In recent years, the use of hybrid entities and hybrid transactions has been a common part of international tax planning strategies. However, under newly enacted Sec. 267A(a), deductions will be disallowed if certain "disqualified related party amounts" paid or accrued to a related party were made pursuant to a hybrid transaction or made by or to a hybrid entity. A disqualified related-party amount is any interest or royalty paid or accrued to a related party if:
1. The amount is not included in the income of the related party under the local tax laws of the country of which the related party is a resident for tax purposes or where the related party is otherwise subject to tax; or
2. The related party is allowed a deduction with respect to the payment under local tax law.
Disqualified related-party amounts do not include payments included in gross income of U.S. shareholders under the rules of Sec. 951(a).
For purposes of the disqualified related-party amount, a related party is defined by reference to Sec. 954(d)(3), which looks to 50% common ownership or control.
Interestingly, prior to the enactment of Sec. 267A, the Organisation for Economic Co-operation and Development (OECD), as part of its base-erosion and profit-shifting (BEPS) framework, also addressed such "income/deduction" mismatches. Specifically, Action 2 of the OECD's 2013 Action Plan on Base Erosion and Profit Shifting addresses hybrid mismatches that result in a deduction without inclusion. In such mismatches, the deduction should be denied in the member state that is the payer jurisdiction. Where the deduction is not denied in the payer jurisdiction, the amount of the payment that would otherwise give rise to a mismatch outcome is to be included in income in the member state that is the payee jurisdiction.
Both Sec. 267A and BEPS Action Plan 2 attempt to address a common subject matter: hybrid arrangements that result in income/deduction mismatches. However, it appears that Sec. 267A may not sufficiently accomplish the intent for which it was enacted, because of uncertainty surrounding key terms and limitations concerning hybrid transactions and entities. Conversely, the new provision may disallow interest deductions in some arrangements that do not result in a mismatch.
Again, Sec. 267A(a) stipulates that for a deduction to be disallowed for certain disqualified related-party amounts, those amounts must be made pursuant to a hybrid transaction or made by or to a hybrid entity. Pursuant to Sec. 267A(d), a hybrid entity is one that is treated as fiscally transparent for U.S. federal income tax purposes (e.g., a disregarded entity or partnership) but not for purposes of the foreign country of which the entity is resident or is subject to tax, or an entity that is treated as fiscally transparent for foreign tax law purposes but not for U.S. federal income tax purposes (a reverse hybrid entity).
Sec. 267A does not include a definition of fiscal transparency, nor is there a specific cross-reference to any other Code sections that provide further clarity. Currently, Regs. Sec. 1.894-1(d)(3)(ii) provides a definition of "fiscally transparent" for the purposes of claiming treaty benefits. Under this provision, an entity is fiscally transparent with respect to an item of income if, under the laws of its jurisdiction, its interest holder is required to separately take into account the item of income on a current basis with the same source and character as if the interest holder had realized the income directly from the originating source. Notably, Regs. Sec. 1.894-1(d)(3)(ii) further states that in determining whether an entity is fiscally transparent with respect to an item of income in the entity's jurisdiction, it is irrelevant that, under the laws of the entity's jurisdiction, the entity is permitted to exclude the item from gross income or that the entity is required to include the item in gross income but is entitled to a deduction for distributions to its interest holders.
It appears that Sec. 267A allows a taxpayer to deduct a disqualified related-party amount if the amount is not paid pursuant to a hybrid transaction or paid by or to a hybrid entity. An income/deduction mismatch could still result, however, through the use of a certain type of European collective investment vehicle (e.g., a German Sondervermögen, a type of open-ended investment fund).
With the introduction of the new taxation system for investment funds in Germany effective in 2018, some of these funds, such as a Sondervermögen, may be considered opaque for both U.S. and German tax purposes. Therefore, under a traditional definition of fiscal transparency, this type of fund may not be a hybrid entity. Further, it appears that although, pursuant to the German tax reform, the Sondervermögen will be subject to German corporate tax at the fund level, the fund will be taxed only on the German-source income. As such, a U.S. subsidiary making interest payments to its parent Sondervermögen may be able to avoid Sec. 267A and deduct the interest payments, since the disqualified related-party amount is not deemed paid pursuant to a hybrid transaction or paid by or to a hybrid entity. Additionally, these U.S.-source interest payments may escape taxation at the German fund level. This potential result of an income/deduction mismatch could appear to be contrary to the intent of Sec. 267A.
On the other hand, certain transactions that do not result in an income/deduction mismatch may trigger a disallowance of an interest deduction under Sec. 267A.
Example: A U.S. corporation (USP) made a loan to a foreign disregarded entity (DRE) wholly owned by a U.S. subsidiary (USS) of USP. DRE is a hybrid entity (i.e., a corporation for non-U.S. tax purposes but fiscally transparent from a U.S. tax perspective). The interest expense generated by USS (via DRE) is offset by USP's interest income, resulting in a "wash" from a U.S. tax perspective, assuming no other limitations apply (e.g., dual-consolidated-loss limitations).
As it currently stands, the application of Sec. 267A under these circumstances is uncertain. One possible interpretation could result in a denial of a deduction from the U.S. perspective because the interest is paid by a hybrid entity. Notably, based on the wording of Sec. 267A(b), the definition of a disqualified related-party amount does not appear to require the recipient to be a foreign person. The example does not appear to result in the erosion of the U.S. tax base, which Sec. 267A was intended to address.
It is important to note that pursuant to Sec. 267A(e), Treasury is directed to issue regulations or other guidance as may be necessary or appropriate to carry out the purposes of Sec. 267A, including, among others: (1) rules providing exceptions from Sec. 267A with respect to cases that it determines do not present a risk of eroding the federal tax base (such as in the example); (2) rules to treat the entire amount of interest or royalty paid or accrued to a related party as a disqualified related-party amount if the amount is subject to a participation exemption system or other system that provides for the exclusion or deduction of a substantial portion of the amount; and (3) rules for the application of Sec. 267A to branches or domestic entities (such as in the example).
The conference report accompanying the legislation enacting Sec. 267A appears to indicate an intent to deny deductions claimed for an interest or royalty payment if the amount is subject to a participation exemption system or other system that provides for the exclusion or deduction of a substantial portion of the amount. However, Sec. 267A(e)(5) only announces an intent to treat the amount as a disqualified related-party amount (H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess. 663 (2017)). Interestingly, there is no language in Sec. 267A(e) to address income/deduction mismatches in situations where a payment of a disqualified related-party amount does not involve a hybrid entity on either side of the transaction (a situation applicable to the German Sondervermögen example above).
It remains to be seen how future regulations will address these and other issues. It is also possible that any future regulations could apply retroactively. Until guidance is issued, however, many taxpayers will find themselves in a tax limbo. As the law in this area continues to evolve, taxpayers should exercise caution when planning their current and future financing and licensing activities.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.