Canada: No US Deduction For Related-Party Interest Or Royalty Paid Abroad

IRC section 267A, added December 2017, denies a deduction to a US-situated payer of interest or a royalty to a related non-US hybrid party or as part of a hybrid transaction. This hybrid mismatch provision was likely influenced by the OECD Base Erosion and Profit Shifting action 2 report (Neutralising the Effects of Hybrid Mismatch Arrangements), which was finalized in 2015.

Section 267A originated in the US Senate Committee on Finance, "International Tax Reform Staff Discussion Draft," released November 19, 2013. Proposed section 267A prevented related-party payments in a base erosion arrangement, defined as a transaction, series thereof, or other arrangement that (1) reduces foreign income tax paid or accrued and (2) involves a hybrid transaction or instrument, a hybrid entity, an exemption arrangement, or a conduit financing arrangement. The proposal was clearly influenced by the said OECD report, but Congress did not entirely follow the report: final section 267A addresses only a hybrid transaction and a hybrid entity.

A US payer of interest or a royalty is denied a related-party deduction if the amount is not included in or is deductible from the related party's income. That latter concern was raised in the 2016 Treasury green book, released February 2015 (the year the OECD action 2 BEPS report was released). Treasury expressed concern that "[t]here has been a proliferation of tax avoidance techniques involving a variety of cross-border hybrid arrangements, such as hybrid entities, hybrid instruments, and hybrid transfers" such as sale-repurchase transactions:

In one such hybrid arrangement, a U.S. person holds an interest in a reverse hybrid, which is an entity that is a corporation for U.S. tax purposes but is a fiscally transparent entity (such as a partnership) or a branch under the laws of a foreign jurisdiction. Because the United States treats the reverse hybrid as a corporation, income earned by the reverse hybrid generally will not be subject to current U.S. tax. Moreover, even if the reverse hybrid is treated as a CFC, interest and royalty income earned by the reverse hybrid from certain foreign related persons (which otherwise would qualify as subpart F income) may nonetheless not be subject to current U.S. taxation as a result of either section 954(c)(3) or section 954(c)(6). Payments to the reverse hybrid, however, generally are also not subject to tax in the foreign jurisdiction in which it is established or organized, because the foreign jurisdiction views reverse hybrid as a fiscally transparent entity and therefore treats that entity's income as derived by its owners, including its U.S. owners. As a result of this hybrid treatment, income earned by the reverse hybrid generally would not be subject to tax currently in the United States or the foreign jurisdiction.

The 2017 green book expresses the ongoing Treasury concern with hybrid entities and transactions.

Section 267A refers to section 954(d)(3) for guidance on the meaning of "related party": a related person that

is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, the controlled foreign corporation, or . . .

is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the controlled foreign corporation.

Section 954(d)(3) defines "control" as the ownership, directly or indirectly, of (1) corporate stock that has more than 50 percent of the total voting power of all classes of stock entitled to vote, or (2) more than 50 percent (by value) of the beneficial interests in a partnership, trust, or estate. Rules similar to those in section 958 also apply.

A US payer of interest or a royalty must determine whether it is related to a non-resident payee; a US fund must ensure that no single non-resident investor may hold 50 percent of the fund's value. The US payer must also determine whether the payee is a hybrid and whether the payment is taxed where the hybrid entity resides for tax purposes (section 267A(d)). A "hybrid transaction" means any transaction, series thereof, agreement, or instrument under which one or more payments are treated as interest or royalties and "are not so treated for purposes [of] the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax."

Needless to say, a Canadian financing structure that uses a hybrid through a jurisdiction such as the Cayman Islands (which hybrid has checked the box and is thus a flowthrough for US purposes) must review its current structure. Also, a US entity with non-resident investors must take a closer look at the recipient of an interest or royalty payment and determine whether at time of payment a non-resident payee might be deemed related and a hybrid.

Given the sparse definition of "a hybrid" or "a hybrid transaction" under section 267A, practitioners await further guidance from section 267A regulations yet to be released.

Originally published in Canadian Tax Foundation

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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