Hybrid deduction accounts (HDAs) that address the timing of foreign tax benefits applying to dividends in a different tax year than the dividend distribution could potentially address similar issues relating to global intangible low-taxed income and subpart F inclusions.
The Tax Cuts and Jobs Act added new section 245A providing a participation exemption for U.S. shareholders of foreign corporations that earn active income outside the United States through a dividends received deduction (DRD). Section 245A(e) provides an exception to tax-free treatment for dividend amounts that are not taxed by the payor’s country.
If the foreign tax benefit applies to the dividend in a different tax year than the distribution, new proposed regulations (REG 104352-18) address the timing issue through use of an HDA.
Hybrid Dividends
Section 245A(a) has a general rule that U.S. corporations receiving dividends from specified 10-percent-owned foreign corporations may deduct the foreign source portion of the dividend. Specified 10-percent-owned foreign corporations are controlled foreign corporations with U.S. corporate shareholders.
Section 245A(e) contains an exception to that general rule for hybrid dividends. A hybrid dividend is an amount received from a CFC that would qualify for a section 245A(a) deduction but for section 245A(e), and for which the CFC receives a distribution-related deduction (or other tax benefit) from any foreign country.
Section 245A(e) prevents double nontaxation by disallowing the DRD for hybrid dividends received from a CFC, and by mandating subpart F inclusions for hybrid dividends received by one CFC from another.
Section 245A(d) provides that no credits or deductions are allowed for foreign taxes paid or deemed paid for amounts that qualify for the DRD. Section 245A(e)(3) applies these rules to hybrid dividends.
Proposed regs interpreting section 245A(e) provide guidance on hybrid dividends and tiered dividends. The guidance is contained in prop. reg. section1.245A(e)-1, because section 245A proposed regs only include rules under section 245A(e). Treasury intends to address other aspects of section 245A (including general eligibility requirements for the DRD) in a separate notice of proposed rulemaking.
Ordering rules provide that amounts received by a U.S. shareholder from a CFC are subject to section 245A(e) based on the order received, starting with the earliest date.
Tiered Hybrid Dividends
If a CFC receives a tiered hybrid dividend from another CFC and a corporation is a U.S. shareholder of both, then the tiered hybrid dividend is treated as subpart F income of the receiving CFC, and the U.S. shareholder must include its pro rata share of the subpart F income in gross income. A tiered hybrid dividend is an amount received by a CFC from another CFC if the amount would be a hybrid dividend if the receiving CFC were a U.S. corporation. Section 245A(d) applies to the inclusion, disallowing foreign tax credits and deductions, including taxes deemed paid under section 960.
Hybrid Deduction Accounts
Prop. reg. section 1.245A(e)-1(d) introduces HDAs maintained by the U.S. shareholder and allocated to each share of CFC stock. The proposed regs narrow the hybrid dividend definition to include amounts only up to the sum of the U.S. shareholder’s HDAs.
A specified owner of CFC stock must maintain an HDA for each share that reflects the amount of the CFC’s hybrid deductions allocated to the share. Hybrid deductions are deductions or other tax benefits (like an exemption, exclusion, or credit) satisfying two requirements:
the deduction or other tax benefit is allowed to the CFC under a relevant foreign tax law; and
the deduction or other tax benefit relates to an amount paid, accrued, or distributed regarding an instrument issued by the CFC and treated as stock for U.S. tax purposes.
“Relevant foreign tax law” is any regime that imposes income tax, war profits, or excess profits tax on a CFC’s income (other than a foreign anti-deferral regime) when a CFC shareholder is subject to tax. It includes foreign laws through which a CFC is taxed as a resident, the CFC has a branch that is a taxable presence, or a person related to the CFC is taxed as a resident and is allowed a deduction for amounts paid by the CFC because it is fiscally transparent.
A deduction or other tax benefit relating to or resulting from a distribution by the CFC regarding an instrument treated as stock for purposes of the relevant foreign tax law is considered a hybrid deduction only to the extent it causes the earnings that funded the distribution to be excluded from income or otherwise not subject to tax under the CFC’s tax law.
For example, a refund to a CFC shareholder (including through a credit) of taxes paid by the CFC on earnings that funded the distribution is a hybrid deduction only if the shareholder does not include the distribution in income under the CFC’s tax law, is not a resident of the CFC’s country, or is not subject to withholding tax on the distribution under the CFC’s tax law.
A hybrid deduction is allocated to a CFC share if it relates to an amount paid, accrued, or distributed by the CFC for that share. However, a hybrid deduction related to equity, such as a notional interest deduction, is allocated to a share of CFC stock based on the product of the amount of the deduction allowed for all the CFC equity and a fraction whose numerator is the value of the share and whose denominator is the value of all CFC stock:
Hybrid deduction related to equity * share value/total equity value = allocation of deduction to share
Each year, a specified owner’s HDAs are increased by the CFC’s hybrid deductions and decreased by its hybrid dividends or tiered hybrid dividends.
The amount of a hybrid deduction and the HDA annual adjustments are maintained in the CFC’s functional currency. The amount of a deduction or other tax benefit is determined considering foreign currency gain or loss recognized under a provision of foreign tax law comparable to section 988.
HDAs are meant to address situations in which the CFC’s dividend payment and hybrid deduction occur in different tax years. They reflect Treasury’s view that disallowance of the section 245A(a) DRD under section 245A(e) should not be limited to cases in which the dividend and hybrid deduction occur in the same year.
Treasury and the IRS considered three options for addressing this timing issue. The first was to treat these transactions as not giving rise to hybrid dividends, which would allow the payments to permanently escape both foreign and U.S. tax.
The second was to address the timing difference under a code section other than section 245A(e); for example, by mandating an income inclusion to the U.S. parent in the year the deduction is permitted under foreign law. This would require a deemed inclusion even though the income has not otherwise been recognized for U.S. tax purposes.
The final option was to require the establishment of HDAs. Treasury and the IRS decided that the benefits of an HDA’s comprehensiveness and clarity were greater than its administration and compliance costs.
In the notice of proposed rulemaking for these regulations, Treasury and the IRS requested comments on whether hybrid deductions related to inclusions under section 951(a) (subpart F) or 951A (GILTI) should not increase an HDA, whether an HDA should be reduced by distributions of previously taxed earnings and profits, and whether to consider deemed paid FTCs related to these inclusions or distributions.
Sales or Exchanges of Stock
The proposed regs provide guidance on hybrid dividends and HDAs when there is a transfer of CFC stock. If a U.S. corporation sells or exchanges lower-tier CFC stock, and gain derived from the CFC’s E&P is included in gross income as a dividend under section 1248, that E&P is treated as a dividend distribution by the lower-tier CFC directly to the U.S. corporation. HDAs related to the shares of the lower-tier CFC are treated as belonging to the U.S. corporation.
For example, if a U.S. corporation sells or exchanges all the stock of an upper-tier CFC and a dividend is deemed paid by the lower-tier CFC to the U.S. corporation, then the dividend is a hybrid dividend up to the sum of the upper-tier CFC’s HDAs related to the lower-tier CFC stock.
If a CFC sells or exchanges stock of a foreign corporation and gain is recognized as a dividend under section 964(e)(1), then rules like the above rules regarding section 1248 deemed dividends apply. If a section 964(e)(1) dividend is a tiered hybrid dividend, section 964(e)(4) does not apply and the U.S. shareholder is not allowed a DRD for the income inclusion.
When a person acquires a share of CFC stock from another person and the acquirer is a specified owner of the share, the transferor’s HDA becomes the HDA of the owner. If the acquirer is not a specified owner of the share, the transferor’s HDA is eliminated and not subsequently considered by any person. HDAs are also carried over to specified acquirers in tax-free transactions. Specified owners are U.S. shareholders of CFCs and upper-tier CFCs that would be U.S. shareholders if they were domestic corporations.
Antiavoidance Rule
Prop. reg. section 1.245A(e)-1(e) contains antiavoidance rules that require adjusting or disregarding transactions or arrangements with a principal purpose of avoiding section 245A(e). Two examples are provided: causing an HDA to be eliminated or avoiding the tiered hybrid dividend rules by failing to satisfy section 246(c)(5) holding period requirements.
Examples
Prop. reg. section 1.245A(e)-1(g) includes two examples that illustrate the hybrid dividend, tiered hybrid dividend, and HDA rules.
Example 1 presents three alternative scenarios in which US1 wholly owns CFC FX incorporated in country X. FX issued two shares of stock of equal value. Share A is treated as debt for tax purposes under country X law, while share B is treated as equity. During year 1, FX accrues $80 of unpaid interest expense to US1 on share A that is deductible under country X law. At the end of year 1, US1’s HDAs related to share A and share B are $80 and zero, respectively.
During year 2, FX distributes $30 to US1 for each of share A and share B. U.S. tax laws treat both $30 distributions as dividends US1 would be able to deduct under section 245A(a) if not for the exception in section 245A(e). The entire $60 distribution is a hybrid dividend because the sum of US1’s HDAs ($80) is greater than the dividends ($60). US1 is not allowed a DRD under section 245A(a) for the $60 dividend, and section 245A(d) disallows FTCs and deductions. At the end of year 2, US1’s $80 HDA related to share A is reduced by $60 to $20.
Example 1’s second scenario uses the same facts except that for each of years 1 and 2, FX is allowed $10 of notional interest deductions (NIDs) related to share B, and during year 2 FX distributes $47.50 (instead of $30) related to each of share A and share B. The total deductions are $100, and the total distributions are $95.
Unlike the accrued but unpaid interest expense, the $10 of NIDs is allocated equally to each of share A and share B because NIDS are allowed for equity and the shares have an equal value. At the end of year 1, US1’s HDAs related to share A and share B are $85 and $5. They are $90 and $10 at the end of year 2.
The entire $95 distribution is a hybrid dividend because the sum of US1’s HDAs ($100) is greater than the dividends ($95). At the end of year 2, US1’s HDAs are adjusted downward for the $95 of hybrid dividend distributions allocated between share A and share B as follows:
$95 dividend * share’s HDA/$100 total deductions = share’s HDA reduction
Pursuant to this formula, share A’s HDA is reduced by $85.50 to $4.50 and share B’s HDA is reduced by $9.50 to $0.50.
Example 1’s third scenario has share A treated as equity under country X tax laws. The $80 deduction for accrued but unpaid interest does not exist. However, FX has a branch in country Z where share A is still treated as debt and share B is treated as equity. The results are like those in the first scenario of Example 1.
During year 1, FX’s $80 accrual of interest to US1 is deductible by its country Z branch and the $30 distribution related to share A in year 2 is treated as an interest payment previously deducted in country Z (so no additional deduction). The $30 distribution related to share B in year 2 is a nondeductible dividend distribution in country Z.
The $80 interest deduction under country Z’s tax law is a hybrid deduction in year 1. At the end of year 2, US1’s HDAs for share A and share B are $80 and $0, respectively. The entire $60 of year 2 dividends are hybrid dividends, and share A’s HDA is reduced to $20 by the end of year 2.
Example 2 presents two tiered hybrid dividend scenarios where US1 wholly owns FX, and FX wholly owns all 100 shares of FZ. The shares have equal value and are treated as equity under country Z’s tax laws. During year 2, FZ distributes $10 per share to FX for a total distribution of $1,000 that is treated as a dividend under U.S. and country Z tax laws and is not subject to any withholding tax in country Z. If FX were a U.S. corporation, the $1,000 would qualify for the DRD except for section 245A(e).
Under country Z tax law, however, 75 percent of corporate income tax paid by a country Z corporation is refunded to the corporation’s shareholders (regardless of where they reside) upon a dividend distribution. The corporate tax rate in country Z is 20 percent.
FX is allowed a refundable tax credit of $187.50 calculated as follows:
$1,000 distribution/(100% - 20%) = $1,250 pretax earnings that funded the dividend * 20% tax rate * 75% credit = $187.50
The refundable tax credit is equivalent to a $937.50 deduction as shown below:
$187.50 credit/20% tax rate = $937.50
The $937.50 is a hybrid deduction because it is allowed to FX, a person related to FZ. It relates to amounts distributed regarding instruments issued by FZ that are treated as stock under U.S. tax law, and it causes the earnings that funded the distribution to not be included in income under country Z’s tax law. FX has an HDA of $9.375 in each of FZ’s 100 shares.
$937.50 of the $1,000 distribution is a tiered hybrid dividend because the sum of FX’s HDAs in its shares of FZ stock at the end of Year 2 is $937.50. At the end of year 2, FX’s HDAs are all reduced by $9.375 to zero.
The tiered hybrid dividend is treated as subpart F income of FX, US1 must include it in gross income, and section 245A(d) disallows FTCs and deductions. The characterization of the FZ stock under country X or any other foreign tax law does not affect the result.
Moreover, the result would be the same if FX were instead a tax resident of country Z and under country Z’s tax law FX did not include the $1,000 in income because, for example, country Z tax law gave country Z resident corporate shareholders a 100 percent exclusion or DRD for dividends received from their country Z subsidiaries.
Example 2’s second scenario assumes the same facts except that country Z tax laws subject the $1,000 dividend to a 30 percent withholding tax of $300, and the $187.50 refundable tax credit reduces the withholding tax to $112.50 ($300 - $187.50). The refundable credit is not a hybrid deduction because FX was subject to country Z withholding tax that was greater than the credit.
HDAs are key to administering the hybrid dividend exception to section 245A’s DRD when a CFC country’s tax benefit is available in a year different than the actual dividend distribution. In its notice of proposed rulemaking, Treasury requested comments on two alternative approaches to combining the HDA concept and previously taxed E&P. The first was not increasing HDAs for subpart F and GILTI inclusions; and the second was reducing HDAs for distributions of previously taxed E&P.
Section 245A(e) was intended to prevent double nontaxation, which is absent if earnings excluded from the foreign tax base though a hybrid deduction are still taxed by the U.S. as GILTI, subpart F income, or any other amount directly included in U.S. income. These income inclusions should not increase an HDA, which would cause double taxation.
HDAs should, however, be reduced by distributions of previously taxed E&P (including section 956 investments in U.S. property that are subpart F inclusions). The proposed regulations may assume that section 245A(e) will have minimal impact since most CFC distributions will be made of previously taxed E&P (significant for many taxpayers due to the section 965 transition tax). However, positive HDAs may require taxpayers to record deferred tax liabilities under generally accepted accounting principles, which will reduce earnings and increase effective tax rates.