IRS issues guidance on treaty application to reverse foreign hybrids

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS Office of Chief Counsel issued a generic legal advice memorandum (GLAM), AM 2025–002, in September 2025 addressing whether relief is available under a U.S. federal income tax treaty from the branch profits tax (BPT) and, if so, to what extent, for a foreign entity that is fiscally transparent for foreign tax purposes but treated as a corporation for U.S. federal income tax purposes (known as a “reverse hybrid entity”).

The IRS concluded that such a reverse hybrid entity may qualify for a reduced rate of BPT under the applicable U.S. federal income tax treaty on the portion of the entity’s dividend equivalent amount (DEA) corresponding to interests held by the indirect owners who are resident in a treaty country and meet certain treaty requirements.

This is the first time the IRS has provided any meaningful guidance on this type of structure. A handful of treaties have previously addressed certain aspects of the hybrid rules, but those provisions were narrow and left several open questions. The new GLAM goes further, filling in many of those gaps and effectively confirming the approach that many taxpayers, particularly in the asset management space, have already been taking. This is a welcome development that brings additional comfort around the availability of treaty relief for reverse hybrids. Although the analysis centers on the 2016 U.S. Model Income Tax Convention (2016 Model), the IRS extends the logic to older treaties with more limited transparency language, making it broadly applicable to most modern treaties.

Background

Generally, under Sec. 882, a foreign corporation that is engaged in a trade or business within the United States (U.S. trade or business) during the tax year is taxed on its income that is effectively connected with that U.S. trade or business (effectively connected income, or ECI). Additionally, a foreign corporation is also generally subject to a BPT of 30% on its DEA under Sec. 884. The BPT is intended to provide parity between operating through a U.S. corporate subsidiary and through a U.S. branch by imposing withholding tax on amounts that are economically equivalent to dividends.

Under Sec. 884(b), a foreign corporation’s DEA is determined based on its effectively connected earnings and profits for the tax year, adjusted to reflect changes in the corporation’s investment in its U.S. business (i.e., the branch). If the foreign corporation increases its U.S. net equity (i.e., it leaves more capital invested in its U.S. branch), the DEA is reduced because those earnings are viewed as reinvested rather than distributed. Conversely, if the corporation decreases its U.S. net equity, the DEA is increased, since that reduction represents a deemed distribution of branch profits. The term “U.S. net equity” is defined under Sec. 884(c) as the excess of U.S. assets over U.S. liabilities.

Under Sec. 884(e), a corporation’s BPT may be reduced or eliminated under certain U.S. federal income tax treaties. Specifically, Sec. 884(e)(1) provides that treaty benefits apply only if the relevant agreement is an income tax treaty and such foreign corporation is a “qualified resident” of that country. A “qualified resident” is a corporate resident of a treaty country that satisfies either the beneficial ownership test or the publicly traded test set out in Sec. 884(e)(4).

With respect to fiscally transparent entities, Sec. 894(c) disallows the application of a reduced treaty rate to any withholding tax imposed on certain income derived through a fiscally transparent entity (FTE). Regs. Sec. 1.894–1(d) further provides that the tax imposed by Secs. 871(a), 881(a), 1443, 1461, and 4948(a) on income received by an FTE is eligible for reduction under the terms of a U.S. income tax treaty only if such income is derived by a resident of the applicable treaty jurisdiction. However, neither Sec. 894(c) nor the regulations thereunder explicitly address the application of U.S. federal income tax treaties on BPT imposed under Sec. 884 on income received by a reverse hybrid entity. In addition, the preamble to T.D. 8889 expressly clarifies the limited scope of Regs. Sec. 1.894–1(d). Specifically, it provides that the regulations address “only the treatment of U.S. source income that is not effectively connected with the conduct of a U.S. trade or business” and notes that “the application of business profits provisions, with respect to the income of [FTEs], particularly where a conflict in entity classification exists” is outside the scope of the final regulations.

Proposed scenario

This GLAM proposes a scenario in which a reverse hybrid entity, RFHX, is formed under the laws of Country X, is taxable as a corporation under U.S. law, and is treated as fiscally transparent under the laws of Countries X, Y, and Z. RFHX has a single class of equity interests, with four equal owners:

• A, an individual resident in Country Y;
• B, a publicly traded Country Y corporation;
• C, a privately held Country Y corporation wholly owned by individuals resident in Country Z; and
• D, an individual resident in Country Z.

RFHX’s income is ECI, and it distributes all ECI to its owners as earned and does not reinvest in its U.S. business. Under U.S. federal income tax law, such income is subject to 21% U.S. federal corporate income tax and BPT, with the DEA generally taxed at 30% under Sec. 884 in the absence of any treaty relief.

Treaty analysis under 2016 Model

The United States has a U.S. income tax treaty with Country Y but not with Country X or Z. The U.S.–Country Y treaty is worded consistently with the 2016 U.S. Model Income Tax Convention (2016 Model).

The 2016 Model contains two provisions particularly relevant to this analysis: the FTE provision under Paragraph 6 of Article 1 and the BPT provision under Paragraph 10 of Article 10. The relevant text of these provisions are as follows:

[A]n item of income, profit or gain derived by or through an entity that is treated as wholly or partly fiscally transparent under the taxation laws of either Contracting State shall be considered to be derived by a resident of a Contracting State, but only to the extent that the item is treated for purposes of the taxation laws of such Contracting State as the income, profit or gain of a resident. [2016 Model, Article 1, Paragraph 6]

1. A company that is a resident of one of the Contracting States and that has a permanent establishment in the other Contracting State … may be subject in that other Contracting State to a tax in addition to the tax allowable under the other provisions of this Convention.
2. Such tax, however, may be imposed:
   1. on only the portion of the business profits of the company … that, in the case of the United States, represents the dividend equivalent amount of such profits or income and, …
   2. at a rate not in excess of the rate specified in subparagraph (a) of paragraph 2 or paragraph 6 of this Article, but only if for the twelve-month period ending on the date on which the entitlement to the dividend equivalent amount is determined, the company has been a resident of the other Contracting State or of a qualifying third state [2016 Model, Article 10, Paragraph 10]

The BPT provision allows a contracting state to impose a BPT on the portion of business profits comprising a DEA of a “company” (resident in the other contracting state) that has a permanent establishment (PE) in the taxing contracting state to which the profits are attributable, with the applicable BPT rate subject to reduction if the company meets the 12–month residence requirement. To align with the object and purpose of this provision, the IRS interprets the term “company” by reference to U.S. law, under which RFHX is treated as a corporation subject to BPT.

In addition, the FTE provision treats an item of income, profit, or gain derived by or through an entity treated as fiscally transparent under the laws of either the source state or residence state as derived by a resident of a contracting state to the extent the item is subject to tax in such contracting state as income of a resident. The IRS, in the GLAM, applies a modified lookthrough approach in interpreting the FTE provision in the context of a DEA. In its analysis, profits derived through an FTE take into account such entity’s tax attributes and characteristics under the source state’s law. Thus, RFHX’s U.S. business is treated under the U.S.–Country Y treaty as an enterprise of a resident of Country Y to the extent RFHX’s owners are residents of CountryY.

Conclusions

This memorandum concludes that RFHX is entitled to a reduction in the rate of BPT to the extent that the DEA corresponds to the percentage interest of an owner in the profits or income of RFHX as of the close of RFHX’s tax year, provided that such owner meets the following conditions that it:

• Is taxable on profits or income earned through RFHX under the laws of Country Y as a resident;
• Has been a resident of Country Y for more than 12 continuous months (as required by the U.S.–Country Y treaty); and
• Satisfies the applicable limitation on benefits (LOB) provision under the U.S.–Country Y treaty.

A, a Country Y individual, and B, a publicly traded Country Y entity, are qualified persons under the LOB provision, while C, wholly owned by a Country Z individual, and D, a Country Z individual, are not qualified. A and B also meet the 12–month residency requirement and are subject to Country Y tax on their share of RFHX income. Accordingly, RFHX is entitled to a reduced rate of BPT on the portion of the DEA corresponding to interests held by A and B but must pay a 30% rate of BPT on the portion of the DEA corresponding to the interests held by C and D.

Other implications and observations

The IRS specifically noted that the same results would occur under treaties containing the FTE provisions in the 1996 and the 2006 U.S. Model Income Tax Convention, notwithstanding slight differences in wording from the 2016 Model, as the IRS does not view those differences as substantive. Additionally, the IRS indicated that similar conclusions would apply under treaties containing the FTE provisions of the draft 1981 U.S. Model Income and Capital Tax Convention.

Without citation, the memorandum also confirms that where a reverse foreign hybrid earns business profits not attributable to a U.S. PE, those profits may qualify for exemption under the treaty’s business profits article. This conclusion aligns with positions commonly adopted in inbound lending and investment structures and provides additional support for applying treaty benefits even under certain treaties that do not explicitly address this treatment.

Taken together, the memorandum offers meaningful insight into the IRS’s current interpretation of treaty relief for reverse foreign hybrids subject to the BPT. It validates the practical market approach reflected in many existing structures, extends the FTE analysis beyond withholding taxes, aligns with Organisation for Economic Co–operation and Development commentary, and confirms that this interpretation applies broadly across multiple U.S. model treaties. While not precedential, it provides welcome clarity on an issue that had long remained uncertain.

Editor

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.