Tax Group Suggests Range of Changes for Anti-Hybrid Regs

February 26, 2018

Internal Revenue Service,
CC:PA:LPD:PR (REG-104352-18),
Room 5203,
Post Office Box 7604,
Ben Franklin Station,
Washington, DC 20044.

Re: Comments on proposed regulations implementing IRC sections 245A(e) and 267A (NPRM REG-104352-18)

Dear Sir or Madam:

The Alliance for Competitive Taxation (“ACT”) is a coalition of leading American companies from a wide range of industries that supports a globally competitive corporate tax system that aligns the United States with other advanced economies.

Attached are ACT's comments on proposed regulations implementing sections 245A(e) and 267A of the Internal Revenue Code (“Code”) as amended by the Tax Cuts and Jobs Act (TCJA) (collectively, the “anti-hybrid proposed regulations”). ACT recognizes and commends the extraordinary efforts of Treasury and IRS staff in issuing TCJA guidance in a timely and comprehensive manner.

We appreciate your consideration of these comments. ACT representatives welcome future discussion of these comments with your staff.

Yours sincerely,

Alliance for Competitive Taxation

cc:
L. G. “Chip” Harter, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury
Harvey B. Mogenson, Tax Specialist, Office of International Tax Counsel, U.S. Department of Treasury
Brenda Zent, Special Advisor on International Taxation, Office of International Tax Counsel, U.S. Department of Treasury
Jason Yen, Attorney-Advisor, Office of International Tax Counsel, U.S. Department of the Treasury
Shane M. McCarrick, Senior Counsel, Office of the Associate Chief Counsel (International, Branch 4), I.R.S.
Tracy M. Villecco, Attorney-Advisor, Office of the Associate Chief Counsel (International, Branch 1), I.R.S.

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COMMENTS BY ALLIANCE FOR COMPETITIVE TAXATION ON THE ANTI-HYBRID PROPOSED REGULATIONS

I. INTRODUCTION

This document sets forth the comments of the Alliance for Competitive Taxation (“ACT”) on the anti-hybrid proposed regulations implementing sections 245A(e) and 267A of the Internal Revenue Code as amended by the Tax Cuts and Jobs Act (NPRM REG-104352-18).

II. COMMENTS RELATING TO CERTAIN ASPECTS OF THE ANTI-HYBRID PROPOSED REGULATIONS

A. INTERACTION OF SUBPART F AND GILTI INCLUSIONS WITH “HYBRID DEDUCTION ACCOUNTS”

Proposed Regulations

The proposed regulations provide that hybrid deduction accounts must be maintained by CFCs and are reduced when an amount in a hybrid deduction account gives rise to a hybrid dividend or tiered hybrid dividend. The proposed regulations do not provide rules regarding how the hybrid deduction account should be adjusted for cases where the U.S. shareholders of the CFC with the hybrid deduction have amounts included in income under section 951 or section 951A.

Treasury Explanation

The preamble to the proposed regulations provides the following explanation:

ACT Recommendation

ACT recommends that final regulations adopt the exemption approach (i.e., the first approach described in the preamble), so that hybrid deductions of a CFC related to earnings of the CFC included in the income of a U.S. shareholder under section 951(a) or 951A do not increase the hybrid deduction account¹. Final regulations should also make clear that such amounts are determined without regard to any section 960 credits.

In addition, the final regulations should provide that hybrid deductions that relate to amounts that are directly included in U.S. income (as ECI or FDAPI) do not increase the hybrid deduction account.

Reasons for ACT Recommendation

ACT believes that it would be inappropriate for the same payment received by a CFC to give rise to subpart F or GILTI inclusions to its U.S. shareholder and also to increase a hybrid deduction account so that a future dividend paid by the CFC earning the subpart F income or GILTI is treated as a hybrid dividend. Section 245A(e) is intended to prevent double non-taxation.² Double non-taxation is absent to the extent earnings excluded from the foreign tax base by reason of a hybrid deduction are taxed by the United States as subpart F income, GILTI, ECI, or FDAPI. The corollary is that such hybrid deductions should not be allocated to untaxed section 959(c)(3) earnings that have not been subject to U.S. tax but that were included in the foreign tax base. Another rule would be at odds with the purpose of the hybrid dividend rules, which is to subject to U.S. tax earnings that otherwise would escape taxation in both the United States and the CFC jurisdiction by reason of a hybrid deduction.

The preamble to the proposed regulations acknowledges this issue by requesting comments on two approaches to addressing the interaction of the hybrid dividend rules and PTEP. The first approach, to exempt hybrid deductions of a CFC from increasing a hybrid deduction account to the extent attributable to the CFC's income subject to U.S. tax under subpart F or GILTI, would ensure a hybrid deduction account is only increased to the extent a hybrid deduction would otherwise result in foreign earnings escaping both the foreign tax base and the U.S. tax base. The second approach, to reduce hybrid deduction accounts for distributions of PTEP, would ensure a hybrid deduction is not taken into account under the hybrid dividend rules to the extent a CFC distributes PTEP related to the hybrid deductions that gave rise to the hybrid deduction account.

For an example of the issue raised by the preamble and potentially addressed by the two approaches described above, assume a domestic corporation, USP, wholly owns a Country X foreign corporation, CFC, which has issued an instrument to USP that is treated as debt under the tax laws of Country X and equity under the tax laws of the United States. Assume further that CFC earns 100u of net income (without regard to foreign income taxes) for U.S. and Country X tax purposes, all of which is tested income, CFC incurs a 40u hybrid deduction, and USP's inclusion percentage is 70% (due to the CFC's qualified business asset investment or QBAI).

In this example, only 60u of CFC's earnings will be included in the Country X tax base due to the 40u hybrid deduction. In addition, 70% of CFC's earnings or 70u will be included in the U.S. tax base by reason of USP's section 951A inclusion, and 70% of the Country X taxes imposed on the 60u Country X tax base will be taken into account in determining the foreign income taxes USP is deemed to have paid with respect to its section 951A inclusion. The remaining 30u of CFC's earnings and profits will be treated as untaxed earnings described in section 959(c)(3). These untaxed earnings will consist of the 30% of the 60u Country X tax base (i.e., 18u) that was not included in USP's section 951A inclusion. CFC's untaxed earnings will also include 12u of earnings (i.e., 30% of the 40u hybrid deduction) that were not included in either the Country X tax base or U.S. tax base. The hybrid dividend rules should apply only to the 12u of earnings that were taxed in neither Country X nor the United States; the remaining 28u of hybrid deduction did not create double non-taxation because of USP's section 951A inclusion and therefore should not increase a hybrid deduction account. ACT's recommendation reaches this result by exempting 28u of the 40u hybrid deduction of CFC from increasing the hybrid deduction account (i.e., the extent attributable to CFC's income subject to U.S. tax under GILTI or 70% of 40u).

Moreover, the amount that is treated as included in the subpart F or GILTI income of a U.S. shareholder should not be reduced for any section 960 credits. Section 245A(e) is intended to prevent double non-taxation, not to cause double taxation. Section 960 credits should not be considered in determining if a dividend is included in U.S. gross income, because absent such credits, double taxation would result.

Of the two potential solutions noted in the preamble, ACT recommends adopting the first approach to ensure the hybrid dividend rules do not apply to a CFC's hybrid deductions attributable to earnings already included in the U.S. tax base. The preamble acknowledges the need to balance the utility of the hybrid dividend rules (in light of the significant previously taxed income that taxpayers have as a result of section 965) against the burdens they impose. The preamble to the proposed regulations presumes that the impact of section 245A(e) will be limited because a large amount of distributions from CFCs will be out of previously taxed income. While this may be true from a cash tax perspective, it ignores the financial statement tax impact. It is likely that financial auditors will require the establishment of deferred tax liabilities for the amount of any positive hybrid deduction accounts, which will reduce company earnings and increase effective tax rates.

Authority for Recommendation

The recommendations are within Treasury's authority under section 245A(g) to issue such regulations as are necessary to carry out the provisions of section 245A.

B. AMOUNTS RECEIVED FROM A CFC WITH RESPECT TO WHICH A RELATED PARTY RECEIVES A DEDUCTION OR OTHER TAX BENEFIT (PROP. REG. § 1.245A(e)-1(d)(2))

Proposed Regulations

Prop. Reg. § 1.245A(e)-1(d)(2)(i) defines a hybrid deduction of a CFC as a deduction or other tax benefit for which two requirements are satisfied. First, the deduction or other tax benefit is allowed to the CFC or a person related to the CFC under a relevant foreign tax law. Second, 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.

Treasury Explanation

The preamble provides the following explanation of this rule:

In general, a dividend is a hybrid dividend if it satisfies two conditions: (i) but for section 245A(e), the section 245A(a) deduction would be allowed, and (ii) the dividend is one for which the CFC (or a related person) is or was allowed a deduction or other tax benefit under a 'relevant foreign tax law'. . . The proposed regulations take into account certain deductions or other tax benefits allowed to a person related to a CFC (such as a shareholder) because, for example, certain tax benefits allowed to a shareholder of a CFC are economically equivalent to the CFC having been allowed a deduction.”

ACT Recommendation

ACT recommends that the application of section 245A(e) be limited to cases where a CFC dividend payor directly receives a foreign tax law deduction or other foreign tax benefit (“hybrid deduction”) that relates to, or results from the dividend, except when (1) the IRS demonstrates under foreign law that a hybrid deduction of a related person is tied directly to the dividend and is claimed if the dividend is paid, (2) treating such hybrid deduction as tied to the dividend does not result in double counting of the hybrid deduction, meaning that the related person and the CFC dividend payor both are ultimately treated as paying hybrid dividends based on a single hybrid deduction, and (3) most importantly, the IRS proves there is double non-taxation as a result of the related person's receiving a hybrid deduction. In addition, ACT recommends that for purposes of testing whether a hybrid deduction of a related person is tied to a dividend paid by a related CFC, the definition of a related person require at least 80 percent relatedness.

Reasons for ACT Recommendation

The expansion of the scope of section 245A(e) to include as hybrid dividends any dividend for which “[t]he deduction or other tax benefit is allowed to the CFC (or a person related to the CFC) under a relevant foreign law” (emphasis added) is overly broad and vague because it is not limited to situations in which the foreign deduction is tied directly to the dividend, e.g., the foreign deduction arises only as a result of the dividend payment and is claimed if the dividend is paid.

The proposed regulations provide that a hybrid deduction of a CFC includes any deduction or other tax benefit allowed to the CFC (or a person related to the CFC) under a relevant foreign tax law, if 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, without specifying how this is to be determined. In ACT's view, the justification in the preamble that “certain tax benefits allowed to a shareholder of a CFC are economically equivalent to the CFC having been allowed a deduction” is insufficient. The proposed regulations impose on taxpayers a heavy and vaguely defined compliance burden by requiring them to identify foreign deductions of related persons (which often number in the hundreds for ACT Members) and then determine in a fashion unspecified by the proposed regulations whether such deductions are tied to dividends paid by another person. Nothing in section 245A or its legislative history (1) indicates that section 245A(e) was intended to apply to foreign deductions claimed by any person except the dividend payor, or (2) contemplates the compliance burden this expansion of the statutory rules would impose.

This rule may have been intended in part to target situations where a country's tax laws provide that when a shareholder receives a dividend from a corporation resident in that country, the shareholder is entitled to claim a refund of the tax paid by the corporation. In such a case, the shareholder refund may be economically equivalent to a dividends paid deduction and thus present double non-taxation concerns. The specific concern is that such a system indirectly leads to a reduction in tax of the corporation paying the dividend for purposes of its tax law. However, as drafted, the proposed regulations may cause deductions that do not lead to double non-taxation nonetheless to be treated as hybrid dividends.

For example, assume a lower-tier CFC 2 pays a dividend to a higher-tier CFC 1, and the CFC 1 country provides for a dividends received deduction for such dividend. In this scenario, a related person of CFC 2 receives a deduction, such that the dividends received deduction arguably could lead to the dividend being treated as a hybrid dividend even though there is no double non-taxation because CFC 2's income was subject to tax in the CFC 2 country. Similar concerns could arise with respect to CFC stock impairment losses³ or mark-to-market losses on CFC stock.⁴ However, none of these present double non-taxation concerns.

In addition, the proposed regulations at issue could lead to double counting of the foreign deduction of the related person, such that this single foreign tax benefit could cause two (or more) dividends to be treated as hybrid: The original dividend and a dividend paid by the related person. No rule in the regulations precludes this unjustified result by, e.g., excluding the foreign deduction from the related person's “hybrid deduction account.”

ACT recommends that the relatedness threshold be 80 percent, rather than more than 50 percent, as provided in the proposed regulations, because a more than 50 percent threshold means that a foreign deduction equal to only 51 percent of a dividend would taint the entire dividend as hybrid. In these cases, it is another party that enjoys any benefit of the foreign deduction, not the owner of the dividend payor. This is a harsh result contemplated by neither the statute nor the legislative history. Analytically, a 100-percent threshold for relatedness would be most in keeping with the statute. ACT recommends the 80-percent threshold as a reasonable compromise; it is also consistent with the relatedness threshold for consolidated groups and, in the proposed 163(j) regulations, for the election of CFC group treatment.

Regulatory Authority for Recommendation

Section 245A(g) states that the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the provisions of section 245A.

C. TREATMENT OF NOTIONAL INTEREST DEDUCTIONS AS HYBRID DEDUCTIONS (PROP. REG. §§ 1.245A(e)-1(d)(2)(i)(B) AND 1.267A-4(b))

Proposed Regulations

Prop. Reg. § 1.245A(e)-1(d)(2)(i)(B) provides that the type of deduction or other tax benefit that gives rise to a hybrid deduction includes a foreign deduction with respect to equity, such as a notional interest deduction.

Similarly, Prop. Reg. § 1.267A-4(b) states that a hybrid deduction includes a deduction allowed to a tax resident of a foreign country that is not a specified party⁵ with respect to equity, such as a notional interest deduction.

Treasury Explanation

The preamble to the proposed regulations provides that notional interest deductions are treated as giving rise to hybrid deductions because these “raise similar concerns as traditional hybrid instruments.”

ACT Recommendation

ACT recommends that the proposed regulations under sections 245A(e) and 267A be modified to provide that deductions with respect to equity, such as notional interest deductions, not be treated as hybrid deductions.

Reasons for ACT Recommendation

Sections 245A(e) and 267A are intended to address scenarios in which a payment made between certain parties may give rise to a tax deduction under one country's foreign tax law without a corresponding income inclusion in the other country. These rules are generally consistent with those developed by the OECD BEPS project, in which the United States actively participated. BEPS Action 2 includes suggested rules addressing anti-hybrid provisions, and sections 245A(e) and 267A, enacted in TCJA, are generally consistent with the recommendations made by the OECD.

Extending the anti-hybrid rules to apply to notional interest deductions is an expansion of sections 245A(e) and 267A beyond the BEPS Action 2 recommendations. Similarly, the European Union's Anti-Tax Avoidance Directive (“ATAD”) does not address notional interest deductions.

Although the availability and determination of a notional interest deduction can vary by jurisdiction, in the typical case, the deduction is equal to the product of (1) a specified percentage representing the long-term, risk-free financing rate, and (2) the sum of the corporation's share capital and retained earnings. Thus, the amount of the deduction is based on the company's equity, not distributed earnings, and is unrelated to any payments of dividends. That is, a notional interest deduction arises irrespective of whether any dividends are ever paid. A country's decision to grant its tax residents notional interest deductions will typically be driven by legitimate policy concerns, such as to reduce the tax incentive for leverage, as excessive leverage may jeopardize financial stability. That incentive is reduced by essentially allowing interest deductions whether funding is via equity or debt.

Accordingly, the proposed regulations, if they apply to notional interest deductions, would make the United States an outlier compared to other countries as regards the anti-hybrid rules and could impair the competitiveness of U.S. companies. ACT believes that this result is inappropriate given that (1) notional interest deductions are not connected to dividends, and (2) a purpose of U.S. tax reform is to make the U.S. corporate income tax regime more in line with those of other countries and the BEPS standards.

Regulatory Authority for Recommendation

The recommendations are within Treasury's authority under sections 245A(g) and 267A(e) to issue such regulations as are necessary to carry out the provisions or purposes of sections 245A and 267A, respectively. Additionally, section 267A(e) lists a number of specific grants of regulatory authority but does not mention expanding the rules to cover notional interest deductions or other local benefits unrelated to dividends. Section 267A(e)(7)(B) expressly mentions regulations where the Secretary determines there is no risk of eroding the U.S. federal tax base.

D. TREATMENT OF CERTAIN GROUP RELIEF CONTRIBUTIONS AS HYBRID DEDUCTIONS (PROP. REG. § 1.245A(e)-1(d)(2))

Proposed Regulations

Prop. Reg. § 1.245A(e)-1(d)(2) defines as a hybrid deduction any deduction or other tax benefit that “relates to or results from” an amount otherwise eligible for the section 245A DRD. As a result, certain group relief or similar payments between related CFCs that are tax residents of the same country could be treated as hybrid dividends to the extent such payments are deemed dividends under section 301 for U.S. tax purposes.

Treasury Explanation

N/A.

ACT Recommendation

ACT recommends that Treasury clarify in final regulations (including through inclusion of examples) that payments between related CFCs for the purpose of sharing or shifting tax liability under a tax consolidation, fiscal unity, group relief, loss sharing, or similar regime are not hybrid deductions.

Reasons for ACT Recommendation

As discussed below, the payments described in the ACT recommendation do not result in double non-taxation and therefore should not give rise to hybrid dividends.

Under a loss surrender regime such as that in the United Kingdom, in some cases the recipient of the surrendered loss (the “surrenderee”) pays the surrendering affiliate (the “surrenderer”) for that loss. Under U.S. rulings,⁶ these payments are treated as constructive capital contributions and/or dividends, as required to account for the fact that the payment moved funds from the surrenderee to the surrenderer. These constructive transfers do not exist for U.K. purposes and thus are not deductible for U.K. tax purposes. Under the U.K. group relief system, the only deduction is for the economic loss suffered by the surrenderer. This deduction is unrelated to the constructive dividend. This is clear from the fact that if, as is common, no payment is made for the surrendered loss, there is no constructive dividend, but the loss is still deductible in the United Kingdom.

A group relief system does not exempt economic income from foreign tax in any manner. Similar to the U.S. consolidated group rules, under a foreign group relief system, economic losses reduce economic profit. As a result, the appropriate amount of economic income is taxed by the foreign country.

In other countries, such as Germany, taxpayers that affiliate in an Organschaft generally appoint their common parent to pay the German tax owed by all the Organschaft members. Sometime later, the affiliates must distribute all their profits to the common parent. As a result, one might say the affiliates receive a deduction for the profits they distribute. However, these profits are fully subject to German tax in the common parent's hands. The reason the affiliates distributing their profits “deduct” them is simply to avoid double taxation by Germany of the German profits. This is essentially the same double taxation avoidance function served by exempting intercompany dividends in a U.S. consolidated group from U.S. tax. Certain other countries permit profit sharing among affiliates resulting in a “deduction” of the profit shared by the affiliate that shares its profit with another entity. The function of this “deduction” again is to prevent double foreign taxation of the same profit.

In none of the regimes described above is there double non-taxation—the perceived abuse at which section 245A(e) is aimed. Whatever the United States may or may not tax in these situations, there is at least one level of taxation occurring under the foreign tax regime. Therefore, section 245A(e) should not apply to the actual or constructive dividends or actual payments occurring under these regimes.

Regulatory Authority for ACT Recommendation

The recommendations are within Treasury's authority under section 245A(g) to issue such regulations as are necessary to carry out the provisions of section 245A.

E. TREATMENT OF TIERED SUBSIDIARIES (PROP. REG. § 1.245A(e)-1(d)(2))

Proposed Regulations

Prop. Reg. § 1.245A(e)-1(b)(2) defines a hybrid dividend as an amount received from a CFC for which (but for section 245A(e) and Prop. Reg. § 1.245A(e)-1) there would be allowed a deduction under section 245A(a). This definition of hybrid dividend under Prop. Reg. § 1.245A(e)-1(b)(2) includes both dividends sourced from earnings and profits of the CFC that benefitted from the relevant hybrid deduction and dividends sourced from earnings and profits of subsidiaries of the CFC that did not so benefit.

In addition, Prop. Reg. § 1.245A(e)-1(d)(2)(i) defines a hybrid deduction to include a deduction or other tax benefit that 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. The proposed regulations do not limit this definition based on whether the deduction or other tax benefit is part of an imported mismatch arrangement (i.e., an arrangement in which a CFC obtains a foreign tax deduction or other foreign tax benefit that offsets a foreign law income inclusion attributable to a hybrid deduction taken into account by a person related to the CFC, resulting in a net tax benefit only for the person related to the CFC).

Treasury Explanation

N/A.

ACT Recommendation

ACT recommends that the final regulations take into account tiered subsidiaries by (1) limiting hybrid dividends to distributions sourced from earnings and profits of a CFC or tiered subsidiaries below it that benefitted from the hybrid deduction, and (2) limiting hybrid deductions to deductions or other tax benefits that are not offset by foreign law income inclusions attributable to hybrid deductions that are taken into account by a person related to the CFC.

Reasons for ACT Recommendation

Section 245A(e) is intended to prevent double non-taxation, not to cause double taxation. In the case of tiered subsidiaries, however, the proposed regulations can result in double taxation by ignoring earnings that have already been subject to foreign tax in treating a deductible distribution of such earnings as a hybrid dividend and denying a section 245A DRD.

Dividends attributable to earnings that did not benefit from a hybrid deduction should not give rise to hybrid dividends. For example, assume a domestic corporation USP wholly owns a Country A foreign corporation CFCA, which wholly owns a Country B foreign corporation CFCB. CFCA has issued an instrument to its shareholder that is treated as debt under the tax laws of Country A and equity under the tax laws of the United States. Assume the CFCA instrument has given rise to a hybrid deduction account with respect to the CFCA instrument, CFCA has no untaxed earnings described in section 959(c)(3), and CFCB has untaxed earnings described in section 959(c)(3), which CFCB distributes to CFCA and which CFCA then distributes to USP. In this case, the distribution of CFCB earnings through CFCA to USP would appear to constitute a hybrid dividend to the extent of the hybrid deduction account with respect to the CFCA instrument, despite the fact that Country B tax was imposed on the distributed earnings. The same issue might arise if CFCB were organized in Country A because Country A tax might be imposed on the CFCB earnings that were ultimately distributed.⁷ Any hybrid deduction account maintained should not cause a dividend to be treated as a hybrid dividend except to the extent the dividend constitutes a distribution of earnings that benefitted (by escaping foreign tax) from the hybrid deductions that gave rise to the hybrid deduction account.

Imported mismatch arrangements can create the appearance of multiple hybrid deductions that in fact produce only a single foreign tax benefit. For example, assume a domestic corporation USP wholly owns a Country X foreign corporation CFCX, which wholly owns a Country Y corporation CFCY. CFCX has issued an instrument to its shareholder, USP, that is treated as debt under the tax laws of Country X and equity under the tax laws of the United States. CFCY has issued an instrument to its shareholder, CFCX, that is treated as debt under the tax laws of Country X and Country Y and equity under the tax laws of the United States. In this case, CFCY has received a Country Y tax benefit from its deduction on the CFCY-issued instrument, but CFCX has not received a net Country X tax benefit because its deduction on the CFCX-issued instrument is offset by the taxable interest income it received on the CFCY-issued instrument. In this case, there is no hybridity in the CFCY-issued instrument with respect to the relevant jurisdictions (Country X and Country Y) because CFCX recognizes income under Country X tax law matching CFCY's deduction. Nevertheless, CFCX offsets this income with a deduction taken with respect to the CFCX-issued instrument, which is a hybrid instrument. Consequently, the hybridity of the CFCX-issued instrument is imported into Country Y by reason of the CFCY-issued instrument in what is, in substance, an imported mismatch arrangement. The proposed regulations would appear to treat this arrangement as giving rise to a hybrid deduction with respect to each of the CFCX-issued and CFCY-issued instruments, but only a single hybrid deduction with respect to the CFCY-issued instrument would be appropriate to take into account because only a single foreign tax benefit has been obtained.⁸

Regulatory Authority for ACT Recommendation

The recommendations are within Treasury's authority to interpret the phrase “deduction (or other tax benefit) with respect to any income, war profits, or excess profits taxes imposed by any foreign country or possession of the United States” to include only deductions that create a local tax benefit, as well as within Treasury's authority under section 245A(g) to issue such regulations as are necessary to carry out the provisions of section 245A.

F. TREATMENT OF HYBRID DEDUCTION FOR WHICH NO LOCAL TAX BENEFIT IS OBTAINED

Proposed Regulations

As indicated above, Prop. Reg. § 1.245A(e)-1(d)(2)(i) defines the term hybrid dividend to include a “deduction or other tax benefit (such as an exemption, exclusion, or credit, to the extent equivalent to a deduction)” (“hybrid deduction”) but does not indicate whether an actual reduction in local tax must be obtained from the deduction or other benefit for the section 245A deduction to be denied.

Treasury Explanation

N/A.

ACT Recommendation

Limit the definition of the term “hybrid deduction” to foreign tax deductions and other benefits for which there is an actual reduction in foreign tax.⁹

Reasons for ACT Recommendation

As indicated above, section 245A(e) is intended to prevent double non-taxation. Where a foreign tax deduction or other foreign tax benefit does not result in an actual reduction in local tax, however, there has been no double non-taxation and therefore section 245A(e) should not apply to deny the section 245A deduction. This circumstance can arise where, for example: (1) a CFC has foreign tax losses that prevent the use of a hybrid deduction in the year the deduction arises or any other year to which it may be carried; (2) a CFC is subject to a local thin capitalization or other limitation on the extent to which it may take a deduction; or (3) a CFC's sole income is exempt income (e.g., because the CFC is a holding company and the local jurisdiction provides a 100% participation exemption) and that exempt income bore foreign tax at a lower-tier subsidiary level. In cases where a hybrid deduction does not result in an actual reduction in local tax, the CFC may have a hybrid deduction within the meaning of the proposed regulations without the foreign tax relief of which Congress disapproved.

The proposed regulations would appear to require a hybrid deduction account be created or increased in the above examples where double non-taxation does not occur. The hybrid deduction account could subsequently result in an unfavorable hybrid dividend on a distribution by a CFC that could not reduce foreign tax with the associated hybrid deduction, or the attachment of the inflated hybrid deduction account to the shares of another CFC that makes distributions.

Authority for Recommendation

The recommendation is within Treasury's authority to interpret the phrase “deduction (or other tax benefit) with respect to any income, war profits, or excess profits taxes imposed by any foreign country or possession of the United States” to include only deductions that create a local tax benefit, as well as within Treasury's authority under section 245A(g) to issue such regulations as are necessary to carry out the provisions of section 245A.

G. INTERACTION OF PROPOSED SECTION 956 REGULATIONS WITH PROP. REG. § 1.245A(e)-1

Proposed Regulations

The proposed section 956 regulations provide that a U.S. shareholder of a CFC that makes an investment in U.S. property will have an inclusion under section 951(a). Prop. Reg. § 1.956-1(a)(2) reduces the inclusion to the extent that a distribution of the earnings of the CFC would be eligible for a section 245A deduction.

If at the time of the section 956 inclusion, the CFC has a hybrid deduction account, then a dividend paid by the CFC would be ineligible for the section 245A deduction to the extent of the amount in such account. Assume the hybrid deduction account equals untaxed E&P. In that case, the U.S. shareholder will have a section 956 inclusion that is fully subject to U.S. tax. Thus, the double non-taxation that would otherwise result from the hybrid deduction giving rise to the hybrid deduction account is avoided. However, under Prop. Reg. § 1.245A(e)-1(b)(2), a CFC's hybrid deduction account is not reduced for inclusions under section 956 because such inclusions are not themselves hybrid dividends. As a result, when the CFC makes a future distribution of non-PTEP, there will be a duplicative hybrid dividend (and only then does the CFC reduce its hybrid deduction account). The result will be taxation by the United States twice with respect to a single reduction of foreign tax.

Treasury Explanation

N/A.

ACT Recommendation

ACT recommends that the final regulations provide a rule that reduces a CFC's hybrid deduction account for section 956 inclusions.

Reasons for ACT Recommendation

Due to the lack of guidance about the interaction of section 956 with the hybrid deduction account, a single hybrid deduction can inappropriately lead to double U.S. taxation with respect to a single hybrid deduction and related foreign tax reduction. The reason that section 956 mandates an inclusion in this case is specifically because the CFC has a hybrid deduction account. For example, assume a CFC has a $100 hybrid deduction in year 1 that gives rise to a $100 hybrid deduction account. In year 2, the CFC makes a $100 investment in U.S. property. If the CFC paid a dividend, section 245A would not be available for such dividend because of the hybrid deduction account, and section 956 would apply. The fact that the presence of the hybrid deduction account causes the investment in U.S. property to be subject to U.S. tax makes it appropriate to reduce the hybrid deduction account by a corresponding $100. Otherwise, a future $100 dividend would be ineligible for the section 245A dividends received deduction, resulting in double U.S. taxation with respect to a single hybrid deduction and related foreign tax reduction.

Authority for Recommendation

The recommendations are within Treasury's authority under section 245A(g) to issue such regulations as are necessary to carry out the provisions of section 245A.

H. CLARIFICATION OF SUBPART F AND GILTI EXCEPTIONS (PROP. REG. §§ 1.245A(e)-1(d) and 1.267A-3(b))

Proposed Regulations

As discussed above, regulations under section 245A(e) provide that a hybrid deduction account is increased by a hybrid deduction of a CFC irrespective of the extent to which this CFC's income results in an income inclusion of a U.S. shareholder under section 951(a) or 951A.

In addition, Prop. Reg. § 1.267A-3(b)(4) provides that a deduction for a payment of interest or royalties is not subject to disallowance under section 267A to the extent that the item is included in a U.S. shareholder's income under section 951(a) or 951A. The proposed regulations make clear that the determination of whether an item is included in income under section 951(a) is made without regard to allocable deductions of the CFC or qualified deficits of the CFC.

The proposed regulations do not, however, address the result if a subpart F inclusion is limited by the E&P limitation of Reg. § 1.951-1(b).

Treasury Explanation

N/A.

ACT Recommendation

ACT recommends the final regulations clarify that when determining the amount of a payment to a CFC that is treated as included in a U.S. shareholder's income currently under subpart F, such determination is made not only without regard to any allocable deductions or qualified deficits of the CFC, but also without regard to whether the U.S. shareholder's current year subpart F inclusion is limited by the E&P limitation of Reg. § 1.951-1(b).

Reasons for ACT Recommendation

ACT welcomes the clarity provided by the proposed regulations that subpart F income must be determined on a gross basis without adjustments for allocable deductions or qualified deficits. ACT believes that similar policy considerations require applying the subpart F exception to gross income without regard to the E&P limitation of Reg. § 1.951-1(b).

The proposed regulations do not specifically address this issue. ACT believes additional clarity is needed. Specifically, ACT notes the legislative history under section 267(a) indicates that the rule ACT recommends here for purposes of the anti-hybrid rules would not apply with respect to section 267(a). For purposes of that rule, a subpart F exception also applies based on the gross amount of subpart F income, but Congress intended the exception to be reduced to the extent that subpart F income is not included due to the E&P limitation.¹⁰ However, as discussed below, ACT believes that the policies underlying this rule in the context of section 267(a) are different from those of section 267A.

Section 267(a) is only a timing rule that determines when a U.S. person may take a deduction for an accrued amount. It defers the deduction until the payment is either actually made or is included in a U.S. shareholder's subpart F income. Even if the subpart F exception under section 267(a) is inapplicable due to the E&P limitation, the deduction is freed up either in the year in which the associated payment is actually made or in the later year in which the E&P limited subpart F income is subject to recapture and subpart F tax. This is consistent with the requirement under section 267(a) that the income is includible in subpart F income in the year of the deduction. It is thus appropriate to apply what is essentially a timing rule under Reg. § 1.951-1(b) to section 267(a).

By contrast, section 267A would permanently disallow a deduction of interest or royalties. Accordingly, reducing the amount of the subpart F inclusion by the amount of the E&P limitation would have the effect of permanently denying the deduction, notwithstanding that the subpart F income may be recaptured and taxed in a future year. Similarly, under section 245A(e), CFC-to-CFC hybrid dividends excluded from current subpart F taxation under the current-year E&P limitation would lead to a hybrid deduction account regardless of whether the subpart F income is recaptured and taxed in a future year. Consistent with the difference between section 267A and section 267(a) described above, the subpart F exception of section 267A(b) (flush language) only requires the income to be included in subpart F income, without the “in the year of the deduction” language of section 267(a).

Thus, because section 267A leads to a permanent denial of a deduction, it is not appropriate to take the E&P limitation into account in determining whether the subpart F inclusion exception of Prop. Reg. § 1.267A-3(b) applies.

Authority for Recommendation

The recommendation is within Treasury's authority under sections 245A(g) and 267A(e) to issue such regulations as are necessary or appropriate to carry out the provisions or purposes of sections 245A and 267A.

I. IMPORTED MISMATCHES (PROP. REG. § 1.267A-4)

Proposed Regulations

Prop. Reg. § 1.267A-4 may result in the double taxation of certain income earned by a CFC by denying the CFC a deduction for interest or royalties paid to a related party that is fiscally transparent for U.S. tax purposes (such as a partnership or disregarded entity), irrespective of whether the related party's income is included in a U.S. shareholder's subpart F or GILTI income.

Under Prop. Reg. § 1.267A-4(b), the imported hybrid mismatch rules of Prop. Reg. § 1.267A-4 can apply to a hybrid deduction allowed to a tax resident of a foreign country or taxable branch of a foreign company that is not a “specified party.”¹¹ Prop. Reg. § 1.267A-5(a)(17) provides that an entity that is fiscally transparent for U.S. tax purposes is not a specified party. Thus, to the extent that such an entity has a hybrid deduction, the imported mismatch rules may apply notwithstanding that the income is included in a U.S. shareholder's subpart F income or GILTI.

Treasury Explanation

N/A.

ACT Recommendation

ACT recommends that Treasury provide either that (1) for purposes of the disqualified imported mismatch rules, a specified party can include an entity that is transparent for U.S. tax purposes, or (2) a payment is not an imported mismatch payment to the extent that it is included in the subpart F income or GILTI of a U.S. shareholder.

Reasons for ACT Recommendation

The proposed regulations can lead to scenarios where a deduction is denied despite a payment being included in a U.S. shareholder's subpart F income or GILTI.

For example, assume a U.S. corporation owns two CFCs (CFC1 and CFC2), and CFC1 and CFC2 each own 50 percent of FX, an entity organized in Country X that is treated as transparent for U.S. tax purposes, with FX in turn owning CFC3. FX incurs a hybrid deduction, and CFC3 makes a payment of interest to FX.

In this example, even though the payment made by CFC3 is included in the income of CFC1 and CFC2, and is included in the U.S. parent's subpart F income or GILTI, the imported hybrid mismatch rules are not turned off.

This result is an apparent oversight. It occurs because the imported hybrid mismatch rules of Prop. Reg. § 1.267A-4 do not coordinate subpart F and GILTI inclusions through the rules of Prop. Reg. § 1.267A-3(b), but instead coordinate the rules by providing that a hybrid deduction incurred by a specified party is not taken into account for purposes of determining whether a disqualified imported mismatch amount exists. In many cases, this result makes sense, as the specified party itself would need to determine whether the hybrid deduction is nondeductible at the specified party level under section 267A. However, in the example depicted above, the deduction would be denied to CFC3, even though the income will be included in subpart F income or GILTI of the U.S. parent. Accordingly, final regulations should modify this result, either by broadening the definition of a specified party for these purposes to include a tax resident of a foreign country that is transparent for U.S. tax purposes, or by applying the subpart F and GILTI exclusions of Prop. Reg. § 1.267A-3(b) to imported hybrid mismatches.

Authority for Recommendation

The recommendation is within Treasury's authority under section 267A(e) to issue such regulations as are necessary or appropriate to carry out the purposes of section 267A.

III. CONCLUSION

We understand that a number of details would need to be addressed if Treasury and the IRS accept the recommendations set forth above. ACT representatives would welcome the opportunity to meet with Treasury and the IRS to discuss any of the above recommendations.