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Firm Seeks Exclusion From Hybrid Deduction Category

FEB. 26, 2019

Firm Seeks Exclusion From Hybrid Deduction Category

DATED FEB. 26, 2019
DOCUMENT ATTRIBUTES

February 26, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Lafayette G. "Chip" Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Douglas L. Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Request for Guidance on Treatment of Notional Interest Deductions For Purposes of Rules Regarding Certain Hybrid Arrangements (REG-104352-18)

Dear Sirs:

We offer the following comments and requests for guidance related to the Notice of Proposed Rulemaking on the Rules Regarding Certain Hybrid Arrangements (the "Proposed Regulations"). We request guidance with respect to the treatment of "notional interest deductions" for purposes of the application of the rules of sections 245A(e) and 267A of the Internal Revenue Code of 1986, as amended (the "Code").1 The Proposed Regulations suggest that a notional interest deduction is always a "deduction with respect to equity" that is treated as a "hybrid deduction" for purposes of applying the rules of section 245A(e) and the proposed imported mismatch rules under section 267A. We commend the efforts of the Department of the Treasury ("Treasury") and the Internal Revenue Service ("IRS") to address international concerns regarding hybrid arrangements used to achieve double non-taxation; however, we do not believe that the proposed treatment of notional interest deductions as hybrid arrangements for this purpose furthers the policy objectives. Accordingly, we request that

1. The Proposed Regulations be revised to exclude "notional interest deductions" from treatment as "hybrid deductions" under Prop. Treas. Reg. § 1.245A(e)-1(d)(2) and Prop. Treas. Reg. § 1.267A-4(b).

2. Alternatively, the Proposed Regulations should be clarified such that only "notional interest deductions" that require the taxpayer to make a payment in order to claim the deduction are treated as giving rise to "hybrid deductions."

3. Alternatively, the Proposed Regulations should be amended to provide that "hybrid deductions" do not include notional interest deductions allowed by a jurisdiction that has a comprehensive income tax treaty with the United States.

I. The Proposed Regulations Should Be Amended to Remove References to Notional Interest Deductions as Hybrid Deductions

As recognized in the preamble to the Proposed Regulations, the legislative history to section 267A explains Congress's intent that section 267A would be interpreted consistent with the approach to addressing hybrid arrangements taken in, among other things, the Base Erosion and Profit Shifting Project ("BEPS") of the Organisation for Economic Co-operation and Development ("OECD").2 In this regard, the OECD, in its report on hybrid mismatch arrangements, stated that:

Rules that entitle taxpayers to a unilateral tax deduction for invested equity without requiring the taxpayer make a payment, such as regimes that grant deemed interest deductions for equity capital, are economically closer to a tax exemption or similar taxpayer specific concessions and do not produce a mismatch in tax outcomes in the sense contemplated by Action 2.3

The above conclusion reflects the fact that notional interest deductions are used by a number of jurisdictions to achieve legitimate tax policy objectives.4

Notional interest deduction regimes are used to combat the excessive use of debt in corporate structures, and eliminate incentives for debt financing over equity financing.5 They reflect a tax policy decision by the taxing authority, generally to encourage investment in the taxing jurisdiction. The European Commission recognizes that properly structured notional interest deduction regimes may reduce the "debt bias" in corporate taxation, which contributes to financial stability risks. Accordingly, the European Commission's proposals for a common consolidated tax base include a notional interest deduction in the form of an "Allowance for Growth and Investment" ("AGI"). The AGI is a deduction for companies that choose to finance new business activities through equity instead of debt, i.e., a notional interest deduction.6

The design principles in Chapter 9 of the OECD Report recognize the importance of avoiding double taxation through rule coordination and consistent application of the rules.7 The treatment of notional interest deductions as "hybrid deductions" in the Proposed Regulations, while many countries and the European Commission are encouraging notional interest deductions to support policy objectives as described above, does not further cooperation and, therefore, is in conflict with the design principles in the OECD Report.8 In order to ensure consistency and coordination in the application of anti-hybrid rules, and avoid double taxation, the Proposed Regulations should be amended such that notional interest deductions are not treated as "hybrid deductions."

In light of the policy objectives that underlie notional interest deduction regimes, and in the interest of ensuring sound tax administration and avoiding double taxation, notional interest deductions should not be treated as "hybrid deductions." Accordingly, Prop. Treas. Reg. §1.245A(e)-1(d)(2)(i)(B) should be amended to remove the reference to a notional interest deduction; Prop. Treas. Reg. §1.245A(e)-1(g)(1)(iii) should be deleted; Prop. Treas. Reg. § 1.267A-4(b) should be amended by deleting the second sentence thereof; and Prop. Treas. Reg. § 1.267A-6(c)(8)(iv) should be deleted. The proposed amendments are reflected in Appendix 1.

II. Alternatively, Final Regulations Should Clarify that Notional Interest Deductions Include Only Deductions with Respect to Amounts Paid, Accrued or Distributed with Respect to an Equity Instrument

Prop. Treas. Reg. § 1.245A(e)-1(d)(2) defines "hybrid deduction" of a CFC as a deduction or other tax benefit that (i) is allowed to the CFC or a related person under foreign tax law and (ii)

relates to or results from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC and treated as stock for U.S. tax purposes. Examples of such a deduction or other tax benefit include an interest deduction, a dividends paid deduction, and a deduction with respect to equity (such as a notional interest deduction). . . . However, a deduction or other tax benefit relating to or resulting from a distribution by the CFC with respect to an instrument treated as stock for purposes of the relevant foreign tax law is considered a hybrid deduction only to the extent that it has the effect of causing the earnings that funded the distribution to not be included in income (determined under the principles of § 1.267A-3(a)) or otherwise subject to tax under the CFC's tax law. Thus, for example, a refund to a shareholder of a CFC (including through a credit), upon a distribution by the CFC to the shareholder, of taxes paid by the CFC on earnings that funded the distribution results in a hybrid deduction of the CFC, but only to the extent that the shareholder, if tax resident of the CFC's country, does not include the distribution in income under the CFC's tax law or, if not a tax resident of the CFC's country, is not subject to withholding tax . . . on the distribution under the CFC's tax law9.

It is implicit from the italicized,language above that deductions are treated as "hybrid deductions" for this purpose only if they relate to an "amount paid, accrued or distributed." Such a reading is consistent with the scope of section 245A(e)(4), which limits the definition of "hybrid dividend" to amounts paid by a CFC "for which the controlled foreign corporation received a deduction (or other tax benefit)" under applicable local tax law.

On the plain language of the regulation, it appears that a notional interest deduction that is determined by reference to equity invested, without regard to whether any amounts are paid, accrued or distributed to the entity's shareholders, therefore, should not be treated as a hybrid deduction. Nevertheless, the example in Prop. Treas. Reg. § 1.245A(e)-1(g)(1)(iii) suggests that the notional interest deduction is a hybrid deduction, regardless of whether a distribution is required to be made in order to claim the notional interest deduction. And, Prop. Treas. Reg. § 1.267A-4(b) refers to a notional interest deduction that is "allowed," not necessarily paid or accrued.

In the absence of a payment, accrual or distribution, the hybrid arrangement that is prerequisite to the application of section 267A is not present. As discussed above, the OECD Report recognizes that notional interest deductions that do not depend on a payment, accrual or distribution reflect economic policy decisions and do not give rise to the mismatches that occur with hybrid arrangements. Accordingly, if the references to notional interest deductions are to be retained, they should be clarified to reflect that notional interest deductions are treated as "hybrid deductions" only where they arise from the payment, accrual or distribution of an amount with respect to stock by the entity claiming the deduction. Amendments to the Proposed Regulations to accomplish this result are attached as Appendix 2. Only under those circumstances is there a hybrid transaction that potentially implicates the application of section 245A(e) or section 267A.

III. Alternatively, the Proposed Regulations Should Be
Amended to Provide that Hybrid Deductions Do Not Include Notional Interest Deductions Allowed by a Treaty Jurisdiction

The denial of deductions for interest or royalties paid to a resident of a jurisdiction that has a notional interest deduction regime is economically equivalent to the imposition of a U.S. tax on the recipient, in contravention of the intent of U.S. income tax treaties. Under the income tax treaty between the United States and Belgium, for example, U.S. source interest paid to a Belgian resident generally is taxable only in Belgium.10 The U.S.-Belgium Treaty further provides with limited exception that interest paid by a resident of the United States to a resident of Belgium shall, for the purposes of determining the taxable profits of the payor, "be deductible under the same conditions as if they had been paid to a resident of the United States."11

The Proposed Regulations provide that a deduction is disallowed under section 267A for a specified payment that is a "disqualified imported mismatch amount," as described in Prop. Treas. Reg. § 1.267A-4.12 A specified payment is treated as a disqualified imported mismatch amount to the extent that "the income attributable to the payment is directly or indirectly offset by a hybrid deduction incurred by a tax resident or taxable branch that is related to the specified party."13 The Proposed Regulations further provide that

A hybrid deduction means, with respect to a tax resident or taxable branch that is not a specified party, a deduction allowed to the tax resident or taxable branch under its tax law for an amount paid or accrued that is interest . . . or royalty under such tax law (regardless of whether or how such amounts would be recognized under U.S. law), to the extent that a deduction for the amount would be disallowed if such tax law contained rules substantially similar to those under 1.267A-1 through 1.267A-3 and 1.267A-5. In addition, with respect to a tax resident that is not a specified party, a hybrid deduction includes a deduction allowed to the tax resident with respect to equity, such as a notional interest deduction.14

A "specified party" is a tax resident of the United States, a CFC (other than a CFC in which there is not a United States shareholder within the meaning of section 958(a)), and a U.S. taxable branch.15

If the Proposed Regulations are finalized in their current form, because Belgium has a notional interest deduction, interest paid by a United States corporation to a related Belgian entity may be treated as a disqualified imported mismatch amount, resulting in the denial of a U.S. tax deduction for such interest under section 267A. This is in direct conflict with the requirements of Article 23 of the U.S.-Belgium Treaty, which requires that interest paid by a U.S. resident to a resident of Belgium be deductible in the United States under the same conditions as if it were paid to a resident of the United States.

In light of the foregoing, if the references to notional interest deductions in the Proposed Regulations are retained in the final regulations, the final regulations should be amended to ensure that payments made to a resident of a jurisdiction with which the United States has a comprehensive income tax treaty are not treated as "hybrid deductions" as a result of notional interest deductions. This will avoid conflicts with existing U.S. treaties, and is consistent with the focused policy approach with respect to notional interest deductions in the U.S. Model Treaty, as described below. A proposed amendment to Prop. Treas. Reg. § 1.267A-4 that would accomplish this objective is attached as Appendix 3.

The provisions of the 2016 United States Model Income Tax Convention (U.S. Model Treaty") support the conclusion that the treatment of notional interest deductions is better left to more focused discussions between the United States and its treaty partners. The U.S. Model Treaty would deny the benefits of Article 11 to interest where the recipient benefits from "notional deductions with respect to amounts that the Contracting State of which the beneficial owner is resident treats as equity.16 The preamble to the U.S. Model Treaty explains that this change from the prior model treaty, which referred to special tax regimes but not specifically notional interest deductions

represents a more focused approach to addressing the policy concern that interest income that benefits from a NID is often subject to no or very little tax because (i) a NID, in effect, allows for a deduction on equity with respect to the time value of money, which is a very significant component of interest income, and (ii) in the related-party context, the holder of the equity often benefits from a participation exemption with respect to any returns on that equity.17

In the treaty context, the policy objectives underlying a notional interest deduction can be balanced with the aforementioned policy concerns, and the interests of the United States protected through the imposition of withholding taxes where appropriate.

If you have any questions, please feel free to contact me.

Robert S. Chase II
Eversheds Sutherland (US) LLP
Washington, DC


 Appendix 1 — Proposed Amendments to Remove References to Notional Interest Deductions

Revised § 1.245A(e)-1(d)(2)(i)(B):

The deduction or other tax benefit relates to or results from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC and treated as stock for U.S. tax purposes. Examples of such a deduction or other tax benefit include an interest deduction; or a dividends paid deduction,  and a deductions with respect to equity (such as a notional interest deduction). See paragraph (g)(1) of this section. However, a deduction or other tax benefit relating to or resulting from a distribution by the CFC with respect to an instrument treated as stock for purposes of the relevant foreign tax law is considered a hybrid deduction only to the extent it has the effect of causing the earnings that funded the distribution to not be included in income (determined under the principles of §1.267A-3(a)) or otherwise subject to tax under the CFC's tax law. Thus, for example, a refund to a shareholder of a CFC (including through a credit), upon a distribution by the CFC to the shareholder, of taxes paid by the CFC on the earnings that funded the distribution results in a hybrid deduction of the CFC, but only to the extent that the shareholder, if a tax resident of the CFC's country, does not include the distribution in income under the CFC's tax law or, if not a tax resident of the CFC's country, is not subject to withholding tax (as defined in section 901(k)(1)(B)) on the distribution under the CFC's tax law. See paragraph (g)(2) of this section.

Revised § 1.245A(e)-1(g)(1)(iii):

Alternative facts — notional interest deductions. The facts are the same as in paragraph (g)(1)(i) of this section, except that for each of year 1 and year 2 FX is allowed $10x of notional interest deductions with respect to its equity, Share B, under Country X tax law (the "NIDs"). In addition, during year 2, FX distributes $47.5x (rather than $30x) to US1 with respect to each of Share A and Share B. For U.S. tax purposes, each of the $47.5x distributions is treated as a dividend for which, but for section 245A(e) and this section, US1 would be allowed a deduction under section 245A(a). For Country X tax purposes, the $47.5x distribution with respect to Share A represents a payment of interest for which a deduction was already allowed (and thus FX is not allowed an additional deduction for the amount), and the $47.5x distribution with respect to Share B is treated as a dividend (for which no deduction is allowed). The entire $47.5x of each dividend received by US1 from FX during year 2 is a hybrid dividend, because the sum of US1's hybrid deduction accounts with respect to each of its shares of FX stock at the end of year 2 ($80x plus $20x, or $100x) is at least equal to the amount of the dividends ($95x). See paragraph (b)(2) of this section. As a result, US1 is not allowed a deduction under section 245A(a) for the $95x hybrid dividend and the rules of section 245A(d) (disallowance of foreign tax credits and deductions) apply. See paragraph (b)(1) (of this section. Paragraphs (g)(1)(iii)(A) through (D) of this section describe the determinations under this section.

(A) The $10x of NIDs allowed to FX under Country X tax law in year 1 are hybrid deductions of FX for year 1. See paragraph (d)(2)(i) of this section. The $10x of NIDs is allocated equally to each of Share A and Share B, because the hybrid deduction is with respect to equity and the shares have an equal value. See paragraph (d)(3) of this section. Thus, $5x of the NIDs is allocated to each of Share A and Share B for year 1. For the reasons described in paragraph (g)(1)(ii)(A) of this section, the entire $80x Hybrid Instrument Deduction is allocated to Share A. Therefore, at the end of year 1, US1's hybrid deduction accounts with respect to Share A and Share B are $85x and $5x, respectively.

(B) Similarly, the $10x of NIDs allowed to FX under Country X tax law in year 2 are hybrid deductions of FX for year 2, and $5x of the NIDs is allocated to each of Share A and Share B for year 2. See paragraphs (d)(2)(i) and (d)(3) of this section. Thus, at the end of year 2 (and before the adjustments described in paragraph (d)(4)(i)(B) of this section), US1's hybrid deduction account with respect to Share A is $90x ($85x plus $5x) and with respect to Share B is $10x ($5x plus $5x). See paragraph (d)(4)(i) of this section.

(C) Because at the end of year 2 (and before the adjustments described in paragraph (d)(4)(i)(B) of this section) the sum of US1's hybrid deduction accounts with respect to Share A and Share B ($100x, calculated as $90x plus $10x) is at least equal to the aggregate $95x of year 2 dividends, the entire $95x of dividends are hybrid dividends. See paragraph (b)(2) of this section.

(D) At the end of year 2, US1's hybrid deduction accounts with respect to Share A and Share B are decreased by the amount of hybrid deductions in the accounts that gave rise to a hybrid dividend or tiered hybrid dividend during year 2. See paragraph (d)(4)(i)(B) of this section. A total of $95x of hybrid deductions in the accounts gave rise to a hybrid dividend during year 2. For the hybrid deduction account with respect to Share A, $85.5x in the account is considered to have given rise to a hybrid deduction (calculated as $95x multiplied by $90x/$100x). See id. For the hybrid deduction account with respect to Share B, $9.5x in the account is considered to have given rise to a hybrid deduction (calculated as $95x multiplied by $10x/$100x). See id. Thus, following these adjustments, at the end of year 2, US1's hybrid deduction account with respect to Share A is $4.5x ($90x less $85.5x) and with respect to Share B is $0.5x ($10x less $9.5x).

Revised § 1.267A-4(b):

Hybrid deduction. A hybrid deduction means, with respect to a tax resident or taxable branch that is not a specified party, a deduction allowed to the tax resident or taxable branch under its tax law for an amount paid or accrued that is interest (including an amount that would be a structured payment under the principles of § 1.267A-5(b)(5)(ii)) or royalty under such tax law (regardless of whether or how such amounts would be recognized under U.S. law), to the extent that a deduction for the amount would be disallowed if such tax law contained rules substantially similar to those under §§ 1.267A-1 through 1.267A-3 and 1.267A-5. In addition, with respect to a tax resident that is not a specified party, a hybrid deduction includes a deduction allowed to the tax resident with respect to equity, such as a notional interest deduction. Further, a hybrid deduction for a particular accounting period includes a loss carryover from another accounting period, to the extent that a hybrid deduction incurred in an accounting period beginning on or after December 20, 2018 comprises the loss carryover.

Revised § 1.267A-6(c)(8)(iv)

Alternative facts — notional interest deduction. The facts are the same as in paragraph (c)(8)(i) of this section, except that the FX-FW instrument does not exist and thus FW does not pay any amounts to FX during accounting period 1. However, during accounting period 1, FW is allowed a $100x notional interest deduction with respect to its equity under Country W tax law. Pursuant to § 1.267A-4(b), FW's notional interest deduction is a hybrid deduction. The results are the same as in paragraph (c)(8)(ii) of this section. That is, the income attributable to US1's $100x imported mismatch payment is offset by FW's hybrid deduction for the reasons described in paragraph (c)(8)(ii) of this section. As a result, a deduction for the payment is disallowed under § 1.267A-1(b)(2).


Appendix 2 — Proposed Amendments to Clarify that Notional Interest Deductions are Hybrid Deductions Only If They Are With Respect to Amounts Paid, Accrued or Distributed

Revised § 1.245A(e)-1(d)(2)(i)(B):

The deduction or other tax benefit relates to or results from an amount paid, accrued, or distributed with respect to an instrument issued by the CFC and treated as stock for U.S. tax purposes. Examples of such a deduction or other tax benefit include an interest deduction, a dividends paid deduction, and a deduction with respect to a payment, accrual or distribution with respect to equity (such as a notional interest deduction). See paragraph (g)(1) of this section. However, a deduction or other tax benefit relating to or resulting from a distribution by the CFC with respect to an instrument treated as stock for purposes of the relevant foreign tax law is considered a hybrid deduction only to the extent it has the effect of causing the earnings that funded the distribution to not be included in income (determined under the principles of §1.267A-3(a)) or otherwise subject to tax under the CFC's tax law. Thus, for example, a refund to a shareholder of a CFC (including through a credit), upon a distribution by the CFC to the shareholder, of taxes paid by the CFC on the earnings that funded the distribution results in a hybrid deduction of the CFC, but only to the extent that the shareholder, if a tax resident of the CFC's country, does not include the distribution in income under the CFC's tax law or, if not a tax resident of the CFC's country, is not subject to withholding tax (as defined in section 901(k)(1)(B)) on the distribution under the CFC's tax law. See paragraph (g)(2) of this section.

Revised § 1.245A(e)-1(g)(1)(iii):

Alternative facts — notional interest deductions. The facts are the same as in paragraph (g)(1)(i) of this section, except that for each of year 1 and year 2 FX is allowed $120x of notional interest deductions with respect to payments made with respect to its equity, Share B, under Country X tax law (the "NIDs"). In addition, during year 2, FX distributes $47.5x (rather than $30x) to US1 with respect to each of Share A and Share B. For U.S. tax purposes, each of the $47.5x distributions is treated as a dividend for which, but for section 245A(e) and this section, US1 would be allowed a deduction under section 245A(a). For Country X tax purposes, the $47.5x distribution with respect to Share A represents a payment of interest for which a deduction was already allowed (and thus FX is not allowed an additional deduction for the amount), and the $47.5x distribution with respect to Share B is treated as a dividend (for which nothe $20x deduction is allowed). The entire $47.5x of each dividend received by US1 from FX during year 2 is a hybrid dividend, because the sum of US1's hybrid deduction accounts with respect to each of its shares of FX stock at the end of year 2 ($80x plus $20x, or $100x) is at least equal to the amount of the dividends ($95x). See paragraph (b)(2) of this section. As a result, US1 is not allowed a deduction under section 245A(a) for the $95x hybrid dividend and the rules of section 245A(d) (disallowance of foreign tax credits and deductions) apply. See paragraph (b)(1) of this section. Paragraphs (g)(1)(iii)(A) through (D) of this section describe the determinations under this section.

(A) The $10x of NIDs allowed to FX under Country X tax law in year 1 are hybrid deductions of FX for year 1. See paragraph (d)(2)(i) of this section. The $10x of NIDs is allocated equally to each of Share A and Share B, because the hybrid deduction is with respect to equity and the shares have an equal value. See paragraph (d)(3) of this section. Thus, $5x of the NIDs is allocated to each of Share A and Share B for year 1. For the reasons described in paragraph (g)(1)(ii)(A) of this section, the entire $80x Hybrid Instrument Deduction is allocated to Share A. Therefore, at the end of year 1, US1's hybrid deduction accounts with respect to Share A and Share B are $85x and $05x, respectively.

(B) Similarly, tThe $120x of NIDs allowed to FX under Country X tax law in year 2 are hybrid deductions of FX for year 2, and $510x of the NIDs is allocated to each of Share A and Share B for year 2. See paragraphs (d)(2)(i) and (d)(3) of this section. Thus, at the end of year 2 (and before the adjustments described in paragraph (d)(4)(i)(B) of this section), US1's hybrid deduction account with respect to Share A is $90x ($850x plus $510x) and with respect to Share B is $10x ($5x plus $5x). See paragraph (d)(4)(i) of this section.

(C) Because at the end of year 2 (and before the adjustments described in paragraph (d)(4)(i)(B) of this section) the sum of US1's hybrid deduction accounts with respect to Share A and Share B ($100x, calculated as $90x plus $10x) is at least equal to the aggregate $95x of year 2 dividends, the entire $95x of dividends are hybrid dividends. See paragraph (b)(2) of this section.

(D) At the end of year 2, US1's hybrid deduction accounts with respect to Share A and Share B are decreased by the amount of hybrid deductions in the accounts that gave rise to a hybrid dividend or tiered hybrid dividend during year 2. See paragraph (d)(4)(i)(B) of this section. A total of $95x of hybrid deductions in the accounts gave rise to a hybrid dividend during year 2. For the hybrid deduction account with respect to Share A, $85.5x in the account is considered to have given rise to a hybrid deduction (calculated as $95x multiplied by $90x/$100x). See id. For the hybrid deduction account with respect to Share B, $9.5x in the account is considered to have given rise to a hybrid deduction (calculated as $95x multiplied by $10x/$100x). See id. Thus, following these adjustments, at the end of year 2, US1’s hybrid deduction account with respect to Share A is $4.5x ($90x less $85.5x) and with respect to Share B is $0.5x ($10x less $9.5x).

Revised § 1.267A-4(b):

Hybrid deduction. A hybrid deduction means, with respect to a tax resident or taxable branch that is not a specified party, a deduction allowed to the tax resident or taxable branch under its tax law for an amount paid or accrued that is interest (including an amount that would be a structured payment under the principles of § 1.267A-5(b)(5)(ii)) or royalty under such tax law (regardless of whether or how such amounts would be recognized under U.S. law), to the extent that a deduction for the amount would be disallowed if such tax law contained rules substantially similar to those under §§ 1.267A-1 through 1.267A-3 and 1.267A-5. In addition, with respect to a tax resident that is not a specified party, a hybrid deduction includes a deduction allowed to the tax resident with respect to an amount paid, accrued or distributed with respect to an instrument treated as equity, such as a notional interest deduction. Further, a hybrid deduction for a particular accounting period includes a loss carryover from another accounting period, to the extent that a hybrid deduction incurred in an accounting period beginning on or after December 20, 2018 comprises the loss carryover.

Revised § 1.267A-6(c)(8)(iv)

Alternative facts — notional interest deduction. The facts are the same as in paragraph (c)(8)(i) of this section, except that the FX-FW instrument does not exist and thus FW does not pay any amounts to FX during accounting period 1. However, during accounting period 1, FW is allowed a $100x notional interest deduction with respect to a distribution with respect to its equity under Country W tax law. Pursuant to § 1.267A-4(b), FW's notional interest deduction is a hybrid deduction. The results are the same as in paragraph (c)(8)(ii) of this section. That is, the income attributable to US1's $100x imported mismatch payment is offset by FW's hybrid deduction for the reasons described in paragraph (c)(8)(ii) of this section. As a result, a deduction for the payment is disallowed under §1.267A-1(b)(2).

Appendix 3 — Proposed Amendments to Provide that Hybrid Deductions Do Not
Include Notional Interest Deductions Allowed By a Treaty Jurisdiction

Revised § 1.267A-4(b):

Hybrid deduction. A hybrid deduction means, with respect to a tax resident or taxable branch that is not a specified party, a deduction allowed to the tax resident or taxable branch under its tax law for an amount paid or accrued that is interest (including an amount that would be a structured payment under the principles of § 1.267A-5(b)(5)(ii)) or royalty under such tax law (regardless of whether or how such amounts would be recognized under U.S. law), to the extent that a deduction for the amount would be disallowed if such tax law contained rules substantially similar to those under §§ 1.267A-1 through 1.267A-3 and 1.267A-5. In addition, with respect to a tax resident that is not a specified party and is not a resident of a jurisdiction with which the United States has a comprehensive income tax treaty, a hybrid deduction includes a deduction allowed to the tax resident with respect to equity, such as a notional interest deduction. Further, a hybrid deduction for a particular accounting period includes a loss carryover from another accounting period, to the extent that a hybrid deduction incurred in an accounting period beginning on or after December 20, 2018 comprises the loss carryover.

Revised § 1.267A-6(c)(8)(iv)

Alternative facts — notional interest deduction. The facts are the same as in paragraph (c)(8)(i) of this section, except that Country W does not have a comprehensive income tax treaty with the United States and the FX-FW instrument does not exist and thus FW does not pay any amounts to FX during accounting period 1. However, during accounting period 1, FW is allowed a $100x notional interest deduction with respect to its equity under Country W tax law. Pursuant to § 1.267A-4(b), FW's notional interest deduction is a hybrid deduction. The results are the same as in paragraph (c)(8)(ii) of this section. That is, the income attributable to US1's $100x imported mismatch payment is offset by FW's hybrid deduction for the reasons described in paragraph (c)(8)(ii) of this section. As a result, a deduction for the payment is disallowed under §1.267A-1(b)(2).

FOOTNOTES

1Except as the context otherwise requires, references to "section" herein are to sections of the Code; references to "Treas. Reg. §" are to sections of the Treasury regulations issued under the Code; and references to "Prop. Treas. Reg. §" are to proposed Treasury regulations issued under the Code.

2See Senate Committee on Finance, Explanation of the Bill, at 384 (Nov. 22, 2017).

3OECD/G20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report, (October 2015), paragraph 11 (hereinafter, the "OECD Report").

4Several jurisdictions in the European Union have notional interest deduction regimes, including Belgium, Italy, Portugal, Cyprus and Malta. See European Commission, Commission Staff Working Document, Tax Policies in the European Union: 2018 Survey (Dec. 7, 2018) (hereinafter, the "EU Survey"), Table 2.1. Denmark also has announced that it will implement a notional interest deduction regime. See id at Section 3.1.1. Switzerland also has proposed a notional interest deduction. See generally, Swiss Federal Department of Finance, Overview of tax reform and AHV financing measures, available at https://www.efd.admin.ch/efd/en/home/dokumentation/legislation/abstimmungen/staf/ueberblick-massnahmen.html.

5See EU Survey, Section 2.1.2. Notional interest deduction regimes are also referred to as an "allowance for corporate equity" or "ACE" regime.

6See European Commission Fact Sheet, Questions and Answers on the package of corporate tax reforms, (Oct. 25, 2016) available at http://europa.eu/rapid/press-release MEMO-16-3488 en.htm rThe [AGI] aims to redress this debt-bias. It will allow a tax deduction for companies that choose to increase equity for financing (e.g. by issuing new shares or retaining profits) rather than take on debt (e.g. a loan)"); see also EU Survey, Sections 2.1.2, 3.1.1.

7See OECD Report, paragraph 272.

8See OECD Report, Recommendation 9.

9Prop. Treas. Reg. .§ 1.245A(e)-1(d)(2)(i)(B) (emphasis added).

10See generally, The Convention between the Government of the United States of America and the Government of the Kingdom of Belgium for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (the "U.S.-Belgium Treaty"), Article 11.

11U.S.-Belgium Treaty Article 23(4).

12Prop. Treas. Reg. § 1.267A-1(b)(2).

13Prop. Treas. Reg. § 1.267A-4(a).

14Prop. Treas. Reg. § 1.267A-4(b) (emphasis added). The application of this rule to a notional interest deduction is reflected in Prop. Treas. Reg. § 1.267A-6(c)(8)(iv).

15Prop. Treas. Reg. § 1.267A-5(a)(17).

16U.S. Model Treaty, Article 11(2)(e).

17Preamble to the 2016 U.S. Model Income Tax Convention (Feb. 17, 2016), p. 3.

END FOOTNOTES

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