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IRS Issues Final and Proposed Regulations on Hybrid Arrangements

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On April 7, 2020, the Internal Revenue Service (“IRS”) issued final and proposed regulations regarding hybrid arrangements. A hybrid arrangement generally refers to a transaction or entity that the U.S. and foreign tax law classify differently for tax purposes.


Sections 245A(e) and 267A were added to the Internal Revenue Code (“Code”) by the Tax Cuts and Jobs Act, Pub. L. No. 115-97 (2017) on December 22, 2017. These Code provisions generally follow recommendations issued by the Organization for Economic Cooperation and Development (the “OECD”) pursuant to Action 2 of its 2015 base erosion and profit-shifting (BEPS) project, which relates to neutralizing the effects of hybrid mismatch arrangements.

Section 245A(e) of the Code disallows the dividends received deduction under Section 245A(a) for any dividend received by a United States shareholder from a controlled foreign corporation (a “CFC”) if the dividend is a hybrid dividend. In addition, Section 245A(e) treats hybrid dividends between CFCs with a common United States shareholder as subpart F income. Section 245A(e) defines a “hybrid dividend” as an amount received from a CFC for which a deduction would be allowed under Section 245A(a) and for which the CFC received a deduction or other tax benefit in a foreign country.

Section 267A of the Code disallows a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. Section 267A defines a “disqualified related party amount” as any interest or royalty paid or accrued to a related party where there is no corresponding income inclusion to the related party in the foreign tax jurisdiction or where the related party is allowed a deduction with respect to such amount in the foreign tax jurisdiction. A “hybrid transaction” is any transaction where payments are treated as interest or royalties for U.S. tax purposes but not for purposes of the foreign tax jurisdiction. A “hybrid entity” is any entity which is treated as fiscally transparent (that is, a flow-through or disregarded entity) for U.S. tax purposes but not for purposes of the foreign tax jurisdiction, or vice versa.

Final Regulations (T.D. 9896)

The final regulations provide detailed guidance regarding:

  • Hybrid dividends under Section 245A(e); and

  • Interest and royalties involving hybrid transactions or hybrid entities under Section 267A. 

The final regulations also provide some guidance regarding dual consolidated losses and entity classifications under Sections 1503(d) and 7701, as well as information reporting requirements to facilitate the administration of the above rules. The final regulations are largely similar to the proposed regulations issued on December 20, 2018, with some modifications to address public comments.

Hybrid Dividends under Section 245A(e)

The final 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” 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.

A hybrid deduction account is maintained across years so that hybrid deductions that accrue in one year are matched to dividends arising in a different year. This generally ensures that income is neither doubly taxed nor doubly non-taxed. In this regard, the final regulations also provide guidance regarding mid-year stock transfers and what types of deductions and other tax benefits are “hybrid deductions.”

Noteworthy provisions in the final regulations under Section 245A(e) include the following:

  • Notional interest deductions (NIDs). The final regulations specifically reference a notional interest deduction (“NID”), a type of deduction with respect to equity, as an example of a hybrid deduction. This is a deviation from recommendations by the OECD. Other examples of hybrid deductions cited in the final regulations include interest deductions and dividends paid deductions.

  • Transitional relief for NIDS. NIDs and other hybrid deductions with respect to equity are taken into account only if they were allowed to the CFC for a taxable year beginning on or after December 20, 2018, the release date of the first proposed regulations. This delay is intended to account for restructurings by taxpayers to eliminate or minimize hybridity.

  • No current use requirement. A deduction or other tax benefit may be a hybrid deduction regardless of whether it is used currently under the relevant foreign tax law. Similarly, the determination of whether a deduction or other tax benefit is a hybrid deduction is made without regard to a rule under the relevant foreign tax law that disallows or suspends deductions if a certain ratio or percentage is exceeded (e.g., under a rule similar to Section 163(j)).

  • Circularity in foreign hybrid mismatch rules. The determination of whether a deduction or other tax benefit is a hybrid deduction 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. This approach follows recommendations by the OECD and is intended to avoid potential circularity or other issues in cases in which the application of foreign hybrid mismatch rules depends on whether an amount will be included under U.S. tax law.

  • Withholding taxes. 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.

Interest and royalties involving hybrid transactions or hybrid entities under Section 267A

The final regulations provide guidance regarding the deductibility of interest or royalties paid or accrued (a “specified payment”) to related parties under Section 267A.

In general, the final regulations disallow a deduction for a specified payment to the extent the specified payment produces: (i) a deduction/no-inclusion (“D/NI”) outcome as a result of a hybrid or branch arrangement; (ii) 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 through use of a non-hybrid arrangement (the “imported mismatch rule”); or (iii) 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.

Noteworthy provisions in the final regulations under Section 267A include the following:

  • Interest-free loans. The final regulations specifically disallow deductions for imputed interest payments on interest-free loans. This is a deviation from recommendations by the OECD.

  • Long-term deferral. The final regulations disallow a deduction for a specified payment if it is not included in the payee’s income under foreign tax law within 36 months. The IRS reasoned that, even though the amount will eventually be included in the payee’s income, the long-term deferral in effect creates a D/NI outcome. At the request of commenters, the final regulations include a “reasonable expectation” standard, which asks whether, at the time of the specified payment, it is reasonable to expect the payment will be included in income within 36 months.

  • Third-Countries. The final regulations disallow a deduction for a specified payment to the extent 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”). This rule is intended to prevent avoidance of Section 267A by routing a specified payment through a low-tax third country.

  • Imported mismatch rule. The final regulations modify the scope of the imported mismatch rule under the prior proposed regulations to address only those payments that result in U.S. tax, such as subpart F income. This makes the imported mismatch rule fairer but also more complex.

  • De Minimis Rule. The final regulations include a de minimis exception that exempts a specified party from the application of Section 267A for any taxable year for which the sum of the specified party’s deductions for specified payments (plus such deductions of any related specified parties) is below $50,000. The final regulations modify the prior proposed regulations by including only interest and royalty deductions involving hybrid or branch arrangements, rather than all interest and royalty deductions regardless of hybridity.

  • Transitional relief for structured arrangements. The final regulations apply to specified payments made under a structured arrangement in tax years beginning after December 31, 2020. A structured arrangement is an arrangement where the mismatch is priced into the terms of the arrangement, or where the mismatch is a principal purpose of the arrangement. This delay allows taxpayers to unwind current financial arrangements in a less costly way then if no such delay were provided.

Other Rules

The final regulations also amend the dual consolidated loss rules to address the double-deduction outcomes that result from domestic reverse hybrid structures. The final regulations require, as a condition to a domestic entity electing to be treated as a corporation under Treas. Reg. § 301.7701-3(c), that the domestic entity agree to be treated as a dual resident corporation for purposes of Section 1503(d) for taxable years in which a related entity that is taxable under foreign law is treated under such law as deriving or incurring tax items of the domestic entity.

Proposed Regulations (REG-106013-19)

Newly proposed regulations provide additional guidance regarding hybrid deduction accounts addressed in the final regulations under Section 245A(e). As described above, a hybrid deduction account is used in characterizing a dividend from a CFC as a hybrid dividend, with the goal of neutralizing the double non-taxation effects of the dividend. Where the Code already provides other rules that neutralize the double non-taxation effects (e.g., subpart F, GILTI), Section 245A(e) does not need to apply to the dividend. To this end, newly proposed regulations provide rules for reducing a hybrid deduction account to take into account earnings and profits of a CFC that are included in income by a United States shareholder (e.g., subpart F inclusions, GILTI inclusion amounts, amounts included in gross income under Sections 951(a)(1)(B) and 956).

The newly proposed regulations also address, for purposes of the conduit financing rules, arrangements involving equity interests that give rise to deductions (or similar benefits) under foreign law. Under the current conduit financing regulations, an instrument that is treated as equity for U.S. tax purposes (and is not redeemable equity described in Treas. Reg. § 1.881-3(a)(2)(ii)(B)) generally will not be characterized as a financing transaction, even though the instrument gives rise to a deduction or other benefit under the tax laws of the issuer’s jurisdiction. The proposed regulations expand the definition of equity interests treated as a financing transaction by taking into account the tax treatment of the instrument under the tax law of the relevant foreign country, which is generally the country where the equity issuer resides. 

Finally, the newly proposed regulations provide guidance relating to the treatment of certain payments under the GILTI provisions. The proposed regulations generally treat deductions attributable to pre-payments (including, but not limited to, deductions attributable to prepaid rents and royalties) as subject to similar treatment as the final GILTI regulations’ treatment of deductions or loss attributable to disqualified basis.

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