United States: Anti-Tax Arbitrage The U.S. Way

Last Updated: May 20 2019
Article by Beate Erwin

The 2017 Tax Cuts and Jobs Act ("T.C.J.A.") introduced two new rules targeting hybrid arrangements. The first deals with hybrid dividends. It denies the U.S. "participation exemption" introduced under the T.C.J.A., which, conceptually, is a 100% dividend received deduction, on a dividend received by a qualifying U.S. Shareholder1 from a controlled foreign corporation ("C.F.C.") 2 if the dividend is a hybrid dividend. 3 The second relates to certain related-party transactions. More specifically, it disallows a deduction for certain related-party amounts paid or accrued (i) pursuant to a hybrid transaction or (ii) by, or to, a hybrid entity. 4

In December 2018, the Treasury released proposed regulations to provide guidance on these new rules.5 While the issues are complex, the following will highlight the main anti-hybrid items addressed by the proposed regulations.

BACKGROUND

In broad terms, hybrid arrangements come in various forms: either a specific type of intercompany payment (i.e., dividend, interest, or royalty payment) or the use of specific types of entities. However, they have one goal in common: to exploit differences in tax treatment between two or more countries in order to secure a more beneficial tax result, also referred to as "tax arbitrage." The proposed regulations also address long-term deferrals.6

An example of a hybrid arrangement is a payment treated as interest in one country but as a dividend in the other. While the source country would allow deductibility of the interest payment, the recipient's country would not tax this income because it is treated as dividend exempt from taxation under its participation exemption regime.

In an intragroup scenario this would result in a reduced (or zero) effective tax rate for the payor and no tax for the recipient – in other words, double non-taxation. While the schemes may be more elaborate, the outcome will always be similar: deduction/ no inclusion ("D./N.I.").

Both the O.E.C.D. and the E.U. have launched initiatives targeting these kinds of structures. 7 While the U.S. has been criticized for half-heartedly, if at all, embracing the O.E.C.D. initiative, hybrid arrangements and other schemes aimed at base erosion have been on the Treasury Department and the I.R.S.'s radar for a long time. 8 Undoubtedly, the O.E.C.D., the E.U., and the U.S. initiatives have influenced one another, and the U.S. regulations, in fact, defer to B.E.P.S. Action 2 in various places.

ANTI-HYBRID DIVIDEND RULES

Under the new rule, hybrid dividends received by U.S. companies that are U.S. Shareholders in a C.F.C. are denied the 100% dividend received deduction on the foreign-source portion of dividends under the new participation exemption as implemented by the T.C.J.A. Similarly, hybrid dividends received by a C.F.C. from a lower tier C.F.C. must be treated as Subpart F Income at the recipient C.F.C. level. A dividend is hybrid if the dividend received deduction of Code §245A(a) would otherwise be available but for the fact that the C.F.C. (or a related party) receives, or received, a deduction or similar benefit under the relevant foreign tax law with regard to the dividend. For this purpose, several provisions are significant:

  • The proposed regulations delineate relevant foreign tax law as any foreign regime that imposes an income, war profits, or excess profits tax with respect to income of the C.F.C. (other than a foreign anti-deferral regime under which an owner of the C.F.C. is liable to tax).9
  • Only deductions or other tax benefits that are "allowed" under the relevant foreign tax law are treated as hybrid deductions. Thus, payments that are disallowed as a deduction under foreign tax laws to prevent D./N.I. outcomes will not give rise to a hybrid deduction.10
  • The regulations provide that foreign rules similar to the U.S. foreign currency gain or loss rules must be taken into account when determining hybrid deduction amounts.
  • Dividend distributions among tiered C.F.C.'s, to the extent they would have constituted hybrid dividends had they been received by a domestic corporation, constitute "tiered hybrid dividends." In the case of a tiered hybrid dividend distributed by one C.F.C. to another C.F.C. that has the same corporate U.S. Shareholder,

    • the tiered dividend constitutes Subpart F Income of the receiving C.F.C.;
    • the U.S. Shareholder includes its pro-rata share of such Subpart F Income; and
    • foreign tax credits or deductions for foreign income taxes paid are denied to the U.S. Shareholder.
    This Subpart F inclusion is even harsher than an "ordinary" Subpart F inclusion (e.g., otherwise applicable Subpart F exceptions are disallowed and the current E&P limitation under Code §952(c) is absent).
  • The proposed regulations exclude distributions of previously-taxed earnings and profits ("P.T.E.P.") to U.S. Shareholders. Distributions of P.T.E.P. from a lower-tier C.F.C. to an upper-tier C.F.C. are also expressly excluded from the definition of tiered hybrid dividends. Technically, these dividends would have been included absent this express exclusion.11
  • The regulations introduce the hybrid deduction account ("H.D.A.") to address the potential difference in timing between when the U.S. considers an amount received and when foreign tax law allows the deduction. These events may occur at different times and, even, in different taxable years, which could result in a deduction being allowed for foreign tax law purposes without a matching dividend for U.S. tax purposes. Absent a dividend, the hybrid dividend rules would not be applicable. To resolve this issue, the proposed regulations provide that for each C.F.C. share that could trigger the application of the hybrid dividend rules, an H.D.A. must be maintained. This H.D.A. reflects the amount of hybrid deductions allowed to the C.F.C. and allocated to the specific share. Upon a dividend distribution, the dividend will be treated as a hybrid dividend or a tiered hybrid dividend to the extent of the shareholder's aggregate balance of the H.D.A. in the particular C.F.C. This, in turn, then triggers a corresponding decrease in the shareholder's H.D.A.'s.12
  • An obscure anti-avoidance rule is also provided for transactions entered into with "a principal purpose of avoiding the purposes of proposed §1.245A(e)-1."

Footnote

1 A U.S. Shareholder is defined as a U.S. person that owns shares of stock representing 10% or more of the total voting power of all stock or, as expanded under the T.C.J.A., the value of all shares of the foreign corporation.

2 A C.F.C. is a foreign corporation from the viewpoint of the U.S. for which more than 50% of its authorized and outstanding shares, measured by total voting power or value, is owned by U.S. Shareholders, as defined.

3 Code §245A(e).

4 Code §267A.

5 REG-104352-18. The proposed regulations contain effective dates that are tied to the date of publication in the Federal Register. They also propose modifications to the dual-consolidated loss ("D.C.L.") rules under Code §1503(d) and the check-the-box rules under Code §7701, as well as amendments to a number of tax reporting requirements under Code §§6038, 6038A, and 6038C.

6 This is consistent with the Senate Committee on Finance, Explanation of the Bill, at 384 (November 22, 2017).

7 B.E.P.S. Action 2; European Council Directive 2016/1164 ("A.T.A.D. 1"); and Council Directive amending Directive 2016/1164 ("A.T.A.D. 2"). A.T.A.D. 2, adopted on May 29, 2017, following the publication of the O.E.C.D.'s final report on B.E.P.S. Action 2, entirely replaces the hybrid mismatch rules of A.T.A.D. 1. It includes rules on hybrid mismatches with non-E.U. countries, where at least one of the parties involved is a corporate taxpayer, or an entity in an E.U. Member State. For a comparison of A.T.A.D. 1 and 2 with the new anti-hybrid transaction rule, see "Hybrid Mismatches: Where U.S. Tax Law and A.T.A.D. Meet," Insights 5, no. 8.

8 The new rules are, indeed, not the first set of rules under U.S. domestic tax law targeting hybrid transactions. Regulations under Code 894(c) designed to prevent taxpayers from using hybrid entities in a treaty context were already in place. Treas. Reg. §1.894-1(d) finalized July 2000. These rules were, however, limited to the eligibility of payments subject to U.S. withholding tax under an applicable income tax treaty.

9 Other than a foreign anti-deferral regime under which an owner of the C.F.C. is liable to tax.

10 This should avoid double-taxation if the dividend would be subjected to both the foreign hybrid mismatch rule and the U.S. anti-hybrid dividend rule.

11 Certain amounts treated as dividends under Code §1248 (e.g., from the sale of stock in a C.F.C. by a U.S. Shareholder) are also treated as hybrid dividends under the proposed regulations and are subject to the tiered hybrid dividend rules (see Prop. Treas. Reg. §§1.245A(e)-1(c)(1) and (4)).

12 Specific rules exist for transfers of stock-carrying H.D.A.'s and for certain Code §1248 dividends.

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