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Highlights of the Final and Proposed Regulations on Hybrid Transactions Issued by Treasury and the IRS on April 7, 2020

By: John V. Aksak Jason Carter |

On April 7, 2020, the US Treasury and IRS released final regulations (T.D.9896) (Final Regulations) and new proposed regulations (REG-106013-19) (Proposed Regulations) for hybrid transactions under §245A(e) and §267A of the Internal Revenue Code.  These transactions were addressed as part of the 2017 US tax reform legislation, referred to as the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97 enacted December 22, 2017).  According to the IRS, the Final Regulations retain the basic approach and structure of the Proposed Regulations, which were released on December 21, 2018 (Prior Regulations).

Please note that the Final and Proposed Regulations cover a significant number of complex issues.

This article will highlight several of the key issues addressed by the Final Regulations.  We will also cover key issues in the new guidance included in the Proposed Regulations.


The TCJA introduced two “anti-hybrid” rules that generally deny US tax deductions in certain cases involving entities and payments of interest, royalties, or dividends, if such entities or payments are treated differently under US and foreign tax laws and such different treatment results in double non-taxation.  These two rules are found in §§245A(e) and 267A.  These rules generally are intended to be consistent with the recommendations in the two final reports under Action 2 of the OECD Base Erosion and Profit Shifting project (BEPS) as noted in the legislative history to the TCJA.

  • 245A provides a participation exemption for certain domestic corporations that are shareholders of a foreign corporation. §245A(a) provides 100-percent dividends received deduction to domestic corporate shareholders for foreign-source dividends received from a 10-percent owned foreign corporation. In order to prevent double non-taxation, §245A(e) denies the dividends received deduction to the extent that the domestic corporate shareholder receives a “hybrid dividend” from the 10-percent owned foreign corporation.  A “hybrid dividend” is a payment that is a dividend for US tax purposes but gives rise to a deduction to the payer in its local country.  §245A(e) also requires a CFC to recognize subpart F income if it receives a hybrid dividend from a lower-tier foreign corporation.
  • 267A generally disallows a deduction in cases of outbound deductible interest or royalty payments paid to a related party where the related party recipient does not pay tax in its local country on the payment as a result of a hybrid or branch arrangement. Such cases are generally referred to as a deduction/no inclusion, or D/NI. A hybrid or branch arrangement exists where the interest or royalty payment is paid pursuant to a hybrid transaction (e.g., a repurchase agreement) or is paid to a hybrid entity (e.g., an entity that is fiscally transparent for US tax purposes but not for foreign tax purposes, or vice versa).

Final Regulations – §245A(e) & §267A

In the Preamble to the Final Regulations, the IRS states that multinational corporations (MNCs) that have operations in both the U.S. and foreign countries can engage in so-called “hybrid arrangements.”  In some instances, the MNC structures its U.S. and foreign operations in a way that exploits differences

between foreign tax rules and U.S. tax rules.  By using particular organizational structures or financial instruments, the MNC can avoid paying taxes in one or both jurisdictions.

The Final Regulations implement the hybrid dividend provisions of §245A(e) and the hybrid mismatch rules of §267A and provide guidance on determining and tracking hybrid dividends and the deductibility of interest or royalties paid as a result of hybrid or branch arrangements.   The new guidance largely adopts the framework of the Prior Regulations and generally retains the proposed applicability dates.  The hybrid dividend provisions apply to distributions made after December 31, 2017, and during taxable years ending on or after December 20, 2018.  The hybrid mismatch provisions generally apply to taxable years beginning after December 31, 2017 and ending after December 20, 2018, but certain other provisions have a later effective date.  Taxpayers may also apply the hybrid mismatch provisions in their entirety for taxable years beginning after December 31, 2017 and ending before December 20, 2018.  In lieu of applying the hybrid mismatch regulations, taxpayers may apply the prior proposed hybrid mismatch regulations for all taxable years ending on or before April 8, 2020.

In the Preamble, the IRS stated that they continue to study disregarded payment structures and may issue guidance addressing these structures in the future.  In addition, the IRS continues to study the comments received regarding the dual consolidated loss regulations.

Final Regulations – §245A(e)

The rule in §245A(e) denies the benefit of the §245A deduction to hybrid dividends.  For hybrid dividends, a separate “hybrid dividend account” is to be maintained for each share of stock of a CFC held by a US C corporation, directly or indirectly, but a new anti-duplication rule is intended to prevent double denial of deductions.  The Proposed Regulations (discussed below) would exclude from the hybrid dividend account an appropriate amount of subpart F income and global intangible low-taxed income (GILTI) and can be relied on before they are finalized.  The Final Regulations provide rules to ensure the preservation of hybrid deduction accounts when shares are transferred or CFCs are liquidated or combined.  The guidance also includes a broad anti-avoidance rule to prevent the hybrid deduction accounts from being eliminated or shifted in a manner that avoids the purposes of §245A(e).

Hybrid Deductions

Treasury and the IRS received various comments to the Prior Regulations with respect to the determination of whether, under foreign tax law, a “foreign deduction or other tax benefit” was received by the relevant CFC and would such amounts give rise to hybrid deductions.  The Final Regulations address the following:

  • No limitation to current year: Deductions or other tax benefits must be added to the hybrid deduction account even if they cannot be used currently and must be carried over to another period.
  • Coordination with foreign disallowance rules: Foreign tax law may suspend or otherwise disallow a given deduction or other tax benefit under a thin capitalization rule or a rule similar to 163(j).  The determination of whether a foreign deduction or other tax benefit is allowed to a CFC (or related person) is made without regard to foreign rules that disallow or suspend deductions if a certain ratio or percentage is exceeded.  Also, the rules confirm that whether a relevant foreign tax law allows a deduction or other tax benefit for an amount is determined without regard to the application of foreign hybrid mismatch rules, provided that the amount gives rise to a dividend for US tax purposes or is reasonably expected for US tax purposes to give rise to a dividend that will be paid within 12 months after the taxable period in which the deduction of other tax benefit would otherwise be allowed.
  • Notional interest deductions (NIDs): NIDs give rise to hybrid deductions, regardless of whether an actual payment, accrual or distribution occurs.  However, the Final Regulations provide that only NIDs allowed to a CFC for taxable years beginning on or after December 20, 2018 are hybrid deductions, which will allow taxpayers additional time to change NID structures.
  • Relevant foreign tax law: The term “relevant foreign tax law” is expanded to include tax law of a political subdivision of a foreign country if taxes imposed by the political subdivision are covered taxes under an income tax treaty with the US.

Hybrid Deduction Accounts

Treasury and the IRS retained the hybrid deduction account approach of the Prior Regulations, but they responded to some comments received with respect to the maintenance of hybrid deduction accounts as follows:

  • No maintenance of hybrid deduction account for technical CFCs: In cases where no domestic corporation owns, within the meaning of 958(a), stock in a CFC (a “Technical CFC” due to the repeal of §958(b)(4)), a tiered hybrid dividend would result in no meaningful US tax consequence because no US shareholder would have a subpart F inclusion.
  • Section 355 transaction: The allocation of a shareholder’s hybrid deduction account with respect to a distributing CFC is required to be in a manner consistent with how the earnings and profits of the distributing CFC are allocated between the distributing CFC and controlled CFC.
  • Anti-duplication rules: An anti-duplication rule is adopted to address cases in which a liquidation of a lower-tier CFC into an upper-tier CFC would in effect result in a duplication of hybrid deductions.  This rule is intended to ensure that when deductions or other tax benefits under a relevant foreign tax law are in effect duplicated at different tiers, the deductions or other tax benefits only give rise to a hybrid deduction of the higher-tier CFC.

Miscellaneous Issues

  • Anti-avoidance rule: Treasury and the IRS did not agree to limit the anti-avoidance rule to transactions or arrangements with related parties. The Final Regulations do state, however, that the anti-avoidance rule does not apply to disregard or recast a restructuring of a hybrid instrument into a non-hybrid instrument even though it avoids the application of 245A(e) going forward.


Final Regulations – §267A

  • 267A denies a deduction for interest and royalties paid or accrued by a US tax resident, CFC or US taxable branch in cases where there is no inclusion of the payment in income by the recipient and the no-inclusion results from the hybrid character of the transaction or the hybrid classification of the participating entities. Specified payments are not deductible if they fall into one of three categories: disqualified hybrid amounts, disqualified imported mismatch amounts, and specified payments subject to an anti-avoidance rule. For example, there is a mismatch where an interest payment by a US corporation to a foreign related corporation leads to a dividend payment by the foreign related corporation to a third-country foreign parent with neither of the latter two corporations being taxed on the interest payment or the dividend.

The Final Regulations identify several types of disqualified hybrid amounts and the conditions under which interest or royalties paid or accrued under agreements without any hybrid features can be changed into imported mismatch amounts when the income of the recipient is offset, directly or indirectly, by a hybrid deduction arising from a transaction involving a related party.

The Final Regulations are aligned closely with the Prior Regulations and follow the position that the scope of the 267A rules is limited to neutralizing deduction/no inclusion (D/NI) outcomes that are attributable to hybrid instruments and/or hybrid entities – and are not designed to neutralize all D/NI outcomes that may arise in cross-border transactions that are attributable to non-hybrid factors.

According to the Preamble, Treasury and the IRS received many comments on the Prior Regulations, and, in response,  the Final Regulations make numerous changes that clarify, narrow, or in some specific cases, expand the scope of the Prior Regulations, although not all stakeholder comments led to changes.

Inclusions & Non-Inclusions 

  • Reasonable expectation for long-term deferral: The Final Regulations retain the 36-month window in which income must be included by the specified recipient in order to avoid a D/NI outcome.  In response to taxpayer comments, however, a reasonable expectation standard is adopted under which it is reasonable to expect, at the time of the specified payment, that the specified payment will be included in income within 36 months.
  • Recovery of basis or principal: The treatment of a specified payment as a recovery of basis or principal in the recipient’s country can cause or create a D/NI outcome.  A special rule provides that a specified recipient’s no-inclusion with respect to a specified payment is reduced by certain amounts that are repayments of principal for US tax purposes but included in income by the specified recipient.

Hybrid Transactions

The Prior Regulations set forth and defined five types of arrangements that may give rise to a disqualified hybrid amount with respect to a D/NI outcome including: (1) hybrid transactions; (2) disregarded payments; (3) deemed branch payments; (4) payments to reverse hybrids; and (5) branch mismatch payments.  The Final Regulations retain the framework and operative rules but make certain modifications with some taxpayer-favorable rules.

  • Interest-free loans: An interest-free loan is treated as a hybrid transaction.  Thus, where a specified payment is made with respect to an interest-free loan and the payor jurisdiction deems a portion of the payment to be interest, but the jurisdiction of the specified recipient does not treat such payment as interest, the regulations disallow a deduction.
  • Hybrid sale/license transactions: There is an exemption for transactions treated as a sale in one country and as a license in the other country from the hybrid transaction rule, recognizing that the overall tax consequences of sale treatment and license treatment are generally not very different.  Note, however, that a sale/license transaction can still be considered as giving rise to no-inclusion under Treas. Reg. 1.267A-3(a) and thus is within the scope of the general anti-avoidance rule under Treas. Reg. §1.267A-5(b)(6).
  • Reverse Hybrids: The Prior Regulations provided that when a specified payment is made to a reverse hybrid (i.e., an entity that is fiscally transparent under the tax law of the country in which it is established but not fiscally transparent under the tax law of an investor in the entity), it generally is a disqualified hybrid amount to the extent that an investor does not include the payment in income without regard to a subsequent distribution by the reverse hybrid.  The Final Regulations add that to the extent the reverse hybrid distributes all of its income during a tax year and an investor includes in income such current-year distribution, the investor is treated as including in income a corresponding portion of the specified payment made to the reverse hybrid during that specific year.  There is a special rule included that is directed at certain collective investment vehicles, according to the Preamble.

Imported Mismatches

The imported mismatch rules address offshore hybrid arrangements that are funded by or connected to an otherwise deductible payment arising within the United States and are intended to prevent a hybrid arrangement from being imported into the US through the use of non-hybrid arrangements.  The Final Regulations follow the framework of the Prior Regulations while providing several clarifications that are intended to facilitate compliance and administration of the rules.

  • Foreign hybrid mismatch rules: For a deduction allowed to a tax resident or taxable branch under its tax law to be a hybrid deduction, it generally must be one that would be disallowed if the relevant foreign tax law contained rules similar to the 267A regulations.  In order to better coordinate with foreign hybrid mismatch rules, the Final Regulations provide that when the existence of a hybrid deduction is being tested under the laws of a foreign country that has its own hybrid mismatch rules, only the following deductions will be treated as hybrid deductions:  deductions with respect to (1) equity, (2) interest-free loans, and (3) amounts that are not included in income in a third foreign country.
  • Notional Interest Deductions (NIDs): The general approach of the Prior Regulations is retained, which finds that NIDs may constitute a hybrid deduction, but the Final Regulations only apply to NIDs allowed for an accounting period beginning on or after December 20, 2018.  Also, NIDs are considered hybrid deductions only to the extent that the double non-taxation produced by the NIDs is a result of hybridity, consistent with other aspects of the 267A regulations.
  • Hybrid Deductions of CFCs: Under the Prior Regulations, only a tax resident or taxable branch that is not a specified party can incur a hybrid deduction.  This meant that a CFC that is partially owned by a US shareholder, by definition, would not have been subject to the imported mismatch rules if that US shareholder made a specified payment to the CFC.  The Final Regulations provide that CFCs can incur hybrid deductions.  To prevent double taxation, however, a payment by a CFC does not give rise to a hybrid deduction to the extent that the payment gives rise to an increase in the US tax base.

Miscellaneous Issues

  • Definition of Interest: Under the Prior Regulations, interest was broadly defined to include not only the types of amounts that generally are treated as interest for US tax purposes, but also other payments that are not interest but that either are economically similar thereto or otherwise are costs that taxpayers may incur when borrowing money.  This definition is in line with the broad definition of interest in the 163(j) proposed regulations (which have not yet been finalized).  The Final Regulations narrow the definition of interest to generally include only the types of payments that generally are treated as interest for US federal income tax purposes.  Also included is an anti-abuse rule that would treat amounts that are economically equivalent to interest as interest if a principal purpose of structuring a transaction is to reduce an amount incurred by the taxpayer that otherwise would have been treated as interest.  The Preamble states that the definition of interest was narrowed for purposes of these Final Regulations in response to comments received with respect to the 163(j) guidance.
  • Structured Arrangements: The definition of a structured arrangement is modified to include a reason-to-know test and a principal purpose test.

2020 Proposed Regulations: §245A(e), §881 & §951A

The Proposed Regulations provide for adjustments in hybrid deduction accounts, expand the types of equity interests treated as financing transactions with respect to the conduit financing rules under §881, and address the treatment of some payments between related CFCs during a GILTI “disqualified period” (the period between January 1, 2018 through the first day of the recipient CFC’s first GILTI inclusion year).

  • 245A(e)

In order to avoid double taxation, the Proposed Regulations provide new rules that allow taxpayers to reduce hybrid deduction accounts for the following three categories of CFC earnings included in the income of a US shareholder:

  1. Adjusted subpart F inclusions
  2. Adjusted GILTI inclusions
  3. 956 inclusions (earnings from investments in US property) to the extent the inclusion results from applying §245A(e) to a hypothetical distribution described in Treas. Reg. §1.956-1(a)(2).

To help ensure that the reductions for subpart F and GILTI are equivalent to the effective rate at which the US shareholder is subject to tax on these items, the amount of the reduction for these inclusions are adjusted to account for the impact of foreign tax credits, §78 deemed dividend income, and §250 deductions related to GILTI.

  • 881/Anti-Conduit Rules

Generally, holding an equity interest does not constitute a financing transaction for purposes of the anti-conduit rules under Treas. Reg. §1.881-3 unless such equity qualifies as ‘redeemable equity’, which means stock in a corporation (or a similar interest in a partnership, trust, or other person) that is subject to certain redemption, acquisition, or payment rights or requirements.

The Proposed Regulations create two new categories of equity that constitute a financing transaction:

  1. The issuer is allowed a tax benefit (i.e., a deduction) for an amount paid, accrued or distributed with respect to such interest (or deemed paid) either under the laws of the issuer’s country of residence or a country in which the issuer has a taxable presence (e.g., a permanent establishment); or
  2. A person related to the issuer is allowed a refund (including a credit) or similar tax benefit for taxes paid by the issuer to its country of residence, without regard to the related person’s tax liability under the laws of the issuer.

The Preamble states that even if these rules cause an entity to be treated as an intermediate entity in a financing arrangement, the intermediate entity will not be a conduit entity unless it satisfies the tax avoidance test or tax reduction test provided under Treas. Reg. §1.881-3(a)(4)(i).

  • 951A/GILTI Rules

The final GILTI regulations included rules that would disregard any deduction or loss attributable to disqualified basis in specified property resulting from the transfer of the property to a related party during the disqualified period and would require deductions attributable to disqualified basis to be allocated and apportioned to residual income.

In these Proposed Regulations, Treasury and the IRS state that these rules should be extended to cover other transactions for which similar timing differences can arise.  Thus, the rules require that all deductions attributable to payments to a related CFC during the disqualified period should be allocated and apportioned to residual income consistent with the asset transfer rules under the final GILTI regulations.

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