits or other preferential regimes. Additionally, income which is deferred beyond 36 months is treated as a no-inclusion outcome.
The proposed regulations provide that Section 267A would not apply to payments made to CFCs, or between CFCs, to the extent the payments are included in income as either subpart F or Global Intangible Low-Taxed Income (GILTI). They also provide that Section 267A would not apply to payments made to tax resident of the U.S. or a U.S. taxable branch to the extent the payments are included in gross income.
The rules generally only apply to one of three categories of payments consisting of disqualified hybrid amounts, disqualified imported mismatch amounts, and specified payments satisfying anti-abuse requirements. A disqualified hybrid amount is a payment that produces a D/NI outcome as a result of a hybrid or branch arrangement. These would include payments with differing characterizations by the payor and the payee (e.g., payments treated as interest expense by payor, but as equity by payee) and payments that are disregarded under the payee’s tax law but regarded by the payors. A disqualified imported mismatch amount is a payment that produces an indirect D/NI outcome as a result of the effects of an offshore hybrid or branch arrangement being imported into the U.S. These would include non-hybrid payments to a foreign recipient for which the income is offset by a hybrid deduction. Finally, the anti-abuse requirements would be satisfied by any payment made pursuant to a transaction the principal purpose of which was to avoid the purposes of the regulations and that produces a D/NI outcome. Examples may include certain structured transactions and use of intermediaries to avoid the purposes of Section 267A.
The definitions of interest and royalties contained in the proposed regulations are broad. Interest is defined to include interest associated with conventional debt instruments, other amounts treated as interest under the Code, as well as transactions that are indebtedness in substance although not in form. This definition is similar to that found in the Section 163(j) proposed regulations. Royalties are defined to include amounts for use of, or the right to use, certain intellectual property and certain information concerning industrial, commercial, or scientific experience. The preamble to the proposed regulations provides that the royalty definition is generally based on the definition contained in Article 12 of the 2006 U.S. Model Income Tax Treaty.
Grant Thornton Insight: The proposed regulations are extremely broad and cover a large group of transactions. The definition of interest in particular can impact the scope of deductions subject to the rules. Taxpayers should assess the impact of these rules and consider whether it is advisable to restructure their intercompany arrangements. Additionally, all structured transactions and other arrangements should be examined in light of the anti-abuse rules.
Sections 6038, 6038A and 6038C impose various information reporting requirements on U.S. persons transacting with or holding certain interests in foreign-related parties. The proposed regulations amend existing regulations and provides that disallowed payments under Section 267A, as well as hybrid dividends and tiered hybrid dividends under Section 245A, must be reported on the appropriate information reporting form (i.e., Forms 5471, 8865, or 5472).
Application to domestic reverse hybrids
The IRS also amended regulations under Section 1503(d) to address structures that use domestic reverse hybrids to obtain double deductions. A domestic reverse hybrid generally refers to a domestic business entity that has elected to be treated as a corporation for U.S. tax purposes, but is treated as fiscally transparent under the tax law that govern its foreign investors. Domestic reverse hybrids were not previously subject to the dual consolidated loss rules because, absent a regulation to the contrary, they were not considered dual resident corporations or separate units.
As a precondition when making an election for an entity to be treated as a reverse hybrid, the proposed regulations generally require that the domestic entity consent to be treated as a dual resident corporation if certain conditions are satisfied. This consent to be treated as a dual resident corporation would subject the company to the dual consolidated loss rules. Application of the dual consolidated loss rules neutralizes the double-deduction outcome.
The conditions are intended to restrict the application of Section 1503(d) and application of the dual consolidated loss rules to cases in which it is likely that losses of the domestic consenting corporation could result in a double-deduction outcome. If a corporation has already made an election, and is a domestic reverse hybrid, transition rules apply which would deem consent.
The guidance expands on the statute and provides specific examples of arrangements subject to the rules. The adoption of rules regarding hybrid payments and entities is generally consistent with certain recommendations made by the OECD to combat base erosion and profit shifting. These provisions are likely to be significant for both U.S.-based and foreign-based multinationals. Taxpayers should begin assessing the impact of these provisions immediately in order to mitigate the effect on their taxable income starting in 2018.
For more information contact:
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Mike Del Medico
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