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Solution Offered for Imported Mismatch Rules Under Anti-Hybrid Regs

FEB. 25, 2019

Solution Offered for Imported Mismatch Rules Under Anti-Hybrid Regs

DATED FEB. 25, 2019
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February 25, 2019

Hon. Charles P. Rettig
Commissioner of Internal Revenue
Internal Revenue Service
CC:PA:LPD:PR (REG-104259-18)
Room 5203, Internal Revenue Service
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Re: Proposed Regulations under Section 267A (RIN 1545–BO53), Section 1.267A-4

Dear Commissioner Rettig:

This letter is submitted in response to the request for comments on the proposed regulations under section 267A, which were published in the Federal Register on December 28, 2018 (the “Proposed Regulations”).1

The Proposed Regulations, in section 1.267A-4(c)(3)(v) and (f), exempt from the imported mismatch rules certain payments to jurisdictions that have adopted rules substantially similar to the Proposed Regulations, provided that those rules deny a deduction for any portion of a related deduction otherwise allowed to the recipient of the payment. For the reasons discussed below, we request that the imported mismatch rules be simplified by exempting payments to jurisdictions that have adopted rules substantially similar to the Proposed Regulations, without requiring tracing through in each case to identify the amount disallowed, however small that amount may be.

To summarize our comments, we believe that our proposal is a relatively minor change from the Proposed Regulations, but one that would significantly reduce the considerable burden arising from the expected reciprocal application of imported mismatch rules, like those contained in the Proposed Regulations, by countries adopting similar rules under the BEPS Action 2 Reports.2 If other countries were to adopt the approach of the Proposed Regulations — and it is reasonable to assume that they soon will — then each jurisdiction would require tracing of payments and deductions in all directions through the overlapping application of each jurisdiction's imported mismatch rules. The resulting complexity and administrative burden would be significant, and in our view unnecessary. A rule that instead encourages each jurisdiction to adopt and apply a single set of BEPS-compliant anti-hybrid rules would accomplish the policy goal of neutralizing double non-taxation in a more administrable and sustainable manner than the Proposed Regulations in their current form.

* * *

In general, the imported mismatch rules in the Proposed Regulations disallow certain deductions for interest and royalty payments that are treated as interest and royalty income under foreign law, which do not themselves involve tax hybridity or a deduction/non-inclusion outcome.3 The Proposed Regulations would disallow these deductions to the extent they are traceable, under the setoff, ordering, and funding rules, to a “hybrid deduction.”4

In pertinent part, a hybrid deduction is defined as any amount of interest or royalties, deductible under foreign law, “to the extent that a deduction for the amount would be disallowed if such [foreign] tax law contained rules substantially similar to those under §§ 1.267A-1 through 1.267A-3 and 1.267A-5.”5 The Proposed Regulations thus require a U.S. tax resident, a U.S. taxable branch, or a controlled foreign corporation (“CFC”) with a 10-percent U.S. shareholder that pays interest or royalties to a foreign related party to re-apply most of the architecture of the Proposed Regulations to the recipient of the payment and any of its affiliates.

Critically, the Proposed Regulations require the U.S. payor to re-apply the Proposed Regulations to the foreign recipient and its affiliates even if they are already subject to rules like the Proposed Regulations under foreign law. Only if the foreign version of the Proposed Regulations actually disallows a deduction under foreign law for some or all of a payment traceable back to the U.S. specified payment do the Proposed Regulations turn off the U.S. expense disallowance.6 If other jurisdictions adopt rules analogous to this rule, which we expect they soon will,7 multinational groups will experience an exponential increase in the number of times they will have to apply overlapping sets of anti-hybrid rules and determine whether amounts were actually disallowed.

It also bears emphasizing that a foreign disallowance of any portion of the deduction in the chain of funded payments turns off the U.S. expense disallowance.8 Thus, for every country that adopts rules substantially similar to the Proposed Regulations, a group of related entities potentially must apply the set of anti-hybrid rules from that country to every entity receiving a payment from that country in order to determine whether any portion of a deduction in the chain of funded payments, however small, has been disallowed. We believe that this overlapping application of rules substantially similar to the Proposed Regulations, in order to confirm what may be small disallowances, is unnecessary and unreasonably burdensome. Elimination of this burden can be addressed with a relatively minor fix to the Proposed Regulations, without in our view sacrificing the integrity of a multilateral system for neutralizing double non-taxation from hybrid instruments.

We illustrate the issue and our proposed solution with an example based on Example 10 of the Proposed Regulations.9 Example 10 of the Proposed Regulations does not fully illustrate the scope and the level of complexity that would arise once other countries adopt anti-hybrid rules analogous to the Proposed Regulations. Cross-border payments of interest and royalties among members of a multinational group often are far more complex than the facts of Example 10. Nevertheless, to give a sense of the issue we expect to arise as other countries adopt similar rules, we would revise Example 10(iv) to add the following facts:

  • US2 owns all the stock of CFC-A, a resident of Country A. US2 has lent funds to CFC-A.

  • FZ is a group treasury center, which both makes and receives payments from FX, FW, FE, US2, and CFC-A.

  • Countries X, Z and A, as well as Country E, have adopted hybrid rules substantially similar to the Proposed Regulations. Thus, only Country W has not yet adopted such rules.

Even in this case, which is still a dramatic oversimplification of multinational group operations, the FX group of affiliated companies would need to apply the following sets of anti-hybrid rules:

  • The U.S. rules to payments made by US1, US2, US3, CFC-A, FW, FZ, and FE.

  • The Country Z rules to payments made by FZ, US2, CFC-A, FX, FW, and FE.

  • The Country A rules to payments made by CFC-A, US2, and FZ.

  • The Country E rules to payments made by FE and FZ.

  • The Country X rules to payments made by FX and FZ.

This repeated application of various countries' anti-hybrid rules outside their own taxing jurisdiction is unnecessary and unreasonably burdensome when the other countries in question already have substantially similar rules. FZ's application of the Country Z imported mismatch rules would disallow its deduction of interest paid to FW, just as the U.S. rules would disallow the deductions of interest paid by US1 and US2 to FW. Therefore, it should be unnecessary to apply the U.S. rules to payments made by FZ and FE; the Country Z rules to payments made by US2, CFC-A, FX, and FE; the Country A rules to payments made by US2 and FZ; the Country E rules to payments made by FZ; and the Country X rules to payments made by FZ.

Among many potential alternatives, one way to implement our proposal would be to amend Proposed Regulations section 1.267A-4(a) to add the following sentence: “ A specified payment is not a disqualified imported mismatch amount if the imported mismatch payee is subject to rules substantially similar to those under §§ 1.267A–1 through 1.267A–5.

If this proposal were to be adopted in the final version of the regulations, the anti-hybrid rules in the foregoing fact pattern would instead apply to the following, more limited set of payments:

  • The U.S. rules to payments made by US1, US2, US3, CFC-A, and FW.

  • The Country Z rules to payments made by FZ and FW.

  • The Country A rules to payments made by CFC-A.

  • The Country E rules to payments made by FE.

  • The Country X rules to payments made by FX.

While still burdensome, this approach reduces by half the number of times that the FX group would have to re-apply the anti-hybrid rules of various countries to payments made by entities in other countries that already have anti-hybrid rules of their own. Applied across groups that have many hundreds of entities making specified payments to each other, our recommendation would save considerable time and expense.10

The proposal would maintain the integrity of a multilateral system for addressing hybrid and branch mismatch arrangements. It would only exempt from the imported mismatch rules payments to countries that have adopted rules substantially similar to the Proposed Regulations, in keeping with the BEPS Action 2 Reports. We expect that in most cases it will be obvious which countries have adopted such rules, but the requirement of “substantial similarity” provides a reasonable standard that can be confirmed in an audit,11 while still allowing for minor variations in the implementation and operation of rules across jurisdictions. As noted, the Proposed Regulations already exempt payments from the funding rules to the extent that any portion of the Foreign Recipient's deduction is disallowed under rules substantially similar to the Proposed Regulations.12 Thus, our proposal is not that big a change. It does not introduce any more ambiguity than is already in the Proposed Regulations, which use the term “substantially similar” to compare the U.S. and foreign anti-hybrid regimes, and it does not require a greater level of confidence regarding how foreign countries will implement BEPS Action 2, given that even a small foreign disallowance would turn off the U.S. expense disallowance under the Proposed Regulations. What the proposal does is mitigate the considerable compliance burden that will arise once other countries adopt similar rules.

According to the Proposed Regulations, the legislative history of section 267A indicates an intent to follow BEPS Action 2.13 The BEPS Action 2 Final Report specifically states that the imported mismatch rules “will not apply to any payment that is made to a taxpayer in a jurisdiction that has implemented the full set of recommendations in this report.”14 Our proposal is thus more consistent with the stated intent of the Proposed Regulations than the current version of the Proposed Regulations.

More generally, the United States should not adopt a version of the anti-hybrid rules that it does not want other countries to adopt.15 Our proposal would better serve "to coordinate proposed § 1.267A-4 with foreign imported mismatch rules, in order to prevent the same hybrid deduction from resulting in deductions for non-hybrid payments being disallowed under imported mismatch rules in more than one jurisdiction."16 We would expect the benefits of this approach in terms of "comprehensiveness, administrability, and conduciveness to taxpayer certainty" to be substantially greater than the Proposed Regulations as drafted.17

For the foregoing reasons, we request that the final version of the Proposed Regulations be simplified by exempting payments to jurisdictions that have adopted rules substantially similar to the final version of the regulations.

We look forward to working together with you to resolve this important issue.

Respectfully submitted,

Dirk Suringa
Covington & Burling LLP
Washington, DC

cc:
Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury
Lafayette "Chip" G. Harter III, Deputy Assistant Secretary (International Tax Affairs), Department of the Treasury
Douglas L. Poms, International Tax Counsel, Department of the Treasury
Brian Jenn, Deputy International Tax Counsel, Department of the Treasury
William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical), Internal Revenue Service
Drita Tonuzi, Deputy Chief Counsel (Operations), Internal Revenue Service
Daniel M. McCall, Deputy Associate Chief Counsel (International — Technical), Internal Revenue Service

FOOTNOTES

1See N.P.R.M., RIN 1545–BO53, 83 Fed. Reg. 67612, 67632 (Dec. 28, 2018).

2OECD/G20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 Final Report (October 2015) [hereinafter “Final Action 2 Report”]; OECD/G20, Neutralising the Effects of Branch Mismatch Arrangements, Action 2: Inclusive Framework on BEPS (July 2017).

3This letter does not address in any manner whether the imported mismatch rules embody a permissible reading of the statute.

4See Prop. Treas. Reg. § 1.267A-4(a).

5Prop. Treas. Reg. § 1.267A-4(b) (emphasis added).

6See Prop. Treas. Reg. § 1.267A-4(c)(3)(v), (f).

7See, e.g., Council Directive (EU) 2017/952, Art. 2(1) (May 29, 2017) (mandating that EU countries adopt comprehensive anti-hybrid legislation by January 1, 2020).

8See id.; see also Prop. Treas. Reg. § 1.267A-6(c)(10)(iv) (“[N]o portion of US3's payment is a disqualified imported mismatch amount. This is because the $50x that FE pays to FZ is not considered to be a funded taxable payment, because under a provision of Country E's hybrid mismatch rules that is substantially similar to § 1.267A–4, FE is denied a deduction for a portion of the $50x.” (emphasis added)).

9See Prop. Treas. Reg. § 1.267A-6(c)(10).

10While not a complete solution, our proposal also may reduce the risk of double taxation, relative to the approach of the Proposed Regulations. In Example 10(iv), it appears likely that $150 of otherwise deductible interest paid by US1 ($50), US2 ($50), and FE ($50) will disallowed, even though the amount of hybrid interest accrued by FW on the FX-FW instrument is the lesser amount of $125. By requiring US3 to prove that FE actually disallowed a portion of its interest payment to FZ, the Proposed Regulations increase the risk of double taxation by a further $50. Our proposal mitigates this latter risk. By eliminating the overlapping application of each country's rules, our proposal facilitates a multilateral approach to “prevent[ing] the same hybrid deduction from resulting in deductions for non-hybrid payments being disallowed under imported mismatch rules in more than one jurisdiction.” 83 Fed. Reg. at 67620.

11See Final Action 2 Report, at 90 (recommending that the taxpayer's “initial burden may be discharged by providing the tax administration with copies of the group calculations together with supporting evidence of the adjustments that have been made under the imported mismatch rules in other jurisdictions.”). For this purpose, we believe that otherwise BEPS-compliant anti-hybrid rules should be “substantially similar” even if a subset of those rules, such as those rules applicable to reverse hybrids, remain to be phased in over a short period of time. See, e.g., Council Directive (EU) 2017/952, Art. 2(3) (May 29, 2017) (providing for a two-year delay in the implementation of reverse hybrid rules within the European Union).

12See Prop. Treas. Reg. §§ 1.267A-4(f)(2), -6(c)(10)(iv).

13See N.P.R.M., RIN 1545–BO53, 83 Fed. Reg. 67612, 67612 (Dec. 28, 2018).

14Final Action 2 Report, at 84.

15See id. at 90 ("[E]ach country that implements the recommendations set out in the report should make reasonable endeavours to implement an imported mismatch rule that adheres to the methodology set out in this guidance and to apply this methodology in the same way.").

1683 Fed. Reg. at 67620.

17Id. at 67627.

END FOOTNOTES

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