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News Analysis: Practitioners Finding Surprises in Proposed Anti-Hybrid Regs

POSTED ON Feb. 12, 2019
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While tax practitioners are not surprised that recently proposed U.S. regulations on hybrid arrangements rely heavily on the OECD’s base erosion and profit-shifting project, they are surprised that the rules appear to adopt a more expansive definition of hybridity, according to experts from Deloitte.

The proposed regs — which tackle hybrid arrangements under sections 245A(e) and 267A — dropped at the tail end of December 2018, and left some taxpayers scrambling to determine what the impact might be since parts of the package are slated to apply retroactively from January 1, 2018. As taxpayers and practitioners comb through 154 pages of regulations, they are noticing a few unexpected developments in the section 267A regs. These include the definition the government wants to apply to hybridity, Anu Alex, a principal with Deloitte’s International Tax practice, said during a January 24 webcast.

Hybrid mismatches occur when an entity, transaction, or financial instrument receives different tax treatment across two or more jurisdictions and is ultimately not taxed in any of them. The situation is referred to as a deduction/no inclusion (D/NI) result.

Hybrid entities are taxable in one jurisdiction, but fiscally transparent in the United States, meaning that the entity’s investors or owners — and not the entity itself — are taxable. The proposed regs for section 267A disallow deductions for interest and royalties that are paid or accrued to a related entity if those amounts are not included in income under the entity’s local tax law or allowable as a deduction, creating a D/NI situation. The amount that is excluded is called a “disqualified related party amount.”

“Instead of limiting hybridity to a character mismatch such as a mismatch between debt and equity, these rules look to the recipient jurisdictions, that if that recipient had included an actual amount of interest or royalty, would they have taken that interest or royalty into account. That expanded concept of hybridity was one area that I thought was a surprise,” Alex said.

Ties to BEPS Action 2

Sections 245A and 267A were implemented in 2017 as part of the Tax Cuts and Jobs Act, and designed to dissuade taxpayers from using hybrid transactions and entities to reduce their tax bills.

The proposed regs borrow their terminology and methodology from BEPS action 2, “Neutralizing the Effects of Hybrid Mismatches,” referenced in the document. However, the webcast explained that there are some differences. The 267A proposed rules generally define a hybrid deduction as one allowed to a foreign tax resident or taxable branch for an amount paid or accrued as interest or royalties that would be disallowed under the provisions of the 267A proposed regs, if the foreign law contained similar rules. The definition also applies to certain equity deductions.

Compare that to the OECD’s definition in action 2, which says that a hybrid deduction may be any of the following:

  • a payment under a financial instrument that creates a hybrid mismatch;

  • a disregarded payment from a hybrid payer that creates a mismatch;

  • a payment to a reverse hybrid that creates a mismatch; or

  • a payment from a hybrid payer or dual resident that creates a duplicate deduction and ultimately a hybrid mismatch.

New Framework and Scenarios

The proposed regs apply to specified parties that are either U.S. tax residents, U.S. taxable branches, or certain controlled foreign corporations. CFCs that lack a direct or indirect 10 percent U.S. shareholder as defined under section 958(a) are exempt from the definition.

The proposed regs disallow deductions for certain kinds of interest and royalties that are paid or accrued, known as “specified payments.” Those payments fall into three groups:

  • disqualified hybrid amounts — situations in which a hybrid or branch arrangement creates a D/NI outcome;

  • disqualified imported mismatch amounts — situations in which an offshore hybrid or branch arrangement is imported into the U.S. tax system and creates an indirect D/NI outcome; and

  • payments meant to circumvent the antiavoidance provisions of 267A that result in a D/NI outcome.

The proposed regs also clarify how specified payments under purchase-repurchase (repo) transactions should be calculated for purposes of 267A, which is a change from the statute, according to Alex. Under U.S. tax law, such payments are not disregarded payments. If they are disregarded under foreign law, but are also connected to an amount that is not disregarded under foreign law, then the specified payment determination is based on the connected amount.

“Arguably, the statute focused on deductions in the context of these repo transactions. There are certain jurisdictions that may give a credit for the dividend as opposed to an exemption system. These regulations treat a credit also as a no inclusion for purposes of the disqualified hybrid amount rule,” Alex said.

The proposed regs also exempt cases in which a D/NI event is not caused by hybridity but is instead caused by a different feature of foreign tax law, like a low-tax regime. The statutory language does not explicitly say that D/NI events must be caused by hybridity, but the legislative history indicates that 267A is supposed to target hybrid-related D/NI results, not all D/NI results. This clarification in the proposed regs is meant to ensure that 267A is applied in the correct manner.

Disqualified hybrid amounts are a specific type of disregarded payment — under the proposed regs, the disregarded payment must exceed the party’s amount of dual inclusion income. That dual inclusion income is calculated by dividing the specified party’s income or gain attributable to its tax resident or branch by the party’s deductions or losses that are allowable under the law. Luckily for taxpayers, the provision on disregarded payments is prospective, applicable to tax years starting after 2018.

The proposed regs also explain the proper treatment for deemed branch payments and branch mismatch payments, to prevent taxpayers from using branches to circumvent the statute. Deemed branch payments are interest and royalty payments that are deducted by a U.S. permanent establishment of a treaty resident and are deemed to be paid to the branch’s home office. However, those payments are not regarded under the tax law of the home office. Under the proposed regs, the D/NI event occurs when the U.S. branch reduces the amount of income attributable to the PE by the interest payments that are sent up to the home office, and the home office fails to include them in income, according to Ryan Bowen, a manager in Deloitte’s Washington National Tax Practice.

“Where you have that situation, the deduction against the U.S. branch’s income in the U.S. is going to be disallowed under 267A,” Bowen said. The provision is also prospective in nature.

Under the proposed regs, “tax residents” are individuals, corporate bodies, or other entities that are liable for tax under a jurisdiction’s laws. The definition applies to entities located in jurisdictions that do not impose corporate income tax, a surprising twist, according to the webcast.

“If you’re in a jurisdiction, maybe Jersey or the Cayman Islands, that does not impose a [corporate] income tax, it still falls within the definition of a tax resident for this purpose, and the individual is also liable to tax under the tax law, and would also be a tax resident,” Alex said.

Timing differences between the period in which a deduction is allowed under U.S. law and the period in which it is included in the payee’s income under foreign law are also addressed under the proposed regs. Historically, those differences could cause long-term deferral. The new solution is to tax long-term timing differences — proposed payments that are recognized more than 36 months after the tax year in which they are made or deducted.

Branch mismatch payments are treated as disqualified hybrid amounts under the proposed regs. This is a new treatment, according to Bowen. Branch mismatches occur when income on a loan is attributable to a branch and not its home office, and therefore, the income goes untaxed by the home office’s jurisdiction. Meanwhile, the branch either doesn’t pay taxes under its local laws or local law treats the income as attributable to the jurisdiction of the home office.

Ultimately, the issue is whether an entity has included an amount in its income, Bowen said. “That’s really a pervasive theme that determines whether an amount will be a disqualified hybrid because if you don’t have a no inclusion, then the regulations won’t treat it as a hybrid amount not subject to payment under these rules.”

Avoiding 267A

There are several ways in which taxpayers can avoid falling under the 267A rules. The minimum requirement is that the payment in question must be taxable by the United States. If a specified recipient is a U.S. taxable branch or tax resident and takes the payment into gross income, the payment won’t be hit by 267A. The same is true for situations in which income received by a CFC is considered by a U.S. shareholder under subpart F or seen as tested income under global intangible low-taxed income. The subpart F provision was already in the statute, but Treasury and the IRS expanded the language to include GILTI to prevent double taxation.

“The practical result . . . here is that in most cases, outbound arrangements involving CFCs won’t be subject to these rules because ultimately, the payment is going to be picked up as either subpart F or tested income under the GILTI regime,” Bowen said.

Potential Business Effects

Comments on the proposed regs are not due until later in February. But in these early days, some potential effects are beginning to emerge.

“These regulations do impact a lot of the common U.S. inbound structures that were in place, and companies are looking to see what opportunities are still there, and I think there are opportunities still there post-regulations,” Alex said. Rob Rothenberg, a managing director in the Washington National Tax practice, agreed with Alex’s take on the regs’ possible effect, considering that they were created to eliminate all or almost all of the traditional double-dip financing structures used by taxpayers, he said.

“They have done a fairly good job and therefore taxpayers have to think about new structures and perhaps less benefits than they previously have gotten from financing,” Rothenberg said.

The effect on outbound clients is also unfolding, Bowen said.

“In most cases, outbound arrangements involving CFCs won’t be subject to these rules because ultimately, the payment is going to be picked up as either subpart F or tested income under the GILTI regime,” Bowen said.

“We have an exception now for amounts that are increased tested income or reduced tested loss. It’s a pretty broad provision, and it’s going to be a provision that will prevent a lot of our outbound clients from having to really dig in deeply into these 267A proposed regulations,” added Matthew Etzl, a manager in the Washington National Tax practice.

In cases in which clients may not have a GILTI or subpart F inclusion, they must evaluate whether they have a disqualified hybrid amount and a deduction that’s not allowed against the income of the CFC, Etzl said.

“One instance would be earnings earned by certain fiscal-year CFCs that [are] caught under these [proposed reg. 1.267A-2] rules, specifically caught under hybrid transactions or reverse hybrids in [proposed reg. 1.267A-2d] and a transaction where the person receiving the income is an 11/30 year-end CFC . . . well, there’s going to be a portion of earnings that might not have been picked up under GILTI because GILTI wasn’t applicable during that period in 2018. Do we need to worry about a portion of those earnings not being picked up under GILTI and not being picked up under subpart F, and therefore having a situation where you need to worry about [proposed reg. 1.267A-2] and having a disqualified hybrid amount?” Etzl asked. “That would be one limited example.”