The Tax Cuts and Jobs Act added two new sections to the code to address hybrid transactions that cause deduction/no-inclusion (D/NI) or double nontaxation. When a D/NI outcome occurs, section 245A(e) disallows a dividends received deduction and section 267A disallows an interest and royalty expense deduction.
Proposed regulations (REG 104352-18) on how to apply sections 245A(e) and 267A arguably overreached in treating notional interest deductions (NIDs) and group relief regimes as generating hybrid deductions, yet didn’t go far enough in addressing section 951 and 951A inclusions that cause double taxation rather than prevent double nontaxation.
In some cases, circumstances unique to either section 245A(e) or 267A cause unexpected outcomes. But treatment of NIDs, group relief regimes, and inclusions under the global intangible low-taxed income and subpart F regimes are problematic under both sections.
Sections 245A(e) and 267A
Section 245A(a) allows domestic corporations of specified 10-percent-owned foreign corporations to deduct 100 percent of their foreign-source dividend income. Section 245A(e) disallows a deduction for hybrid dividends, which is a dividend that would otherwise qualify for the dividends received deduction, except the controlled foreign corporation receives a deduction or other tax benefit for the payment under foreign tax law. Section 245A(d) provides that no deduction or credit for foreign taxes paid on dividends is allowed if the dividend qualifies for the deduction or is a hybrid dividend.
Section 267A disallows a deduction for interest and royalty payments to a related party if the amount isn’t included in the recipient’s income or the recipient is allowed a deduction under foreign law.
The proposed regulations under both sections generally treat NIDs and global relief regimes as generating hybrid deductions. They treat GILTI and subpart F inclusions differently, but both have the potential to cause double taxation.
Notional Interest Deductions
Both sections treat NIDs as hybrid deductions, which means NIDs don’t qualify for the dividends received deduction under section 245A(e) and are treated as disqualified imported mismatch payments (IMPs) under section 267A.
NIDs typically allow domestic corporations, as well as branches or permanent establishments of nonresident ones, to deduct a portion of their equity as a way to alleviate debt bias. In the typical case, a NID is the product of an annual percentage representing the long-term risk-free financing rate and some combination of the taxpayer’s share capital or retained earnings.
Prop. reg. section 1.245A(e)-1(d)(2)(i)(B) states that NIDs give rise to a hybrid deduction, and a scenario in Example 1 of prop. reg. section 1.245A(e)-1(g) involves nondeductible NIDs. Prop. reg. section1.267A-4(b) provides guidance on IMPs, stating that a hybrid deduction includes a deduction for equity, such as a NID. One scenario in Example 8 of prop. reg. section 1.267A-6 involves NIDs treated as hybrid deductions and disqualified IMPs so that no deduction is allowed.
The preamble provides that NIDs are hybrid deductions because they raise concerns similar to those for traditional hybrid instruments — but that treatment overreaches. Sections 245A(e) and 267A are intended to address situations in which a payment gives rise to a tax deduction under the payer country’s tax law without a corresponding inclusion in the payee’s country.
A NID is based on equity, however, not distributed earnings, and is unrelated to dividend payments because it arises regardless of whether dividends are ever paid. NIDs are analogous to deductions like accelerated depreciation that are intended to encourage investment. When a taxpayer isn’t required to make a distribution or payment to claim the NID, hybridity is absent.
Action 2 of the OECD’s base erosion and profit-shifting project includes anti-hybrid rules, and sections 245A(e) and 267A generally follow the OECD’s recommendations. Applying the hybrid rules to NIDs is beyond both the OECD’s recommendations and the scope of the EU’s antiavoidance tax directive. One purpose of U.S. tax reform was to make the U.S. corporate tax regime more aligned with the BEPS standards and the tax regimes of other countries, and treating NIDs as nondeductible reduces U.S. competitiveness.
Section 245A(g) provides Treasury a broad grant of regulatory authority, while section 267A(e) lists eight specific grants thereof. Neither section mentions expanding the hybrid deduction rules to address NIDs or other local benefits unrelated to dividends. Treatment of NIDs as hybrid deductions contradicts calls for regulations that avoid eroding the U.S. tax base.
Final regulations should state that a NID is a hybrid deduction only when it’s accompanied by an amount paid, accrued, or distributed that the recipient includes in income or is allowed to deduct.
Group Relief Regimes
Both sections also treat group relief regimes unfavorably and are the result of overreaching.
Prop. reg section 1.245A(e)-1(d)(2) defines a hybrid deduction to include any deduction or other tax benefit that relates to or results from an amount otherwise eligible for the dividends received deduction. Some group relief or similar payments between related CFCs that are tax residents of the same country could be treated as hybrid dividends if they’re treated as dividends under section 301.
Payments between related CFCs to share or shift tax liability under a tax consolidation, fiscal unity, group relief, loss sharing, or similar regime shouldn’t be hybrid deductions, because they don’t result in double nontaxation. A group relief system doesn’t exempt income from foreign tax and is similar to the U.S. consolidated group rules.
For example, under the United Kingdom’s loss surrender regime, the recipient of a surrendered loss pays the surrendering affiliate for the loss. The IRS has treated those payments as constructive capital contributions or dividends, but those constructive transfers don’t exist under the U.K. system and aren’t deductible. Under the U.K. group relief system, the only deduction is for the surrendering affiliate’s loss.
In Germany, affiliated taxpayers appoint their common parent to pay tax owed by all affiliates, which must subsequently distribute their profits to the parent. Those profits are subject to tax at the common parent level and the distributing affiliates deduct them only to avoid double taxation in Germany — similar to intercompany dividends in a U.S. consolidated group. There’s always at least one level of taxation.
The proposed section 267A regulations handle those payments differently than the section 245A(e) regs do, but they still disallow a deduction even when there’s no D/NI outcome. Under prop. reg. section 1.267A-4(d)’s sixth funding rule to determine whether a disqualified IMP exists, if a deduction or loss not incurred by a tax resident or taxable branch is made available to offset the taxpayer’s income (for example, under a consolidation, group relief, or loss-sharing regime), then the taxpayer for which the deduction or loss is made available and the taxpayer that incurs the deduction or loss are treated as a single taxpayer. One scenario of Example 9 involves a group relief regime that causes a disqualified IMP.
GILTI and Subpart F
Sections 245A(e) and 267A both potentially cause double taxation when a disallowed hybrid deduction is coupled with a GILTI or subpart F inclusion. That occurs under section 245A(e) if a hybrid deduction account (HDA) is adjusted upward for the inclusions, and under section 267A if an entity that’s fiscally transparent for U.S. purposes has a hybrid dividend deduction but receives a specified payment from a related party treated as an IMP.
Prop. reg. section 1.245A(e)-1(d) requires CFCs to maintain HDAs to address timing differences between accrual of a hybrid deduction and an actual dividend distribution. HDAs are increased by a CFC’s hybrid deductions and decreased by its hybrid dividends or tiered hybrid dividends.
However, the proposed regulations don’t say how an HDA should be adjusted when U.S. shareholders of CFCs with hybrid deductions have inclusions under section 951 (subpart F) or 951A (GILTI) attributable to the hybrid dividend.
In the notice of proposed rulemaking, Treasury and the IRS requested comments on whether hybrid deductions related to subpart F or GILTI inclusions shouldn’t increase an HDA, or alternatively, whether an HDA should be reduced by distributions of previously taxed earnings and profits. They also asked whether final regs should consider the effect of any deemed-paid section 960 foreign taxes associated with those inclusions and distributions.
Final regulations should clarify that a CFC’s hybrid deductions for earnings included in a U.S. shareholder’s income under GILTI or subpart F do not increase an HDA, and those amounts should be determined without considering section 960 foreign tax credits. If a payment that gives rise to a GILTI or subpart F inclusion also increases an HDA, a future dividend treated as a hybrid dividend not eligible for the dividends received deduction results in double taxation.
For example, U.S. Parent wholly owns in country X Subsidiary, which issues an instrument to Parent that’s treated as debt under X law and as equity under U.S. law. Sub earns $200 of net income for U.S. and X tax purposes, all of which is tested income. CFC incurs a $60 hybrid deduction and Parent’s GILTI inclusion percentage is 80 percent (because of Sub’s qualified business asset investment).
Only $140 of Sub’s earnings is in X’s tax base because of the $60 hybrid deduction; $160 of CFC’s earnings is included in the U.S. tax base under GILTI because of the 80 percent inclusion percentage. Parent is deemed to have paid 80 percent of the X taxes imposed on CFC’s $140 taxable income in X.
The remaining $40 of Sub’s E&P is section 959(c)(3) untaxed earnings consisting of 20 percent of the $140 X tax base ($28) not in Parent’s GILTI inclusion plus 20 percent of the $60 hybrid deduction ($12) not included in either the X or U.S. tax base.
The hybrid dividend rules should apply only to the $12 not taxed in either country. The remaining $48 of the hybrid deduction (80 percent of $60) didn’t result in double nontaxation because of Parent’s GILTI inclusion, and shouldn’t increase an HDA.
The amount of a subpart F or GILTI inclusion not subject to the hybrid dividend rules shouldn’t be reduced for any section 960 FTCs because that would cause double taxation.
The proposed regulations exclude amounts included in the U.S. tax base from the prop. reg. section1.267A-2 rules. However, the IMP rules in prop. reg. section 1.267A-4 cause double taxation if a foreign entity that is fiscally transparent for U.S. tax purposes incurs a hybrid deduction and a related party makes an interest or royalty payment to the entity that’s GILTI or subpart F income.
Double taxation occurs because the IMP rules don’t address subpart F and GILTI inclusions through the rules in prop. reg. section 1.267A-3 that govern amounts not treated as disqualified hybrid amounts if included in income. They instead provide that a specified party’s hybrid deduction is not considered in determining whether a disqualified IMP exists. The definition of specified party doesn’t include fiscally transparent entities. Final regulations should either broaden the definition of specified party or apply the rules in prop. reg. section 1.267A-3(b) to disqualified IMPs.
The proposed regulations gave sections 245A(e) and 267A three things in common: unfavorable treatment of NIDs, unfavorable treatment of group relief regimes, and the potential for the double taxation of GILTI and subpart F inclusions. Denying a deduction for NIDs with no accompanying payment is beyond the scope of Treasury’s authority and risks eroding the U.S. tax base. Denying a deduction for group relief regimes imposes the hybrid rules when there’s no D/NI outcome because all income is subject to one layer of foreign tax. Applying HDA adjustment and disqualified IMP rules for GILTI or subpart F inclusions risks double taxation. Treasury’s final regulations should reflect more restraint on the first two items, and more oversight of double taxation possibilities in the third.