# Rules Regarding Certain Hybrid Arrangements > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-05924 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** April 8, 2020 - **Citation:** 85 FR 19802 ## Text DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 301 [TD 9896] RIN 1545-BO53 Rules Regarding Certain Hybrid Arrangements AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final regulations providing guidance regarding hybrid dividends and certain amounts paid or accrued pursuant to hybrid arrangements, which generally involve arrangements whereby U.S. and foreign tax law classify a transaction or entity differently for tax purposes. This document also contains final regulations relating to dual consolidated losses and entity classifications to prevent the same deduction from being claimed under the tax laws of both the United States and a foreign jurisdiction. Finally, this document contains final regulations regarding information reporting to facilitate the administration of certain rules in the final regulations. The final 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: Effective date: These regulations are effective on April 8, 2020. Applicability dates: For dates of applicability, see §§ 1.245A(e)-1(h), 1.267A-7, 1.1503(d)-8(b), 1.6038-2(m), 1.6038-3(l), 1.6038A-2(g), and 301.7701-3(c). FOR FURTHER INFORMATION CONTACT: Tracy Villecco at (202) 317-6933 or Tianlin (Laura) Shi at (202) 317-6936 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background Sections 245A(e) and 267A were added to the Internal Revenue Code (“Code”) by the Tax Cuts and Jobs Act, Public Law 115-97 (2017) (the “Act”), which was enacted on December 22, 2017. On December 28, 2018, the Department of the Treasury (“Treasury Department”) and the IRS published proposed regulations (REG-104352-18) under sections 245A(e), 267A, 1503(d), 6038, 6038A, 6038C, and 7701 in the Federal Register (83 FR 67612) (the “proposed regulations”). Terms used but not defined in this preamble have the meaning provided in the final regulations. A public hearing on the proposed regulations was scheduled for March 20, 2019, but it was not held because no speaker outlines were submitted to the IRS by the due date for submission, March 15, 2019. The Treasury Department and the IRS received written comments with respect to the proposed regulations. Comments received outside the scope of this rulemaking are generally not addressed but may be considered in connection with future regulations. All written comments received in response to the proposed regulations are available at www.regulations.gov or upon request. Summary of Comments and Explanation of Revisions I. Overview The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. This Summary of Comments and Explanation of Revisions section discusses the revisions as well as comments received in response to the solicitation of comments in the proposed regulations. II. Comments and Revisions to Proposed § 1.245A(e)-1—Special Rules for Hybrid Dividends A. Background Section 245A(e) and the proposed regulations neutralize the double non-taxation effects of a hybrid dividend or tiered hybrid dividend through either denying the section 245A(a) dividends received deduction with respect to the dividend or requiring an inclusion under section 951(a)(1)(A) (“subpart F inclusion”) with respect to the dividend, depending on whether the shareholder receiving the dividend is a domestic corporation or a controlled foreign corporation (“CFC”). The proposed regulations require that certain shareholders of a CFC maintain a hybrid deduction account with respect to each share of stock of the CFC that the shareholder owns, and provide that a dividend received by the shareholder from the CFC is a hybrid dividend or tiered hybrid dividend to the extent of the sum of those accounts. A hybrid deduction account with respect to a share of stock of a CFC reflects the amount of hybrid deductions of the CFC that have been allocated to the share. In general, a hybrid deduction is a deduction or other tax benefit allowed to a CFC (or a related person) under a relevant foreign tax law for an amount paid, accrued, or distributed with respect to an instrument of the CFC that is stock for U.S. tax purposes. B. Hybrid Deductions 1. Current Use of Deduction or Other Tax Benefit One comment requested that for a deduction or other tax benefit allowed under a relevant foreign tax law to be a hybrid deduction, it must be used currently under the relevant foreign tax law and, thus, currently reduce foreign tax liability. The comment noted that a current use might not occur if, for example, the CFC has other deductions or losses under the relevant foreign tax law, or all of a CFC's income is exempt income (for example, if the CFC is a holding company and all of its income benefits from a 100 percent participation exemption). The comment asserted that absent a current use of a deduction, double non-taxation does not occur. The Treasury Department and the IRS have determined that it would not be appropriate for a deduction or other tax benefit to be a hybrid deduction only to the extent it is used currently. Even though a deduction or other tax benefit may not be used currently, it could be used in another taxable period—for example, as a result of a net operating loss carrying over to a subsequent taxable year—and thus could produce double non-taxation. In addition, it could be complex or burdensome to determine whether a deduction or other tax benefit is used currently (because it could, for example, require a factual analysis of how particular deductions offset items of gross income under the relevant foreign tax law) and then, to the extent not used currently, track the deduction or other tax benefit so that it is added to a hybrid deduction account only once it is in fact used. Accordingly, the final regulations do not adopt the comment, and the regulations clarify that a deduction or other tax benefit may be a hybrid deduction regardless of whether it is used currently under the relevant foreign tax law. See § 1.245A(e)-1(d)(2). 2. Coordination With Foreign Disallowance Rules i. Thin Capitalization and Other Rules A comment requested that a deduction or other tax benefit not be a hybrid deduction if under the relevant foreign tax law the deduction or other tax benefit is disallowed under a thin capitalization rule or a rule similar to section 163(j). Similar to the comment discussed in part II.B.1 of this Summary of Comments and Explanation of Revisions section, the comment asserted that such a disallowed deduction or other tax benefit does not produce double non-taxation. The final regulations do not adopt the comment for reasons similar to those discussed in part II.B.1 of this Summary of Comments and Explanation of Revisions section. For example, a thin capitalization rule or a rule similar to section 163(j) may suspend rather than disallow a deduction, and thus may not prevent eventual double non-taxation. Moreover, because a thin capitalization rule or a rule similar to section 163(j) generally applies to all otherwise allowable deductions, it would be unduly complex and burdensome to determine the extent to which an amount disallowed under such a rule relates to a particular otherwise allowable deduction. Accordingly, the final regulations do not adopt the comment, and the regulations clarify that the determination of whether a deduction or other tax benefit is allowed is made without regard to a rule that disallows or suspends deductions if a certain ratio or percentage is exceeded. See § 1.245A(e)-1(d)(2)(ii)(A). ii. Foreign Hybrid Mismatch Rules The proposed regulations do not provide rules to take into account the application of foreign hybrid mismatch rules—that is, hybrid mismatch rules under the relevant foreign tax law. Accordingly, if such hybrid mismatch rules deny a deduction to neutralize a deduction/no-inclusion (“D/NI”) outcome, then, because the deduction is not allowed under the relevant foreign tax law, the deduction cannot be a hybrid deduction under the proposed regulations. The Treasury Department and the IRS have concluded that, in certain cases, whether a deduction or other tax benefit is a hybrid deduction should be determined without regard to foreign hybrid mismatch rules (and thus without regard to whether such rules disallow the deduction). The determination should be made in this manner in cases in which there is a close temporal connection between the amount giving rise to the deduction or other tax benefit and the payment of the amount as a dividend for U.S. tax purposes. In these cases, in order to prevent a D/NI outcome, the participation exemption under section 245A(a) should not apply to the dividend, as opposed to the participation exemption applying to the dividend to the extent that the foreign hybrid mismatch rules disallow a deduction for the amount in order to neutralize a D/NI outcome. This approach more closely aligns the rules of section 245A(e) with the approach set forth in the OECD/G20 report, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report (the “Hybrid Mismatch Report”). Such an approach avoids potential circularity or other issues in cases in which the application of foreign hybrid mismatch rules depends on whether an amount will be included in income under U.S. tax law. See Hybrid Mismatch Report, para. 35 and Ex. 2.3. In addition, this approach is consistent with an approach suggested in a comment (which was received before the proposed regulations were issued but after the proposed regulations had been substantially developed) with respect to section 245A generally. Accordingly, the final regulations provide that the determination of whether a relevant foreign tax law allows a deduction or other tax benefit for an amount is made without regard to the application of foreign hybrid mismatch rules, provided that the amount gives rise to a dividend for U.S. tax purposes or is reasonably expected for U.S. tax purposes to give rise to a dividend that will be paid within 12 months after the taxable period in which the deduction or other tax benefit would otherwise be allowed. See § 1.245A(e)-1(d)(2)(ii)(B). As an example, assume that but for foreign hybrid mismatch rules, a CFC would be allowed a deduction under the relevant foreign tax law for an amount paid or accrued pursuant to an instrument issued by the CFC and treated as stock for U.S. tax purposes. If the amount is an actual payment that gives rise to a dividend for U.S. tax purposes (or the amount is an accrual but is reasonably expected to give rise to a dividend for U.S. tax purposes that will be paid within 12 months after the taxable period for which the deduction would otherwise be allowed), then the amount generally gives rise to a hybrid deduction regardless of whether the foreign hybrid mismatch rules may disallow a deduction for the amount. If, on the other hand, the amount would give rise to a dividend in a later period, then the amount would not give rise to a hybrid deduction to the extent that the foreign hybrid mismatch rules disallow a deduction for the amount. 3. Effect of Withholding Taxes Under the proposed regulations, the determination of whether a deduction or other tax benefit is a hybrid deduction is generally made without regard to whether the amount is subject to withholding tax under the relevant foreign tax law. But see proposed § 1.245A(e)-1(g)(2), Example 2 (illustrating that withholding taxes imposed pursuant to an integration or imputation system may prevent a deduction or other tax benefit from being a hybrid deduction). A comment asserted that, to prevent double-taxation, a deduction or other tax benefit under a relevant foreign tax law should not be a hybrid deduction to the extent the amount giving rise to the deduction or other tax benefit is subject to withholding tax under such tax law. The purpose of withholding taxes generally is not to address mismatches in tax outcomes, but rather to allow the source jurisdiction to retain its right to tax the payment. For example, in many cases withholding taxes are imposed on payments not giving rise to D/NI concerns, such as nondeductible dividends. In addition, had Congress generally intended for withholding taxes to be taken into account for purposes of section 245A(e), it could have included in section 245A(e) a rule similar to the one in section 59A(c)(2)(B), which was enacted at the same time as section 245A(e). Thus, the Treasury Department and the IRS have concluded that withholding taxes generally should not be viewed as neutralizing a D/NI outcome. In addition, generally taking withholding taxes into account for purposes of determining whether a deductible amount gives rise to a hybrid deduction could raise administrability issues if the amount is subject to withholding taxes at the time of payment (with the result that the amount is not added to a hybrid deduction account at that time) but the taxes are refunded in a later period; in these cases it could be difficult or burdensome to retroactively add the amount to the hybrid deduction account and make corresponding adjustments. Accordingly, the final regulations do not adopt this comment. See also part II.B.5 of this Summary of Comments and Explanation of Revisions section (deductions or other tax benefits pursuant to imputation systems or other regimes intended to relieve double-taxation). 4. Deductions With Respect to Equity The proposed regulations provide that a hybrid deduction includes a deduction with respect to equity, such as a notional interest deduction (“NID”). See proposed § 1.245A(e)-1(d)(2)(i)(B). The preamble to the proposed regulations explains that NIDs are hybrid deductions because they raise concerns similar to those raised by traditional hybrid instruments. Several comments asserted that NIDs should not be hybrid deductions because NIDs do not involve sufficient hybridity so as to be within the intended scope of section 245A(e). These comments noted that NIDs are generally available tax concessions that reflect tax policy decisions, and that NIDs are typically allowed without regard to dividend distributions, if any. Another comment asserted that because NIDs are the equivalent of a lower tax rate on profits, any policy concerns with NIDs are appropriately addressed by the global intangible low-taxed income regime (“GILTI”) under section 951A. Other comments raised concerns that treating NIDs as hybrid deductions departs from the Hybrid Mismatch Report (and thus the approaches taken by other countries to implement the Report) and, as a result, could impair the competiveness of U.S. multinational groups. As an alternative to not treating NIDs as hybrid deductions, some comments suggested other approaches. For example, a comment suggested that the final regulations reserve on whether NIDs are hybrid deductions so that, to the extent NIDs are viewed as providing inappropriate results, NIDs can be addressed on a multilateral basis. Other comments suggested that only NIDs resulting from an actual payment, accrual, or distribution should constitute hybrid deductions. Lastly, comments suggested that the final regulations treat NIDs as hybrid deductions on a delayed basis, or only if the NIDs are allowed with respect to an instrument issued after a certain date, to allow taxpayers to restructure certain instruments or undertake other restructurings. The Treasury Department and the IRS have concluded that NIDs should be hybrid deductions, without regard to whether NIDs result from an actual payment, accrual, or distribution. First, because NIDs offset income but generally do not give rise to a corresponding income inclusion, NIDs produce double non-taxation, and such double non-taxation can occur regardless of whether NIDs result from an actual payment, accrual, or distribution. Second, the double non-taxation resulting from NIDs is in general a result of a mismatch in how different tax laws view an instrument of a CFC; that is, the relevant foreign tax law views the instrument as generating amounts similar to interest—to minimize the disparate treatment of debt and equity—and, were the tax law of the United States (the investor jurisdiction of the CFC) to similarly view the instrument as generating amounts treated as interest, there would generally be a corresponding income inclusion in the United States. Such double non-taxation resulting from the mismatch in the treatment of an instrument is the fundamental policy concern underlying section 245A(e). Moreover, including NIDs in the definition of a hybrid deduction is consistent with the broad language of section 245A(e)(4)(B), which refers to any “deduction (or other tax benefit).” Thus, the final regulations generally retain the approach of the proposed regulations and treat NIDs as hybrid deductions. However, in response to comments, the final regulations provide that only NIDs allowed to a CFC for taxable years beginning on or after December 20, 2018, are hybrid deductions. See § 1.245A(e)-1(d)(2)(iv). The Treasury Department and the IRS have determined that this delay (relative to the proposed regulations) is appropriate in order to account for restructurings intended to eliminate or minimize hybridity. 5. Deductions Pursuant to Imputation Systems or Other Regimes Intended To Relieve Double-Taxation In the case of a deduction or other tax benefit relating to or resulting from a distribution by a CFC with respect to an instrument treated as stock for purposes of a relevant foreign tax law, a special rule under the proposed regulations provides that the deduction or other tax benefit is a hybrid deduction only to the extent that it has the effect of causing the earnings that funded the distribution to not be included in income or otherwise subject to tax under such tax law. See proposed § 1.245A(e)-1(d)(2)(i)(B). As noted in the preamble to the proposed regulations, this special rule ensures that deductions or other tax benefits allowed pursuant to certain integration or imputation systems, including through systems implemented in part through the imposition of withholding taxes, do not constitute hybrid deductions. The final regulations clarify the operation of this special rule. First, the final regulations clarify that the special rule only applies to deductions or other tax benefits relating to or resulting from a distribution by the CFC that is a dividend for purposes of the relevant foreign tax law. See § 1.245A(e)-1(d)(2)(i)(B). Thus, for example, the special rule does not apply to NIDs as to which withholding tax is imposed under the relevant foreign tax law, because the imposition of withholding tax in these cases is not pursuant to an integration or imputation system (as such systems generally only apply to dividends) and, instead, may be imposed to provide parity between NIDs and an actual interest payment. Second, the final regulations clarify that the imposition of withholding tax pursuant to an integration or imputation system can reduce or eliminate the extent to which dividends paid deductions (as well as other similar tax benefits) give rise to a hybrid deduction. See id. ; see also § 1.245A(e)-1(g)(2), Example 2, alt. facts (imposition of withholding tax at a rate less than the tax rate at the which dividends paid deduction is allowed only prevents a portion of the deduction from being a hybrid deduction). Lastly, the final regulations clarify that, as a result of the special rule, dividends received deductions allowed pursuant to regimes intended to relieve double-taxation within a group do not constitute hybrid deductions. See § 1.245A(e)-1(d)(2)(i)(B). 6. Deductions or Other Tax Benefits Allowed to a Person Related to the CFC Under the proposed regulations, a hybrid deduction of a CFC includes certain deductions or other tax benefits allowed under a relevant foreign tax law to a person related to the CFC (such as a shareholder of the CFC). See proposed § 1.245A(e)-1(d)(2). The proposed regulations provide that relatedness is determined by reference to the rules of section 954(d)(3) (defining a related person based on ownership of more than 50 percent of interests in entities). See proposed § 1.245A(e)-1(f)(4). A comment asserted that, although in certain cases it may be appropriate to treat a deduction or other tax benefit allowed to a related person as a hybrid deduction, the related person rule raises issues, including compliance issues, because it could be burdensome to determine whether any person related to a CFC receives certain deductions or other tax benefits. Accordingly, the comment recommended that the rule be narrowed in certain respects. For example, the comment suggested increasing the threshold for relatedness to 80 percent, including because such a threshold would be consistent with certain other areas of the Code such as the provisions involving consolidated groups. In addition, the comment suggested that a deduction or other tax benefit allowed to a related person be a hybrid deduction only if criteria in addition to those in the proposed regulations are satisfied, such as if (i) treating the deduction or other tax benefit as a hybrid deduction does not result in double-counting, and (ii) the IRS affirmatively demonstrates that, absent treating the deduction or other tax benefit as a hybrid deduction, double non-taxation would occur. Lastly, the comment asserted that the related person rule could inappropriately treat as a hybrid deduction a dividends received deduction, an impairment loss deduction, or a market-to-market deduction allowed to a shareholder. The Treasury Department and the IRS have determined that, because a deduction or other tax benefit allowed to a person related to a CFC may be economically equivalent to the CFC having been allowed a deduction or other tax benefit, or may otherwise produce a D/NI outcome, the related person rule is necessary to carry out the purpose of section 245A(e). The final regulations therefore retain this rule, including defining relatedness by reference to section 954(d)(3), a well-established standard applicable to controlled foreign corporations and consistent with section 267A, which similarly addresses hybrid mismatches. See section 267A(b)(2) (defining related person by reference to section 954(d)(3)). However, recently-issued final regulations under section 954(d)(3) narrow the definition of relatedness for section 954(d)(3) purposes by providing that relatedness is determined without regard to “downward” attribution. See TD 9883, 84 FR 63802. The Treasury Department and the IRS have determined that narrowing the definition of relatedness in this manner addresses the comment's concerns about potential burdens. In addition, the final regulations clarify that only deductions allowed under a relevant foreign tax law to a person related to a CFC may be hybrid deductions of the CFC; in general, a relevant foreign tax law is a foreign tax law under which the CFC is subject to tax. See § 1.245A(e)-1(d)(2)(i) and (f)(5). Thus, for example, in the case of a CFC and a corporate shareholder of the CFC that are tax residents of different foreign countries, a dividends received deduction allowed to the corporate shareholder under its tax law for a dividend received from the CFC is not a hybrid deduction of the CFC. 1 1 As an additional example, in the case of a CFC and a corporate shareholder of the CFC that are tax residents of different foreign countries, an exclusion (similar to the exclusion for previously taxed earnings and profits under section 959) allowed to the corporate shareholder under its tax law upon a distribution by the CFC of earnings and profits previously taxed under such tax law by reason of an anti-deferral regime is not a hybrid deduction of the CFC. The final regulations do not adopt the comment's suggestion to include additional criteria to the related person rule. The Treasury Department and the IRS have concluded that other aspects of the final regulations generally address the comment's double-counting concerns. See part II.B.5 (deductions or other tax benefits pursuant to imputation systems or other regimes intended to relieve double-taxation) and part II.C.3 (discussing an anti-duplication rule) of this Summary of Comments and Explanation of Revisions section. In addition, the Treasury Department and the IRS have concluded that requiring the IRS to affirmatively demonstrate double non-taxation would impose an excessive burden on the IRS and raise significant administrability concerns, particularly because the taxpayer may have better access to information (including information regarding the application of foreign tax law) than the IRS. Lastly, the final regulations clarify that a hybrid deduction of a CFC does not include an impairment loss deduction or a mark-to-market deduction allowed to a shareholder of the CFC with respect to its stock of the CFC. This is because such deductions do not relate to or result from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC, and are not deductions allowed to the CFC with respect to equity. See § 1.245A(e)-1(d)(2)(i)(B). 7. 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). In some countries, however, income taxes imposed by a subnational authority of the country (for example, a state, province, or canton of the country) may constitute a significant portion of a tax resident's overall income tax burden in the country. Accordingly, the Treasury Department and the IRS have determined that, in cases in which subnational income taxes of a country are covered taxes under an income tax treaty between the country and the United States (and therefore are likely to represent a significant portion of the overall income tax paid in the country), the tax law of the subnational authority should be treated as a tax law of a foreign country for purposes of section 245A(e). Thus, under the final regulations, a relevant foreign tax law may include a tax law of a political subdivision or other local authority of a foreign country. See § 1.245A(e)-1(f)(5). C. Hybrid Deduction Accounts 1. Nexus Between Hybrid Dividends and Hybrid Deductions Under the proposed regulations, a dividend received by a United States shareholder (“U.S. shareholder”) from a CFC is generally a hybrid dividend to the extent of the sum of the U.S. shareholder's hybrid deduction accounts with respect to each share of stock of the CFC, even if the dividend is paid on a share that has not had any hybrid deductions allocated to it. See proposed § 1.245A(e)-1(b)(2). As explained in the preamble to the proposed regulations, this approach is intended to prevent the avoidance of the purposes of section 245A(e). One comment noted that the hybrid deduction account approach in the proposed regulations appropriately safeguards against certain abuse. However, the comment and others asserted that, at least in certain cases, the approach is overbroad and could lead to inappropriate results, including causing a dividend to be a hybrid dividend even though a hybrid deduction was not allowed for the amount to which the dividend is attributable but instead was allowed for another amount. The comments recommended alternative approaches. Under some alternatives, an exception or similar rule would provide that a dividend is not a hybrid dividend to the extent that the distributed earnings and profits are attributable to earnings and profits that did not benefit from a hybrid deduction, or to the extent that the transactions giving rise to the dividend did not give rise to a hybrid deduction. For example, in the case of a dividend paid by a lower-tier CFC to an upper-tier CFC pursuant to a non-hybrid instrument, followed by a dividend paid by the upper-tier CFC to a domestic corporation pursuant to a hybrid instrument, the dividend paid by the upper-tier CFC would not be a hybrid dividend to the extent it is composed of earnings and profits (i) attributable to earnings and profits of the lower-tier CFC, and (ii) not offset under the upper-tier CFC's tax law by the upper-tier CFC's hybrid deductions (which might occur, for example, if, by reason of a participation exemption, the upper-tier CFC excludes from income the dividend paid by the lower-tier CFC). Or, deemed dividends such as a dividend under section 1248(a), or a dividend arising as a result of a compensatory payment for the surrender of a loss pursuant to a foreign group relief or similar regime, generally would not be a hybrid dividend, as the transactions giving rise to such deemed dividends typically do not give rise to a deduction or other tax benefit under a relevant foreign tax law. Under another alternative, the hybrid deduction account approach in the proposed regulations would not apply to an amount if there is a legal obligation to pay it within 36 months (and the parties reasonably expect it to be so paid). In these cases, the comment recommended that the amount simply be subject to section 245A(e) once paid, such that it would not affect a hybrid deduction account—that is, the account would neither be increased at the time a deduction for the amount is allowed, nor decreased at the time of payment. The Treasury Department and the IRS have concluded that the hybrid deduction account approach under the proposed regulations appropriately carries out the purposes of section 245A(e), and prevents the avoidance of section 245A(e), in an administrable manner. Alternative approaches, such as those suggested by the comments, could be difficult to administer or could lead to inappropriate results. For example, the approach under the proposed regulations obviates the need (as would be the case under some of the alternatives) for complex analyses or rules tracking which particular earnings and profits benefited from a hybrid deduction, and how those earnings and profits are distributed to particular shareholders. In addition, excepting certain types of dividends from section 245A(e) could defer, potentially long-term, the application of section 245A(e), as those dividends would reduce (or in some cases eliminate) the CFC's earnings and profits and thereby might cause a subsequent distribution pursuant to a hybrid instrument to be described in section 301(c)(2) or (3) (rather than giving rise to a dividend subject to section 245A(e)). Further, if a 36-month approach like the one suggested in the comment were to apply, then additional rules would be necessary to ensure that, upon certain subsequent transfers of stock of the CFC, the transferee appropriately applies section 245A(e) when an amount to which the hybrid deduction account approach did not apply is paid. Accordingly, the final regulations do not adopt these comments. 2. Reduction for Certain Amounts Included in Income by U.S. Shareholders Under the proposed regulations, a hybrid deduction account is reduced only to the extent that an amount in the account gives rise to a hybrid dividend or a tiered hybrid dividend. See proposed § 1.245A(e)-1(d). The preamble to the proposed regulations requests comments on whether hybrid deductions attributable to a subpart F inclusion or an amount included in income under section 951A (“GILTI inclusion amount”) should not increase a hybrid deduction account, or, alternatively, on whether a hybrid deduction account should be reduced by distributions of previously taxed earnings and profits, and the effect of any deemed paid foreign tax credits associated with such inclusions. In response to the comment request, some comments suggested that subpart F inclusions or GILTI inclusion amounts (or a distribution of previously taxed earnings and profits) provide a dollar-for-dollar reduction of a hybrid deduction account. However, another comment noted that a dollar-for-dollar reduction could give rise to inappropriate results because the inclusions may not be fully taxed in the United States, given foreign tax credits associated with the amounts or, in the case of a GILTI inclusion amount, the deduction under section 250. The comment thus suggested that, as part of the end-of-year adjustments to a hybrid deduction account, the account be reduced by certain subpart F inclusions or GILTI inclusion amounts with respect to that year, but only to the extent that such amounts are fully taxed in the United States (determined by accounting for foreign tax credits and the section 250 deduction). Another comment suggested that a hybrid deduction not be added to the hybrid deduction account to the extent that the deduction relates to an amount directly included in U.S. income (for example, under section 882). Finally, comments suggested that, to avoid double-taxation, a hybrid deduction account should also be reduced when an amount is included in a U.S. shareholder's gross income under sections 951(a)(1)(B) and 956 by reason of the application of section 245A(e) to the hypothetical distribution described in § 1.956-1(a)(2). Section 245A(e) is generally intended to ensure that to the extent earnings and profits of a CFC have not been subject to foreign tax as a result of certain hybrid arrangements, earnings and profits of the CFC of an equal amount will, once distributed as a dividend, be “included in income” in the United States (that is, taken into account in income and not offset by, for example, a deduction or credit particular to the inclusion). To the extent the earnings and profits are so included by other means (for example, as a subpart F inclusion or GILTI inclusion amount), with the result that the double non-taxation effects of the hybrid arrangement are neutralized, section 245A(e) need not apply to a corresponding amount of earnings and profits. Accordingly, in these cases, the Treasury Department and the IRS have determined that hybrid deduction accounts with respect to stock of the CFC—which are generally intended to represent earnings and profits of the CFC that have neither been subject to foreign tax nor yet included in income in the United States—should be reduced. A separate notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register (REG-106013-19) provides rules to this effect, which taxpayers may rely on before the regulations described therein are effective. These rules are consistent with the comment recommending that a hybrid deduction account be reduced by amounts included in gross income under sections 951(a)(1)(B) and 956, as well as the comment recommending an account be reduced by certain subpart F inclusions or GILTI inclusion amounts, to the extent fully taxed in the United States. The Treasury Department and the IRS have determined that it would be too complex to adjust hybrid deduction accounts based on the extent to which under a relevant foreign tax law a hybrid deduction offsets certain types of income (such as effectively connected income subject to tax under section 882), and thus the final regulations do not adopt the comment suggesting such an approach. 3. Rules Regarding Transfers of Stock Because hybrid deduction accounts are maintained with respect to stock of a CFC, the proposed regulations provide rules that take into account transfers of stock of a CFC, including transfers pursuant to certain nonrecognition exchanges and liquidations. See proposed § 1.245A(e)-1(d)(4). In general, and depending on the type of transaction pursuant to which the transfer occurs, the transferee succeeds to the transferor's hybrid deduction accounts with respect to the transferred stock, or hybrid deduction accounts with respect to the transferred stock are tacked onto successor or similar interests. However, if the stock is transferred to a person that is not required to maintain a hybrid deduction account, such as an individual or a foreign corporation that is not a CFC, the hybrid deduction account generally terminates. Although a comment noted that these rules generally provide for appropriate results, the comment (and others) recommended that the rules be modified to address certain issues involving transfers of stock. First, a comment recommended that the rules address certain distributions of stock under section 355. The comment suggested that the balance of a hybrid deduction account with respect to stock of the distributing CFC be allocated to a hybrid deduction account with respect to stock of the controlled CFC in a manner similar to how basis in stock of the distributing CFC is allocated to stock of the controlled CFC under section 358. The Treasury Department and the IRS agree that allocation rules should apply with respect to certain section 355 distributions, but have concluded that the allocation should be consistent with how earnings and profits of the distributing CFC are allocated between the distributing CFC and the controlled CFC. The final regulations thus provide a rule to this effect. See § 1.245A(e)-1(d)(4)(iii)(B)( 4 ). This rule, like the other rules in § 1.245A(e)-1(d)(4)(iii)(B) that adjust hybrid deduction accounts upon certain nonrecognition transactions, is in addition to the general rule of § 1.245A(e)-1(d)(4)(iii)(A), pursuant to which an acquirer of stock of a CFC generally succeeds to the transferor's hybrid deduction accounts with respect to the stock. Accordingly, if the section 355 distribution involves a pre-existing controlled CFC, the shareholder's hybrid deductions accounts with respect to the controlled CFC immediately after the distribution are generally equal to the sum of (i) the hybrid deduction accounts with respect to the controlled CFC to which the shareholder succeeds under the rules of § 1.245A(e)-1(d)(4)(iii)(A), and (ii) the portions of the hybrid deduction accounts with respect to the distributing CFC that are allocated to hybrid deduction accounts with respect to stock of the controlled CFC under § 1.245A(e)-1(d)(4)(iii)(B)( 4 ). Second, a comment suggested that the final regulations adopt an anti-duplication rule to address cases in which a liquidation of a lower-tier CFC into an upper-tier CFC would in effect result in a duplication of hybrid deductions. For example, the comment noted that if the upper-tier CFC and lower-tier CFC have issued “mirror” hybrid instruments, then hybrid deduction accounts with respect to shares of stock of the upper-tier CFC would already reflect amounts attributable to hybrid deductions of the lower-tier CFC, with the result that, upon the liquidation of the lower-tier CFC, it would not be appropriate to increase hybrid deduction accounts with respect to shares of stock of the upper-tier CFC by the hybrid deductions of the lower-tier CFC. The Treasury Department and the IRS agree with this comment. However, rather than addressing this duplication issue only in the context of transfers of stock of a CFC, the final regulations provide a general anti-duplication rule. See § 1.245A(e)-1(d)(2)(iii). This rule generally ensures that when deductions or other tax benefits under a relevant foreign tax law are in effect duplicated at different tiers, the deductions or other tax benefits only give rise to a hybrid deduction of the higher-tier CFC. Thus, in the mirror hybrid instrument example, the deduction allowed to the upper-tier CFC, but not the deduction allowed to the lower-tier CFC, would be a hybrid deduction, provided that the deductions arise under the same relevant foreign tax law. Lastly, a comment requested clarification that, when a section 338(g) election is made with respect to a CFC target, the shareholder of the new target does not succeed to a hybrid deduction account with respect to a share of stock of the old target. The comment asserted that such a result is appropriate because the old target is generally treated as transferring all of its assets to an unrelated person, and the new target is generally treated as acquiring all of its assets from an unrelated person. The Treasury Department and the IRS agree with this comment because, in general, the new target does not inherit any of the earnings and profits of the old target and, as a result, no distributions by the new target could represent a distribution of earnings and profits of the old target sheltered from foreign tax by reason of hybrid deductions incurred by the old target. Accordingly, the final regulations clarify that, in connection with an election under section 338(g), a hybrid deduction account with respect to stock of the old target generally does not carry over to stock of the new target. See § 1.245A(e)-1(d)(4)(iii)(B)( 5 ). 4. Mid-Year Transfers of Stock Under the proposed regulations, if there is a transfer of stock of a CFC during the CFC's taxable year, then the determinations and adjustments that would otherwise be made at the close of the CFC's taxable year are generally made at the close of the date of the transfer. See proposed § 1.245A(e)-1(d)(5). A comment requested clarification regarding how, in such cases, a hybrid deduction account with respect to a share of stock of the CFC is adjusted on the date of transfer, and whether hybrid dividends and tiered hybrid dividends that arise during the post-transfer period affect such adjustments. In response to this comment, the final regulations provide additional rules that, in general, adjust the hybrid deduction account based on the number of days in the taxable year within the pre-transfer period to the total number of days in the taxable year. See § 1.245A(e)-1(d)(5). The rules also coordinate the end-of-the year adjustments and the adjustments that must be made on the transfer date. See Id. 5. Applicability Date The proposed regulations provide that proposed § 1.245A(e)-1, including the hybrid deduction account rules, applies to distributions made after December 31, 2017. However, the preamble to the proposed regulations explains that if proposed § 1.245A(e)-1 is finalized after June 22, 2019, then § 1.245A(e)-1 will apply only to distributions made during taxable years ending on or after the date the proposed regulations were issued (December 20, 2018). Some comments requested that, given that the statutory language of section 245A(e) does not include the concept of an account, the hybrid deduction account rules apply on a prospective basis to provide taxpayers time to comply with the rules and to prevent harsh results. One comment suggested that the rules apply only to distributions made after the proposed regulations were issued, and another suggested that the rules apply only to distributions made after December 31, 2018. The final regulations provide that the hybrid deduction account rules apply to distributions made after December 31, 2017, provided that such distributions occur during taxable years ending on or after the date the proposed regulations were issued. See § 1.245A(e)-1(h)(1). The Treasury Department and the IRS have determined that it would not be appropriate to delay the applicability date of the hybrid deduction account rules because the enactment of section 245A(e) provided notice that D/NI outcomes involving instruments that are stock for U.S. tax purposes—including D/NI outcomes involving a deduction or other tax benefit allowed for an amount on a particular date and a payment of a corresponding amount of earnings and profits as a dividend for U.S. tax purposes on a later date—would be neutralized under section 245A(e) (including in conjunction with the regulatory authority under section 245A(g)), and the hybrid deduction account rules are necessary to ensuring such D/NI outcomes are so neutralized. D. Miscellaneous Issues 1. Treatment of Amounts Under Tax Law of Another Foreign Country Under the proposed regulations, a tiered hybrid dividend means an amount received by a CFC (“receiving CFC”) from another CFC to the extent that the amount would be a hybrid dividend under the proposed regulations if the receiving CFC were a domestic corporation. See proposed § 1.245A(e)-1(c)(2). As noted in the preamble to the proposed regulations, whether a dividend is a tiered hybrid dividend is determined without regard to how the amount is treated under the tax law of which the receiving CFC is a tax resident (or under any other foreign tax law). Similarly, whether a deduction or other tax benefit allowed to a CFC (or a related person) under a relevant foreign tax law is a hybrid deduction is determined without regard to how the amount is treated under another foreign tax law. Comments suggested that the treatment of an amount under another foreign tax law be taken into account in two cases. First, a comment recommended an exception pursuant to which a dividend is not a tiered hybrid dividend to the extent that the receiving CFC includes the dividend in income under its tax law (or is subject to withholding tax under the payer CFC's tax law). The comment suggested that this approach only apply, however, to the extent that the inclusion (or withholding tax) is at a tax rate at least equal to the rate at which the hybrid deduction was allowed. The comment noted that such an approach could prevent double-taxation, though it might also result in additional complexity. The Treasury Department and the IRS have determined that not taking into account the treatment of an amount under the receiving CFC's tax law (or other foreign tax law), as provided in the proposed regulations, is consistent with the plain language of section 245A(e)(2). In addition, the Treasury Department and the IRS have concluded that such an exception could give rise to inappropriate results in certain cases. For example, if the exception applied without regard to tax rates, then an inclusion by the receiving CFC at a low tax rate applicable to all income would discharge the application of section 245A(e) to a dividend even though the payer CFC deducted the amount at a high tax rate. See also part III.C.1 of this Summary of Comments and Explanation of Revisions section (discussing the effect of inclusions in another foreign country). Moreover, and as noted by the comment, a comparative tax rate test would create complexity and administrability issues—for example, it would require that hybrid deduction accounts track the tax rate at which the CFC (or a related person) was allowed a hybrid deduction. Accordingly, the final regulations do not adopt this comment. Second, a comment suggested that, in cases involving tiers of CFCs that are tax residents of different foreign countries, a deduction or other tax benefit allowed to the upper-tier CFC under a relevant foreign tax law not be a hybrid deduction to the extent that the deduction or other tax benefit offsets an amount that the upper-tier CFC includes in its income and that is attributable to a hybrid deduction of a lower-tier CFC. 2 For example, the comment noted that, in the case of back-to-back hybrid instruments involving CFCs that are tax residents of different foreign countries (pursuant to which, for U.S. tax purposes, the lower-tier CFC pays a dividend to the upper-tier CFC and the upper-tier CFC pays a dividend to a domestic corporation), in effect only a single D/NI outcome occurs if under its tax law the upper-tier CFC includes in income the amount paid by the lower-tier CFC. The comment asserted that, in such a case, the deduction allowed to the upper-tier CFC should not be treated as a hybrid deduction because, by reason of treating the amount paid by the lower-tier CFC as a tiered hybrid dividend, the D/NI outcome associated with the arrangement is neutralized. The final regulations do not adopt this comment because it would be inconsistent with the statute, which does not take into account the overall effect of a deduction or other tax benefit under the relevant foreign tax law. In addition, the Treasury Department and the IRS have determined that such an exception would be complex and would give rise to administrability issues because it could require, for example, a factual analysis of how particular deductions offset items of gross income under a relevant foreign tax law. Moreover, pursuant to rules described in a separate notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register (REG-106013-19), the subpart F inclusion arising by reason of the upper-tier CFC receiving the tiered hybrid dividend will, to an extent, generally reduce the hybrid deduction accounts with respect to stock of the upper-tier CFC. 2 In these cases, the anti-duplication rule described in part II.C.3 of this Summary of Comments and Explanation of Revisions section, which applies only to certain deductions or tax benefits under the same relevant foreign tax law, would not apply. 2. Application of Tiered Hybrid Dividend Rule to Non-Corporate U.S. Shareholders If an upper-tier CFC receives a tiered hybrid dividend from a lower-tier CFC, and a domestic corporation is a U.S. shareholder of both CFCs, then, notwithstanding any other provision of the Code (i) the tiered hybrid dividend is treated for purposes of section 951(a)(1)(A) as subpart F income of the upper-tier 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). A comment requested that the final regulations address how the tiered hybrid dividend rule applies with respect to a non-corporate U.S. shareholder of the upper-tier CFC. The final regulations provide that the tiered hybrid dividend rule applies only as to a domestic corporation that is a U.S. shareholder of both the upper-tier CFC and the lower-tier CFC. See § 1.245A(e)-1(c)(1). Thus, for example, if a domestic corporation and a U.S. individual equally own all of the stock of an upper-tier CFC, and the upper-tier CFC receives a tiered hybrid dividend from a wholly-owned lower-tier CFC, the tiered hybrid dividend rule does not apply to cause a subpart F inclusion to the individual U.S. shareholder (though the dividend may otherwise result in a subpart F inclusion to the individual U.S. shareholder). If the dividend does not give rise to a subpart F inclusion to the individual U.S. shareholder, the earnings associated with the dividend would generally be subject to full U.S. tax when distributed to the individual as a dividend because individuals are not allowed a deduction under section 245A(a) and, as a result, it would be inappropriate for the tiered hybrid dividend rule to have applied to the individual. 3. Upper-Tier CFCs Required To Maintain Hybrid Deduction Accounts Under the proposed regulations, an upper-tier CFC is generally a specified owner of shares of stock of a lower-tier CFC, and thus the upper-tier CFC must maintain hybrid deduction accounts with respect to those shares. See proposed § 1.245A(e)-1(d)(1) and (f)(5). However, in certain cases there may not be a domestic corporation that is a U.S. shareholder of the upper-tier CFC. For example, the only U.S. shareholders of the upper-tier CFC may be individuals, with the result that section 245A(e)(2) would not apply to a dividend received by the upper-tier CFC from the lower-tier CFC. Or, the upper-tier CFC may be a CFC solely by reason of the repeal of the limitation on the “downward” attribution rule under section 958(b)(4), with the result that even if a dividend received by the upper-tier CFC from the lower-tier CFC were a tiered hybrid dividend, there would be no meaningful U.S. tax consequence because no U.S. shareholder would have a subpart F inclusion with respect to the upper-tier CFC. To obviate the need for hybrid deduction accounts to be maintained in these cases, the final regulations provide that an upper-tier CFC is a specified owner of shares of stock of a lower-tier CFC only if, for purposes of sections 951 and 951A, a domestic corporation that is a U.S. shareholder of the upper-tier CFC owns (within the meaning of section 958(a), but for this purpose treating a domestic partnership as foreign) one or more shares of stock of the upper-tier CFC. See § 1.245A(e)-1(f)(6). The Treasury Department and the IRS expect that when proposed regulations under section 958 (REG-101828-19, 84 FR 29114) are finalized, the rule described in the preceding sentence treating a domestic partnership as foreign will be removed, as it will no longer be necessary. See proposed § 1.958-1(d)(1). 4. Anti-Avoidance Rule The proposed regulations include an anti-avoidance rule that requires appropriate adjustments to be 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 the proposed regulations. As an example, the anti-avoidance rule disregards a transaction or arrangement that is undertaken to affirmatively fail to satisfy the holding period requirement under section 246, such as the sale of lower-tier CFC stock before satisfying the holding period, if a principal purpose of the transaction or arrangement is to avoid the tiered hybrid dividend rules. A comment suggested that the anti-avoidance rule should not apply to a sale of lower-tier CFC stock before satisfying the holding period if the sale is to an unrelated party, even though the timing of the sale may be driven by tax considerations. Another comment requested clarification that the anti-avoidance rule does not apply to disregard a transaction pursuant to which the hybrid nature of an arrangement is eliminated (for example, a restructuring of a hybrid instrument into a non-hybrid instrument, so as to eliminate the accrual of a hybrid deduction under a relevant foreign tax law). The Treasury Department and the IRS have determined that the anti-avoidance rule should not be limited to transactions or arrangements with related parties, as otherwise transactions or arrangements with unrelated parties could lead to the avoidance of section 245A(e) and the regulations thereunder. Accordingly, the final regulations retain the anti-avoidance rule in the proposed regulations, and thus whether the anti-avoidance rule applies to a transaction or arrangement depends solely on a principal purpose of the transaction or arrangement for the avoidance of section 245A(e) and the regulations thereunder and does not take into account the status of a counter party. See § 1.245A(e)-1(e). The Treasury Department and the IRS agree, however, with the comment asserting that the anti-avoidance rule should not apply to disregard a restructuring of a hybrid arrangement into a non-hybrid arrangement and, accordingly, the rule is modified to this effect. See id. III. Comments and Revisions to Proposed §§ 1.267A-1 Through 1.267A-7—Certain Payments Involving Hybrid and Branch Mismatches A. Background The proposed regulations disallow a deduction for any interest or royalty paid or accrued (“specified payment”) to the extent the specified payment produces a D/NI outcome as a result of a hybrid or branch arrangement. The proposed regulations also disallow a deduction for a specified payment to the extent the specified payment 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. Finally, the proposed regulations disallow a deduction for a specified payment to the extent the specified payment produces a D/NI outcome and is made pursuant to a transaction a principal purpose of which is to avoid the purposes of the regulations under section 267A. B. Hybrid and Branch Arrangements 1. Arrangements Giving Rise to Long-Term Deferral i. In General Several provisions of the proposed regulations address long-term deferral, which results when there is deferral beyond a taxable period ending more than 36 months after the end of the specified party's taxable year. For example, to address long-term deferral arising as a result of different ordering or other rules under U.S. and foreign tax law, a hybrid transaction includes an instrument a payment with respect to which is interest for U.S. tax purposes but a return of principal for purposes of the tax law of a specified recipient of a payment. See proposed § 1.267A-2(a)(2). In addition, the proposed regulations deem a specified payment as made pursuant to a hybrid transaction if differences between U.S. tax law and the taw law of a specified recipient of the payment (such as differences in tax accounting treatment) result in more than a 36-month deferral between the time the deduction would be allowed under U.S. tax law and the time the payment is taken into account in income under the specified recipient's tax law. See id. Further, a D/NI outcome is considered to occur with respect to a specified payment if under a relevant foreign tax law the payment is not included in income within the 36-month period. See proposed § 1.267A-3(a)(1). One comment supported these provisions, on balance, noting that long-term deferral can create D/NI outcomes that should be neutralized by section 267A, but recommending certain of the modifications discussed in this part III.B.1 of the Summary of Comments and Explanation of Revisions section. Other comments suggested that the provisions be eliminated, because according to such comments they are potentially burdensome or are not appropriate since a D/NI outcome should not be viewed as occurring if the amount will eventually be included in income; in addition, one comment asserted that the provision dealing with mismatches in tax accounting treatment is neither supported by section 267A nor within the regulatory authority granted under section 267A(e). However, some comments also noted that the burden concerns could be addressed by adopting certain of the comments discussed in this part III.B.1 of the Summary of Comments and Explanation of Revisions section. The Treasury Department and the IRS have determined that the final regulations should retain the long-term deferral provisions because long-term deferral can in effect create D/NI outcomes and, absent such provisions, hybrid arrangements could be used to achieve results inconsistent with the purposes of section 267A. See S. Comm. on the Budget, Reconciliation Recommendations Pursuant to H. Con. Res. 71, S. Print No. 115-20, at 389 (2017) (expressing concern with hybrid arrangements that “achieve double non- taxation, including long-term deferral.”). In addition, the Treasury Department and the IRS have concluded that the provisions are consistent with section 267A and the broad regulatory authority thereunder. In particular, the Treasury Department and the IRS have concluded that deeming mismatches in tax accounting treatment to be hybrid transactions is consistent with section 267A(c) (defining a hybrid transaction), because in these cases a specified payment is deductible interest under U.S. tax law on a particular date whereas it is not includible interest under the foreign tax law until a later date. Therefore, the final regulations retain the long-term deferral provisions but, in response to comments, modify the provisions as discussed in this part III.B.1 of the Summary of Comments and Explanation of Revisions section. ii. Recovery of Basis or Principal One comment requested that, in the case of a specified payment that is treated as a recovery of basis or principal under the tax law of a specified recipient, the final regulations clarify whether the specified recipient is considered to include the payment in income. The comment asserted that basis or principal should be viewed as a “generally applicable” tax attribute such that recovery of basis or principal should not create a D/NI outcome and, therefore, the specified recipient should be considered to include the payment in income. The Treasury Department and the IRS have determined that basis or principal recovery can give rise to long-term deferral and thus can create a D/NI outcome. For example, consider a specified payment that is made pursuant to an instrument treated as indebtedness for U.S. tax purposes and equity for purposes of the tax law of a specified recipient, and that is treated as interest for U.S. tax purposes and a recovery of basis (under a rule similar to section 301(c)(2)) for purposes of the specified recipient's tax law. If section 267A were to not apply in such a case, then the specified party would generally be allowed a deduction at the time of the specified payment but the specified recipient would not have a taxable inclusion at that time and, indeed, might not have a taxable inclusion, if any, for an extended period. Accordingly, the final regulations clarify that a recovery of basis or principal can create a D/NI outcome. See § 1.267A-3(a)(1)(ii). However, as discussed in parts III.B.1.iii (discussing a rule reducing a no-inclusion by certain amounts that are repayments of principal for U.S. tax purposes but included in income for foreign tax purposes) and III.B.1.iv (discussing hybrid sale/license transactions) of this Summary of Comments and Explanation of Revisions section, the final regulations modify the long-term deferral provisions. The Treasury Department and the IRS expect that these modifications will in many cases prevent a specified payment from being a disqualified hybrid amount when the payment is treated as a recovery of basis or principal under the tax law of a specified recipient. iii. Defining Long-Term Deferral; Reduction of No-Inclusion by Certain Amounts Some comments noted that under the proposed regulations, to determine whether long-term deferral occurs with respect to a specified payment, the specified party must know at the time of the payment if, under the tax law of a specified recipient, the payment will be taken into account and included in income within the 36-month period. The comments stated that in certain cases this could be difficult or burdensome, including because, after the payment is made, the specified party might need to monitor the payment during the 36-month period to ensure that it is in fact taken into account and included in income (and, if it is not so taken into account and included, the specified party might need to amend its tax return to reflect a disallowance of the deduction). The comments suggested addressing these concerns by providing for a reasonable expectation standard, based on whether, at the time of the specified payment, it is reasonable to expect that the payment will be taken into account and included in income within the 36-month period. The Treasury Department and the IRS agree with these comments and, thus, the final regulations provide rules to such effect. See §§ 1.267A-2(a)(2)(ii)(A) and 1.267A-3(a)(1)(i). Comments also suggested that, to address certain cases in which there are different ordering or other rules under U.S. tax law and the tax law of a specified recipient, certain amounts related to a specified payment be aggregated for purposes of determining whether long-term deferral occurs. For example, under such an approach, if a year 1 $100x specified payment is interest for U.S. tax purposes and a return of principal for purposes of a specified recipient's tax law, but a year 2 $100x payment is a repayment of principal for U.S. tax purposes and interest for purposes of the specified recipient's tax law (and is included in income by the specified recipient), then there is no long-term deferral with respect to the year 1 payment and, as a result, the payment is not a disqualified hybrid amount. The Treasury Department and the IRS generally agree that the year 1 $100x specified payment should not be a disqualified hybrid amount. However, rather than addressing through an aggregation rule, which could give rise to uncertainty in certain cases, the final regulations provide a special rule pursuant to which a specified recipient's no-inclusion with respect to a specified payment is reduced by certain amounts that are repayments of principal for U.S. tax purposes but included in income by the specified recipient. See § 1.267A-3(a)(4); see also § 1.267A-6(c)(1)(vi). iv. Hybrid Sale/License Transactions Some comments suggested that hybrid sale/license transactions not be subject to the hybrid transaction rule. A hybrid sale/license transaction can occur, for example, when a specified payment is treated as a royalty for U.S. tax purposes, and a contingent payment of consideration for the purchase of intangible property under the tax law of a specified recipient. In such a case, if under the specified recipient's tax law the payment is treated as a recovery of basis, then a D/NI outcome would occur. Accordingly, if the specified payment is considered made pursuant to a hybrid transaction, then the payment would generally be a disqualified hybrid amount. Comments asserted that these transactions should be excluded because they are common, may be unavoidable, and are not abusive. The Treasury Department and the IRS have determined that in many cases there might not be a significant difference between the results occurring under a hybrid sale/license transaction and the results that would occur were the specified recipient's tax law to (like U.S. tax law) also view the transaction as a license and the specified payment as a royalty. For example, if the specified recipient's tax law were to view the transaction as a license and the specified payment as a royalty, then the payment could be offset by an amortization deduction attributable to the basis of the intangible property. In such a case, the amortization deduction—a generally available deduction or other tax attribute—would not prevent the specified recipient from being considered to include the payment in income. See § 1.267A-3(a)(1). Thus, regardless of whether the transaction is a hybrid sale/license or an actual license, the specified payment could under the specified recipient's tax law be offset by basis or a deduction that is a function of basis. These cases are generally distinguishable from ones in which a transaction is a hybrid debt instrument, because tax laws typically do not provide amortization or similar deductions with respect to indebtedness. Accordingly, the Treasury Department and the IRS have concluded that it is appropriate to exempt hybrid sale/license transactions from the hybrid transaction rule. The final regulations thus provide a rule to this effect. See § 1.267A-2(a)(2)(ii)(B). v. Other Modifications or Clarifications Comments suggested several other modifications to the long-term deferral provisions. First, although one comment generally supported a bright-line standard for measuring long-term deferral because it provides certainty, other comments suggested modifying the standard for measuring long-term deferral, either by lengthening the period to, for example, 120 months, or defining long-term deferral as an unreasonable period of time based on all the facts and circumstances. The final regulations do not adopt these comments because the Treasury Department and the IRS have concluded that, in general, a bright-line 36-month standard appropriately distinguishes between short-term and long-term deferral and avoids administrability issues that would likely arise if long-term deferral were based on a subjective standard (such as an “unreasonable” period of time). See also Hybrid Mismatch Report para. 56 (bright-line safe harbor pursuant to which inclusions within a 12-month period are not considered to give rise to long-term deferral). Second, a comment suggested that, to balance the benefits of the bright-line standard with the resulting cliff effects, the final regulations provide a rule, similar to section 267(a)(3), that defers a deduction for a specified payment until taken into account under the foreign tax law. The final regulations do not adopt this approach because it would be inconsistent with the plain language of section 267A, which provides for the disallowance of a deduction at the time of the payment, and not a deferral of a deduction. In addition, the Treasury Department and the IRS have determined that, if such an approach were adopted, tracking rules would be necessary and such rules would create additional complexity and administrative burden. Third, a comment requested that the final regulations clarify that if a specified payment will never be recognized under the tax law of a specified recipient (because, for example, such tax law does not impose an income tax), then the long-term deferral provision does not apply so as to deem the payment as made pursuant to a hybrid transaction. Finally, a comment requested clarification that a specified payment is treated as included in income if the payment is included in income in a prior taxable period. The Treasury Department and the IRS agree with these comments, and the final regulations thus include these clarifications. See § 1.267A-2(a)(2)(ii)(A); § 1.267A-3(a)(1)(i). 2. Interest-Free Loans An interest-free loan includes, for example, an instrument that is treated as indebtedness under both U.S. tax law and the tax law of the holder of the instrument but provides no stated interest. If the issuer is allowed an imputed interest deduction, but the holder is not required to impute interest income, the instrument would give rise to a D/NI outcome. Because the imputed interest deduction is not regarded under the tax law of the holder of the instrument, the disregarded payment rule of the proposed regulations treats the imputed interest as a disregarded payment and, accordingly, a disqualified hybrid amount to the extent it exceeds dual inclusion income. A comment noted that the Hybrid Mismatch Report generally does not disallow deductions for imputed interest payments, such as interest imputed with respect to interest-free loans, and that imputed interest raises issues that should be further considered on a multilateral basis. The comment thus suggested that the final regulations generally reserve on whether imputed interest is subject to section 267A. The final regulations do not adopt this comment because imputed interest can give rise to D/NI outcomes that are no different than D/NI outcomes produced by other hybrid and branch arrangements. However, to more clearly address these transactions, and because interest-free loans are similar to hybrid transactions and are unlikely to involve dual inclusion income, the final regulations address imputed interest under the hybrid transaction rule, rather than the disregarded payment rule. See § 1.267A-2(a)(4). The rules in the final regulations addressing interest-free loans and similar arrangements apply for taxable years beginning on or after December 20, 2018. See § 1.267A-7(b)(1). 3. Disregarded Payments i. Dual Inclusion Income In general, the proposed regulations provide that a disregarded payment is a disqualified hybrid amount to the extent it exceeds the specified party's dual inclusion income. For this purpose, an item of income of a specified party is dual inclusion income only if it is included in the income of both the specified party and the tax resident or taxable branch to which the disregarded payment is made (as determined under the rules of § 1.267A-3(a)). See proposed § 1.267A-2(b)(3). A comment suggested that the final regulations address whether an item of income is dual inclusion income even though, as a result of a participation exemption, patent box, or other exemption regime, it is not included in the income of the tax resident or taxable branch to which the disregarded payment is made. The Treasury Department and the IRS have concluded that an item of income of a specified party should be dual inclusion income even though, by reason of a participation exemption or other relief particular to a dividend, it is not included in the income of the tax resident or taxable branch to which the disregarded payment is made, provided that the application of the participation exemption or other relief relieves double-taxation (rather than results in double non-taxation). The final regulations are thus modified to this effect. See § 1.267A-2(b)(3)(ii); see also § 1.267A-6(c)(3)(iv). The final regulations provide a similar rule in cases in which an item of income of a specified party is included in the income of the tax resident or taxable branch to which the disregarded payment is made but not included in the income of the specified party by reason of a dividends received deduction (such as the section 245A(a) deduction). These rules do not apply to items that are excluded from income under a patent box or similar regime because, to the extent the payer of the item is allowed a deduction for the item under its tax law, the deduction and the exclusion, together, result in double non-taxation. See also Hybrid Mismatch Report para. 126. ii. Exception for Payments Otherwise Taken Into Account Under Foreign Law Under the proposed regulations, a special rule ensures that a specified payment is not a deemed branch payment to the extent the payment is otherwise taken into account under the home office's tax law in such a manner that there is no mismatch. See proposed § 1.267A-2(c)(2). Absent such a rule, a deduction for a deemed branch payment could be disallowed even though it does not give rise to a D/NI outcome. Thus, for example, if under an applicable treaty a U.S. taxable branch is deemed to pay an amount of interest or royalty to the home office that is not regarded under the home office's tax law, the payment is nevertheless not a deemed branch payment to the extent that under the home office's tax law a corresponding amount of interest or royalties is allocated and attributable to the U.S. taxable branch and therefore is not deductible. See id. However, the proposed regulations do not provide a similar special rule in analogous cases involving disregarded payments. For example, assume FX1, a tax resident of Country X, owns FX2, also a tax resident of Country X, and FX2 has a U.S. taxable branch (“USB”). Further, assume that FX1 borrows from a bank and on-lends the proceeds to FX2, and that pursuant to such transactions FX1 pays $100x of interest to the bank and FX2 pays $100x of interest to FX1 but, as a consequence of the Country X consolidation regime, FX2's payment to FX1 is treated as a disregarded transaction between group members. Lastly, assume that the entire $100x of FX2's payment of interest to FX1 is allocable to USB's effectively connected income under section 882 and thus is a specified payment under proposed § 1.267A-5(b)(3). Under the proposed regulations, USB's specified payment of interest would be a disregarded payment, regardless of whether the payment is otherwise taken into account under Country X tax law. The specified payment would otherwise be taken into account under Country X tax law if, for example, FX1's payment of interest to the bank were allocated and attributed to USB and were therefore not deductible. Cf. § 1.267A-2(c)(2). To provide symmetry between the disregarded payment rule and the deemed branch payment rule, the final regulations add to the disregarded payment rule a special rule similar to the special rule in the deemed branch payment context. See § 1.267A-2(b)(2)(ii)(B). 4. Payments by U.S. Taxable Branches i. Allocation of Interest Expense to U.S. Taxable Branches The proposed regulations provide that a U.S. taxable branch of a foreign corporation is considered to pay or accrue interest allocable under section 882(c)(1) to effectively connected income of the U.S. taxable branch. See proposed § 1.267A-5(b)(3). The proposed regulations include rules to identify the manner in which a specified payment of a U.S. taxable branch is considered made. See id. For directly allocable interest described in § 1.882-5(a)(1)(ii)(A), or a U.S. booked liability described in § 1.882-5(d)(2), a direct tracing approach applies; for any excess interest, the U.S. taxable branch is treated as paying or accruing interest to the same persons and pursuant to the same terms that the home office paid or accrued such interest on a pro-rata basis. See id. As explained in the preamble to the proposed regulations, these rules are necessary to determine whether a U.S. taxable branch's specified payment is made pursuant to a hybrid or branch arrangement (for example, made pursuant to a hybrid transaction or to a reverse hybrid). The proposed regulations do not, however, contain rules for tracing a foreign corporation's distributive share of interest expense when the foreign corporation is a partner in a partnership that has a U.S. asset, as described in § 1.882-5(a)(1)(ii)(B), or rules for tracing interest that is determined under the separate currency pools method, as described in § 1.882-5(e). The final regulations therefore provide that, like directly allocable interest and U.S. booked liabilities, a U.S. taxable branch must use a direct tracing approach to identify the person to whom interest described in § 1.882-5(a)(1)(ii)(B) or § 1.882-5(e) is payable. See § 1.267A-5(b)(3)(ii)(A). In addition, the Treasury Department and the IRS have determined that a consistent approach should apply for purposes of identifying a U.S. branch interest payment in order to avoid treating similarly situated taxpayers differently under section 267A. Accordingly, similar to the tracing rules provided in the final regulations under section 59A, the final regulations provide that foreign corporations should use U.S. booked liabilities to identify the person to whom an interest expense is payable, without regard to which method the foreign corporation uses to determine its interest expense under section 882(c)(1). See id. ; see also § 1.59A-3(b)(4)(i)(B). ii. Interaction With Income Tax Treaties Under the proposed regulations, the deemed branch payment rule addresses 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 (or another branch of the home office) and offsets income not taxable to the home office, but the payment is not taken into account under the tax law of the home office or other branch. See proposed § 1.267A-2(c)(2). A deemed branch payment is a notional payment that arises from applying Article 7 (Business Profits) of certain U.S. income tax treaties, which takes into account only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment to determine the business profits that may be taxed where the permanent establishment is situated. 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.”). A comment questioned whether the deemed branch payment rule is a treaty override because it creates a new condition on the allowance of a deduction for purposes of computing the business profits of a U.S. permanent establishment based upon an intervening change in U.S. law. The comment noted that the deemed branch payment rule affects the allocation of taxing rights of business profits under the treaty. Another comment raised a similar concern and requested that the deemed branch payment rule be withdrawn because it is inconsistent with U.S. income tax treaty obligations. The Treasury Department and the IRS have determined that the deemed branch payment rule is not a treaty override and is consistent with U.S. income tax treaty obligations. The treaties that allow notional payments under Article 7 take into account interbranch transactions and value such interbranch transactions using the most appropriate arm's length methodology. Once expenses are either allocated or determined under arm's length principles to be taken into account in determining the business profits of the permanent establishment under Article 7, domestic limitations on deductibility of such expenses may apply in the same manner as they would if the amounts were paid by a domestic corporation. In other words, sections 163(j), 267(a)(3), and 267A generally apply to the same extent to the notional payments as they would to actual interest payments by a domestic subsidiary to a foreign parent. The commentary to paragraph 2 of Article 7 of the OECD Model Tax Convention adopts a comparable interpretation. See Para. 30 and 31 of the commentary to para. 2 of Article 7 of the OECD Model Tax Convention. Accordingly, the final regulations retain the deemed branch payment rule. 5. Reverse Hybrids i. Fiscally Transparent 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 an investor of the entity. See § 1.267A-2(d)(2). Under the proposed regulations, whether an entity is fiscally transparent with respect to an item of income is determined under the principles of § 1.894-1(d)(3)(ii) and (iii). See proposed § 1.267A-5(a)(8). The final regulations provide special rules to address certain cases in which, given § 1.894-1(d)(3)'s definition of fiscally transparent, an entity might not be considered a reverse hybrid under the proposed regulations with respect to a payment received by the entity, even though neither the entity nor an investor of the entity take the payment into account in income, with the result that the payment gives rise to a D/NI outcome. Pursuant to the special rules, an entity is considered fiscally transparent with respect to the payment under the tax law of the country where it is established if, under such tax law, the entity allocates the payment to an investor, with the result that under such tax law the investor is viewed as deriving the payment through the entity. See § 1.267A-5(a)(8)(i); see also § 1.267A-6(c)(5)(vi). A similar rule applies for purposes of determining whether the entity is fiscally transparent with respect to the payment under an investor's tax law. See § 1.267A-5(a)(8)(ii). Lastly, to address the fact that under § 1.894-1(d)(3)(ii), certain collective investment vehicles and similar arrangements may not be considered fiscally transparent under the tax law of the country where established, a special rule provides that such arrangements are considered fiscally transparent under the tax law of the establishment country if neither the arrangement nor an investor is required to take the payment into account in income. See § 1.267A-5(a)(8)(iii); see also § 1.894-1(d)(5), Example 7. ii. Current-Year Distributions From Reverse Hybrid Under the proposed regulations, 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. See proposed § 1.267A-2(d)(1). For this purpose, whether an investor includes the specified payment in income is determined without regard to a subsequent distribution by the reverse hybrid. See proposed § 1.267A-3(a)(3). As explained in the preamble to the proposed regulations, 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. A comment noted that if a reverse hybrid distributes all of its income during a taxable year, then current year distributions should be taken into account for purposes of determining whether an investor of the reverse hybrid includes in income a specified payment made to the reverse hybrid. The comment asserted that not doing so would be unduly harsh and could create unwarranted disparities between cases involving current year distributions and anti-deferral inclusions (which are taken into account for purposes of determining whether an investor includes in income a specified payment). The comment also suggested that the final regulations reserve on whether subsequent year distributions are taken into account. The Treasury Department and the IRS agree with the comment that current year distributions should be taken into account in cases in which the reverse hybrid distributes all of its income during the taxable year. The final regulations thus provide that in these cases a portion of a specified payment made to the reverse hybrid during the taxable year is considered to relate to each of the current year distributions from the reverse hybrid. As a result, to the extent that an investor includes in income a current year distribution, the investor is treated as including in income a corresponding portion of a specified payment made to the reverse hybrid during the year. See § 1.267A-3(a)(3). The Treasury Department and the IRS have determined that it would be too complex to take into account current year distributions in cases in which the reverse hybrid does not distribute all of its income during the taxable year, as in these cases stacking or similar rules would likely be needed to determine the extent that a specified payment is considered to relate to a distribution. For similar reasons, the Treasury Department and the IRS have determined that it would be too complex to take into account subsequent year distributions. iii. Multiple Investors The final regulations clarify the application of the reverse hybrid rule in cases in which an investor of the reverse hybrid owns only a portion of the interests of the reverse hybrid and does not include in income a specified payment made to the reverse hybrid. In these cases, given the “as a result of” test, only the no-inclusion of the investor that occurs for its portion of the payment may give rise to a disqualified hybrid amount. For example, consider a case in which a $100x specified payment is made to a reverse hybrid 60% of the interests of which are owned by a Country X investor (the tax law of which treats the reverse hybrid as not fiscally transparent) and 40% of the interests of which are owned by a Country Y investor (the tax law of which treats the reverse hybrid as fiscally transparent). If the Country X investor does not include any portion of the payment in income, then $60x of the payment would generally be a disqualified hybrid amount under the reverse hybrid rule, calculated as $100x (the no-inclusion that actually occurs with respect to the Country X investor) less $40x (the no-inclusion that would occur with respect to the Country X investor absent hybridity). See §§ 1.267A-2(d) and 1.267A-6(c)(5)(iv). iv. Inclusion by Taxable Branch in Country in Which Reverse Hybrid is Established The final regulations provide an exception pursuant to which the reverse hybrid rule does not apply to a specified payment made to a reverse hybrid to the extent that, under the tax law of the country in which the reverse hybrid is established, a taxable branch the activities of which are carried on by an investor of the reverse hybrid includes the payment in income. See § 1.267A-2(d)(4). The Treasury Department and the IRS have determined that, in these cases, the inclusion in the establishment country generally prevents a D/NI outcome and thus it is appropriate for an exception to apply. C. Exceptions Relating to Disqualified Hybrid Amounts 1. Effect of Inclusion in Another Foreign Country Under the proposed regulations, a specified payment generally is a disqualified hybrid amount to the extent that a D/NI outcome occurs with respect to any foreign country as a result of a hybrid or branch arrangement, even if the payment is included in income in another foreign country (a “third country”). See also part III.C.2 of this Summary of Comments and Explanation of Revisions section (exceptions for amounts included or includible in income in the United States). Absent such a rule, an inclusion of a specified payment in income in a third country would discharge the application of section 267A even though a D/NI outcome occurs in a foreign country as a result of a hybrid or branch arrangement. The preamble to the proposed regulations expresses particular concern with cases in which the third country imposes a low tax rate. Comments requested that this rule be eliminated because requiring an income inclusion in multiple jurisdictions is not necessary or appropriate to prevent a D/NI outcome. One of these comments asserted that the rule is unfair and does not effectively prevent rate arbitrage. The comments further asserted that the rule is inconsistent with the policies of section 267A, other provisions of the Code (such as section 894(c) and § 1.894-1(d)), and the Hybrid Mismatch Report. One comment stated that the rule is neither included in section 267A nor permissible under the regulatory authority under section 267A(e). Although the comments noted potential concerns associated with an income inclusion in a low-tax third country discharging the application of section 267A, the comments suggested addressing the concerns through the anti-avoidance rule included in the proposed regulations. Alternatively, a comment suggested retaining the general approach of the proposed regulations but permitting an inclusion in a third country to discharge the application of section 267A if the inclusion satisfies a rate test (for example, to the extent the inclusion is at a tax rate at least equal to the U.S. tax rate or the tax rate of the foreign country in which the no-inclusion occurs). The Treasury Department and the IRS have determined that the approach of the proposed regulations should be retained to prevent the avoidance of section 267A by routing a specified payment through a low-tax third country, and to prevent the use of a hybrid or branch arrangement from placing a taxpayer in a better position than it would have been in absent the arrangement. In addition, the Treasury Department and the IRS have concluded that the rule is consistent with section 267A and the broad regulatory authority thereunder. Finally, the Treasury Department and the IRS have concluded that relying on the anti-avoidance rule would give rise to uncertainty and be an insufficient remedy, and that a rate test would also be an insufficient remedy because it would give rise to additional complexity and would require taking into account tax rates, which is beyond the scope of hybrid mismatch rules. 2. Amounts Included or Includible in Income in the United States The proposed regulations provide rules that, in general, ensure that a specified payment is not a disqualified hybrid amount to the extent it is included in the income of a tax resident of the United States or a U.S. taxable branch, or is taken into account by a U.S. shareholder under the subpart F or GILTI rules. See proposed § 1.267A-3(b). Several comments suggested retaining these rules, but revising them in certain respects. One comment suggested revising the rules relating to amounts taken into account under subpart F so that the determination is made without regard to the earnings and profits limitation under section 952. Another comment noted that the rules relating to amounts taken into account under GILTI could potentially give rise to rate arbitrage (for example, if the rate on the GILTI inclusion amount is in effect reduced by reason of the deduction under section 250(a)(1)(B), and the deduction for the specified payment offsets income that is not eligible for a reduced rate). 3 Finally, a comment suggested an exception for specified payments received by a qualified electing fund (as described in section 1295) and taken into account by a tax resident of the United States under section 1293. 3 For instance, in the case of a structured arrangement pursuant to which a domestic corporation (US1) makes a specified payment to a CFC of an unrelated domestic corporation (US2), a deduction allowed to US1 for the specified payment would offset income subject to tax at the full U.S. corporate tax rate, whereas US2's GILTI inclusion attributable to the payment would generally be subject to tax at a reduced rate by reason of the deduction under section 250(a)(1)(B). The Treasury Department and the IRS agree with these recommendations, and thus the final regulations provide rules to such effect. See § 1.267A-3(b)(3) through (5). 3. Effect of Withholding Taxes on a Specified Payment Under the proposed regulations, 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 U.S. source-based tax under section 871 or 881 and such tax has been deducted and withheld under section 1441 or 1442. The preamble to the proposed regulations explains that withholding tax policies are unrelated to the policies underlying hybrid arrangements and, because the approach of the proposed regulations is consistent with the Hybrid Mismatch Report, it may improve the coordination of section 267A with hybrid mismatch rules of other countries. In response to a request for comments in the proposed regulations, several comments recommended that withholding taxes be taken into account for purposes of section 267A. For example, comments suggested that to the extent the United States imposes withholding tax on a specified payment, section 267A generally should not apply to the payment because, otherwise, the payment may be effectively taxed twice by the United States (once as a result of the withholding tax, and second as a result of the denial of a deduction for the payment). The comments also asserted that such an approach would generally be consistent with the policies underlying the exceptions in § 1.267A-3(b) (certain amounts not treated as disqualified hybrid amounts to extent included or includible in income). Although one comment acknowledged that adopting an approach to withholding taxes that is inconsistent from the Hybrid Mismatch Report could raise potential coordination concerns, it recommended further work be undertaken on a multilateral level to avoid such issues and to ensure that economic double taxation does not occur. The Treasury Department and the IRS have determined that it would not be appropriate for withholding taxes to be taken into account for purposes of section 267A. The purpose of withholding taxes is generally not to address mismatches in tax outcomes but, rather, to allow the source jurisdiction to retain its right to tax a payment. In addition, and as explained in the preamble to the proposed regulations, taking withholding taxes into account could create issues regarding how section 267A interacts with foreign hybrid mismatch rules—for example, a foreign country with hybrid mismatch rules may not treat the imposition of U.S. withholding taxes on a specified payment as neutralizing a D/NI outcome and may therefore apply a secondary or defensive rule requiring the payee to include the payment in income. Moreover, had Congress intended for withholding taxes to be taken into account for purposes of section 267A, it could have added a rule similar to the one in section 59A(c)(2)(B), which was enacted at the same time as section 267A. Finally, providing an exception for withholding taxes could raise administrability issues in cases in which a specified payment is subject to U.S. withholding taxes at the time of payment (with the result that a deduction for the payment is not disallowed under section 267A at that time) but the taxes are refunded in a later period; in these cases, it could be difficult or burdensome to retroactively deny the deduction and make corresponding adjustments. Thus, the Treasury Department and the IRS have determined that the exceptions in § 1.267A-3(b) should generally be limited to inclusions similar to those described in the flush language of section 267A(b)(1) (inclusions under section 951(a)), which, unlike U.S. source income that is subject to withholding taxes, are included in the U.S. tax base on a net basis. Accordingly, the final regulations do not adopt the comment. D. Disqualified Imported Mismatch Amounts 1. In General Under the proposed regulations, an “imported mismatch rule” prevents the effects of an offshore hybrid arrangement from being imported into the U.S. taxing jurisdiction through the use of a non-hybrid arrangement. Pursuant to this rule, a specified payment is generally a disqualified imported mismatch amount, and therefore a deduction for the payment is disallowed, to the extent that the payment is (i) an imported mismatch payment, and (ii) income attributable to the payment is directly or indirectly offset by a hybrid deduction of a tax resident or taxable branch. See proposed § 1.267A-4(a). The extent that a hybrid deduction directly or indirectly offsets income attributable to an imported mismatch payment is determined pursuant to a series of operating rules, including ordering rules, funding rules, and a pro rata allocation rule. See proposed § 1.267A-4(c) and (e). Under these rules, a hybrid deduction is considered to offset income attributable to an imported mismatch payment only if the imported mismatch payment directly or indirectly funds the hybrid deduction. See proposed § 1.267A-4(c). Some comments asserted that the imported mismatch rule is complex and could be difficult to administer. These comments suggested various ways to address these concerns. One comment suggested removing the imported mismatch rule because of the complexity and administrability concerns and also because, according to the comment, the rule exceeds the authority granted under section 267A. Another comment suggested modifying the rule such that an imported mismatch payment is a disqualified imported mismatch amount only if the income attributable to the payment is offset by a hybrid deduction that as a factual matter is connected to the payment; thus, under this approach, the operating rules under the proposed regulations would generally be replaced with a broader facts and circumstances inquiry, possibly supplemented by rebuttable presumptions. Other comments suggested modifications to specific aspects of the imported mismatch rule, such as the operating rules. The Treasury Department and the IRS have concluded that the general approach of the imported mismatch rule under the proposed regulations should be retained, and that the rule is consistent with the grant of regulatory authority under section 267A(e)(1) (regarding regulations to address conduit arrangements involving hybrid transactions or hybrid entities). The Treasury Department and the IRS have determined that the operating rules under the proposed regulations provide more certainty than under alternative approaches, such as determining disqualified imported mismatch amounts based on a factual tracing of hybrid deductions to imported mismatch payments. In addition, the Treasury Department and the IRS have determined that the general approach under the proposed regulations promotes parity between similarly situated taxpayers. For example, in the case of one taxpayer with an imported mismatch payment factually linked to a hybrid deduction and another taxpayer with an imported mismatch payment not factually linked to a hybrid deduction, only the first taxpayer's payment would be a disqualified imported mismatch amount under a factual tracing approach, even though as an economic matter (and taking into account the fungibility of money) the income attributable to each taxpayer's payment may be offset by a hybrid deduction. Further, the general approach under the proposed regulations is consistent with the approach recommended under the Hybrid Mismatch and Branch Mismatch reports, which would better align these rules with hybrids mismatch rules of other jurisdictions to ensure that imported mismatches are adequately addressed and do not result in a single hybrid deduction giving rise to a disallowance in more than one jurisdiction. See Hybrid Mismatch Report Recommendation 8; see also OECD/G20, Neutralising the Effects of Branch Mismatch Arrangements, Action 2: Inclusive Framework on BEPS (July 2017) Recommendation 5. However, in response to comments, the final regulations modify certain aspects of the imported mismatch rule in order to reduce complexity and facilitate compliance and administration of the rule. These modifications and others are discussed in parts III.D.2 through 5 of this Summary of Comments and Explanation of Revisions section. 2. Imported Mismatch Payments Several comments suggested that the imported mismatch rule could result in double U.S. taxation in certain cases. For example, assume US1, a domestic corporation, owns all the interests of each of US2, a domestic corporation, and FX, a tax resident of Country X that is a CFC for U.S. tax purposes. Also assume that FX owns all the interests of FY, a tax resident of Country Y that is a disregarded entity for U.S. tax purposes. Lastly, assume that US2 makes a $100x non-hybrid specified payment to FY, and that FY incurs a $100x hybrid deduction. In such a case, according to the comments, treating US2's payment as a disqualified imported mismatch amount could result in double U.S. taxation, as the United States would be disallowing US2 a deduction for the payment even though the entire amount is indirectly included in US1's income as a subpart F inclusion. The comments thus requested modifying the imported mismatch rule such that it does not apply in cases like these. The Treasury Department and the IRS agree with these comments. As a result, the final regulations revise the definition of an imported mismatch payment, which under the proposed regulations is defined as any specified payment to the extent not a disqualified hybrid amount. Under the final regulations, a specified payment is an imported mismatch payment only to the extent that it is neither a disqualified hybrid amount nor included or includible in income in the United States (as determined under the rules of § 1.267A-3(b)). See § 1.267A-4(a)(2)(v). Thus, in the example in the previous paragraph, none of US2's payment would be an imported mismatch payment, calculated as $100x (the amount of the payment) less $0 (the disqualified hybrid amount with respect to the payment), less $100x (the amount of the payment that is included or includible in income in the United States). Accordingly, none of the payment would be subject to disallowance under the imported mismatch rule. 3. Hybrid Deductions i. Deductions Constituting Hybrid Deductions Under the proposed regulations, for a deduction allowed to a tax resident or taxable branch under its tax law to be a hybrid deduction, it generally must be one that would be disallowed if such tax law contained rules substantially similar to the rules under §§ 1.267A-1 through 1.267A-3 and 1.267A-5. See proposed § 1.267A-4(b). A comment requested guidance on how this standard applies when the tax law of a tax resident or taxable branch contains hybrid mismatch rules. The comment posited several approaches, including (i) not treating deductions allowed to such a tax resident or taxable branch under its tax law as a hybrid deduction, or (ii) treating deductions allowed to a such a tax resident or taxable branch under its tax law as a hybrid deduction if the deduction would be disallowed if such tax law contained rules nearly identical to those under section 267A. The comment recommended the first approach. The Treasury Department and the IRS have determined that the first approach could give rise to inappropriate results. For example, in the case of a deduction allowed to a foreign tax resident under its tax law with respect to an interest-free loan, the deduction would not be a hybrid deduction under the first approach if the tax resident's tax law contains hybrid mismatch rules, even though the deduction would be disallowed under section 267A were section 267A to apply to the deduction. The Treasury Department and the IRS believe that these results could lead to avoidance of the purposes of section 267A. That is, the first approach could incentivize taxpayers to implement certain offshore hybrid arrangements and import the effects of the arrangement into the U.S. taxing jurisdiction, even though a deduction would be disallowed under section 267A were the arrangement to involve the U.S. taxing jurisdiction directly. Accordingly, the final regulations do not adopt this approach. However, in response to the comment, the final regulations provide an exclusive list of deductions that constitute hybrid deductions with respect to a tax resident or taxable branch the tax law of which contains hybrid mismatch rules. See § 1.267A-4(b)(2)(i). This list, which represents deductions that would be disallowed under section 267A but may be allowed under the hybrid mismatch rules of the foreign country, includes deductions with respect to (i) equity, (ii) interest-free loans (and similar arrangements), and (iii) amounts that are not included in income in a third foreign country. Thus, in the case of a tax resident or taxable branch the tax law of which contains hybrid mismatch rules, a taxpayer need only consider these three types of arrangements when determining whether the tax resident or taxable branch has hybrid deductions for purposes of the imported mismatch rule. The Treasury Department and the IRS have concluded that this approach increases certainty and improves the administration of the imported mismatch rule. ii. NIDs Under the proposed regulations, a hybrid deduction includes NIDs allowed to a tax resident under its tax law. See proposed § 1.267A-4(b). The comments regarding NIDs in the context of section 267A were substantially similar to the comments regarding NIDs in the context of section 245A(e). See part II.B.4 of this Summary of Comments and Explanation of Revisions section. Thus, for reasons similar to the reasons discussed in that section, the final regulations generally retain the approach of the proposed regulations regarding NIDs, but provide that only NIDs allowed to a tax resident under its tax law for accounting periods beginning on or after December 20, 2018, are hybrid deductions. See § 1.267A-4(b)(2)(iii). In addition, a comment suggested that including NIDs as a hybrid deduction conflicts with nondiscrimination provisions of income tax treaties that require interest and royalties paid by U.S. residents to residents of the other treaty country be deductible under the same conditions as if they had been paid to a resident of the United States. See, for example, paragraph (4) of Article 23 (Nondiscrimination) of the income tax convention between the United States and Belgium, signed November 27, 2006. However, the U.S. Treasury Department Technical Explanation of Article 23 of the U.S.-Belgium income tax treaty provides that “. . . the common underlying premise [in each paragraph of the Article] is that if the difference in treatment is directly related to a tax-relevant difference in the situations of the domestic and foreign persons being compared, that difference is not to be treated as discriminatory. . . .” In this case, the disallowance of a deduction is dependent solely on differences in U.S. tax law and the tax law of an imported mismatch payee (or certain other foreign parties), and the tax benefits allowed to the imported mismatch payee (or certain other foreign parties) under foreign tax law. Payments to related domestic persons would always be governed by the same Federal tax laws, and domestic law does not provide hybrid deductions, including NIDs, to domestic persons. Accordingly, the Treasury Department and the IRS have concluded that including NIDs as a hybrid deduction does not conflict with the nondiscrimination provision of applicable U.S. income tax treaties. The proposed regulations do not provide a rule pursuant to which NIDs are hybrid deductions only to the extent that the double non-taxation produced by the NIDs is a result of hybridity. However, consistent with other aspects of the section 267A regulations, the Treasury Department and the IRS have concluded that such a rule is appropriate and the final regulations therefore provide a rule to this effect. See § 1.267A-4(b)(1)(ii). Thus, for example, in the case of a tax resident all the interests of which are owned by an investor that is a tax resident of another country, NIDs allowed to the tax resident are not hybrid deductions if the tax law of the investor has a pure territorial regime (that is, only taxes income from domestic sources) or if such tax law does not impose an income tax. iii. Deemed Branch Payments Under the proposed regulations, a hybrid deduction of a taxable branch includes a deduction that would be disallowed if the tax law of the taxable branch contained a provision substantially similar to proposed § 1.267A-2(c) (regarding deemed branch payments). See proposed § 1.267A-4(b). Proposed § 1.267A-2(c) generally disallows a deduction for a deemed branch payment of a U.S. taxable branch only if the tax law of the home office provides an exclusion or exemption for income attributable to the branch. Proposed § 1.267A-2(c) thus provides a simpler standard than the dual inclusion income standard of proposed § 1.267A-2(b) (regarding disregarded payments). The simpler standard applies for deemed branch payments because these payments may arise due to simply operating a U.S. trade or business (as opposed to disregarded payments that typically result from structured tax planning), as well as because, given that U.S. permanent establishments cannot consolidate or otherwise share losses with U.S. taxpayers, there is a more limited opportunity for a deduction for such payments to offset non-dual inclusion income. A comment noted that under a tax law of a foreign country a taxable branch could be permitted to consolidate or otherwise share losses with a tax resident of that country. The comment thus questioned whether, in the imported mismatch context, it is appropriate for the deemed branch payment rule to apply the branch exemption standard, rather than the dual inclusion income standard. The Treasury Department and the IRS have concluded that, in the imported mismatch context, the dual inclusion income standard should apply in cases in which the tax law of the taxable branch permits a loss of the taxable branch to be shared with a tax resident or another taxable branch, because in these cases the excess of the taxable branch's deemed branch payments over its dual inclusion income could offset non-dual inclusion income. The final regulations therefore provide a rule to this effect. See § 1.267A-4(b)(2)(ii). iv. Hybrid Deductions of CFCs Under the proposed regulations, only a tax resident or taxable branch that is not a specified party can incur a hybrid deduction. See proposed § 1.267A-4(b). Similarly, under the proposed regulations, only a tax resident or a taxable branch that is not a specified party can make a funded taxable payment. See proposed § 1.267A-4(c)(3). This approach was generally intended to ensure that section 267A does not result in double U.S. taxation in cases of specified payments involving CFCs, because payments to CFCs are generally includible in income in the United States and payments by CFCs are generally subject to disallowance as disqualified hybrid amounts. A comment noted that this approach could lead to inappropriate results in certain cases. For example, it could lead to the avoidance of the imported mismatch rule through the use CFCs that are not wholly-owned by tax residents of the United States. The comment therefore recommended that the final regulations provide that CFCs can incur hybrid deductions and make funded taxable payments. However, to prevent double U.S. taxation, the comment suggested that a payment by a CFC not give rise to a hybrid deduction or a funded taxable payment to the extent that the payment gives rise to an increase in the U.S. tax base. The Treasury Department and the IRS agree with the comment and the final regulations therefore provide that CFCs can incur hybrid deductions and make funded taxable payments. See § 1.267A-4(b)(1) and (c)(3)(v). The final regulations also provide rules to ensure that a hybrid deduction or funded taxable payment of a CFC does not include an amount that is a disqualified hybrid amount or included or includible in income in the United States (as determined under the rules of § 1.267A-3(b)). See § 1.267A-4(b)(2)(iv) and (c)(3)(v)(C). However, in the case of a disqualified hybrid amount of a CFC that is only partially owned by tax residents of the United States (or a disqualified hybrid amount a deduction for which would be allocated and apportioned to income not subject to U.S. tax), only a portion of the disqualified hybrid amount prevents a payment of the CFC from giving rise to a hybrid deduction or a funded taxable payment, as disallowing the CFC a deduction for the disqualified hybrid amount will only partially increase the U.S. tax base (or will not increase the U.S. tax base at all). See § 1.267A-4(g). A new example illustrates these rules. See § 1.267A-6(c)(11). 4. Setoff Rules i. Funded Taxable Payments Under the proposed regulations, for an imported mismatch payment to indirectly fund a hybrid deduction, the imported mismatch payee must directly or indirectly make a funded taxable payment to the tax resident or taxable branch that incurs the hybrid deduction. See proposed § 1.267A-4(c)(3). A comment requested that the final regulations clarify that, for a payment to be a funded taxable payment, it must be included in income of a tax resident or taxable branch. The Treasury Department and the IRS agree with the comment and the final regulations thus provide a clarification to this effect. See § 1.267A-4(c)(3)(v)(B). ii. Hybrid Deduction First Offsets Imported Mismatch Payment With Closest Nexus to Deduction Under the proposed regulations, when there are multiple imported mismatch payments, a hybrid deduction is first considered to offset income attributable to the imported mismatch payment that has the closest nexus to the hybrid deduction. See proposed §§ 1.267A-4(c)(2) and 1.267A-6(c)(10). For example, in the case of two imported mismatch payments, one of which is made pursuant to a transaction entered into pursuant to the same plan pursuant to which the hybrid deduction is incurred (a “factually-related imported mismatch payment”) and the other of which is not a factually-related imported mismatch payment, the hybrid deduction is first considered to offset income attributable to the factually-related imported mismatch payment. As an additional example, in the case of two imported mismatch payments, one of which is directly connected to a hybrid deduction (because the imported mismatch payee with respect to the payment is the tax resident or taxable branch that incurs the hybrid deduction) and the other of which is indirectly connected to the hybrid deduction (because the imported mismatch payee with respect to the payment makes a funded taxable payment to the tax resident or taxable branch that incurs the hybrid deduction), the hybrid deduction is first considered to offset income attributable to the imported mismatch payment that is directly connected to the hybrid deduction. The final regulations retain this approach and provide two clarifications. First, the final regulations clarify that an imported mismatch payment is a factually-related imported mismatch payment—and therefore is given priority in terms of funding the hybrid deduction over other imported mismatch payments—only if a design of the plan or series of related transactions pursuant to which the hybrid deduction is incurred was for the hybrid deduction to offset income attributable to the payment. See § 1.267A-4(c)(2)(i). Second, the final regulations clarify that when there are multiple imported mismatch payments that are indirectly connected to the tax resident or taxable branch that incurs the hybrid deduction, the hybrid deduction is first considered to offset income attributable to an imported mismatch payment that is connected, through the fewest number of funded taxable payments, to the tax resident or taxable branch that incurs the hybrid deduction. See § 1.267A-4(c)(3)(vii) and (viii). For example, in the case of back-to-back imported mismatch payments, the first such payment is given priority over more removed imported mismatch payments. iii. Relatedness Requirement Under the proposed regulations, a hybrid deduction offsets income attributable to an imported mismatch payment only if the tax resident or taxable branch that incurs the hybrid deduction is related to the imported mismatch payer (or is a party to a structured arrangement pursuant to which the payment is made). See proposed § 1.267A-4(a). A comment requested that, for an imported mismatch payment to indirectly fund a hybrid deduction and thus be offset by the deduction, the imported mismatch payee (and, if applicable, each intermediary tax resident or taxable branch in the chain of funded taxable payments) must be related to the imported mismatch payer (or a party to a structured arrangement pursuant to which the payment is made). The Treasury Department and the IRS agree with the comment and the final regulations therefore provide rules to this effect. See § 1.267A-4(c)(3)(ii) and (iv). 5. Coordination With Foreign Imported Mismatch Rules i. Certain Payments Deemed To Be Imported Mismatch Payments The proposed regulations coordinate the U.S. imported mismatch rule 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. In general, the proposed regulations do so through a special rule pursuant to which certain payments by non-specified parties are deemed to be imported mismatch payments (the “Deemed IMP Rule”). See proposed § 1.267A-4(f). In certain cases, the effect of the Deemed IMP Rule is that the rule reduces the extent to which a payment of a specified party is considered to fund a hybrid deduction (and therefore reduces the extent to which the hybrid deduction is considered to offset the income attributable to the imported mismatch payment). For example, a hybrid deduction may be considered directly funded by a payment of a non-specified party, rather than indirectly funded by a payment of a specified party; or, a hybrid deduction may be considered pro rata funded by a payment of a specified party and a payment of a non-specified party, rather than solely funded by the payment of the specified party. Under the proposed regulations, the Deemed IMP Rule applies only to payments by a tax resident or taxable branch the tax law of which contains hybrid mismatch rules, and only to the extent that pursuant to an imported mismatch rule under such tax law, the tax resident or taxable branch is denied a deduction for all or a portion of the [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-05924. Public record. Not legal advice.