Treasury Issues Final and Proposed Anti-Hybrid Regulations

Summary of Treasury Updates to Anti-Hybrid Rules

On April 8, 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) published in the Federal Register final regulations that finalized proposed regulations addressing anti-hybrid rules under certain sections of the Code, including Sections 245A(e), 267A, and 1503(d). The final regulations affect taxpayers that would otherwise claim a deduction related to 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. The final regulations also affect certain shareholders of foreign corporations that pay or receive hybrid dividends.
 
On the same date, Treasury published in the Federal Register proposed regulations that provide guidance on hybrid arrangements and the allocation of deductions attributable to certain disqualified payments under Section 951A (Global Intangible Low-Taxed Income or GILTI). The proposed regulations affect U.S. shareholders of foreign corporations and persons that make payments in connection with certain hybrid arrangements.
 

Details

Final Regulations

On December 28, 2018, Treasury 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). For a summary discussion on the 2018 proposed regulations, see our January 2019 tax alert.
 
The final regulations retain the basic approach and structure of the 2018 proposed regulations, with certain revisions. Some of the key clarifications and modifications included in the final regulations are summarized below. The below highlights are not an exhaustive list of all items discussed in the preamble to the final regulations.
 

Special Rules for Hybrid Dividends

Section 245A(e) and the 2018 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 2018 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.
 
The final regulations under Section 245A(e) largely adopt the 2018 proposed regulations with certain clarifications and targeted modifications to the hybrid deduction rules, including rules relating to:

1. The current use of a deduction or other tax benefit. See §1.245A(e)-1(d)(2) for details.
2. Coordination with foreign disallowance rules. See §1.245A(e)-1(d)(2)(ii)(A) and §1.245A(e)-1(d)(2)(ii)(B) for details.
3. Deductions with respect to equity (e.g. notional interest deductions (NIDs)). The final regulations generally retain the approach of the 2018 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).
4. Deductions pursuant to imputation systems or other regimes intended to relieve double-taxation. See §1.245A(e)-1(d)(2)(i)(B), and §1.245A(e)-1(g)(2), Example 2, alt. facts for details.
5. Deductions or other tax benefits allowed to a person related to the CFC. See §1.245A(e)-1(d)(2)(i), §1.245A(e)-1(f)(5), and §1.245A(e)-1(d)(2)(i)(B) for details.
6. What is a relevant foreign tax law. See §1.245A(e)-1(f)(5) for details.

 

The final regulations under Section 245A(e) also clarify and make certain targeted modifications to the hybrid deduction account rules, including rules relating to:

1. Reductions for certain amounts included in income by U.S. shareholders. See summary discussion below regarding the new proposed regulations that provide the details to such rules.
2. Transfers of stock, including transfers pursuant to certain nonrecognition exchanges and liquidations. See §1.245A(e)-1(d)(2)(iii) for details. Also, 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) for details.
3. Mid-year transfers of stock. See §1.245A(e)-1(d)(5) for details.
4. The applicability date of the Section 245A(e) regulations. See §1.245A(e)-1(h)(1) for details.

 

Also, the final regulations under Section 245A(e) clarify and make certain targeted modifications to the rules relating to:

1. The treatment of amounts under the tax law of another foreign country.
2. The application of the tiered hybrid dividend rule to non-corporate U.S. shareholders. See §1.245A(e)-1(c)(1) for details.
3. Upper-tier CFCs required to maintain hybrid deduction accounts. See §1.245A(e)-1(f)(6) for details.
4. The 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 Section 245A(e) regulations. See §1.245A(e)-1(e) for details.

 

Certain Payments Involving Hybrid and Branch Mismatches

The 2018 proposed regulations under Section 267A disallow a deduction for any interest or royalty paid or accrued (specified payment) to the extent the specified payment produces a deduction/no-inclusion (D/NI) outcome as a result of a hybrid or branch arrangement, 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 and 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.
 
The final regulations under Section 267A adopt the 2018 proposed regulations and also clarify and make certain targeted modifications to the hybrid and branch arrangement rules, including rules relating to:

1. Arrangements giving rise to long-term deferral. See §1.267A-3(a)(1)(i), 1.267A-3(a)(1)(ii), §1.267A-2(a)(2)(ii)(A), §1.267A-2(a)(2)(ii)(B), §1.267A-3(a)(1)(i), §1.267A-(4), and §1.267A -6(c)(1)(vi) for details.
2. Interest free loans. See §1.267A-2(a)(4) for details. 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) for details.
3. Disregarded payments. See §1.267A-2(b)(3)(ii), §1.267A-2(b)(2)(ii)(B) and §1.267A-6(c)(3)(iv) for details.
4. Payments by U.S. taxable branches. See §1.267A-5(b)(3)(ii)(A) for details. 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) for details.
5. Reverse hybrids. See §1.267A-5(a)(8)(i), §1.267A-5(a)(8)(ii), §1.267A-5(a)(8)(iii), §1.267A-3(a)(3), §1.267A-2(d), §1.267A-6(c)(5)(iv), §1.267A-2(d)(4); see also §1.894-1(d)(5), Example 7 and §1.267A-6(c)(5)(vi) for details.

 

The final regulations under Section 267A also clarify and make certain targeted modifications to the exceptions relating to disqualified hybrid amounts, including rules relating to amounts included or includible in income in the United States. See §1.267A-3(b)(3) through (5).
 
The final regulations under Section 267A also clarify and make certain targeted modifications to the rule relating to disqualified imported mismatch amounts, including rules relating to:

1. Imported mismatch payments. 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) for details.
2. Hybrid deductions. 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) for details. In addition, the final regulations generally retain the approach of the 2018 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) for details. The final regulations also 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. See §1.267A-4(b)(1)(ii) for details. The final regulations also include rules relating to deemed branch payments (see §1.267A-4(b)(2)(ii) for details) and hybrid deductions of CFCs (see §1.267A-4(b), (c), (g) and §1.267A-6(c)(11) for details).
3. The setoff rules. See §1.267A-4(c)(3)(v)(B), §1.267A-4(c)(2)(i), §1.267A-4(c)(3)(vii) and (viii), and §1.267A-4(c)(3)(ii) and (iv) for details.
4. Coordination with foreign imported mismatch rules. See §1.267A-4(f)(2), §1.267A-4(f)(1), §1.267A-6(c)(10)(iv) and (c)(12) for details.

 

In addition, the final regulations under Section 267A address other issues, including rules relating to:

1. The definition of interest. See §1.267A-5(a)(12) for details.
2. Structured payments treated as interest. See §1.267A-5(b)(5)(i) and §1.267A-5(b)(5)(ii) for details.
3. Coordination with capitalization and recovery provisions. See §1.267A-5(b)(1)(iii) for details.
4. Structured arrangements. See §1.267A-5(a)(20) for details. The final regulations apply to specified payments made pursuant to a structured arrangement only for taxable years beginning after December 31, 2020. See §1.267A-7(b)(2) for details.
5. The de minimis exception. See §1.267A-1(c) for details.
6. The term “tax law of a country.” See §1.267A-5(a)(21) for details.
7. Specified parties.
8. Coordination with Section 163(j). See §1.267A-5(b)(1) for details.
9. The anti-avoidance rule. See §1.267A-5(b)(6) for details.
10. The effect of disallowance of earnings and profits. See §1.267A-5(b)(4) for details.

 

In addition, the final regulations under Sections 1503(d) and 7701 retain the approach of the 2018 proposed regulations without modification and require as a condition to a domestic entity electing to be treated as a corporation under §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 certain requirements are satisfied.
 
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).

 

New Proposed Regulations

The new proposed regulations provide rules that (1) adjust hybrid deduction accounts to take into account earnings and profits of a CFC that are included in income by a U.S. shareholder, (2) address, for purposes of the conduit financing rules, arrangements involving equity interests that give rise to deductions (or similar benefits) under foreign law and (3) address the treatment of certain payments under the GILTI provisions.
 

Rules Under Section 245A(e) to Reduce Hybrid Deduction Accounts

The proposed regulations provide a new rule that, as part of the end-of-the-year adjustments to a hybrid deduction account, reduces the account by three categories of amounts included in the gross income of a domestic corporation with respect to the share.^[1] The first category relates to an inclusion under Section 951(a)(1)(A) (Subpart F inclusion) with respect to the share, and the second relates to a GILTI inclusion amount with respect to the share.^[2] The proposed regulations generally reduce a hybrid deduction account with respect to a share of stock of a CFC by an “adjusted Subpart F inclusion” or an “adjusted GILTI inclusion” (or both) with respect to the share.^[3] An adjusted Subpart F inclusion or an adjusted GILTI inclusion is intended to measure, in an administrable manner, the extent to which a domestic corporation’s Subpart F inclusion or GILTI inclusion amount is likely included in income in the United States, taking into account foreign tax credits associated with the inclusion and, in the case of a GILTI inclusion amount, the deduction under Section 250(a)(1)(B).
 
The third category is for inclusions under Sections 951(a)(1)(B) and 956 with respect to the share, to the extent the inclusion occurs by reason of the application of Section 245A(e) to the hypothetical distribution described in §1.956-1(a)(2).^[4] An amount in the third category provides a dollar-for-dollar reduction of the account because, due to the lack of an availability of deductions or credits particular to the amount (including foreign tax credits) to offset or reduce such amount, the entirety of such amount is assumed to be included in income in the United States.^[5]
 
The proposed rules relating to hybrid deduction accounts are proposed to apply to taxable years ending on or after the date that final regulations are published in the Federal Register. For taxable years before the years covered by such final regulations, a taxpayer may apply the rules set forth in the final regulations, provided that it consistently applies the rules to those taxable years.^[6] In addition, a taxpayer may rely on the proposed rules with respect to any period before the date that the proposed regulations are published as final regulations in the Federal Register, provided that it consistently does so.

 

Conduit Regulations under §1.881-3 to Address Equity Interests that Give Rise to Deductions or other Benefits under Foreign Law

The proposed regulations expand the types of equity interests treated as a financing transaction to include stock or a similar interest if under the tax laws of a foreign country where the issuer is a resident, the issuer is allowed a deduction or another tax benefit for an amount paid, accrued or distributed with respect to the stock or similar interest. Similarly, if the issuer maintains a taxable presence, referred to as a permanent establishment (PE) under the laws of many foreign countries without regard to a treaty, and such country allows a deduction (including a notional deduction) for an amount paid, accrued or distributed with respect to the deemed equity or capital of the PE, the amount of the deemed equity or capital will be treated as a financing transaction.^[7] The proposed regulations also treat stock or a similar interest as a financing transaction if a person related to the issuer, generally a shareholder or other interest holder in an entity, is entitled to a refund (including a credit) or similar tax benefit for taxes paid by the issuer to its country of residence, without regard to the person’s tax liability with respect to the payment, accrual or distribution under the laws of the issuer.^[8]
 

The proposed rules relating to conduit transactions are proposed to apply to payments made on or after the date that final regulations are published in the Federal Register.

 

Rules under Section 951A to Address Certain Disqualified Payments Made During the Disqualified Period

Proposed §1.951A-2(c)(6) treats a deduction by a CFC related to a deductible payment to a related recipient CFC during the disqualified period (i.e., the period after December 31, 2017, the final date for measuring earnings and profits for purposes of Section 965, and before the date on which Section 951A first applies with respect to the CFC’s income (for example, December 1, 2018, for a CFC with a taxable year ending November 30)) as allocated and apportioned solely to residual CFC gross income, as defined in §1.951A-2(c)(5)(iii)(B), and provides that any deduction related to such a payment is not properly allocable to property produced or acquired for resale under Section 263, 263A, or 471, consistent with §1.951A-2(c)(5)(i) and the authority therefore described in the preamble to the final GILTI regulations.^[9] This rule applies only to the extent the payments would constitute income described in Section 951A(c)(2)(A)(i) and §1.951A-2(c)(1), without regard to whether Section 951A applies.^[10]
 
The proposed rules relating to Section 951A are proposed to apply to taxable years of foreign corporations ending on or after April 8, 2020, and to taxable years of United States shareholders in which or with which such taxable years end.^[11] Given the applicability date, these rules would effectively be limited to payments made during the disqualified period that give rise to deductions or loss in taxable years of foreign corporations ending on or after April 8, 2020, and would not, for example, affect payments made during the disqualified period for which the associated deduction or loss is taken into account in the year paid.

 

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