# Rules Regarding Certain Hybrid Arrangements

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2018-27714

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** December 28, 2018
- **Citation:** 83 FR 67612

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 301
[REG-104352-18]
RIN 1545-BO53
Rules Regarding Certain Hybrid Arrangements

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations implementing sections 245A(e) and 267A of the Internal Revenue Code (“Code”) regarding hybrid dividends and certain amounts paid or accrued in hybrid transactions or with hybrid entities. Sections 245A(e) and 267A were added to the Code by the Tax Cuts and Jobs Act, Public Law 115-97 (2017) (the “Act”), which was enacted on December 22, 2017. This document also contains proposed regulations under sections 1503(d) and 7701 to prevent the same deduction from being claimed under the tax laws of both the United States and a foreign country. Further, this document contains proposed regulations under sections 6038, 6038A, and 6038C to facilitate administration of certain rules in the proposed regulations. The proposed regulations affect taxpayers that would otherwise claim a deduction related to such amounts and certain shareholders of foreign corporations that pay or receive hybrid dividends.

DATES:

Written or electronic comments and requests for a public hearing must be received by February 26, 2019.

ADDRESSES:

Send submissions to: Internal Revenue Service, CC:PA:LPD:PR (REG-104352-18), Room 5203, Post Office Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (indicate REG-104352-18), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224, or sent electronically, via the Federal eRulemaking Portal at
www.regulations.gov
(IRS REG-104352-18).

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, contact Tracy Villecco at (202) 317-3800; concerning submissions of comments or requests for a public hearing, Regina L. Johnson at (202) 317-6901 (not toll free numbers).

SUPPLEMENTARY INFORMATION:

Background

I. In General

This document contains proposed amendments to 26 CFR parts 1 and 301 under sections 245A(e), 267A, 1503(d), 6038, 6038A, 6038C, and 7701 (the “proposed regulations”). Added to the Code by sections 14101(a) and 14222(a) of the Act, section 245A(e) denies the dividends received deduction under section 245A with respect to hybrid dividends, and section 267A denies certain interest or royalty deductions involving hybrid transactions or hybrid entities. The proposed regulations only include rules under section 245A(e); rules addressing other aspects of section 245A, including the general eligibility requirements for the dividends received deduction under section 245A(a), will be addressed in a separate notice of proposed rulemaking. Section 14101(f) of the Act provides that section 245A, including section 245A(e), applies to distributions made after December 31, 2017. Section 14222(c) of the Act provides that section 267A applies to taxable years beginning after December 31, 2017. Other provisions of the Code, such as sections 894(c) and 1503(d), also address certain hybrid arrangements.

II. Purpose of Anti-Hybrid Rules

A cross-border transaction may be treated differently for U.S. and foreign tax purposes because of differences in the tax law of each country. In general, the U.S. tax treatment of a transaction does not take into account foreign tax law. However, in specific cases, foreign tax law is taken into account—for example, in the context of 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 order to address policy concerns resulting from the different treatment of the same transaction or arrangement under U.S. and foreign tax law.

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 thereunder, address hybrid and branch mismatch arrangements.
See
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”). The Hybrid Mismatch Report sets forth recommendations to neutralize the tax effects of hybrid arrangements that exploit differences in the tax treatment of an entity or instrument under the laws of two or more countries (such arrangements, “hybrid mismatches”). The Branch Mismatch Report sets forth recommendations to neutralize the tax effects of certain arrangements involving branches that result in mismatches similar to hybrid mismatches (such arrangements, “branch mismatches”). Given the similarity between hybrid mismatches and branch mismatches, the Branch Mismatch Report recommends that a jurisdiction adopting rules to address hybrid mismatches adopt, at the same time, rules to address branch mismatches.
See
Branch Mismatch Report, at p. 11, Executive Summary. Otherwise, taxpayers might “shift[ ] from hybrid mismatch to branch mismatch arrangements in order to secure the same tax advantages.”
Id.

The Act's legislative history 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.”
See
Senate Committee on Finance, Explanation of the Bill, at 384 (November 22, 2017). 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.”
Id.
Hybrid arrangements targeted by these provisions are those that rely on a hybrid element to produce such outcomes.

These concerns also arise in the context of section 245A as a result of the enactment of a participation exemption system for taxing foreign income. Under this system, section 245A(e) generally prevents double non-taxation by disallowing the 100 percent dividends received deduction for dividends received from a controlled foreign corporation (“CFC”), 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.

Explanation of Provisions

I. Section 245A(e)—Hybrid Dividends

A. Overview

The proposed regulations under section 245A(e) address certain dividends involving hybrid arrangements. The proposed regulations

neutralize the double non-taxation effects of these dividends by either denying the section 245A(a) dividends received deduction with respect to the dividend or requiring an inclusion under section 951(a) with respect to the dividend, depending on whether the dividend is received by a domestic corporation or a CFC.

The proposed regulations provide that if a domestic corporation that is a United States shareholder within the meaning of section 951(b) (“U.S. shareholder”) of a CFC receives a “hybrid dividend” from the CFC, then the U.S. shareholder is not allowed the section 245A(a) deduction for the hybrid dividend, and the rules of section 245A(d) (denial of foreign tax credits and deductions) apply.
See
proposed § 1.245A(e)-1(b). In general, a dividend is a hybrid dividend if it satisfies 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” (such a deduction or other tax benefit, a “hybrid deduction”).
See
proposed § 1.245A(e)-1(b) and (d). The proposed regulations take into account certain deductions or other tax benefits allowed to a person related to a CFC (such as a shareholder) because, for example, certain tax benefits allowed to a shareholder of a CFC are economically equivalent to the CFC having been allowed a deduction.

B. Relevant Foreign Tax Law

The proposed regulations define a relevant foreign tax law as, with respect to a CFC, any regime of any foreign country or possession of the United States that imposes an income, war profits, or excess profits tax with respect to income of the CFC, other than a foreign anti-deferral regime under which an owner of the CFC is liable to tax.
See
proposed § 1.245A(e)-1(f). Thus, for example, a relevant foreign tax law includes the tax law of a foreign country of which the CFC is a tax resident, as well as the tax law applicable to a foreign branch of the CFC.

C. Deduction or Other Tax Benefit

1. In General

Under the proposed regulations, only deductions or other tax benefits that are “allowed” under the relevant foreign tax law may constitute a hybrid deduction.
See
proposed § 1.245A(e)-1(d). Thus, for example, if the relevant foreign tax law contains hybrid mismatch rules under which a CFC is denied a deduction for an amount of interest paid with respect to a hybrid instrument to prevent a deduction/no-inclusion (“D/NI”) outcome, then the payment of the interest does not give rise to a hybrid deduction, because the deduction is not “allowed.” This prevents double-taxation that could arise if a hybrid dividend were subject to both section 245A(e) and a hybrid mismatch rule under a relevant foreign tax law.

For a deduction or other tax benefit to be a hybrid deduction, it must relate to or result from an amount paid, accrued, or distributed with respect to an instrument of the CFC that is treated as stock for U.S. tax purposes. That is, there must be a connection between the deduction or other tax benefit under the relevant foreign tax law and the instrument that is stock for U.S. tax purposes. Thus, a hybrid deduction includes an interest deduction under a relevant foreign tax law with respect to a hybrid instrument (stock for U.S. tax purposes, indebtedness for foreign tax purposes). It also includes dividends paid deductions and other deductions allowed on equity under a relevant foreign tax law, such as notional interest deductions (“NIDs”), which raise similar concerns as traditional hybrid instruments. However, it does not, for example, include an exemption provided to a CFC under its tax law for certain types of income (such as income attributable to a foreign branch), because there is not a connection between the tax benefit and the instrument that is stock for U.S. tax purposes.

The proposed regulations provide that deductions or other tax benefits allowed pursuant to certain integration or imputation systems do not constitute hybrid deductions.
See
proposed § 1.245A(e)-1(d)(2)(i)(B). However, a system that has the effect of exempting earnings that fund a distribution from foreign tax at both the CFC and shareholder level gives rise to a hybrid deduction.
See id.;

see also
proposed § 1.245A(e)-1(g)(2),
Example 2.

2. Effect of Foreign Currency Gain or Loss

The payment of an amount by a CFC may, under a provision of foreign tax law comparable to section 988, give rise to gain or loss to the CFC that is attributable to foreign currency. The proposed regulations provide that such foreign currency gain or loss recognized with respect to such deduction or other tax benefit is taken into account for purposes of determining hybrid deductions.
See
proposed § 1.245A(e)-1(d)(6);
see also
section II.K.1 of this Explanation of Provisions (requesting comments on foreign currency rules).

D. Tiered Hybrid Dividends

Proposed § 1.245A(e)-1(c) sets forth rules related to hybrid dividends of tiered corporations (“tiered hybrid dividends”), as provided under section 245A(e)(2). A tiered hybrid dividend means an amount received by a CFC from another CFC to the extent that the amount would be a hybrid dividend under proposed § 1.245A(e)-1(b) if the receiving CFC were a domestic corporation. Accordingly, the amount must be treated as a dividend under U.S. tax law to be treated as a tiered hybrid dividend; the treatment of the amount under the tax law in which the receiving CFC is a tax resident (or under any other foreign tax law) is irrelevant for this purpose.

If a CFC receives a tiered hybrid dividend from another CFC, and a domestic corporation is a U.S. shareholder of both CFCs, then (i) the tiered hybrid dividend is treated as subpart F income of the receiving CFC, (ii) the U.S. shareholder must include in gross income its pro rata share of the subpart F income, and (iii) the rules of section 245A(d) apply to the amount included in the U.S. shareholder's gross income.
See
proposed § 1.245A(e)-1(c)(1). This treatment applies notwithstanding any other provision of the Code. Thus, for example, exceptions to subpart F income such as those provided under section 954(c)(3) (“same country” exception for income received from related persons) and section 954(c)(6) (look-through rule for related CFCs) do not apply. As additional examples, the gross amount of subpart F income cannot be reduced by deductions taken into account under section 954(b)(5) and § 1.954-1(c), and is not subject to the current earnings and profits limitation under section 952(c).

E. Interaction With Section 959

Distributions of previously taxed earnings and profits (“PTEP”) attributable to amounts that have been taken into account by a U.S. shareholder under section 951(a) are, in general, excluded from the gross income of the U.S. shareholder when distributed under section 959(a), and under section 959(d) are not treated as a dividend (other than to reduce earnings and profits). As a result, distributions from a CFC to its U.S. shareholder out of PTEP are not eligible for the dividends received deduction under section 245A(a), and section 245A(e) does not apply. Similarly, distributions of PTEP from a CFC to an upper-tier CFC are excluded from the gross income of the upper-tier CFC under section 959(b), but

only for the limited purpose of applying section 951(a). In addition, such amounts continue to be treated as dividends because section 959(d) does not apply to such amounts. Accordingly, distributions out of PTEP could qualify as tiered hybrid dividends that would result in an income inclusion to a U.S. shareholder. To prevent this result, the proposed regulations provide that a tiered hybrid dividend does not include amounts described in section 959(b).
See
proposed § 1.245A(e)-1(c)(2).

F. Interaction With Section 964(e)

Under section 964(e)(1), gain recognized by a CFC on the sale or exchange of stock in another foreign corporation may be treated as a dividend. In certain cases, section 964(e)(4): (i) Treats the dividend as subpart F income of the selling CFC; (ii) requires a U.S. shareholder of the CFC to include in its gross income its pro rata share of the subpart F income; and (iii) allows the U.S. shareholder the section 245A(a) deduction for its inclusion in gross income. As is the case with the treatment of tiered hybrid dividends, the treatment of dividends under section 964(e)(4) applies notwithstanding any other provision of the Code.

The proposed regulations coordinate the tiered hybrid dividend rules and the rules of section 964(e) by providing that, to the extent a dividend arising under section 964(e)(1) is a tiered hybrid dividend, the tiered hybrid dividend rules, rather than the rules of section 964(e)(4), apply. Thus, in such a case, a U.S. shareholder that includes an amount in its gross income under the tiered hybrid dividend rule is not allowed the section 245A(a) deduction, or foreign tax credits or deductions, for the amount.
See
proposed § 1.245A(e)-1(c)(1) and (4).

G. Hybrid Deduction Accounts

1. In General

In some cases, the actual payment by a CFC of an amount that is treated as a dividend for U.S. tax purposes will result in a corresponding hybrid deduction. In many cases, however, the dividend and the hybrid deduction may not arise pursuant to the same payment and may be recognized in different taxable years. This may occur in the case of a hybrid instrument for which under a relevant foreign tax law the CFC is allowed deductions for accrued (but not yet paid) interest. In such a case, to the extent that an actual payment has not yet been made on the instrument, there generally would not be a dividend for U.S. tax purposes for which the section 245A(a) deduction could be disallowed under section 245A(e). Nevertheless, because the earnings and profits of the CFC would not be reduced by the accrued interest deduction, the earnings and profits may give rise to a dividend when subsequently distributed to the U.S. shareholder. This same result could occur in other cases, such as when a relevant foreign tax law allows deductions on equity, such as NIDs.

The disallowance of the section 245A(a) deduction under section 245A(e) should not be limited to cases in which the dividend and the hybrid deduction arise pursuant to the same payment (or in the same taxable year for U.S. tax purposes and for purposes of the relevant foreign tax law). Interpreting the provision in such a manner would result in disparate treatment for hybrid arrangements that produce the same D/NI outcome. Accordingly, the proposed regulations define a hybrid dividend (or tiered hybrid dividend) based, in part, on the extent of the balance of the “hybrid deduction accounts” of the domestic corporation (or CFC) receiving the dividend.
See
proposed § 1.245A(e)-1(b) and (d). This ensures that dividends are subject to section 245A(e) regardless of whether the same payment gives rise to the dividend and the hybrid deduction.

A hybrid deduction account must be maintained with respect to each share of stock of a CFC held by a person that, given its ownership of the CFC and the share, could be subject to section 245A upon a dividend paid by the CFC on the share.
See
proposed § 1.245A(e)-1(d) and (f). The account, which is maintained in the functional currency of the CFC, reflects the amount of hybrid deductions of the CFC (allowed in taxable years beginning after December 31, 2017) that have been allocated to the share. A dividend paid by a CFC to a shareholder that has a hybrid deduction account with respect to the CFC is generally treated as a hybrid dividend or tiered hybrid dividend to the extent of the shareholder's balance in all of its hybrid deduction accounts with respect to the CFC, even if the dividend is paid on a share that has not had any hybrid deductions allocated to it. Absent such an approach, the purposes of section 245A(e) might be avoided by, for example, structuring dividend payments such that they are generally made on shares of stock to which a hybrid deduction has not been allocated (rather than on shares of stock to which a hybrid deduction has been allocated, such as a share that is a hybrid instrument).

Once an amount in a hybrid deduction account gives rise to a hybrid dividend or a tiered hybrid dividend, the account is correspondingly reduced.
See
proposed § 1.245A(e)-1(d). The Treasury Department and the IRS request comments on whether hybrid deductions attributable to amounts included in income under section 951(a) or section 951A should not increase the hybrid deduction account, or, alternatively, the hybrid deduction account should be reduced by distributions of PTEP, and on whether the effect of any deemed paid foreign tax credits associated with such inclusions or distributions should be considered.

2. Transfers of Stock

Because hybrid deduction accounts are with respect to stock of a CFC, the proposed regulations include rules that take into account transfers of the stock.
See
proposed § 1.245A(e)-1(d)(4)(ii)(A). These rules, which are similar to the “successor” PTEP rules under section 959 (
see
§ 1.959-1(d)), ensure that section 245A(e) properly applies to dividends that give rise to a D/NI outcome in cases where the shareholder that receives the dividend is not the same shareholder that held the stock when the hybrid deduction was incurred. These rules only apply when the stock is transferred among persons that are required to keep hybrid deduction accounts. Thus, if the stock is transferred to a person that is not required to keep a hybrid deduction account—such as an individual or a foreign corporation that is not a CFC—the account terminates (subject to the anti-avoidance rule, discussed in section I.H of this Explanation of Provisions). Finally, the proposed regulations include rules that take into account certain non-recognition exchanges of the stock, such as exchanges in connection with asset reorganizations, recapitalizations, and liquidations, as well as transfers and exchanges that occur mid-way through a CFC's taxable year.
See
proposed § 1.245A(e)-1(d)(4)(ii)(B) and (d)(5). The Treasury Department and the IRS request comments on these rules.

3. Dividends From Lower-Tier CFCs

The proposed regulations provide a special rule to address earnings and profits of a lower-tier CFC that are included in a domestic corporation's income as a dividend by virtue of section 1248(c)(2). In these cases, the proposed regulations treat the domestic corporation as having certain hybrid deduction accounts with respect to the lower-tier CFC that are held and

maintained by other CFCs.
See
proposed § 1.245A(e)-1(b)(3). This ensures that, to the extent the earnings and profits of the lower-tier CFC give rise to the dividend, hybrid deduction accounts with respect to the lower-tier CFC are taken into account for purposes of the determinations under section 245A(e), even though the accounts are held indirectly by the domestic corporation. A similar rule applies with respect to gains on stock sales treated as dividends under section 964(e)(1).
See
proposed § 1.245A(e)-1(c)(3).

H. Anti-Avoidance Rule

The proposed regulations include an anti-avoidance rule. This rule provides that appropriate adjustments are made, including adjustments that would disregard a transaction or arrangement, if a transaction or arrangement is engaged in with a principal purpose of avoiding the purposes of proposed § 1.245A(e)-1.

II. Section 267A—Related Party Amounts Involving Hybrid Transactions and Hybrid Entities

A. Overview

As indicated in the Senate Finance Committee's Explanation of the Bill, hybrid arrangements may exploit differences under U.S. and foreign tax law between the tax characterization of an entity as transparent or opaque or differences in the treatment of financial instruments or other transactions. The proposed regulations under section 267A address certain payments or accruals of interest or royalties for U.S. tax purposes (the amount of such interest or royalty, a “specified payment”) that involve hybrid arrangements, or similar arrangements involving branches, that produce D/NI (deduction/no inclusion) outcomes or indirect D/NI outcomes.
See also
section II.J.1 of this Explanation of Provisions (discussing certain amounts that are treated as specified payments). The proposed regulations neutralize the double non-taxation effects of the arrangements by denying a deduction for the specified payment to the extent of the D/NI outcome.

B. Scope

1. Disallowed Deductions

The proposed regulations generally disallow a deduction for a specified payment if and only if the payment is (i) a “disqualified hybrid amount,” meaning that it produces a D/NI outcome as a result of a hybrid or branch arrangement; (ii) a “disqualified imported mismatch amount,” meaning that it 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. tax system; or (iii) made pursuant to a transaction a principal purpose of which is to avoid the purposes of the regulations under section 267A and it produces a D/NI outcome.
See
proposed § 1.267A-1(b). Thus, the proposed regulations do not address D/NI outcomes that are not the result of hybridity.
See also
section II.E of this Explanation of Provisions (discussing the link between hybridity and a D/NI outcome). In addition, the proposed regulations do not address double-deduction outcomes. Section 267A is intended to address D/NI outcomes; transactions that produce double-deduction outcomes are addressed through other provisions (or doctrines), such as the dual consolidated loss rules under section 1503(d).
See also
section IV.A.1 of this Explanation of Provisions (discussing the dual consolidated loss rules).

2. Parties Subject to Section 267A

The application of section 267A by its terms is not limited to any particular category of persons. The proposed regulations, however, narrow the scope of section 267A so that it applies only to deductions of “specified parties.” Deductions of persons other than specified parties are not subject to disallowance under section 267A because the deductions of such other persons generally do not have significant U.S. tax consequences.

A specified party means any of (i) a tax resident of the United States, (ii) a CFC for which there is one or more United States shareholders that own (within the meaning of section 958(a)) at least ten percent of the stock of the CFC, and (iii) a U.S. taxable branch (which includes a U.S. permanent establishment of a tax treaty resident).
See
proposed § 1.267A-5(a). The term generally includes a CFC because, for example, a specified payment made by a CFC to the foreign parent of the CFC's U.S. shareholder, or a specified payment by the CFC to an unrelated party pursuant to a structured arrangement, may indirectly reduce income subject to U.S. tax. Specified payments made by a CFC to other related CFCs or to U.S. shareholders of the CFC, however, typically will not be subject to section 267A because of the rules in proposed § 1.267A-3(b) that exempt certain payments included in income of a U.S. tax resident or taken into account under the subpart F or global intangible low-tax income (“GILTI”) rules.
See also
section II.F of this Explanation of Provisions (discussing the relatedness or structured arrangement limitation); section II.H of this Explanation of Provisions (discussing exceptions for amounts included or includible in income). Similarly, the term includes a U.S. taxable branch because a payment made by the home office may be allocable to and thus reduce income subject to U.S. tax under sections 871(b) or 882.
See also
section II.K.2 of this Explanation of Provisions (discussing amounts considered paid or accrued by a U.S. taxable branch for section 267A purposes).

The term specified party does not include a partnership because a partnership generally is not liable to tax and therefore is not the person allowed a deduction. However, a partner of a partnership may be a specified party. For example, in the case of a payment made by a partnership a partner of which is a domestic corporation, the domestic corporation is a specified party and its allocable share of the deduction for the payment is subject to disallowance under section 267A.

C. Amount of a D/NI Outcome

1. In General

Proposed § 1.267A-3(a) provides rules for determining the “no-inclusion” aspect of a D/NI outcome—that is, the amount of a specified payment that is or is not included in income under foreign tax law. The proposed regulations provide that only “tax residents” or “taxable branches” are considered to include an amount in income. Parties other than tax residents or taxable branches, for example, an entity that is fiscally transparent for purposes of the relevant tax laws, do not include an amount in income because such parties are not liable to tax.

In general, a tax resident or taxable branch includes a specified payment in income for this purpose to the extent that, under its tax law, it includes the payment in its income or tax base at the full marginal rate imposed on ordinary income, and the payment is not reduced or offset by certain items (such as an exemption or credit) particular to that type of payment.
See
proposed § 1.267A-3(a)(1).

Whether a tax resident or taxable branch includes a specified payment in income is determined without regard to any defensive or secondary rule in hybrid mismatch rules (which generally requires the payee to include certain amounts in income, if the payer is not denied a deduction for the amount), if any, under the tax resident's or taxable branch's tax law. Otherwise, in cases in which such tax law contains a secondary response, the analysis of whether the specified payment is

included in income could become circular: For example, whether the United States denies a deduction under section 267A may depend on whether the payee includes the specified payment in income, and whether the payee includes it in income (under a secondary response) may depend on whether the United States denies the deduction.

A specified payment may be considered included in income even though offset by a generally applicable deduction or other tax attribute, such as a deduction for depreciation or a net operating loss. For this purpose, a deduction may be treated as being generally applicable even if closely related to the specified payment (for example, if the deduction and payment are in connection with a back-to-back financing arrangement).

If a specified payment is taxed at a preferential rate, or if there is a partial reduction or offset particular to the type of payment, a portion of the payment is considered included in income. The portion included in income is the amount that, taking into account the preferential rate or reduction or offset, is subject to tax at the full marginal rate applicable to ordinary income.
See
proposed § 1.267A-3(a)(1);
see also
proposed § 1.267A-6(c),
Example 2
and
Example 7.

2. Timing Differences

Some specified payments may never be included in income. For example, a specified payment treated as a dividend under a tax resident's tax laws may be permanently excluded from its income under a participation exemption. Permanent exclusions are always treated as giving rise to a no-inclusion.
See
proposed § 1.267A-3(a)(1).

Other specified payments, however, may be included in income but on a deferred basis. Some of these timing differences result from different methods of accounting between U.S. tax law and foreign tax law. For example, and subject to certain limitations such as those under sections 163(e)(3) and 267(a) (generally applicable to payments involving related parties, but not to payments involving structured arrangements), a specified payment may be deductible for U.S. tax purposes when accrued and later included in a foreign tax resident's income when actually paid.
See also
section II.K.3 of this Explanation of Provisions (discussing the coordination of section 267A with rules such as sections 163(e)(3) and 267(a)). Timing differences may also occur in cases in which all or a portion of a specified payment that is treated as interest for U.S. tax purposes is treated as a return of principal for purposes of the foreign tax law.

In some cases, timing differences reverse after a short period of time and therefore do not provide a meaningful deferral benefit. The Treasury Department and the IRS have determined that routine, short-term deferral does not give rise to the policy concerns that section 267A is intended to address. In addition, subjecting such short-term deferral to section 267A could give rise to administrability issues for both taxpayers and the IRS, because it may be challenging to determine whether the taxable period in which a specified payment is included in income matches the taxable period in which the payment is deductible.

Other timing differences, though, may provide a significant and long-term deferral benefit. Moreover, taxpayers may structure transactions that exploit these differences to achieve long-term deferral benefits. Timing differences that result in long-term deferral have an economic effect similar to a permanent exclusion and therefore give rise to policy concerns that section 267A is intended to address.
See
Senate Explanation, at 384 (expressing concern with hybrid arrangements that “achieve double non-taxation, including long-term deferral.”). Accordingly, proposed § 1.267A-3(a)(1) provides that short-term deferral, meaning inclusion during a taxable year that ends no more than 36 months after the end of the specified party's taxable year, does not give rise to a D/NI outcome; inclusions outside of the 36-month timeframe, however, are treated as giving rise to a D/NI outcome.

D. Hybrid and Branch Arrangements Giving Rise to Disqualified Hybrid Amounts

1. Hybrid Transactions

Proposed § 1.267A-2(a) addresses hybrid financial instruments and similar arrangements (collectively, “hybrid transactions”) that result in a D/NI outcome. For example, in the case of an instrument that is treated as indebtedness for purposes of the payer's tax law and stock for purposes of the payee's tax law, a payment on the instrument may constitute deductible interest expense of the payer and excludible dividend income of the payee (for instance, under a participation exemption).

In general, the proposed regulations provide that a specified payment is made pursuant to a hybrid transaction if there is a mismatch in the character of the instrument or arrangement such that the payment is not treated as interest or a royalty, as applicable, under the tax law of a “specified recipient.” Examples of such a specified payment include a payment that is treated as interest for U.S. tax purposes but, for purposes of a specified recipient's tax law, is treated as a distribution on equity or a return of principal. When a specified payment is made pursuant to a hybrid transaction, it generally is a disqualified hybrid amount to the extent that the specified recipient does not include the payment in income.

The proposed regulations broadly define specified recipient as (i) any tax resident that under its tax law derives the specified payment, and (ii) any taxable branch to which under its tax law the specified payment is attributable.
See
proposed § 1.267A-5(a)(19). In other words, a specified recipient is any party that may be subject to tax on the specified payment under its tax law. There may be more than one specified recipient of a specified payment. For example, in the case of a specified payment to an entity that is fiscally transparent for purposes of the tax law of its tax resident owners, each of the owners is a specified recipient of a share of the payment. In addition, if the entity is a tax resident of the country in which it is established or managed and controlled, then the entity is also a specified recipient. Moreover, in the case of a specified payment attributable to a taxable branch, both the taxable branch and the home office are specified recipients.

The proposed regulations deem a specified payment as made pursuant to a hybrid transaction if there is a long-term mismatch between when the specified party is allowed a deduction for the payment under U.S. tax law and when a specified recipient includes the payment in income under its tax law. This rule applies, for example, when a specified payment is made pursuant to an instrument viewed as indebtedness under both U.S. and foreign tax law and, due to a mismatch in tax accounting treatment between the U.S. and foreign tax law, results in long-term deferral. In these cases, this rule treats the long-term deferral as giving rise to a hybrid transaction; the rules in proposed § 1.267A-3(a)(1) (discussed in section II.C.2 of this Explanation of Provisions) treat the long-term deferral as creating a D/NI outcome.

Lastly, proposed § 1.267A-2(a)(3) provides special rules to address securities lending transactions, sale-repurchase transactions, and similar transactions. In these cases, a specified payment (that is, interest consistent with the substance of the transaction) might not be regarded under a foreign

tax law. As a result, there might not be a specified recipient of the specified payment under such foreign tax law, absent a special rule. To address this scenario, the proposed regulations provide that the determination of the identity of a specified recipient under the foreign tax law is made with respect to an amount connected to the specified payment and regarded under the foreign tax law—for example, a dividend consistent with the form of the transaction. The Treasury Department and the IRS request comments on whether similar rules should be extended to other specific transactions.

2. Disregarded Payments

Proposed § 1.267A-2(b) addresses disregarded payments. Disregarded payments generally give rise to a D/NI outcome because they are regarded under the payer's tax law and are therefore available to offset income not taxable to the payee, but are disregarded under the payee's tax law and therefore are not included in income.

In general, the proposed regulations define a disregarded payment as a specified payment that, under a foreign tax law, is not regarded because, for example, it is a disregarded transaction involving a single taxpayer or between consolidated group members. For example, a disregarded payment includes a specified payment made by a domestic corporation to its foreign owner if, under the foreign tax law, the domestic corporation is a disregarded entity and therefore the payment is not regarded. It also includes a specified payment between related foreign corporations that are members of the same foreign consolidated group (or can otherwise share income or loss) if, under the foreign tax law, payments between group members are not regarded, or give rise to a deduction or similar offset to the payer member that is available to offset the corresponding income of the recipient member.

In general, a disregarded payment is a disqualified hybrid amount only to the extent it exceeds dual inclusion income. For example, if a domestic corporation that for foreign tax purposes is a disregarded entity of its foreign owner makes a disregarded payment to its foreign owner, the payment is a disqualified hybrid amount only to the extent it exceeds the net of the items of gross income and deductible expense taken into account in determining the domestic corporation's income for U.S. tax purposes and the foreign owner's income for foreign tax purposes. This prevents the excess of the disregarded payment over dual inclusion income from offsetting non-dual inclusion income. Such an offset could otherwise occur, for example, through the U.S. consolidation regime, or a sale, merger, or similar transaction.

A disregarded payment could also be viewed as being made pursuant to a hybrid transaction because the payment of interest or royalty would not be viewed as interest or royalty under the foreign tax law (since the payment is disregarded). The proposed regulations address disregarded payments separately from hybrid transactions, however, because disregarded payments are more likely to offset dual inclusion income and therefore are treated as disqualified hybrid amounts only to the extent they offset non-dual inclusion income.

3. Deemed Branch Payments

Proposed § 1.267A-2(c) addresses deemed branch payments. These payments result in a D/NI outcome when, under an income tax treaty, a deductible payment is deemed to be made by a permanent establishment to its home office and offsets income not taxable to the home office, but the payment is not taken into account under the home office's tax law.

In general, the proposed regulations define a deemed branch payment as interest or royalty considered paid by a U.S. permanent establishment to its home office under an income tax treaty between the United States and the home office country.
See
proposed § 1.267A-2(c)(2). Thus, for example, a deemed branch payment includes an amount allowed as a deduction in computing the business profits of a U.S. permanent establishment with respect to the use of intellectual property developed by the home office.
See,
for example, the U.S. Treasury Department Technical Explanation to the income tax convention between the United States and Belgium, signed November 27, 2006 (“[T]he OECD Transfer Pricing Guidelines apply, by analogy, in determining the profits attributable to a permanent establishment.”).

When a specified payment is a deemed branch payment, it is a disqualified hybrid amount if the home office's tax law provides an exclusion or exemption for income attributable to the branch. In these cases, a deduction for the deemed branch payment would offset non-dual inclusion income and therefore give rise to a D/NI outcome. If the home office's tax law does not have an exclusion or exemption for income attributable to the branch, then, because U.S. permanent establishments cannot consolidate or otherwise share losses with U.S. taxpayers, there would generally not be an opportunity for a deduction for the deemed branch payment to offset non-dual inclusion income.

4. Reverse Hybrids

Proposed § 1.267A-2(d) addresses payments to reverse hybrids. In general, and as discussed below, a reverse hybrid is an entity that is fiscally transparent for purposes of the tax law of the country in which it is established but not for purposes of the tax law of its owner. Thus, payments to a reverse hybrid may result in a D/NI outcome because the reverse hybrid is not a tax resident of the country in which it is established, and the owner does not derive the payment under its tax law. Because this D/NI outcome may occur regardless of whether the establishment country is a foreign country or the United States, the proposed regulations provide that both foreign and domestic entities may be reverse hybrids. A domestic entity that is a reverse hybrid for this purpose therefore differs from a “domestic reverse hybrid entity” under § 1.894-1(d)(2)(i), which is defined as “a domestic entity that is treated as not fiscally transparent for U.S. tax purposes and as fiscally transparent under the laws of an interest holder's jurisdiction[.]”

For an entity to be a reverse hybrid under the proposed regulations, two requirements must be satisfied. These requirements generally implement the definition of hybrid entity in section 267A(d)(2), with certain modifications. First, the entity must be fiscally transparent under the tax law of the country in which it is established, whether or not it is a tax resident of another country. For this purpose, the determination of whether an entity is fiscally transparent with respect to an item of income is made using the principles of § 1.894-1(d)(3)(ii) (but without regard to whether there is an income tax treaty in effect between the entity's jurisdiction and the United States).

Second, the entity must not be fiscally transparent under the tax law of an “investor.” An investor means a tax resident or taxable branch that directly or indirectly owns an interest in the entity. For this purpose, the determination of whether an investor's tax law treats the entity as fiscally transparent with respect to an item of income is made under the principles of § 1.894-1(d)(3)(iii) (but without regard to whether there is an income tax treaty in effect between the investor's jurisdiction and the United States). If an investor views the entity as not fiscally transparent, the investor generally will not be currently taxed under its tax law

on payments to the entity. Thus, the non-fiscally-transparent status of the entity is determined on an investor-by-investor basis, based on the tax law of each investor. In addition, a tax resident or a taxable branch may be an investor of a reverse hybrid even if the tax resident or taxable branch indirectly owns the reverse hybrid through one or more intermediary entities that, under the tax law of the tax resident or taxable branch, are not fiscally transparent. In such a case, however, the investor's no-inclusion would not be a result of the payment being made to the reverse hybrid and therefore would not be a disqualified hybrid amount.
See also
section II.E of this Explanation of Provisions (explaining that the D/NI outcome must be a result of hybridity); proposed § 1.267A-6(c),
Example 5
(analyzing whether a D/NI outcome with respect to an upper-tier investor is a result of the specified payment being made to the reverse hybrid).

When a specified payment is made to a reverse hybrid, it is generally a disqualified hybrid amount to the extent that an investor does not include the payment in income. For this purpose, whether an investor includes the specified payment in income is determined without regard to a subsequent distribution by the reverse hybrid. Although a subsequent distribution may be included in the investor's income, the distribution may not occur for an extended period and, when it does occur, it may be difficult to determine whether the distribution is funded from an amount comprising the specified payment.

In addition, if an investor takes a specified payment into account under an anti-deferral regime, then the investor is considered to include the payment in income to the extent provided under the general rules of proposed § 1.267A-3(a).
See
proposed § 1.267A-6(c),
Example 5.
Thus, for example, if the investor's inclusion under the anti-deferral regime is subject to tax at a preferential rate, the investor is considered to include only a portion of the specified payment in income.

5. Branch Mismatch Payments

Proposed § 1.267A-2(e) addresses branch mismatch payments. These payments give rise to a D/NI outcome due to differences between the home office's tax law and the branch's tax law regarding the allocation of items of income or the treatment of the branch. This could occur, for example, if the home office's tax law views a payment as attributable to the branch and exempts the branch's income, but the branch's tax law does not tax the payment.

Under the proposed regulations, a specified payment is a branch mismatch payment when two requirements are satisfied. First, under a home office's tax law, the specified payment is treated as attributable to a branch of the home office. Second, under the tax law of the branch country, either (i) the home office does not have a taxable presence in the country, or (ii) the specified payment is treated as attributable to the home office and not the branch. When a specified payment is a branch mismatch payment, it is generally a disqualified hybrid amount to the extent that the home office does not include the payment in income.

E. Link Between Hybridity and D/NI Outcome

Under section 267A(a), a deduction for a payment is generally disallowed if (i) the payment involves a hybrid arrangement, and (ii) a D/NI outcome occurs. In certain cases, although both of these conditions are satisfied, the D/NI outcome is not a result of the hybridity. For example, in the hybrid transaction context, the D/NI outcome may be a result of the specified recipient's tax law containing a pure territorial system (and thus exempting from taxation all foreign source income) or not having a corporate income tax, or a result of the specified recipient's status as a tax-exempt entity under its tax law.

The proposed regulations provide that a D/NI outcome gives rise to a disqualified hybrid amount only to the extent that the D/NI outcome is a result of hybridity.
See,
for example, proposed § 1.267A-2(a)(1)(ii);
see also
Senate Explanation, at 384 (“[T]he Committee believes that hybrid arrangements exploit differences in the tax treatment of a transaction or entity under the laws of two or more jurisdictions
to achieve
double non-taxation . . .”) (emphasis added).

To determine whether a D/NI outcome is a result of hybridity, the proposed regulations generally apply a test based on facts that are counter to the hybridity at issue. For example, in the hybrid transaction context, a specified recipient's no-inclusion is a result of the specified payment being made pursuant to the hybrid transaction to the extent that the no-inclusion would not occur were the payment to be treated as interest or a royalty for purposes of the specified recipient's tax law.

This test also addresses cases in which, for example, a specified payment is made to a fiscally transparent entity (such as a partnership) and owners of the entity that are specified recipients of the payment each derive only a portion of the payment under its tax law. The test ensures that, with respect to each specified recipient, only the no-inclusion that occurs for the portion of the specified payment that it derives may give rise to a disqualified hybrid amount. In addition, as a result of the relatedness or structured arrangement limitation discussed in section II.F of this Explanation of Provisions, the no-inclusion with respect to the specified recipient is taken into account under the proposed regulations only if the specified recipient is related to the specified party or is a party to a structured arrangement pursuant to which the specified payment is made.

F. Relatedness or Structured Arrangement Limitation

In determining whether a specified payment is made pursuant to a hybrid or branch mismatch arrangement, the proposed regulations generally only consider the tax laws of tax residents or taxable branches that are related to the specified party.
See
proposed § 1.267A-2(f). For example, in general, only the tax law of a specified recipient that is related to the specified party is taken into account for purposes of determining whether the specified payment is made pursuant to a hybrid transaction. Because a deemed branch payment by its terms involves a related home office, the relatedness limitation in proposed § 1.267A-2(f) does not apply to proposed § 1.267A-2(c).

The proposed regulations provide that related status is determined under the rules of section 954(d)(3) (involving ownership of more than 50 percent of interests) but without regard to downward attribution.
See
proposed § 1.267A-5(a)(14). In addition, to ensure that a tax resident may be considered related to a specified party even though the tax resident is a disregarded entity for U.S. tax purposes, the proposed regulations provide that such a tax resident is treated as a corporation for purposes of the relatedness test. A similar rule applies with respect to a taxable branch.

However, the Treasury Department and the IRS are aware that some hybrid arrangements involving unrelated parties are designed to give rise to a D/NI outcome and therefore present the policy concerns underlying section 267A. Furthermore, it is likely that in such cases the specified party will have, or can reasonably obtain, the information necessary to comply with section 267A. Accordingly, the proposed regulations generally provide

that the tax law of an unrelated tax resident or taxable branch is taken into account for purposes of section 267A if the tax resident or taxable branch is a party to a structured arrangement.
See
proposed § 1.267A-2(f). The proposed regulations set forth a test for when a transaction is a structured arrangement.
See
proposed § 1.267A-5(a)(20). In addition, the proposed regulations impute an entity's participation in a structured arrangement to its investors.
See id.
Thus, for example, in the case of a specified payment to a partnership that is a party to a structured arrangement pursuant to which the payment is made, a tax resident that is a partner of the partnership is also a party to the structured arrangement, even though the tax resident may not have actual knowledge of the structured arrangement.

G. Effect of Inclusion in Another Jurisdiction

The proposed regulations provide that a specified payment is a disqualified hybrid amount if a D/NI outcome occurs as a result of hybridity in any foreign jurisdiction, even if the payment is included in income in another foreign jurisdiction.
See
proposed § 1.267A-6(c),
Example 1.
Absent such a rule, an inclusion of a specified payment in income in a jurisdiction with a (generally applicable) low rate might discharge the application of section 267A even though a D/NI outcome occurs in another jurisdiction as a result of hybridity.

For example, assume FX, a tax resident of Country X, owns US1, a domestic corporation, and FZ, a tax resident of Country Z that is fiscally transparent for Country X tax purposes. Also, assume that Country Z has a single, low-tax rate applicable to all income. Further, assume that FX holds an instrument issued by US1, a $100x payment with respect to which is treated as interest for U.S. tax purposes and an excludible dividend for Country X tax purposes. In an attempt to avoid US1's deduction for the $100x payment being denied under the hybrid transaction rule, FX contributes the instrument to FZ, and, upon US1's $100x payment, US1 asserts that, although a $100x no-inclusion occurs with respect to FX as a result of the payment being made pursuant to the hybrid transaction, the payment is not a disqualified hybrid amount because FZ fully includes the payment in income (albeit at a low-tax rate). The proposed regulations treat the payment as a disqualified hybrid amount.

This rule only applies for inclusions under the laws of foreign jurisdictions. See proposed § 1.267A-3(b), and section II.H of this Explanation of Provisions, for exceptions that apply when the payment is included or includible in a U.S. tax resident's or U.S. taxable branch's income.

The Treasury Department and IRS request comments on whether an exception should apply if the specified payment is included in income in any foreign jurisdiction, taking into account accommodation transactions involving low-tax entities.

H. Exceptions for Certain Amounts Included or Includible in a U.S. Tax Resident's or U.S. Taxable Branch's Income

Proposed § 1.267A-3(b) provides rules that reduce disqualified hybrid amounts to the extent the amounts are included or includible in a U.S. tax resident's or U.S. taxable branch's income. In general, these rules ensure that a specified payment is not a disqualified hybrid amount to the extent included in the income of a tax resident of the United States or a U.S. taxable branch, or taken into account by a U.S. shareholder under the subpart F or GILTI rules.

Source-based withholding tax imposed by the United States (or any other country) on disqualified hybrid amounts does not neutralize the D/NI outcome and therefore does not reduce or otherwise affect disqualified hybrid amounts. Withholding tax policies are unrelated to the policies underlying hybrid arrangements—for example, withholding tax can be imposed on non-hybrid payments—and, accordingly, withholding tax is not a substitute for a specified payment being included in income by a tax resident or taxable branch.
See also
section II.L of this Explanation of Provisions (interaction with withholding taxes and income tax treaties). Furthermore, other jurisdictions applying the defensive or secondary rule to a payment (which generally requires the payee to include the payment in income, if the payer is not denied a deduction for the payment under the primary rule) may not treat withholding taxes as satisfying the primary rule and may therefore require the payee to include the payment in income if a deduction for the payment is not disallowed (regardless of whether withholding tax has been imposed).

Thus, the proposed regulations do not treat amounts subject to U.S. withholding taxes as reducing disqualified hybrid amounts. Nevertheless, the Treasury Department and the IRS request comments on the interaction of the proposed regulations with withholding taxes and whether, and the extent to which, there should be special rules under section 267A when withholding taxes are imposed in connection with a specified payment, taking into account how such a rule could be coordinated with the hybrid mismatch rules of other jurisdictions.

I. Disqualified Imported Mismatch Amounts

Proposed § 1.267A-4 sets forth a rule to address “imported” hybrid and branch arrangements. This rule is generally intended to prevent the effects of an “offshore” hybrid arrangement (for example, a hybrid arrangement between two foreign corporations completely outside the U.S. taxing jurisdiction) from being shifted, or “imported,” into the U.S. taxing jurisdiction through the use of a non-hybrid arrangement.

Accordingly, the proposed regulations disallow deductions for specified payments that are “disqualified imported mismatch amounts.” In general, a disqualified imported mismatch amount is a specified payment: (i) That is non-hybrid in nature, such as interest paid on an instrument that is treated as indebtedness for both U.S. and foreign tax purposes, and (ii) for which the income attributable to the payment is directly or indirectly offset by a hybrid deduction of a foreign tax resident or taxable branch. The rule addresses “indirect” offsets in order to take into account, for example, structures involving intermediaries where the foreign tax resident that receives the specified payment is different from the foreign tax resident that incurs the hybrid deduction.
See
proposed § 1.267A-6(c),
Example 8, Example 9,
and
Example 10.

In general, a hybrid deduction for purposes of the imported mismatch rule is an amount for which a foreign tax resident or taxable branch is allowed an interest or royalty deduction under its tax law, to the extent the deduction would be disallowed if such tax law were to contain rules substantially similar to the section 267A proposed regulations. For this purpose, it is not relevant whether the amount is recognized as interest or a royalty under U.S. law, or whether the amount would be allowed as a deduction under U.S. law. Thus, for example, a deduction with respect to equity (such as a notional interest deduction) constitutes a hybrid deduction even though such a deduction would not be recognized (or allowed) under U.S. tax law. As another example, a royalty deduction under foreign tax law may constitute a hybrid deduction even though for U.S. tax purposes the royalty is viewed as made

from a disregarded entity to its owner and therefore is not regarded.

The requirement that the deduction would be disallowed if the foreign tax law were to contain rules substantially similar to those under section 267A is intended to limit the application of the imported mismatch rule to cases in which, had the foreign-to-foreign hybrid arrangement instead involved a specified party, section 267A would have applied to disallow the deduction. In other words, this requirement prevents the imported mismatch rule from applying to arrangements outside the general scope of section 267A, even if the arrangements are hybrid in nature and result in a D/NI (or similar) outcome. For example, in the case of a deductible payment of a foreign tax resident to a tax resident of a foreign country that does not impose an income tax, the deduction would generally not be a hybrid deduction—even though it may be made pursuant to a hybrid instrument—because the D/NI outcome would not be a result of hybridity.
See
section II.E of this Explanation of Provisions (requiring a link between hybridity and the D/NI outcome, for a specified payment to be a disqualified hybrid amount).

Further, the proposed regulations include “ordering” and “funding” rules to determine the extent that a hybrid deduction directly or indirectly offsets income attributable to a specified payment. In addition, the proposed regulations provide that certain payments made by non-specified parties the tax laws of which contain hybrid mismatch rules are taken into account when applying the ordering and funding rules. Together, these provisions are intended to coordinate proposed § 1.267A-4 with foreign imported mismatch rules, in order to prevent the same hybrid deduction from resulting in deductions for non-hybrid payments being disallowed under imported mismatch rules in more than one jurisdiction.

J. Definitions of Interest and Royalty

1. Interest

There are no generally applicable regulations or statutory provisions addressing when financial instruments are treated as debt for U.S. tax purposes or when a payment is interest. As a general matter, however, the factors that distinguish debt from equity are described in Notice 94-47, 1994-1 C.B. 357, and interest is defined as compensation for the use or forbearance of money.
Deputy
v.
Dupont,
308 U.S. 488 (1940).

Using these principles, the proposed regulations define interest broadly 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.
See
proposed § 1.267A-5(a)(12).

In addition, in order to address certain structured transactions, the proposed regulations apply equally to “structured payments.” Proposed § 1.267A-5(b)(5) defines structured payments to include a number of items such as an expense or loss predominately incurred in consideration of the time value of money in a transaction or series of integrated or related transactions in which a taxpayer secures the use of funds for a period of time. This approach is consistent with the rules treating such payments similarly to interest under §§ 1.861-9T and 1.954-2.

The definitions of interest and structured payments also provide for adjustments to the amount of interest expense or structured payments, as applicable, to reflect the impact of derivatives that affect the economic yield or cost of funds of a transaction involving interest or structured payments. The definitions of interest and structured payments contained in the proposed regulations apply only for purposes of section 267A. However, solely for purposes of certain other provisions, similar definitions apply. For example, the definition of interest and structured payments under the proposed regulations is similar in scope to the definition of items treated similarly to interest under § 1.861-9T for purposes of allocating and apportioning deductions under section 861 and similar to the items treated as interest expense for purposes of section 163(j) in proposed regulations under section 163(j).

The Treasury Department and the IRS considered three options with respect to the definition of interest for purposes of section 267A. The first option considered was to not provide a definition of interest, and thus rely on general tax principles and case law to define interest for purposes of section 267A. While adopting this option might reduce complexity for some taxpayers, not providing an explicit definition of interest would create its own uncertainty as neither taxpayers nor the IRS might have a clear sense of what types of payments are treated as interest expense subject to disallowance under section 267A. Such uncertainty could increase burdens to the IRS and taxpayers by increasing the number of disputes about whether particular payments are interest for section 267A purposes. Moreover, this option could be distortive as it would provide an incentive to taxpayers to engage in transactions generating deductions economically similar to interest while asserting that such deductions are not described by existing principles defining interest expense. If successful, such strategies could allow taxpayers to avoid the application of section 267A through transactions that are similar to transactions involving interest.

The second option considered would have been to adopt a definition of interest but limit the scope of the definition to cover only amounts associated with conventional debt instruments and amounts that are generally treated as interest for all purposes under the Code or regulations prior to the passage of the Act. This would be equivalent to only adopting the rule that is proposed in § 1.267A-5(a)(12)(i) without also addressing structured payments, which are described in proposed § 1.267A-5(b)(5). While this would clarify what would be deemed interest for purposes of section 267A, the Treasury Department and the IRS have determined that this approach would potentially distort future financing transactions. Some taxpayers would choose to use financial instruments and transactions that provide a similar economic result of using a conventional debt instrument, but would avoid the label of interest expense under such a definition, potentially enabling these taxpayers to avoid the application of section 267A. As a result, under this second approach, there would still be an incentive for taxpayers to engage in the type of avoidance transactions discussed in the first alternative.

The final option considered and the one ultimately adopted in the proposed regulations is to provide a complete definition of interest that addresses all transactions that are commonly understood to produce interest expense, as well as structured payments that may have been entered into to avoid the application of section 267A. The proposed regulations also reduce taxpayer burden by adopting definitions of interest that have already been developed and administered in §§ 1.861-9T and 1.954-2 and that have been proposed for purposes of section 163(j). The definition of interest provided in the proposed regulations applies only for purposes of section 267A and not for other purposes of the Code, such as section 904(d)(3).

The Treasury Department and the IRS welcome comments on the definition of

interest for purposes of section 267A contained in the proposed regulations.

2. Royalty

Section 267A does not define the term royalty and there is no universal definition of royalty under the Code. The Treasury Department and the IRS considered providing no definition for royalties. However, similar to the discussion in Section II.J.1 of this Explanation of Provisions with respect to the definition of interest, not providing a definition for royalties and relying instead on general tax principles could create uncertainty as neither taxpayers nor the IRS might have a clear sense of what types of payments are treated as royalties subject to disallowance under section 267A. Such uncertainty could increase burdens to the IRS and taxpayers with respect to disputes about whether particular payments are royalties for section 267A purposes.

Instead, the Treasury Department and the IRS have determined that providing a definition of royalties would increase certainty, and therefore the proposed regulations define the term royalty for purposes of section 267A to include amounts paid or accrued as consideration for the use of, or the right to use, certain intellectual property and certain information concerning industrial, commercial or scientific experience.
See
proposed § 1.267A-5(a)(16). The term does not include amounts paid or accrued for after-sales services, for services rendered by a seller to the purchaser under a warranty, for pure technical assistance, or for an opinion given by an engineer, lawyer or accountant. The definition of royalty provided in the proposed regulations applies only for purposes of section 267A and not for other purposes of the Code, such as section 904(d)(3).

The definition of royalty is generally based on the definition used in tax treaties and, in particular, the definition incorporated into Article 12 of the 2006 U.S. Model Income Tax Treaty. This definition is also generally consistent with the language of section 861(a)(4). In addition, similar to the approach in the technical explanation to Article 12 of the 2006 U.S. Model Income Tax Treaty, the proposed regulations provide certain circumstances where payments are not treated as paid or accrued in consideration for the use of information concerning industrial, commercial or scientific experience. By using definitions that have already been developed and administered in other contexts, the proposed regulations provide an approach that reduces taxpayer burdens and uncertainty. The Treasury Department and the IRS welcome comments on the definition of royalty for purposes of section 267A contained in the proposed regulations.

K. Miscellaneous Issues

1. Effect of Foreign Currency Gain or Loss

The proposed regulations provide that foreign currency gain or loss recognized under section 988 is not separately taken into account under section 267A.
See
proposed § 1.267A-5(b)(2). Rather, foreign currency gain or loss recognized with respect to a specified payment is taken into account under section 267A only to the extent that the specified payment is in respect of accrued interest or an accrued royalty for which a deduction is disallowed under section 267A. Thus, for example, a section 988 loss recognized with respect to a specified payment of interest is not separately taken into account under section 267A (even though under the tax law of the tax resident to which the specified payment is made the tax resident does not include in income an amount corresponding to the section 988 loss, as the specified payment is made in the tax resident's functional currency).

The Treasury Department and the IRS recognize that additional rules addressing the effect of different foreign currencies may be necessary. For example, a hybrid deduction for purposes of the imported mismatch rule may be denominated in a different currency than a specified payment, in which case a translation rule may be necessary to determine the amount of the specified payment that is subject to the imported mismatch rule. The Treasury Department and the IRS request comments on foreign currency rules, including any rules regarding the translation of amounts between currencies, for purposes of the proposed regulations under sections 245A and 267A.

2. Payments by U.S. Taxable Branches

Certain expenses incurred by a nonresident alien or foreign corporation are allowed as deductions under sections 873(a) and 882(c) in determining that person's effectively connected income. To the extent the deductions arise from transactions involving certain hybrid or branch arrangements, the deductions should be disallowed under section 267A, as discussed in section II.B of this Explanation of Provisions. The proposed regulations do so by (i) treating a U.S. taxable branch (which includes a permanent establishment of a foreign person) as a specified party, and (ii) providing rules regarding interest or royalties considered paid or accrued by a U.S. taxable branch, solely for purposes of section 267A (and thus not for other purposes, such as chapter 3 of the Code).
See
proposed § 1.267A-5(b)(3). The effect of this approach is that interest or royalties considered paid or accrued by a U.S. taxable branch are specified payments that are subject to the rules of proposed §§ 1.267A-1 through 1.267A-4.
See also
proposed § 1.267A-6(c),
Example 4.

In general, a U.S. taxable branch is considered to pay or accrue any interest or royalties allocated or apportioned to effectively connected income of the U.S. taxable branch.
See
proposed § 1.267A-5(b)(3)(i). However, if a U.S. taxable branch constitutes a U.S. permanent establishment of a treaty resident, then the U.S. permanent establishment is considered to pay or accrue the interest or royalties deductible in computing its business profits. Although interest paid by a U.S. taxable branch may be subject to withholding tax as determined under section 884(f)(1)(A) and § 1.884-4, those rules are not relevant for purposes of section 267A.

The proposed regulations also provide rules to identify the manner in which a specified payment of a U.S. taxable branch is considered made.
See
proposed § 1.267A-5(b)(3)(ii). Absent such rules, it might be difficult to determine whether the specified payment is made pursuant to a hybrid or branch arrangement (for example, made pursuant to a hybrid transaction or to a reverse hybrid). However, these rules regarding the manner in which a specified payment is made do not apply to interest or royalties deemed paid by a U.S. permanent establishment in connection with inter-branch transactions that are permitted to be taken into account under certain U.S. tax treaties—such payments, by definition, constitute deemed branch payments (subject to disallowance under proposed § 1.267A-2(c)) and are therefore made pursuant to a branch arrangement.

3. Coordination With Other Provisions

Proposed § 1.267A-5(b)(1) coordinates the application of section 267A with other provisions of the Code and regulations that affect the deductibility of interest and royalties. This rule provides that, in general, section 267A applies after the application of other provisions of the Code and regulations. For example, a specified payment is subject to section 267A for the taxable year for which a deduction for the payment would

otherwise be allowed. Thus, if a deduction for an accrued amount is deferred under section 267(a) (in certain cases, deferring a deduction for an amount accrued to a related foreign person until paid), then the deduction is tested for disallowance under section 267A for the taxable year in which the amount is paid. Absent such a rule, an accrued amount for which a deduction is deferred under section 267(a) could constitute a disqualified hybrid amount even though the amount will be included in the specified recipient's income when actually paid. This coordination rule also provides that section 267A applies to interest or royalties after taking into account provisions that could otherwise recharacterize such amounts, such as § 1.894-1(d)(2).

4. E&P Reduction

Proposed § 1.267A-5(b)(4) provides that the disallowance of a deduction under section 267A does not affect whether or when the amount paid or accrued that gave rise to the deduction reduces earnings and profits of a corporation. Thus, a corporation's earnings and profits may be reduced as a result of a specified payment for which a deduction is disallowed under section 267A. This is consistent with the approach in the context of other disallowance rules.
See
§ 1.312-7(b)(1) (“A loss . . . may be recognized though not allowed as a deduction (by reason, for example, of the operation of sections 267 and 1211 . . .) but the mere fact that it is not allowed does not prevent a decrease in earnings and profits by the amount of such disallowed loss.”);
Luckman
v.
Comm'r,
418 F.2d 381, 383-84 (7th Cir. 1969) (“[T]rue expenses incurred by the corporation reduce earnings and profits despite their nondeductibility from current income for tax purposes.”).

5. De Minimis Exception

The proposed regulations provide a de minimis exception to make the rules more administrable.
See
proposed § 1.267A-1(c). As a result of this exception, a specified party is excepted from the application of section 267A for any taxable year for which the sum of its interest and royalty deductions (plus interest and royalty deductions of any related specified parties) is below $50,000. This rule applies based on any interest or royalty deductions, regardless of whether the deductions would be disallowed under section 267A. In addition, for purposes of this rule, specified parties that are related are treated as a single specified party.

The Treasury Department and the IRS welcome comments on the de minimis exception and whether another threshold would be more appropriate to implement the purposes of section 267A.

L. Interaction With Withholding Taxes and Income Tax Treaties

The determination of whether a deduction for a specified payment is disallowed under section 267A is made without regard to whether the payment is subject to withholding under section 1441 or 1442 or is eligible for a reduced rate of tax under an income tax treaty. Since the U.S. tax characterization of the payment prevails in determining the treaty rate for interest or royalties, regardless of whether the payment is made pursuant to a hybrid transaction, the proposed regulations will generally result in the disallowance of a deduction but treaty benefits may still be claimed, as long as the recipient is the beneficial owner of the payment and otherwise eligible for treaty benefits. On the other hand, if interest or royalties are paid to a fiscally transparent entity that is a reverse hybrid, as defined in proposed § 1.267A-2(d), the payment generally will not be deductible under the proposed regulations if the investor does not derive the payment, and will not be eligible for treaty benefits if the interest holder under § 1.894-1(d) does not derive the payment. The proposed regulations will only apply, however, if the investor is related to the specified party, whereas the reduced rate under the treaty may be denied without regard to whether the interest holder is related to the payer of the interest or royalties.

Certain U.S. income tax treaties also address indirectly the branch mismatch rules under proposed § 1.267A-2(e). Special rules, generally in the limitation on benefits articles of income tax treaties, increase the tax treaty rate for interest and royalties to 15 percent (even if otherwise not taxable under the relevant treaty article) if the amount paid to a permanent establishment of the treaty resident is subject to minimal tax, and the foreign corporation that derives and beneficially owns the payment is a resident of a treaty country that excludes or otherwise exempts from gross income the profits attributable to the permanent establishment to which the payment was made.

III. Information Reporting Under Sections 6038, 6038A, and 6038C

Under section 6038(a)(1), U.S. persons that control foreign business entities must file certain information returns with respect to those entities, which includes information listed in section 6038(a)(1)(A) through (a)(1)(E), as well as information that “the Secretary determines to be appropriate to carry out the provisions of this title.” Section 6038A similarly requires 25-percent foreign-owned domestic corporations (reporting corporations) to file certain information returns with respect to those corporations, including information related to transactions between the reporting corporation and each foreign person which is a related party to the reporting corporation. Section 6038C imposes the same reporting requirements on certain foreign corporations engaged in a U.S. trade or business (also, a reporting corporation).

The proposed regulations provide that a specified payment for which a deduction is disallowed under section 267A, as well as hybrid dividends and tiered hybrid dividends under section 245A, must be reported on the appropriate information reporting form in accordance with sections 6038 and 6038A.
See
proposed §§ 1.6038-2(f)(13) and (14), 1.6038-3(g)(3), and 1.6038A-2(b)(5)(iii).

IV. Sections 1503(d) and 7701—Application to Domestic Reverse Hybrids

A. Overview

1. Dual Consolidated Loss Rules

Congress enacted section 1503(d) to prevent the “double dipping” of losses.
See
S. Rep. 313, 99th Cong., 2d Sess., at 419-20 (1986). The Senate Report explains that “losses that a corporation uses to offset foreign tax on income that the United States does not subject to tax should not also be used to reduce any other corporation's U.S. tax.”
Id.
Section 1503(d) and the regulations thereunder generally provide that, subject to certain exceptions, a dual consolidated loss of a corporation cannot reduce the taxable income of a domestic affiliate (a “domestic use”).
See
§§ 1.1503(d)-2 and 1.1503-4(b). Section 1.1503(d)-1(b)(5) defines a dual consolidated loss as a net operating loss of a dual resident corporation or the net loss attributable to a separate unit (generally defined as either a foreign branch or an interest in a hybrid entity).
See
§ 1.1503(d)-1(b)(4).

The general prohibition against the domestic use of a dual consolidated loss does not apply if, pursuant to a “domestic use election,” the taxpayer certifies that there has not been and will not be a “foreign use” of the dual consolidated loss during a certification period.
See
§ 1.1503(d)-6(d). If a foreign use or other triggering event occurs during the certification period, the dual consolidated loss is recaptured. A

foreign use occurs when any portion of the dual consolidated loss is made available to offset the income of a foreign corporation or the direct or indirect owner of a hybrid entity (generally non-dual inclusion income).
See
§ 1.1503(d)-3(a)(1). Other triggering events include certain transfers of the stock or assets of a dual resident corporation, or the interests in or assets of a separate unit.
See
§ 1.1503(d)-6(e).

The regulations include a “mirror legislation” rule that, in general, prevents a domestic use election when a foreign jurisdiction has enacted legislation similar to section 1503(d) that denies any opportunity for a foreign use of the dual consolidated loss.
See
§ 1.1503(d)-3(e). As a result, the existence of mirror legislation may prevent the dual consolidated loss from being put to a domestic use (due to the domestic use limitation) or to a foreign use (due to the foreign “mirror legislation”) such that the loss becomes “stranded.” In such a case, the regulations contemplate that the taxpayer may enter into an agreement with the United States and the foreign country (for example, through the competent authorities) pursuant to which the losses are used in only one country.
See
§ 1.1503(d)-6(b).

2. Entity Classification Rules

Sections 301.7701-1 through 301.7701-3 classify a business entity with two or more members as either a corporation or a partnership, and a business entity with a single owner as either a corporation or a disregarded entity. Certain domestic business entities, such as limited liability companies, are classified by default as partnerships (if they have more than one member) or as disregarded entities (if they have only one owner) but are eligible to elect for federal tax purposes to be classified as corporations.
See
§ 301.7701-3(b)(1).

B. Domestic Reverse Hybrids

The Treasury Department and the IRS are aware that structures involving domestic reverse hybrids have been used to obtain double-deduction outcomes because they were not subject to limitation under current section 1503(d) regulations. A domestic reverse hybrid generally refers to a domestic business entity that elects under § 301.7701-3(c) to be treated as a corporation for U.S. tax purposes, but is treated as fiscally transparent under the tax law of its investors. In these structures, a foreign parent corporation typically owns the majority of the interests in the domestic reverse hybrid. Domestic reverse hybrid structures can lead to double-deduction outcomes because, for example, deductions incurred by the domestic reverse hybrid can be used (i) under U.S. tax law to offset income that is not subject to tax in the foreign parent's country, such as income of domestic corporations with which the domestic reverse hybrid files a U.S. consolidated return, and (ii) under the foreign parent's tax law to offset income not subject to U.S. tax, such as income of the foreign parent other than the income (if any) of the domestic reverse hybrid. Taxpayers take the position that these structures are not subject to the current section 1503(d) regulations because the domestic reverse hybrid is neither a dual resident corporation (because it is not subject to tax on a residence basis or on its worldwide income in the foreign parent country) nor a separate unit of a domestic corporation.

A comment on regulations under section 1503(d) that were proposed in 2005 asserted that this result is inconsistent with the policies underlying section 1503(d), which was adopted, in part, to ensure that domestic corporations were not put at a competitive disadvantage as compared to foreign corporations through the use of certain inbound acquisition structures.
See
TD 9315. The comment suggested that the scope of the final regulations be broadened to treat such entities as separate units, the losses of which are subject to the restrictions of section 1503(d).
Id.

In response to this comment, the preamble to the 2007 final dual consolidated loss regulations stated that the Treasury Department and the IRS acknowledged that this type of structure results in a double dip similar to that which Congress intended to prevent through the adoption of section 1503(d). The final regulations did not address these structures, however, because the Treasury Department and the IRS determined at that time that a domestic reverse hybrid was neither a dual resident corporation nor a separate unit and, therefore, was not subject to section 1503(d).
See
TD 9315. The preamble noted, however, that the Treasury Department and the IRS would continue to study these and similar structures.

The Treasury Department and the IRS have determined that these structures are inconsistent with the principles of section 1503(d) and, as a result, raise significant policy concerns. Accordingly, the proposed regulations include rules under sections 1503(d) and 7701 to prevent the use of these structures to obtain a double-deduction outcome. The proposed regulations require, as a condition to a domestic entity electing to be treated as a corporation under § 301.7701-3(c), that the domestic entity consent to be treated as a dual resident corporation for purposes of section 1503(d) (such an entity, a “domestic consenting corporation”) for taxable years in which two requirements are satisfied.
See
proposed § 301.7701-3(c)(3). The requirements are intended to restrict the application of section 1503(d) to cases in which it is likely that losses of the domestic consenting corporation could result in a double-deduction outcome.

The requirements are satisfied if (i) a “specified foreign tax resident” (generally, a body corporate that is a tax resident of a foreign country) under its tax law derives or incurs items of income, gain, deduction, or loss of the domestic consenting corporation, and (ii) the specified foreign tax resident is related to the domestic consenting corporation (as determined under section 267(b) or 707(b)).
See
proposed § 1.1503(d)-1(c). For example, the requirements are satisfied if a specified foreign tax resident directly owns all the interests in the domestic consenting corporation and the domestic consenting corporation is fiscally transparent under the specified foreign tax resident's tax law. In addition, an item of the domestic consenting corporation for a particular taxable year is considered derived or incurred by the specified tax resident during that year even if, under the specified foreign tax resident's tax law, the item is recognized in, and derived or incurred by the specified foreign tax resident in, a different taxable year.

Further, if a domestic entity filed an election to be treated as a corporation before December 20, 2018 such that the entity was not required to consent to be treated as a dual resident corporation, then the entity is deemed to consent to being treated as a dual resident corporation as of its first taxable year beginning on or after the end of a 12-month transition period. This deemed consent can be avoided if the entity elects, effective before its first taxable year beginning on or after the end of the transition period, to be treated as a partnership or disregarded entity such that it ceases to be a corporation for U.S. tax purposes. For purposes of such an election, the 60 month limitation under § 301.7701-3(c)(1)(iv) is waived.

Finally, the proposed regulations provide that the mirror legislation rule does not apply to dual consolidated losses of a domestic consenting corporation.
See
proposed § 1.1503(d)-3(e)(3). This exception is intended to minimize cases in which dual

consolidated losses could be “stranded” when, for example, the foreign parent jurisdiction has adopted rules similar to the recommendations in Chapter 6 of the Hybrid Mismatch Report. The exception does not apply to dual consolidated losses attributable to separate units because, in such cases, the United States is the parent jurisdiction and the dual consolidated loss rules should neutralize the double-deduction outcome.

V. Triggering Event Exception for Compulsory Transfers

As noted in section IV.A.1 of this Explanation of Provisions, certain triggering events require a dual consolidated loss that is subject to a domestic use election to be recaptured and included in income. The dual consolidated loss regulations also include various exceptions to these triggering events, including an exception for compulsory transfers involving foreign governments.
See
§ 1.1503(d)-6(f)(5).

A comment on the 2007 final dual consolidated loss regulations stated that the policies underlying the triggering event exception for compulsory transfers involving foreign governments apply equally to compulsory transfers involving the United States government. Accordingly, the comment requested guidance under § 1.1503(d)-3(c)(9) to provide that the exception is not limited to foreign governments. The comment suggested, as an example, that the exception should apply to a divestiture of a hybrid entity engaged in proprietary trading pursuant to the “Volcker Rule” contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (2010).

The Treasury Department and the IRS agree with this comment and, accordingly, the proposed regulations modify the compulsory transfer triggering event exception such that it will also apply with respect to the United States government.

VI. Disregarded Payments Made to Domestic Corporations

As discussed in sections II.D.2 and 3 of this Explanation of Provisions, the proposed regulations under section 267A address D/NI outcomes resulting from actual and deemed payments of interest and royalties that are regarded for U.S. tax purposes but disregarded for foreign tax purposes. The proposed regulations under section 267A do not, however, address similar structures involving payments to domestic corporations that are regarded for foreign tax purposes but disregarded for U.S. tax purposes.

For example, USP, a domestic corporation that is the parent of a consolidated group, borrows from a bank to fund the acquisition of the stock of FT, a foreign corporation that is tax resident of Country X. USP contributes the loan proceeds to USS, a newly formed domestic corporation that is a member of the USP consolidated group, in exchange for all the stock of USS. USS then forms FDE, a disregarded entity that is tax resident of Country X, USS lends the loan proceeds to FDE, and FDE uses the proceeds to acquire the stock of FT. For U.S. tax purposes, USP claims a deduction for interest paid on the bank loan, and USS does not recognize interest income on interest payments made to it from FDE because the payments are disregarded. For Country X tax purposes, the interest paid from FDE to USS is regarded and gives rise to a loss that can be surrendered (or otherwise used, such as through a consolidation regime) to offset the operating income of FT.

Under the current section 1503(d) regulations, the loan from USS to FDE does not result in a dual consolidated loss attributable to USS's interest in FDE because interest paid on the loan is not regarded for U.S. tax purposes; only items that are regarded for U.S. tax purposes are taken into account for purposes of determining a dual consolidated loss.
See
§ 1.1503(d)-5(c)(1)(ii). In addition, the regarded interest expense of USP is not attributed to USS's interest in FDE because only regarded items of USS, the domestic owner of FDE, are taken into account for purposes of determining a dual consolidated loss.
Id.
The result would generally be the same, however, even if USS, rather than USP, were the borrower on the bank loan.
See
§ 1.1503(d)-7(c),
Example 23
.

The Treasury Department and the IRS have determined that these transactions raise significant policy concerns that are similar to those relating to the D/NI outcomes addressed by sections 245A(e) and 267A, and the double-deduction outcomes addressed by section 1503(d). The Treasury Department and the IRS are studying these transactions and request comments.

VII. Applicability Dates

Under section 7805(b)(2), and consistent with the applicability date of section 245A, proposed § 1.245A(e)-1 applies to distributions made after December 31, 2017. Under section 7805(b)(2), proposed §§ 1.267A-1 through 1.267A-6 generally apply to specified payments made in taxable years beginning after December 31, 2017. This applicability date is consistent with the applicability date of section 267A. The Treasury Department and the IRS therefore expect to finalize such provisions by June 22, 2019.
See
section 7805(b)(2). However if such provisions are finalized after June 22, 2019, then the Treasury Department and the IRS expect that such provisions will apply only to taxable years ending on or after December 20, 2018.
See
section 7805(b)(1)(B).

As provided in proposed § 1.267A-7(b), certain rules, such as the disregarded payment and deemed branch payment rules as well as the imported mismatch rule, apply to specified payments made in taxable years beginning on or after December 20, 2018.
See
section 7805(b)(1)(B).

Proposed §§ 1.6038-2, 1.6038-3, and 1.6038A-2, which require certain reporting regarding deductions disallowed under section 267A, as well as hybrid dividends and tiered hybrid dividends under section 245A, apply with respect to information for annual accounting periods or tax years, as applicable, beginning on or after December 20, 2018.
See
section 7805(b)(1)(B).

Proposed §§ 1.1503(d)-1 and -3, treating domestic consenting corporations as dual resident corporations, apply to taxable years ending on or after December 20, 2018.
See
section 7805(b)(1)(B).

Proposed § 1.1503(d)-6, amending the compulsory transfer triggering event exception, applies to transfers that occur on or after December 20, 2018, but taxpayers may apply the rules to earlier transfers.
See
section 7805(b)(1)(B).

Proposed § 301.7701-3(a) and (c)(3) apply to a domestic eligible entity that on or after December 20, 2018 files an election to be classified as an association (regardless of whether the election is effective before December 20, 2018). These provisions also apply to certain domestic eligible entities the interests in which are transferred or issued on or after December 20, 2018.
See
section 7805(b)(1)(B).

Special Analyses

I. Regulatory Planning and Review

Executive Orders 13771, 13563, and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits, including potential economic, environmental, public health and safety effects, distributive impacts, and equity. Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, reducing costs,

harmonizing rules, and promoting flexibility. The preliminary E.O. 13771 designation for this proposed rulemaking is regulatory.

The proposed regulations have been designated by the Office of Management and Budget's Office of Information and Regulatory Affairs (OIRA) as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations (“MOA”). OIRA has determined that the proposed rulemaking is economically significant and subject to review under E.O. 12866 and section 1(c) of the Memorandum of Agreement. Accordingly, the proposed regulations have been reviewed by the Office of Management and Budget.

A. Background

Hybrid arrangements include both “hybrid entities” and “hybrid instruments.” A hybrid entity is generally an entity which is treated as a flow-through or disregarded entity for U.S. tax purposes but as a corporation for foreign tax purposes or vice versa. Hybrid instruments are financial instruments that share characteristics of both debt and equity and are treated as debt for U.S. tax purposes and equity in the foreign jurisdiction or vice versa.

Before the Act, U.S. subsidiaries of foreign-based multinational enterprises could employ cross-border hybrid arrangements as legal tax-avoidance techniques by exploiting differences in tax treatment across jurisdictions. These arrangements allowed taxpayers to claim tax deductions in the United States without a corresponding inclusion in another jurisdiction.

The United States has a check-the-box regulatory provision, under which some taxpayers can choose whether they are treated as corporations, where they may face a separate entity level tax, or as partnerships, where there is no such separate entity tax (but rather only owner-level tax), under the U.S. tax code. This choice allows taxpayers the ability to become hybrid entities that are viewed as corporations in one jurisdiction, but not in another. For example, a foreign parent could own a domestic subsidiary limited liability partnership (LLP) that, under the check-the-box rules, elects to be treated as a corporation under U.S. tax law. However, this subsidiary could be viewed as a partnership under foreign tax law. The result is that the domestic subsidiary could be entitled to a deduction for U.S. tax purposes for making interest payments to the foreign parent, but the foreign country would see a payment between a partnership and a partner, and therefore would not tax the interest income. That is, the corporate structure would enable the business entity to avoid paying U.S. tax on the interest by allowing a deduction attributable to an intra-group loan, despite the interest income never being included under foreign tax law.

In addition, there are hybrid instruments, which share characteristics of both debt and equity. Because of these shared characteristics, countries may be inconsistent in their treatment of such instruments. One example is perpetual debt, which many countries treat as debt, but the United States treats as equity. If a foreign affiliate of a U.S.-based multinational issued perpetual debt to a U.S. holder, the interest payments would be tax deductible in a foreign jurisdiction that treats the instrument as debt, while the payments are treated as dividends in the United States and potentially eligible for a dividends received deduction (DRD).

The Act adds section 245A(e) to the Code to address issues of hybridity by introducing a hybrid dividends provision, which disallows the DRD for any dividend received by a U.S. shareholder from a controlled foreign corporation if the dividend is a hybrid dividend. The statute defines a hybrid dividend as an amount received from a controlled foreign corporation for which a deduction would be allowed under section 245A(a) and for which the controlled foreign corporation received a deduction or other tax benefit in a foreign country. Hybrid dividends between controlled foreign corporations with a common U.S. shareholder are treated as subpart F income.

The Act also adds section 267A of the Code to deny a deduction for any disqualified related party amount paid or accrued as a result of a hybrid transaction or by, or to, a hybrid entity. The statute defines a disqualified related party amount as any interest or royalty paid or accrued to a related party where there is no corresponding inclusion to the related party in the other tax jurisdiction or the related party is allowed a deduction with respect to such amount in the other tax jurisdiction. The statute's definition of a hybrid transaction is any transaction where there is a mismatch in tax treatment between the U.S. and the other foreign jurisdiction. Similarly, a hybrid entity is any entity which is treated as fiscally transparent for U.S. tax purposes but not for purposes of the foreign tax jurisdiction, or vice versa.

B. Overview

The hybrids provisions in the Act and the proposed regulations are anti-abuse measures. Taxpayers have been taking aggressive tax positions to take advantage of tax treatment mismatches between jurisdictions in order to achieve favorable tax outcomes at the detriment of tax revenues (see OECD/G20 Hybrid Mismatch Report, October 2015 and OECD/G20 Branch Mismatch Report, July 2017). The statute and the proposed regulations serve to conform the U.S. tax system to recently agreed-upon international tax principles (see OECD/G20 Hybrids Mismatch Report, October 2015 and OECD/G20 Branch Mismatch Report, July 2017), consistent with statutory intent, while protecting U.S. interests and the U.S. tax base. International tax coordination is particularly advantageous in the context of hybrids as it has the potential to greatly curb opportunities for hybrid arrangements, while avoiding double taxation. The anticipated effect of the statute and proposed regulations is a reduction in tax revenue loss due to hybrid arrangements, at the cost of an increase in compliance burden for a limited number of sophisticated taxpayers, as explained below.

C. Need for the Proposed Regulations

Because the Act introduced new sections to the Code to address hybrid entities and hybrid instruments, a large number of the relevant terms and necessary calculations that taxpayers are currently required to apply under the statute can benefit from greater specificity. Taxpayers will lack clarity on which types of arrangements are subject to the statute without the additional interpretive guidance and clarifications contained in the proposed regulations. This lack of clarity could lead to a shifting of corporate income overseas through hybrid arrangements, further eroding U.S. tax revenues. Without accompanying rules to cover branches, structured arrangements, imported mismatches, and similar structures, the statute would be extremely easy to avoid, a pathway that is contrary to Congressional intent. It could also lead to otherwise similar taxpayers interpreting the statute differently, distorting the equity of tax treatment for otherwise similarly situated taxpayers. Finally, the lack of clarity could cause some taxpayers unnecessary compliance burden if they misinterpret the statute.

D. Economic Analysis

1. Baseline

The Treasury Department and the IRS have assessed the benefits and costs of the proposed regulations relative to a no-action baseline reflecting anticipated tax-related behavior and other economic behavior in the absence of the proposed regulations.

The baseline includes the Act, which effectively cut the top statutory corporate income tax rate from 35 to 21 percent. This change lowered the value of using hybrid arrangements for multinational corporations, because the value of such arrangements is proportional to the tax they allow the corporation to avoid. As such, some firms with an incentive to set up hybrid arrangements prior to the Act would no longer find it profitable to maintain these arrangements. The Act also modified section 163(j), and regulations interpreting this provision are expected to be finalized soon, which together further limit the deductibility of interest payments. These statutory and regulatory changes further curb the incentive to set up and maintain hybrid arrangements for multinational corporations, since interest payments are a primary vehicle through which hybrid arrangements generated deductions prior to the Act. Further, prior to the Act, the Treasury Department and the IRS issued a series of regulations that reduced or eliminated the incentive for multinational corporations to invert, or change their tax residence to avoid U.S. taxes (including setting up some hybrid arrangements). As a result, under the baseline, the value of hybrid arrangements reflects the existing regulatory framework and the Act and its associated soon-to-be-finalized regulations, all of which strongly affect the value of hybrid arrangements as a tax avoidance technique.

2. Anticipated Costs and Benefits

i. Economic Effects

The Treasury Department has determined that the discretionary non-revenue impacts of the proposed hybrid regulations will reduce U.S. Gross Domestic Product (GDP) by less than $100 million per year ($2018).

To evaluate this effect, the Treasury Department considered the share of interest deductions that would be disallowed by the proposed regulations. Using Treasury Department models applied to confidential 2016 tax data, the Treasury Department calculated the average effective tax rate for potentially affected taxpayers under a range of levels of interest payment deductibility, including the level of deductibility under the Act without the proposed regulations. The difference between the estimated effective tax rate under the Act and without the discretionary elements of the proposed regulations and the range of estimated effective tax rates that include the proposed regulations provides a range of estimates of the net increase in the effective tax rate due to the discretion exercised in the proposed regulations. The Treasury Department next applied an elasticity of taxable income to the range of estimated increases in the effective tax rate to estimate the reduction in taxable income for each of the affected taxpayers in the sample. The Treasury Department then examined a range of estimates of the relationship between the change in taxable income and the real change in economic activity. Finally, the Treasury Department extrapolated the results through 2027.

The Treasury Department concludes from this evaluation that the discretionary aspects of the proposed rules will reduce GDP annually by less than $100 million ($2018). The projected effects reflect the proposed regulations alone and do not include non-revenue economic effects stemming from the Act in the absence of the proposed regulations. More specifically, the analysis did not estimate the impacts of the statutory requirement that hybrid dividends shall be treated as subpart F income of the receiving controlled foreign corporations for purposes of section 951(a)(1)(A) for the taxable year and shall not be permitted a foreign tax credit.
See
section 245A(e).

The Treasury Department solicits comments on the methodology used to evaluate the non-revenue economic effects of the proposed regulations and anticipates that further analysis will be provided at the final rule stage.

ii. Anticipated Costs and Benefits of Specific Provisions

a. Section 245A(e)

Section 245A(e) applies in certain cases in which a CFC pays a hybrid dividend, which is a dividend paid by the CFC for which the CFC received a deduction or other tax benefit under foreign tax law (a hybrid deduction). The proposed regulations provide rules for identifying and tracking such hybrid deductions. These rules set forth common standards for identifying hybrid deductions and therefore clarify what is deemed a hybrid dividend by the statute and ensure equitable tax treatment of otherwise similar taxpayers.

The proposed regulations also address timing differences to ensure that there is parity between economically similar transactions. Absent such rules, similar transactions may be treated differently due to timing differences. For example, if a CFC paid out a dividend in a given taxable year for which it received a deduction or other tax benefit in a prior taxable year, the taxpayer might claim the dividend is not a hybrid dividend, since the taxable year in which the dividend is paid for U.S. tax purposes and the year in which the tax benefit is received do not overlap. Absent rules, such as the proposed regulations, the purpose of section 245A(e) might be avoided and economically similar transactions might be treated differently.

Finally, these rules excuse certain taxpayers from having to track hybrid deductions (namely taxpayers without a sufficient connection to a section 245A(a) dividends received deduction). The utility of requiring these taxpayers to track hybrid deductions would be outweighed by the burdens of doing so. The proposed regulations reduce the compliance burden on taxpayers that are not directly dealing with hybrid dividends.

b. Section 267A

Section 267A disallows a deduction for interest or royalties paid or accrued in certain transactions involving a hybrid arrangement. Congress intended this provision to address cases in which the taxpayer is provided a deduction under U.S. tax law, but the payee does not have a corresponding income inclusion under foreign tax law, dubbed a “deduction/no-inclusion outcome” (D/NI outcome). See Senate Explanation, at 384. This affects taxpayers that attempt to use hybrid arrangements to strip income out of the United States taxing jurisdiction.

The proposed regulations disallow a deduction under section 267A only to the extent that the D/NI outcome is a result of a hybrid arrangement. Note that under the statute but without the proposed regulations, a deduction would be disallowed simply if a D/NI outcome occurs and a hybrid arrangement exists (see section II.E of the Explanation of Provisions). For example, a royalty payment made to a hybrid entity in the U.K. qualifying for a low tax rate under the U.K. patent box regime could be denied a deduction in the U.S. under the statute. However, the low U.K. rate is a result of the lower tax rate on patent box income and not a result of any hybrid arrangement. In this example, there is no link between hybridity and the D/NI outcome, since it is the U.K. patent box regime that

yields the D/NI outcome and the low U.K. patent box rate is available to taxpayers regardless of whether they are organized as hybrid entities or not. The proposed regulations limit the application of section 267A to cases where the D/NI outcome occurs as a result of hybrid arrangements and not due to a generally applicable feature of the jurisdiction's tax system.

The proposed regulations also provide several exceptions to section 267A in order to refine the scope of the provision and minimize burdens on taxpayers. First, the proposed regulations generally exclude from section 267A payments that are included in a U.S. tax resident's or U.S. taxable branch's income or are taken into account for purposes of the subpart F or global intangible low-taxed income (GILTI) provisions. While the exception for income taken into account for purposes of subpart F is in the statute, the proposed regulations expand the exception to cover GILTI. This avoids potential double taxation on that income. In addition, as a refinement compared with the statute, the extent to which a payment is taken into account under subpart F is determined without regard to allocable deductions or qualified deficits. The proposed regulations also provide a de minimis rule that excepts small taxpayers from section 267A, minimizing the burden on small taxpayers.

Finally, the proposed regulations address a comprehensive set of transactions that give rise to D/NI outcomes. The statute, as written, does not apply to certain hybrid arrangements, including branch arrangements and certain reverse hybrids, as described above (see section II.D of the Explanation of Provisions). The exclusion of these arrangements could have large economic and fiscal consequences due to taxpayers shifting tax planning towards these arrangements to avoid the new anti-abuse statute. The proposed regulations close off this potential avenue for additional tax avoidance by applying the rules of section 267A to branch mismatches, reverse hybrids, certain transactions with unrelated parties that are structured to achieve D/NI outcomes, certain structured transactions involving amounts similar to interest, and imported mismatches.

3. Alternatives Considered

i. Addressing conduit arrangements/imported mismatches

Section 267A(e)(1) provides regulatory authority to apply the rules of section 267A to conduit arrangements and thus to disallow a deduction in cases in which income attributable to a payment is directly or indirectly offset by an offshore hybrid deduction. The Treasury Department and the IRS considered four options with regards to conduit arrangement rules.

The first option was to not implement any conduit rules, and thus rely on existing and established judicial doctrines (such as conduit principles and substance-over-form principles) to police these transactions. A second option considered was to address conduit arrangement concerns through a broad anti-abuse rule. On the one hand, both of these approaches might reduce complexity by eliminating the need for detailed regulatory rules addressing conduit arrangements. On the other hand, such approaches could create uncertainty (as neither taxpayers nor the IRS might have a clear sense of what types of transactions might be challenged under the judicial doctrines or anti-abuse rule) and could increase burdens to the IRS (as challenging under judicial doctrines or anti-abuse rules are generally difficult and resource intensive). Significantly, such approaches could result in double non-taxation (if judicial doctrines or anti-abuse rules were to not be successfully asserted) or double-taxation (if judicial doctrines or anti-abuse rules were to not take into account the application of foreign tax law, such as a foreign imported mismatch rule).

A third option considered was to implement rules modeled off existing U.S. anti-conduit rules under § 1.881-3. On the positive side, such an approach would rely on an established and existing framework that taxpayers are already familiar with and thus there would be a lesser need to create and apply a new framework or set of rules. On the negative side, existing anti-conduit rules are limited in certain respects as they apply only to certain financing arrangements, which exclude certain stock, and they address only withholding tax policies, which pose separate concerns from section 267A policies (D/NI policies). Furthermore, taxpayers have implemented structures that attempt to avoid the application of the existing anti-conduit rules. Detrimental to tax equity, such an approach could also lead to double-taxation, as the existing anti-conduit rules do not take into account the application of foreign tax law, such as a foreign imported mismatch rule.

The final option considered was to implement rules that are generally consistent with the BEPS imported mismatch rule. The first advantage of such an approach is that it provides certainty about when a deduction will or will not be disallowed under the rule. The second advantage of this approach is that it neutralizes the risk of double non-taxation, while also neutralizing the risk of double taxation. This is because this option is modeled off the BEPS approach, which is being implemented by other countries, and also contains explicit rules to coordinate with foreign tax law. Coordinating with the global tax community reduces opportunities for economic distortions. Although such an approach involves greater complexity than the alternatives, the Treasury Department and IRS expect the benefits of this approach's comprehensiveness, administrability, and conduciveness to taxpayer certainty, to be substantially greater than the complexity burden in comparison with the available alternative approaches. Thus, this is the approach adopted in the proposed regulations.

ii. De Minimis Rules

The proposed regulations provide a de minimis exception that exempts taxpayers from the application of section 267A for any taxable year for which the sum of the taxpayer's interest and royalty deductions (plus interest and royalty deductions of any related specified parties) is below $50,000. The exception's $50,000 threshold looks to a taxpayer's amount of interest or royalty deductions without regard to whether the deductions involve hybrid arrangements and therefore, absent the de minimis exception, would be disallowed under section 267A.

The Treasury Department and the IRS considered not providing a de minimis exception because hybrid arrangements are highly likely to be tax-motivated structures undertaken only by mostly sophisticated investors. However, it is possible that, in limited cases, small taxpayers could be subject to these rules, for example, as a result of timing differences or a lack of familiarity with foreign law. Furthermore, section 267A is intended to stop base erosion and tax avoidance, and in the case of small taxpayers, it is expected that the revenue gains from applying these rules would be minimal since few small taxpayers are expected to engage in hybrid arrangements.

The Treasury Department and IRS also considered a de minimis exception based on a dollar threshold with respect to the amount of interest or royalties involving hybrid arrangements. However, such an approach would require a taxpayer to first apply the rules of section 267A to identify its interest or royalty deductions involving hybrid arrangements in order to

determine whether the de minimis threshold is satisfied and thus whether it is subject to section 267A for the taxable year. This would therefore not significantly reduce burdens on taxpayers with respect to applying the rules of section 267A.

Therefore, the proposed regulations adopt a rule that looks to the overall amount of interest and royalty payments, whether or not such payments involve hybrid arrangements. This has the effect of exempting, in an efficient manner, small taxpayers that are unlikely to engage in hybrid arrangements, and therefore such taxpayers do not need to consider the application of these rules.

iii. Deemed Branch Payments and Branch Mismatch Payments

The proposed regulations expand the application of section 267A to certain transactions involving branches. This was necessary in order to ensure that taxpayers could not avoid section 267A by engaging in transactions that were economically similar to the hybrid arrangements that are covered by the statute. For example, assume that a related party payment is made to a foreign entity in Country X that is owned by a parent company in Country Y. Further assume that there is a mismatch between how Country X views the entity (fiscally transparent) versus how Country Y views it (not fiscally transparent). In general, section 267A's hybrid entity rules prevent a D/NI outcome in this case. However, assume instead that the parent company forms a branch in Country X instead of a foreign entity, and Country Y (the parent company's jurisdiction) exempts all branch income under its territorial system. On the other hand, due to a mismatch in laws governing whether a branch exists, Country X does not view the branch as existing and therefore does not tax payments made to the branch. Absent regulations, taxpayers could easily avoid section 267A through use of branch structures, which are economically similar to the foreign entity structure in the first example.

In the absence of the proposed regulations, taxpayers may have found it valuable to engage in transactions that are economically similar to hybrid arrangements but that avoided the application of 267A. Such transactions would have resulted in a loss in U.S. tax revenue without any accompanying efficiency gain. Furthermore, to the extent that these transactions were structured specifically to avoid the application of section 267A and were not available to all taxpayers, they would generally have led to an efficiency loss in addition to the loss in U.S. tax revenue.

iv. Exceptions for Income Included in U.S. Tax and GILTI Inclusions

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2018-27714. Public record. Not legal advice.