On April 7, 2020 the United States Treasury and the Internal Revenue Service released final and proposed regulations aimed at curbing hybrid mismatch arrangements. A hybrid mismatch occurs when a transaction is treated differently between countries and one of the main reasons of the transaction is to avoid taxes both in the foreign country and in the United States.
Rules preventing hybrid mismatch arrangements were part of the Organization for Economic Cooperation and Development’s (OECD) project to curb base erosion and profit shifting (BEPS). The 2017 Tax Cuts and Jobs Act (TCJA) implemented some of the OECD’s anti-hybrid guidance into the U.S. Internal Revenue Code.
Previous proposed regulations (REG-104352-18) were issued on December 28, 2018. These regulations, (at 217 pages) as amended by comments received, are now final effective as of the date of their publication in the Federal Register. These regulations provide guidance for IRC§§ 245A(e), 267A, 1503(d), 6038, 6038A, 6038C and 7701.
New proposed regulations (REG-106013-19) were also issued. These regulations are intended to provide “Guidance Involving Hybrid Arrangements and the Allocation of Deductions Attributable to Certain Disqualified Payments under Section 951A (Global Intangible Low-Taxed Income)”. These proposed Regulations encompass 59 pages of guidance.
What is a hybrid mismatch?
Entities may be classified differently in different countries. In addition, under U.S. tax law it may be possible to choose an entity classification under the U.S. “check-the-box” rules. For example, under U.S. tax law (absent an election under the “check-the-box” rules) a Limited Liability Company (LLC) is treated as disregarded entity for U.S. tax purposes. If the LLC is a single member entity it is taxed as a sole proprietorship. If it is a multi-member LLC, it is treated as a partnership for U.S. tax purposes. In the U.S., an LLC does not pay tax, the LLC members do.
Many foreign countries, however, treat an LLC as a corporation and the corporation would pay the tax. As such, we have a hybrid mismatch, a taxable entity in the foreign country and a disregarded entity in the U.S. Ultimately we have different taxpayers responsible for paying the tax.
Sophisticated tax planning has been undertaken to take advantage of this mismatch. Such planning would lead, for example, to deducting expenses twice (once in the foreign country and again in the United States) or the non-recognition of income. It is this type of planning that led to the OECD BEPS initiative, changes to the Internal Revenue Code, and the issuance of the Regulations. In general, the main rationale for these provisions, is that income needs to be taxed somewhere (either in the foreign country or in the United States).
An example
Assume that we have a U.S. domestic corporation that owns a controlled foreign corporation (CFC 1) in a high tax jurisdiction. As a “United States shareholder” (a defined term under the IRC), the U.S. domestic corporation would be subject to the U.S. subpart F provisions, GILTI and the deduction under IRC §245A (Deduction For Foreign Source-Portion Of Dividends Received By Domestic Corporations From Specified 10-Percent Owned Foreign Corporations).
Further assume that CFC1 creates a subsidiary, CFC 2, in another low tax jurisdiction. CFC 1 funds CFC 2 with 100% equity. CFC 1 then borrows the entire amount of funds which capitalized CFC 2. CFC 1 then pays interest to CFC 2 and deducts the interest expense in computing its taxable income under the laws of the country in which CFC 1 is resident. CFC 2 may or may not have taxable income depending on the laws of country 2.
If CFC 2 is or has elected to be a disregarded entity (under U.S. tax law), for U.S. tax purposes, this transaction is completed ignored as CFC2 would be considered to be a branch of CFC 1. If properly structured minimal or no foreign taxes may have been paid.
When CFC 1 then repatriates funds back to the U.S. parent (as a dividend), absent any anti-avoidance provisions, in general the dividend would not be taxable in computing U.S. taxable income.
The changes to the IRC and the Regulations aim to prevent this type of abuse. Such a dividend may be classified as a “hybrid dividend” or “tiered hybrid dividend” and would not be deductible in computing U.S. taxable income.
The above example is not meant to be definitive but is just meant to give the reader an idea of one area of potential abuse.
Why should I care?
When structuring U.S. inbound or outbound investments, it is important to understand the potential U.S. tax implications if entities are, are can be, treated differently in the foreign country and the United States. Failure to understand and plan accordingly can lead to unexpected and undesirable tax outcomes.
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